AGEN 566 – ENGINEERING

ECONOMICS

Dr. Romulus Okoth Okwany, PhD

Agricultural and Biological Systems Engineering
Department of Agricultural Engineering
[email protected] / [email protected]
+25470214572

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 Course Description
Quantifying alternatives for easier decision making, time value for present and
future payments, future payments compared to series of periodic payments,
value of present payment compared to a series of periodic payments and the
constant increment to a series of periodic payments. Present worth method;
annual payments, future worth, rate of return method, incremental rate of return,
break - even comparisons. Probability evaluation and benefit/cost analysis.
Project investment evaluation: Taxes, deprecations, bond financing for public
and private investment, mortgage investment property, utility rate studies,
economic life, maintenance costs, life cycle costs and sensitivity analysis,
double arithmetic gradient and inflation analysis

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The objectives of this course are to impart knowledge on:
i. The techniques, methods, and concepts of the economic assessment of engineering
projects
ii. The understanding of financing of a project, the source of finance, and the
structure of financial arrangements
iii. The financial evaluation and the funding of capital projects
iv. The techniques and methods of capital budgeting and engineering economics

Expected Learning Outcomes of the course

1. Appreciate the importance of economics in engineering
2. Understand the dynamics of the economic value of engineering projects
3. Assess and apply project financing strategies for internal and external sources
of funding and structures of financial arrangements
4. Apply the techniques and methods of capital budgeting and engineering
economics to practical situations 3
Core Reading Materials
1. Engineering Economy, 7th Edition by Leland Blank and Anthony Tarquin, Publisher: McGraw-Hill
Education, 2011. ISBN-10: 0073376302.
2. Engineering Economic Analysis, Edition 12 by Donald G. Newnan, Jerome P. Lavelle, Ted G.
Eschenbach
3. Fundamentals of Engineering Economic Analysis, Edition 1 by John A. White, Kellie S. Grasman,
Kenneth E. Case, Kim LaScola Needy

Recommended Reference Materials

1. Principles of Engineering Economic Analysis, Edition 6 by John A. White, Kenneth E. Case, David
B. Pratt.
2. Applied Economic Analysis for Technologists, Engineers, and Managers, Edition 2 by Michael S.
Bowman.
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WHAT IS ECONOMICS?
“Economics is the study of how people and society choose to employ scarce resources
that could have alternative uses in order to produce various commodities and to
distribute them for consumption, now or in the future, …”

*from Paul Samuelson and William Nordhaus, Economics, 12th Ed., McGraw-Hill, New York, 1985.

WHAT IS ENGINEERING ECONOMICS?

The application of economic principles to engineering problems - in comparing the
comparative costs of alternative capital projects or in determining the optimum
engineering course from the cost aspect
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 Why do engineers need to learn economics?
• We don’t design just for the sake of creating/building new developments
• Resources used are becoming scarce and more expensive
• More sensitivity to negative effects of designs
• Thus, designs need to cater to a larger perspective of the natural
environment
• Thus: functionality, impacts, economics

“Engineering activities deal with elements of the physical environment that

take place to meet human needs that arise in an economic setting”

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An engineer needs to understand economics for several reasons:
i. Cost-benefit Analysis - resource allocation decisions; economics assists
them in weighing the costs and benefits
ii. Financial Feasibility: financial viability, good return on investment - evaluate
the profitability of different alternatives
iii. Resource Allocation: decisions on how to best allocate limited resources -
assists in understanding the trade-offs involved
iv. Long-term Planning: Economics helps assess the long-term financial
implications of decisions and to choose the most cost-effective options
v. Essential in Everyday Life: useful in both personal and social scenarios;
ability to evaluate operating and maintenance costs is critical in determining
which materials should be utilized and why
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 Engineering Process
1. Determination of Objectives: what is needed and what can engineering
supply
2. Identification of Strategic Factors:
i. Limiting factors stand in the way of attaining objectives eg spade too small to bucket too
small to supply mess water
ii. Strategic factors are those that can be altered to remove limitations restricting the
success of an undertaking eg procurement of a pumping system
3. Determination of means (engineering proposals) – means to alter strategic
factors to overcome limiting factors
4. Evaluate the engineering proposals – technical and economic analysis for
the best means to solve problem
5. Decision making – provide knowledge on physical and economic impacts of
alternatives
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 Symbols and Their Meaning

✓ P = value or amount of money at a time denoted as present (present worth or

present value)
✓ F = value or amount of money at some future time (future worth or future value)
✓ A = series of consecutive, equal, end-of-period amounts of money (equivalent
value per period or annual worth) – KES/year (or per month)
✓ n = number of interest periods (years, months, days)
✓ i = interest rate per interest period (%/year)
✓ t = time stated in periods (years, months, days)

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 Fundamental Economic Concepts
• Utility – power of a good or service to satisfy needs
• Value – worth attached to an object or service, appraisal of utility; is not same
as cost/price
• Consumer goods – goods and services that directly satisfy human wants eg
shoes, TV
• Producer goods – are used in production or construction process eg factory
equipment
• Economy of exchange – results from exchange of utilities by two or more
people; represents mutual benefit in exchange
• Economy of organization – ends can be attained more economically eg
labour saving, efficiency of capital use

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 Fundamental Economic Concepts
• Objective of engineering applications is the satisfaction of needs; which implies a cost
• Economic analyses can be based on various costs:
• First cost – cost to get activity started eg installation
• Operation and maintenance costs – costs to maintain/sustain productive life of activity
• Fixed cost – relatively constant activity costs to prepare for future operations eg rental
fees
• Variable cost – related to level of operational activity eg cost of fuel
• Incremental/marginal cost – additional expense incurred from increased output; arises
from the variable costs
• Sunk cost – costs that cannot be recovered or altered by future action such as past
cost of machinery
• Life-cycle cost – expenses over entire life-cycle of a product/service; from feasibility to
disposal

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 Key Concepts in Engineering Economics
1. Time value of money: the value of a given amount of money changes over time due
to inflation and the opportunity cost of not investing the money elsewhere
2. Net present value (NPV): a measure of the profitability of an investment, calculated
by taking the present value of the expected cash flows and subtracting the initial
investment
3. Internal rate of return (IRR): the discount rate that makes the NPV of an
investment equal to zero; used to compare the profitability of different
investments
4. Benefit-cost ratio (BCR): the ratio of the benefits of an investment to its costs; a
BCR greater than 1 indicates that the investment is financially viable
5. Demand and Supply: free market economic principles or forces that govern what
producers want to produce and what buyers want to buy and pay for.

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WHY DO WE NEED TO KNOW ABOUT THIS?!
– Optimal cost-effectiveness
– Alternative possibilities

WHAT DO WE NEED TO KNOW?

– Time value of money
– Estimation of cash flows
– Quantitative measurements of profitability
– Systematic comparison of alternatives

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A. Time Value of Money
➢ The fundamentals underlying all financial activities!

Why does money have time value?

✓ The owner of the money must defer its use - the person using the money must pay for
deferring the benefits
✓ An alternative use of the money could have generated other benefits, e.g. interests.

How do we characterize time value?

– Interest rate - effect of time is proportional to the total amount of money involved and
positively related with the length of time of deferment

𝐹𝑉
𝑃𝑉 =
1+𝑟 𝑛
PV – present value; FV – future value; r – interest rate; n – length of time

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B. Cash Flow Diagram (CFD)
➢ Shows the cash flows for a project over time
NOTE:
• End-of-year convention –
transactions are assumed to
occur at end of the year in which
they occur
-10 -5 • Revenues/receipts – upward
pointing arrows
Purchase Disposal
• Disbursements/payments –
downward pointing arrows
• Arrow lengths approximate
magnitude of cash flow
➢ How to project cash flows? • Cash flow directions depend on
– Cost estimation (the task of engineers!) point of view of taken – borrower
– Product pricing and sales projection (Mutual efforts of or lender
S&M dept., consulting, engineers, and project
managers)

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Equivalence
Time value of money considered together with interest rate help define the
concept of money equivalence – different sums of money at different times are
equal in economic value
• If the interest rate is 13% per year, KES 50,000 today (present time) would
be equivalent to KES 56,500 one year from today
• Likewise, KES 50,000 today is equivalent to KES 44,248 one year ago

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C. Quantification of Profitability
• NET PRESENT VALUE (NPV)
𝑁
−𝑛
𝑁𝑃𝑉 = ෍ 𝐶𝑛 1 + 𝑖
𝑛=1

• Examines the total value of all cash flows at time 0, where,

“i” is defined as the rate of return that could be achieved otherwise, or cost of capital.
• If NPV>0, the project is acceptable.
• For our sample CFD
• The expected rate of return (cost of capital) is 16%
• The present value of C(0): PV[C(0)] = -$10M
• The present value of C(3): PV[C(3)] = 7/(1+10%)^3 = $5.23M
• The net present

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• PAYBACK PERIOD
– This measure is often used as a “quick and dirty” measure of profitability
– Also called Payout Time
– Defined in units of time (months or years)
– The time for the cumulative cash flow to achieve a value of 0.0. Usually, payback time
does not consider interest.

• RETURN ON INVESTMENT
– A comparison of the money earned (or lost) on an investment to the amount of money
invested
𝐴𝑛𝑛𝑢𝑎𝑙 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡
– 𝑅𝑂𝐼 =
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
– Generally does not calculate time value.
– In the example, if we assume cash flows at year 1&2 are total investment,
we have ROI=(7+7+15-10-5)/4/(10+5)=~24%

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• INTERNAL RATE OF RETURN (IRR)
• The IRR is defined as any discount rate that results in a
net present value of zero, and is usually interpreted as the
expected return generated by the investment
• In general, if the IRR is greater than the project's cost of
capital rate, the project will add value for the company.
𝑁
−𝑛
𝑁𝑃𝑉 = ෍ 𝐶𝑛 1 + 𝐼𝑅𝑅
𝑛=1
In our example, IRR is calculated to be 26%

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D. Cost Estimation
• Types of costs
– Capital Costs: fixed equipment & working capital
– Operating Costs: direct costs, fixed costs & general costs

✓ Operating costs are those incurred with every unit of production and do not
include capital items:
• Direct - -Materials, labor, utilities, supplies, waste treatment, etc.
• Fixed (indirect) -Land taxes, insurance, plant administration, etc.
• General expenses - Corporation, sales & marketing, R&D, etc.

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Terms: INTEREST
1. Interest: manifestation of the time value of money
✓ Interest = present value – original principal
2. Interest period: period to which time value of money is considered
3. Interest rate: rate of change of the time value of money
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑢𝑛𝑖𝑡
✓ % 𝐼𝑅 = ∗ 100%
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡

Simple interest: based on principal only, no accrued interest

Interest = (principal*interest period*interest rate)
Compound Interest: interest accrued over each interest period added to
principal (accumulated principal)
Compounded Interest = ((principal+all accumulated interest)
*interest rate) 21
IR is expressed as decimal
 Loan Repayment Plans
• Plan 1: simple interest, pay all at end – no interest or
principal is paid until end of period; interest accumulates
yearly on the principal only
• Plan 2: Compound interest, pay all at end – no interest or
principal paid until period end; interest accumulates yearly
on total of principal and all accrued interest
• Plan 3: Simple interest paid as accrued; principal paid at
end – accrued interest paid yearly and the entire principal
repaid at end of period
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 Loan Repayment Plans
• Plan 4: Compound interest and portion of principal paid
annually – accrued interest and 1/Nth of principal paid
yearly. Outstanding balance decreases each year so the
interest decreases yearly
• Plan 5: Equal payments made annually of compound
interest and principal – equal payments made annually
towards principal and accrued interest; Loan balance
decreases at a slower rate than in Plan 4 due to the equal
end-of-year payments
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