Department of Mechanical Engineering
Bangladesh University of Engineering and Technology
ME 310
Thermo-Fluid System Design
1.5 Credit Hours
Economic consideration
Economic consideration
Among the most important indicators of the success of an engineering
enterprise are the profit achieved and the return on investment. Therefore,
economic considerations play a very important role in the decision-making
processes that govern the design of a system.
Because of the crucial importance of economic considerations in most
engineering decisions, it is necessary to understand the basic principles of
economics and to apply these to the evaluation of investments, in terms of
costs, returns, and profits.
2
Time Value of Money
Congratulations!!!
You have won a cash prize!
There are two optional payment
schedules:
A - receive $100,000 now
B - receive $100,000 in five years.
Which option would you choose?
3
Why money has Time Value?
➢ Purchase Power: Because of inflation, $100,000 can be used to buy more
goods and services today than $100,000 in 5 years from now.
➢ Opportunity Cost: Money received today can be invested now to earn
interest, this can result higher value in the future.
➢ Risk vs Return: If you are giving your money to be used by another person
/ company, that means you are taking the risk associated with it, which is
known as ‘default risk’ (you may or may not get back your payments). So,
you expect return / interest to compensate the risk.
4
Cash Flow Diagram
i The interest rate per interest period
N The number of interest periods
A Uniform series amount
F Future worth amount
P Present worth amount
5
SIMPLE INTEREST
COMPOUND INTEREST (BASIC)
m number of compounding
periods per year
0 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n
$x
6
Continuous Compounding
The number of times per year that the interest is compounded may be
increased beyond monthly or even daily compounding to reflect the financial
status of a company or an investment at a given instant. The upper limit on
the frequency of compounding is continuous compounding, which employs an
infinite number of compounding periods over the year.
7
Effective Interest Rate
It is often convenient and useful to express the compounded interest in terms
of
an effective, or equivalent, simple interest rate for 1 year
It is also possible to obtain an equivalent interest rate over a number of years n.
8
TASK-1
Calculate the resulting sum F for an investment of $100 after 1, 2, 5, 10, 20,
and 30 years at a nominal interest rate of 10%, using simple interest as well as
yearly, monthly, daily, and continuous compounding. From these results,
calculate the effective interest rates over a year and also 10 years.
Hints:
9
Solution
the effective interest rates over 10 years for yearly, monthly, daily, and continuous
compounding are obtained as 15.937, 17.070, 17.179, and 17.183%, respectively
10
Present Worth
Yearly compounding:
m times yearly compounding:
Continuous compounding:
Future Worth
Yearly compounding:
m times yearly compounding:
Continuous compounding: FW =
Peni 11
TASK-2
The design of the cooling system for a quantum computer requires an array of
specialized fans. Three different manufacturers are willing to provide a fan with
the given specifications. The first one, Fan A, is at $54K, payable immediately on
delivery. The second one, Fan B, requires two payments of $30K each at the end
of the first and second years after delivery. The last one, Fan C, requires a
payment of $65K at the end of two years after delivery. Since a large number of
fans are to be purchased, the price is an important consideration. Consider
three different interest rates, 6, 8, and 10%.
Which fan is the best buy?
12
Solution Procedure
Discount rate 6.00%
Cash flow
$ -$30.00
$ -$30.00
NPV ($55.00)
13
Solution
Fan A: PW = $54.00
14
Task - 3
Rony has become more conscientious about paying off his credit card bill
promptly to reduce the amount of interest paid. He was surprised to learn
that he paid $400 in interest in 2023 and the amounts shown in figure
below over the previous several years. If he made his payments to avoid
interest charges, he would have these funds plus earned interest available
in the future. What is the equivalent amount 5 years from now that Rony
could have available had he not paid the interest penalties? Let i = 5% per
year. Use cash flow diagram to solve the problem.
Year 2018 2019 2020 2021 2022 2023
Interest Paid, 600 0 300 0 0 400
$
15
Solution
Cash Flow Diagram:
F = 600(FP,5%,10) + 300(FP,5%,8) + 400(FP,5%,5)
= 600(1.6289) + 30011.4775) + 400(1.2763)
= $1931.11
16
Inflation
Inflation refers to the decline in the purchasing power of money with time
due to increase in the price of goods and services. This implies that the
return on an investment must be considered along with the inflation rate
in order to determine the real return in terms of buying power.
• j rate of inflation
• ir real rate of return
17
Task-4
An engineering firm has to decide whether it should withdraw an investment that pays
8% interest, compounded monthly, and use it on a new product. It would undertake the
new product if the real rate of increase in buying power from the current investment is
less than 4%. The rate of inflation is given as 3.5%. Calculate the real rate of increase in
buying power. Will the company decide to go for the new product? What should the yield
from the investment be if the company wants a 5% rate of increase in buying power?
Hints:
18
Solution
19
Series of Payments
A common circumstance encountered in engineering enterprises is that of
a series of payments. Frequently, a loan is taken out to acquire a given
facility and then this loan is paid off in fixed payments over the duration of
the loan.
FUTURE WORTH OF UNIFORM SERIES OF AMOUNTS
20
Series of Payments
• The uniform series A begins at the
end of period 1 continuing through
the year of the given F.
• The last A and F value occur at the
same time.
21
PRESENT WORTH OF UNIFORM SERIES OF AMOUNTS
1.
2.
3.
22
Task-5
• $ 20,000 equipment expected to last 5 years
• $ 4,000 salvage value
• Minimum attractive rate of return 15%
• What are the?
• A - Annual Equivalent
• P - Present Equivalent
23
Solution Procedure
24
Solution
❑A = -20,000 * (A/P, 0.15, 5) + 4,000 * (A/F, 0.15, 5)
= -20,000 * (0.2983) + 4,000 * (0.1483)
= -5,373
❑P = -20,000 + 4,000 * (P/F, 0.15, 5)
= -20,000 + 4,000 * (0.4972)
= -18,011
25
Excel Command for Discount factor
26
DEPRECIATION
An important concept with respect to the calculation of taxes is that of
depreciation. Since a given facility has a finite useful life, after which it must
be replaced, at its salvage value. In essence, an amount is allowed to be put
aside each year for its replacement at the end of its useful life. This amount is
the depreciation and is taken as an expense each year, thus reducing the
taxes to be paid by the company.
There are several approaches to calculating depreciation:
27
Economic Consideration of Thermo-fluid System Design
❑Cost Comparison
❑Rate of Return
❑Payback Period
28
Rates
❑Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.
❑Interest Rate
• Contractual arrangement between a borrower and a lender
❑Discount Rate (real change in value to a person or group)
• Worth of Money + Risk
• Discount Rate > Interest Rate
❑Minimum Accepted Rate of Return (MARR)
• Minimum discount rate accepted by the market corresponding to the risks of a project (i.e.,
minimum standard of desirability)
29
Choice of Discount Rate
r = rf + ri + rr
where,
r is the discount rate
rf the risk-free interest rate. Normally government bond
ri Rate of inflation. It is measured by either by consumer price index or GDP deflator
rr Risk factor consisting of market risk, industry risk, firm specific risk and project risk
rr = Market Risk
Industry Risk
Firm Specific Risk
Project Risk
GDP = Gross Domestic Product 30
Net Present Value (NPV)
• The net present value (NPV) is the sum of the present values for all of these costs and
revenues
NET PRESENT VALUE DECISION RULE
© McGraw-Hill
Ryerson Limited.,
2004
31
Calculation of Net Present Value
Total Revenue (R) (+) Various Costs (C) (-)
Calculate Gross Return
Tax (-)
Calculate Net Return
Discount Rate (r)
PV of Net Return
Initial Invest (-I)
NPV of the Project
32
Task-6
• The cash flow profiles of four independent projects are shown below. Using a MARR
of 20%, determine the acceptability of each of the projects on the basis of the net
present value criterion for accepting independent projects.
33
Excel Solution
Discount rate 20.00%
Cash flow
0 -75.3 investment
$ $28.00
$ $28.00
$ $28.00
$ $28.00
$ $28.00
NPV $8.44
34
Solution
[NPV1]20%
= -77 + (235)(P/F, 0.2, 5) = -77 + 94.4
= 17.4 $235 M
NPV1 – Cash Flow Year 0 1 2 3 4 5
-$77 M
[NPV2]20%
= -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7
= 8.4
$28 M each year
NPV2 – Cash Flow Year 0 1 2 3 4 5
35
-$75.3 M
Solution
[NPV3]20%
= -39.9 + (28)(P/A, 20%, 4) - (80)(P/F, 20%, 5)
= -39.9 + 72.5 - 32.2
= 0.4 $28 M each year
NPV3 – Cash Flow
Year 0 1 2 3 4 5
-$39.9 M
-$80 M
[NPV4]20%
= 18 + (10)(P/F, 20%, 1) - (40)(P/F, 20%, 2)
- (60)(P/F, 20%, 3) + (30)(P/F, 20%, 4)
+ (50)(P/F, 20%, 5)
= 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6 $50 M
$30 M
$18 M $10 M
NPV4 – Cash Flow
Year 0 1 2 3 4 5
-$40 M
-$60 M 36
Source: Hendrickson and Au, 1989/2003
Solution
[NPV1] = 17.4
[NPV2] = 8.4
[NPV3] = 0.4
[NPV4] = -1.6
37
Source: Hendrickson and Au, 1989/2003
Discount Rate in NPV
• NPV (and PV) is relative to a discount rate
• In the absence of risk or inflation, this is just the interest rate of the
“reliable source” (opportunity cost)
• Correct selection of the discount rate is fundamental. If too high,
projects that could be profitable can be rejected. If too low, the firm will
accept projects that are too risky without proper compensation.
• Its choice can easily change the ranking of projects.
38
Task-7
NPV = -20,000 + 5,600 (P/A, i, 5) + 4,000 (P/F, i, 5)
39
Relationship between NPV & IRR
IRR
40
IRR Investment Rule
r = IRR, r* = MARR
“Accept a- project with IRR larger than MARR”
Alternatively,
“Maximize IRR across mutually exclusive projects.”
41
IRR vs. NPV
• Oftentimes, IRR and NPV give the same decision/ranking among projects.
• IRR only looks at rate of gain – not size of gain
• IRR does not require you to assume (or compute) a discount rate.
• IRR ignores capacity to reinvest
• IRR may not be unique
NPV
Discount Rate
42
Payback Period
• Payback period (“Time to return”)
• Minimal length of time over which benefits repay costs
• Typically only used as secondary assessment
43
Payback Period
• Payback period (“Time to return”)
• Minimal length of time over which benefits repay costs
• Typically only used as secondary assessment
• Important for selection when the risk is extremely high
• Drawbacks
• Ignores what happens after payback period
• Does not take into account discounting
44
Comparing Projects
• Financing has major impact on project selection
• Suppose that one had to choose between 2 investment projects
• How can one compare them?
• Use NPV
• Verify IRR
• Check payback period
45
Project Evaluation
• For an equipment, there are TWO cost elements:
1) Initial Cost, and
2) Operation & Maintenance Cost
• The identification of cost elements and their sub-division are based on
the purpose and scope of the LCC study.
*LCC-Life Cycle Cost
46
Cost element
• Initial Cost:
• Design & development cost,
• Investment on asset, or cost of equipment,
• Installation cost or erection & commission cost.
47
Cost element
• Operation & Maintenance Cost:
• Labor cost,
• Energy cost,
• Spare & maintenance cost,
• Raw material cost.
48
Steps for computation of LCC
• Step 1: Determine time for each cost element,
• Step 2: Estimate value of each cost element,
• Step 3: Calculate Net Present Value of each element, for every year (over its
time period),
• Step 4: Calculate LCC by adding all cost element, at every year,
• Step 5: Analyze the results.
49
ASSIGNMENT-1
Excess amount of heat from a 10 TPH boiler is exhausted to the atmosphere
which can be recovered by using an economizer. Annual energy savings by
using an economizer would be 12,50,000 BDT. A brand-new economizer would
cost 15,00,000 BDT and installation cost would be around 10% of the capital
cost. Yearly maintenance cost can be assumed as 1% of the capital cost and
expected life of the economizer is 15 years. The company can invest by
borrowing from a bank with an annual interest rate of 12%. Present the
detailed financial analysis for this project (NPV, IRR, Payback period). It is
assumed that the fuel cost may increase by 10% every 3 years.
Show both hand and an excel spreadsheet calculation, and upload in the assignment mentioned
in the teams before the next class.
50
ASSIGNMENT-2
In a food-processing system, the refrigeration and storage unit is to be purchased. A
new unit can be obtained by paying $100,000 on delivery and 5 annual payments of
$25,000 at the end of each year, starting at the end of the first year. A used and
refurbished unit can be obtained by paying $60,000 at delivery and 10 annual
payments of $20,000 at the end of each year. The salvage value of the new unit is
$75,000 and that of the used one is $50,000 both being disposed of at the end of 10
years. The interest rate is 9%, compounded annually. Which alternative is financially
more attractive?
51
Thank You!
52
