Introduction

❑ Engineering economics is a subset of economics

for application to engineering projects.
❑ Engineers seek solutions to problems, and the
economic viability of each potential solution is
normally considered along with the technical
aspects.
“It is science as well as an art”

Introduction

❑ Engineering Economics analysis is a technique

that assists in the solution of substantial
engineering problems where economic aspects
dominate over a considerable amount of time.

❑ The objective of ENGR 3222 is to establish a

framework for the modelling & subsequent
comparison of engineering problems in terms
of time value of money.

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 Decision-making process
“Economic analyses are typically performed as a part of the overall decision-making process”

❑ Decision Types
 Simple decisions
◼ Doesn’t require much time or effort
◼ Buy a parking pass or pay per one?
◼ Buy a shuttle pass or pay per ride?
 Intermediate decisions
◼ Primarily economic decisions
◼ Which material should be used for roofing?
 Complex decisions
◼A mixture of strategic, cultural, political & economic
decisions
◼ Where should the company build its next factory?

Decision-making process (Cont’d)

“Economic analyses are typically performed as a part of the overall decision-making process”

❑ Role of Engineering Economic Analysis

 Most suitable for intermediate and complex
decision-making.
 Answers questions such as:
◼ Which engineering projects are worthwhile?
◼ Which engineering projects should have a higher
priority?
◼ How should the engineering project be designed?
◼ How to compare different ways to finance
projects?
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 Decision-making process (Cont’d)
“Economic analyses are typically performed as a part of the overall decision-making process”

❑ Rational Decision-Making is a complex process

that contains 5 main steps:
1) Formulation of the problem

2) Analysis of the problem

3) Identify alternatives

4) Selection of the preferred solution

5) Planning & Implementation

Decision-making process (Cont’d)

“Economic analyses are typically performed as a part of the overall decision-making process”

1) Formulation of the problem involves the

establishment of the boundaries for the
problem
❑ Care must be taken that
 cause/effect relationships are not missed because of
under scoping the problem.
 Not to develop a scope that is too broad that nothing
is accomplished.
 Avoid being overly influenced by the presence of a
present solution.

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 Decision-making process (Cont’d)
“Economic analyses are typically performed as a part of the overall decision-making process”

2) Analysis of the problem consists of relatively

detailed phrasing of the characteristics of the
problem, including restrictions and the criteria
(monetary or intangibles) to evaluate alternatives
such as:
 Budget,
 Quality,
 Safety,
 Personnel,
 Environmental,
 Ethics, and
 Constraints that may exist.

Decision-making process (Cont’d)

“Economic analyses are typically performed as a part of the overall decision-making process”

3) Identify alternatives involves the use of engineer’s

creativity in developing feasible solutions to the
addressed problem.

“Rarely is one person able to generate the range of creative

options generated by a team, particularly a team that is
diverse in experience, education, personalities, and ethnicity.”

❑ Brainstorming as well as other group process techniques

should be used to stimulate the creativity of the team
members.

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 Decision-making process (Cont’d)
“Economic analyses are typically performed as a part of the overall decision-making process”

4) Selection of the preferred solution consists of

the measurement of the alternatives, using the
appropriate criteria.
1) The alternatives are compared with the constraints and
infeasible alternatives are eliminated.
2) Then, the benefits of the feasible solutions are
compared.
3) Among the criteria considered for selection is the
economic performance of each alternative.

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Decision-making process (Cont’d)

“Economic analyses are typically performed as a part of the overall decision-making process”

5) Planning & Implementation consists of a

detailed description of the solution to be
implemented.

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 Decision-making process (Cont’d)
“Economic analyses are typically performed as a part of the overall decision-making process”

❑ Rational Decision-Making is a complex process

that contains 5 main steps:
1) Formulation of the problem

2) Analysis of the problem

3) Identify alternatives

4) Selection of the preferred solution

5) Planning & Implementation

Economic
Analyses

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Decision-making process (Cont’d)

“Economic analyses are typically performed as a part of the overall decision-making process”

❑ Economic Analyses consists of: Time-

1) Capturing alternatives, Value of
Money
2) Planning horizon,

3) Cash flow profile,

4) Define the Minimum Attractive rate of return

(MARR)
5) Comparison of alternatives

6) Perform supplementary analyses (risk&sensitivity)

7) Selection

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 Basics of Economic Analysis

Cash
in
+ve

Time
(EOY)
0 1 2 3 n
-ve

Cash
out

Cash Flow Profile (CFP)

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Basics Economic Analysis (Cont’d)

❑ Cash out flow represents the investments’

expenses such as:
 Initialinvestment (today dollars) (e.g. initiation,
manufacturing, construction or purchase cost).
 Annual expenses (future dollars) costs incurred
during project life on annual basis (e.g. O & M).
 Disposal costs (future dollars) costs incurred to
dispose of project (e.g. disposal of nuclear waste).
 Marketing.

 Indirect costs (Overheads).

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 Basics Economic Analysis (Cont’d)

❑ Cash in flow represents the investments’ income

such as:
❑ Annual income (future dollars) generated
during project life (e.g. rent, sales revenues, or
outside incentives).
❑ Salvage value (future dollars) income due to
selling at the end of project’s life (e.g. someone
else interested in project for scrap value)

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Basics Economic Analysis (Cont’d)

❑ Comparing Different alternatives Y3

Y1
Y2
+ve Time
(EOY)
Alt. 1) -ve 0 1 2 3 4

Y6
X1 X2
Y5 Y7
+ve Y4 Time
(EOY)
Alt. 2)
-ve 0 1 2 3 4
X3
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 Basics Economic Analysis (Cont’d)

❑ The cash flow profiles are usually quite different

among the several investment alternatives.

❑ In order to compare the economic performances of

the alternatives, one must compensate for the
differences in the timing of cash flows.

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Time-Value of Money
- Interest
- Equivalence
- Types of CFPs

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 Time-Value of Money - Interest

❑ The value of a given sum of money depends not

only on the amount of money but rather when
the money is received.
❑ Interest
 The fee that a borrower pays to a lender for the use of his
or her money.
 The cost of using capital.
 Having money today is preferable than having the same
amount one year later.
 Interest rate Is the percentage that borrowed money will
cost.
◼ Interest paid …when borrowing money.
◼ Interest earned……When lending money.

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Time-Value of Money - Interest

❑ One Dollar today is worth more than one Dollar

2 years from today.
 This is because if we have one dollar today, we
can invest it in a bank account paying i% interest,
& we would have more than $1 2 years from
today.

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 Time-Value of Money - Interest

❑ Ifa sum of money has the current (principal)

value of $P, then its value in n years, Fn, is
equal to
Fn=P+I n
where I n is the increase in the value of P in n
years (interest earned/paid)

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Time-Value of Money - Interest

❑ There are 2 kinds of interest:

 Simple interest
 Compound interest

❑ Most monetary transactions are based on

interest compounded annually.

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 Time-Value of Money - Interest

❑ Simple interest
 P increases by an amount ixP each
year, where i is the annual interest
rate.

Fn= P + i x P x n = P (1+ i x n)

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Time-Value of Money - Interest

❑Simple interest
 Example
An investor deposits $35,000 in a bank account
earns 5% simple interest annually. How much will
be in his account after 15 years?

Solution
F=? P=$35,000 i=5% n=15
F=$35,000(1+15x0.05)
F=$61,250
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 Time-Value of Money - Interest

❑ Compound interest
Each period (year) the interest is
based on the total amount owed at
end of previous period.

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Time-Value of Money - Interest

❑ Compound interest
At end of year 1: F1=P(i+1)
At end of year 2: F2= F1(i+1)= P(i+1)2
At end of year 3: F3= F2(i+1)= P(i+1)3
At end of year n: Fn= Fn-1(i+1)= P(i+1)n

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 Time-Value of Money - Interest

❑ Example (Simple X Compound interest)

P=$1,000 i=7% n=30 years F=??
A) Simple interest

F30=P(1+ixn)=1,000(1+0.07x30)

F30= 1,000x3.1

F30=$ 3,100

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Time-Value of Money - Interest

❑ Example (Simple X Compound interest)

P=$1,000 i=7% n=30 years F=??

B) Compound interest
F30=P(1+i)n=1,000(1+0.07)30
F30= 1,000x7.6123
F30=$ 7,612 far greater than $ 3,100

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 Quick Review
Decision-Making process

❑ Mini Exercise
Assume that you are employed as an engineer for
Wreckall Engineering Inc., a firm specializing in
demolition of high-rise buildings. The firm has won a
bid to tear down a 30-story building in a heavily
developed downtown area. The crane owned by the
company only reaches to 29 stories.
Your boss asks you to perform an economic analysis of
buying a new crane to complete the job. How would
you handle the analysis?
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Quick Review
Decision-Making process

❑ Mini Exercise
The important point of this problem is to realize that:
your boss may not have recognized what the true problem is
in this case. To buy a new crane is only one alternative, &
quite likely not the best alternative.
Other alternatives; Extension on current crane, ramp for
current crane, rent a crane to remove top story, explosive
demolition..
If this is a fixed output project (Lump-Sum), we want to
minimize costs. Weigh alternatives using economic criteria
to choose the best alternative.
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 Quick Review
Cash flow profile

❑ Example on cash flow

A project has initial investment of $100,000, annual
maintenance & operation costs of $1,000, & generates
annual income of $19,000. The project has an economic
life of 7 years, & a salvage value of $10,000. Draw its
cash flow diagram.

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Quick Review
Time-Value of Money - Interest

❑ Example 1
At an interest rate i=5%, how many years would it
take for the interest earned compounded to be 10
fold that earned through simple interest?

Solution
Fs=P(1+0.05n)
Fc=P(1+0.05)n=P(1.05)n
Fc/Fs=10=(1.05)n/(1+.05n)
By trial & error, n≈80 years
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 Quick Review
Time-Value of Money - Interest

❑ Example 2
An individual invests $10,000 in a fund that pays
an interest rate of 8%, compounded annually. At
the end of the fifth year, that individual withdraws
half the funds available. Three years later, (s)he
withdraws the remaining money.
a) How much was withdrawn at the end of the fifth
year?
b) How much was withdrawn at the end of the
eighth year?
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Quick Review
Time-Value of Money - Interest

Solution
a) P=$10,000 i=8% n=5 years
F5=P(1+i)n
F5=10,000(1+0.08)5=14,693.28
Since half F5 is withdrawn at end of fifth year,
therefore $7,346.64 are withdrawn.

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 Quick Review
Time-Value of Money - Interest

Solution
b) Since half F5 is withdrawn at end of fifth
year, therefore the remaining $7,346.64 are
re-invested for another three years.
P= F5=$7,346.64 i=8% n=3
F8= F5(1+i)3
F8=7,346.64(1+0.08)3= $ 9,254.65
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Quick Review
Time-Value of Money - Interest

❑ Example 3
You have agreed to loan a friend EGP 5,000 at a simple
interest rate of 8% per year. How much interest will you
receive from the loan at the end of 5 years? How much
will your friend pay you at the end of 5 years?

Solution
Interest received (I)= ixPxn=0.08x5,000x5 =EGP2,000
Amount due=
P+I=5,000+2,000 = EGP 7,000

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 Quick Review
Time-Value of Money - Interest

❑ Example 4
You have agreed to loan a friend EGP 5,000 at a
compound interest rate of 8% per year. How much
interest will you receive from the loan? How much will
your friend pay you at the end of 5 years?

Solution
P=EGP5,000 i=8% n=5
F = P(1+i)n
F = 5,000(1.08)5= 5,000 x 1.4693 = EGP 7,347
Interest received = EGP 7,347 –5,000= EGP 2,347
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Quick Review
Time-Value of Money - Interest

❑ Example 5
In the previous example, how much would the
simple interest need to be to result in an interest
amount equal to that of compound interest in five
years?

Solution
P=EGP 5,000 F=EGP 7,347 n=5
I = Pin ……(7,347 –5,000) = 5,000 x i x 5
i = 2,347/25,000 = 0.09388 = 9.39%
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 Quick Review
Time-Value of Money - Interest

❑ Example 6
In the previous example, how many years would be
required for simple interest at 8% to accumulate
interest of EGP 2,347?

Solution
P=EGP 5,000 F=EGP 7,347 i=8%
I = Pin ……..(7,347 –5,000) = 5,000 x 0.08 x n
i = 2,347/(400) = 0.09388 = 5.87 years
n≈6
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Quick Review
Time-Value of Money - Interest

❑ Example 7
An individual wishes to double his savings in an
account that pays 5% annual interest. How
long would it take the investment to double if:
A) simple interest, &
B) compound interest are employed?

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 Quick Review
Time-Value of Money - Interest

Solution
i=5% P=X FN=2X

A)Simple interest
FN=P(1+iN)
2X=X(1+0.05N)
N=1/0.05=20 years

B)Compound interest
FN=P(1+i)N
2X=X(1.05)N
N=log(2)/log(1.05)=14.2 years
15years
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Make the Economic Tables listed in the

Textbook (Leland Blanc) available in
next Class

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 Thank You
Questions ?

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