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Lecture 2

The document outlines key concepts in engineering economics, focusing on financial performance, decision-making processes, and the importance of cash flows. It covers topics such as time value of money, interest rates, and economic equivalence, emphasizing their relevance in engineering decision-making. Additionally, it provides examples of simple to complex problems that engineering economics can address, highlighting the need for economic analysis in engineering practices.

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Saad Abbasi
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5 views

Lecture 2

The document outlines key concepts in engineering economics, focusing on financial performance, decision-making processes, and the importance of cash flows. It covers topics such as time value of money, interest rates, and economic equivalence, emphasizing their relevance in engineering decision-making. Additionally, it provides examples of simple to complex problems that engineering economics can address, highlighting the need for economic analysis in engineering practices.

Uploaded by

Saad Abbasi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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LECTURE 2

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LECTURE 1

Financial Performance

Financial position
Financial
Statements
Cashflows

Share Holders Wealth

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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. Minimum attractive rate of return MARR
10. Spreadsheet functions
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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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Engineering
Economics

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Problems Engineering Economics Can Solve
1. Simple Problems (mainly personal/individual)
• Should I pay or use credit?
• Shall we replace a burned-out motor?
• If we use three crates of an item a week, how
many crates should we buy at a time?

2. Intermediate Problems (mainly economic)


• Which equipment should be selected for a new assembly line?
• Which materials should be used as roofing, siding, and structural
support for a new building?
• Which printing press should be purchased? A low cost press requiring
three operators, or a more expensive one needing only two operators?

3. Complex Problems (mixture of economic, political, and social)


• The decision of Mercedes Benz to build an automobile assembly plant in Pakistan
• Setting the annual budget for a corporation.
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Examples of EE Analysis Questions

• Which engineering projects are worthwhile?

• Which engineering projects should have a higher priority?

• How the engineering project should be designed?

• How to achieve long-term financial goals?

• How to compare different ways to finance purchases?

• How to make short and long-term investment decisions?

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Why Engineering Economy is Important to Engineers

• Engineers design and create


• Designing involves economic decisions
• Engineers must be able to incorporate economic analysis into
their creative efforts
• Often engineers must select and implement from multiple
alternatives
• Understanding and applying time value of money, economic
equivalence, and cost estimation are vital for engineers
• A proper economic analysis for selection and execution is a
fundamental task of engineering

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Time Value of Money (TVM)

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Time Value of Money is one of the most important concept in
financial management.
It helps us to make sound decisions on investments, leasing, mortgage and
decisions related to financial management.
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Interest & Interest Rates

• 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
➢ Interest = amount owed now – principal
• Interest Rate – Interest paid over a time period expressed as a
percentage of principal

• Rate of Return Interest earned over a period of time is


expressed as a percentage of the original amount (principal)

❖ Borrower’s perspective – interest rate paid


❖ Lender’s or investor’s perspective – rate of return earned 1-16
INTEREST & INTEREST RATES

INTEREST PAID INTEREST EARNED

Interest Rate Rate of Return


Both represented by 𝒊
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Interest – Example [1]

• An employee borrows $10,000 on May 1 and must


repay a total of $10,700 exactly 1 year later

• Determine the interest amount and interest rate


paid
Solution

• Interest amount = $10,700 - $10,000 = $700

• Interest rate = $700/$10,000 = 7% per year

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Interest – Example [2]

• A company plans to borrow $20,000 from a bank for


one year at 9% interest for a new recording
equipment

• 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
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Interest – Example [3]

• Calculate the amount deposited one year ago to have


$1,000 now at an interest rate of 5% per year
• Solution
The total amount accrued ($1,000) is the sum of the
original deposit and the earned interest. If “y” is the
original deposit then,

Total amount accrued = original + original × interest rate


$1,000 = y + y(0.05) which gives a value of y = $952.38

• Calculate the amount of interest earned during this time


period
Interest = $1,000 – 952.38 = $47.62
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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
•Two sums of money at different points in time can be made economically
equivalent if:
• We consider an interest rate and,
• number of Time periods between the two sums

$20,000 is
received here

T=0 t = 1 Yr
$21,800 paid
back here

$20,000 now is economically equivalent to $21,800 one year from now


IF the interest rate is set to equal to ? 1-21
Economic Equivalence

•$20,000 now is not equal in magnitude to $21,800


1 year from now
•But, $20,000 now is economically equivalent to
$21,800 one year from now if the interest rate in 9% per
year.

•To have economic equivalence you must specify:


•timing of the cash flows
•interest rate (i% per interest period)
•Number of interest periods (N)

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CASH FLOWS

• Cash Inflows – Revenues (R), receipts, incomes, savings


generated by projects and activities that flow in. Plus sign used
• Cash Outflows – Disbursements (D), costs, expenses, taxes
caused by projects and activities that flow out. Minus sign used

• Net Cash Flow (NCF) for each time period:


NCF = cash inflows – cash outflows
=R–D
End-of- time period assumption:
Funds flow at the end of a given interest period

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PARAMETERS AND CASH FLOWS

•Parameters
•First cost (investment amounts)
•Estimates of useful or project life
•Estimated future cash flows (revenues and expenses and
salvage values)
•Interest rate

•Cash Flows
•Estimate flows of money coming into the firm – revenues,
salvage values, etc. – positive cash flows--cash inflows
•Estimates of investment costs, operating costs, taxes paid
– negative cash flows -- cash outflows

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CASH FLOWS STATEMENT

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THE CASH FLOW DIAGRAM: CFD

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CASH FLOW: ESTIMATES

✓ Point estimate – A single-value estimate of a cash flow element


of an alternative
Cash inflow: Income = $150,000 per month

✓ Range estimate – Min and max values that estimate the cash
flow
Cash outflow: Cost is between $2.5 M and $3.2 M

Point estimates are commonly used; however, range estimates


with probabilities attached provide a better understanding of
variability of economic parameters used to make decisions

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THE CASH FLOW DIAGRAM: CFD

What a typical cash flow diagram might look like

Draw a time line Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time period
F = $100

0 1 2 … … … n-1 n

P = $-80
Cash flows are shown as directed arrows: + (up) for inflow
- (down) for outflow
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THE CASH FLOW DIAGRAM: EXAMPLE
Plot observed cash flows over last 8 years and estimated sale next
year for $150.

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THE CASH FLOW DIAGRAM: EXAMPLE
Plot observed cash flows over last 8 years and estimated sale next
year for $150.

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Engineering Economy

• Engineering Economy involves


• Formulating
• Estimating,
• Evaluating
expected economic outcomes of alternatives
designed to accomplish a defined purpose
• Easy-to-use math techniques simplify the
evaluation
• Estimates of economic outcomes can be
deterministic or stochastic in nature

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The Big Picture

• Engineering economy is at the heart of making


decisions.
• These decisions involve the fundamental elements of
cash flows of money, time and interest rates.
• Chapter 1 introduces the basic concepts and
terminology necessary for an engineer to combine these
three essential elements in organized, mathematically
correct ways to solve problems that will lead to better
decisions.

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Thank You

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