2012 by McGraw-Hill, New York, N.

Y All Rights Reserved

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Lecture slides to accompany
Engineering Economy
7
th
edition

Leland Blank
Anthony Tarquin
Chapter 1
Foundations Of
Engineering
Economy
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TOPIC OUTCOMES
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
9. Minimum attractive
rate of return
10. Spreadsheet
functions
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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)
Description: TVM explains the change in the
amount of money over time for funds owed by
or owned by a corporation (or individual)

Corporate investments are expected to earn a return
Investment involves money
Money has a time value

The time value of money is the most
important concept in engineering
economy
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Engineering Economy
Engineering Economy involves
Formulating
Estimating, and
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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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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Steps in an Engineering Economy Study
Ethics Different Levels
Universal morals or ethics Fundamental
beliefs: stealing, lying, harming or murdering
another are wrong
Personal morals or ethics Beliefs that an
individual has and maintains over time; how a
universal moral is interpreted and used by
each person
Professional or engineering ethics Formal
standard or code that guides a person in work
activities and decision making

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Code of Ethics for Engineers
All disciplines have a formal code of ethics. National Society of
Professional Engineers (NSPE) maintains a code specifically for
engineers; many engineering professional societies have their own code
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Interest and Interest Rate
Interest the manifestation of the time value of money
Fee that one pays to use someone elses 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



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Rate of Return
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
Borrowers perspective interest rate paid
Lenders or investors perspective rate of return earned
Interest paid Interest earned
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Interest rate Rate of return
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Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount 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 Flows: Terms
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-period assumption:
Funds flow at the end of a given interest period
Cash Flows: Estimating
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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Cash Flow Diagrams
What a typical cash flow diagram might look like


0 1 2 n - 1 n
Draw a time line
One time
period
0 1 2 n-1 n
Show the cash flows (to approximate scale)
Cash flows are shown as directed arrows: + (up) for inflow
- (down) for outflow
Always assume end-of-period cash flows
Time
F = $100
P = $-80
Cash Flow Diagram Example
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Plot observed cash flows over last 8 years and estimated sale next
year for $150. Show present worth (P) arrow at present time, t = 0
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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Example of Equivalence
Different sums of money at different times may
be equal in economic value at a given rate
0 1
$100 now
$110
Rate of return = 10% per year
$100 now is economically equivalent to $110 one year from
now, if the $100 is invested at a rate of 10% per year.
Year
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Simple and Compound Interest
Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = Pni

Example: $100,000 lent for 3 years at simple i = 10%
per year. What is repayment after 3 years?

Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000
Simple and Compound Interest
Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time

Interest = (principal + all accrued interest) (interest rate)

Interest for time period t is

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Compound Interest Example
Example: $100,000 lent for 3 years at i = 10% per
year compounded. What is repayment after 3
years?
Interest, year 1: I
1
= 100,000(0.10) = $10,000
Total due, year 1: T
1
= 100,000 + 10,000 = $110,000

Interest, year 2: I
2
= 110,000(0.10) = $11,000
Total due, year 2: T
2
= 110,000 + 11,000 = $121,000

Interest, year 3: I
3
= 121,000(0.10) = $12,100
Total due, year 3: T
3
= 121,000 + 12,100 = $133,100

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



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Minimum Attractive Rate of Return
MARR is a reasonable rate
of return (percent)
established for evaluating
and selecting alternatives
An investment is justified
economically if it is
expected to return at least
the MARR
Also termed hurdle rate,
benchmark rate and cutoff
rate
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MARR Characteristics
MARR is established by the financial
managers of the firm
MARR is fundamentally connected to the cost
of capital
Both types of capital financing are used to
determine the weighted average cost of capital
(WACC) and the MARR
MARR usually considers the risk inherent to a
project

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Types of Financing

Equity Financing Funds either from retained
earnings, new stock issues, or owners
infusion of money.
Debt Financing Borrowed funds from outside
sources loans, bonds, mortgages, venture
capital pools, etc. Interest is paid to the lender
on these funds
For an economically justified project
ROR MARR > WACC
EXAMPLE of WACC
If you wish to buy a car by paying 40% using
your savings that earns 10% per year and
another 60% by using credit card at 18% per
year. What is your weighted average cost of
capital (WACC)? If your MARR=15% and your
ROR=18%, would you proceed with the
purchase?
WACC=0.4 (10) + 0.6(18) = 14.8% per year
Since WACC<MARR so proceed with the
purchase
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Opportunity Cost
Definition: Largest rate of return of all projects not
accepted (forgone) due to a lack of capital funds
If no MARR is set, the ROR of the first project not undertaken
establishes the opportunity cost

Example: Assume MARR = 10%. Project A, not
funded due to lack of funds, is projected to
have ROR
A
= 13%. Project B has ROR
B
= 15%
and is funded because it costs less than A
Opportunity cost is 13%, i.e., the opportunity to
make an additional 13% is forgone by not
funding project A
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Introduction to Spreadsheet Functions
Excel financial functions

Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%,second_cell:last_cell) + first_cell

Example: Estimates are P = $5000 n = 5 years i = 5% per year
Find A in $ per year
Function and display: = PMT(5%, 5, 5000) displays A = $1154.87
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Chapter Summary
Engineering Economy fundamentals
Time value of money
Economic equivalence
Introduction to capital funding and MARR
Spreadsheet functions
Interest rate and rate of return
Simple and compound interest
Cash flow estimation
Cash flow diagrams
End-of-period assumption
Net cash flow
Perspectives taken for cash flow estimation
Ethics
Universal morals and personal morals
Professional and engineering ethics (Code of Ethics)


REVIEW QUESTIONS
1.The concept that different sums of money at
different points in time can be said to be equal
to each other is known as:
A. Evaluation criterion
B. Equivalence
C. Cash flow
D. Intangible factors

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REVIEW QUESTIONS
2.The evaluation criterion that is usually used
in an economic analysis is:
A. Time to completion
B. Technical feasibility
C. Sustainability
D. Financial units (dollars or other currency)
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REVIEW QUESTIONS
3. All of the following are examples of each
cash flows, except:
A. Asset salvage value
B. Income taxes
C. Operating cost of assets
D. First cost of asset
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REVIEW QUESTIONS
4. In most engineering economy studies, the
best alternative is the one that:
A. Will last the longest time
B. Is most politically correct
C. Is easiest to implement
D. Has the lowest cost
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REVIEW QUESTIONS
5.All of the following are examples of equity
financing, except:
A. Mortgage
B. Money from savings
C. Cash on hand
D. Retained earnings
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REVIEW QUESTIONS
6.At an interest rate of 10% per year, the
equivalent amount of $10,000 one year ago is
closest to:
A. $8264
B.$9091
C.$11,000
D.$12,000
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REVIEW QUESTIONS
7.Assume that you and your best friend each have $1000 to
invest. You invest your money in a fund that pays 10% per year
compound interest. Your friend invests her money at a bank that
pays 10% per year simple interest. At the end of 1 year, the
difference in the total amount for each of you is:
A. You have $10 more than she does
B. You have $100 more than she does
C. You both have the same amount of money
C. She has $10 more than you do

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REVIEW QUESTIONS
8.The time it would take for a given sum of
money to double at 4% per year simple
interest is closest to:
A. 30 years
B. 25 years
C. 20 years
D. 10 years
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REVIEW QUESTIONS

9.To finance a new project costing $30 million,
a company borrowed $21 million at 16% per
year interest and used retained earnings
valued at 12% per year for the remainder of the
investment. The companys weighted average
cost of capital for the project was closest to:
A.12.5% B.13.6% C.14.8% D.15.6%
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REVIEW QUESTIONS
10.Amounts of $1000 1 year ago and $1345.60
1 year hence are equivalent at what compound
interest per year?
A.12.5% per year
B.14.8% per year
C.17.2% per year
D. None of the above
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