What is Engineering Economics?

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 What is Engineering Economics?
 Subset of General Economics
 Different from general economics situations
- project driven
 Analysis performed by technical
professionals (not economists)
 Requires advanced technical knowledge in
some cases
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Lots of Questions: Project/$ driven
 Why do this at all?
 Is there a need for the project?

 Why do it now?
 Can it be delayed? Can we afford it now?

 Why do it this way?

 Is this the best alternative? Is this the optimal

solution?
 Will the project pay?
 Will we run a loss or make a profit?

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 Sample Engineering Project
 Hydro vs. Thermal power
 Hydro:  Thermal
 expensive initially  less expensive initially

 far away from load  can be near load centres

centres (high
transmission cost)
 no fuel required
 require fuel
 longer life
 shorter life
 no pollution
 can cause pollution 4
 Other examples
 Buy vs. rent (car, house, equipment)

 Good quality (expensive) but longer life vs.

poor quality (cheap) but shorter life
 car, shoes, computers

 Investmentsdecisions - GIC, RRSP, Bonds,

Stocks and Shares

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Steps in Engineering Economics Study

 Define alternatives in physical terms

 Cost and revenue estimates
 All money estimates placed on a comparable basis
 appropriate interest rate used

 time horizon (economic life)

 Recommend choice among alternatives

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Engineering Economics on the Web
 Thediscipline that translates engineering
technology into a form that permits evaluation by
businesses or investors.

 The application of economic principles to

engineering problems, for example in comparing
the comparative costs of two alternative capital
projects or in determining the optimum
engineering course from the cost aspect.
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 The Time Value of Money
Would you prefer to
have $1 million now or
$1 million 100 years
from now?

Of course, we would all

prefer the money now!
This illustrates that there
is an inherent monetary
value attached to time. 8
 What is Time Value?
 We say that money has a time
value because that money can be
invested with the expectation of
earning a positive rate of return
 In other words, “a dollar received
today is worth more than a dollar
to be received tomorrow”
 That is because today’s dollar can
be invested so that we have more
than one dollar tomorrow
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What is The Time Value of Money?
 A dollar received today is worth more than a
dollar received tomorrow
 This is because a dollar received today can

be invested to earn interest

 The amount of interest earned depends on

the rate of return that can be earned on the

investment
 Time value of money quantifies the value of a
dollar through time

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 Uses of Time Value of Money
 Time Value of Money, is a concept that
is used in all aspects of finance
including:

 Stock valuation
 Financial analysis of firms
 Accept/reject decisions for project
management
 And many others!
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The Terminology of Time Value
 Present Value - An amount of money today, or
the current value of a future cash flow
 Future Value - An amount of money at some
future time period
 Period - A length of time (often a year, but can
be a month, week, day, hour, etc.)
 Interest Rate - The compensation paid to a
lender (or saver) for the use of funds expressed
as a percentage for a period (normally
expressed as an annual rate) 12
 Abbreviations

 PV - Present value
 FV - Future value
 Pmt - Per period payment amount
 i - The interest rate per period

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Purchasing Power and Value

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 Account Value Cost of Refrigerator

Case 1: N = 0 $100 N = 0 $100

Inflation
exceeds N = 1 $106 N = 1 $108
earning power
(earning rate =6%) (inflation rate = 8%)
Case 2: N = 0 $100 N = 0 $100
Earning power
exceeds N = 1 $106 N = 1 $104
inflation
(earning rate =6%) (inflation rate = 4%)

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 Timelines
 A timeline is a graphical device used to clarify
the timing of the cash flows for an investment

 Each tick represents one time period

PV FV

0 1 2 3 4 5
Today
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 Calculating the Future Value
 Suppose that you have an extra $100 today that you
wish to invest for one year. If you can earn 10% per
year on your investment, how much will you have in
one year?

-100 ?

0 1 2 3 4 5

FV1  1001  010

.   110

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 Calculating the Future Value
 Suppose that at the end of year 1 you decide to extend
the investment for a second year. How much will you
have accumulated at the end of year 2?

-110 ?

0 1 2 3 4 5

FV2  1001  0.101  0.10  121

or
FV2  1001  0.10  121
2

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 Generalizing the Future Value
 Recognizing the pattern that is developing, we
can generalize the future value calculations

FVN  PV1  i
N

 Ifyou extended the investment for a third

year, you would have:

FV3  1001  010

.   13310
3
.
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 Compound Interest
 Note from the example that the future value is
increasing at an increasing rate
 In other words, the amount of interest earned each
year is increasing
 Year 1: $10

 Year 2: $11

 Year 3: $12.10

 The reason for the increase is that each year you

are earning interest on the interest that was earned
in previous years in addition to the interest on the
original principle amount 20
 Compound Interest Graphically
4500
3833.76
4000
5%
3500
10%
3000
15%
Future Value

2500 20%

2000 1636.65

1500

1000
672.75

500 265.33

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years
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 The Magic of Compounding
 On Nov. 25, 1626 Peter Minuit, purchased Manhattan
from the Indians for $24 worth of beads and other
trinkets. Was this a good deal for the Indians?
 This happened about 378 years ago, so if they could
earn 5% per year they would in 2005 have
$2,400,000,000  24(1.05)378

 If they could have earned 10% per year, they would now have:
$106,000,000,000,000,000  24(1.10)378

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 Calculating the Present Value
 So far, we have seen how to calculate the
future value of an investment
 But we can turn this around to find the
amount that needs to be invested to
achieve some desired future value:
FVN
PV 
1  i N

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 Present Value: An Example
 Your five-year old daughter
has just announced her
desire to attend college.
After some research, you
determine that you will need
about $100,000 on her 18th
birthday to pay for four
years of college. If you can
earn 8% per year on your 100,000
PV   $36,769.79
investments, how much do 108
. 
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you need to invest today to

achieve your goal?
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 Continuous Compounding
 There is no reason why we need to stop increasing the
compounding frequency at daily
 We could compound every hour, minute, or second
 We can also compound every instant (i.e.,
continuously):

F  Pe rt

 Here, F is the future value, P is the present value, r is the

annual rate of interest, t is the total number of years, and e
is a constant equal to about 2.718

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 Continuous Compounding
 Suppose that the Fourth National Bank is offering to
pay 10% per year compounded continuously. What is
the future value of your $1,000 investment?
0.10 1
F  1,000e  110517
, .
 This is even better than daily compounding
 The basic rule of compounding is: The more frequently
interest is compounded, the higher the future value

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 Continuous Compounding
 Suppose that the Fourth National Bank is
offering to pay 10% per year compounded
continuously. If you plan to leave the money
in the account for 5 years, what is the future
value of your $1,000 investment?

0.10 5
F  1,000e  1,648.72
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 Summary
 Engineering Economics
 The Time Value of Money
 Calculating the Future/Present Value
 Simple/Compound Interest

 Self-Study: Simple Interest P+P*N*5% 1+1=2

 Required: Slides/Book Chapter 2.1 2.2 2.3 2.5

 Feedback: QuizReview before Quiz

 Feedback: Book Library: waiting for answer
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