Principles of Engineering Economics

 Discounted Cash Flow Rules

 Discounted Cash Flow Examples

 Use of Excel for Discounted Cash Flow Analysis

 Ten Principles of Engineering Economic Analysis

 Discounted Cash Flow Rules
1. Money is a resource and has time value
• Present Value
• Future Value
• Equivalent Annual Worth
• Rate of Return

2. Money cannot be added or subtracted unless it

occurs at the same point(s) in time
3. To move money forward one time unit, multiply
by (1 + i) where i is the discount or interest rate
4. To move money backward one time unit, divide by
(1 + i)
 The First Five of Ten Principles

1. Money has time value

2. Make investments that are economically justified
3. Chose the mutually exclusive investment
alternative that maximizes economic worth
4. Two investment alternatives are equivalent if
they have the same economic worth
5. Marginal revenue must exceed marginal cost
The Second Five of Ten Principles
6. Continue to invest as long as each additional
increment of investment yields a return that is
greater than the investor’s TVOM
7. Consider only differences in cash flows among
investment alternatives
8. Compare investment alternatives over a common
period of time
9. Risks and returns tend to be positively correlated
10. Past costs (often called sunk costs) are irrelevant
in engineering economic analysis, unless they
impact future costs
 Seven Key Questions
 Seven key questions to answer:
1. What investment alternatives are available?
2. What is the length of time over which the decision is to
be made?
3. What TVOM will be used to move monies forward or
backward in time?
4. What are the best estimates of the cash flows for each
alternative?
5. Which investment seems best, based on the economic
criterion chosen?
6. How sensitive is the economic preference to changes or
errors in the estimates used in the analysis?
7. Which investment is recommended?
 SEAT
(Systematic Economic Analysis Technique)

 Seven Steps for Seven Questions

1. Identify the investment alternatives
2. Define the planning horizon
3. Specify the discount rate
4. Estimate the cash flows
5. Compare the alternatives
6. Perform supplementary analysis
7. Select the preferred investment
 Time Value of Money
(TVOM)
 P = present value
 n = time period (usually years)
 Fn = Future value of P in “n” years
 In = accumulated interest over “n” years
 A = value of a uniform series of cash flows
 Cash Flow Diagrams

$10,000
$9,000
$8,000
$7,000
(+) $5,000

0
1 2 3 4 5

End of Year
(-)

$12,000
 Another Cash Flow Diagram
(Uniform Series)

(+) $2500 $2500 $2500 $2500 $2500

0
1 2 3 4 5

End of Year
(-)

$10,000
 One More Cash Flow Diagram
(Gradient Series)
A1 + 4G

A1 + 3G

A1 + 2G

A1 + G
(+) 2G
A1 G

0
1 2 3 4 5

End of Year
(-)

P
 More Notation
 F = P(F/P, i%, n): Find the future value given the present value

 F = A(F/A, i%, n): Find the future value given the annuity

 P = F(P/F, i%, n): Find the present value given the future value

 P = A(P/A, i%, n): Find the present value given the annuity

 A = P(A/P, i%, n): Find the annuity given the present value

 A = F(A/F, i%, n): Find the annuity given the future value
 Use of Tables and Excel

 See Tables A-a-1 thru A-a-25

 Example:
– Assume we just invested $10,000 into a CD paying 5% and
compounded annually. What will the investment be worth
in 10 years?
 Solution:
– Using Table A-a-11 to find the factor for F given P at 5% for
n = 10 years (F/P, 5%, 10) = 1.62889.
– F = ($10,000) * 1.62889 = $16288.90
– Excel orders the inputs for FV as (Rate,Nper,Pmt,PV,Type)
– Using Excel: FV(5%, 10, ,10000) = $16288.95
 Another Example
 Example:
– Assume we want $20,000 in 10 years. How much do we
need to set aside today if the investment pays 5%
compounded annually.
 Solution:
– Using Table A-a-11 to find the factor for P given F at 5%
for n = 10 years (P/F, 5%, 10) = 0.61391.
– F = ($20,000) * 0.61391 = $12278.20
– Using Excel: (Rate, Nper, Pmt, FV) = (5%, 10, , 20000)
– F = $12,278.26
 Still More Examples
 Example:
– Suppose you want to set aside $5,000 a year into a
retirement account (IRA). What will the investment be
worth in 40 years if the rate of return is 5% ? 8% ?
 Solution:
– Using Table A-a-11 to find the factor for F given A at 5%
for n = 40 years (F/A, 5%, 40) = 120.79977.
– F = ($5,000) * 120.79977 = $603,998.90
– Using Excel: (Rate, Nper, Pmt, PV) = (5%, 40, 5000)
– F = $603998.87
– Using Table A-a-14 to find the factor for F given A at 8%
for n = 40 years (F/A, 8%, 40) = 250.05652.
– F = ($5,000) * 250.05652 = $1,250,283
 And Finally
 Example:
– Suppose you want to have $1,000,000 in your IRA in 25
years. At an 8% return on the investment, how much
would you have to put into the investment each year?
 Solution:
– Using Table A-a-14 to find the factor for A given F at 8%
for n = 25 years (A/F, 8%, 25) = 0.01368.
– F = ($1,000,000) * 0.01368 = $13,680
– Using Excel: (Rate, Nper, PV, FV) = (8%, 25, , 1000000)
– A = $13,678.78
 Cost Estimation Example
 Suppose you are trying to Year System I System II System III
decide between three
proposed systems. The Dev O&M Dev O&M Dev O&M
development time and 1 10 15 20
expected operational life for 2 10 10 5 3
each system is shown in the 3 5 5 3 4
table below. Which system
4 5 5 4
should be selected if it is
assumed that the 5 6 5 4
performance aspects are 6 6 6 6
basically equivalent and 7 7 6 6
investments in systems 8 8 6 6
return 10% on average?
9 8 7 8
10 10 7 9
Sum 20 55 30 45 25 50
Solution to Cost Estimation Example
Year System I System II System III
Total PV Total PV Total PV
1 10 9.09 15 13.64 20 18.18
2 10 8.26 10 8.26 8 6.61
3 5 3.76 8 6.01 4 3.01
4 5 3.42 5 3.42 4 2.73
5 6 3.73 5 3.10 4 2.48
6 6 3.39 6 3.39 6 3.39
7 7 3.59 6 3.08 6 3.08
8 8 3.73 6 2.80 6 2.80
9 8 3.39 7 2.97 8 3.39
10 10 3.86 7 2.70 9 3.47
total 75 46.21 75 49.36 75 49.14