Ceng-5191

Engineering Economics

By SINISHAW S

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What is Engineering Economics

Engineering economics is Systematic evaluation of the

economic merits of proposed solutions to engineering
problems
Engineering economy, quite simply, is about determining the
economic factors and the economic criteria utilized when one
or more alternatives are considered for selection

Example
Engineering Economics

Objective-Evaluation
 How to compare the economic value of alternative design option?

Example

Basis-Cash Flow Analysis

 Which project or alternative has better net cash flow?
Key issues-
 Time value of money
 Cash flow occurring at different time
 Designs with different durations
Why Is Engineering Economics
Important?

• Engineers DESIGN things and perform PROJECTS

• Therefore, engineers must be concerned with the
economic aspects of designs that they recommend,
and projects that they perform
• What can go wrong when we don’t have the
concepts of engineering economics?
•_____________________?
•_____________________?
•_____________________?

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What Kinds of Questions Can
Engineering Economics Answer?

Engineering economics is needed

for many kinds of decision making
 Example: Buying a car

 Alternatives:
 Not buying
 Buying with $18,000 now, or

 Buying for $600 per month for 3 years

 Which is better?

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What Kinds of Questions Can
Engineering Economics Answer?

• It will help you make good decisions:

• In your professional life
• (Regardless of whether you go into
the private or public sector)
• And in your personal life!
• Knowledge of engineering economics will
have a significant impact on you personally!

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What Kinds of Questions Can
Engineering Economics Answer?

ENGINEERING ECONOMICS INVOLVES:

FORMULATING, ESTIMATING, AND
EVALUATING ECONOMIC OUTCOMES
WHEN CHOICES OR ALTERNATIVES ARE
AVAILABLE

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How Does It Do This?

BY USING SPECIFIC
MATHEMATICAL RELATIONSHIPS
TO COMPARE THE CASH FLOWS OF THE
DIFFERENT ALTERNATIVES
(typically using spreadsheets)

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Where Does Engineering Economics Fit?

Here is an approach to problem-solving:

• Understand the problem
• Collect all relevant data/information
• Define the feasible alternatives
• Evaluate each alternative
• Select the “best” alternative
• Implement and monitor the decision
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Where Does Engineering Economics Fit?

1. Understand the Problem

2. Collect all relevant data/information (difficult!)
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor This is the major role of
engineering economics

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Where Do I Get the Data?

• Engineering economics is based mainly on

estimates of future costs and benefits:
• So it has to deal with risk and uncertainty
• The costs, benefits, and other parameters are
typically unknown, and can vary over time:
• The values of these parameters will dictate a
particular numerical outcome
• And therefore a particular decision!
• Sensitivity analysis can be used to explore how
the decision changes as our estimates change 11
What If I Don’t Like the Answers?

• Remember:
• “Tools” don’t make decisions
• People make decisions, based on values
• Engineering economics is just a set of
tools:
• It can help in decision making
• But it won’t make the decision for you
• Which alternative is “best” is up to you! 12
Engineering Economics Helps Make
Cash Flow Comparisons!

 Example: Buying a car

 Alternatives:
 Not buying
 Buying with $18,000 now, or
 Buying for 600 per month for 3 years
(= $21,600 total)

 Which is better?
 It depends!
 Issue: how much is money now worth compared to
money in the future?
 Leads to idea of time value of money!

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Key Concept: Time Value of Money

Would you rather have:

 $100 today, or

 $100 a year from now?

“A bird in hand is worth two in a bush!”

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Time Value of Money

Would you rather have:

 $100 today, or

 $100 a year from now?

Basic assumption:
 Given a fixed amount of money, and

 A choice of having it now or in the future,

Most people would prefer to have it

sooner rather than later

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Time Value of Money

Basic assumption:
 Given a fixed amount of money, and

 A choice of having it now or in the future,

 Most people would prefer to have it sooner

Reasons:
 ?
 ?
 ?
 ?

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Time Value of Money

Basic assumption:
 Given a fixed amount of money, and

 A choice of having it now or in the future,

 Most people would prefer to have it sooner

rather than later

This assumption is not universally satisfied:
 E.g., saving money for graduate school

But it is nearly universal, especially in

business

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Time Value of Money

One consequence of the time value of

money:
 Suppose you are willing to exchange a

certain amount now for some other

amount later
 Then the later amount has to be

________________?

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Time Value of Money

• The time value of money manifested the idea of

an interest rate (if projecting into the future)
Or, equivalently, a discount rate (if rolling back
to the present), Inflation or deflation and risk.

Time value of money deals with changes in the

value of money over some period of time (due to
investment opportunities, uncertainty, etc.)
This is the single most important concept in
engineering economics!

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What Does This Mean for Us?

In this course, we will learn methods to:

 Compare different cash flows over time

Using the interest rate or discount rate:

 How much more a dollar today is worth,

 Compared to a dollar in one year

For example, if the interest rate is 5%:

 $1 today is worth as much as $1.05 next year

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Illustration of Discounting

100
0
Present Value

80
0.01
60 0.05
40 0.1
0.2
20
0.3
0
0

12

14

18
10

16

20
Time

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Interest Formula and Equivalence

Interest:
It is the increase between an original sum of
money borrowed and the final amount owed,
or the original amount owned (or invested)
and the final amount accrued.

In simple terms interest is the price or cost of

the use of money.

When interest is expressed as a percentage of

the original amount per time unit, the result is
an interest rate. This rate is calculated as:

Final owned  Pr incipal

i *100%
Pr incpal
Interest Formula and Equivalence

Equivalence
Issue: Time Value of money

Even though the amounts and timing of the cash

flows may differ, the appropriate interest rate makes
them equal.
Example: ____________________?
Simple interest
Compounded Interest (interest of the interest)
 Example on Simple and compounded interest
Compute the compound interest and loan balance for each year for the
$1000 a certain person borrowed at 5% per year. Graphically compare the
result for compound interest and simple
Solution:

Final Value Final Value

Initial Inter at the end at the end
End of Amount e Simple of Comp. of
Year (Principal) st interest each yrs  interest each yrs  
  Rate interest Balance interest Balance
0 $1,000.00 5%   $1,000.00   $1,000
1     $50.00 $1,050.00 $50 $1,050
2     $50.00 $1,100.00 $52.50 $1,102.50
1. Interest= (principal + all accrued interest)X(interest rate) ------ for
3     $50.00 $1,150.00 55.13
compound Interest
1157.63
2. Interest=(principal)x(number of periods)x(interest rate)---- for
Simple interest
Nominal and Effective Interest Rates

Nominal interest rate (r)

Even though financial institutions may use more than one
interest period per year in compounding the interest, they
usually quote the interest on an annual basis. The annual base
interest rate which doesn’t consider the compounding period is
said to be Nominal interest rate.

Effective Interest rate (ie)

The effective interest rate represents the actual interest
earned or charged for a specified time period
m
 r
i e  1    1
 m
Nominal and Effective ……

where,
r = nominal interest rate (per year)
i= actual (effective interest rate) per year
m= number of interest periods per year
ie= effective annual interest rate
Continuous compounding

As a limit interest may be considered to be compounded an infinite

number of times per year, i.e. continuously.
m
 r
i e  1    1
Let,  m
r
m  m
 m
 r  r  
r r
ie  lim 1    1 , but   1  m    1  m 
m  m     
 
y
m  1
Let , y  lim 1    e
r y 
 y
m
 r
ie  lim 1    1  e r  1
y 
 m
Cash Flow Diagram

Important elements for cash flow diagram.

1. A time interval divided into an appropriate number of equal
periods
2. All cash outflows (deposits, expenditures, etc.) in each
period
3. All cash inflows (withdrawals, income, etc.) for each period

Cash inflows:
Revenues
Salvage value
Cash outflows:
First cost of asset
Operation cost
Periodic maintenance costs
Taxes
Cash Flow Diagram

•Revenue
+ Cash inflow •Salvage value
•Operating costTime
reduction

•First cost of asset

•Operation cost
•Periodic maintenance costs
- Cash outflow
•taxes
Notation
Interest Factor Derivation

Derivation Of The Single Payment Factors (F/P And

P/F)
Interest Factor Derivation
Interest Factor Derivation

Relating a uniform series of payment to P and F

Interest Factor Derivation
P

. 1 2 3 4 5 n

 1   1   1   1 
P  A 1
 A  2
 A  3
 ...  A  N 
  1  i     1  i     1  i     1  i  
 1 1 1 
P  A   ....  n
...........(a )
 1  i  1  i  1  i  
1 2

1
Multiply both side by
1 i

P  1 1 1 
 A   ....  n 1 
..........(b)
1 i  1  i  1  i  1  i  
2 3
Interest Factor Derivation

After some simplification of the above equation, we

com up with

 1  i  n  1 
P  A n 
....i  0
 i 1  i  
The terms in brackets is called the uniform-series present-worth
factor (US-PWF) or the P/A factor.

 i 1  i  n 
A  P 
 1  i   1 
n
Interest Factor Derivation

Derivation Of The Sinking Fund Factor And The Uniform –

Series Compound-Amount Factor (A/F And F/A)

 i 
A  F  A / F Factor
 1  i   1 
n

 1  i  n  1 
F  A  F / A Factor
 i 