ENGINEERING ECONOMICS

Foundation of Engineering
Economy

Class Introduction

1-1.1
 Why Take Engineering Economics
Course?
◆ Required by civil engineering major as per
the PEC/ HEC guidelines (elective
course).
◆ Understanding the financial aspects of
engineering design, construction and
operations.
◆ Often engineers must select and implement
from multiple alternatives.
◆ To make sound engineering and financial
decisions (essential elements; cash flows of
money, time value of money, and interest
rates).
◆ Most of the professional engineering
exams require understanding of
engineering economics.

5
Importance for Civil Engineering
◆ Civil engineering deals with project that includes
design, build and operate over a long-time
frame:
■ Implications of borrowing money and revenue
generation by the projects
■ Projects generally have high construction (capital)
costs
■ Costs to operate and maintain over long lifetime
(50-100 years).
■ Understanding of benefits accrue over long
lifetimes
◆ How do you manage finances on a project
(borrowing money, revenue, capital costs)
◆ Understanding of cash flow; Time Value of
Money (TVM)
◆ Make sound decisions in the face of
uncertainties. 1-1.2
◆ Development of financial proposals.
6
 What is Engineering Economy?
◆ It is a collection of techniques that simplify
comparisons of alternatives on an economic
basis.
■ Formulating
■ Estimating and
■ Evaluating
◆ Not a process for determining what the
alternatives are?
◆ Selection of an alternative will be based on
economics. However, other factors may also play
an important role in the decision-making process.
The inclusion of other factors (besides economics)
in the decision-marking process is called multiple
attribute analysis.

Performing and Engineering Economic

Study
◆ Alternatives
◆ Cash flows
◆ Alternative selection
◆ Evaluation criteria
◆ Intangible factors
◆ Time value of money

1-1.3
 Performing and Engineering
Economic Study
◆ Cash flows
Alternatives Alternatives in
◆ Alternative engineering
selection considerations usually
◆ Evaluation involve such items as
criteria purchase cost (first
cost), anticipated
◆ Intangible useful life, yearly costs
factors of maintaining assets
◆ Time value of (annual maintenance
money and operating costs),
anticipated resale
value (salvage value),
and the interest rate.
9

Performing and Engineering

Economic Study
◆ Cash flows
Alternatives The estimated inflows
◆ Alternative (revenues) and
selection outflows (costs) of
◆ Evaluation money are called cash
criteria flows. They also
represent the weakest
◆ Intangible part of the analysis,
factors because of
◆ Time value of uncertainty of future
money predictions.

1
0

1-1.4
 Performing and Engineering
Economic Study
◆ Cash flows
Alternatives Every situation has at
◆ Alternative least, minimum of two
selection alternatives. Alternative
◆ Evaluation of inaction, called the
criteria do-nothing alternative.
This is the as-is or
◆ Intangible status quo condition
factors and may or may not be
◆ Time value of the most favorable
money economic outcome.
Objective is to
consciously identify the
alternative(s) that is
1
1
(are) economically the
best.

Performing and Engineering

Economic Study
◆ Cash flows
Alternatives We use criteria every
◆ Alternative day to choose between
selection alternatives, i.e., when
◆ Evaluation you drive to campus,
criteria your criteria for route
may be the safest,
◆ Intangible shortest, fastest,
factors cheapest, most scenic,
◆ Time value of or what?
money In economic analysis,
financial units (rupees
or other currency) are
generally used as the
1
2
tangible basis for
evaluation.

1-1.5
 Performing and Engineering
Economic Study
◆ Cash flows
Alternatives Factors that are difficult
◆ Alternative to quantify. When
selection alternatives under
◆ Evaluation consideration are hard
criteria to distinguish
economically. Intangible
◆ Intangible factors may tilt the
factors decision in the direction
◆ Time value of of one of the
money alternatives.
Examples: goodwill,
convenience,
friendship, political,
1
3
and morale.

Performing and Engineering

Economic Study
◆ Cash flows
Alternatives The change in the
◆ Alternative amount of money over
selection a given time period is
◆ Evaluation called the time value of
criteria money (TVM). TVM
defines the worth of
◆ Intangible output at specific time.
factors This measure is used to
◆ Time value of accept/reject an
money alternative.

1
4

1-1.6
 Interest
◆ Interest is a payment the borrower pays to the
lender to compensate for the risk associated with
the lending of capital.
■ Risk of not being paid back (defaulting)
■ Compensate for the loss of purchasing power due
to inflation
◆ Interest provides you the opportunity to increase
the value of money over time, by lending it
out.
◆ It essentially represents rent paid for use of the
money.
◆ Two perspectives:
■ Interest paid: when a person or organization
borrows money (obtains a loan) and repays
a larger amount.
■ Interest earned: when a person or organization
saves, invests, or lends money and obtains a
return of a larger amount.
15 Inter
est
◆ Equations:
Interest = end amount − original amount
interest accured per unit time
Interest rate % = x
original
100
amount
Total accured end amt. = original
amount
+ original amount
interest rate
= original amount
1 + interest rate
◆ Interest period: typically; yearly,
quarterly or monthly…….
◆ Interest is also defined as the return on investment
1
6
(ROI) or rate of return (ROR).
◆ Interest paid is more appropriate for the borrower’s
perspective, while ROR is better from the
investor’s perspective. 1-1.7
 Example 1.1

WHAT YOU HAVE AND WHAT

ARE YOU LOOKING
FOR ?

17

Example 1.2
a. Calculate the amount deposited 1 year ago to have $1000 now at an
interest rate of 5% per year.
b. Calculate the amount of interest earned during this time period.

18

1-1.8
 Cost of Capital and MARR
◆ Engineering alternatives are evaluated to get
reasonable ROR.
◆ Minimum Attractive Rate of Return (MARR)
■ It is the rate of return which a firm must earn in
order to keep its value stable, must be higher than
the cost of capital use to finance the alternative.
■ Ex: if a corporation can borrow capital funds at an
average of 5% per year and expects to clear at
least 6% per year on a project, the minimum
MARR will be 11% per year.
■ It is sometimes called the “hurdle rate”, should
be chosen to maximize the economic well-being
of an organization.

19

Cost of Capital and MARR

◆ Cost of Capital
■ Is the cost of acquiring the funds (the business
has to pay some additional amount in the form of
interest).
■ It is the minimum rate of return that the company
must earn on its investments to fulfill the
expectations of the investors.
ROR ≥ MARR > Cost of Capital
◆ Consideration of Inflation in selection of
alternatives.

20
1-1.9
 Inflation
◆ Inflation is the rate of increase in prices over a
given period. Inflation is typically a broad
measure, such as the overall increase in
prices or the increase in the cost of living in
a country.
◆ Example:
■ An interest rate of, say, 9% per year will probably
have inflation rate to be in the range of 5% to 6%
per year.
■ Will result into 3% to 4% real rate of return.
◆ Bank interest rates must reflect two things:
■ Real rate of return and
■ The expected inflation rate
◆ Inflation causes interest rates to rise.
21

Equivalence
◆ Since the value of money changes over time,
comparing options or alternatives must be done
at the same point in time.
◆ Alternatives that may vary in time, costs, and
interest (or discount) rate need to be compared
from a common reference point.
◆ Note: Interest rate and discount rate are
functionally the same but different.
■ Interest is the money earned into the future on a
cash
■ Discount is when the future cash is discounted
back into the present time

22

1-1.10
 Example - Equivalence
◆ Given an interest rate of 𝑖%, having 𝑋 amount
at 𝑡 = 0, is equivalent to having 𝑌 amount
at 𝑡 = 𝑛.
◆ Different sums of money at different times would
be equal in economic value.
Interest rate = 6% per
-1 year 1
0

$106 one
$94.34 last year $100 year from
now now
◆ INTERPRETATION: $94.34 last year, $100 now, and
$106 one year from now are equivalent only at an
interest rate of 6% per year.
2
3

Example 1.3

24

1-1.11
 Simple Interest (Multiple Periods)
◆ Interest earned is linearly proportional to the initial
investment, over number of years, and at the
given interest rate.
◆ So far we have introduced: interest and
interest rate for one period. For than one
period, we use:
◆ Simple interest
Ignoring any interest accrued in preceding interest
periods
Interest, i = principal, 𝑃 interest rate, i%
#of periods, 𝑡 Total due, F = 𝑃 + 𝑃
i)(t = 𝑃(1 + 𝑖𝑡)
◆ Simple interest is always based on the original
amount, which is also called the principal.

25

Simple Interest

WHAT YOU HAVE AND WHAT ARE YOU LOOKING FOR ?

EX

$1000 (Principal)

26

1-1.12
 Compound Interest
◆ Interest earned is reinvested into the initial
investment and used in the calculation of future
interest payments.
◆ Interest paid on top of interest (in real life, if not
mentioned, if is generally compound interest, is
the default interest).
Interest = principal + all accrued interest interest rate ;
for one period
Total Interest = principal 1 + interest rate n umb er of periods −
principal
Total due = principal 1 + interest rate n u m b e r of periods

Ex:

27

Compound Interest

28

1-1.13
 Example 1.6 (Self Solving)

29

Terminology and Symbols

𝑃 = value or amount of money at a time designated

𝐹 = value or amount of money at some future

as the present or time 0 - one time occurrence.

𝐴 = series of consecutive, equal, end-of-period

time - one time occurrence.

amounts of money – uniform repeated occurrence,

starting at the end of the first period and

𝑛 = number of interest or discount periods; years,

continuing through the last period.

𝑖 = interest or discount rate or rate of return per time

months, days

period; percent per year, percent per month,

𝑡 = time, stated in periods; years, months, days.

percent per day

30
1-1.14
 Example 1.7 and Example 1.8

WHAT YOU HAVE AND WHAT ARE YOU LOOKING FOR ?

31

Example
1.10

Interest rate = 6% per F=

?
year A =
1,000/year

0 1 2 3 4 5 6
n=5 n=6

P=
5000 CASH FLOW
DIAGRAM
Note: we have three capital letters from slide #30, resulting in
2 n-values.

32

1-1.15
 Cash Flows
◆ Graphical representation of cash inflows and cash
out flows on a time scale.
◆ May be estimates or observed values - revenue
and income (inflows, + sign); expenses,
and costs (outflows, - sign).
◆ Cash flow are estimates and helps in the
decision-making process. Decision based
on:
■ Cash inflows: revenue, savings, loans, etc.
■ Cash outflows: design, operating cost,

Net cash flow = cash inflows − cash outflows

maintenance, interest, etc.

◆ Net cash flow is assumed to occur at the end

of the interest period.

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Cash Flow
Diagram
Interest rate = i % per year
+ve flow
Beginning of
first +ve +ve
period flow flow

0 1 2 3 4 ▪▪▪▪▪
n
End of first
period,
-ve
corresponds to n
flow =1
CASH FLOW
DIAGRAM

3
4

1-1.16
 Example: Cash Flow
◆ An investment of Rs. 10,000 is made that will
produce an annual revenue of Rs. 5,310 for five
years and have a market (recovery) value of Rs.
2,000 at end of year five. Annual expenses will be
Rs. 3,000 at the end of each year for operating
and maintaining
◆ Cash the project.
flow diagram:
𝑛 = 5 years 𝑃 = Rs. -10,000
𝐴1 = Rs. 5, 310 annually 𝐴2 = Rs. -3,000
■

𝐹= Rs. 2,000 at end of annually

■

𝑨 = 5,310 5,310 𝑭=2,000

five years𝟏 5,310 5,310 5,310

0 1 2 3 4 5 Cash Flow

𝑨𝟐 = 3,000
Calculations.x
3,000 3,000 3,000 3,000 lsx
𝑷=
35 10,000

Example 1.11

36

1-1.17
 Example
1.12

0 1 2 3 4 5

Notes:
1. “n” must be equal to number of cash flows
2. Cannot start “A” at year zero (0), “A” can only occur at the
end of one period.
3. Renumber the years

37

Example
1.13

0 1 2 3 4 5

Notes:
1. “n” must be equal to 5 years matching “A”,
cash flows.
2. “P” is always located one period prior to first
“A”.
3. No activity prior to “P”, so we can renumber
years.
3
8

1-1.18
 The Rule of 72

of years 𝑛 or the compound interest rate (or rate

◆ The rule of 72 can estimate either the number

of return) 𝑖 required for a single amount of

72 72
money to double in size.
𝑛= 𝑜𝑟 𝑖 =
𝑖 𝑛
◆ At 5% per year, it takes approximately
72/5=14.4 years to double the amount.
◆ If the cost of gasoline doubles in 6 years, the
compound rate is approximately 72/6 =
12%per year.

39

Excel Equations
◆ Present value P of an A series: = PV(i%, n, A, F)
◆ Future value F of an A series: = 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)
◆ P of any series: = NPV i%, secondc e ll : last c e ll +
first_cell

40

1-1.19
 Example 1.7 and Example 1.8

Book Examples.xlsx

41

QUESTIONS ???

1-1.20