(HM-231) Engineering Economics

Chapter – 1
Lecture – 1
(Foundation of Engineering
Economics)
Textbook: Engineering Economy, 7th edition , Leland T. Blank and
Anthony J. Tarquin, McGraw-Hill

2
3
4
 Course Text Overview
• Level 1This is How It AllStarts
Chapter 1: Foundations of Engineering Economy Chapter 2: Factors: How Time
and Interest Affect Money Chapter 3: Combining Factors
Chapter 4: Nominal and Effective Interest Rates

• Level 2Tools for EvaluatingAlternatives Chapter 5: Present

Worth Analysis Chapter 6: Annual Worth Analysis
Chapter 7: Rate of Return Analysis: Single Alternative Chapter 8: Rate of Return
Analysis: Multiple Alternatives Chapter 9: Benefit/Cost Analysis and Public Sector
Economics

• Level 3Making Decisions on Real-WorldProjects

Chapter 11: Replacement and Retentions Decisions

• Level 4Rounding Out theStudy

Chapter 14: Effects of Inflation
Chapter 17: After-Tax EconomicAnalysis
Chapter 18: Formalized Sensitivity Analysis and Expected Value Decisions

3
Introduction

 Engineering Economics:
“Systematic evaluation of the economic
merits of proposed solutions to engineering
problems”

Muhammad Qasim
Principles of Engineering
Economics:
1) Develop the Alternatives
2) Focus on the Differences
3) Use a Consistent Viewpoint
4) Use a Common Unit of Measure
5) Consider All Relevant Criteria
6) Make Risk and Uncertainty Explicit
7) Revisit your Decisions
DEVELOP THE ALTERNATIVES

 The final choice (decision) is among alternatives. The

alternatives need to be identified and then defined for
subsequent analysis.

 Creativity and innovation !!

FOCUS ON THE DIFFERENCES

 Only the differences in expected future outcomes

among the alternatives are relevant to their comparison
and should be considered in the decision.
USE A CONSISTENT VIEWPOINT

 The prospective outcomes of the alternatives,

economic and other, should be consistently developed
from a defined viewpoint (perspective).
USE A COMMON UNIT OF MEASURE

 Using a common unit of measurement to enumerate as

many of the prospective outcomes as possible will
make easier the analysis and comparison of
alternatives.
 CONSIDER ALL RELEVANT CRITERIA
 Selection of a preferred alternative
(decision making) requires the use
of a criterion (or several criteria).
The decision process should
consider the outcomes enumerated
in the monetary unit and those
expressed in some other unit of
measurement or made explicit in a
descriptive manner.
MAKE UNCERTAINTY EXPLICIT

 Uncertainty is inherent in projecting (or estimating) the

future outcomes of the alternatives and should be
recognized in their analysis and comparison.
REVISIT YOUR DECISIONS

 Improved decision making results from an adaptive

process; to the extent practicable, the initial projected
outcomes of the selected alternative should be
subsequently compared with actual results achieved.
ENGINEERING ECONOMIC ANALYSIS
PROCEDURE
1. Problem recognition, definition, and evaluation.
2. Development of the feasible alternatives.
3. Development of the cash flows for each alternative.
4. Selection of a criterion ( or criteria).
5. Analysis and comparison of the alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post-evaluation results
 Example Problem
While studying for the Engineering Economy final exam,
you and two friends find yourselves craving for a fresh
pizza. You can’t spare the time to pick up the pizza and
must have it delivered.
 “Pick-Up-Sticks” offers a 1-1/4” thick (including toppings),
20” square pizza with your choice of two toppings for $15
plus 5% sales tax and a $1.50 delivery charge (no sales tax
on delivery charge).
 “Fred’s” offers the round, deep-dish Sasquatch which is 20
inches in diameter. It is 1-3/4” thick, which includes two
toppings, and costs $17.25 plus 5% sales tax and free
delivery.
 Application of Engineering Economics
Principles
(a)What is the problem in this situation? Please state it in
a lucid manner.
(b) Systematically apply the seven principles of
engineering economy to the problem you have defined
in part (a).
(c) Assuming that your common unit of measure is $ (i.e.,
cost), what is the better value for getting a pizza based
on the criterion of minimizing cost per unit of volume?
(d) What other criteria might be used to select which
pizza to purchase?
Discussion/Solution:
(a)
Our problem involves how to satisfy the hunger of three
students -- assume a hot delicious pizza will satisfy
this need
Let’s use “hunger satisfaction with a pizza” as the
problem/need definition.
(b) Principle 1 - Develop the Alternatives

1) Alternative A is to order a pizza from “Pick-Up

Sticks”
2) Alternative B is to order a pizza from “Fred’s”

Other options probably exist but we’ll stick to these two

alternatives
Principle 2 - Focus on the Differences

 Difference in delivery time could be an issue.

 Quality of the ingredients used to make the pizza

could be another factor to consider.

 We’ll concentrate our attention on cost differences in

part (c) to follow.
Principle 3 - Use a Consistent Viewpoint

 Consider your problem from the perspective of three

customers wanting to get a good deal.

 Does it make sense to buy a pizza having a crust that

your dog enjoys?

 Use the customer’s point of view in this situation

rather than that of the owner of the pizza shop or the
driver of the delivery vehicle.
Principle 4 - Use a Common Unit of Measure
 Most people use “dollars” as one of the most important
measures for examining differences between
alternatives.

 In deciding which pizza to order, we’ll use a cost-

based metric in part (c).
Principle 5 - Consider All Relevant Criteria
 Factors other than cost may affect the decision about
which pizza to order.
 For example, variety and quality of toppings and
delivery time may be extremely important to your
choice.
Principle 6 - Make Uncertainty Explicit

 The variability in quality of the pizza

 Its delivery time and

 Even its price should be carefully examined in making

your selection.

 (Advertised prices are often valid under special

conditions -- call first to check on this!)
 Principle 7 - Revisit Your Decision
After you’ve consumed your pizza and returned to
studying for the final exam,

Were you pleased with the taste of the toppings?

 On the downside, was the crust like cardboard?

You’ll keep these sorts of things in mind (good and

bad) when you order your next pizza!
(c) Finally some numbers to crunch
Analysis: Alternative A “Pick-Up-Sticks”

Volume = 20 x 20 x 1 ¼ = 500 in.3

Total Cost = $15 (1.05) + $1.50 = $17.25
Cost per in.3 = $0.035
Alternative B “Fred’s”

Volume = (3.1416)(10)2 (1.75) = 550 in.3

Total Cost = $17.25 (1.05) = $18.11
Cost per in.3 = $0.033

Therefore, order the pizza from “Fred’s” to minimize

total cost per cubic inch.
(d)Typical other criteria you and your friends could
consider are:
(i) cost per square inch of pizza (select “Pick-Up-
Sticks”)
(ii) minimize total cost regardless of area or volume
(select “Pick-Up-Sticks”), and
(iii) “Fred’s” can deliver in 30 minutes but “Pick-Up-
Sticks” cannot deliver for one hour because one of
their ovens is not working properly (select “Fred’s”).
Time Value of Money
What is Time Value of Money?
Would you prefer to have $1
million now or $1 million 10
years from now?

Of course, we would all prefer

the money now!

This illustrates that there is an

inherent monetary value attached
to time.
Time Value of Money
A dollar received today is worth more than a dollar
received tomorrow.

• Money can “make” money if invested.

This is because a dollar received today can be invested
to earn interest.
• The change in the amount of money over a given time
period is called the time valueof money.
Time Value of Money
It has been said that often the riskiest thing a
person can do with money is nothing!

If un invested, value is lost!!!

The Cash Flow Diagram: CFD

33
 Parameters and Cash Flows
Parameters
•First cost (investment amounts)
•Estimates of useful or project life
•Estimated future cash flows (revenues and expenses and salvage
values)
•Interest rate
Cash Flows
•Estimate flows of money coming into the firm – revenues,
salvage values, etc. – positive cash flows--cash inflows
• Estimates of investment costs, operating costs, taxes paid –
negative cash flows -- cash outflows

34
 Net Cash Flows
A NET CASH FLOW IS

• Cash Inflows – Cash Outflows

• (for a given time period)
• We normally assume that all cash flows occur:
• At the END of a given time period
• End-of-Period Assumption

35
Capital
Wealth in the form of money or property that can
be used to produce more wealth.
 Interest
Time value of money quantifies the value of a
dollar through time
INTEREST
The fee that a borrower pays to a lender for the use of
his or her money.

INTEREST RATE
The percentage of money being borrowed that is paid to
the lender on some time basis.
SIMPLE INTEREST

 The total interest earned or charged is linearly

proportional to the initial amount of the loan
(principal), the interest rate and the number of interest
periods for which the principal is committed.

 When applied, total interest “I” may be found by I = (

P ) ( N ) ( i ), where
 P = principal amount lent or borrowed
 N = number of interest periods ( e.g., years )
 i = interest rate per interest period
 Interest – Lending Example

Example 1.3
• You borrow $10,000 for one full year
• Must pay back $10,700 at the end of one year
• Interest Amount (I) = $10,700 - $10,000
• Interest Amount = $700 for the year
• Interest rate (i) = 700/$10,000 = 7%/Yr

39
 Interest – Example
•Borrow $20,000 for 1 year at 9% interest per year i = 0.09 per year
and N = 1 Year

• Pay $20,000 + (0.09)($20,000) at end of 1 year

•Interest (I) = (0.09)($20,000) = $1,800
• Total Amt Paid in one year:

$20,000 + $1,800 = $21,800

40
 Economic Equivalence
• Two sums of money at different points in time can be made
economically equivalent if:
• We consider an interest rate and,
• number of Time periods between the two sums

$20,000 is
received here

T=0 t = 1 Yr

$21,800 paid
back here
$20,000 now is economically equivalent to $21,800 one year from now IF the interest rate is set to equal
9%/year 19
 COMPOUND INTEREST
• Whenever the interest charge for any interest
period is based on the remaining principal
amount plus any accumulated interest charges
up to the beginning of that period.
Period
Period Amount
Amount Owed
Owed Interest
Interest Amount
Amount Amount
Amount Owed
Owed
Beginning
Beginning of
of for
for Period
Period at
at end
end of
of
period
period (( @
@ 10%
10% )) period
period
11 $1,000
$1,000 $100
$100 $1,100
$1,100
22 $1,100
$1,100 $110
$110 $1,210
$1,210
33 $1,210
$1,210 $121
$121 $1,331
$1,331
Interest “earns interest”
Mujasim Ali Rizvi
 COMPOUND INTEREST
Equivalence Illustrated
• Whenever the interest charge for any interest
period is based
•$20,000 onequal
now is not theinremaining
magnitude toprincipal
$21,800 1 year
from nowplus any accumulated interest charges
amount
up•But, $20,000
to the now is economically
beginning equivalent to $21,800
of that period.
one year from now if the interest rate in 9% per year.
Period
Period Amount
Amount OwedOwed Interest
Interest Amount
Amount Amount
Amount OwedOwed
•To have economic
Beginning
Beginning of equivalence
of for you must specify:
for Period
Period at
at end
end of
of
timing of the cash flows
•period
period (( @
@ 10%
10% )) period
period
11 $1,000
•interest $100
rate (i% per interest
$1,000 $100period) $1,100
$1,100
22 $1,100
•Number$1,100 $110
$110
of interest periods (N) $1,210
$1,210
33 $1,210
$1,210 $121
$121 $1,331
$1,331

Interest “earns interest” 43

 Terminology and Symbols
P= value or amount of money at a time designated as the
present or time0.
F= value or amount of money at some futuretime.
A= series of consecutive, equal, end-of-period amounts of
money.
n = number of interest periods; years
i = interest rate or rate of return per time period;
percent per year, percent per month
t = time, stated in periods; years, months,days, etc

44
 Pand F
• The symbols P and F represent one-time occurrences:
• It should be clear that a present value P represents a single
sum of money at some time prior to a future value F
$F

0 1 2 … … n-1 n

$P
45
 Annual Amounts
•It is important to note that the symbol A always represents
a uniform amount (i.e., the same amount each period) that
extends through consecutive interest periods.
• Cash Flow diagram for annual amounts might look like the
following:
$A $A $A $A $A

…………
0 1 2 3 .. N-1 n

A = equal, end of period cash flow amounts

46
 The MARR
•Firms will set a minimum interest rate that the financial
managers of the firm require that all accepted projects must
meet or exceed.
•The rate, once established by the firm is termed the
Minimum Attractive Rate of Return (MARR)
• The MARR is expressed as a per cent per year
• In some circles, the MARR is termed the Hurdle Rate

47
 Rule of 72’s for Interest
• A common question most often asked by investors is:
•How long will it take for my investment to double in
value?
•Must have a known or assumed compound interest rate
in advance
•Assume a rate of 13%/year to illustrate….

48
 Rule of 72’s for Interest
• The Rule of 72 states:
•The approximate time for an investment to double in
value given the compound interest rate is:

•Estimated time (n) = 72/i

• For i = 13%: 72/13 = 5.54 years

49
 Rule of 72’s for Interest
•Can also estimate the required interest rate for an
investment to double in value over time as:

•i approximate = 72/n
•Assume we want an investment to double in say 3
years.
• Estimate i – rate would be: 72/3 = 24%

50
 Spreadsheets
•Excel supports (among many others) six built- in
functions to assist in time value of money analysis
•Master each on your own and set up a variety of
the homework problems (on your own)

51
 Excel’s Financial Functions
To find the:
• 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)
• These built-in Excel functions support a wide variety of
spreadsheet models that are useful in engineering
economy analysis.

52