Engineering Economy

7th edition

Leland Blank

Anthony Tarquin

Main Text Book

Possible Scenario

You, as a process engineer in one renowned wafer fabrication has

been tasked to study, evaluate and recommend an alternative

process technology to be implemented in the company’s new

product.

CONCEPT MAPImportant Concepts in Engineering Economy

• Money

• Time-Money Relationship

• Cost

How Time and Interest Affect Money

Cost

Nominal and Effective Interest Rate

Analysis Tools

• Present, Future and Annual Worth Analysis

• Rate of Return Analysis

• Benefit Cost Analysis

Decision Making

• Effect of Inflation

• Depreciation

• Tax

The Fundamentals

(3 Lectures)

Basic Analysis Tools

(2 Lectures)

Rounding Off

(2 Lectures)

LECTURE 1:

FUNDAMENTALS OF ENGINEERING

ECONOMY

LEARNING OUTCOMES

1. The importance of Engineering Economy knowledge in decision making process

2. Ethics and economics

3. Time Value of Money

4. Interest Rate (Simple, Compound and Effective)

5. Cash Flow

7. Economic Equivalence

8. Minimum Attractive Rate of Return (MARR)

9. Terms and Symbols

6. Cost

1.1 What Is Engineering ?

A branch of Science and Technology concerned with the design,

building, manufacturing, use of engines, machines and structures.

1.2 What Is Economy ?

Definition #1 (Adam Smith)

A branch of the science of a statesman or legislator[with the twofold objective of providing] a plentifulrevenue or subsistence for the people ... [and] tosupply the state or commonwealth with a revenue forthe public services.

Definition #2 (Investopedia)

The economy encompasses everything related to the production and consumption of goods and services in an area.

Definition #3

The study of the production and consumption of goods and the transfer of wealth to produce and obtain those goods. Economics explains how people interact within markets to get what they want or accomplish certain goals.

The study or science of how limited resources is used or engineered to satisfy unlimited human wants i.e. Production (supply) and Consumption (demand).

1.3 What Is Engineering Economy ?

Land Labor Capital

All gifts of nature, such as: water, air, minerals, sunshine, plant

and tree growth, as well as the land itself which is applied to the

production process.

The efforts, skills, and knowledge of people which are applied to

the production process.

Real Capital (Physical Capital )- Tools, buildings, machinery -- things

which have been produced which are used in further production

1.4 Resources

Financial Capital - Assets and money which are used in the

production process

Human Capital - Education and training applied to labor in the

production process

1.5 Why Engineering Economy is Important

to Engineers?

Engineers will involve in all kinds of projects.

Almost all decision are money related i.e Cost and ROI (return of

investment). Therefore, they must be able to incorporate economic

analysis in their decision making process.

In most cases, engineers must select and implement from multiple

possible alternatives. Therefore, understanding and applying time

value of money, economic equivalence, and cost estimation are vital.

2.0 The Application of Engineering

Economy

1. To determine the cost of products or services.

2. To provide a rational basis for pricing goods or services.

3. To provide a means for controlling expenditures.

4. To provide information on which operating decisions may be

based and the results evaluated.

3.0 The Scope of Engineering Economy

Involves.Formulating.

Estimating.

Evaluating.

the expected economic outcomes of alternatives designed to

accomplish a defined purpose.

Simple math techniques for evaluation purposes to produce

the outcomes, which is deterministic or stochastic in nature

(something measurable and quantifiable).

Essential Elements of Engineering Economy

1. Cash flows

2. Time of occurrence of cash flows

3. Interest rates for time value of money

4. Measure of economic worth for selecting an alternative

Sensitivity analysis – to determine how a decision might

change according to varying estimates.

4.0 General Steps for Decision Making

Processes

1. Understand the problem – define objective.

2. Collect relevant information.

3. Define the set of feasible alternatives.

4. Identify the criteria for decision making.

5. Evaluate the alternatives and apply financial analysis (costing,

cash flow analysis, risk, return of investment.

6. Select the best alternative.

7. Implement the chosen alternative and monitor results.

Steps in an Engineering Economy Study

5.0 Ethics – Different Levels

• Universal morals or ethics – Fundamental beliefs:

stealing, lying, harming or murdering another are

wrong

• Personal morals or ethics – Beliefs that an individual

has and maintains over time; how a universal moral is

interpreted and used by each person

• Professional or engineering ethics – Formal standard

or code that guides a person in work activities and

decision making

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6.0 Code of Ethics for Engineers

All disciplines have a formal code of ethics. National Society of

Professional Engineers (NSPE) maintains a code specifically for

engineers; many engineering professional societies have their own code

1-19

1-20

Congratulations!!! You have won a cash prize!

You have two payment options:

A - Receive $10,000 now OR

B - Receive $10,000 in three years.

Which option would you choose?

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Because of this universal instinctive, we would

prefer to receive money today rather than the same

amount in the future.

7.0 Time Value of Money (TVM)

That is called the Time Value of Money

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Actually, although the sum is the same, you can do

much more with the money if you have it now

because over time you can earn more interest on

your money i.e. money makes money.

WHY ?

1-23

Back to example: by receiving $10,000 today, you are poised

to increase the future value of your money by investing and

gaining interest over a period of time. For Option B, you

don't have time on your side, and the payment received in

three years would be your future value.

1-24

To illustrate in the form of a cash-flow timeline:

1-25

Another Scenario

Congratulations!!! You have won a cash prize!

You have two payment options:

A - Receive $100,000 now OR

B - Receive $1,000,000 in three years.

Which option would you

choose?

1-26

Description: TVM explains the change in the

amount of money over time for funds owed by or

owned by a corporation (or individual)

The time value of money is the most

important concept in engineering

economy

Corporate investments are expected to earn a return

Investment involves money

Money has a ‗time value‘

1-27

What is MONEY ???

―Money (Finance) is the gun, politics is knowing when to pull

the trigger‖

Quote from The Godfather

1-28

Money can be anything that can serve as a

• store of value, which means people can save it

and use it later—smoothing their purchases over

time;

• unit of account - A unit of account in economics is a

nominal monetary unit of measure or currency used to

value/cost goods, services, assets, liabilities, income,

expenses; i.e., any economic item. It is one of three

well-known functions of money.

• medium of exchange, something that people can

use to buy and sell from one another

1-29

(Investopedia - An officially-issued legal tender generally consisting

of currency and coin. Money is the circulating medium of exchange

as defined by a government. Money is often synonymous with cash,

including negotiable instruments such as checks. Each country has

its own money, or currency, that is used as a medium of exchange

within that country (some countries share a type of currency, such as

the euro used by the European Union). The currency of one country

can be exchanged for the currency of another via a currency

exchange. The current exchange rate determines how much of one

currency must be used to purchase a specified amount of the other

currency. For example, the exchange rate between the euro and the

US dollar may be 1.2596, where 1 euro can buy 1.2596 US dollars).

1-30

To put it a different way, money is something that holds its

value over time, can be easily translated into prices, and

is widely accepted. Many different things have been used

as money over the years—among them, cowry shells,

barley, peppercorns, gold, silver and other precious

metals.

1-31

Barter trade (long long time ago – 9000 BC).

Individual exchange

A system of exchange where goods or services are directly

exchanged for other goods or services without using a medium

of exchange, such as money.

The History of Money: From Barter System

To PetroDollar

1-32

Mesopotamia 3000 BC. Specific weight of barley.

Bartering has several problems, most notably that it requires a

"coincidence of wants". For example, if a wheat farmer needs

what a fruit farmer produces, a direct swap is impossible as

seasonal fruit would spoil before the grain harvest. A solution is

to trade fruit for wheat indirectly through a third, "intermediate",

commodity: the fruit is exchanged for the intermediate

commodity when the fruit ripens.

Commodity Money

1-33

The earliest recorded – Zhou Dynasty (China) – 1000 BC.

Precious metals (esp. gold and silver);

• A stable unit of account, a durable store of value, and a convenient

medium of exchange.

• They are hard to obtain. There is a finite supply of them in

the world.

• They stand up to time well.

• They are easily divisible into standardized coins and do not

lose value when made into smaller units.

1-34

England – 16th Century

• The precious metals were deposited with the goldsmiths. The

goldsmiths issued receipts (cheque) certifying the quantity and

purity of the metal they held as a trust with certain fee. Initially,

these receipts could not be re-assigned (only original owner could

reclaim the gold).

Goldsmith Bankers i.e. Money Lenders

• Later, those receipt could act as a medium of business transaction

i.e. other people could reclaim it.

• Eventually, goldsmiths function as money lender as well, charging

interest for loan. Later on, they become so greedy and giving loan

without gold backup (abusing the trust of the people). As a result,

the goldsmiths amassed a lot of wealth. The same modus operandi

as the current banking system (fractional-reserve banking – banks

can lend much more money than what they actually own – 90%

more) .

1-35

Europe / USA : 16th – 19th Century

• Some of prominent goldsmiths form a more legitimate system

called bank (the birth of modern banking system). They began

issuing paper money i.e. banknotes without government control.

Banknotes (Paper Money) by Private Commercial Banks

• Those banknotes as a currency for business transaction and was

well accepted by public.

• Later on, again they became too greedy and produced a lot of

paper money without gold back up.

• When people realize that banks issued banknotes far in excess of

the gold and silver they kept on deposit, it led to mass redemption

of banknotes and result in bankruptcy.

1-36

World – Bank of England since 1694 (UK). Federal Reserve since

1913 (USA)

• The government controls and regulates the issuance of banknotes

through Central Bank (for eg Bank Negara).

Banknotes (Paper Money) Regulated by Government

Several Phases for World Financial Regulation (The New World Order)

Bretton Woods Agreement – (1944 – 1971)

US banknotes as PetroDollar – (1973 – Now)

Bretton Woods Agreement, mid-1944 (44 Government leaders

from the Allied Nations)

• US as the winner of WW2 and the new world’s superpower replacing Great

Britain (debt-ridden and war-torn).

• Establishing US dollar as world reserve currency - International gold-backed

monetary standard i.e. tying all major currencies to US dollar

• Banknotes issued by Federal Reserve to be back up by Gold at 1 ounce =

USD 35. (Now 1165 USD per ounce)

• Anyone who wanted to redeem could go to the US Central Bank and get the

precious metal that backs the note (only national bank of the country).

• Federal Reserve start to print money, and loan it to the US Government,

tons of money to finance US hegemony around the world (secretly without

being backup with gold).

• US Government now clocked (http://www.usdebtclock.org/) 18.4 Trillion

USD.

1-38

The Failure of Bretton Woods Agreement.

The USA printed more banknotes than they could back up (they want

to spend more than what they have.

On August 15, 1971, President Richard M. Nixon shocked the global

economy when he officially ended the international convertibility from

U.S. dollars into gold, thereby bringing an official end to the Bretton

Woods arrangement i.e. US dollar floating not tied up to any

currencies (they can freely printing their banknotes).

France (Charles De Gaulle) became worried about their US currency

reserves, feeling that the U.S. couldn't continue to spend and borrow

at their current rate and guarantee delivery of gold. As such, they

started to make noises that they were going to insist on gold delivery.

This posed a big problem to the USA

1-39

The Emergence of Fiat Money.

With the collapse of Bretton Woods Agreement, signalling the

collapse of gold back up banknotes.

Fiat money is currency which derives its value from government

regulation or law (wikipedia)

From there onwards, money creation is no longer back up by gold.

This is called Fiat Money.

Fiat money is materially worthless, but has value simply because a

nation (imposed by the government) to collectively agrees to ascribe a

value to it. (open the door for the currency manipulation and attack,

currency devaluation, inflation etc.)

1-40

DEFINITION of 'Fiat Money‘

(http://www.investopedia.com/terms/f/fiatmoney.asp)

Currency that a government has declared to be legal tender, but is

not backed by a physical commodity. The value of fiat money is

derived from the relationship between supply and demand rather than

the value of the material that the money is made of. Historically, most

currencies were based on physical commodities such as gold or

silver, but fiat money is based solely on faith.

1-41

Petrol Dollar (Fiat Money + World Control)

The USA has something under their sleeve when they terminate The

Bretton Woods Aggreement.

In 1973, a deal was struck between Saudi Arabia and the United

States (Dr Henry Kissinger) in which every barrel of oil purchased

from the Saudis would be denominated in U.S. dollars

Under this new arrangement, any country that sought to purchase oil

from Saudi Arabia (then later expand to OPEC in 1975) would be

required to first exchange their own national currency for U.S. dollar

In exchange for Saudi Arabia's willingness to denominate their oil sales

exclusively in U.S. dollars, the United States offered weapons and

protection of their oil fields from neighboring nations, including Israel.

This petrodollar system, or more simply known as an "oil for dollars"

system, created an immediate artificial demand for U.S. dollars

around the globe. And of course, as global oil demand increased, so

did the demand for U.S. dollars.

Therefore, the USA could continue printing the money out of thin air.

As the U.S. dollar continued to lose purchasing power, several oil-

producing countries began to question the wisdom of accepting

increasingly worthless paper currency for their oil supplies.

Today, several countries have attempted to move away, or already have

moved away, from the petrodollar system. Examples include Iran, Syria,

Venezuela, and North Korea. Additionally, other nations are choosing to

use their own currencies for oil like China, Russia, and India, among

others.

1-43

8.0 Interest and Interest Rate

Interest – the manifestation of the time value of money

Interest is money paid by a borrower to a lender for a credit or a similar liability.

Important examples are bond yields, interest paid for bank loans, and returns

on savings. Interest differs from profit in that it is paid to a lender, whereas profit

is paid to an owner. In economics, the various forms of credit are also referred

to as loanable funds.

Fee that one pays to use someone else’s money (PTPTN)

Therefore, interest is the difference between an ending amount of money and

a beginning amount of money

Interest = ending amount– beginning amount

Interest = amount owed now – principal

1-44

Interest rate – Interest paid over a time period expressed as

a percentage of principal

1-45

An employee at the Company X borrows RM10,000 on November 1

and must repay a total of RM10,700 exactly 1 year later. Determine

the interest amount and the interest rate paid.

Interest paid = RM10,700 – RM10,000

= RM700

Interest rate per year = RM700/RM10,000 x 100 % = 7 % per year

1-46

9.0 Rate of Return

interest accrued per time unitRate of return (%) = x 100%

original amount

Borrower’s perspective – interest rate paid

Lender’s or investor’s perspective – rate of return earned

Interest paid Interest earned

1-47

Interest rate Rate of return

1-48

a) Calculate the amount deposited 1 year ago to have RM1000 now

at the interest rate of 5% per year.

b) Calculate the amount of interest earned during this time period.

a) The total amount accrued (RM1000) is the sum of the original

deposit and the earned interest.

If X is the original deposit,

Total accrued = deposit + deposit (interest rate)

RM1000 = X + X (0.05) ; X = RM952.38

b) The interest earned = RM1000 – 952.38 = RM47.62

1-49

10.0 Cash Flows: Terms

Cash Inflows – Revenues (R), receipts, incomes, savings generated by projects and activities that flow in. Plus sign used

Cash Outflows – Disbursements (D), costs, expenses, taxes caused by projects and activities that flow out. Minus sign used

Net Cash Flow (NCF) for each time period:

NCF = cash inflows – cash outflows = R – D

End-of-period estimation:Funds flow at the end of a given interest period

1-50

Cash Flow Diagrams

What a typical cash flow diagram might look like

0 1 2 … … … n - 1 n

Draw a time line

One time

period

0 1 2 … … … n-1 n

Cash flows are shown as directed arrows: + (up) for inflow

- (down) for outflow

Time

F = RM1000

P = RM100

1-51

10. Commonly used Symbols

t = time, usually in periods such as years or months

P = value or amount of money at a time t

designated as present or time 0

F = value or amount of money at some future

time, such as at t = n periods in the future

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

amounts of money

n = number of interest periods; years, months

i = interest rate or rate of return per time period;

percent per year or month

Cash Flow Diagram Example

1-52

An engineer wants to deposit an amount of P now such that he can withdraw

an equal annual amount of A1 = RM2000 per year for the first 5 years, starting

1 year after the deposit, and a different annual withdrawal of A2=RM3000 for

the following 3 years. How would the cash flow diagram appear if i=8.5% per

year?

0 1 2 3 4 5 7 86

Year

P=?

A1=RM2000

A2=RM3000

i = 8.5%

11.0 Economic Equivalence

What is equivalence?

1-53

The comparability of certain entities of parameters based on the

same scale.

For example, to compare the length or distance, the measurement

must be based on the same unit such as meter or feet.

Definition: Economic Equivalence is a Combination

of interest rate (rate of return) and time value of

money to determine different amounts of money at

different points in time that are economically

equivalent

1-54

Example: If the interest rate is 6% per year, RM100 today is

equivalent to RM106 one year from today.

1-55

Meaning that, from the economic perspective if somebody offered

you a gift of RM100 today or RM106 one year from today, it would

make no different which offer you accepted.

However, the two sums of money are only equivalent to each other

when the interest rate is 6%.

1-56

Example of Equivalence

Different sums of money at different times may be equal in economic value at a given rate

0 1

RM100 now

RM106

Rate of return = 6% per year

RM100 now is economically equivalent to RM106 one year from

now, if the RM100 is invested at a rate of 6% per year.

Year

1-57

12. Simple and Compound Interest

Example: RM100,000 lent for 3 years at simple i =

10% per year. What is repayment after 3 years?

Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000

Simple Interest

Interest is calculated using principal only

Interest = (principal)(number of periods)(interest rate)

I = Pni

Compound Interest

Interest is based on principal plus all accrued interest

(interest compounds over time)

Interest = (principal + all accrued interest) (interest rate)

Interest It for time period t and interest i is

1-58

Compound Interest Example

Example: $100,000 lent for 3 years at i = 10% per

year compounded. What is repayment after 3

years?

Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: T1 = 100,000 + 10,000 = $110,000

Interest, year 2: I2 = 110,000(0.10) = $11,000

Total due, year 2: T2 = 110,000 + 11,000 = $121,000

Interest, year 3: I3 = 121,000(0.10) = $12,100

Total due, year 3: T3 = 121,000 + 12,100 = $133,100

Compounded: $133,100 Simple: $130,000

1-59

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved1-60

13.0 Minimum Attractive Rate of Return

• MARR is a reasonable rate of return (percent) established for evaluating and selecting alternatives

• An investment is justified economically if it is expected to return at least the MARR

• Also termed hurdle rate, benchmark rate and cutoff rate

1-61

MARR Characteristics

• MARR is established by the financial managers of

the firm

• MARR is fundamentally connected to the cost of

capital (for e.g. interest charged by the bank for the

loan).

• Both types of debt & equity financing are used to

determine the weighted average cost of capital

(WACC) and the MARR

• MARR usually considers the risk inherent to a

project

ROR ≥ MARR > WACC

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved1-62

Chapter Summary

Engineering Economy fundamentals Time value of money

Economic equivalence

Introduction to capital funding and MARR

Interest rate and rate of return Simple and compound interest

Cash flow estimation Cash flow diagrams

End-of-period assumption

Net cash flow

Perspectives taken for cash flow estimation

Ethics Universal morals and personal morals

Professional and engineering ethics (Code of Ethics)