Engineering EconomyEngineering EconomyFoundations Of Engineering Economy (CH1)Foundations Of Engineering Economy (CH1)

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Why Engineering Economy is important? Why Engineering Economy is important?

Engineering Design involves economic decisionsEngineers must be able to incorporate economic

analysis into their creative effortsOften engineers must select and implement from

multiple alternativesUnderstanding and applying time value of money,

economic equivalence, and cost estimation are vital for engineers

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Why Engineering Economy is important?Why Engineering Economy is important?

Your company is considering buying a new cement mixer, ◦ what economic questions you will try to

answer?

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What is Engineering Economy? What is Engineering Economy? Engineering Economy involves ◦ Formulating◦ Estimating and ◦ Evaluatingexpected economic outcomes of alternatives

designed to accomplish a defined purpose

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Engineering Economy in Decision MakingEngineering Economy in Decision Making

1. Understand the problem – define objectives2. Collect relevant information3. Define the set of feasible alternatives4. Identify the criteria for decision making5. Evaluate the alternatives and apply sensitivity

analysis6. Select the “best” alternative7. Implement the alternative8. monitor results

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Common Terms Common Terms 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

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Engineering Economy in Decision MakingEngineering Economy in Decision Making

Your company wants to decide to buy or to rent a cement mixer? How can you decide which decision to take?

Measures of worth: ◦ Capitalized cost, economic value added◦ Present worth, future worth, annual worth,◦ Payback period, Rate of Return,

Time value of money(TMV): The change in the amount of money over a given time period.

TMV is the most important concept in engineering economy

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Engineering Economic Study StepsEngineering Economic Study Steps

Decision making process

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Interest Rate Interest Rate It is the manifestation of the time value of money• Fee that one pays to use someone else’s money• Difference between an ending amount of money

and a beginning amount of moneyInterest = amount owed now – principal

Interest rate – Interest paid over a time period expressed as a percentage of principal

Interest rate is Borrower’s perspective

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Rate of ReturnRate of ReturnLender’s or investor’s perspective – rate of return

earned

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Interest Rate ProblemInterest Rate ProblemCalculate the amount deposited 1 year ago to

have $1000 now at an interest rate of 5% per year, then calculate the amount of interest earned during this period.

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Simple Interest RatesSimple Interest RatesSimple interest is calculated using the

principal only, ignoring any interest accrued in preceding interest periods.

Interest = principal x (Number of Periods) x interest rate

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Simple Interest Rate - ExampleSimple Interest Rate - Example

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Compound Interest Compound Interest The interest accrued for each interest

period is calculated on the principal plus the total amount of interest accumulated in all previous periods.

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

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Compound InterestCompound Interest

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Cash Flow: BasicsCash Flow: BasicsCash flow are described as the inflows and outflows of

money. Every person or company has ◦ Inflows: cash receipts or revenue or income◦ Outflows: Cash disbursement, costs

Cash flow estimation can be inexact Cash Inflow Types: Operating cost reduction, asset salvage

value, receipt of loan principal, income tax savings, construction cost savings.

Cash Outflow types: operating cost, maintenance, loan interest,

Net Cash Flow (NCF) for each time period: NCF = cash inflows – cash outflows

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How to construct Cash Flow How to construct Cash Flow Diagram (CFD)Diagram (CFD)

Timeline

Draw cash flows with approximate scale

0 1 2 … … … n - 1 nOne time

period

0 1 2 … … … n-1 n

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

- (down) for outflow

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Cash Flow Example 1Cash Flow Example 1

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Cash flow Diagram ApproachCash flow Diagram Approach

Start with tabular form to construct CFD for complicated problems

Complicated problems best solved with a table first

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Cash Flow Example2Cash Flow Example2

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Cash Flow Example2Cash Flow Example2

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An Example of Cash Flow DiagramAn Example of Cash Flow DiagramA man borrowed $1,000 from a bank at 8%

interest. Two end-of-year payments: at the end of the first year, he will repay half of the $1000 principal plus the interest that is due. At the end of the second year, he will repay the remaining half plus the interest for the second year.

Cash flow for this problem is:End of year Cash flow 0 +$1000 1 -$580 (-$500 - $80) 2 -$540 (-$500 - $40)

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Cash Flow DiagramCash Flow Diagram

$1,000

0

1 2

$580$540