Economics Combined

Engineering Economics
(ME 2001)
3 credits- 3 0 0 3
By:
Dr. Saurabh Dewangan
Asst Professor
Mechanical Engineering
Manipal University Jaipur
Course Outcomes: At the end of the course, students will be able to
1. Understand various economic decision-making concepts applicable to engineering.

2. Estimate the Present, annual and future worth, rate of return for various types of cash
flows.
3. Evaluate uncertainty and risk analysis in future events.
4. Analyse for replacement analysis and break-even analysis.
5. Calculate depreciation and expenses.
Syllabus
Economic Decision Making – Overview, Problems, Role, Decision Making Process. Indian Industries
Introduction, The Pattern of Industrialization, Large Scale Industries, Labour Problems and Policies,
Unorganized Sector.
Engineering Cost & Estimation – Fixed, Variable, Marginal & Average Costs, Sunk Costs, Opportunity Costs,
Recurring & Nonrecurring Costs, Incremental Costs, Cash Costs Vs Book Costs, Life- Cycle Costs, Types of
Estimate, Estimating Models Improvement & Learning Curve, Benefits, Economic order Quantity.
Uncertainty in future Events – Estimates and their use in economic analysis, economic decision tree, Risk, Risk
vs Return.
Depreciation – Depreciation and expenses, depreciation calculation fundamentals, depreciation and capital
allowance methods, Common elements of tax regulations for depreciation and capital allowances.
Replacement Analysis, Inflation and Price Change, Forecasting, Break Even Analysis
Text Books
T1. R. Panneerselvam, Engineering Economics, Prentice Hall of India.
T2. J.L. Riggs, D.D. Bedworth and S.U. Randhawa, Engineering Economics, McGraw Hill Education.
T3. P.L. Mehta, Managerial Economics, Sultan Chand & Sons.

Reference Books
R1. E.L. Grant, W.G. Ireson and R.S. Leavenworth, Principles of Engineering Economic Analysis, John
Wiley.
R2. G,J. Tuesen, W.J. Fabrycky and H.G. Tuesen, Engineering Economy, Prentice Hall of India.
R3. L. Blank and A. Tarquin, Engineering Economy, McGraw Hill Education.
Assessment Rubrics:
Criteria Description Maximum
Marks
Sessional Exam 30
Internal Assessment In class Quizzes and Assignments, 30
(Summative) Activity feedbacks (CWS)
End Term Exam End Term Exam 40
(Summative)
Total 100
Attendance A student must have maintained a 75% attendance rate
(Formative) in order to sit for the final test at the conclusion of the
semester. The 25% allowance covers all leaves, not
just medical ones.
Introduction
• The word economy comes from the Greek word “oikonomos” which means “one who
manages a household.” At first, this origin might seem peculiar. But, in fact, households
and economies have much in common.
• A household faces many decisions.
• Like a household, society faces many decisions.
• The management of society’s resources is important because resources are scarce.
• Scarcity means that society has limited resources and therefore cannot produce all the
goods and services people wish to have.
• Economics is the study of how society manages its scarce resources.

• In most societies, resources are allocated not by a single central planner but through the
combined actions of millions of households and firms.
• Economists, therefore, study how people make decisions: how much they work, what
they buy, how much they save, and how they invest their savings. Economists also study
how people interact with one another.
• For instance, they examine how the multitude of buyers and sellers of a good together
determine the price at which the good is sold and the quantity that is sold. Finally,
economists analyze forces and trends that affect the economy as a whole, including the
growth in average income, the fraction of the population that cannot find work, and
the rate at which prices are rising.
Nature & Scope of Economics - Definitions
Economics - defined in simple terms as “The science of the useful

application of wealth or material resources.”
Other definitions under different contexts:
• J. E. Cairnes - Science of Wealth / Study of wealth
• Marshall - Science of Material Welfare – Study of man’s actions in the

ordinary business of life. Here man’s actions are related to how wealth is
produced, consumed, exchanged, and distributed in society.
The above definitions give importance to wealth in the study of

economics.
Economics Definitions - continued
• Robbins - Science of Scarcity or Science of Choice – Study of human behavior as a

relationship between ends (Wants –unlimited, competing, always changing) and
scarce means (limited resources) which have alternative uses. Thus a choice is to be
made on the most urgent needs. Study of allocation of scarce (relative to demand)
means for max. satisfaction of these ends.
• Modern definition – J. M. Keynes: Economics is the Study of the administration of

resources and the determinants of income and employment of an economy. It
studies the economic fluctuations to promote means for economic stability through
size, distribution & stability of national income, and growth.
Economics Definitions - continued
Economics is the science that deals with the production and consumption
of goods and services and the distribution and rendering of these for
human welfare.
Following are the economic goals.

ü High level of employment
ü Price stability
ü Equitable distribution of income
ü Growth
Some of the above goals are interdependent, not always complementary,
and may be conflicting.
Eg. Any move to have a significant reduction in unemployment will lead to
an increase in inflation.
Engineering Economics - Definitions
• Engineering - “is that profession in which the knowledge of

mathematics & natural sciences gained through studies, experience &
practice is systematically analyzed & applied with judgment to develop
ways & means to utilize economically the materials & forces of nature
for the benefit of mankind.”
• Engineering Economics - deals with decisions to be taken based on

need/want recognition to its satisfaction, through a series of steps
involving developing alternatives, evaluating them & decision-making,
and its efficient execution.
• Engineering Economics deals with systematic evaluation of the costs &

benefits of proposed technical and business ventures/projects.
TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
• PRINCIPLE #1: PEOPLE FACE TRADEOFFS: The first lesson about making decisions is
summarized in the adage: “There is no such thing as a free lunch.” To get one thing that we like,
we usually have to give up another thing that we like. Making decisions requires trading off one
goal against another.
• PRINCIPLE #2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET IT: Because
people face tradeoffs, making decisions requires comparing the costs and benefits of alternative
courses of action. In many cases, however, the cost of some action is not as obvious as it might
first appear.
• PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN: Decisions in life are rarely
black and white but usually involve shades of gray. Marginal changes----Marginal cost.
• PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES: Because people make decisions by

comparing costs and benefits, their behavior may change when the costs or benefits change. That
is, people respond to incentives.
HOW PEOPLE INTERACT
PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF
PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC

ACTIVITY
PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET

OUTCOMES- an invisible hand to support, enforces rules, reforms, avoid market failures
HOW THE ECONOMY AS A WHOLE WORKS
PRINCIPLE #8: A COUNTRY’S STANDARD OF LIVING DEPENDS ON ITS ABILITY

TO PRODUCE GOODS AND SERVICES- “Productivity”
PRINCIPLE #9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO MUCH
MONEY –
PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF BETWEEN

INFLATION AND UNEMPLOYMENT
Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3
Lecture 2
Theory of demand and supply analysis
15
Nature of Demand Lecture 2
The desire,
ability, and
willingness
to buy a
product or
service
Desire? Ability? Willingness?
16
Nature of Demand Lecture 2
Desire There are three important points to remember

about the quantity demanded:
Desire is just a wish on the part of the consumer to
o First, the quantity demanded is the quantity
possess a commodity.
desired to be purchased. It is the desired
purchase. The quantity actually bought is
referred to as actual purchase.
Want
o Secondly, quantity demanded is always
If the desire to take a commodity is backed by the considered as a flow measured over a period
purchasing power and the consumer is also willing of time.
to buy that commodity, it becomes want. Ø if the quantity demanded of oranges is 10, it
must be per day or per week, etc.
Demand o Thirdly, the quantity demanded will have an

economic meaning only at a given price.
Demand is the wish of the consumer to get a Ø For example, the demand for oranges equal to
definite quantity of a commodity at a given price in 10 units per week at a price of Rs. 100 per
the market backed by a sufficient purchasing dozen is a full and meaningful statement.
power.
17
Economic Analysis Lecture 2
o Variables are not dated
Economic o The demand-supply model of market behaviour is a
Static Model
Analysis static model.
o In this model, demand depends on own price, supply
Static Dynamic depends on own price, with an equilibrium condition
model model that demand must equal supply, time does not enter into
the picture at all and the variables are all undated.
o Variables are dated o According to some economists, even if the variables

are dated the model does not become dynamic.
o If the demand-supply model is
Dynamic Model
restructured as follows, then the o According to this definition, variables must be dated
model would become dynamic and a time lag must exist in their relationships.
according to this criterion: With this criterion, a dynamic model would be:
𝐃𝐭 = 𝐟 𝐏𝐭 𝐃𝐭 = 𝐟 𝐏𝐭
𝐒𝐭 = 𝐠 𝐏𝐭 𝐒𝐭 = 𝐠 𝐏𝐭"𝟏
𝐃 𝐭 = 𝐒𝐭 𝐃 𝐭 = 𝐒𝐭
18
• Where, ‘t’ is the relevant time unit.
Determinants of Demand by a Consumer Lecture 2
ü The demand for commodity is dependent on a number of factors. These are mentioned as
follows:
o Price of the commodity: Normally, higher the price of the commodity, the lower the
1 demand of the commodity. This is the law of demand.
Price Per # of CDs 30

CD Demanded
$1 300 25
$2 162 20
$3 94
$4 58 15
$5 37
10
$6 25
$10 18 5
$15 13
$20 10 0
0 100 200 300
19
Law of demand.
P= Price QD= Quantity Demanded
Pé QDê
Price
Pê QD é
Quantity Demanded
o Size of consumers income/ Buyer’s income: When the increase in income leads to an
2 increase in the quantity demanded, the commodity is called a ‘normal good’. If an
increase in income leads to a fall in the quantity demanded, we call that commodity an
‘inferior good’.
Income é Demandé
Income ê Demandê
21
o Prices of other related commodities: A consumer’s demand for a commodity may also
3 be influenced by the prices of some other commodities. Some are complementary
goods, which are consumed along with the commodity, while others may be used in
place of this commodity. This category is called substitutes.
22
o Taste of the consumers: If a consumer has developed a taste for a particular commodity,
4 he/she will demand more of that commodity. Similarly, if a consumer has changed his taste
against a particular commodity, less of it will be demanded at any particular price. This
development of tastes may be related to seasons of the year as well.
23
o Demand function refers to the rule that shows how the quantity demanded depends
upon above factors.
o A demand function can be shown as:
𝐃 𝐱 = 𝐟 𝐏𝐱 , 𝐏𝐲 , 𝐏𝐳 , 𝐌, 𝐓
where,
Ø If all the factors influencing the
Dx is quantity demanded of X commodity
demand for a commodity X vary
Px is the price of X commodity simultaneously, the picture would be
highly complicated.
Py is the price of substitute commodity
Pz is price of a complement good Ø Therefore, normally we allow only
one of the factors to change, assuming
M stands for income
that all other factors remain
T is the taste of the consumer unchanged
24
Determinants of Market Demand Lecture 2
ü The factors determining the demand for a commodity in a market are the same as those
which determine the demand for the commodity on the part of a consumer.
ü Besides that two additional factors are also to be included. These two factors are:
o Size of the population: All other factors

remaining unchanged, the greater is the
size of the population, more of a
commodity will be demanded.
o Income distribution: : People in different

income groups show marked differences in
their preferences. So if larger share out of
national income goes to the rich, demand for
the luxury goods may rise and a rise in
income share of the poor will increase
demand for the wage goods.
25
Thank you
26
Lecture 3
27
Law of Demand Lecture 2
o The inverse relationship between the quantity of a commodity and its price, given all
other factors that influence the demand is called ‘law of demand’.
o It gives us a demand curve that slopes downwards to the right. We can explain this idea
with help of a demand schedule
Demand curve
o The demand curve graphically shows

the relationship between the quantity
of a good that consumers are willing to
buy and the price of the good.
Price of Apple per Kg. Quantity Demanded of
(in Rs.) Apples
(in Kg. per week)
100 15
200 12
300 8
400 3 28
Why does a Demand Curve Slope Downwards? Lecture 2
o Substitution Effect: The substitution effect refers to the change in o Income Effect: This is the
demand for a good as a result of a change in the relative price of the effect of a change in the
good compared to that of other substitute goods. For example, total purchasing power of
when the price of a good rises, it becomes more expensive relative the money income of the
to other goods in the market. As a result, consumers switch away consumer.
from the good toward its substitutes. o With falling the price of
mangos, the purchasing
Example: Consider the following example: John eats rice that costs $5 power rises within the
per pound and pasta that costs $10 per pound. The relative price of 1 given income. Thus, he
pound of pasta is 2 pounds of rice. At their current prices, John can buy more of the
consumes 1 pound of pasta and 2 pounds of rice. mangoes with the same
Due to some technological advances in rice cultivation, there has been money income.
a fall in rice prices from $5 a pound to $2 a pound. The relative price of o His demand for any other
1 pound of pasta has now increased from 2 pounds of rice to 5 pounds commodities may also
of rice. Therefore, John switches away from pasta and to rice. The rise. This is called the
change in consumption occurs purely due to the changes in the relative ‘income effect’.
price of the goods and not because of a change in income.
29
Why does a Demand Curve Slope Downwards? Lecture 2
Price Effect: Price Effect is the sum total of the substitution

effect and income effect, i.e.
PE = SE + IE
Where PE = Price Effect.
SE = Substitution Effect
IE = Income Effect
o It is important to note that the substitution

effect and income effect operate
simultaneously with the change in the
price of the commodity.
o ‘Substitution effect’, and ‘income effect’
taken together give ‘price effect.’
30
CHANGE IN QUANTITY DEMANDED Vs. CHANGE IN DEMAND
o When the demand for a commodity changes Change in Demand
because of the change in its price, it is called The shift of the demand curve to the right shows
‘change in quantity demanded’. On the other ‘increase in demand’ and a movement of the
hand, when the change in demand is due to demand curve to the left of the initial demand
the factors other than its price cause a curve is a ‘decrease in demand’.
change it is called ‘change in demand’.
Expansion and Contraction in Demand (Change in quantity
demanded)
31
Concept of Supply Lecture 2
o Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time.
ü A higher price would mean more profits. The producer will supply more at a higher price.
ü Similarly, a producer will supply smaller quantity at a lower price.
ü This is a direct relationship between the price and the quantity supplied of a commodity and is
called the ‘Law of Supply’.
Ø A producer aims to maximize profits

ü Therefore, profit is estimated through difference between total revenue and total cost.
ü Total revenue is the price of the product multiplied by its quantity sold.
ü Total cost is the cost of production.
Profit = TR – TC
TR = Total Revenue (q.p)
TC = Total Cost (q.AC)
where AC is average cost.
32
Determinants of Supply Lecture 2
1. Price of the commodity supplied

o The price is most immediate determinant of supply.
o A person or firm will make quick check whether the costs will be covered by
the price. As the price goes up, a firm/person will be willing to sell larger
quantity.
2. The prices of factors of production or cost of production
o These affect the cost of production and possible profits of the firm. A rise in the
prices of factors of production discourages the production and supply of the
commodity.
3. Prices of other goods
o As the prices of other commodities rise, they become more attractive to
produce for a profit maximising firm. Hence supply of commodity whose price
is unchanged will decline.
33
Determinants of Supply Lecture 2
4. The state of technology
o The improvement in the knowledge about the means and the methods of
production lead to lower costs of production and helps increasing output.
5. Goals of the producer
o The objective with which the producer undertakes production also influences
his production and supply decisions.
Price (in Rs) per Pen Quantity Supplied (in thousand per Month
2 25
3 40
4 50
5 60
6 70
34
Concept of Supply Lecture 2
o Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time.
𝐒𝐭 = 𝐠 𝐏𝐭
o The supply of a commodity is a function of its price, the price of all other
commodities, the prices of factors of production, technology, the objectives of
producers and other factors remaining unchanged. So:
𝐒𝐭 = 𝐠 𝐏𝟏, 𝐏𝟐, 𝐏𝟑. . . 𝐏𝐧, 𝐅𝟏 … 𝐅𝐚, 𝐓, 𝐆, … .
Where: Qs stands for the quantity of the commodity supplied;
P1 is the price of that commodity, P2, P3...Pa are the prices of other
commodities;
F1 …… Fn are the prices of all factors of production;
T is the state of technology;
G is the goal of the producer.
35
Lecture 4
(Numerical Problems)
3
6
Problem No: 1
The demand and supply equations of a commodity are given as Xd =½ (5-P) and Xs =2P -3.
i. Find the equilibrium price and quantity?
ii. Find the new price and quantity if a tax of Rs. 6/5 per unit is imposed on the
commodity?
iii. Find the total tax revenue generated by the government?
iv. Find the price actually realized by the seller?
37
Given: Solution
Find the equilibrium quantity
Demand equation: Xd = ½ (5 - P) Demand equation: Xd = ½ (5 - P)
Supply equation: Xs = 2P - 3 Xd = ½ (5 – (11/5))
Xd = ½ (14/5)
i. Find the equilibrium price and quantity: Xd = 7/5 = 1.4 = Equilibrium quantity
At equilibrium, Xd = Xs
Therefore,
½ (5 - P) = 2P - 3
Now solve for P:
5 - P = 4P - 6
5 + 6 = 4P + P
11 = 5P
P = 11 / 5 = 2.2 = Equilibrium price (P)
3
8
How does the imposition of a unit tax affect the
supply curve of a firm?
• When there is an increase in unit tax on the production of goods by
the government, the unit cost of production will rise and
consequently, the firm would supply less than before at the given
price. The supply would decrease implying that the supply curve
would shift to the left.

39
ii. Solution
Find the new price and quantity if a tax of Find the equilibrium quantity
Rs. 6/5 per unit is imposed:
Xs' = 2P' – (27/5) (P'= 79/25 )
ØWhen a tax is imposed on the commodity, the Xs' = 2*(79/25) – (27/5)
new supply equation becomes
Xs' = (158/25) – (27/5)
Xs' = 2{P‘- T} - 3 (where, T is the tax per unit)
Xs' = (23/25) = 0.92 = New equilibrium quantity
Xs' = 2{P‘- (6/5)} - 3
Xs' = 2P' – (12/5) – 3
Xs' = 2P' – (27/5) (New Supply Equation)
At equilibrium, Xd = Xs'
½ (5 - P') = 2P'– (27/5)
5 - P' = 4P'- (54/5)
3P'= 5 + (54/5)
P'= 79/25 = 3.16 = New equilibrium price
4
0
Solution
iii. Find the total tax revenue generated by the
iv. Find the price actually realised by the seller:
government: Price realized by seller = New equilibrium price -
Tax revenue = Tax per unit*Quantity sold with tax Tax per unit
Tax revenue = (6/5) * Xs' Price realized by seller = 79/25 - 6/5
= (6/5) * (23/25) Price realized by seller = 49/25
Tax revenue = 138/125
4
1
Problem No: 2
Solve the following problem: The demand function is P=5-2X and the supply function is
P=½(X+5) respectively.
ii. Find the new price and quantity if a subsidy of Rs. 5/2 per unit is granted on the
commodity?
iii. Find the total amount of subsidy granted by the government?
42
Given: Solution
ii. Find the new price and quantity if a subsidy
Demand equation: P = 5 - 2X of Rs. 5/2 per unit is granted
Supply equation: P = ½(X + 5) When a subsidy is granted on the commodity, the

new demand equation becomes:
i. Find the equilibrium quantity:
{P’ - S} = 5 – 2X’ (where S is the subsidy per unit)
At equilibrium, f(P) = g(P)
{P’ - (5/2)} = 5 – 2X’ S=5/2
5 - 2X = ½(X + 5)
(2P’- 5)/2 = 5 – 2X’
10 - 4X= X + 5
(2P’- 5) = 10 – 4X’
5X = 5
P’ = (15 – 4X’)/2
X = 1 = Equilibrium quantity
At equilibrium, f(P) = g(P)
Find the equilibrium price
(15 – 4X’)/2 = ½(X’ + 5)
Demand equation: P = 5 - 2X
15 – 4X’ = X’ + 5
P = 5 – 2(1)
5X’ = 10
Equilibrium price = P = 3
X’ = 2 = Equilibrium quantity 4
3
Solution
Substitute the new equilibrium quantity back iii. Find the total amount of subsidy granted by the
into either the demand or supply equation to government?
find the new equilibrium price (P'). Total subsidy = New quantity demanded *
Let's use the supply equation: subsidy per unit
P' = 5 – 2X = 2 * (5/2)
P' = 5 – 2(2) Total subsidy = 5
P' = 1
So, with the subsidy granted, the new price is

approximately 1 and the new quantity is 2.
4
4
i.
Problem No: 3
Suppose the value of demand and supply curves of a Commodity-X is given by the
following two equations simultaneously:
Qd = 200 –10P; Qs = 50 + 15P
Find the equilibrium price and equilibrium quantity of commodity X.
ii. Suppose that the price of a factor inputs used in producing the commodity has
changed, resulting in the new supply curve given by the equation
Qs’ = 100 + 15P’
Analyze the new equilibrium price and new equilibrium quantity as against the original
equilibrium price and equilibrium quantity.
45
Given: Solution
ii. If the price of factor of production has
Demand equation: Qd = 200- 10P changed, then under the new conditions
Supply equation: Qs = 50 +15P Given;

New supply chain equation;
i. Find the equilibrium price and quantity: Qd = Qs’
Qd = Qs 200- 10P’ = 100 + 15P’
200- 10P = 50 +15P 25P’ = 100
150 = 25P Equilibrium Price P’ = 4
P = 6 = Equilibrium price
Qs = 200 – (10)(4) = 160 units
Find the equilibrium quantity

Thus as the equilibrium price is decreasing the
Qd = 200- 10P equilibrium quantity is increased.
Qd = 200 – (10) (6) = 140 units
4
6
Problem No: 4
The demand function = 3Q +4P =24 and the supply function is P=¼Q+3 respectively.
ii. Find the new price and quantity if a tax of Rs. 1/3 per unit is imposed on the
commodity?
iii. Find the total tax revenue generated by the government?
iv. Find the price actually realised by the seller?
47
Given: Solution
ii. Find the new price and quantity if a tax of Rs.
Demand equation: Dx = 3Q + 4P = 24 1/3 per unit is imposed:
4P = 24 – 3Q ØWhen a tax is imposed on the commodity, the

new supply equation becomes
P = 6 – (3/4)Q………..(1)
{P’ – T} = ¼Q+3 (where, T is the tax per unit)
Supply equation: P = ¼Q+3 …………..(2)
P’ – 1/3 = ¼Q+3
i. Find the equilibrium price and quantity:
P’ = ¼Q + 10/3………..(3) (New Supply Equation)
At equilibrium, Dx = Sx
At equilibrium,
6 – (3/4)Q = (1/4)Q +3
¼Q + 10/3 = 6 – (3/4)Q (Eq3 = Eq1)
Q= 3 = quantity demanded
Q'= 6 – (10/3) = 8/3
P = (1/4)Q +3
P = ¼ (3) +3
P’ = ¼Q + 10/3
P = ¾ +3
P’ = ¼ (8/3) + 10/3 = 8/12 + 10/3
P = 15 / 4 = Equilibrium price (P)
P’ = 4 4
8
Solution
iii. Find the total tax revenue generated by the
iv. Find the price actually realised by the seller:
government: Price realized by seller = New equilibrium price -
Tax revenue = Tax per unit*Quantity sold with tax Tax per unit
Tax revenue = (1/3) * Xs' Price realized by seller = 4- 1/3
= (1/3) * (8/3) Price realized by seller = 11/3
Tax revenue = 8/9
4
9
Lecture 5
Cost Analysis
50
ELEMENTS OF COSTS Lecture 5
• Cost can be broadly classified into variable cost and overhead cost. Variable cost varies with the
volume of production while overhead cost is fixed, irrespective of the production volume.
• Variable cost can be further classified into direct material cost, direct labour cost, and direct
expenses.
• The overhead cost can be classified into factory overhead, administration overhead, selling
overhead, and distribution overhead.
• The selling price of a product is derived as shown below:

(a) Direct material costs + Direct labour costs + Direct expenses = Prime cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock = Cost of goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit
51
OTHER COSTS/REVENUES Lecture 4
Marginal Cost
• Marginal cost of a product is the cost of producing an additional unit of that product. Let the cost
of producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of the same
product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45.
Marginal Revenue
• Marginal revenue of a product is the incremental revenue of selling an additional unit of that
product. Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling
21 units of the same product be Rs. 15,085. Then, the marginal revenue of selling the 21st unit is
Rs. 85.
Sunk Cost
• This is known as the past cost of an equipment/asset. Let us assume that an equipment has been
purchased for Rs. 1,00,000 about three years back. If it is considered for replacement, then its
present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present
value of the equipment for further analysis. So, the purchase value of the equipment in the past is
known as its sunk cost. The sunk cost should not be considered for any analysis done from
nowonwards.
52
Opportunity Cost Lecture 4
• In practice, if an alternative (X) is selected from a set of competing alternatives (X,Y), then the
corresponding investment in the selected alternative is not available for any other purpose. If
the same money is invested in some other alternative (Y), it may fetch some return. Since the
money is invested in the selected alternative (X), one has to forego the return from the other
alternative (Y). The amount that is foregone by not investing in the other alternative (Y) is
known as the opportunity cost of the selected alternative (X). So the opportunity cost of an
alternative is the return that will be foregone by not investing the same money in another
alternative.
53
BREAK-EVEN ANALYSIS Lecture 5
This point is also called the no-loss or no-gain

situation. For any production quantity which
is less than the break-even quantity, the total
cost is more than the total revenue. Hence, the
firm will be making loss.
For any production quantity which is more than

the break-even quantity, the total revenue will
be more than the total cost. Hence, the firm will
be making profit.
54
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S=s Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost = v Q + FC
Profit = Sales – (Fixed cost + Variable costs)
= s Q – (FC + v Q)
Break-even quantity = Fixed cost/Selling price/unit - Variable cost/unit
=FC/s-v (in units)
Break-even sales
= {Fixed cost/Selling price/unit - Variable cost/unit }* Selling price/unit
= {FC/s-v }*s (Rs)
Contribution = Sales – Variable costs
Contribution/unit = Selling price/unit – Variable cost/unit
M.S. = Actual sales – Break-even sales
= {Profit/Contribution}*sales
M.S. as a per cent of sales = (M.S./Sales)*100
55
Problem No: 1
Alpha Associates has the following details:
i. Fixed cost = Rs. 20,00,000
ii. Variable cost per unit = Rs. 100
iii. Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.
56
Solution (ii) Margin of safety
Fixed cost (FC) = Rs. 20,00,000 METHOD I
Variable cost per unit (v) = Rs. 100 M.S. = Sales – Break-even sales
Selling price per unit (s) = Rs. 200 = 60,000 *200 – 40,00,000
(a) Break-even quantity = FC/s-v = 1,20,00,000 – 40,00,000 = Rs. 80,00,000
= 20,00,000/100 = 20,000 units METHOD II
(b) Break-even sales = [FC/s-v] *s (Rs.) M.S. = Profit/Contribution * Sales
= 20 00 000/100 * 200 Profit = Sales – (FC + v Q)
= Rs. 40,00,000 • = 60,000 *200 – (20,00,000 + 100 * 60,000)
(c) (i) Contribution = Sales – Variable cost = 1,20,00,000 – 80,00,000 = Rs. 40,00,000
= s *Q – v *Q M.S. =40,00,000/60,00,000 *1,20,00,000
= 200 *60,000 – 100 *60,000 = Rs. 80,00,000
= 1,20,00,000 – 60,00,000 M.S. as a per cent of sales = (M.S./Sales)*100
= Rs. 60,00,000 = 80,00,000/ 1,20,00,000 *100
= 67%
57
PROFIT/VOLUME RATIO (P/V RATIO)
P/V ratio is a valid ratio which is useful for further analysis.

P/V ratio = Contribution/Sales
= Sales - Variable costs/ Sales
The relationship between BEP and P/V ratio is as follows:
BEP = Fixed cost/(P/V ratio)
The following formula helps us find the M.S. using the P/V
ratio:
M.S. = Profit / (P/V ratio)
58
Problem No: 2
Consider the following data of a company for the year 1997:
(i) Sales = Rs. 1,20,000
(ii) Fixed cost = Rs. 25,000
(iii) Variable cost = Rs. 45,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
59
Solution
Given: BEP = Fixed cost/ (P/V ratio)
(i) Sales = Rs. 1,20,000 = 25000/62.50* 100
(ii) Fixed cost = Rs. 25,000 = Rs. 40,000
(a) Contribution = Sales – Variable costs M.S. = Profit/P/V ratio
= Rs. 1,20,000 – Rs. 45,000 = 50 000/62 50 * 100
= Rs. 75,000 = Rs. 80,000
(b) Profit = Contribution – Fixed cost
= Rs. 75,000 – Rs. 25,000
= Rs. 50,000
(c) BEP
P/V ratio = Contribution / Sales
= 75,000/1,20,000 = 62.50%
60
Problem No: 3
Consider the following data of a company for the year 1998:
(i) Sales = Rs. 80,000
(ii) Fixed cost = Rs. 15,000
(iii) Variable cost = 35,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
61
Solution
Given: BEP = Fixed cost/ (P/V ratio)
(i) Sales = Rs. 80,000 = 15000/56.25* 100
(ii) Fixed cost = Rs. 15,000 = Rs. 26,667
(a) Contribution = Sales – Variable costs M.S. = Profit/(P/V ratio)
= Rs. 80,000 – Rs. 35,000 = 30 000/56.25 * 100
= Rs. 45,000 = Rs. 53,333.33
(b) Profit = Contribution – Fixed cost
= Rs. 45,000 – Rs. 15,000
= Rs. 30,000
(c) BEP
P/V ratio = Contribution / Sales
= 45,000/80,000
= 56.25%
62
Cost Estimation Definition
Cost estimation refers to a statement that provides the value of the cost sustained in the manufacturing or
producing a finished good. This process facilitates determining the selling price of the finished or final product after
deducting reasonable fixed costs and leaving substantial profit margins.
Cost estimation considers any expenditure incurred in designing and producing a good or product and any
associated service provisions such as physical capital, tool production, marketing and sales costs, administrative
expenditure, and other overhead costs.
Cost Estimation Example

The following example of cost estimation would help to make its meaning better understandable:
The cost estimation of a refrigerator would be:
Cost of raw material: ₹15,000
Cost of labour: ₹5,000
Cost of painting: ₹1,000
Cost of electricity required in manufacturing: ₹500
Cost of transportation: ₹1,000
Cost of marketing: ₹1,000
Total estimated cost or cost estimation: ₹23,800.
Benefits of Estimating:
Accurate estimating is crucial for effective project management and decision-making. Some benefits
include:
• Resource Allocation: Proper estimates help allocate resources effectively, ensuring that projects have
the necessary manpower, materials, and budget.
• Risk Management: Accurate estimates allow for better identification and management of potential
risks, helping to mitigate negative impacts.
• Project Planning: Estimates are essential for creating realistic project schedules, setting milestones,
and defining project objectives.
• Cost Control: Accurate cost estimates help control project budgets and prevent cost overruns.
• Client Communication: Clear and accurate estimates enhance communication with clients, establishing
trust and transparency.
• Economic Order Quantity (EOQ):
• EOQ is a formula used in inventory management to determine the optimal order quantity that
minimizes total inventory costs. It balances the costs of holding inventory (storage, handling, etc.)
against the costs of ordering more inventory (order processing, setup, etc.). The formula
considers factors such as demand rate, ordering cost, and carrying cost.
The EOQ formula is:
EOQ = √((2 * D * S) / H),
Where:
D = Demand rate (units per period)
S = Ordering cost per order
H = Holding cost per unit per period
By calculating the EOQ, a company can find the order quantity that minimizes the combined costs of
holding inventory and ordering. This helps in optimizing inventory management and cost efficiency.
Question 1 Question 2
Calculate Economic Order Quantity From the following particulars, calculate the Economic
(EOQ) from the following: Order Quantity (EOQ):
Annual consumption 6,000 units Annual requirements 1,600 units
Cost of ordering Rs. 60 Cost of materials per units Rs. 40
Carrying costs Rs. 2 Cost of placing and receiving one order: Rs. 50
Annual carrying cost for inventory value 10%
EOQ = (2 ∗ 𝐷 ∗ 𝑆)/(𝐻 ∗ %𝐶𝐶)

EOQ = (2 ∗ 𝐷 ∗ 𝑆)/𝐻
Where
Where
D = Demand = 1600 units
D = Demand = 6000 units
S= Ordering cost per order = 50 Rs
S= Ordering cost per order = 60 Rs
H = Holding Cost = 40 Rs
H = Holding Cost = 2 Rs
'∗+)**∗,*
'∗)***∗)* EOQ = = 100 Units
EOQ = = 424 Units -*∗+*%
'
Practice Problem
A company has an annual demand of 10,000 units, an ordering cost of INR 150 per order, and a holding cost of
INR 7 per unit per year. Calculate the optimal reorder quantity and the minimum total cost.
Estimating Models
• Estimating models for engineering economics involve using various mathematical and analytical techniques to
predict and evaluate the financial performance of engineering projects and investments. These models help
engineers and decision-makers make informed choices about whether to proceed with a project based on its
potential economic returns. Here are some common estimating models used in engineering economics:
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback Period
• Benefit-Cost Ratio (BCR)
• Sensitivity Analysis
• Scenario Analysis
• Monte Carlo Simulation
• Capital Budgeting Techniques
• Internal Rate of Return (IRR)
• Replacement Analysis
• Real Options Analysis
Net Present Value (NPV)
• NPV is a fundamental concept in engineering economics. It involves estimating the
present value of all expected cash inflows and outflows associated with a project or
investment. The NPV is calculated by discounting future cash flows to their present value
using a predetermined discount rate. If the NPV is positive, the project is usually
considered economically viable.
Net present value (NPV) is the difference between the present value of cash inflows and the present value of
cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the
profitability of a projected investment or project.
NPV is the result of calculations that find the current value of a future stream of payments, using the proper
discount rate. In general, projects with a positive NPV are worth undertaking while those with a negative NPV
are not.
KEY POINTS:
•Net present value (NPV) is used to calculate the current value of a future stream of payments from a
company, project, or investment.
•To calculate NPV, you need to estimate the timing and amount of future cash flows and pick a discount rate
equal to the minimum acceptable rate of return.
•The discount rate may reflect your cost of capital or the returns available on alternative investments of
comparable risk.
•If the NPV of a project or investment is positive, it means its rate of return will be above the discount rate.
NPV=
[Today’s value of the exp
ected cash flows−
Today’s value of invested
where: cash]
Rt=net cash inflow- outflows during a single period
ti=discount rate or return that could be earned in alternative investments
t=number of time periods
The Net Present Value (NPV) of an
investment is calculated by
discounting the future cash flows
generated by the investment back to
their present value and subtracting the
initial investment cost.
Q-1: You are considering an

investment opportunity to purchase a
piece of equipment for your
manufacturing business. The initial
cost of the equipment is 1,50,000 INR.
The equipment is expected to
generate cash flows of 50,000 INR at
the end of each year for the next 5
years. The cost of capital for your
business is 10%. Calculate the Net
Present Value (NPV) of the investment
and determine whether it's a
financially viable decision.
Practice Problem
• You are considering investing in a real estate project. The project involves purchasing a piece of land for
2,00,000 INR. You anticipate that the project will generate cash flows of 30,000 INR at the end of each
year for the next 8 years. However, the cost of capital for this type of project is 12%. Calculate the Net
Present Value (NPV) of the investment and determine whether it's financially feasible.
Ans: NPV = -22578.67
Since the calculated NPV is negative (-22,578.67 INR), it indicates that the investment is not financially
feasible. A negative NPV suggests that the project's potential returns do not exceed the cost of capital,
making it an unfavorable investment decision. In such cases, it's generally advisable to avoid pursuing the
investment as it may not provide satisfactory returns.
Internal Rate of Return (IRR):
• IRR is the discount rate that makes the NPV of a project equal to zero. It
represents the effective interest rate at which an investment breaks even.
Projects with an IRR higher than the required rate of return are generally
considered attractive.
Problem: Calculating Internal Rate of Return (IRR) for a Software
Engineering Project
• Suppose a software engineering company is evaluating an investment in a new project
that involves developing a cutting-edge software product. The project requires an initial
investment of 3,00,000 INR to cover development costs and equipment purchase. The
company expects to generate cash flows of 1,00,000 INR at the end of each year for the
next five years from selling licenses of the software. After five years, the company also
plans to sell the project at an estimated net cash flow of 1,50,000 INR. The company's
required rate of return is 12%. Calculate the Internal Rate of Return (IRR) for this project
and determine whether the company should proceed with it.
• Step 1: Identify the cash flows for each year, including the initial investment and future cash flows:
• Initial Investment: -3,00000 (outflow)
• End of Year 1: 1,00000 (inflow)
• End of Year 6 (sale of project): 1,50,000 (inflow)

• Step 2: Calculate the Net Cash Flows for each year:
• Year 1: 1,00000 – 3,00000 = -2,00000
• Year 2: 1,00000
• Year 3: 1,00000
• Year 4: 1,00000
• Year 5: 1,00000
• Year 6: 1,50000
• Step 3: Set up the equation to find the IRR. The IRR is the discount rate that makes the present value of cash
inflows equal to the initial investment:
• NPV = 0 = -3,00000 + (1,00000 / (1 + IRR)^1) + (1,00000 / (1 + IRR)^2) + (1,00000 / (1 + IRR)^3) + (1,00000 /

(1 + IRR)^4) + (1,00000 / (1 + IRR)^5) + (1,50000 / (1 + IRR)^6)
• Step 4: Solve for IRR using trial and error or by using computational tools (e.g., financial calculators,
spreadsheet software). In this case, the calculated IRR is approximately 16.35%.
• Step 5: Compare the calculated IRR (16.35%) with the company's required rate of return (12%). Since the
calculated IRR (16.35%) is greater than the required rate of return (12%), the project is considered financially
viable. The company should proceed with the software engineering project as it is expected to provide
returns that exceed the company's cost of capital.
• Conclusion:
• The software engineering company should proceed with the project because the calculated Internal Rate of
Return (IRR) of approximately 16.35% is higher than the company's required rate of return of 12%. This
indicates that the project is expected to generate a return that justifies the initial investment and provides
additional value to the company.
Payback Period
• The payback period is the time required for an investment to generate sufficient cash flows to recover the
initial investment cost. Projects with shorter payback periods are often preferred as they provide quicker
returns.
• The Payback Period is a financial metric used to evaluate the time it takes for an investment to generate
enough cash flows to recover the initial investment cost. In the context of an engineering project, it helps
assess the time it will take for the project to recoup its initial costs through the cash flows it generates. The
formula to calculate the payback period is:
• Payback Period = Initial Investment / Annual Cash Flow

Here's how you can calculate the Payback Period for an engineering project:
• Determine the Initial Investment: Identify all the costs associated with starting the engineering project. This could
include expenses like equipment costs, labor costs, research and development expenses, etc. Add up all these costs
to get the initial investment.
• Estimate Annual Cash Flows: Estimate the cash flows the project is expected to generate on an annual basis. This
could include revenue from sales, cost savings, or any other relevant income generated by the project.
• Calculate the Payback Period: Divide the Initial Investment by the Annual Cash Flow to calculate the payback period
in years.
• Payback Period = Initial Investment / Annual Cash Flow
• It's important to note that the Payback Period metric has its limitations. It doesn't take into account the time value
of money (the fact that money received in the future is worth less than money received today due to inflation and
the opportunity cost of not investing the money elsewhere). Additionally, it doesn't provide insights into the
profitability of the project beyond the payback period itself.
• In engineering projects, it's advisable to use the Payback Period in conjunction with other financial metrics like Net
Present Value (NPV), Internal Rate of Return (IRR), and Discounted Payback Period to get a more comprehensive
view of the project's financial viability and potential risks. These metrics consider the time value of money and
provide a better understanding of the project's long-term profitability.
Benefit-Cost Ratio (BCR)
• The BCR is the ratio of the present value of benefits to the present value of costs. A BCR greater than 1
indicates that the benefits outweigh the costs, making the project potentially desirable.
• Problem: Inefficient Resource Allocation for Infrastructure Projects

Many government agencies and organizations struggle with the efficient allocation of resources for
infrastructure projects. Limited budgets and competing project options often lead to decisions that may not
yield the best outcomes in terms of societal benefits and costs. Without a proper assessment of projects, there
is a risk of investing in projects with low returns and missing out on those with higher potential.
• Solution: Benefit-Cost Ratio (BCR) Analysis
• The Benefit-Cost Ratio (BCR) analysis is a valuable tool for evaluating and comparing the economic feasibility
of different infrastructure projects. It helps decision-makers make informed choices by quantifying the ratio
of the benefits derived from a project to the costs incurred. The BCR is calculated by dividing the present
value of the project's benefits by the present value of its costs.
Steps for BCR Analysis:
• Identify and quantify benefits: Identify the positive impacts that the project will bring to society, such as
increased productivity, reduced travel time, improved safety, and environmental benefits. Quantify these
benefits in monetary terms whenever possible.
• Estimate project costs: Consider all relevant costs associated with the project, including construction costs,
operational costs, maintenance costs, and any other direct or indirect expenses.
• Timeframe and discounting: BCR analysis takes into account the time value of money by discounting future
benefits and costs to present value. This ensures that the impact of money over time is properly considered.
• Calculate BCR: Divide the present value of the benefits by the present value of the costs to calculate the BCR.
A BCR greater than 1 indicates that the benefits outweigh the costs, making the project economically viable.
• Compare projects: Rank and compare different projects based on their BCR values. Projects with higher BCR
values are generally preferred, as they indicate a higher return on investment.
• Sensitivity analysis: Since BCR analysis involves assumptions and estimates, it's important to perform
sensitivity analysis to assess the impact of variations in key parameters. This helps decision-makers
understand the robustness of their decisions.
Benefits of BCR Analysis:
• Informed decision-making: BCR analysis provides a clear and quantitative basis for comparing projects,
helping decision-makers allocate resources to projects with the highest potential benefits relative to costs.
• Efficient resource allocation: By prioritizing projects with higher BCR values, organizations can maximize the
impact of their limited resources.
• Accountability and transparency: BCR analysis provides a transparent method for justifying project choices to
stakeholders and the public, enhancing accountability.
• Risk assessment: BCR analysis encourages the consideration of potential risks and uncertainties, fostering
better risk management practices.
• In conclusion, the Benefit-Cost Ratio (BCR) analysis is a powerful tool for addressing the problem of
inefficient resource allocation for infrastructure projects. By utilizing BCR analysis, decision-makers can
ensure that the projects they choose to invest in are economically sound and deliver the greatest societal
benefits relative to the costs incurred.
A city is considering a road construction project that aims to improve traffic flow and reduce congestion. The
estimated costs and benefits of the project are as follows:
• Estimated construction cost: 50,00,000
• Annual operational and maintenance cost: 2,00,000
• Project duration: 10 years
• Annual benefits in reduced travel time and fuel savings: 15,00000
• Salvage value of the project at the end of 10 years: 5,00000
• The city uses a discount rate of 8% for project evaluations. Calculate the Benefit-Cost Ratio (BCR) to
determine whether the road construction project is economically viable.
• Solution:
• Step 1: Calculate Present Value of Costs and Benefits
• To perform the BCR analysis, we need to calculate the present value of both costs and benefits over the project's
duration.
• Present Value (PV) formula: PV = Future Value / (1 + Discount Rate)^Number of Years
• Present Value of Construction Cost:
• PV of Construction Cost = 50,00000 / (1 + 0.08)^0 = 50,00000
• Present Value of Annual Operational and Maintenance Costs (for 10 years):
• PV of Annual Costs = 2,00000 * [1 - (1 + 0.08)^-10] / 0.08 = 14,64097.28
• Present Value of Annual Benefits (for 10 years):
• PV of Annual Benefits = 15,00000 * [1 - (1 + 0.08)^-10] / 0.08 = 1,10,40,328.51
• Present Value of Salvage Value:
• PV of Salvage Value = 5,00000 / (1 + 0.08)^10 = 2,80,785.371

• Step 2: Calculate Net Present Value (NPV)
• Net Present Value (NPV) = PV of Benefits - PV of Costs
• NPV = (11040328.51 + 280785.37) - (5000000 + 1464097.28) = 5857016.6
• Step 3: Calculate BCR
• BCR = (PV of Benefits + PV of Salvage Value) / (PV of Costs)
• BCR = (11040328.51 + 280785.37) / (5000000 + 1464097.28) ≈ 2.22
• Interpretation: The calculated BCR is approximately 2.22. Since the BCR is greater than 1, it indicates that
the benefits of the road construction project outweigh the costs. A BCR greater than 1 indicates that for
every dollar invested, there are 2.22 INR in benefits. Therefore, the road construction project is economically
viable and would likely provide positive returns.
• This analysis helps the city make an informed decision by quantifying the economic feasibility of the project
and demonstrating its potential to generate significant benefits relative to the costs involved.
Sensitivity Analysis:
• This involves analyzing how changes in key input parameters (such as cost estimates, revenue projections,
and discount rates) affect the financial viability of a project. Sensitivity analysis helps identify the sensitivity
of the project's outcome to variations in these parameters.
Case Study: Sensitivity Analysis in Financial Investment
• Background:
• ABC Investments is a financial firm that offers investment advice and manages portfolios for their clients.
They have recently proposed an investment strategy to a high-net-worth client, Mr. Smith, which involves
allocating his portfolio across various assets such as stocks, bonds, and real estate. Mr. Smith is concerned
about the potential risks and uncertainties associated with this strategy, and he wants to understand how
sensitive his returns would be to changes in certain key variables.
• Objective: The objective of this sensitivity analysis is to assess the impact of changes in key variables on the
overall returns of Mr. Smith's investment portfolio. This analysis will help Mr. Smith understand the potential
risks and uncertainties associated with the proposed investment strategy.
Variables of Interest:
• Stock Market Performance: This variable represents the annual return of the stock market, which directly
influences the returns from the stocks in Mr. Smith's portfolio.
• Interest Rates: Fluctuations in interest rates affect the returns from bonds and other fixed-income
investments.
• Real Estate Market: Changes in the real estate market impact the value and returns of the real estate
holdings in the portfolio.
• Inflation Rate: Inflation erodes the purchasing power of investments, affecting their real returns.
Methodology:
• ABC Investments uses a financial modeling tool to perform sensitivity analysis. They create a model that
simulates the performance of Mr. Smith's portfolio based on historical data, economic forecasts, and
assumptions. Monte Carlo simulation is employed to generate multiple scenarios by randomly varying the
input variables within defined ranges.
Steps:
• Data Collection: ABC Investments gathers historical data on stock market returns, interest rates, real estate
market trends, and inflation rates. They also collect information about Mr. Smith's portfolio allocation.
• Scenario Definition: ABC Investments defines ranges for each key variable. For instance, they might consider
a range of -2% to +2% for stock market returns, ±0.5% for interest rates, etc.
• Model Development: Using the collected data and assumptions, ABC Investments builds a financial model
that calculates the overall returns of Mr. Smith's portfolio based on different combinations of input variables.
• Monte Carlo Simulation: They run the model through thousands of iterations, randomly selecting values for
each key variable within their defined ranges. For each iteration, the model calculates the portfolio returns.
• Results Analysis: ABC Investments analyzes the simulation results to identify patterns and trends. They
create various visualizations, such as histograms and scatter plots, to demonstrate the distribution of
possible portfolio returns under different scenarios.
• Sensitivity Metrics: ABC Investments calculates sensitivity metrics such as the standard deviation of portfolio
returns, correlation coefficients, and value-at-risk (VaR) to quantify the impact of each variable on the
portfolio's overall performance.
• Recommendations: Based on the analysis, ABC Investments provides Mr. Smith with insights into the
potential range of returns and risks associated with the proposed investment strategy. They discuss
strategies to mitigate risks, such as diversification and hedging.
• Conclusion: Sensitivity analysis helps Mr. Smith and ABC Investments understand the potential vulnerabilities
and uncertainties in the proposed investment strategy. By quantifying the impact of key variables on
portfolio returns, they can make more informed decisions and tailor the strategy to Mr. Smith's risk tolerance
and financial goals.
Scenario Analysis:
• Similar to sensitivity analysis, scenario analysis involves examining different scenarios that could impact the
project's financial performance. It goes beyond single-variable changes and considers multiple variables
together.
Suppose you are a financial analyst evaluating an investment opportunity in a startup company. The company
is developing a new product, and its success will depend on various market conditions. You've identified three
potential scenarios with associated probabilities and projected cash flows. You want to use scenario analysis to
assess the investment's potential returns.
• Scenarios:
• Optimistic Market (Probability: 40%)
• Projected Cash Flow: 3,00000
• Moderate Market (Probability: 50%)
• Projected Cash Flow: 1,50000
• Pessimistic Market (Probability: 10%)
• Projected Cash Flow: -50,000 (Negative value indicates a loss)
• Calculate the expected cash flow and standard deviation of cash flows to assess the investment's potential
outcomes.
Solution:
• Expected Cash Flow = (Probability of Scenario 1 * Cash Flow of Scenario 1) + (Probability of Scenario 2 * Cash Flow of
Scenario 2) + (Probability of Scenario 3 * Cash Flow of Scenario 3)
• Expected Cash Flow = (0.40 * 300000) + (0.50 * 150000) + (0.10 * -50000) = 120000 + 75000 - 5000 = 190000
• The expected cash flow for the investment is 190000.
• Standard Deviation of Cash Flows = √[ (Probability of Scenario 1 * (Cash Flow of Scenario 1 - Expected Cash Flow)^2) +
(Probability of Scenario 2 * (Cash Flow of Scenario 2 - Expected Cash Flow)^2) + (Probability of Scenario 3 * (Cash Flow
of Scenario 3 - Expected Cash Flow)^2) ]
• Standard Deviation of Cash Flows = √[ (0.40 * (300000 - 190000)^2) + (0.50 * (150000 - 190000)^2) + (0.10 * (-50000 -
190000)^2) ]
• Standard Deviation of Cash Flows = √[ (40000)^2 + (-40000)^2 + (240000)^2 ] = √[ 1600000000 + 1600000000 +

57600000000 ] = √60160000000 = 245148.68
• The standard deviation of cash flows for the investment is approximately 245148.68 INR.
• Conclusion: Based on scenario analysis, the expected cash flow from the investment is 190000 INR, with a standard
deviation of approximately 245148.68 INR. This indicates that while the investment has a positive expected outcome,
there is a notable level of uncertainty associated with the potential cash flows.
Monte Carlo Simulation:
• This advanced technique involves running thousands of simulations using probability distributions for key
input parameters. It provides a range of possible outcomes and their associated probabilities, offering a
more comprehensive understanding of project risk.
• Monte Carlo simulation is a computational technique used to estimate outcomes or analyze complex
systems by generating random samples and analyzing their statistical properties. The technique is named
after the famous casino in Monaco because of the element of randomness involved, similar to the random
outcomes in gambling.
• Monte Carlo simulation is widely used in various fields, including physics, engineering, finance, statistics, and
more.
Monte Carlo Simulation: Process Flow
• Problem Formulation: Start with a problem that involves uncertainty or randomness. This could be anything from
calculating the value of a financial option to predicting the behavior of a physical system.
• Modeling: Create a mathematical or computational model that represents the system you're analyzing. This model
should include variables with uncertain values or parameters.
• Random Sampling: Generate a large number of random samples for the uncertain variables. These samples are
often drawn from probability distributions that reflect the uncertainty of the real-world system.
• Simulation: For each set of random samples, use the model to simulate the behavior of the system. This might
involve performing calculations, running simulations, or following a set of rules based on the model.
• Statistical Analysis: Collect data from the simulations and perform statistical analysis on the results. This could
include calculating averages, standard deviations, percentiles, and other relevant measures.
• Interpretation: The statistical analysis provides insights into the behavior of the system and the potential outcomes.
You can use these results to make predictions, assess risks, or make informed decisions.
• Monte Carlo simulations are particularly useful when dealing with complex systems that are difficult to
model analytically. They can handle a wide range of scenarios, including situations with multiple interacting
variables and uncertainties.
• One classic example is using Monte Carlo simulation to estimate the value of π (pi), where random points
are generated within a square and the ratio of points falling within a quarter circle to the total number of
points gives an approximation of π/4.
• In finance, Monte Carlo simulations are used to model the behavior of financial instruments like options,
bonds, and portfolios under various market conditions. This helps investors and analysts make informed
decisions about risk management and investment strategies.
• Overall, Monte Carlo simulation is a powerful tool for gaining insights into complex systems and making
informed decisions in the presence of uncertainty.
Capital Budgeting Techniques:
• Techniques like the Profitability Index, Equivalent Annual Cost, and Modified Internal Rate of Return (MIRR)
take into account the time value of money and are used to evaluate the financial performance of complex
projects with varying cash flows over time.
• Capital budgeting techniques are methods used by businesses and organizations to evaluate and prioritize
potential investment projects or expenditures that involve significant financial resources. These techniques
help in assessing the feasibility, profitability, and overall value of different investment opportunities.
• Here are some common capital budgeting techniques:
• Net Present Value (NPV): NPV calculates the present value of future cash flows generated by an investment project,
taking into account the initial investment cost. If the NPV is positive, it indicates that the project is expected to
generate more cash inflows than outflows and is potentially a profitable investment.
• Formula: NPV = Σ [CFt / (1 + r)^t] - Initial Investment
Where CFt = Cash flow at time t, r = discount rate, and t = time period.
Decision rule: Accept the project if NPV > 0; reject if NPV < 0.
• Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of an investment becomes zero. It represents
the rate of return the project is expected to generate. Comparing the IRR to the company's required rate of return
helps determine project feasibility.
Decision rule: Accept the project if IRR > Required Rate of Return; reject if IRR < Required Rate of Return.
• Payback Period: The payback period is the time it takes for an investment to recover its initial cost through generated
cash flows. It's a simple measure of liquidity and risk. Shorter payback periods are generally preferred, as they indicate
quicker recovery of the initial investment.
Decision rule: Accept the project if Payback Period < Preset Time; reject if Payback Period > Preset Time.
• Discounted Payback Period: Similar to the payback period, this method considers the time it takes for an
investment to recover its initial cost, but it takes into account discounted cash flows. This accounts for the
time value of money.
Decision rule: Accept the project if Discounted Payback Period < Preset Time; reject if Discounted Payback
Period > Preset Time.
• Profitability Index (PI): The profitability index is the ratio of the present value of future cash flows to the
initial investment. It measures the bang for the buck—the higher the index, the more desirable the
investment.
Formula: PI = Present Value of Future Cash Flows / Initial Investment
Decision rule: Accept the project if PI > 1; reject if PI < 1.
• Modified Internal Rate of Return (MIRR): MIRR overcomes some of the limitations of the traditional IRR by
assuming that intermediate cash flows are reinvested at a specified rate, rather than at the project's IRR. It
provides a more realistic estimate of an investment's profitability.
These techniques have their strengths and weaknesses, and they may be used in combination to make well-
informed decisions about capital investments. The choice of which technique(s) to use depends on the specific
circumstances of the investment and the company's preferences for risk, return, and other factors.
Replacement Analysis:
• Used for deciding when to replace an existing asset, this analysis considers factors such as the asset's current
value, future maintenance costs, and the value of the replacement asset.
• Replacement analysis, also known as capital budgeting or asset replacement analysis, is a financial
evaluation technique used by businesses to decide whether to replace an existing asset or piece of
equipment with a new one. This analysis is typically performed when an existing asset becomes outdated,
inefficient, or no longer cost-effective to maintain, and the business is considering investing in a
replacement.
• The primary objective of replacement analysis is to determine whether the benefits and cost savings
associated with the new asset justify the investment required. The analysis involves comparing the costs and
benefits of keeping the existing asset versus replacing it with a new one.
Here's a general process for conducting replacement analysis:
• Identify the Existing Asset: Determine the characteristics, current condition, and operational costs of the
existing asset that needs replacement.
• Estimate the Remaining Useful Life: Estimate how much longer the existing asset can continue to provide
value before it becomes obsolete or its maintenance costs outweigh its benefits.
• Identify the New Asset: Identify the potential replacement asset and gather information about its cost,
expected useful life, operating costs, and any other relevant factors.
• Estimate Costs and Benefits: Calculate the total costs associated with keeping the existing asset, including
maintenance, repair, and any other relevant expenses. Similarly, calculate the total costs associated with
acquiring and operating the new asset.
• Quantify Benefits: Identify and quantify the benefits that the new asset will bring, such as increased
efficiency, reduced operating costs, improved quality, increased production capacity, and other potential
advantages.
• Discounted Cash Flow Analysis: Apply techniques like discounted cash flow (DCF) analysis to
assess the net present value (NPV) of both the existing asset and the new asset over their
respective useful lives. This involves discounting future cash flows back to their present value to
account for the time value of money.
• Compare NPVs: Compare the NPV of the existing asset with the NPV of the new asset. A positive
NPV indicates that the investment in the new asset is likely to be financially beneficial, while a
negative NPV suggests that sticking with the existing asset may be a better option.
• Sensitivity Analysis: Perform sensitivity analysis by varying key assumptions (such as useful life,
discount rate, maintenance costs, and benefits) to assess the impact on the decision. This helps
understand the robustness of the decision under different scenarios.
• Make the Decision: Based on the comparison of NPVs and the results of sensitivity analysis, make
an informed decision on whether to replace the existing asset with the new one.
• It's important to note that replacement analysis can be complex, as it involves predicting future
costs and benefits over the life of the assets. Different industries and businesses may have unique
factors to consider. Therefore, careful consideration of assumptions, accurate data, and sound
financial analysis are crucial for making the best decision.
Problem: Replacement Analysis in Software Engineering
• Company XYZ is considering whether to replace an old software system with a new one. The old system was purchased 5
years ago for 150000 INR and has an expected remaining useful life of 3 years. The new system is expected to cost 250000
INR and has an expected useful life of 5 years. The salvage value of the old system is negligible, while the salvage value of
the new system is estimated to be 50000 INR after 5 years. The company's required rate of return is 10%. Should the
company replace the old system with the new one?
• Solution: To determine whether the company should replace the old system with the new one, we can use the Net Present
Value (NPV) method. NPV helps us calculate the present value of cash flows associated with each option and compare
them to make an informed decision.
• Calculate the Cash Flows:

Cash flows for the old system:
• For the old system:
Year 0: -150000
• Initial cost: 150000
Year 1: 0
• Salvage value: 0 Year 2: 0
• Remaining useful life: 3 years Year 3: 0
• For the new system:
Calculate Present Values:
• Initial cost: 250000 Using the formula for present value:
PV = CF / (1 + r)^n
• Salvage value: 50000
Where:
• Useful life: 5 years
PV = Present Value
• Cash flows for the new system: CF = Cash Flow
r = Required rate of return
• Year 0: -250000
n = Time period
• Year 1: 0
Present value of each cash flow for the old system (r = 10%):
• Year 2: 0 Year 0: -150000 / (1 + 0.10)^0 = -150000
• Year 3: 0 Year 1: 0 / (1 + 0.10)^1 = 0

Year 2: 0 / (1 + 0.10)^2 = 0
• Year 4: 0
Year 3: 0 / (1 + 0.10)^3 = 0
• Year 5: 50000
• Present value of each cash flow for the new system (r = 10%):
Calculate Net Present Value (NPV):
• Year 0: -250000 / (1 + 0.10)^0 = -250000 NPV = Sum of Present Values of Cash Flows -
Initial Cost
• Year 1: 0 / (1 + 0.10)^1 = 0
• Year 2: 0 / (1 + 0.10)^2 = 0
For the old system: NPV = (-150000) + 0 + 0 + 0 -
• Year 3: 0 / (1 + 0.10)^3 = 0 (-150000) = 0
For the new system: NPV = (-250000) + 0 + 0 + 0
• Year 4: 0 / (1 + 0.10)^4 = 0
+ 0 + 31026.55 ≈ -218973.45
• Year 5: 50,000 / (1 + 0.10)^5 = 50,000 / 1.61051 ≈ 31,026.55
Since the NPV of the new system is negative (-218973.45), it means that the new system's expected cash flows do
not cover the initial investment and are not sufficient to generate a return greater than the required rate of return.
Therefore, the company should not replace the old system with the new one based on the NPV analysis.
Keep in mind that other factors like strategic alignment, technological advancements, and qualitative considerations
may also influence the decision-making process.
Real Options Analysis:
• This approach applies option pricing principles from finance to evaluate projects with uncertainty. It
considers the flexibility to adapt and change course as new information emerges.
• Real Options Analysis (ROA) is a decision-making framework used in finance and investment to evaluate
projects or investment opportunities that possess embedded "real options." These real options refer to the
strategic choices available to a business or investor regarding their investments, operations, or projects in
response to changing market conditions, uncertainty, and future developments. Unlike financial options,
which are tradable securities, real options are the non-financial choices that can affect the value of an
investment.
• The concept of real options emerged as a way to address the limitations of traditional discounted cash flow
(DCF) methods, which are commonly used to evaluate investment projects. DCF methods typically assume
that once an investment decision is made, it cannot be changed and that cash flows are certain and known.
However, in reality, managers often have flexibility to adapt and change their decisions based on new
information and changing market conditions.
• Real Options Analysis takes into account the flexibility to adjust or change investment decisions over time.
It involves estimating the value of real options within an investment by considering various factors, including:
• Timing Options: The option to delay or accelerate an investment decision based on the timing of market
developments.
• Expansion or Contraction Options: The option to expand or contract the scale of an investment based on
market conditions.
• Abandonment or Shutdown Options: The option to abandon or shut down an investment if it becomes
unprofitable or unfavorable.
• Switching Options: The option to switch between different lines of business or projects based on changing
circumstances.
• Growth Options: The option to invest in additional stages or phases of a project if the initial stages are
successful.
• The real options approach involves using various quantitative techniques to estimate the value of these
options and incorporating them into the investment evaluation process. Some common methods and
models used in Real Options Analysis include the Binomial Option Pricing Model, Black-Scholes Option
Pricing Model (adapted for real options), Decision Trees, Monte Carlo Simulation, and others.
• Real Options Analysis can provide a more nuanced understanding of the value of an investment opportunity,
especially in situations where uncertainty is high, and the ability to adapt to changing circumstances is
crucial. However, it's worth noting that implementing ROA can be complex and data-intensive, requiring
accurate estimates of various parameters and assumptions. As a result, it's often applied to significant
investment decisions where the potential benefits of incorporating real options outweigh the added
complexity.
• The choice of estimating model depends on the complexity of the project, the availability of data, and the
level of accuracy required in the economic evaluation. It's important to carefully select and apply the
appropriate model(s) to ensure that investment decisions are well-informed and aligned with the
organization's goals.
Risk and Risk Vs Returns
Risk is a fundamental concept in engineering economics. It refers
to the uncertainty and variability associated with the outcomes
of engineering projects, investments, or decisions. Understanding
and managing risk is crucial in making informed and responsible
economic decisions in engineering. Here, we'll explain in detail
the various aspects of risk related to engineering economics.
Types of Risk:
a. Business Risk: This arises from the inherent uncertainty in the market and industry conditions. Economic
fluctuations, changes in demand, and competitive pressures can all affect the financial performance of
engineering projects.
b. Technical Risk: Technical challenges, such as unexpected design flaws, technological obsolescence, or
equipment failures, can lead to cost overruns or project delays.
c. Operational Risk: This encompasses risks related to the day-to-day operations of a project, including factors
like labor strikes, supply chain disruptions, and regulatory changes.
d. Financial Risk: Financial risk refers to the potential impact of market fluctuations on project financing,
interest rates, and currency exchange rates.
e. Political and Regulatory Risk: Changes in government policies, regulations, or political instability can affect
engineering projects significantly, especially in sectors like energy, infrastructure, and construction.
f. Environmental and Social Risk: Increasingly, engineering projects are scrutinized for their environmental
and social impact. Failure to address these concerns can lead to reputational damage, legal liabilities, or
project cancellations.
Assessing Risk:
a. Probability and Impact: Risk assessment involves estimating the probability of various
risks occurring and evaluating their potential impact on project outcomes. This can be
done through quantitative methods, such as Monte Carlo simulations, or qualitative
methods, like expert judgment.
b. Sensitivity Analysis: Engineers often conduct sensitivity analyses to understand how

changes in key variables, like project cost or revenue, can impact the project's financial
viability.
c. Risk Registers: Maintaining a risk register helps in systematically identifying, assessing,

and managing risks throughout the project lifecycle. Each risk is typically assigned a
probability and impact rating.
Managing Risk:
a. Risk Mitigation: This involves taking proactive steps to reduce the probability or impact of identified
risks. Strategies can include design improvements, diversification, and contingency planning.
b. Risk Transfer: Sometimes, risks can be transferred to other parties through contracts, insurance, or
partnerships. For example, a construction company might transfer construction-related risks to a
subcontractor.
c. Risk Financing: Engineering projects may involve setting aside financial reserves or establishing
contingency budgets to cover unexpected costs associated with risk events.
d. Risk Acceptance: In some cases, risks may be deemed acceptable, especially if their probability and
impact are low, and the cost of mitigation outweighs the potential losses.
Decision-Making Under Risk:
a. Expected Value Analysis: Engineers often use expected value analysis to make decisions when faced
with multiple possible outcomes and their associated probabilities. This approach helps in selecting the
option with the highest expected value.
Example to calculate expected value:
Estimated potential profits for the new product line under two different scenarios:
1) 90% chance of moderate demand, which would result in an Rs. 50,000/- profit
2) 10% chance of low demand, which would result in an Rs. 10,000/- profit.
To use the Expected Value strategy, you would multiply each scenario's potential profit or loss by its
probability and add them together. In this case, the expected value of launching the new product line
would be:
Expected Value = (0.90 x Rs. 50,000) + (0.10 x Rs. 10,000) Expected Value = Rs. 46,000/-
The expected value of launching the new product line is Rs. 46,000/-, which is the sum of the potential
profits and losses weighted by their probabilities.
• b) Decision Trees: Decision trees are graphical representations of decision-making processes that
incorporate various decision points and potential outcomes, including risks and uncertainties.
c. Real Options Analysis: This approach extends decision-making to consider the flexibility to adjust or
abandon a project in response to changing conditions, allowing for more adaptive responses to risk.
Example:
A company is considering investing in the development of a new product. However, there is uncertainty
about the market demand for this product.
Option to Expand: The company has the option to expand production and marketing if the product proves
to be successful and demand increases.
Option to Abandon: If the product's demand is lower than expected, the company can choose to abandon
the project, saving the remaining investment costs.
In real option analysis, the company would consider the flexibility to expand or abandon based on the
actual market conditions that unfold over time.
Monitoring and Controlling Risk:
a. Continuous Monitoring: Risks should be continuously monitored throughout the

project's lifecycle. Regular reviews and updates to risk assessments and mitigation plans
are essential.
b. Risk Reporting: Transparent and regular communication of risk status to stakeholders

is crucial for maintaining trust and ensuring timely decision-making.
In conclusion, risk is a multifaceted aspect of engineering economics that engineers and

project managers must diligently assess, manage, and incorporate into decision-making
processes. It requires a combination of quantitative analysis, qualitative judgment, and
strategic planning to ensure the economic success and sustainability of engineering
projects.
Risk Vs Returns
In engineering economics, the concept of risk versus return is

essential in making decisions about investments, projects,
and resource allocation. This concept revolves around the
trade-off between the potential for higher returns and the
associated level of risk. Let's explore how risk and returns are
interconnected in engineering economics:
Risk:
Definition: Risk refers to the uncertainty and variability associated with the
outcomes of an investment or project. It encompasses the possibility of not
achieving the expected results, which can lead to financial losses or project failure.
Types of Risk: As mentioned earlier, there are various types of risk in engineering
economics, including business risk, technical risk, operational risk, financial risk,
political and regulatory risk, and environmental and social risk.
Sources of Risk: Risks can originate from factors such as economic conditions,
technology, project complexity, market competition, and external factors like changes
in laws and regulations.
Returns:
Definition: Returns represent the financial benefits or gains generated
from an investment or project. In engineering economics, returns can
include revenues, cost savings, increased efficiency, and other financial
benefits.
Depending on the nature of the investment or project, returns can be
calculated using various methods including net present value (NPV),
internal rate of return (IRR), return on investment (ROI), and payback
period.
`
Risk-Return Relationship:
There is generally a positive correlation between risk and potential returns in engineering economics.
This means that investments or projects with higher levels of risk often have the potential for greater
returns, and vice versa.
Higher-risk projects typically offer the possibility of higher financial rewards, but they also come with
a greater chance of financial loss or failure.
Balancing Risk and Return:
Engineering economists and project managers must carefully balance risk and return when making
decisions. The goal is to optimize the risk-return trade-off to maximize the overall value or benefit of a
project or investment.
The appropriate balance between risk and return depends on various factors, including the
organization's risk tolerance, financial constraints, strategic objectives, and the specific characteristics
of the project or investment.
Risk Management:
Engineering economics involves not only assessing and understanding risk but also implementing risk
management strategies. This includes risk mitigation, risk transfer, risk financing, and risk acceptance.
Effective risk management can help reduce the negative impact of unforeseen events and uncertainties on
the financial outcomes of engineering projects or investments.
Decision-Making:
In engineering economics, decision-making often involves evaluating multiple options and selecting the
one that offers the most favorable risk-return profile. This can be done through techniques such as NPV
analysis, IRR analysis, and sensitivity analysis, which consider both the potential returns and the associated
risks.
In summary, engineering economics recognizes that risk and returns are interrelated. Higher-risk projects
can offer the potential for higher returns, but they also carry a greater chance of financial setbacks.
Therefore, engineering economists and project managers must carefully assess, manage, and balance
these factors to make informed decisions that align with the organization's goals and risk tolerance.
Example: Renewable Energy Investment
Imagine a utility company is considering two different investment options for expanding its energy generation capacity:
Option A: Solar Power Plant
This option involves building a solar power plant with photovoltaic panels to generate electricity.
The technology is well-established and has a proven track record.
The investment is expected to have a moderate upfront cost.
The returns are relatively stable and predictable due to consistent sunlight levels in the region.
The risk associated with this investment is considered low
Option B: Experimental Tidal Energy Project

This option involves developing an experimental tidal energy project using cutting-edge technology to harness energy
from ocean tides.
The technology is relatively untested on a large scale, and there is limited historical data available.
The upfront investment cost is significantly higher than Option A.
The returns are potentially high if the technology succeeds and becomes a breakthrough in renewable energy.
The risk associated with this investment is considered high due to the uncertainty surrounding the technology's
performance, regulatory challenges, and construction difficulties related to the marine environment.
Risk versus Return Analysis:
Option A (Solar Power Plant):
Return: Predictable and moderate returns over time with a relatively low risk of significant financial loss.
Risk: Low due to the established technology and favorable environmental conditions.
Option B (Experimental Tidal Energy Project):

Return: Potentially high returns if the project succeeds and becomes a game-changer in renewable energy.
Risk: High due to the experimental nature of the technology, uncertainty about its performance, and the
substantial upfront investment.
Decision-Making:
The utility company must carefully evaluate the risk-return trade-off when deciding between Option A and
Option B:
If the company has a high-risk tolerance, a long-term perspective, and the financial resources to absorb
potential losses, it might choose Option B in the hope of reaping substantial rewards if the experimental
technology succeeds.
If the company prioritizes stability, a lower level of risk, and a quicker return on investment, it might opt for
Option A, which offers a more predictable and established path to returns.
In this example, the utility company's decision hinges on its risk appetite, financial capacity, and strategic
objectives. It illustrates the fundamental principle that higher potential returns often come with higher
associated risks, and engineering economists must carefully consider this trade-off when making investment
decisions in the field of renewable energy or any other engineering project.
Problem 1: Calculating Net Present Value (NPV) and Risk Assessment
You are considering two investment projects for your engineering company. Project A involves a conventional
manufacturing process with a moderate level of risk, while Project B involves a new and innovative technology with a higher
level of risk. The expected cash flows for both projects are as follows:
Project A: Project B:
Initial Investment: 5,00,000 Initial Investment: 7,50,000
Year 1 Cash Flow: 1,50,000 Year 1 Cash Flow: 1,00,000
Both projects have a discount rate of 10%. Calculate the NPV for each project and provide a risk assessment.
Solution:
First, calculate the NPV for both projects using the given cash flows and the discount rate (r = 0.10):
NPV of Project A:
NPV_A = -500000 + 150000/(1+0.10) + 200000/(1+0.10)^2 + 250000/(1+0.10)^3 + 300000/(1+0.10)^4
NPV_A ≈ 139917.35
NPV of Project B:
NPV_B = -750000 + 100000/(1+0.10) + 300000/(1+0.10)^2 + 500000/(1+0.10)^3 + 700000/(1+0.10)^4
NPV_B ≈ 147230.99
Now, let's assess the risk:
Project A has a lower initial investment and more predictable cash flows,
resulting in a positive NPV. It is considered a lower-risk project.
Project B has a higher initial investment and larger variability in cash flows, which
could result in a negative NPV if the expected cash flows are not realized. It is
considered a higher-risk project due to the uncertainty associated with the new
technology.
Problem 2: Sensitivity Analysis for a Project
You are evaluating an engineering project with an initial investment of

10,00,000 and expected cash flows of 3,00,000 per year for five years.
The discount rate is 12%. Perform a sensitivity analysis to determine
the project's NPV under different discount rates (r = 10%, 12%, and
14%).
Solution:
Calculate the NPV for the project under each discount rate:
NPV (r = 10%):
NPV_10% = -1000000 + 300,000/(1+0.10) + 300000/(1+0.10)^2 + 300000/(1+0.10)^3 +
300000/(1+0.10)^4 + 300000/(1+0.10)^5
NPV_10% ≈ 89319.47
NPV (r = 12%):
NPV_12% = -1000000 + 300,000/(1+0.12) + 300000/(1+0.12)^2 + 300000/(1+0.12)^3 +
300000/(1+0.12)^4 + 300000/(1+0.12)^5
NPV_12% ≈ 44516.53
NPV (r = 14%):
NPV_14% = -1000000 + 300000/(1+0.14) + 300000/(1+0.14)^2 + 300000/(1+0.14)^3 +
300000/(1+0.14)^4 + 300000/(1+0.14)^5
NPV_14% ≈ -2526.62
In this sensitivity analysis, you can see how changes in the discount rate impact
the project's NPV. At a discount rate of 12%, the project has a positive NPV,
indicating its economic viability. However, at a higher discount rate of 14%, the
NPV becomes negative, suggesting that the project may not be financially
feasible. This analysis helps in understanding how sensitive the project's
profitability is to changes in the discount rate, which is a crucial risk factor.
Indian Industries
138
Indian Industries: Introduction
139
Indian Industries- Development
Indian industrial landscape is continually evolving, and future progress will depend on a multitude of factors,
including government policies, global economic conditions, and technological advancements.
Pre-Independence Era: The early stages of industrialization in India were primarily focused on the establishment of
industries for raw material processing and export-oriented industries like textiles, jute, tea, and mining.
Import Substitution Industrialization (ISI) (1950s-1980s): After independence, India adopted a policy of import substitution to
promote domestic industries. The government imposed high tariffs and restricted imports of certain goods to encourage local
production and reduce dependency on foreign imports.
Mixed Economy and Licensing Raj: During this period, India adopted a mixed economy approach with a combination of private
and public sectors. However, the government heavily controlled and regulated the private sector through the licensing system,
which often led to bureaucratic red tape and inefficiencies.
Economic Liberalization (1990s-present): In 1991, India initiated economic reforms and liberalization to open up the economy to
foreign investments and reduce government control over industries. This policy shift aimed to enhance competitiveness,
improve productivity, and attract foreign direct investment (FDI).
Information Technology and Services Sector: India's industrialization also witnessed a significant shift towards the information
technology (IT) and services sector. India became a global hub for IT services, software development, and business process
outsourcing (BPO).
Special Economic Zones (SEZs): The government of India established Special Economic Zones to attract foreign investment
and promote exports. These SEZs offer various incentives and tax benefits to industries, making them attractive destinations for
manufacturing and export-oriented businesses.
140
Indian Industries- Types
141
142
IT and Software Services
India's IT and software services sector experienced exponential growth, becoming a global hub for software
development, IT outsourcing, and business process outsourcing (BPO). Cities like Bengaluru, Hyderabad, and Pune
emerged as major technology hubs, attracting multinational corporations and contributing significantly to the country's
export earnings.
Automobile Industry
The Indian automobile industry also witnessed remarkable growth, with both domestic and international
players establishing manufacturing facilities in the country. This sector not only met the growing domestic demand but
also became an export-oriented industry.
Service Sector Dominance:
The service sector emerged as the dominant contributor to India's Gross Domestic Product (GDP). Apart from IT
services, other service industries such as banking, finance, insurance, healthcare, tourism, and entertainment
grew substantially, creating significant employment opportunities.
143
Labour Policies
• The Constitution of India under Article 41 directs the state to ensure public assistance in cases of
unemployment, old age, sickness, and disablement, highlighting the government's responsibility towards the
welfare of workers.
• The Industrial Disputes Act, 1947, governs the resolution of industrial disputes, layoff, retrenchment, and related
matters. It aims to promote industrial peace and safeguard the interests of both employers and employees.
• The Minimum Wages Act, 1948, ensures that workers are paid a minimum wage, preventing exploitation
and improving their standard of living.
• The Factories Act, 1948, regulates the working conditions and safety standards in factories, ensuring the well-
being of industrial workers.
• The Maternity Benefit Act, 1961, provides maternity benefits to female employees, including paid leave
during pregnancy and after childbirth.
• The Employees' Provident Fund Organization (EPFO) manages the Employee Provident Fund (EPF), a retirement
savings scheme for employees across various sectors.
144
Labour Problems
Informal Sector: A significant portion of India's workforce is employed in the informal sector, lacking job security, social benefits, and legal
protections. This makes them vulnerable to exploitation and low wages.
Unemployment: India faces persistent issues of unemployment, especially among the youth. Rapid population growth and a mismatch
between education and job requirements contribute to this problem.
Child Labour: Despite legislative measures, child labour remains a concern in India, particularly in sectors like agriculture, domestic
work, and small-scale industries.
Exploitation and Low Wages: Many workers, especially in unorganized sectors, endure long working hours, low wages, and poor working
conditions.
Occupational Health and Safety: Safety standards in various industries often fall short, leading to accidents and health issues for
workers.
Contractual Employment: The prevalence of contract-based employment can lead to job insecurity and reduced access to benefits like
health insurance or retirement plans.
Trade Union Challenges: While trade unions play a crucial role in advocating for workers' rights, some challenges include political
affiliations, fragmented unionization, and occasional conflicts with employers.
Gender Inequality: Women often face discrimination and wage disparity in the workforce, making it challenging for them to access equal
opportunities and growth.
145
Unorganized Sector
This sector comprises a wide range of economic activities, including small-scale enterprises, casual laborers,
self-employed individuals, and household-based industries. It plays a crucial role in India's economy,
accounting for a substantial share of employment and economic output.
Key characteristics of the unorganized sector in India include:
Lack of formal registration: Many businesses and workers in the unorganized sector are not registered with
any government authority. This informal nature makes it challenging to track their activities accurately.
Limited legal protection: Workers in the unorganized sector often do not enjoy the same legal protections
and social security benefits as formal employees, leaving them vulnerable to exploitation and economic risks.
Low wages and job insecurity: Jobs in the unorganized sector are often characterized by low wages and irregular
working hours, leading to financial instability for workers and their families.
Informal work arrangements: In this sector, contracts are often verbal or based on informal arrangements,
leading to uncertain working conditions.
146
Unorganized Sector
Small-scale enterprises: The unorganized sector includes numerous small-scale businesses and micro-enterprises,
often operating in sectors like agriculture, construction, street vending, domestic work, and various informal services.
Lack of access to credit and resources: Businesses in the unorganized sector may face difficulties in accessing formal
credit and resources due to their informal nature, limiting their growth potential.
Importance in rural and urban areas: The unorganized sector is present both in rural and urban areas,
contributing significantly to the economy of India.
The unorganized sector has both positive and negative implications for the Indian economy. On one hand, it provides
employment opportunities to a vast segment of the population and contributes to the country's economic growth. On
the other hand, the lack of regulation and social security can lead to issues like income inequality, exploitation of
workers, and limited productivity.
147
Thank you
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Engineering Economics

1. Understand various economic decision-making concepts applicable to engineering.

T1. R. Panneerselvam, Engineering Economics, Prentice Hall of India.

T3. P.L. Mehta, Managerial Economics, Sultan Chand & Sons.

• A household faces many decisions.

• Like a household, society faces many decisions.

• The management of society’s resources is important because resources are scarce.

• Economics is the study of how society manages its scarce resources.

Economics - defined in simple terms as “The science of the useful

Other definitions under different contexts:

• J. E. Cairnes - Science of Wealth / Study of wealth

• Marshall - Science of Material Welfare – Study of man’s actions in the

The above definitions give importance to wealth in the study of

• Robbins - Science of Scarcity or Science of Choice – Study of human behavior as a

• Modern definition – J. M. Keynes: Economics is the Study of the administration of

Following are the economic goals.

• Engineering - “is that profession in which the knowledge of

• Engineering Economics - deals with decisions to be taken based on

• Engineering Economics deals with systematic evaluation of the costs &

• PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES: Because people make decisions by

PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF

PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC

PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET

PRINCIPLE #8: A COUNTRY’S STANDARD OF LIVING DEPENDS ON ITS ABILITY

PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF BETWEEN

Theory of demand and supply analysis

Desire? Ability? Willingness?

Desire There are three important points to remember

Demand o Thirdly, the quantity demanded will have an

o Variables are dated o According to some economists, even if the variables

Price Per # of CDs 30

P= Price QD= Quantity Demanded

o A demand function can be shown as:

o Size of the population: All other factors

o Income distribution: : People in different

Theory of demand and supply analysis

o The demand curve graphically shows

Price Effect: Price Effect is the sum total of the substitution

o It is important to note that the substitution

Ø A producer aims to maximize profits

1. Price of the commodity supplied

• When there is an increase in unit tax on the production of goods by

the government, the unit cost of production will rise and

would shift to the left.

Supply equation: P = ½(X + 5) When a subsidy is granted on the commodity, the

So, with the subsidy granted, the new price is

Supply equation: Qs = 50 +15P Given;

Find the equilibrium quantity

4P = 24 – 3Q ØWhen a tax is imposed on the commodity, the

• The selling price of a product is derived as shown below:

This point is also called the no-loss or no-gain

For any production quantity which is more than

P/V ratio is a valid ratio which is useful for further analysis.

Cost Estimation Example

EOQ = (2 ∗ 𝐷 ∗ 𝑆)/(𝐻 ∗ %𝐶𝐶)

Q-1: You are considering an

Ans: NPV = -22578.67

• Initial Investment: -3,00000 (outflow)

• End of Year 1: 1,00000 (inflow)

• End of Year 2: 1,00000 (inflow)