1-Fundamental Concepts

BES EE- Engineering Economy
Foundations of
Engineering Economy
Lecture 1:
1.Role in decision making
2.Study approach
3.Ethics and economics
4.Interest rate
5.Terms and symbols
LEARNING OUTCOMES 6.Cash flows
7.Economic equivalence
8.Simple and compound interest
9.Minimum attractive rate of return
10.Spreadsheet functions
WHY ENGINEERING ECONOMY IS
IMPORTANT TO ENGINEERS
 Engineers design and create

 Designing involves economic decisions
 Engineers must be able to incorporate economic analysis into their creative
efforts
 Often engineers must select and implement from multiple alternatives
 Understanding and applying time value of money, economic equivalence, and
cost estimation are vital for engineers
 A proper economic analysis for selection and execution is a fundamental task of
engineering
Time Value of Money (TVM)
Description: TVM explains the change in the amount of money over time for funds
owed by or owned by a corporation (or individua)l.
– Corporate investments are expected to earn a return

– Investment involves money
– Money has a ‘time value’
The time value of money is the most important concept in engineering

economy.
Engineering Economy
• Engineering Economy involves

– Formulating
– Estimating, and
– Evaluating
expected economic outcomes of alternatives designed to accomplish a defined
purpose
• Easy-to-use math techniques simplify the evaluation
• Estimates of economic outcomes can be deterministic or stochastic in nature
General Steps for Decision Making Processes
1. Understand the problem – define objectives

2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply sensitivity analysis
6. Select the “best” alternative
7. Implement the alternative and monitor results
Steps in an Engineering
Economy Study
Ethics – Different Levels
 Universal morals or ethics – Fundamental beliefs: stealing, lying, harming or

murdering another are wrong
Personal morals or ethics – Beliefs that an individual has and maintains over time;
how a universal moral is interpreted and used by each person
 Professional or engineering ethics – Formal standard or code that guides a person in
work activities and decision making
CODE OF ETHICS FOR AGRICULTURAL AND
BIOSYSTEMS ENGINEERS
https://drive.google.com/file/d/1nTUz9wgZp657xxTANJNuFp_HhGh_Sfup/view?usp
=sharing
All disciplines have a formal code of ethics. The Philippine Society of Agricultural
and Biosystem Engineers (PSABE) maintains a code specifically for agricultural and
biosystems engineers; many engineering professional societies have their own
code.
Interest and Interest Rate
• Interest – the manifestation of the time value of money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money and a beginning amount of
money
 Interest = amount owed now – principal
• Interest rate – Interest paid over a time period expressed as a percentage of principal

Rate of Return
• Interest earned over a period of time is expressed as a percentage of
the original amount (principal)
interest accrued per time unit

Rate of return (%) = x 100%
original amount
 Borrower’s perspective – interest rate paid

 Lender’s or investor’s perspective – rate of return earned
1-12
Interest rate Rate of return

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

P = value or amount of money at a time t designated as present or time 0
F = value or amount of money at some future time, such as at t = n periods in
the future
A = series of consecutive, equal, end-of-period amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period; percent per year or month
Cash Flows: Terms
• Cash Inflows – Revenues (R), receipts, incomes, savings generated by projects
and activities that flow in. Plus sign used.
• Cash Outflows – Disbursements (D), costs, expenses, taxes caused by projects
and activities that flow out. Minus sign used.
• Net Cash Flow (NCF) for each time period:

NCF = cash inflows – cash outflows = R – D
• End-of-period assumption:
Funds flow at the end of a given interest period
Cash Flows: Estimating
 Point estimate – A single-value estimate of a cash flow element of an alternative

Cash inflow: Income = ₱150,000 per month
 Range estimate – Min and max values that estimate the cash flow
Cash outflow: Cost is between ₱2.5 M and ₱3.2 M
Point estimates are commonly used; however, range estimates with probabilities
attached provide a better understanding of variability of economic parameters
used to make decisions
Cash Flow Diagrams
What a typical cash flow diagram might look like
Always assume end-of-period cash flows
Time
0 1 2 … … … n-1 n
One time
period
F = ₱100
0 1 2 … … … n-1
n Cash flows are shown as directed arrows: + (up) for inflow
P = ₱-80 - (down) for outflow
Cash Flow Diagram
Example
Plot observed cash flows over
last 8 years and estimated sale
next year for ₱150. Show 1-17
present worth (P) arrow at
present time, t = 0
Economic Equivalence
Definition: Combination of interest rate (rate of return) and time value of

money to determine different amounts of money at different points in
time that are economically equivalent
How it works: Use rate i and time t in upcoming relations to move money
(values of P, F and A) between time points t = 0, 1, …, n to make them
equivalent (not equal) at the rate i
Example of Equivalence
₱110
Different sums of money at different times may be
equal in economic value at a given rate
Year
0 1
Rate of return = 10% per year
₱100 now
₱100 now is economically equivalent to ₱110 one year from now, if the ₱100 is invested at a
rate of 10% per year.
Simple and Compound Interest
• Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = Pni
Example: ₱100,000 lent for 3 years at simple i = 10% per year. What is repayment after 3
years?
Interest = 100,000(3)(0.10) = ₱30,000
Total due = 100,000 + 30,000 = ₱130,000
Simple and Compound Interest
• Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time
Interest = (principal + all accrued interest) (interest rate)

Interest for time period t is
Compound Interest Example
Example: ₱100,000 lent for 3 years at i = 10% per year compounded. What is
repayment after 3 years?
Interest, year 1: I1 = 100,000(0.10) = ₱10,000

Total due, year 1: T1 = 100,000 + 10,000 = ₱110,000
Interest, year 2: I2 = 110,000(0.10) = ₱11,000
Total due, year 2: T2 = 110,000 + 11,000 = ₱121,000
Interest, year 3: I3 = 121,000(0.10) = ₱12,100
Total due, year 3: T3 = 121,000 + 12,100 = ₱133,100
Compounded: ₱133,100 Simple: ₱130,000

Minimum Attractive Rate
of Return
 MARR is a reasonable rate of return (percent)

established for evaluating and selecting
alternatives
 An investment is justified economically if it is
expected to return at least the MARR
 Also termed hurdle rate, benchmark rate and
cutoff rate
MARR Characteristics
• MARR is established by the financial managers of the firm

• MARR is fundamentally connected to the cost of capital
• Both types of capital financing are used to determine the weighted average cost
of capital (WACC) and the MARR
• MARR usually considers the risk inherent to a project
Types of Financing
• Equity Financing –Funds either from retained earnings, new stock issues, or
owner’s infusion of money.
• Debt Financing –Borrowed funds from outside sources – loans, bonds,
mortgages, venture capital pools, etc. Interest is paid to the lender on these funds
For an economically justified project
ROR ≥ MARR > WACC

Opportunity Cost
 Definition: Largest rate of return of all projects not accepted (forgone) due to a
lack of capital funds
 If no MARR is set, the ROR of the first project not undertaken establishes the
opportunity cost
Example: Assume MARR = 10%. Project A, not funded due to lack of funds, is
projected to have RORA = 13%. Project B has RORB = 15% and is funded because it
costs less than A
Opportunity cost is 13%, i.e., the opportunity to make an additional 13% is forgone
by not funding project A
Introduction to Spreadsheet Functions
 EXCEL FINANCIAL
FUNCTIONS
Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%,second_cell:last_cell) + first_cell
Example: Estimates are P = ₱5000 n = 5 years i = 5% per year

Find A in ₱ per year
Function and display: = PMT(5%, 5, 5000) displays A = ₱1154.87
 Engineering Economy fundamentals
–Time value of money
–Economic equivalence
–Introduction to capital funding and MARR
–Spreadsheet functions
Chapter  Interest rate and rate of return
–Simple and compound interest
Summary  Cash flow estimation
–Cash flow diagrams
–End-of-period assumption
–Net cash flow
–Perspectives taken for cash flow estimation
 Ethics
–Universal morals and personal morals
–Professional and engineering ethics (Code of Ethics)

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BES EE- Engineering Economy

 Engineers design and create

– Corporate investments are expected to earn a return

The time value of money is the most important concept in engineering

• Engineering Economy involves

1. Understand the problem – define objectives

 Universal morals or ethics – Fundamental beliefs: stealing, lying, harming or

interest accrued per time unit

 Borrower’s perspective – interest rate paid

Interest rate Rate of return

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

• Net Cash Flow (NCF) for each time period:

 Point estimate – A single-value estimate of a cash flow element of an alternative

Definition: Combination of interest rate (rate of return) and time value of

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

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

Compounded: ₱133,100 Simple: ₱130,000

 MARR is a reasonable rate of return (percent)

• MARR is established by the financial managers of the firm

For an economically justified project

ROR ≥ MARR > WACC

Example: Estimates are P = ₱5000 n = 5 years i = 5% per year

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