Chapter 1

Foundations Of
Engineering
Economy

Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

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Textbook: Engineering Economy, 7th edition , Leland T. Blank and
Anthony J. Tarquin, McGraw-Hill

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 LEARNING OUTCOMES

1. Role in decision
7. Economic equivalence
making
8. Simple and compound
2. Study approach
interest
3. Ethics and economics
9. Minimum attractive
4. Interest rate rate of return
5. Terms and symbols 10. Spreadsheet
functions
6. Cash flows

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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
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Steps in an
Engineering
Economy
Study

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 Decision making is a broad topic, for it is a major aspect of
everyday human existence.

 There are lots of problems in the world:

1) Simple Problems
 Should I pay or use credit?
Shall we replace a burned-out motor?
 If we use three crates of an item a week, how many crates
should we buy at a time?

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2) Intermediate Problems (mainly economic)
 Which equipment should be selected for a new assembly line?
 Which materials should be used as roofing, siding, and structural
support for a new building?
 Which printing press should be purchased? A low cost press
requiring three operators, or a more expensive one needing only two
operators?

3) Complex Problems (mixture of economic, political, and social)

 The decision of Mercedes Benz to build an automobile assembly
plant in Tuscaloosa, Alabama.
 Setting the annual budget for a corporation.

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 Examples of Engineering Economic
Analysis
 Which engineering projects are worthwhile?

 Which engineering projects should have a higher priority?

 How the engineering project should be designed?

 How to achieve long-term financial goals?

 How to compare different ways to finance purchases?

 How to make short and long-term investment decisions?

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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
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 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 individual)

 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
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 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
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 The Big Picture
Engineering economy is at the heart of making
decisions.
These decisions involve the fundamental elements of
cash flows of money, time and interest rates.
Chapter 1 introduces the basic concepts and
terminology necessary for an engineer to combine
these three essential elements in organized,
mathematically correct ways to solve problems that
will lead to better decisions.

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 Ethics – Different Levels
 Universal morals or ethics – Fundamental
beliefs: stealing, lying, harming or murdering
another are wrong
Personal morals or ethics – Beliefs that an
individual has and maintains over time; how a
universal moral is interpreted and used by
each person
 Professional or engineering ethics – Formal
standard or code that guides a person in work
activities and decision making

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 Code of Ethics for Engineers
All disciplines have a formal code of ethics. National Society of
Professional Engineers (NSPE) maintains a code specifically for
engineers; many engineering professional societies have their own code

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 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

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 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

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Interest paid Interest earned

Interest rate Rate of return

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 Interest – Example [1]
An employee borrows $10,000 on May 1 and must
repay a total of $10,700 exactly 1 year later

Determine the interest amount and interest rate

paid

Interest amount = $10,700 - $10,000 = $700

Interest rate = $700/$10,000 = 7% per year 1-18

 Interest – Example [2]
 A company plans to borrow $20,000 from a bank for one
year at 9% interest for a new recording equipment

 Compute the interest and the total amount due after 1

year

 The total interest accrued:

Interest = $20,000 × 0.09 = $1,800

 The total amount due is the sum of principal and interest:

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

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 Interest – Example [3]
 Calculate the amount deposited one year ago to have
$1,000 now at an interest rate of 5% per year
The total amount accrued ($1,000) is the sum of the
original deposit and the earned interest. If “y” is the
original deposit then,

Total amount accrued = original + original × interest rate

$1,000 = y + y(0.05) which gives a value of y = $952.38

 Calculate the amount of interest earned during this time

period
Interest = $1,000 – 952.38 = $47.62
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 Interest – Example [4]
 Calculate the amount deposited one year ago to have
$1,000 as a net benefit now at an interest rate of 5% per
year
The total amount accrued after one year of deposition
equals the sum of the original deposit and the earned
interest. If “y” is the original deposit then,

Total amount accrued = original + original × interest rate

y + 1,000 = y + y(0.05) which gives a value of y $20,000

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Cash Flows

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 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
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 Parameters and Cash Flows
•Parameters
•First cost (investment amounts)
•Estimates of useful or project life
•Estimated future cash flows (revenues and expenses and
salvage values)
•Interest rate

•Cash Flows
•Estimate flows of money coming into the firm – revenues,
salvage values, etc. – positive cash flows--cash inflows
•Estimates of investment costs, operating costs, taxes paid –
negative cash flows -- cash outflows

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The Cash Flow Diagram: CFD

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 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

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 Cash Flow Diagrams
What a typical cash flow diagram might look like
Draw a time line Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period
F = $100
Show the cash flows (to approximate scale)

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $-80
- (down) for outflow
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 Cash Flow Diagram Example
Plot observed cash flows over last 8 years and estimated sale next
year for $150.

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 Cash Flow Diagram Example
Plot observed cash flows over last 8 years and estimated sale next
year for $150.

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 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

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

$20,000 is
received here

T=0 t = 1 Yr

$21,800 paid
back here
$20,000 now is economically equivalent to $21,800 one year from now IF the interest rate is set to equal to
?
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 Equivalence Illustrated
•$20,000 now is not equal in magnitude to $21,800 1
year from now
•But, $20,000 now is economically equivalent to $21,800
one year from now if the interest rate in 9% per year.
•To have economic equivalence you must specify:
•timing of the cash flows
•interest rate (i% per interest period)
•Number of interest periods (N)

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 Economic Equivalence
 For example, if the interest rate is 6% per year, $100 today
(present time) is equivalent to $106 one year from today

 So, if someone offered you a gift of $100 today or $106 one year
from today, it would make no difference from an economic
perspective

 The two sums of money are equivalent to each other only when
the interest rate is 6% per year

 That is, at a higher or lower interest rate, $100 today is not

equivalent to $106 one year from today

 The same concept applies a year ago, that is a total of $100

today is economically equivalent to $100/1.06 = $94.34
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 Simple and Compound Interest

•Two “types” of interest calculations

• Simple Interest
• Compound Interest
•Compound Interest is more common worldwide
and applies to most analysis situations

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 Simple and Compound Interest
• Simple Interest is calculated on the principal amount
only
•Easy (simple) to calculate
•Simple Interest is:
•(principal)(interest rate)(time); $I = (P)(i)(n)
• Borrow $1000 for 3 years at 5% per year
• Let “P” = the principal sum
• i = the interest rate (5%/year)
• Let N = number of years (3)

•Total Interest over 3 Years...

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 For One Year
•$50.00 interest accrues but not paid
•“Accrued” means “owed but not yet paid”
•First Year:
P=$1,000

1 2 3

I1=$50.00

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 End of 3 Years

•$150 of interest has accrued

P=$1,000

1 2 3

I1=$50.00 I2=$50.00 I3=$50.00

Pay back $1000

+ $150 of
interest
The unpaid interest did not earn
interest over the 3-year period

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 Simple Interest – Example
 A company loaned money to an engineering staff member for a radio-
controlled model airplane. The loan is for $1,000 for 3 years at 5% per
year simple interest

 How much money will the engineer repay at the end of 3 years?

 The interest for each of the 3 years is:

Interest per year = $1,000 × 0.05 = $50
Total interest for 3 years is $1,000 × 0.05 × 3 = $150
The amount due after 3 years is $1,000 + $150 = $1,150

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 Simple Interest – Example
 The $50 interest accrued in the first year and the $50
accrued in the second year do not earn interest

 The interest due each year is calculated only on the

$1,000 principal
End of Amount Interest Amount Amount
Year Borrowed Owed Paid
0 $1,000 0 0 0
1 - $50 $1,050 0
2 - $50 $1,100 0
3 - $50 $1,150 $1,150
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 Compound Interest – Example
 If an engineer borrows $1,000 at 5% per year compound interest,
compute the total amount due after 3 years

 The interest and total amount due each year are computed:

 Year 1 interest: $1,000 × 0.05 = $50.00

Total amount due after year 1 = $1,000 + $50 = $1,050

Year 2 interest: $1,050 × 0.05 = $52.50

Total amount due after year 2 = $1,050 + $52.5 = $1,102.50

Year 3 interest: $1,102.5 × 0.05 = $55.13

Total amount due after year 3 = $1,102.5 + $55.13 = $1,157.63
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 Compound Interest – Example
 The $50 interest accrued in the first year and the $50
accrued in the second year do not earn interest

 The interest due each year is calculated only on the

$1,000 principal
End of Amount Interest Amount Amount
Year Borrowed Owed Paid
0 $1,000 0 0 0
1 - $50 $1,050 0
2 - $52.5 $1,102.5 0
3 - $55.13 $1,157.63 $1,157.63
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 Example [1]
Time Value of Money
 You have $1,000 and you want to buy a $1,000 machine

 Suppose that you can invest money at 6% interest, but

the price of the machine increases only at an annual rate
of 4% due to inflation. After a year, you can still buy the
machine and you will have $20 left over (earning power
exceeds inflation)

 If the price of the machine increases at an annual rate of

8% instead, you will not have enough money to buy the
machine a year from today. In this case, it is better to buy
it today (inflation exceeds earning power)

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 Example [2]
The Concept of Equivalence
 Demonstrate the concept of equivalence using the different loan
repayment plans described below. Each plan repays a $5,000 loan
in 5 years at 8% interest per year

 Plan 1: Simple interest, pay all at end. No interest or principal is

paid until the end of year 5. interest accumulates each year on the
principal only
 Plan 2: Compound interest, pay all at end. No interest or principal
is paid until the end of year 5. interest accumulates each year on
the total of principle and all accrued interest
 Plan 3: Simple interest paid annually, principal repaid at end. The
accrued interest is paid each year, and the entire principal is
repaid at the end of year 5
 Plan 4: Compound interest and portion of principal repaid
annually. The accrued interest and one-fifth of the principal is
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 Payment Plan

End of Amount Interest Amount Amount

Year Borrowed Owed Paid
0
1
2
3
4

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 Example [2]
The Concept of Equivalence – Plan 1

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 Example [2]
The Concept of Equivalence – Plan 2

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 Example [2]
The Concept of Equivalence – Plan 3

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 Example [2]
The Concept of Equivalence – Plan 4

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 Terminology and Symbols
P = value or amount of money at a time designated as
the present or time 0.
F = value or amount of money at some future time.
A = series of consecutive, equal, end-of-period amounts
of money.
n = number of interest periods; years
i = interest rate or rate of return per time period;
percent per year, percent per month
t = time, stated in periods; years, months, days, etc

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 P and F

• The symbols P and F represent one-time occurrences:

•It should be clear that a present value P represents a single sum
of money at some time prior to a future value F

$F

0 1 2 … … n-1 n

$P
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 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 1-53
 Cost of Capital ( WACC )

Suppose the Alpha Company has a capital structure composed of the

following, in millions:

 Debt = 10
 Common equity = 40

f the cost of debt is 9%, the cost of equity is 15%,

what is Alpha’s weighted average cost of capital?

Solution:
WACC = [(0.20)(0.09) + [(0.8)(0.15)]
= 0.018 + 0.120
= 0.138, or 13.8%
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 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

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 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

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 Rule of 72’s for Interest

• A common question most often asked by

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

• The Rule of 72 states:

•The approximate time for an investment to
double in value given the compound interest
rate is:
•Estimated time (n) = 72/i
•For i = 13%: 72/13 = 5.54 years
 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
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 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

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 Chapter Summary
 Engineering Economy fundamentals
 Time value of money
 Economic equivalence
 Introduction to capital funding and MARR
 Spreadsheet functions
 Interest rate and rate of return
 Simple and compound interest

 Cash flow estimation

 Cash flow diagrams
 End-of-period assumption
 Net cash flow
 Perspectives taken for cash flow estimation
 Ethics
 Universal morals and personal morals
 Professional and engineering ethics (Code of Ethics)
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 Assignment no. 1
Chapter 1
Q. no.1, 4, 7, 10, 13, 16, 19, 22, 25

Total Marks : 10
Submission : In the next class
( no late submission )

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