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CH 27 Basic Engineering Economics

- Engineering economics helps analyze capital budgeting decisions by evaluating investment alternatives. - Key topics include time value of money concepts like simple and compound interest, present and future value, discount rates, and minimum attractive rates of return. - Methods like present worth, future worth, and annual worth use discounting factors to evaluate the equivalent worth of cash flows over time for decision making.

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Ahmed Assaf
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28 views15 pages

CH 27 Basic Engineering Economics

- Engineering economics helps analyze capital budgeting decisions by evaluating investment alternatives. - Key topics include time value of money concepts like simple and compound interest, present and future value, discount rates, and minimum attractive rates of return. - Methods like present worth, future worth, and annual worth use discounting factors to evaluate the equivalent worth of cash flows over time for decision making.

Uploaded by

Ahmed Assaf
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter

h 27
Basic Engineering Economics
Introduction

• Engineering economics helps in finding solutions


for capital budgeting decisions.
• It helps in selecting the best investment decision
by analyzing alternatives.
alternatives
Learning Objectives

• Calculate simple and compound interest


• Solve interest problem using
– Single payment
– Uniform payment
– Gradient formulae
• Calculate
– Present value
– Future value
– Equivalent uniform annual value of a cash flow series
– Determine discounted rate of return of a cash flow series
Equivalence

• Alternatives can only be compared at a common


interest rate.
INDIFFERENCE

USD 100 USD 110


NOW AFTER 1 YEAR

Two Sum of money are equivalent at an interest rate of 10%


Key Topics
Key Topics

• Time Value of Money


– Since money is a valuable asset
asset, people are willing to
pay to have it available for their use.
– With money, the charge for its use is called interest.
Simple Interest
• Simple Interest is calculated only on the principal, or on
that portion of the principal which remains unpaid.
unpaid
• For example, imagine Jim borrows $23,000 to buy a car,
and simple interest is charged at a rate of 6% per
annum. After three years, and assuming none of the
loan has been ppaid off,, Jim owes: $27,140
$ ,

PRINCIPAL $23000 A = P x ( r /100 ) x n


Interest accrued EOY1 1380 A is the amount of interest
Interest accrued EOY2 1380
Interest accrued EOY3 1380 P the principal
r the
th interest
i t t rate
t as a percentage
t
Total $27,140 n the number of time periods
Compound Interest
• Compound Interest is very similar to Simple
Interest however,
Interest, however as time continues the
difference becomes considerably larger.
• The
h conceptuall difference
d ff is that
h the
h principall
changes with every time period, as any interest
incurred
d over the
h periodd is added
dd d to the
h
principal.
PRINCIPAL $23000
Interest accrued EOY1 1380 Find F Given P
New Principal with accrued Interest $24380
Interest accrued EOY2 1463 P(F/P,i,n)
New Principal with accrued Interest $25843 F is the Future Value
Interest accrued EOY3 1550 i the interest rate as a percentage
n the number of time periods
Total $27393
Nominal and Effective Interest Rate
• The nominal interest rate is the periodic interest rate
times the number of periods per year; for example, a
nominal annual interest rate of 12% based on monthly
compounding means a 1% interest rate per month.
• The effective interest rate is always calculated as if
compounded annually. The effective rate is calculated in
the following way, where r is the effective rate, i the
nominall rate, and
d n the
h number b off compounding
d periodsd
per year (for example, 12 for monthly compounding):
• r = (1+i/n)n‐1
1
Example
• Given an interest rate of 12 percent, find the
effective and annual rate for yearly, semi‐annual,
and monthly compounding.
For yearly compounding the annual rate is same of 12%

For semi‐annual compounding For monthly compounding


 r = (1+i/n)n‐1  r = (1+i/n)n‐1

 r = (1+.12/2)2‐1  r = (1+.12/12)12‐1

 r = 12.4%  r = 12.7%
MARR
• Minimum Attractive Rate of Return (Hurdle Rate)
– The hurdle rate, also known as the cost of capital, is a minimum rate
of return that must be met for a company to undertake a particular
project.
– The hurdle rate is usually determined by evaluating existing
opportunities in operations expansion, rate of return for
investments, and other factors deemed relevant by management.
• For e.g.,
g , A firm has compiled
p the followingg data:
– Cost of borrowed money, loan A = 9 Percent
– Investment Opportunity, Project B = 16 Percent; and
– Cost of capital = 20 Percent
The MARR should be equal to or greater than the highest of the three values.
Measures of Equivalent Worth

• Present Worth
• Future Worth
• Annual Worth
Present Worth

Yr Expense Income Net Factor P


• The present worth of a cash flow can
be computed given a lump‐sum
(38,000) 0 (38000) 1.000 (38000)
future value, a uniform series, or an 0
arithmetic gradient series.
• For example 1 0 11000 11,000 .9434 10,377

– A contractor is considering the


acquisition of a piece of equipment 2 (1000) 11000 10,000 .8900 8,900
with anticipated financial impact as
shown in the following table. If the
contractors MARR is 6%, should the 3 (2000) 11000 9,000 .8396 7,556
investment be made?

4 (3000) 11000 8,000 .7921 6,337

($4830)
Present worth – Discount Factor

P = P0+P1+P2

P1 = ‐G(P/G,I,n) = ‐1,000(P/G,6%,4) = ‐ 4,945


P2= A(P/A,I,n) = 11,000(P/A,6%,4)=38,115
P=‐38,000 ‐ 4,945+38,115 = ‐ $4,830
$
Future Worth

• The future worth method uses Yr Net Factor F


the end of the planning horizon
as a reference point. Typical ($38000) 1 262
1.262 ($47956)
applications would include 0

investment growth and 1 11,000 1.191 13101


equipment replacement costs.
2 10,000 1.124 11240

3 9,000 1.060 9540

4 8,000 1.000 8000

($6075)

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