Engineering Economy

Learning Outcomes
• Terminologies Cont.

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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
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Cash Flow Diagram

Future cash inflows

time

Future cash outflows

Present

It is a graphical representation of cash flows drawn on

the y axis with a time scale on the x axis.

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 Cash Flow Diagram

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

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Cash Flow Diagram

Example Cash Flow Diagram

60

40
Annual benefits
20

Now
0

0 1 2 3 4 5 6
-20

-40
End of
period 1 End of
-60
period 4
-80

-100

Initial investment
-120

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 Different payment types
• Single amount, (P,F). That is, when only one
payment or receipt is involved.
• Uniform series, (A). Uniform amount received or
paid out each compounding period, otherwise it
will be handled as single payments.
• Arithmetic gradient, (G). It is a cash
flow series that either increases or
decreases by a constant amount with
symbol G.
• Geometric gradient, (g). It is a cash flow
series that either increases or decreases
from period to period by a constant
percentage with symbol of g

Symbols
• P= Present value, principle amount
(Today's Dollars)
• F= Future value (Tomorrow’s Dollars)
• n = Number of compounding periods
between “present” and “future”
• A = uniform Amount received or paid
out each compounding period
• i or r = Interest rates, expressed in
percent per interest period

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 Cash Flow Diagram Example
Plot observed cash flows and show present worth (P) arrow at
present time, t = 0

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Cash Flow Diagram Example

A rental company spent $2500 on a new air compressor 7 years

ago. The annual rental income from the compressor has been
$750. $100 has been spent on maintenance the first year and has
increased each year by $25. The company plans to sell the
compressor at the end of next year for $150.

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Cash Flow Diagram Example
You plan to make a lump-sum deposit of $5000
now into an investment account that pays 6% per
year, and you plan to withdraw an equal end-of-
year amount of $1000 for 5 years, starting one
year from now. At the end of the sixth year, you
plan to close your account by withdrawing the
remaining money. Define the engineering economy
symbols involved.

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 Simple and Compound Interest
For more than one interest period, the terms simple
interest and compound interest become important.
• Simple interest, is calculated using the principle
only, ignoring any interest accumulated in
preceding interest periods.

• Compound interest, the interest accumulated for

each interest period. It is being calculated on the
principle plus the total amount of interest
accumulated in all previous periods. Compound
interest reflects the effect of the time value of
money on the interest as well as on the principle
amount.

Simple Interest Example

Simple Interest: Interest is calculated
using principal only
Interest at period t =
(principal) (interest rate)
Total simple interest =
(principal) (interest rate) (no. of periods)
Example: $100,000 is invested for 3
years at a simple i = 10% per year.
What is the repayment after 3 years?

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 Simple Interest Example
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 = 100,000(0.10) = $10,000

Total due, year 2: T2 = 110,000 + 10,000 = $120,000

Interest, year 3: I3 = 100,000(0.10) = $10,000

Total due, year 3: T3 = 120,000 + 10,000 = $130,000

Interest at period t = 100,000(0.10) = $10,000

Total Interest = 10,000(3) = $30,000
Total due = 100,000 + 30,000 = $130,000

Compound Interest Example

• Compound Interest:
Interest is based on the principal plus all
accrued interest. That is, interest
compounds over time.

Interest at period t = (principal + all accrued

interest) (interest rate)

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 Compound Interest Example
• Compound Interest:
Interest is based on the principal plus all
accrued interest. That is, interest
compounds over time.
Example:
$100,000 is invested for 3 years at a
compound interest i = 10% per year.
What is the repayment after 3 years?

Compound Interest Example

Example: $100,000 invested 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

Or I3 = (100,000 + 10,000+11000) (0.10) = $12,100
Total due, year 3: T3 = 121,000 + 12,100 = $133,100
Compounded: $133,100 Simple: $130,000
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 Additional Terminology
Minimum Attractive Rate of Return (MARR)
• 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
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Additional Terminology
Opportunity Cost
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

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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