Main Text Book

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin
Possible Scenario

You, as a process engineer in one renowned wafer fabrication has

been tasked to study, evaluate and recommend an alternative
process technology to be implemented in the company’s new
product.
 CONCEPT MAP
Important Concepts in Engineering Economy
• Money
• Time-Money Relationship
• Cost
The Fundamentals
(3 Lectures) How Time and Interest Affect Money

Cost

Nominal and Effective Interest Rate

Analysis Tools
Basic Analysis Tools • Present, Future and Annual Worth Analysis
(2 Lectures) • Rate of Return Analysis
• Benefit Cost Analysis

Decision Making
Rounding Off • Effect of Inflation
• Depreciation
(2 Lectures)
• Tax
 LECTURE 1:
FUNDAMENTALS OF ENGINEERING
ECONOMY
 LEARNING OUTCOMES
1. The importance of Engineering Economy knowledge in
decision making process
2. Ethics and economics
3. Time Value of Money

4. Interest Rate (Simple, Compound and Effective)

5. Cash Flow
6. Cost

7. Economic Equivalence

8. Minimum Attractive Rate of Return (MARR)

9. Terms and Symbols

 1.1 What Is Engineering ?

A branch of Science and Technology concerned with the design,

building, manufacturing, use of engines, machines and structures.
 1.2 What Is Economy ?

Definition #1 (Adam Smith)

A branch of the science of a statesman or legislator

[with the twofold objective of providing] a plentiful
revenue or subsistence for the people ... [and] to
supply the state or commonwealth with a revenue for
the public services.
Definition #2 (Investopedia)

The economy encompasses everything related to the

production and consumption of goods and services in
an area.
Definition #3

The study of the production and consumption of goods

and the transfer of wealth to produce and obtain
those goods. Economics explains how people interact
within markets to get what they want or accomplish
certain goals.
 1.3 What Is Engineering Economy ?

The study or science of how limited resources is used or

engineered to satisfy unlimited human wants i.e.
Production (supply) and Consumption (demand).
 1.4 Resources
Land Labor Capital
All gifts of nature, such as: water, air, minerals, sunshine, plant
and tree growth, as well as the land itself which is applied to the
production process.
The efforts, skills, and knowledge of people which are applied to
the production process.
Real Capital (Physical Capital )- Tools, buildings, machinery -- things
which have been produced which are used in further production
Financial Capital - Assets and money which are used in the
production process
Human Capital - Education and training applied to labor in the
production process
 1.5 Why Engineering Economy is Important
to Engineers?
Engineers will involve in all kinds of projects.

Almost all decision are money related i.e Cost and ROI (return of
investment). Therefore, they must be able to incorporate economic
analysis in their decision making process.

In most cases, engineers must select and implement from multiple

possible alternatives. Therefore, understanding and applying time
value of money, economic equivalence, and cost estimation are vital.
 2.0 The Application of Engineering
Economy
1. To determine the cost of products or services.

2. To provide a rational basis for pricing goods or services.

3. To provide a means for controlling expenditures.

4. To provide information on which operating decisions may be

based and the results evaluated.
 3.0 The Scope of Engineering Economy
Involves.
Formulating.
Estimating.
Evaluating.
the expected economic outcomes of alternatives designed to
accomplish a defined purpose.

Simple math techniques for evaluation purposes to produce

the outcomes, which is deterministic or stochastic in nature
(something measurable and quantifiable).
Essential Elements of Engineering Economy

1. Cash flows

2. Time of occurrence of cash flows

3. Interest rates for time value of money

4. Measure of economic worth for selecting an alternative

Sensitivity analysis – to determine how a decision might
change according to varying estimates.
 4.0 General Steps for Decision Making
Processes in Engineering Economy Study
1. Understand the problem – define objective.
2. Collect relevant information.
3. Define the set of feasible alternatives.
4. Identify the criteria for decision making.
5. Evaluate the alternatives and apply financial analysis (costing,
cash flow analysis, risk, return of investment.
6. Select the best alternative.
7. Implement the chosen alternative and monitor results.
Steps in an Engineering Economy Study
 5.0 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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 6.0 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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Congratulations!!! You have won a cash prize!
You have two payment options:
A - Receive $10,000 now OR
B - Receive $10,000 in three years.

Which option would you choose?

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 7.0 Time Value of Money (TVM)

Because of this universal instinctive, we would

prefer to receive money today rather than the same
amount in the future.

That is called the Time Value of Money

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WHY ?

Actually, although the sum is the same, you can do

much more with the money if you have it now
because over time you can earn more interest on
your money i.e. money makes money.

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Back to example: by receiving $10,000 today, you are poised
to increase the future value of your money by investing and
gaining interest over a period of time. For Option B, you
don't have time on your side, and the payment received in
three years would be your future value.

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To illustrate in the form of a cash-flow timeline:

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Another Scenario

Congratulations!!! You have won a cash prize!

You have two payment options:
A - Receive $100,000 now OR
B - Receive $1,000,000 in three years.

Which option would you

choose?

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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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 What is MONEY ???

―Money (Finance) is the gun, politics is knowing when to pull

the trigger‖
Quote from The Godfather

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Money can be anything that can serve as a

• store of value, which means people can save it

and use it later—smoothing their purchases over
time;

• unit of account - A unit of account in economics is a

nominal monetary unit of measure or currency used to
value/cost goods, services, assets, liabilities, income,
expenses; i.e., any economic item. It is one of three
well-known functions of money.

• medium of exchange, something that people can

use to buy and sell from one another

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(Investopedia - An officially-issued legal tender generally consisting
of currency and coin. Money is the circulating medium of exchange
as defined by a government. Money is often synonymous with cash,
including negotiable instruments such as checks. Each country has
its own money, or currency, that is used as a medium of exchange
within that country (some countries share a type of currency, such as
the euro used by the European Union). The currency of one country
can be exchanged for the currency of another via a currency
exchange. The current exchange rate determines how much of one
currency must be used to purchase a specified amount of the other
currency. For example, the exchange rate between the euro and the
US dollar may be 1.2596, where 1 euro can buy 1.2596 US dollars).

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To put it a different way, money is something that holds its
value over time, can be easily translated into prices, and
is widely accepted. Many different things have been used
as money over the years—among them, cowry shells,
barley, peppercorns, gold, silver and other precious
metals.

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 The History of Money: From Barter System
To PetroDollar

Barter trade (long long time ago – 9000 BC).

Individual exchange

A system of exchange where goods or services are directly

exchanged for other goods or services without using a medium
of exchange, such as money.

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Commodity Money

Mesopotamia 3000 BC. Specific weight of barley.

Bartering has several problems, most notably that it requires a

"coincidence of wants". For example, if a wheat farmer needs
what a fruit farmer produces, a direct swap is impossible as
seasonal fruit would spoil before the grain harvest. A solution is
to trade fruit for wheat indirectly through a third, "intermediate",
commodity: the fruit is exchanged for the intermediate
commodity when the fruit ripens.

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 Precious metals (esp. gold and silver);
The earliest recorded – Zhou Dynasty (China) – 1000 BC.
• A stable unit of account, a durable store of value, and a convenient
medium of exchange.
• They are hard to obtain. There is a finite supply of them in
the world.
• They stand up to time well.
• They are easily divisible into standardized coins and do not
lose value when made into smaller units.

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 Goldsmith Bankers i.e. Money Lenders
England – 16th Century
• The precious metals were deposited with the goldsmiths. The
goldsmiths issued receipts (cheque) certifying the quantity and
purity of the metal they held as a trust with certain fee. Initially,
these receipts could not be re-assigned (only original owner could
reclaim the gold).
• Later, those receipt could act as a medium of business transaction
i.e. other people could reclaim it.
• Eventually, goldsmiths function as money lender as well, charging
interest for loan. Later on, they become so greedy and giving loan
without gold backup (abusing the trust of the people). As a result,
the goldsmiths amassed a lot of wealth. The same modus operandi
as the current banking system (fractional-reserve banking – banks
can lend much more money than what they actually own – 90%
more) . 1-34
 Banknotes (Paper Money) by Private Commercial Banks

Europe / USA : 16th – 19th Century

• Some of prominent goldsmiths form a more legitimate system

called bank (the birth of modern banking system). They began
issuing paper money i.e. banknotes without government control.
• Those banknotes as a currency for business transaction and was
well accepted by public.
• Later on, again they became too greedy and produced a lot of
paper money without gold back up.

• When people realize that banks issued banknotes far in excess of

the gold and silver they kept on deposit, it led to mass redemption
of banknotes and result in bankruptcy.
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 Banknotes (Paper Money) Regulated by Government

World – Bank of England since 1694 (UK). Federal Reserve since

1913 (USA)

• The government controls and regulates the issuance of banknotes

through Central Bank (for eg Bank Negara).

Several Phases for World Financial Regulation (The New World Order)

Bretton Woods Agreement – (1944 – 1971)

US banknotes as PetroDollar – (1973 – Now)

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 Bretton Woods Agreement, mid-1944 (44 Government leaders
from the Allied Nations)
• US as the winner of WW2 and the new world’s superpower replacing Great
Britain (debt-ridden and war-torn).
• Establishing US dollar as world reserve currency - International gold-backed
monetary standard i.e. tying all major currencies to US dollar
• Banknotes issued by Federal Reserve to be back up by Gold at 1 ounce =
USD 35. (Now 1165 USD per ounce)

• Anyone who wanted to redeem could go to the US Central Bank and get the
precious metal that backs the note (only national bank of the country).
• Federal Reserve start to print money, and loan it to the US Government,
tons of money to finance US hegemony around the world (secretly without
being backup with gold).
• US Government now clocked (http://www.usdebtclock.org/) 18.4 Trillion
USD.
 The Failure of Bretton Woods Agreement.

The USA printed more banknotes than they could back up (they want
to spend more than what they have.
France (Charles De Gaulle) became worried about their US currency
reserves, feeling that the U.S. couldn't continue to spend and borrow
at their current rate and guarantee delivery of gold. As such, they
started to make noises that they were going to insist on gold delivery.
This posed a big problem to the USA
On August 15, 1971, President Richard M. Nixon shocked the global
economy when he officially ended the international convertibility from
U.S. dollars into gold, thereby bringing an official end to the Bretton
Woods arrangement i.e. US dollar floating not tied up to any
currencies (they can freely printing their banknotes).
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 The Emergence of Fiat Money.

With the collapse of Bretton Woods Agreement, signalling the

collapse of gold back up banknotes.
From there onwards, money creation is no longer back up by gold.
This is called Fiat Money.

Fiat money is currency which derives its value from government

regulation or law (wikipedia)

Fiat money is materially worthless, but has value simply because a

nation (imposed by the government) to collectively agrees to ascribe a
value to it. (open the door for the currency manipulation and attack,
currency devaluation, inflation etc.)

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DEFINITION of 'Fiat Money‘
(http://www.investopedia.com/terms/f/fiatmoney.asp)

Currency that a government has declared to be legal tender, but is

not backed by a physical commodity. The value of fiat money is
derived from the relationship between supply and demand rather than
the value of the material that the money is made of. Historically, most
currencies were based on physical commodities such as gold or
silver, but fiat money is based solely on faith.

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 Petrol Dollar (Fiat Money + World Control)

The USA has something under their sleeve when they terminate The
Bretton Woods Aggreement.
In 1973, a deal was struck between Saudi Arabia and the United
States (Dr Henry Kissinger) in which every barrel of oil purchased
from the Saudis would be denominated in U.S. dollars
Under this new arrangement, any country that sought to purchase oil
from Saudi Arabia (then later expand to OPEC in 1975) would be
required to first exchange their own national currency for U.S. dollar
In exchange for Saudi Arabia's willingness to denominate their oil sales
exclusively in U.S. dollars, the United States offered weapons and
protection of their oil fields from neighboring nations, including Israel.
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This petrodollar system, or more simply known as an "oil for dollars"
system, created an immediate artificial demand for U.S. dollars
around the globe. And of course, as global oil demand increased, so
did the demand for U.S. dollars.
Therefore, the USA could continue printing the money out of thin air.

As the U.S. dollar continued to lose purchasing power, several oil-

producing countries began to question the wisdom of accepting
increasingly worthless paper currency for their oil supplies.

Today, several countries have attempted to move away, or already have

moved away, from the petrodollar system. Examples include Iran, Syria,
Venezuela, and North Korea. Additionally, other nations are choosing to
use their own currencies for oil like China, Russia, and India, among
others.
 8.0 Interest and Interest Rate
Interest – the manifestation of the time value of money
Interest is money paid by a borrower to a lender for a credit or a similar liability.
Important examples are bond yields, interest paid for bank loans, and returns
on savings. Interest differs from profit in that it is paid to a lender, whereas profit
is paid to an owner. In economics, the various forms of credit are also referred
to as loanable funds.
Fee that one pays to use someone else’s money (PTPTN)

Therefore, interest is the difference between an ending amount of money and

a beginning amount of money
Interest = ending amount– beginning amount
Interest = amount owed now – principal
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Interest rate – Interest paid over a time period expressed as
a percentage of principal

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An employee at the Company X borrows RM10,000 on November 1
and must repay a total of RM10,700 exactly 1 year later. Determine
the interest amount and the interest rate paid.

Interest paid = RM10,700 – RM10,000

= RM700

Interest rate per year = RM700/RM10,000 x 100 % = 7 % per year

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 9.0 Rate of Return

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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a) Calculate the amount deposited 1 year ago to have RM1000 now
at the interest rate of 5% per year.
b) Calculate the amount of interest earned during this time period.

a) The total amount accrued (RM1000) is the sum of the original

deposit and the earned interest.
If X is the original deposit,
Total accrued = deposit + deposit (interest rate)
RM1000 = X + X (0.05) ; X = RM952.38

b) The interest earned = RM1000 – 952.38 = RM47.62

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 10.0 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 estimation:
Funds flow at the end of a given interest period

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 Cash Flow Diagrams
What a typical cash flow diagram might look like

Draw a time line

Time
0 1 2 … … … n-1 n
One time
period
F = RM1000

0 1 2 … … … n-1 n

P = RM100
Cash flows are shown as directed arrows: + (up) for inflow
1-50 - (down) for outflow
 10. 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
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 Cash Flow Diagram Example
Plot observed cash flows over last 8 years and estimated sale next
year for $150. Show present worth (P) arrow at present time, t = 0

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

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 Cash Flow Diagram Example
An engineer wants to deposit an amount of P now such that he can withdraw
an equal annual amount of A1 = RM2000 per year for the first 5 years, starting
1 year after the deposit, and a different annual withdrawal of A2=RM3000 for
the following 3 years. How would the cash flow diagram appear if i=8.5% per
year?

A2=RM3000
A1=RM2000

0 1 2 3 4 5 6 7 8
Year
i = 8.5%
P=?
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 11.0 Economic Equivalence

What is equivalence?

The comparability of certain entities of parameters based on the

same scale.

For example, to compare the length or distance, the measurement

must be based on the same unit such as meter or feet.

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Definition: Economic Equivalence is a 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

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Example: If the interest rate is 6% per year, RM100 today is
equivalent to RM106 one year from today.

Meaning that, from the economic perspective if somebody offered

you a gift of RM100 today or RM106 one year from today, it would
make no different which offer you accepted.

However, the two sums of money are only equivalent to each other
when the interest rate is 6%.

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 Example of Equivalence
Different sums of money at different times may be equal
in economic value at a given rate

RM106

Year

0 1
Rate of return = 6% per year

RM100 now

RM100 now is economically equivalent to RM106 one year from

now, if the RM100 is invested at a rate of 6% per year.
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 12. Simple and Compound Interest

Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = Pni

Example: RM100,000 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

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Compound Interest
Interest is based on principal plus all accrued interest
(interest compounds over time)

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

Interest It for time period t and interest i is

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 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
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 13.0 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
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 Cost of Capital and MARR
Cost of capital is the weighted average interest rate paid based
on debt and equity sources

 Debt capital represents borrowing outside company

 Equity capital is from owners’ funds and retained earnings
MARR is set relative to cost of capital

10-62 © 2012 by McGraw-Hill All Rights Reserved

 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
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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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 (for e.g. interest charged by the bank for the
loan).
• Both types of debt & equity financing are used to
determine the weighted average cost of capital
(WACC) and the MARR ROR ≥ MARR > WACC
• MARR usually considers the risk inherent to a
project
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 Factors Affecting MARR
Project risk: higher risk leads to higher MARR
Investment opportunity: in order to capture perceived opportunity, MARR
may be temporarily lowered
Government intervention: gov‘t actions such as tariffs, subsidies, etc.
can cause companies to raise or
lower MARR
Tax structure: rising corporate tax rates lead to higher MARR
Limited capital: as capital becomes limited, MARR increases
Rates at other corporations: competition can cause companies to
raise or lower MARR

10-65 © 2012 by McGraw-Hill All Rights Reserved

 Chapter Summary
 Engineering Economy fundamentals
 Time value of money
 Economic equivalence
 Introduction to capital funding and MARR
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)

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

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