Za GL. Book House SALIENT FEATURES Complete conceptual theory content in lucid language Examination solution up to 2079 Sufficient additional solutionGiL_ BOOK HOUSE ee | Dd serie manual BACHELOR OF ENGINEERING Er. Hari Ram Pyakurel Er. Laxman Lamsal Publisher G.L. Book House Pvt. Ltd. Infront of Thapathali Campus, Maitighar, Kathmandui | Engineering Economics ee Bachelor of Engineering uthors Er. Hari Ram Pyakuref Er, Laxman Lamsal All rights are reserved. No part of this publication may be reproduced, stored in a retrigy,, system or transmitted in any form or’ by any means, electronic mechanical, photocopying, recording or otherwise, without prior permission of G.L. Book House Pvt. Ltd. See Publisher G.L. Book House Pvt. Ltd. Maitighar; Kathmandu Distributor Laxmi Pustak Bhandar Maitighar, Kathmandu 9841-250324 Printed in Nepal ts te pe ass ee ee Se Copyright © Authors Fifth Edition + 202/024 Price + Rs, 500,00 Layout + Pratap Acharya Graphics + Sanyr PrajapatiPeface lo the Giik & Revived Ecltion ‘The changes made and addressed criticisms in the previous editions inspires us to express heartily thanks to our readers. Also, the upheaving appreciation of the previous editions motivated us to come out with the fifth revised edition of this book. There remained some flaws that needed more tribulation to publish this edition. We cannot’ remain impartial to voice our publisher with appraisal for continuous admiration and support. In this edition, suggestions from our good will-readers have been rectified in all chapters. Similarly, solutions of latest examination questions.of Tribhuvan University have been added. We are eager to write our gratitude to our deferent readers in the next edit. on to come. ~” \uthorsCONTENTS coapter 1 INTRODUCTION 1-14 u Ww Origin of Engineering Economy .. Principles of Engineering Economit 13 Role of Engineer's in Decision Making 14 Cash Flow... 15 Some Other Useful Topic. 1.5.1 _ Elements of Cost 1.5.2 Break-Even Analysis > Old Question Solution... ‘Chapter 2 INTEREST AND TIME VALUE OF MONEY 15-42 21 Introduction to Time Value of Money 22 Simple Interest... 23 Compound Interest. 23.1 Nominal Interest Rate. 2.3.2 Effective Interest Rate. 23.3 Continuous Compounding 24 — Economic Equivalence... 25 Development of Interest Formula .. > Solved Examples... * Old Question Solution... Chapter 3 BASIC METHODOLOGIES OF ENGINEERING ECONOMICS ANALYSIS ' 43-96 3.1 Determining Minimum Attractive (Acceptable) Rate of Return (MARR) ...44 32 Payback Period Method... 53° Equivalent Worth Methods... 3.3.1 Present Worth Method .. 3.3.2 Future Worth Method 4 33.3 Annual Worth Metho Rate of Return Method. 3.4.1 Infernal Rate of Return Method 3.4.2 Extemnal/Modified Rate of Return Method.....ic Analysis (Benefit Cost Ratio Method) 3.5 Public Sector Econom 3.6 Introduction to Life Cycle Costing .. 3.7 _ Introduction to Financial and Economical Analysis. > Old Question Solution > Extra Questions Solution Chapter 4 COMPARATIVE ANALYSIS OF ALTERNATIVES 7-14 Same Useful Life. 9 ‘Comparing Mutually Exclusive Alternatives H 4.1.1 Payback Period Method and Equivalent Worth Method. “41.2 Rate of Return Method and Benefit Cost Ratio Metho 4.2 Comparing Mutually Exclusive Alternatives Having Different Useful Lives .. 42.1 Repeatability Assumption .. 4.2.2. Co-Terminated Assumption... 4.2.3 Capitalized Worth Method. 4.3 Comparing Mutually Exclusive, Contingent and Independent Projects in Combination. > Old Question Solution 4] Chapter 5 REPLACEMENT ANALYSIS 5.1 Fundamentals of Replacement. Analysis 5.1.1 Basic Concepts and Terminolog) 5.1.2 Approaches for Comparing Defender and Challenger. 5.2 Economic Service Life of Challenger and Defender... 5.3 Replacement Analysis When Required Service Life is Long .. 5.3.1 Requirement Assumption and Decision Framework 5.3.2 Replacement Analysis under Infinite Planning Horizon 5.3.3 Replacement Strategies under the Finite Planning Horizon... > - Old Question Solution . 160 Dg Exira Questions Solution . Chapter 6 RISK MANAGEMENT 6.1 Origin/Sources of Project Risks... 6.2 Methods of Describing Project Risk. 6.2.1 Sensitivity Analysis...6.2.2. Breakeven Analysis .. 6.2.3 Scenario Analysis.. 63 Probability Concept of Economic Analysis. 6.4 Decision Tree and Sequential Investment Decisior y» Old Question Solution... > Extra Questions Solution... Chapter 7 DEPRECIATION AND CORPORATE INCOME TAX 235-270 7.1 Concept and Terminology of Depreciation. 7.2 Basic Methods of Depreciation. 7.2.1 Straight Line Method. ” 7.2.2 Diminishing/Declining Balance Method/Matheson Method/Constant Percentage Method 7.2.3 Sinking Fund Metho 7.2.4 Sum of the Year Digit Method (SOYD) “7.2.5 Modified Accelerated Cost Recovery System (MACRS). 7.3 Introduction to Corporate Income Tax... 7.4 - After Tax Cash Flow Estimate... 75 — General Procedure for Making after Tax Economic Analysi 7.5.1 Some terms and Definition 75.2 General Procedure for ATC! > Old Question Solution .. > Extra Questions Solution Chapter 8 INFLATION AND ITS IMPACT ON PROJECT CASH FLOWS — 271-291 8.1. Concept of Inflation 8.2 Measuring Inflation. 83 Equivalence Calculation Under Inflation... 8.3.1 Different Interest Rate..... 8.3.2 Adjusted-Discount Methos 84 Impact of Inflation on Economic Evaluation. oe wi Old Question Solution Extra Questions SolutionIntroduction ¥ Chapter 1 | 1 INTRODUCTION 74 Origin of Engineer 1.2 Principles of Engineering Economics 13. Role of Engineer's in Decision Making. a " 15 Some Other Useful Topi ~ 15.1. Elements of Cost. 152 Break-Even Analysis. Se ( Engineering economics is the application of economic techniques for the evaluatiorr of design and engineering alternative, The role of engineering economic is to > Access the appropriateness of a given project. yo Estimate its value ~_-Iustify it from an engineering point of view It involves the systematic and technical evaluation of analysis, with emphasis on the economic aspects and has the objective of assisting in - decision making. ‘ (_taginecring economics deals with the methods that enable one to take Sconomic decisions towards minimizing costs and/or maximizing benefits to business organizations. \ iii a Bie. &2 | Complete Manual of Engineering Economics Some Economics Terminology 1 v 6. 7 ‘Annuity: An amount of money payable to a beneficiary at regu sntervals for a prescribed period of time out of a fund reserved ‘or that purpose. Break Even Point: + Inbusiness operation, the rate of operations output or sales at which income is equal to operation cost. + The percentage of capacity operation of a manufacturing plant at which income will just cover expenses. Capital: Thé non-human ingredients that contribute to the production of goods and services, including land, raw and semi finished materials, tools building machinery and inventories. Sunk Cost: A sunk cost is a cost that an entity has incurred and which it can no longer recover by any means. Sunk cost should not be considered when making the decision to continue investing in an ongoing project, since we cannot recover the cost sunk cost includes marketing study, research and development, training, hiring bonus. Opportunity Cost: The cost of an alternative that must be forgone in order to pursue a certain action. It can also be defined as, the value of benefits sacrificed in selecting a course of action among alternatives. ‘Assets: An economic resource of entity (including money resources, physical researches, and intangible resources). Marginal cost: The cost associated with one additional unit of production, also called the incremental cost. ‘Types of Business Organization As an engineer, we should understand the nature of the business organization with which we are associated. This section will present some basic information about the type of organization you sh ould. choose should you decide to go into business for yourself. ‘The three legal forms of business, each having certain advantages and disadvantages, are proprietorships, partnerships, and corporations. L Proprietorships: A proprietorship is a business owned by one individual. This person is responsible for the firm’s policies, oW"S all its assets, and is personally liable for its debts. A proprietorship has two major advantages. First, it can be formed easily 4% inexpensively, No legal and organizational requirements 2" associated with setting up a proprietorship, and organizational costs are therefore virtually nil. Second, the earnings of * proprietorship are taxed at the owner's personal tax rate, which may be lower than the rate at which corporate income is taxed: aIntroduction ¥ Chapter 1 | Apart from personal liability considerations, the — major disadvantage of a proprietorship is that it cannot issue stocks and bonds, making it difficult to raise capital for any business expansion. Partnerships: A partnership is similar to a proprietorship, except that it has more than one owner. Most partnerships are established by a written contract between the partners, The contract normally specifies salaries, contributions to capital, and the distribution of profits and losses, A partnership has many advantages, among which are its low cost and ease of formation. Because more than one person makes contributions, a partnership typically has a larger amount of capital available for business use. Since the personal assets of all the partners stand behind the business, a partnership can borrow money more easily from a bank. Each partner pays only personal income tax on his or her share of a partnership's taxable income. : On the negative side, ‘under partnership law each partner is liable for a business’s debts. This means that the partners must risk all their personal assets—even those not invested in the business. And while each partner is responsible for his or her portion of the debts in the event of bankruptcy, if any partners cannot meet their pro rata claims, the remaining partners must take over the unresolved claims. Finally, a partnership has a limited life, insofar as it must be dissolved and reorganized if one of the partners quits. Corporations} A corporation is ‘a legal entity created under provincial or federal | managers. This separation gives the corporation four major advantages: It can raise capital from a large number of investors by issuing stocks and bonds; ) * It permits easy transfer of ownership interest by trading shares of stock; "It allows limited liability-personal liability is limited to the amount of the individual's investment in the business; and * “It is taxed differently than proprietorships and partnerships, and under certain conditions, the tax laws favor corporations. On the negative side, it is expensive to establish a corporation. Furthermore, a corporation is ‘subject to numerous governmental requirements and regulations, ORIGIN OF ENGINEERING ECONOMY The perspective that ultimate economy is a concern to the engineer and the availability of sound techniques to address this concern differentiates this aspect of modern engineering practice from that of the past,4 _| Complete Manual of Engineering Beonomies > Moneers Arthur M. Wellington, civil engincer in later pan nineteenth conn, THe aldeesed tole of economic ana engineering project. The main area of interest for him was rane” building, followed by other contributions which emphasiney techniques depencling on financial and actuarial mathematics > Later his work was followed by other Eugene Grant who Published the first edition of his book which was the milestone in te development of engineering economy. > In 1942 Woods and Degarmo published the first edition of the book, later entitled engineering economy. 1.2 PRINCIPLES OF ENGINEERING ECONOMICS The four fundamental principles that must be applied in all engineering economic decisions are i) The time value of money ii) Differential (incremental) cost and revenue, iii) Marginal cost and revenue, and iv) The trade-off between risk and reward. Principle 1: A ‘nearby penny is worth a distant dollar. A fundamental concept in engineering economics is that money has a: time value associated with it.-Because we can earn interest on money received today, it is better to receive money earlier than later. This concept will be the basic foundation for all engineering project evaluation. Principle 2: All that counts are the differences among alternatives. An economic decision should be based on the differences among the alternatives considered. All that is common is irrelevant to the decision. Certainly, any economic decision is no better than the alternatives being considered. Thus, an economic decision should be based on the objective of making the best use of limited resources. Whenever a choice is made; something is given up. The opportunity cost of a choice ‘is the value of the best alternative given up. Principle 3: Marginal revenue must exceed marginal cost. Effective decision making requires comparing the additional costs of alternatives with the additional benefits. Each decision alternative must be justified on its own economic merits before being compared with other alternatives. Any increased economic activity must be justified on the basis of the fundamental economic principle that marginal revenue must exceed marginal cost, Here, marginal revenue means the additional revenue made possible by increasing the activity by one unit (or small: unit), Margin cost has an analogous definition, Productive resources- the natural resources, human resources, and capital goods available to’ make goods and services- are limited,Introduction ¥ Chapter 1 | 5 Therefore, people cannot have all the goods and services they want; as a yesult, they must choose some things and give up others. principle 4: Additional risk is not taken without the expected additional return. For delaying consumption, investors demand a minimum return that must be greater than the anticipated rate of inflation or any perceived risk. If they didn’t receive enough to compensate for anticipated inflation and the perceived investment risk, investors would purchase whatever ods they desired ahead of time or invest in assets that would provide a sufficient return to compensate for any loss from inflation or potential risk. The Seven Principles of engineering economics are: Principle 1: Develop thé Alternatives: There must be-more than one alternatives, the-choice is made among these after subsequent analysis. Principle 2: Focus on the difference: Only the differences in expected ‘outcomes among the alternatives are relevant to their. comparison and should be considered in decision. Principle e a consistent viewpoint: The likely outcomes’ of the various alternatives, initial cost, future saving, etc. should be consistently developed from a defined view point. . Principle: Use a common unit of measure: Using a common unit of measurement to specify as many of the prospective outcomes as possible will make easier the analysis and comparison of the alternatives. Principle 5: Consider all relevant criteria: Selection of best alternative required consideration of almost all relevant criteria. This includes both the outcomes specified in the monetary unit and those expressed int some other unit of measurement. Principle 6\_ Make uncertainty explicit: Uncertainty is inbuilt in projecting the future outcomes of the alternatives and it should be honored in their analysis and comparison. Principle 7: Revisit the decision: The initial projected outcomes of the selected“Alternative should be subsequently compared with the actual ele achieved, Revisiting of decision ensure the good result of the final lecision, 1.3 ROLE OF ENGINEER'S IN DECISION MAKING What role do engineers play within a. firm? What specific tasks are assigned to the engineering staff, and what tools and techniques are available to it to improve a firm's profits? Engineers are called upon to Participate in a variety of decisions, ranging from manufacturing, through marketing, to financing decisions, We will restrict our focus, however, to pio economic decisions related to engineering projects. We refer to se decisions as engineering economic decisions.ing Economics 6 | Complete Manual of Engin In manufacturing, engineering is involved in every detail of a producy, production, from conceptual design to shipping. In fact, engineerin decisions account for the majority (some say 85%) of product cose Engineers must consider the effective use of capital assets such a, buildings and machinery. One of the engineer's primary tasks is to pian for the acquisition of equipment (capital expenditure) that will enable the firm to design and produce products economically. With the purchase of any fixed asset-equipment, for instance-we need tg estimate the profits (more precisely, cash flows) that the asset wil) generate during its period of service. In other words, we have to make capital expenditure decisions based on predictions about the future, Suppose, for example, you are considering the purchase of a deburring machine to meet the anticipated demand for hubs and sleeves used in the production of gear couplings.’You expect the machine to last 10 years, This decision thus involves an implicit 10-year sales forecast for the gear couplings, which means that a long waiting period will be required before you will know whether the purchase was justified. An inaccurate estimate of the need for assets can have serious consequences. If you invest too much in assets, you incur unnecessarily heavy expenses. Spending too little on- fixed assets, however, is also harmful, for then the firm’s equipment may be too obsolete to produce products competitively, and without an adequate capacity, you may lose a portion of your market share to rival firms. Regaining lost customers involves heavy marketing expenses and may even require price reductions or product improvements, both of which are costly. In summary, - decision making is always challenging. Analysis of each alternatives by considering all relevant criteria, technically, economically (initial cost and future saving) is must necessary. The role of engineers in the decision making is that evaluate the condition, feasibility and appropriateness of an alternatives of a given project. Estimates its value and justify it from an engineering stand point 'and finally discover the best alternative for implementation. Role of engineers in decision making (stepwise duty) > Understand the problem and define the objectives.“ > - Collect relevant information ~~“ > Define the feasible alternative solution and make realistic estimates” / > Identify the criteria for decision making using one or more attribute” » Evaluate each alternative, using sensitivity analysis to enhance thie evaluation / > Select the best alternatives / > Implement the solution and monitor the result.n_¥ Chapter 1 | 1 14 dash flow is he statement which shows inflows and outflows of cash and Sh equivalents during life of project. ie, actual rupees coming into a tr actual rupees going out from firm in different time periods. fim a rtisthe basis for the evaluation of different alternatives. cash flow diagram (CFD): The graphical representation of the cash flows streams i.e, both cash outflows and cash inflows with respect to a time scale is generally referred as cash flow diagram. Ttshould show three thing: i) A time interval divided into an appropriate number of equal riods. All cash out flows in each period. ‘All cash inflows for each period: ii) iti) NOTE ; ialess otherwise indicated, all such cash flows ate’ considered ta occur at the end of their respective periods. 3 es Figure: Cash flow diagram where, I= Initial investment ss : R= Reyenue (Benefit) _ E = Expenses (cost) S= Salvage vali = How to draw cash flow diagram? Steps of drawing a cash flow diagram: 1. Horizontal line is time scale with progression of time moving from left to right. (Normally starts from 0 to year N) where end of previous year coincide with beginning of next year. 2 Inflows and outflows of money are expressed by upward and downward arrows respectively. Here inflows of cash represent annual benefit (revenue), salvage values etc and outflows represent ; initial capital investment, annual cost etc. It is better to show two or more cash flows occurring in the same year individually to make clear connection in between problem Statement and cash flows in the diagram.neering Economics 8 __1 Complete Manual of F NOTE ‘Always Kept in miind, arrow lengths are approximate proportional to the magay i ‘of their respective cash flows: Beginning of year3 and ending of year 3° ‘Year 1 Year8 pt tt tH 0 1 2 Bina 5 6 Feo y Figure: Typical CFD for 8 years It shows cash flows begins from year 0 to year N = 8, 1.5 SOME OTHER USEFUL TOPIC 1.5.1 Elements of Cost Cost can be broadly classified into variable cost and overhead co Variable cost varies with the volume of production while overhead cost fixed, irrespective of the production volume. Variable cost can be further classified into direct material cost, dire labour cost, and direct expenses. The overhead cost can be classified in factory overhead, administration overhead, selling overhead, ar distribution overhead. Direct material costs are those costs of materials that are used to produ: the product. Direct labour cost is the amount of wages paid to the dire labour involved in‘the production activities. Direct expenses are thot expenses that vary in relation to the production volume, other than tt direct material costs and direct labour costs. Overhead cost is th aggregate of indirect material costs, indirect labour costs and indire expenses. Administration overhead includes all the costs that are incurre in administering the business. Selling overhead is the total expense that incurred in the promotional activities and the expenses relating to sale force. Distribution overhead is the total cost of shipping the items frot the factory site to the customer sites. The selling price of a product is derived as shown below: a) Direct material costs + Direct labour costs + Direct expenses Prime cost : b) _ Prime cost + Factory overhead = Factory cost c) Factory cost + Office and administrative overhead = Costs ° production d) Cost of production + Opening finished stock - Closing finish® stock = Cost of goods sold €) Cost of goods sold + Selling and distribution overhead = Cost of sa f) Cost of sales + Profit = Sales g) _ Sales/Quantity sold = Selling price per unitee Introduction ¥ Chapter 1 | 9 In the above calculations, if the opening finished stock is equal to the closing finished stock, then the cost of production is equal to the cost of goods sold. other Costs/Revenues The following are the costs/revenues other than the costs which are presented in the previous section: a) Marginal cost >) Marginal revenue ©) Sunk cost d) Opportunity cost Marginal Cost: Marginal cost of a product is the cost of producing an | additional unit of that product. Let the cost of producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of the same product be Rs. 10,045. Then the marginal cost of producing the 21" unit is Rs. 45. | Marginal Revenue: Marginal revenue of a product is the incremental revenue of selling an additional unit of that product. Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling 21 units of the same product be Rs. 15,085. Then, the marginal revenue of selling the 21" unit is Rs. 85. Sunk Cost: This is known as the past cost of an equipment/asset. Let us assume that an equipment has been purchased for Rs. 1,00,000 about three yeats back. If it is considered for replacement, then its present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present value of the equipment for further analysis. So, the purchase value of the equipment in the past is known as its sunk cost. The sunk cost should not be considered for any analysis done from now onwards. Opportunity Cost: In practice, if an alternative (X) is selected from a set of competing alternatives (X, Y), then the corresponding investment in the selected alternative is not available for any other purpose. If the same money is invested in some other alternative (Y), it may fetch some return. Since the money is invested in the selected alternative (X), one has to forego the return from the other alternative’ (Y). The amount that is foregone by not investing in the other alternative (Y) is known as the | portunity cost of the selected alternative (X). So the opportunity cost of an alternative is the return that will be foregone by not investing the same Money in another alternative. Consider that a person has invested a sum of Rs, 50,000 in shares. Let the ©xpected annual return by this alternative be Rs, 7,500. If the same amount is invested in a fixed deposit, a bank will pay a return of 18%. Then, the corresponding total return per year for the investment in theering ae] return is greater than the return from shares, yy of not investing in the bank bank is Rs, 9,000, This foregone excess return of Rs. 1,500 by wa the opportunity cost of investing in shares. 1.5.2 Break-Even Analysis The main objective of break-even anal volume from where a firm will make profit. Let, _s = Selling price per unit v = Variable cost per unit FC = Fixed cost per period Q= Volume of production The total sales revenue (6) of the firm is given by the following formula; S=sxQ The total cost of the firm for a given production volume is given as TC =Total variable cost + Fixed cost =vQ+FC The linear plots of the above two equations are shown in figure beloy The intersection point of the total sales revenue line and the total cost lin is called the break-even point. The corresponding volume of productia on the X-axis is known as the break-even sales quantity. At th intersection point, the total cost is equal to the total revenue. This point} also called the no-loss or no-gain situation. For any production quanti which is less than the break-even quantity, the total cost is more than th total revenue. Hence, the firm will be making loss. ysis is to find the cut-off producti Variable cost (VC) Fixed cost (VC) BEP (2°) Production quantity Figure; Break even Chart For any production quantity which is more than the break-even quantity the total revenue will be more than the total cost. Hence, the firm will bt making profit. Profit = Sales - (Fixed cost + Variable costs) =8xQ-(FC+vxQ)7 Introdwetion ¥ Chapter1| 11 “ye formulae to find the break-even quantity and break-even sales quantity Fixed cost Breakeven quantily = Selling price _ Variable cost Unit ~~‘ Unit fc. = Fry lin units) Fixed cost Selling price Breakeven sales = Selling price Variable cost “Unit ‘unit Unit FC =5-y*s(Rs) “The contribution is the difference between the sales and the variable costs. The margin of safety (M.S) is the sales over and above the break-even sales, The formulae to compute these values are Contribution = Sales - ‘Variable costs Contribution Selling price Variable cost Unit =~ ——Ss« Unit Unit MS. = Actual sales - Break-even sales Profit _- * Contribution * Seles MS. MS. as a percent of sales = 5-7=~ « 10012 | Complete Manual of Engineering Economics OLD QUESTION SOLUTION 1, Define engineering economics and enlist the Principle engineering economics. _ ogg Bhay Solution: Engineering economics is the application techniques for the evaluation, design and engineering altematives, The role of engineering economics ig > Access the appropriateness of a given project. 2 > Estimate its value > Justify it from an engineering point of view » Principles of Engineering Economics: Principle 1: Develop the Alternatives 5 There must be more than one alternatives, the choice is made amon these after subsequent analysis. Principle 2: Focus on the difference Only the differences in expected outcomes among the alternatives a relevant to their comparison and shoitld be considered in decision: Principle 3: Use a consistent viewpoint The likely outcomes of the various alternatives, initial cost, future savin etc. should be consistently developed from a‘defined view point. Principle 4: Use a contmon’unit of measure © Using a common unit of measurement to. specify as many of th prospective outcomes as possible will make easier the. analysis an comparison of the alternatives. : Principle 5: Consider all relevant criteria. = Selection of best alternative, required consideration of almost all relevan criteria. This includes both the outcomes specified in the monetary uni and those expressed in some other unit of measurement, Principle 6: Make uncertainty explicit Uncertainty is inbuilt in projecting the future outcomes of the alernative and it should be honored in their analysis and comparison. Principle 7: Revisit the decision The initial projected outcomes of the selected alternative should be subsequently compared with the actual results achieved. Revisiting 0! decision ensure the good result of the final decision. 2, Explain the roles of engineers in the decision making examples: [2070 Magb] Solution: See the definition part 1,3 3, Scarcity is the emerging issue in engineering field. How the study economics does help an engineer for decision making? [2070 Bhadral Solution: Scarcity is a naturally occurring limitation on the resources of that can be replenished, Scarcity may be classified as:Infroduction ¥ Chapter1| 13 Financial scarcity ii) Material scarcity ;) Labour scarcity iv) Technology scarcity Machine scarcity vi) Scarcity in time | is the emerging issue in the field of engineering. To implement [Gay Kind of project it demands a lot of financial resources, material, | machine, long time various kinds of manpower. Proper arrangement, | management and coordination were all those factors is much necessary for any project to succeed. It is always desirable to complete the project within possible short period, economically without compromising on quality. For this wisely decision making plays vital role and engineers ‘must be responsible for this. | For Role of engineers in Decision making: See the definition part 1.3 4, Listout the principles of engineering economics. [2071 Magh] Solation: See the definition part 1.2 5. Defined engineering economics. Write down the principles of engineering economic analysis. [2071 Bhadra] Solution: See the solution of Q. no, 1 [2069 Bhadra] 6. Explain why the subject of engineering economics is important to civil engineer. [2072 Ashwin] Solution: Fields of civil engineering. involves construction of big projects with huge investment which directly related to the economy of the society. There occur a lot of alternatives; selection of best alternatives is always a very important task. So, decision making is always challenging and tough. Analysis of each alternatives by considering, all relevant criteria, technically, economically (initial cost, future saving) is must necessary. Civil engineers can play vital role in decision making to evaluate the condition, feasibility and appropriateness of an ‘alternatives of a given project, estimate its value and justify it from an engineering stand point and finally discover the best alternative for implementation. For this knowledge about both in the field of civil engineering and engineering economics is necessary which clearly shows the important of engineering economics to civil engineer. 7... Define, engineering economics. Write down the principles of engineering economic analysis. [2073 Bhadra] Solution: See the solution af Q. no. 1 [2069 Bhadra] 8. "Knowledge of engineering economics helps in decision making process", Justify it by the principles of engineering economics: [2073 Magh) Solution: etpomis models help managers and economists analyze the economics ecision-making process. Each model relies on a number of assumptions» Manual of Engineering Econom hat are present in all decision situation, vision making is individuals of gos The fay maximize benefits. Baizatige he, sev the reasons to have knowledge of engingers suet ~ in decision making process 8 econ | velop the alternatives Mls non unit of measure ent viewpoint all relevant criteria Make uncertainty explicit the decision ¢ economics is useful to indentify alternatives wand to select the preferred course of action. Trg. °F ln em solving and decision making at the operations leve “Yd ty it $. State and explain principles of engineering economic 2 Solution: See the definition part 1.2 : E 074 haa, 10, Define term engineering economics. Explain prin. engineering economy. aorgeis Bhaai, Solution: See the solution of Q no. 1 [2069 Bhadra} 11. Define engineering economics. Why engineering econas: considered as important aspect for making decision for engi t : | Replain: [2076 Bhadra| For the first part: See the solution of Q. no. 1 {2069 Bhadra] For the second part: See the definition part 12 12. Explain the role of engineers in Engineering Economics, [2077 Chait Solution: See the definition part 1.3 13. "Use the consistent view point" and “make uncértainty explicit Explain these two principles of engineering economics. [2078 Chitra] Solution: See the definition part 1,2 14. Describe different principles of engineering economics. What 4? you mean by sunk cost and opportunity cost? [2079 Jesths] Solution: See the definition part 1.2 and 1.54 15. Explain the role of engineers in decision making in investment. ; [2079 Ashwitl Solution: See the definition part 13_Intorest Aha Time Valle Of Money ¥Chapter2| 15 owns INTEREST AND TIME VALUE OF MONEY kk |25 Development of Interest Formula. tok 2.1 INTRODUCTION TO TIME VALUE OF MONEY ‘The idea that a rupees today worth more than a rupees in the future because the rupees today can earn interest, 50 itis defined as "Time value of money is the time dependent value of Money stemming both from changes in purchasing power of money {nllation and deflation) and from the real earning potential of alternative juzstment overtime." Since money has the ability to earn interest. Its value “eease with time, Hence itis the relationship between interest and time.oy ote Manual of Engineering Beonomics The value of a currency expressed in terms of the amount of Boods o, services that one unit of money can buy is called purchasing power, Ad tinve lefts purchasing power of money is reduced. 1234386 Figure: Time vs value of money ‘2.2 SUMPLE INTEREST imple interest is interest earned on only the principal amount durin, each interest period. In other words, with simple interest, the interest earned during each interest period does-not earn additional interest in the Temaining periods, even though you don't withdraw it. In general, for a deposit of P dollars at a simple interest rate of r for N Periods, the total earned interest would be, T= (xP/D 23 COMPOUND INTEREST When the interest earn in each period is calculated on the basis of the total amount at the end of the previous period and this total amount includes the original principal plus the accumulated interest that has been left in the account is called compound interest. So, the total amount, at the end of N period when sum P is deposited at interest rate ‘i’ is F=P (1 +i) 2.3.1 Nominal Interest Rate The nominal interest rate is periodic interest rate times the number of Periods per year. It does not include any consideration of compounding. For example, a nominal annual interest rate of 12% based on monthly compounding means 1% interest rate per month. Jf a financial institution uses a unit of time other than a year. A month or quarter (For example, when calculating interest payments), the institution usually quotes the interest rate on annual basis. Commonly this rate is stated as r% compounded M - ly where, r = Nominal interest rate per year 2 M = Compounding frequency or number of interest periods per year 3 = Interest rate per compounding period For example, : r= 12% compounded quarterly, i,, M = 4 s0 rate = aa (3% per 3 month) ie eaInterest and Time Value of Money YChapter 21 17 acwell as, r= 12.% compounded monthly, re Me Tso rate =“F5° (1% per month) 2.3.2 Effective Interest Rate The actual rate of interest earned. during one year is known effective rate 1 it is also express ani it is al ed on the annual basis unless specifically stated otherwise; Effective interest rate is Tepresented by ‘i! en Then, iz +2) -1 wwhere, m= Compounding period per year Also, in= (ti) where, N = Number of compounding period terest rate per compounding period. M= compounding period per year. Example: From above formula the effective interest rate for 12% Compounded semi-annually, 2 i=(1+ 92) -1-1236% [er=12% and m=3] ‘Aa interest rate takes two forms: nominal interest rate and effective interest sate. The nominal interest rate does not take into account the compounding’ Period, The effective interest rate does take the compounding period inte account and thus is a more accurate measure of interest charges. A statement that the “interest rate is 10%" means that interest is 10% per year, compounded annually. In this case, the nominal annual interest rate is 10%, and ‘the effective annual interest rate is also 10%. However, if compounding is more frequent than once per-year, then the effective interest rate will be greater than 10%, The more often compounding occurs, the higher the effective interest rate,’ All of the formulas used in making time value calculations are based on effective interest rates. Therefore, whenever the interest rate that is provided is a nominal rate, it is necessary to convert it to an effective interest rate, As shown below, an effective interest rate, i, can be calculated for any time period longer than the compounding period, The most common way that nontinal interest rates are stated is in the form 'x% per year compounded y' where x = interest rate and y= (yipounding period.“An example is 18% per year compounded monthly. When interest rates are stated this way, the simplest effective rate to get is the one over the compounding period because all that is required is a Simple division. For example, from the interest rate of 18% per year jeuPounded monthly, a monthly interest rate of 1.5% is obtained (ie, 16s per year/12 compounding periods per year) and this is an effective ‘ale because it is the rate per compounding period. To get an effective rateos 18 | Complete Manual of Engineering Keanomtes ¥ than the compounding period use thy for any period tony interest rate formula im(re yy where, | = Effective int Shoetyy rate per period 1 = Nominal interest rate per period m © Number of time interest [s compounded per period The types of calculations used to obtain effective interest Fate ary summarized in Table below Interest ~ To Find | for To Find I for any Period ~ Statement | Compounding Period | Longer than Compoundin, Period is already expressed | Use effective interest rate over compounding equation riod Divide 12% by 4 Use effective interest rate compounded equation uarterl i= nominal 16% |Divide 16% by2 Use effective interest rate per year equation compounded semiannually : i= effective 14% [Use effective interest _ |For effective i values other per year rate equation and solve | than yearly, solve for r in compounded [for r/m effective interest rate monthly equation and then proceed 2.3.3 Continuous Compounding Continuous compounding can be thought of as making compounding period infinitesimally small. Here cash flows occurs at discrete interval but it is compounded continuously. Therefore it can be achieved by taking limit of m (no of compounding periods in year) to infinity. wo se liye) =] + fize-@ or, ef =(1 +i) We have, F=pa+iy’ or Be Pe f= P{B/P, r%, N) y 1 % ié used to denote the nominal rate and the wse of continuous compounding,Interest and Time Value of Money ¥Chapter2 119 2.4 ECONOMIC EQUIVALENCE ‘The process of comparing two different cash amounts at different points jn time is called economic equivalence. It indicates that different amount of money at different time periods are equivalent by considering the time value of money. Different sums of money at different times are equal in economic value “ Calculations for determining the economic effects of one or more cash flows are based on the concept of economic equivalence, Economic equivalence refers to the fact that cash flow whether a single payment or a series of payments can be converted to an equivalent cash flow at any point in time. ‘The equivalent value of an amount that is borrowed now, at future time period at a given interest rate depends on the type of interest whether simple or compound and the different loan repayment arrangements like payment of accumulated interest annually and principal at the end of the stipulated interest periods or payment of both the principal and interest at the end interest periods or payment of uniform amounts annually that comprises a portion towards the payment of principal amount and remaining for the accumulated interest throughout the interest periods. For example, we could find the equivalent future value of F or a present - amount P at interest rate i at period n; or we could determine the equivalent present value of P of n equal payment A. Equivalence Calculations General Principles are: Principle 1: Equivalence calculations made to compare alternatives require a common time basis: E To establish an economic equivalence between two cash flow amounts, a common base period must be selected. Principle 2: Equivalence depends on interest rate: ‘The equivalence between two cash flows is a function of the magnitude and timing of individual cash flows and the interest rate will destroy the equivalence between these two sums, as we will demonstrate in example 4. Principle 3: Equivalence calculation may require the conversion of multipfe payment cash flows to a single cash flow. Principle 4: Equivalence is maintained regardless of point of view. |L Complete Manual of Engineering Heonomics a SOLVED EXAMPLES a —— 1, Suppose you deposit $1000 in a bank savings accounts interest rate of 10% compounded annually. Assume that ya withdraw the interest earned at the end of each periog (20% on but let it accumulate, How much would you have at the gent * 3? of, Solution: Given that; P= $1000 N=3 years and, i=10% per year Find F, : F= $1000 (1 + 0:20 hak 4354 (2 From F=Pq 45) 2. In 1626, Peter of the Dutch west company paid $24 to purcha, Manhattan Island in New York from the Chinese. In Bi peter had invested $24 in a saving account that earned 8% interes rate, how much would it be worth in 2007? Solution: Given that; P = $24, i= 8% per year and N = 381 yrs (2007-1626) Find F, based on (a) 8% simple interest, F = $24 [1 + 0.08 x 381]= $755.52 b) 8% compound interest, F = $24 (1 + 0.08)" = $130,215,319,909,015 3. Suppose you are offered the alternative of receiving either $ 3,00 at the end of 5 yrs or P dollars today. There is no quéstion that tht $ 3,000 will be paid in full (no risk). Because you have no curren! need for money, you deposit the p.dollars in an account that pays 8% interest. What value of P would make you indifferent to choose between p dollars today and the promise of $ 3,000 at the end of 5 years? $3,000 N=5yrs nM P= rai” (1+ O.0ay — 82042 So, it is clear that if P is anything less than $2,042 you would prefer the promise of $3,000 in five years to P dollars today. Otherwise prefer $3,000-Interest and Time Value of Money ¥ Chapter 2 | 21 In example 2.3, we determined that, given an interest rate of 8% per year, receiving $ 2,042 today is equivalent to receiving $ 3,000 in five yrs. Ave these cash flows equivalent at an interest rate of 2 10%? i=10% i F=P(1 +i)" = 2042 [1 + 0.10)" = $3,289 | since the amount is greater than $ 3,000, the change in interest rate |. destroys the equivalence between the two cash flows. f 5, Suppose you have invested Rs. 1000 at present. How long does it ' take for your investment to double if interest rate is 8% 4 compounded annually? | Letinvestment F will become 2P after N yrs ; F F=2P | From F=P(1+i)% i 2P =P(1+i)% or, 2=(1-+0.08)% 1.08% = 2° N log 1.08 = log 2 [+ taking log on both sides] N=9yrs is 6. _ Find effective interest rate when nominal rate of interest is 18% per year and compounding is (i) Monthly (ii) Daily (iii) Hourly (iv) Continuously. Solution: 18\2 2 *) -1=19.561% ) Monthly, i= (1 +4) a =(1+ 77 an ao 0.18) i) Daily i=(1+535) -1=19.716% itl) Hourly, i (+ O18 JP a 1970% % 365 x 24, : iv) Continuously, (from equation (a) from 2.33) i=er~1 = 08-1 = 19.7217% If a lender charges 12% interest, compounded quarterly, what effective annual interest rate is the lender. charging? Solution; 1 «(0.12 ie 140) = 1 (1.03)'~ 1 = 1255 = 12.55%coring Bconomi mA compounded monthly, what re en to’ VW U4 8 \\en Yentler charges 12% interest, effective interest rate per quarter? Hint: m = Number of compounding periods per quarter Solution: Let, i= Effective interest rate per quarter. ea 2 4% = 3% and m= 3 (Number of months per quarter) 3 is( oe = 1 = (1.01)* - 1 = 0.0303 = 3.08% 9, If a money lender charges interest 1% per month what is 4 effective interest rate per year? Solution: iy = Effective interest rate per year Lakes: M=12 ; iy = [1 + 0.01)? - 1 = 0.1268 = 12.68% per year. 2.5 DEVELOPMENT OF INTEREST FORMULA As we begin to compare series of cash flow instead of single payments th required analysis become more complicated. However, when patterns i cash flow transactions ‘can be identified, we can take advantage of thes patterns by developing concise expression for computing either present a future worth of the series. We will classify the five major categories d cash flow transactions; develop interest formulas for them. ~ 1. Single Cash flow It involves the equivalence of a-single present amount and its future worth.’So it deals with only a single present amount P and its future worth F and is given by I P=100 F=P(1+i)% Figure: Single Cash Flows 2. Equal payment series : This describes the cash flow of the common fa installment loan ‘contract, which’ arranges Pea gna repayment of the loan in equal periodic installments. Figure: Uneven Series F=A—> where, A = Annual payments or incomes Payments are made at the end of each equal periods, These transaction are graphically illustrated in figure. Looking at this diagram, we see tha! if an amount A is invested at the end of each period, for N periods, thé total amount F that can be withdrawn at the end of the N periods will b& the sum of the compound amounts of the individual deposits.__Intorest and Time Value of Money Chapter? | 23 As shown in figure, the A dollars we put into the fund at the end of the sect period will be worth A (I+ i)8 at the end of N periods. The A dollars we put into the fund at the end of the second period will be worth ‘a (14. JSS, and so forth. Finally, the last A dollars that we contribute at the end of the Nth period will be worth exactly A dollars at that time. This means that there exists a series of the form. FRAC HON HA (LFS EH se HA LHI) EA expressed alternatively, : FEAtA (LHI) +A (1 Fi) + cose tA (14 iNT ay Multiplying equation (1) by (1 + i) results in (+)FHAQ+i)+AQ+iP t+... +A (+i) (2) on, "subtracting equation (1) from equation (2) to eliminate common terms jves us F(+i)-F=-A+A(1 +i)" Solving for F yields, +iN-1 real ]-n@/aum 3. _ Linear gradient series: > The amounts are not always uniform, when many transactions involves series of cash flows but they vary in some regular difference. > One common pattern of variation occurs-when each other cash flow in a series increases (or decreases) by a fixed amount: : Wane Yan Figure: Linear Gradient Series Present-Worth Factor: Linear Gradient: Find P, Given G,N, and I How much would you have to deposit now to withdraw the gradient amounts specified in figure? To find an expression for the present amount P we apply the single-payment present-worth factor to each term of the series and obtain. wig law snd (N-1) rot Ge ae N % Ped in-1)G(+iy™ Letting G = aand ty x yields + (N= 1)ax" (N-1) x4] P =O +ax2 + 2ax3+ = ax [0+ x + 2x24> Since an arithmetic-geometric series i erent =A he Ne = =1)x! 4 +(N-1)x' Pes hy We can rewrite equation as ‘L- NxN-1+ (N= 1)x Replacing the original values for A and x, we obtain NN Pepa g [att cect The resulting factor in brackets is called the gradient Series Preseng., factor, which we denote as (P/G, i, N) Won, To find F, 24 1 Complete Manual of Engineering Beonomieg OFN + Wn? 4, Fol! Functionally IG S@/GiN MS To find A, i N A-ol} ira Functionally, G(A/G,i,N) 4. Geometric Gradient series: i When the series in cash flow: is. = determined ‘not by a fixed amount like A above but by some fixed rate, then the series is called Geometric’ gradient series, Here, a js et Neri eons Fa= A(1 +g)? (1 +i)'? Fy =A(L +g)" so, F =F, +h, + 1 By FAI +) + A+ gL) + A+ pd 49? FI + AL + BL + D+ Ag ara ava (From sequence and series formula [+ 2= Common ratio] ) ;| Interest and Time Value of Money ¥Chapter2| 95 - ———rrom»wveeney Shnapter2| 25 is -(Lesy" reat lL oe 4) 1+i Nj eagle, aka T+i-I-g “Gai Irie gthen F=NA (+ i find p. - Afi-(+g)0+i*] (i-8) ;, Unequal payment series/Irregular series .. ies ‘of cash flow which are irregular and doesn't exhibit an overall regular pattern. Some formulae: a) — Equal payment series: _ +i8-1 . ree b) Linear gradient series: pG[aeut] No i i i Lae (+ 7 Gfa+i%-Ni-1 and, P= ¢{ a+’ | Geometric gradient series; i rea[ Aina ] ing 926 __| Complete Manual of Ky a) Por compounding: Rule 1: From higher compounding period to lower compounding Pett For example: i nl lar or lune “5 trem * 7 Rule 2: From lower compounding period to higher compounding Petigg For example; jnemi © (1 + iguarter)? = 1 fear = (1+ bons)" ~ 1 4 For withdrawn: if i = Interest rate per year and withdraw is monthly th, imonth = (1 + iyear)!/"? = 1 6. Continuous compounding and continuous compounding formula, 4) Continuous compounding and discrete cash flow Here cash flows occurs at discrete interval (eg. once per year) but} is compounded continuously throughout the interval Let the nominal rate of interest per year be r, and the use ¢ continuous compounding izer-1 We have, F=piti)’ F=PeN F= P(F/P, r%,N) Interest Factors and Symbols ToFind|Given| Factor | FactorName | Functional é -| Symbol Single cash flow F P eN Continuous {F/P, 1%, N) compounding ‘compound factor P FP e*N/Continuous 1P/F, r%, N} ‘compounding present equivalent Uniform series F AT e%-1 ]Continuous {F/A, 1%, N} €=T — |compounding compound amount P A Continuous {P/A,r%,N) | compounding | present equivalentInterest and Time Value of Money + Chapter2| 27 ene mite of Money # Chapter 2| 27. N F e-1 [Continuous (A/F, r%, Ny eN=T |compounding sinking fund | P| eX (e™~1) | Continuous {A/P, r%, N} ev] compounding I capital recovery Continuous compounding and continuous cash flow Continuous cash flow means a series of ‘tash flows occurring at infinitesimally short interval, Letr = nominal interest per year If there are P numbers of payment per year which amount toa total of one unit per year, then Ta Yow We have, : F=A((1+i)%-1)/i} F=A((1+i)-0/i) @EN=1) Future equivalent at the end of year 1 =5Uld-+r/p)=0/¢/) F={((+1/p)-1)/r} As F=P(l+1/p)P (1+ r/p)P-1 Pe" +t/pP As pi (1+ 1/p)?= Present equivalent of continuous ane year cash flow P=1(e-1/r(e)} Peer-1/rer is =erN-1/re" we An agua ony Thus, i) P= A(@-1)/re%) ii) Pe Aft |28 | Complete Manual of Engineoring SOLVED EXAMPLES 1. Aperson deposits a sum of Rs 5000 in a bank ap ins rate of 12% for 10 yrs. The compounding i, wy maturity of deposit after 10 yrs. et Solution: Given that P= Rs. 500 N=10yr5 = 10% compounded quarterly ri - S temme= (142) a= (1482) 4 12.5508% per yer F=PC +i)" = 5000 1 + 01255)" = Rs, 16319 iS interest annually. Solution: Given that; F=§1000000, N = 15 yrsi=8% per year I 3 9 wo A A A A A Find A, First discounting F = 1000000 to year 10 Fio= Fx (1 +i)" = 1000000 x (1 + 0.08)" = $ 680,583.19 Now, from equal payment series formula ref i Ache] Fay o7 7 680588.19 x [sFisk 0.08 (0a y= 8 46,9803 3, Aman aged 40 years now had borrowed Rs, 500000 from abauikf his future studies at the age of 20 yrs, Interest was charged at i per year compounded rterly, He wished to pay loat semiannual equal installments with the first installa beginning 5 yro after receiving loan, He just cleared the Joan me} What amount did he pay ineach installment?Interest and Time Value of Money ¥ Chapter 2 I 29 Solution: " it; CP oa Rs, 500000 ie ie per year and compounding quarterly N=20 years A=? Quarterly interest rate, 11% ay T= 2.75% [From formula number 4] Semi-annual interest rate isemi = (1+ ig)? -1 = (1 + 0,0275)?-1 =5,57% Using single payment compound amount factor F=P(1 +i) = 500000(1 + 0.057) o71 () Using uniform series compound (amour Oe Aes a+ iy’ -1 BRAT G ‘(1+0.057)" - 1 a al 0.057 2) Equating equation (1) and (2); we get, 2 500000 (1.057)" = aes $1333, A=Rs,61217.32is semi-annual payment, 4. Aperson is planning for his retired life and has 10 more years of service. He would like to deposit 30% of his salary, which is Rs _5000-at the end of first year and he wishes to deposit the amount with an annual increase of fs, 1006 for next 9 yrs with an interest rate of 15%, Fis the Sots} eicomat eit 0 10 your with the above series. Solution: Given that; Itis the problem of Linear gradient series G=Rs, Y N=10yrs Ay Cf ct and, i=15% per year i Find F = Future worth FaF,+Fe F, = Future worth from equal payment series Fc = Future worth from linear gradient series™~ | Complete Manual of Engineering Economies 30 123 ANAARK , 4 e ase AARAY = ‘A= 5000 SD eg 9123456785 ¥ $e ? * 3) aN an ez rea fed 1). $[ae 1).NG (1+ 0.15)"-1] 1000/1 + 0.15)-1] 10x 1099 = 5000 Co 1° 0s 045 |? as = Rs. 170209.33 5. An investment of Rs. 100,000 is made in a company. The first ye, of the investment produce net revenue of Rs, 20,000. Over a4 year period, the net revenue received from the - decreased by 10% each year. If the interest rate is 12%, what is th Present worth for the investment? Solution: Given that; A= 20,000, I= 12%, g = -10%, N= 40 years, Nae Pw = -10000 + 2000 a aces") 0 = ~100000 + 20909 2=9.9" x1.12) =as" ay 5 = Rs, 13,6183 6. What is the effective interest rate of nominal interest rate 10% pet year if the compounding is a) yearly b) quarterly ©) monthly d) daily e) continuously Solution: For compound a) Yearly sore nell__Tnterest ahd Time Valle Of Money ¥ Chapter 2| 31 Quarterly, m= 4 » one i, (1 7 oP) -1= 0.1038 = 10.38% onthly, m = 12 9 Mon o.1\2 i= ( ie %) -1= 0.1047 = 10.47% @) Daily, m= 365 ’ 01s i 6 +365) ~1=0.1051= 10.51% Continuously, m = 00 2 0.1)” : ie(t +3) -1=e'-1=e%-1=0,10517 = 10517% 7, _ Determine the FW of given cash flow data. ‘at 8% compounded continuously for five years. i) _ Rs, 50,000 at the beginning of each year | i) Rs. 50,000 at the end of each year Solution: i F 0 1) 2) 3) 4S A= 50,000 Using continuous compound amount factor (at the end of 4 year) Nel ees 7 = 50,000 « “Sag —z = Rs. 29525874 so, Pat4" year = 295258.74 F = Pet' = 295258.74 % e001 = 319849,98 Again, \ FEA A= 50,000 enve1 e085 1 Fs A"Z77 = 50,000 * “Grog q = Rs. 295258.7482__| Complete Manual of Engineering Economics OLD QUESTION SOLUTION 1. Ramesh, a civil engineer is planning to plane a total of 20% of hi, salary, which is Rs. 250,000 per year. He expects 7% increase ig salary for next 15 years if the mutual fund results in 10% annua, return, what will be the amount at the end of 15 years. If increases by 25000/ year, what will be the amount? [2069 Bhadral Solution: For the first case, the flow is geometric A= 20% of 250,000 = 50000 We have, 1-(+g)% +i i-g 1-(1.07)"x 1.107? = 50000 x" "90 -0.07 = 565849.642 F=P(1 +i)" = 2363694.381 b) __Ifsalary increases by Rs. 25,000/year than A= 50000 G=5000/year 5000/1.10°-1) 15x 5000 -F = 50000 (F/A, 10%, 15) + a (eae) aD S 1.10°.-1 1.10 -1) © 15x 5000 SOON Gag OO a0 Joe F = Rs, 24,27,248.164 2. Define nominal and effective interest rate. [2071 Bhadra] Solution: See the definition part 2.3.1 and 2.3.2 3. Evaluate FW at the end of 15 yrs with 10% interest rate compounded monthly on a cash flow of 50,000 at the beginning of each first 10 years, [2071 Bhadra] Solution: AAAAAAAAAA F ors ¢s67ra9 15 Given that; A= 50000 r=10%Interest and Time Value of Money ¥ Chapter 2 | 33 i: eee Y Chapter 2 | 33 “y 2 ( aay my a atthe end of 9" year or begging of 10" year N 1+ - (1+ 0.1047) - 1 FW= al | = so000| O1 = Rs, 853360.65 1047 = 10.47% So, the value of FW at the end of 15" year is F=P(1 + i)’ = 853360.65 (1 + 0.1047)° = Rs. 1550953.35, 4, What will be the amount of money at the end, if youi deposit Rs. 5000 per month for five years continuously? If nominal interest rate is 10% and compounded quarterly. [2071 Magh] _ Solution: Given that; ‘A= Rs. 5000 per month for five yrs nominal = 10% and compounded quarterly innptly = (1+ iguarte)/* ~ = 0.62% _ fGeaX=1]_ ‘(1+ 0.0062) 1] _ so, FW= al! 7 = 5000 0.0062 = 362070.93 | 5. Calculate the value of x from the following figure. (i= 10%) t [2071 Magh] 15 20°20-20 15 49 Solution: Compounding 15, 20, 20, 20 to year-6 and discounting 15 and 10 to year-6 that, 1 Fon (etiat | I Ole 5(1 +0.) + 2 i |*@+0a) * soap *"? 19.965 + 66.2 + 13,636 + 8,264 ~ x= 0 x= 108,065 What is the effective and nominal interest rate? Evaluate FW at the end of 10 yrs with 8% interest rate compounded continuously with cash flow of Rs. 500 at the beginning of each year for first five years, [2070 Bhadra] Solution: n or theory part: See the definition part 2.3.1 and 2.3.21 complete Manual of Engineering Eeonomicn a4 x=? Py 12345 0 Transforming the amount to end of each year T= 500 x eo The worth of all at the end of 5" year is Y = 500 x o88 (F/A, 8%, 5) oss = 500 x e088 x x z = 3198.499 The worth of it at the end of 10 years is x= 3198.439 (F/e, 8%, 5) = 3198,439 x e0se's =47716 7. Kyou deposit Re, 10,000 is a saving account now, which gives y nominal interest rate, what will be the amount after 5 year interest is compounded (@ Semi annually (ii) Monthly [2070 Mag, Solution: i) _ If interest is compounded semi-annually then m = 2 and é effective interest rate is ; oe 10? ia=(1+2) -1=(1+28) =1= 10.25% F=P (F/P, 10.25%, 5) : = 10000(1.1025)* = Rs, 16288952 ii) For monthly compounding : o.0y? ia=(1 +5) -1= 10.47% F = P(/P, 10.47, 5) = 10000 x (1.1047) = Rs, 16452.116 Find the value of P if i = 10%, use gradient formula also. Magi! [2070 1616 16 16 nla |Interest and Time Value of Money ¥Chapter2| 35, ont sents all cash flow to year 2, G N p=10(F/A, 10%, 3) +E (F/G, 10%, 3) --> : 1 i + 16(P/A, 10%, 4) 4 16 16 16 16 AE or » 4 a (1+i8-1 NG P=10x x i i |*16x ia+y® 110-1 (5 110°-1_ 3x2) - 110-1 =10x 970 *\010*" 010 ~ 010) *26* 539.449 = Rs. 90.004 : 9, What is difference between nominal and effective interest rate? [2072 Ahswin) "Solution: Nominal: Interest rates are the stated, advertised or quoted rates where no time period is started, than per year (also known as per annum) is assumed. . - Effective: Interest rates are what borrow have to actually pay, and depend on how frequently the nominal rate is compounded: (i,, which means adding interest to the balance of the loan). For formula and examples: See the definition part 2.3.1 and 2.3.2 10, You deposit Rs. 1000 in your bank account. If the bank pays 4% simple interest, how much will you accumulate in your account after 10 years? What if the bank pays compound interest? How much of your earnings will be interest on interest? [2072 Ashwin] Given that; Principle (P) = 1000 Simple interest rate (i) = 4% Time (N) = 10 years The amount accumulated in bank @ 4% Simple interest =P+ PIN = 1000 + 1000 x 0.04 x 10 = Rs. 1400 Amount accumulated in bank @ 4% compound interest, =P(1 +i) = 1000 (1 + 0.04)" = Rs, 1480.24 Interest on interest = 1480.24 - 14000 = Rs, 80.2436___ | Complete Manual of nj What is nominal and effective interest rate? Evaluate FW at the 11. end of 10 years with 12% interest rate compounded monthly of cash flow of Ra. (10,000 at the begining of eacl year for 5 years. - [2073 Bhadra} Solution: For Nominal and effective interest rate: See the definition part 2.3.1 and 2.3.2 F tT | 10 d 12345 A= 40,000 R=12% ‘as 0.12)? - i-(+2) -1=(1+59 -1= 0.1268 = 12.68% At the end &(5* year) beginning of 6" year a ont X=A [ou = «0000 = ae = 330,395.98 So, the value of FW at the end of 10" year is F = P(1 + i)% = 330,395.98 (1 + 0.127)° = 600,695.45 A person invest a sum of 50,000 in bank at a nominal interest rate of 18% for 15 years. The compounding is monthly. Find the maturity amount of the deposit after 15 years. Also briefly explain the importance of time value of money. [2073 Magh] Solution: : ; For the first part: Invest sum = 50,000 Nominal interest rate = 18% 12. ‘ Hs 0.18) ¥ Effect interest rate (ie) = ( + 2) -1= ( + oP) -1= 19.56% Maturity amount of the deposit after 15 years F = P(R/P, 19.56%, 15) = 50,000 x 1.1956" = Rs. 729052.15 For the second part: ‘Time Value of Money (T'VM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. The dollar on hand today can be used to invest and earn interest or capilal gain.__Interest and Time Value of Mon y¥Chapter2| 37 A dollar promised in the future is actually worth less than a dollar today because of inflation. The time value of money can be broken up into two areas. > Present value > Future value Future value value = Present value (1+ rate of return) Pm Present value determine what a cash flow to be received in the future is worth in today's dollars. It discounts the future cash flow back to the present date, using the average rate of return and the number of periods. No matter what the present value is, if you invest that present value amount at the specified rate of return and number of periods, the investment would grow into the future cash flow amount. Similarly, Future value = Present value * (1 + Rate of return)™"* Paes Future value determines what a cash flow received today is worth in the future, based on interest rates or capital gains. It calculates what a current cash flow would be worth in the future, it was invested at a specified rate of return rate of return and number of periods. Both present value and future value take into account compounding or capital gains, another important aspect for investors looking for good investments. 13. If you make equal monthly deposits of Rs. 5000 in the bank for 10 years, saving accounts that pays interest rate of 6% compounded monthly, what could be the amount at the end of 15 years? [2074 Bhadra] Solution: Here; Deposit is monthly (A) = 5000 Interest rate = 6% compounded monthly 6 3g = 0.5% per month Up to 10 years, number of payments (N) = 10 x 12 = 120 A= Rs, 5000 0.5 % = 0.005 819396.73 . (1+ 0.005) i = sooo O08 Atthe end of 10" year PLO = 819396.73 Yearly effective interest rate (j,) = (1 + ig) ~1 = (1 + 0.005)"*~ 1 = 0.062 | 288 | Complete Manual of Er Now, Bis = Pho (1+ iy)" [Here n = 5 years] = 819396,73 (1 + 0.062)° = Rs, 110692146 ie, Amount at the end of 15 years is Rs. 1106921.46 14, How many rupees should you deposit now so that YOU will bg to draw Rs. 5000 at the end of thi¢ month which incre "4 Percent per month for 15 years? Bank interest rate is 5% pey by, seat Pet yey Sulittaas MONWMA 1 o6e4} {2074 Bad Given that; weber Yeatly interest ratd (a) = 3% | (alopeev0tioy Interest on first month ie, (A)=5000 se@at Cs Geometric Gradient (g) = 2% = 0.02 asuen N =15 years = 15 x 12 = 180 months a 5 Monthly interest rate (in) = 75 % = 0.417% = 0.00417 Now, using Geometric gradient formula | G+iX-(+g)X] - : e al i-g 2 S sooo | + 0.00417)! - (1 + oo) 0.00417 - 0.02 = 10376562.50 Now, ‘ = P=F(1+i) = 10376562.50 (1 + 0.00417)” = 4906252.05 SoIMCuG-U27] * So you have to deposit Rs. 4906252.05 nes z 15. Define time value of money, nominal interest rate and effectiy interest rate. Calculate the future sum at the end of 5* year whe| monthly deposit is Rs. 6000 for 3 years that earns 7% interest pél year. [2075 Baisakd] Solution: For definition refer to chapter content. Given that; Monthly deposit (A) = Rs, 6000 up to 3 years n#=3*12=36 Yearly interest = 7% ie,___Interest and timo Va _ of Money. ¥Chapter2| ag Srey y Chapter? | a9 7 72 % = 0.583% = 0.00583 Atthe end of3 years Fy = 4 [arr ; i = 6ogg) ft-+ 9.00589)" 1 cao 0.00583 = 6000 x 39.927 = 239566.21 Monthly interest (j,) = Now, “At3™ year P3 = 239566.21 i=7% = 0.07 For 5" year n= 2 years B =Ps (1 + i)" =239566.21 (1 + 0.07) = 274979,35 ‘That is future sum at the end of 5" year is Rs, 27427935 16. A machine needs uniform semi-annual cash flow of $ 10,000 for fuel for 5 years. If interest rate is 12% compounded quarterly, what is its equivalent present worth? [2076 Bhadra] Solution: A=$ 10,000 semi-annual for 5 years e N=5x2=10 gins pw R=12% compounded quarterly = o.12\¢ ia (1+) -1-(1+92) = 10.1255 = 12.55% fscini annual = (1 + deg)"/? - 1 = (1. + 0.1255)"? —1 = 6.09 % a7. (i \What is the time value of money? Suppose that you make the monthly deposits of Ré.'5,000 each into a bank account that pays an interest rate of 8% compounded weekly for 5 years. After 5 years, interest rate changes to 6% per year. How much money will you have accumulated in this bank account at the end 6f 8 years,» [2077 Chaitra] Solution: For the first part: See the definition part 2,1 For the second part: A= 5000 monthly for 5 years = 5 x 12 = 60 months T=8% compounded weekly (1 year = 52 week) ‘ 52 iat -(143) -1=(1 +9) ~1= 0.08322 Aoortny = (1 + igg)'”"* — 1 = 0,00668, i.., 0.668%a a0 Complete Manual of Engineering Economics se Now 1+ i Fee A AGS. N) = S00 ' When i = 6% per year after 5 years Re? 6) Fe = Fs (F/P, i%, N) =3,67,538 ( + ie) = 4,37,744 18. A couple is planning for their child's education. They wish ty deposit Rs. 10,000 now in a bank account that gives 12% per year compounded monthly and increase the amount by Rs. 3,000 each year from the previous year for next 9 years. How much amount they will expect at the end of 10 years? [2077 Chaitra} Solution: : P = 10,000 that increases 2,000 each year from the previous year for 9 years. 1 = 12% compounded monthly. Fo=? > 28000 jeg =(1+Z)-1-(1+ = 0.1268 = 12.68% Fy = 10,000 (F/A, 12.68%, 10) (1 + i) + 2,000 (F/A, 12.68%, 9) (1 +1) + 2,000 (F/G, 12.68%, 9) (1 +i) 12.68)" a 1+ "700 a some’ 1] 12.8 * 2000 ~~ 0.1266 100 2000 [ (1 + 0.1268)’-1] 9 x 2000 x + ime 0.1268 | 0.1268 Ha + 0.1268) = (181360 = 30415 + 15773 x 15,208 - 141956) (1.1268) = 3,48,959Interest and Time Value of-Money ¥ Chapter 2 | 41 9, What is the time value of money? Explain and differentiate nominal and effective interest rate. How long will it take for Rs. 25000 to triple itself, if the interest rate is 8% per year? L [2078 Chaitra] olution: ‘or the first part: e the definition part 2.1 and 2.3 ‘or the second part: P=Rs. 25,000 F=3-% 25,000 = Rs. 75,000 We know that, |. Fepa+iy’ I 75,000 = 25000 (1 + 0.08)" } | } I 2 r, — 3=(1,08)" Taking log on both sides, N log (1.08) = log 3 eee - 14.275 N= jog 1.08 = 0. Airplane ticket. price will increase 8% in each of the next four years. The cost of end of the 1" year is Rs. 2,000. How much needs to put away not to cover the passenger travel at the end of year for | the next 4 years, taking i= 5%. [2078 Chaitra] Solution: : Given that; g=8% ~ Ar=Rs, 2,000 i=5% N=4 years Now, using gradient formula when i # g and iis increasing ff, (ite mw -aet-(rai) | 2000 +0.08\¢ Pw “ea? -ik | PW =7,952 21. How much money must be invested in an account that pay 9% per Year interest compounded quarterly to draw Rs. 6,000 at the end of first year and drawing amount increases Rs. 1,000 there after upto 10 years (use gradient formula). * [2079 Jestha] Solution: ~ Given that; A= 6,000$2__| Complete Manual of Engineering Economics an G=1,000 N= 10 years ¥= 9% compounded quarterly We know that, rn 1 iam (145 -1s(t+ 1 = 0.093 = 9.30% Using uniform series and gradient to compute present equivalent. P=Pa+Po P= A, (P/A, 9.30%, 10) + G(P/G, 9.30%, 10) 4 (1 +0.093)"-1 [2 + 0.093)" - 1 - 10 * 0.093 “600 [az (1 + 0.093] * 10] (0.093 + 0.98) = 6,000 x 6,334 + 1000 x 23.916 = 61,920 22 Ifyou planned to borrow some amount of money from your friey, \ Hight now by promising that you will repay her at the end of t year by Rs. 10,000 and will be decreased the amount for succediy years by Rs. 1,000 per year then after for another next 4 yean consider 12% interest pa compounding daily, what amount will sh, be ready to lend you? [2079 Ashwi| Solution: A®= Rs. 10,000 for the first year and decreases each year by 1,000 N=5 years r= 12% compounding daily Now, : ry os ia=(a +2) =(1 + 3g) -1=0.12747= 12.747 % Now, using uniform series and gradient to compute Present equivalent; P= P,-Po = Ai(P/ Ax, 12.747%, 5) - G(P/G, 12.747%, 5) (1+ 0.12747) -1 | = (aes « (L127475 7 (1.12747) - 1 - 5 «012747 100 (0.12747) (1.12747) = 10,000 x 3,539 ~ 1000 » 6,234 = 35,390 - 6,234 = 29,156 23,/ Explain different types of standard cash flow with thelr econo equivalence formula, [2079 Ashwit Solution: See the definition part 2.5os «Methodologies of Enginooring Benomick AnAlysid ¥ Chapter 3 | 43 BASIC METHODOLOGIES OF ENGINEERING ECONOMICS ANALYSIS ok 34 35 (37. Determining Minimum Attractive (Acce| Payback Period Method. Equivalent Worth Methods, 33.1 Present Worth Meth 332. Future Worth Meth 333 Annual Worth Mel Rate of Return Method. 34,1 Internal Rate of 34.2 External/Modified Rate of Retu Public Sector Economic Analysis (Ber Introduction to Life Cycle Costing Introduction to Financial and Econ took44 | Complete Manual of In most of the practical decision environments, executives will be fox, to solect the best altemative from a set of competing alternatives. Le, assume that an organization has a huge sum of money for poten, investment and there are number of different projects whose initial ou, and annual revenues during their lives are known. The executive has, select the best alternative among these competing projects. There are several bases for comparing the worthiness of the projey These bases are: Present worth method Future worth method Annual equivalent method 4. Rate of return method 3.1 DETERMINING MINIMUM ATTRACTIVE (ACCEPTABLE) RATE 0; RETURN (MARR) MARR is the interest rate at which firm can always earn or borro, money. MARR can also be regarded as the minimum return required, get investors to put up the money. MAAR can be developed from existin projects and may be different from time to time within the same firm. _ Factors influence the determination of MARR The amount of fund available for investment and its source. The nature of investment alternatives. The amount of risk perceived in the investment. The type of organization involved. (Government, public, private) "-MAAR is determined from the opportunity cost viewpoint. Sel Consider the following schedule, which shows prospective annual rates« profit for a company's portfolio of capital investment projects. Pee Expected Annual Rate of Investment Cumulative Profit Requirements Investment 4% and over Rs, 2,200 Rs. 2,200 30-39,9% 3,400 5,600 20-29,9% 6,800 12,400 10-19.9% 14,200 26,600 Below 10% 22,800 49,400 If the supply of capital obtained from internal and external sources has cost of 15% per year for the first Rs. 5,000,000 invested and the increases 1% for every Rs. 5,000,000 thereafter, what is this company MAAR when using an opportunity cost viewpoint? Solution: Cumulative capital demand versus supply can be plotted agait prospective annual rate of profit, as shown in figure. The point ¢ intersection is approximately 18% per year, which represents a realist!