Engineering Economics Module 2

The time value of money (TVM): is the concept that a sum of money is worth more
now than the same sum will be at a future date due to its earnings potential in the
interim. The time value of money is a core principle of finance. A sum of money in
the hand has greater value than the same sum to be paid in the future.
Money has time value for the following reasons:
1. Money can be employed productively in order to generate real returns. E.g.,
if Rs 100 is invested in material and labour and it produced finished goods
worth Rs 105 we can say that the investment of rs 100 has earned a return
of Rs 5 per cent.
2. Due to inflation value of a rupee today is more than a rupee in future.
3. As because future is uncertain, people like current consumption more than
future consumption.
Importance: Companies need to take new projects for the purpose of expansion
diversification or modernization. A project involves investing a sum of money now in
anticipation of benefits spread over a period of time in the future. If the total value of
future benefits is more than the current investment then the project is said to be
financially viable, here we assumed the value of money is same all the time.
Simple Interest: Simple interest is interest that is compounded only on the original
sub, not on accrued interest.
Total interest earned = Initial amount * rate of interest * no. of years
Compound Interest: With simple interest, the amount earned(for invested money) or
due(for borrowed money) in one period does not affect the principle for interest
calculations in later periods. However, this is not how interest is normally calculated.
Compound interest is calculated on both the initial principal and the accumulated
interest from previous periods.
FV=PV(1+ i/n)n×t
FV=Future value of money (PV + Interest)
PV=Present value of money
i=Interest rate
n=Number of compounding periods per year
t=Number of years
PVIF = Present Value Interest Factor
PVIF = Present Value Interest Factor of Annuity
PVIF = PV when n = 1 (Compounding periods per year) and FV = 1 (Future value)
 FV=PV(1+ r/n)n×t putting n =1
  FV=PV(1+ r)t
 PV = 1 / (1+r)t (putting FV = 1)
 PVIF = 1 / (1+r)t PVIFA =
 PVIF = (1+r)-t
 PVIFA = (1-(1+r)-t)/r or (1-PVIF)/r
 CRF (Capital Recovery Factor) = 1 / PVIFA

Debt Repayment: Debt repayment can also be called loan amortization. Although the
manner in which the debt is repaid, that is repayment schedule depends on the terms
of agreement between lender and debtor but generally there are few common
methods of loan repayment.
1. Repayment of loan in equal periodic instalments, which can be monthly
quarterly or annually covering interest as well as principal.
2. Only the interest view is paid each year, with no principal payment. Instead the
principal amount is paid in a lump sum at the end of the last year.
3. No payment is made until the end of last year, when the loan is completely
repaid. Note that in this case the interest of each year is again added into the
principal and the interest for the next year is calculated based on the new
principal amount.
Nominal Rate of Interest: Nominal interest rate also known as annualized percentage
rate or APR. It is the annual interest rate without considering the effect of any
compounding, also it does not consider the effect of inflation thus it can make a big
dent in an investor’s purchasing power.
Effective Rate of Interest: It is the annual interest rate taking into account the effect
of any compounding during the year.
ia= (1+ i/n)n-1
ia = effective interest rate per year
i = nominal interest rate
m = number of compounding subperiods per time period

Proti year er sheshe A invest korle, i interest rate, n

years,
Maturity Amount = A * ((1+i)n-1)/i
https://www.e-education.psu.edu/eme460/node/659
Ekebare P invest korbo, proti year er sheshe A
amount er taka tulbo, bank e thaka takai rate
of interest i, total years n
P = A * ((1+i)n-1) /( i*(1+i)n)
NPV : https://www.youtube.com/watch?v=N-
lN5xORIwc
NPV : (Net Present Value) Net present value (NPV) is the difference between the
present value of cash inflows and the present value of cash outflows over a period of
time after deducting the initial investment. NPV is used in capital budgeting and
investment planning to analyse the profitability of a projected investment or project.
If the value of NPV is positive the project proposal is accepted else rejected.

Ct =net cash inflow-outflows during a single period t

IRR=discount rate or return that could be earned in alternative investments
t=number of time periods
Limitations:
1. Difficult to calculate and understand.
2. Calculating the discount rate is complicated.
3. If two projects of different life spans are evaluated, this method may not
provide satisfactory result.
Profitability Index Method (PI)/ Benefit Cost Ratio (BCR):
https://www.youtube.com/watch?v=Md5ocNqKHq8
The profitability index (PI) or Benefit Cost Ratio (BCR), describes an index that
represents the relationship between the costs and benefits of a proposed project.
Profitability Index is the ratio of the present value of inflows to the initial cash outflow
or investment. If profitability index is greater than 1 the proposal is accepted else
rejected.
IRR Internal rate of return: (what is the discount rate that makes the NPV=0)
https://www.youtube.com/watch?v=aS8XHZ6NM3U
Internal rate of return is a percentage discount rate which is defined as the rate at
which the net present value is 0. IR is the rate of return for which the initial investment
is equal to the sum of present value of future cash flows. the higher an internal rate
of return, the more desirable an investment is to undertake. The IRR can be
determined by solving the following equation for r which is discount rate.

Sensitivity Analysis:
https://www.youtube.com/watch?v=o6-HCOG1Cp4
Costs include variable costs which depend on the sales volume. The NPV or IRR of
the project is again determined by analysing the cash flows. We can understand that
it is difficult to arrive at an unbiased and accurate forecast of each variable, if the
forecasts go wrong the reliability of NPV or IRR is lost therefore each item of forecast
is changed. NPV is re-calculated on pessimistic, expected, optimistic assumptions,
this method of re-calculating NPV or IRR for each forecast is called sensitivity
analysis.
Advantages Disadvantages
It shows how robust or vulnerable a Does not provide the probability of
project is to changes in values of change in variable.
underlying variables.
If NPV is highly sensitive we should In real world many variables change
explore how the variability of the critical together whereas in sensitive analysis
factor may be reduced. only one variable is changed at a time.
It covers the concerns of the project The results of sensitive analysis may be
evaluators. interpreted differently.

Break-Even Analysis: In sensitivity analysis we ask what will happen to the project if
sales decline or costs increases or something else happens. As a financial manager,
you will also be interested in knowing how much should be produced and sold at a
minimum to ensure that the project does not ‘lose money’. Such an exercise is called
break-even analysis and the minimum quantity at which loss is avoided is called the
break-even point (BEP). The break-even point may be defined in accounting terms
or financial terms.
Importance:
1. Determines the number of units to be sold: The calculation of break-even
analysis is done so that the owner knows the number of units to be sold in order
to break-even i.e., no profit no loss.
2. Helps in budgeting and setting targets: Since you know at which point you can
break even, you accordingly can set budgets.
3. Determine the margin of safety: The margin of safety can be calculated by
subtracting the current level of sales less the break-even point and then dividing
it by the selling price per unit.
4. Cost control and monitoring: Since the fixed and variable costs affect the
profitability of the business, they can see the effect of the changes to costs with
the help of break-even analysis.
Profit-Volume Ratio or Contributional Ratio or Marginal Ratio: Contribution / Sales *
100, Contribution is the amount of sales revenue available to cover up for the fixed
costs and profit. Contribution = Sales Revenue – Variable Costs. PV Ratio = (Sales
– Variable Cost)*100/Sales.
PV Ratio of Multiple Years = Change in Profit / Change in Sales
It represents the ratio of contribution to sales and called as p/v ratio. p/v ratio can be
increased by reducing variable cost, or by increasing selling price or by increasing
overall p/v ratio of the sales mix. Profit-Volume ratio is the measure of efficiency of a
product.
What is Capital budgeting && Relevance of Capital budgeting: (Eco-39) Capital
budgeting is the process of making investment decisions in long term assets. It is the
process of deciding whether or not to invest in a particular project as all the
investment possibilities may not be rewarding.
1. Time Period: Capital budgeting decisions has got long term implication.
2. Risk: The estimates about the cost, revenues, and profits may vary depending
upon the time. Longer the period of the project, more the risk and uncertainty
involved.
3. Amount: Any organization needs considerable investment to grow as the
company has limited resources to grow while taking the investment decision,
it has to make a wise decision.
4. Reversibility: Most of the time the capital budgeting decisions are irreversible.
5. Decision: Penalties for any wrong capital budgeting decision is very severe,
there may be heavy loss due to this.
6. Others: Capital budgeting decisions provide the structure that supports the
operating activities of the firm.
Average rate of Return: Average Rate of Return (ARR) refers to the percentage rate
of return expected on investment or asset is the initial investment cost or average
investment over the life of the project. The formula for an average rate of return is
derived by dividing the average annual net earnings after taxes or return on the
investment by the original investment or the average investment during the life of the
project and then expressed in terms of percentage.
Average Rate of Return formula = Average Annual Net Earnings After Taxes / Initial
investment * 100%
Average Rate of Return formula = Average annual net earnings after taxes / Average
investment over the life of the project * 100%
Advantages: Simplicity: ARR method is simple to understand and use. It does not
involve complicated computations.
NPV vs IRR:
1. In net present value method cash flows are converted into present values by
using discount rates which is usually taken to be the firm’s cost of capital. In
IRR method discount rate is to be selected such that the NPV becomes zero.
2. NPV is used to maximize the benefit where’s IRR denotes the interest rate at
which the investment can be recovered.
Salvage Value: Salvage value is the estimated book value of an asset after
depreciation is complete, based on what a company expects to receive in exchange
for the asset at the end of its useful life. As such, an asset’s estimated salvage value
is an important component in the calculation of a depreciation schedule.
PBP (Payback Period): Payback period is a financial or capital budgeting method that
calculates the number of days required for an investment to produce cash flows equal
to the original investment cost. In other words, it’s the amount of time it takes an
investment to earn enough money to pay for itself or breakeven. This time-based
measurement is particularly important to management for analysing risk. Payback
period does not consider the time value of money.