ENGINEERING ECONOMY, Sixth Edition

by Blank and Tarquin

CHAPTER I

FOUNDATIONS OF
ENGINEERING ECONOMY
Mc
Graw
Hill
1. Foundations: Overview

1. Questions
2. Decision Making
3. Study Approach
4. Interest Rate
5. Equivalence
6. Simple and Compound Interest

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1. Foundations: Overview

7. Symbols
8. Spreadsheet Functions
9. Minimum Attractive Rate of Return
10. Cash Flows
11. Doubling Time
12. Spreadsheets

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Section 1

Why Engineering Economy is

Important to Engineers (and
other professionals)
 Section 1.1
Importance

• Engineers “Design”
•Engineers must be concerned with the economic
aspects of designs and projects they recommend
and perform
•Analysis
•Design
•Synthesis

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Section 1.1 Questions

• Engineers must work within the realm of

economics and justification of engineering projects
•Work with limited funds (capital)
•Capital is not unlimited – rationed
•Capital does not belong to the firm
•Belongs to the Owners of the firm
•Capital is not “free”…it has a “cost”

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Section 1.1 Definition

ENGINEERING ECONOMY IS INVOLVED

WITH THE FORMULATION, ESTIMATION,
AND EVALUATION OF ECONOMIC
OUTCOMES WHEN ALTERNATIVES TO
ACCOMPLISHED A DEFINED PURPOSE ARE
AVAILABLE.

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Section 1.1 Definition

ENGINEERING ECONOMY IS INVOLVED

WITH THE APPLICATION OF DEFINED
MATHEMATICAL RELATIONSHIPS THAT AID
IN THE COMPARISON OF ECONOMIC
ALTERNATIVES

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Section 1.1 Questions

•Knowledge of Engineering Economy will

have a significant impact on you,
personally.
•Make proper economic comparisons
•In your profession
•Private sector
•Public sector
•In your personal life
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 Section 1.2
Role of Engineering Economy in
Decision Making

•Remember: People make decisions – not

“tools”
•Engineering Economy is a set of tools that
aid in decision making – but will not make
the decision for you
•Engineering economy is based mainly on
estimates of future events – must deal with
the future and risk and uncertainty

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Section 1.2 Role of Engineering Economy

• The parameters within an engineering

economy problem can and will vary over
time
•Parameters that can vary will dictate a
numerical outcome – apply and
understand ..
•Sensitivity Analysis

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Section 1.2 Role of Engineering Economy

• Sensitivity Analysis plays a major role in

the assessment of most, if not all,
engineering economy problems
•The use of spreadsheets is now common
and students need to master this valuable
tool as an analysis aid

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Section 1.2 Problem Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor

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Section 1.2 Problem Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor

Major Role of
Engineering
Economy

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Section 1.2 Problem Solving Approach
1. Understand the Problem
2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor

One of the more

difficult tasks

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Section 1.2 Problem Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor Where the major
tools of Engr.
Economy are
applied

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Section 1.2 Problem Solving Approach

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor Tools
Present Worth, Future Worth
Annual Worth, Rate of Return
Benefit/Cost, Payback,
Capitalized Cost, Value Added

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Section 1.2 Time Value of Money

• Time Value of Money

• Money can “make” money if Invested
• Centers around an interest rate

The change in the amount of money over a

given time period is called the time value of
money; by far, the most important concept
in engineering economy

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 Section 1.3
Performing a Study

•To have a problem, one must have

alternatives (two or more ways to solve a
problem)
•Alternative ways to solve a problem must
first be identified
•Estimate the cash flows for the
alternatives
•Analyze the cash flows for each alternative

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Section 1.3 Alternatives
•To analyze must have:
•Concept of the time value of $$
•An Interest Rate
•Some measure of economic worth
•Evaluate and weigh
•Factor in noneconomic parameters
•Select, implement, and monitor

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Section 1.3 Needed Parameters

•First cost (investment amounts)

•Estimates of useful or project life
•Estimated future cash flows (revenues and
expenses and salvage values)
•Interest rate
•Inflation and tax effects

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Section 1.3 Cash Flows

•Estimate flows of money coming into the

firm – revenues salvage values, etc.
(magnitude and timing) – positive cash
flows
•Estimates of investment costs, operating
costs, taxes paid – negative cash flows

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Section 1.3 Alternatives

•Each problem will have at least one

alternative – DO NOTHING
•May not be free and may have future
costs associated
•Do not overlook this option!

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Section 1.3 Alternatives

•Goal: Define, Evaluate, Select and Execute

The Question:
Do
Alt. 1 Which One do
Nothing
we accept?

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Section 1.3 Mutually Exclusive

•Select One and only one from a set of

feasible alternatives
•Once an alternative is selected, the
remaining alternatives are excluded at
that point.

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Section 1.3 More Alternatives

•Goal: Define, Evaluate, Select and Execute

Do
Alt. 1 ………... Alt. j
Nothing

Which one do we accept?

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Section 1.3 Default Position

•If all of the proposed alternatives are not

economically desirable then…
•One usually defaults to the DO-NOTHING
alternative

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Section 1.3 Taxes

•Taxes represent a significant negative cash

flow to the for-profit firm.
•A realistic economic analysis must assess
the impact of taxes
•Called and AFTER-TAX cash flow
analysis
•Not considering taxes is called a BEFORE-
TAX Cash Flow analysis

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Section 1.3 Taxes

• A Before-Tax cash flow analysis (while not

as accurate) is often performed as a
preliminary analysis
•A final, more complete analysis should be
performed using an After-Tax analysis
•Both are valuable analysis approached

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 Section 1.4
Interest Rate
INTEREST - MANIFESTATION OF THE
TIME VALUE OF MONEY. THE AMOUNT
PAID TO USE MONEY.
 INVESTMENT

 INTEREST = VALUE NOW - ORIGINAL

AMOUNT
 LOAN
 INTEREST = TOTAL OWED NOW - ORIGINAL
AMOUNT
RENTAL FEE PAID FOR THE USE OF SOMEONE
ELSES MONEY…EXPRESSED AS A %

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1.4 Interest Rate

INTEREST RATE - INTEREST PER

TIME UNIT

INTEREST PER TIME UNIT

INTEREST RATE 
ORIGINAL AMOUNT

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1.4 Interest Rates and Returns

•Interest can be viewed from two

perspectives:
•1. Lending situation
•Investing situation

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1.4 Interest - Lending

•You borrow money (renting someone

else's money)
•The lender expects a return on the money
lent
•The return is measured by application of
an interest rate

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1.4 Interest – Lending Example 1.3

•Example 1.3
•You borrow $10,000 for one full year
•Must pay back $10,700 at the end of one
year
•Interest Amount (I) = $10,700 - $10,000
•Interest Amount = $700 for the year
•Interest rate (i) = 700/$10,000 = 7%/Yr

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1.4 Interest Rate - Notation

•For 1.3 the interest rate is..

•Expressed as a per cent per year
•Notation
•I = the interest amount is $
•i = the interest rate (%/interest period)
•N = No. of interest periods (1 for this
problem)

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1.4 Interest – Borrowing (Ex 1.3)
•The interest rate (i) is 7% per year
•The interest amount is $700 over one year
•The $700 represents the return to the
lender for this use of his/her funds for one
year
•7% is the interest rate charged to the
borrower
•7% is the return earned by the lender

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1.4 Interest – Example 1.4
•Borrow $20,000 for 1 year at 9% interest
per year
•i = 0.09 per year and N = 1 Year
•Pay $20,000 + (0.09)($20,000) at end of 1
year
•Interest (I) = (0.09)($20,000) = $1,800
•Total Amt Paid one year hence
•$20,000 + $1,800 = $21,800
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1.4 Interest – Example 1.4

•Note the following

•Total Amount Due one year hence is
•($20,000) + 0.09($20,000)
•=$20,000(1.09) = $21,800
•The (1.09) factor accounts for the repayment
of the $20,000 and the interest amount
•This will be one of the important interest
factors to be seen later

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 1.4 Interest – Investing Perspective

•Assume you invest $20,000 for one year in a

venture that will return to you, 9% per year.
•At the end of one year, you will have:
•Original $20,000 back
•Plus……..
•The 9% return on $20,000 = $1,800

We say that you earned 9%/year on the investment!

This is your RATE of RETURN on the investment

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1.4 Inflation Effects

•A social-economic occurrence in which

there is more currency competing for
constrained goods and services
•Where a country’s currency becomes worth
less over time thus requiring more of the
currency to purchase the same amount of
goods or services in a time period

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1.4 Inflation Rate(s)

•Inflation impacts:
•Purchasing Power (reduces)
•Operating Costs (increases)
•Rate of Returns on Investments
(reduces)
•Specifically covered in Chapter 14

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 Section 1.5
EQUIVALENCE

•Example
•You travel at 68 miles per hour
•Equivalent to 110 kilometers per hour
•Thus:
•68 mph is equivalent to 110 kph
•Using two measuring scales
•Miles and Kilometers
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1.5 EQUIVALENCE

•Is “68” equal to “110”?

•No, not in terms of absolute numbers
•But they are “equivalent” in terms of the
two measuring scales
•Miles
•Kilometers

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1.5 ECONOMIC EQUIVALENCE

•Economic Equivalence
•Two sums of money at two different points
in time can be made economically
equivalent if:
•We consider an interest rate and,
•No. of Time periods between the two
sums
Equality in terms of Economic Value

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1.5 Equivalence Illustrated

•Return to Example 1.4

•Diagram the loan (Cash Flow Diagram)
•The company’s perspective is shown
$20,000 is
received here

T=0 t = 1 Yr

$21,800 paid
back here

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 1.5 Equivalence Illustrated

$20,000 is
received here

T=0 t = 1 Yr

$21,800 paid
back here

$20,000 now is economically equivalent to $21,800

one year from now IF the interest rate is set to
equal 9%/year

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1.5 Equivalence Illustrated

•$20,000 now is not equal in magnitude to

$21,800 1 year from now
•But, $20,000 now is economically
equivalent to $21,800 one year from now if
the interest rate in 9% per year.
•Another way to put it is ……..

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1.5 Equivalence Illustrated

•If you were told that the interest rate is

9%....
Read over
•Which is worth more? Example 1.6

•$20,000 now or
•$21,800 one year from now?
•The two sums are economically equivalent
but not numerically equal!

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1.5 Equivalence Illustrated

•To have economic equivalence you must

specify:
Read over
•Timing of the cash flows Example 1.6

•An interest rate (i% per interest period)

•Number of interest periods (N)

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 Section 1.6
Simple and Compound Interest

•Two “types” of interest calculations

•Simple Interest
•Compound Interest
•Compound Interest is more common
worldwide and applies to most analysis
situations

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1.6 Simple and Compound Interest

• Simple Interest
•Calculated on the principal amount only
•Easy (simple) to calculate
•Simple Interest is:

(principal)(interest rate)(time)
$I = (P)(i)(n)

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1.6 Simple and Compound Interest

• Example 1.7
•Borrow $1000 for 3 years at 5% per year
•Let “P” = the principal sum
•i = the interest rate (5%/year)
•Let N = number of years (3)

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1.6 Simple and Compound Interest

•Simple Interest
•DEFINITION
•I = P(i)(N)
•For Ex. 1.7:
•I = $1000(0.05)(3) = $150.00
•Total Interest over 3 Years

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1.6 Simple and Compound Interest

•Year by Year Analysis Simple Interest

•Year 1
•I1 = $1,000(0.05) = $50.00
•Year 2
•I2 = $1,000(0.05) = $50.00
•Year 3
•I3 = $1,000(0.05) = $50.00
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1.6 Accrued Interest Year 1

•“Accrued” means “owed but not yet paid”

•First Year:
P=$1,000

1 2 3

I1=$50.00

$50.00 interest accrues but not paid

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1.6 Accrued Interest Year 2

•Year 2

P=$1,000

1 2 3

I1=$50.00 I2=$50.00

$50.00 interest accrues but not paid

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1.6 End of 3 Years

•$150 of interest has accrued

P=$1,000

1 2 3

I1=$50.00 I2=$50.00 I3=$50.00

Pay back $1000

The unpaid interest did not + $150 of
interest
earn interest over the 3-year
period
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 1.6 Simple Interest: Summary

• In a multiperiod situation with simple interest:

•The accrued interest does not earn interest
during the succeeding time period
•Normally, the total sum borrowed (lent) is paid
back at the end of the agreed time period PLUS
the accrued (owed but not paid) interest.

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1.6 Compound Interest

•Compound Interest is much different

•Compound means to stop and compute
•In this application, compounding means to
compute the interest owed at the end of the
period and then add it to the unpaid
balance of the loan
•Interest then “earns interest”

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1.6 Compound Interest

• To COMPOUND – stop and compute the

associated interest and add it to the unpaid
balance.
•When interest is compounded, the interest that is
accrued at the end of a given time period is added
in to form a NEW principal balance.
•That new balance then earns or is charged
interest in the succeeding time period

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1.6 Compound Interest

• To COMPOUND – stop and compute the

associated interest and add it to the unpaid
balance.
•When interest is compounded, the interest that is
accrued at the end of a given time period is added
in to form a NEW principal balance.
•That new balance then earns or is charged
interest in the succeeding time period

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1.6 Compound Interest: Ex. 1.8

• Assume:
•P = $1,000
• i = 5% per year compounded annually (C.A.)
•N = 3 years

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1.6 Compound Interest Cash Flow

• For compound interest, 3 years, we have:

P=$1,000
Owe at
Owe at tt =
= 33
years:
years:
1 2 3
$1,000 +
$1,000 + 50.00
50.00 +
+
I1=$50.00 52.50 +
52.50 + 55.13
55.13 ==
I2=$52.50 $1157.63
$1157.63
I3=$55.13

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1.6 Compound Interest: Calculated

• For the example:

•P0 = +$1,000
•I1 = $1,000(0.05) = $50.00
•Owe P1 = $1,000 + 50 = $1,050 (but, we don’t
pay yet!)
•New Principal sum at end of t = 1: = $1,050.00

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1.6 Compound Interest: t = 2

• Principal and end of year 1: $1,050.00

•I1 = $1,050(0.05) = $52.50 (owed but not paid)
•Add to the current unpaid balance yields:
•$1050 + 52.50 = $1102.50
•New unpaid balance or New Principal Amount
•Now, go to year 3…….

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1.6 Compound Interest: t = 3

• New Principal sum: $1,102.50

•I3 = $1102.50(0.05) = $55.125 = $55.13
•Add to the beginning of year principal yields:
•$1102.50 + 55.13 = $1157.63
•This is the loan payoff at the end of 3 years
•Note how the interest amounts were added to
form a new principal sum with interest calculated
on that new amount

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1.6 Example 1.9

• Five plans are shown that will pay off a loan of

$5,000 over 5 years with interest at 8% per year.
•Plan1. Simple Interest, pay all at the end
•Plan 2. Compound Interest, pay all at the end
•Plan 3. Simple interest, pay interest at end of each
year. Pay the principal at the end of N = 5
•Plan 4. Compound Interest and part of the
principal each year (pay 20% of the Prin. Amt.)

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1.6 Example 1.9: 5 Plans

• Plan 5. Equal Payments of the compound interest

and principal reduction over 5 years with end of
year payments.

Note: The following tables will show the five

approaches. For now, do not try to understand
how all of the numbers are determined (that will
come later!) Focus on the methods and these table
illustrate economic equivalence

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1.6 Plan 1: @ 8% Simple Interest

• Simple Interest: Pay all at end on $5,000 Loan

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1.6 Plan 2: Compound Interest 8%/yr

• Pay all at the End of 5 Years

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1.6 Plan 3: Simple Interest Pd. Annually

• Principal Paid at the End (balloon Note)

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1.6 Plan 4 Compound Interest

• 20% of Principal Paid back annually

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1.6 Plan 5: Equal Repayment Plan

• Equal Annual Payments (Part Principal and Part

Interest

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1.6 Comparisons – 5 Plans

• Plan 1 Simple interest = (original principal)

(0.08)
•Plan 2 Compound interest = (total owed previous
year)(0.08)
•Plan 3 Simple interest = (original principal)(0.08)
•Plan 4 Compound interest = (total owed previous
year)(0.08)
•Plan 5 Compound interest = (total owed previous
year)(0.08)

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1.6 Analysis

• Note that the amounts of the annual payments

are different for each repayment schedule and that
the total amounts repaid for most plans are
different, even though each repayment plan
requires exactly 5 years.
•The difference in the total amounts repaid can be
explained (1) by the time value of money, (2) by
simple or compound interest, and (3) by the partial
repayment of principal prior to year 5.

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 Section 1.7
Terminology and Symbols

• Specific symbols and their respective

definitions has been developed for use in
engineering economy
•Symbols tend to be standard in most
engineering economy texts world-wide
• Mastery of the symbols and their respective
meanings is most important in understanding of
the subsequent material!

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1.7 Terminology and Symbols

•P = value or amount of money at a time

designated as the present or time 0.
•Also P is referred to as present worth (PW),
present value (PV), net present value (NPV),
discounted cash flow (DCF), and capitalized
cost (CC); dollars

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1.7 Terminology and Symbols

• F = value or amount of money at some

future time.
•Also F is called future worth (FW) and
future value (FV); dollars

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1.7 Terminology and Symbols

•A = series of consecutive, equal,

end‑of‑period amounts of money.
•Also A is called the annual worth (AW) and
equivalent uniform annual worth (EUAW);
dollars per year, dollars per month
•n = number of interest periods; years,
months, days

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1.7 Terminology and Symbols

• i = interest rate or rate of return per

time period; percent per year, percent per
month
• t = time, stated in periods; years,
months, days, etc

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1.7 P and F

• The symbols P and F represent one-time

occurrences:
$F
•Specifically:

0 1 2 … … n-1 n
t=n

$P

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1.7 P and F:

• It should be clear that a present value P

represents a single sum of money at some
time prior to a future value F
•This is an important basic point to
remember

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1.7 Annual Amounts

• It is important to note that the symbol A

always represents a uniform mount (i.e.,
the same amount each period) that
extends through consecutive interest
periods.

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1.7 Annual Amounts

• Cash Flow diagram for annual amounts

might look like the following:
$A $A $A $A $A

…………
0 1 2 3 .. N-1 n

A = equal, end of period cash flow amounts

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1.7 Interest Rate – i% per period

• The interest rate i is assumed to be a

compound rate, unless specifically stated
•As “simple interest”

•The rate i is expressed in percent per

interest period, for example, 12% per
year.

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1.7 Terminology and Symbols

• For many engineering economy

problems:
•Involve the dimension of time
•At least 4 of the symbols { P, F, A, i%
and n }
•At least 3 of 4 are either estimated or
assumed to be know with certainty.

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 Section 1.8
Intro to Solution by Computer

• Use of a spreadsheet similar to

Microsoft’s Excel is fundamental to the
analysis of engineering economy
problems.
•Appendix A of the text presents a primer
on spreadsheet use
•All engineers are expected by training to
know how to manipulate data, macros,
and the various built-in functions common
to spreadsheets
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1.8 Spreadsheets

• Excel supports (among many others) six

built-in functions to assist in time value of
money analysis
•Master each on your own and set up a
variety of the homework problems (on
your own)

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1.8 Excel’s Financial Functions

• To find the present value P: PV(i%,n,A,F)

•To find the future value F: FV(i%,n,A,P)

•To find the equal, periodic value A:

PMT(i%,n,P,F)

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 1.8 Financial Functions - continued

• To find the number of periods n:

NPER(i%,A,P,F)
•To find the compound interest rate i:
RATE(n,A,P,F)
•To find the compound interest rate i:
IRR(first_ cell:last_ cell)

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1.8 Financial Functions - continued

• To find the present value P of any series:

NPV(i%,second_cell_last cell) + first cell
• These built-in Excel functions support a
wide variety of spreadsheet models that
are useful in engineering economy
analysis.
•Study Examples 1.10 and 1.11

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 Section 1.9
Minimum Attractive Rate of Return
(MARR)
• Firms will set a minimum interest rate that the
financial managers of the firm require that all
accepted projects must meet or exceed.
•The rate, once established by the firm is termed
the Minimum Attractive Rate of Return (MARR)
•The MARR is expressed as a per cent per year
•Numerous models exist to aid the financial
managers is estimating what this rate should be
in a given time period.

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1.9 Minimum Attractive Rate of Return

• An investment is a commitment of funds and

resources in a project with the expectation of
earning a return over and above the worth of the
resources that were committed.
•Economic Efficiency means that the returns
should exceed the inputs.
•In the for profit enterprise, economic
efficiencies greater than 100% are required!

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1.9 MARR – Hurdle Rate

• In some circles, the MARR is termed the Hurdle

Rate
• Capital (investment funds) is not free
•It costs the firm money to raise capital or to use
the owners of the firm’s capital.
•This cost is often expressed as a % per year

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1.9 Cost of Capital: Personal Example

• Assume you want to purchase a new computer

•Assume you have a charge card that carries a
18% per year interest rate.
•If you charge the purchase, YOUR cost of capital
is the 18% interest rate.
•Very high!

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1.9 Cost to a Firm

• Firm’s raise capital from the following sources

•Equity – using the owner’s funds (retained
earnings, cash on hand )belongs to the
owners)
•Owners expect a return on their money and
hence, there is a cost to the firm
•DEBT – the firm borrows from outside the firm
and pays an interest rate on the borrowed funds

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1.9 Costing Capital

• Financial models exist that will approximate

the firm’s weighted average cost of capital for a
given time period.
•Once this “cost” is approximated, then, new
projects up for funding MUST return at least the
cost of the funds used in the project PLUS some
additional per cent return.
•The cost is expressed as a % per year just like
an interest rate.

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1.9 Setting the MARR: Safe Investment

• First, start with a “safe” investment possibility

• A firm could always invest in a short term CD
paying around 4-5%
• But investors will expect more that that!
• The firm should compute it’s current weighted
average cost of capital (See Chapter 10)
•This cost will almost always exceed a “safe”
external investment rate!

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1.9 Setting the MARR - continued

• Assume the weighted average cost of capital

(WACC) is say, 10.25% (for the sake of
presentation)
• Certainly, the MARR must be greater than the
firms cost of capital in order to earn a “profit” or
“return” that satisfies the owners!
•Thus, some additional “buffer” must be
provided to account for risk and uncertainty!

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1.9 Setting a MARR

• Start with the WACC…

•Add a buffer percent (?? Varies from firm to
firm)
• This yields an approximation to a reasonable
MARR
•This becomes the Hurdle Rate that all
prospective projects should earn in order to be
considered for funding.

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1.9 Graphical Presentation: MARR
RoR - %

Acceptable range for new

projects

MARR - %

Safe Investment WACC - %

0%

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1.9 Opportunity forgone

• Assume a firm’s MARR = 12%

•Two projects, A and B
•A costs $400,000 and presents an estimated
13% per year.
•B cost $100,000 with an estimated return of
14.5%

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1.9 Opportunity Forgone

• What if the firm has a budget of say $150,000

•A cannot be funded – not sufficient funds!
•B is funded and earns 14.5% return or more
•A is not funded, hence, the firm looses the
OPPORTUNITY to earn 13%
•This often happens!

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 Section 1.10
Cash Flow Diagramming

• Engineering Economy has developed a

graphical technique for presenting a problem
dealing with cash flows and their timing.
•Called a CASH FLOW DIAGRAM
•Similar to a free-body diagram in statics
• First, some important TERMS . . . .

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1.10 Important TERMS

• CASH INFLOWS
•Money flowing INTO the firm from outside
•Revenues, Savings, Salvage Values, etc

•CASH OUTFLOWS
•Disbursements
• First costs of assets, labor, salaries, taxes
paid, utilities, rents, interest, etc

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1.10 Cash Flows

• For many practical engineering economy

problems the cash flows must be:
•Assumed know with certainty
•Estimated
•A range of possible realistic values provided
•Generated from an assumed distribution and
simulated

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1.10 Net Cash Flows

• A NET CASH FLOW is

• Cash Inflows – Cash Outflows
•(for a given time period)
• We normally assume that all cash flows
occur:
•At the END of a given time period
•End-of-Period Assumption

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1.10 End of Period Assumption

• END OF PERIOD convention

ALL CASH
ALL CASH FLOWS
FLOWS ARE
ARE ASSUMED
ASSUMED TOTO OCCUR
OCCUR ATAT
THE END
THE END OF
OF AN
AN INTEREST
INTEREST PERIOD
PERIOD EVEN
EVEN IF
IF THE
THE
MONEY FLOWS
MONEY FLOWS AT
AT TIMES
TIMES WITHIN
WITHIN THE
THE
INTEREST PERIOD.
INTEREST PERIOD.
THIS IS
THIS IS FOR
FOR SIMPLIFICATION
SIMPLIFICATION PURPOSES
PURPOSES

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1.10 The Cash Flow Diagram: CFD

• Extremely valuable analysis tool

• First step in the solution process
• Graphical Representation on a time scale
•Does not have to be drawn “to exact scale”
•But, should be neat and properly labeled
•Required on most in class exams and part of
the grade for the problem at hand

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1.10 Example Cash Flow diagrams

• Assume a 5-year problem

•The basic time line is shown below

•“Now” is denoted as t = 0

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1.10 Displaying Cash Flows

• A sign convention is applied

• Positive cash flows are normally drawn
upward from the time line
• Negative cash flows are normally drawn
downward from the time line

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1.10 Sample CF Diagram
Positive CF at t = 1

Negative CF’s at t = 2 & 3

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1.10 Problem Perspectives

• Before solving, one must decide upon the

perspective of the problem
•Most problems will present two perspectives
•Assume a borrowing situation for example
•Perspective 1: From the lender’s view
•Perspective 2: From the borrower’s view
•Impact upon the sing convention

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1.10 Lending – Borrowing Example

• Assume $5,000 is borrowed and payments are

$1100 per year.
•Draw the cash flow diagram for this
•First, whose perspective will be used?
•Lender’s or the Borrower’s ? ? ?
•Problem will “infer” or you must decide….

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1.10 Lending - Borrowing

• From the Lender’s Perspective

A = +$1100/yr

0 1 2 3 4 5

-$5,000

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1.10 Lending - Borrowing

• From the Lender’s Perspective

P = +$5,000

0 1 2 3 4 5

A = -$1100/yr

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1.10 Example 1.17

• A father wants to deposit an unknown

lump‑sum amount into an investment
opportunity 2 years from now that is large
enough to withdraw $4000 per year for state
university tuition for 5 years starting 3 years
from now.
•If the rate of return is estimated to be 15.5%
per year, construct the cash flow diagram.

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1.10 Example 1.17 CF Diagram

12/08/21 Authored by Don Smith, TX A&M University 118

CHAPTER I Section 1.11

Rule of 72: Estimating

doubling Time and Interest
Rate
 Section 1.11
Rule of 72: Estimating Doubling Time and
Interest Rate
• A common question most often asked by
investors is:
•How long will it take for my investment to
double in value?
•Must have a known or assumed compound
interest rate in advance
•Assume a rate of 13%/year to illustrate….

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1.11 Rule of 72’s for Interest

• The Rule of 72 states:

•The approximate time for an investment to
double in value given the compound interest
rate is:

•Estimated time (n) = 72/i

•For i = 13%: 72/13 = 5.54 years

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1.11 Rule of 72’s for Interest

• Likewise one can estimate the required

interest rate for an investment to double in value
over time as:

•i approximate = 72/n
•Assume we want an investment to double in
say 3 years.
•Estimate i –rate would be: 72/3 = 24%

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 Section 1.12
Spreadsheet Applications

• Section 1.12 introduces the concepts

associated with using a spreadsheet program
like Microsoft Excel.
•To build and improve your knowledge of
modeling by using Excel you must build your own
models and experiment with the various
functions
•You instructor will determine the extent and
depth of use of Excel for this course

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 Chapter 1 Summary

• Engineering Economy:
•Application of economic factors and
criteria to evaluate alternatives
considering the time value of money
(interest and time)

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• Engineering Economy Study:
•Involves modeling the cash flows
•Computing specific measures of
economic worth
•Using an interest rate(s)
•Over a specified period of time

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• The concept of equivalence helps in
understanding how different sums of
money at different times are equal in
economic terms

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• Simple and Compound Interest
•The differences between simple interest
(based on principal only) and compound
interest (based on principal and interest upon
interest) have been described in formulas,
tables, and graphs

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• Compounding of Interest
•The power of compounding is very
noticeable, especially over long periods of
time.
•Notion of computing interest on interest

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• The MARR
•The MARR is a reasonable rate of return
established as a hurdle rate to determine if an
alternative is economically viable.
•The MARR is always higher than a return
from a safe investment.

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• Attributes of Cash Flows
•Difficulties with their estimation.
•Difference between estimated and actual
value.
•End‑of‑year convention for cash flow
location.

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• Attributes of Cash Flows
•Net cash flow computation.
•Different perspectives in determining the
cash flow sign convention.
•Construction of a cash flow diagram.
•Introduction to spreadsheet analysis

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ENGINEERING ECONOMY Sixth Edition
Blank and Tarquin

End of Slide Set

M c
Graw
Hill