FOUNDATIONS OF

ENGINEERING ECONOMIC

Why Engineering Economy is

Important to Engineers
(and other professionals)

02/21/24 Authored by Don Smith, TX A&M University 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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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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Definition

ENGINEERING ECONOMY IS INVOLVED WITH THE

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

ENGINEERING ECONOMY IS INVOLVED WITH THE

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

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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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 Role of Engineering Economy
in Decision Making

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Role of Engineering Economy

• 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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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 ..

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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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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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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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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
Engineering
Economy
are applied

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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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Quiz

1. "Engineering Economics is the tool to study interest

and interest rate only", do you agree with this
statement? Give an explanation of your answer
2. Why Engineering Economics must deal with risk and
uncertainty?
3. Give example of case in the field of civil engineering
that requires Engineering Economics to solve
4. “Engineering Economics in the tool for assessing one
aspect of project feasibility study only”, please explain
your understanding of this statement

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 Performing
an Engineering Economy Study

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 Performing

• 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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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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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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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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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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 Alternatives

• Goal: Define, Evaluate, Select and Execute

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

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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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 More Alternatives

• Goal: Define, Evaluate, Select and Execute

Do
Alt. 1 ………... Alt. j
Nothing

Which one do we accept?

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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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Taxes

• Taxes represent a significant negative

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

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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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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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 INTEREST RATE AND
RATE OF RETURN

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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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Interest Rate

INTEREST RATE
Interest / time unit (%)

Interest Per Time Unit

Interest Rate = x 100%
Original Amount

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Interest Rates and Returns

• Interest can be viewed from two

perspectives:
1. Lending situation
2. Investing situation

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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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Interest – Lending Example

Example
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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Interest Rate - Notation

• 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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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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Interest

• 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 amount paid one year hence
$20,000 + $1,800 = $21,800
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Interest

• 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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 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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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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 Inflation Rate(s)

• Inflation impacts:
 Purchasing Power (reduces)
 Operating Costs (increases)
 Rate of Returns on Investments
(reduces)

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 Equivalence

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 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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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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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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Equivalence Illustrated

• 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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 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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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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Equivalence Illustrated

• If you were told that the interest rate is

9%....
• Which is worth more?
 $20,000 now or
 $21,800 one year from now?
• The two sums are economically
equivalent but not numerically equal!

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Equivalence Illustrated

• To have economic equivalence you must

specify:
 Timing of the cash flows
 An interest rate (i% per interest
period)
 Number of interest periods (n)

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 Simple and Compound
Interest

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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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 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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 Simple and Compound Interest

• Example
 Borrow $1000 for 3 years at 5% /year
 Let “P” = the principal sum
 i = the interest rate (5%/year)
 Let n = number of years (3)
 I = $1000(0.05)(3) = $150.00 (Total
Interest over 3 Years)

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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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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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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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Accured Interest 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

+ $150 of
The unpaid interest did not earn interest
interest over the 3-year period

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 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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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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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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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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 Compound Interest

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

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 Compound Interest Cash Flow
• For compound interest, 3 years, we have:

P=$1,000

1 2 3

I1=$50.00
I2=$52.50

I3=$55.13

Owe at
Owe at tt =
= 33 years:
years:
$1,000 +
$1,000 + 50.00
50.00 +
+ 52.50
52.50 +
+ 55.13
55.13 =
= $1157.63
$1157.63

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Compound Interest

• 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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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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 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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Compound Interest

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

$5,000 over 5 years with interest at 8% / 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 principal
amount)

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Compound Interest

• 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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Plan 1

Plan 1: : Simple Interest @ 8%, pay all at end on

$5,000 Loan

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Plan 2
Plan 2: Compound Interest 8%/yr, pay all at the
end of 5 Years

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Plan 3
• Plan 3: Simple Interest paid annually, principal
paid at the end

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Section 1.6 Plan 4

• Plan 4: Compound Interest 20% of principal paid

back annually

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Plan 5

• Plan 5: equal repayment plan equal annual

payments (part principal and part interest)

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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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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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 Terminology and Symbols

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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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Terminology and Symbols
• P = value or amount of money at a time
designated as the present or time 0
• P is also referred to as present worth (PW),
present value (PV), net present value (NPV),
discounted cash flow (DCF), and capitalized
cost (CC); dollars
• F = value or amount of money at some future
time
• F is also called future worth (FW) and future
value (FV); dollars
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Terminology and Symbols
• A = series of consecutive, equal, end‑of‑period
amounts of money
• A is aslo 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
• 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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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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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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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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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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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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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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MARR

• 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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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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Summary

• Engineering Economy: application of

economic factors and criteria to
evaluate alternatives considering the
time value of money (interest and time)
• 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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Summary

• The concept of equivalence helps in

understanding how different sums of
money at different times are equal in
economic terms
• 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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Summary
• Compounding of Interest
• The power of compounding is very
noticeable, especially over long periods of
time
• Notion of computing interest on interest

• 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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Exercise

Investment program gives 10% interest rate to the

investor. Our company invests $240,000 now into this
program for new office building plan that will be
constructed 3 years from now. How much money that
can be withdrawn by our company when the new office
building project is constructed, 3 years from now. If the
10% interest rate is considered as simple interest and
compound interest.

02/21/24 Authored by Don Smith, TX A&M University 91