Principal of money – time

relationships
• Money has a time value because a dinar today is
worth more than a dinar one or more years from
now. Therefore the effect of time is considered in
the majority of engineering economy studies.
• Capital in the form of money for the people,
machines, materials, energy, and other things
needed in the operation of an organization may be
classified into two basic categories.
• Equity capital : capital that owned by individuals who have
invested their money or property in business project or
venture in the hope of receiving a profit.
• Debt capital: Some time called borrowed capital, is obtained
from lenders (through the sale of bonds) for investment. In
return the lenders receive interest from borrowers.
• There are fundamental reasons why return to
capital in the form of interest and profit is an
essential ingredient of engineering economy
studies.
• first, interest and profit pay the providers of capital for
the given up its use during the time the capital is being
used.
• Second, interest and profit are payments of the risk the
investor takes in permitting another person, or an
organization, to use his or her capital.
 Interest
• Interest is a fee paid by a borrower
of assets to the owner as a form of
compensation for the use of the assets. It is
most commonly the price paid for the use of
borrowed money, or money earned by
deposited funds.
 Simple interest
• When the total interest earned or charged is linearly proportional
to the initial amount of the loan (principal), the interest rate and
the number of interest periods for which the principal is
committed, the interest and the interest rate are said to be simple.
• Simple interest is calculated only on the principal amount, or on
that portion of the principal amount that remains unpaid.
• The amount of simple interest is calculated according to the
following formula:
I = (P)(N)(i)
Where P = principal amount lent or borrowed.
N = number of interest periods (years).
i = interest rate per interest period.
The total amount repaid at the end of N interest periods P + I.
 Compound interest
• Arises when interest is added to the principal,
so that from that moment on, the interest that
has been added also it-self earns interest. This
addition of interest to the principal is
called compounding.
• Compound interest is interest that is calculated on
both the money deposited and the interest earned
from that deposit.

A=P(1+r/n)^nt
• Where A represents the final balance after the
interest has been calculated for the time, t, in years,
on a principal amount, P, at an annual interest rate, r
The number of times in the year that the interest is
compounded is n
1- Ahmed deposits $520 into a savings account
that has a 3.5% interest rate compounded
monthly. What will be the balance of Ahmed’s
savings account after two years?
A=520(1+ 0.035/12)^{12(2)}
= 557.65
2- Laila has $1,780.80 in her savings account that
she opened 6 years ago. Her account has an
annual interest rate of 6.8% compounded
annually. How much money did Laila use to open
her savings account?

• 1,780.80=P(1+0.068/1)^(1(6))
• 1,780.80=1.484P
• P = 1200
CASH FLOW DIAGRAMS
 Life-Cycle Costs
Two key concepts in life-cycle costing:
The later design changes are made, the higher
the costs,
Decisions made early in the life cycle tend to
"lock in" costs that are incurred later
 COST ESTIMATING
• Types of Estimate:
– Rough estimates: It is used for high-level planning,
for determining macro feasibility, and in a
project's initial planning and evaluation phases.
– Semi-detailed estimates: Used for budgeting
purposes at a project's conceptual or preliminary
design stages.
– Detailed estimates: Used during a projects
detailed design and contract bidding phases.
 CASH FLOW DIAGRAMS
• The costs and benefits of engineering projects
occur overtime and are summarized on a cash
flow diagram (CFD).
• A CFD illustrates the size, sign, and timing of
individual cash flows.
• The CFD is the basis for engineering economic
analysis.
• A cash flow diagram is created by first drawing a
segmented time-based horizontal line, divided
into appropriate time units.
• The time units on the CFD can be years,
months, quarters, or any other consistent time
unit.
• At each time at which a cash flow will occur, a
vertical arrow is added-pointing down for costs
and up for revenues or benefits.
• These cash flows are drawn to relative scale.
• The cash flows are assumed to occur at time 0
or at the end of each period.
 Timing of Cash Flow Size of Cash Flow

At time zero (now or today) A positive cash flow of $100

1 time period from today A negative cash flow of $100

2 time periods from today A positive cash flow of $100

3 time periods from today A negative cash flow of $150

4 time periods from today A negative cash flow of $150

5 time periods from today A positive cash flow of $50

100

100 50

+
0
1 2 3 444 5

- Time 0 today
150
150
100
 Categories of Cash Flows
• The expenses and receipts due to engineering projects usually fall into
one of the following categories.
• First cost = expense to build or to buy and install.
• Operations and maintenance (O&M) = annual expense, such as
electricity, labor, and minor repairs.
• Salvage value = receipt at project termination for sale or transfer of the
equipment (can be a salvage cost).
• Revenues = annual receipts due to sale of products or services.
• Overhaul = major capital expenditure that occurs during the asset's life.
• Individual projects will often have specific costs, revenues, or user
benefits.
• For example, annual operations and maintenance (O&M) expenses on
an assembly line might be divided into direct labor, power, and other.
Similarly, a public-sector project might have its annual benefits divided
into flood control, agricultural irrigation, and recreation.
 Example:
A manager has decided to purchase a
new$30,000 mixing machine. The machine
may be paid for in one of two ways:
1. Pay the full price now minus a 3% discount.
2. Pay $5000 now; at the end of one year pay
$8000; at the end of each of the next four
years, pay $6000.
List the alternatives in the form of a table of
cash flows.
• Solution:
• In this problem the two alternatives represent different ways to
pay for the mixing machine.
• While the first plan represents a lump sum of $29,100 now, the
second one calls for payments continuing until the end of the
fifth year. The problem is to convert an alternative into cash
receipts or payments and show the timing of each receipt or
payment. The result is called a cash flow table or more simply a
set of cash flows.
• The cash flows for both the alternatives in this problem are very
simple. The cash flow table, with payments given negative signs,
is as End
follows:
of year Pay in Full Now Pay over 5 Years
0 -29,100 -5000
1 0 -8000
2 0 -6000
3 0 -6000
4 0 -6000
5 0 -6000
 29.100

-5000 -6000 -6000 -6000

-8000 -6000
• Example:
A man borrowed $1000 from a bank at 8%
interest. He agreed to repay the loan in two
end-of-year payments. At the end of the first
year, he will repay half of the $1000 principal
amount plus the interest that is due. At the
end of the second year he will repay the
remaining half of the principal amount plus
the interest for the second year. Compute the
borrower's cash flow.
 Solution:
• In engineering economic analysis we normally refer to the beginning of the
first year as "time 0." At this point the man receives $1000 from the bank.(A
positive sign represents a receipt of money and a negative sign, a
payment.)Thus, at time 0, the cash flow is +$1000.
• At the end of the first year, the man pays 8%interest for the use of $1000 for
one year. The interest is 0.08 x $1000 = $80. In addition, he repays half the
$1000 loan, or $500. Therefore, the end-of-year-I cash flow is -$580.
• At the end of the second year, the payment is 8% for the use of the balance of
the principal ($500) for the one-year period, or 0.08 x 500 = $40. The $500
principal is also repaid for a total end of year 2cash flow at -$540. The cash
End of year Cash flow
flow is:
0 1000

1 -580

2 -540

+1000

-580 -540