Chapter 1: Foundations of

Engineering Economy
Engineering Economy
ENMG 400

What is Engineering Economy?

It involves estimating, formulating and evaluating the financial
outcomes of alternatives.
It is a collection of mathematical techniques that simplify
economic comparison.
Accurately identify the true costs and benefits associated with
alternatives over time.
It provides a criteria for decision making.
Select the solution(s) that best utilize resources (money,
people, equipment, etc.) for the well being of the company
and/or society.

Why is Engineering Economy important to

engineers?
Engineers design and create
Often engineers must select and execute from multiple
alternatives
A proper economic analysis for selection and execution is a
fundamental aspect of engineering

What kinds of problems can you evaluate

with engineering economy?
Personally (economic decisions)
Buying a car
Taking loans (credit cards, student loans, etc.)
Making investments

Professionally

Justifying new projects, methods, equipment, etc.

Finding the value of capital (land, buildings, equipment)
Evaluating alternative plans
Every time you need to sell something to upper management, you
will need to attach some monetary value, which will come from
engineering economic analysis.

Steps of a decision-making process

1.
2.
3.
4.
5.
6.
7.
8.
9.

Understand the problem and define the objective

Collect relevant information
Define alternatives and estimate relevant costs
Identify the criteria
Evaluate each alternative
Select the best alternative
Implement the solution
Monitor the results
Refine the solution (go back to 3)

Time Value of Money

$1 today is not equivalent to $1 a year later.
Money makes money - If we invest money today, we expect to have more money in
the future.
If money is borrowed today, by tomorrow more than the
original loan principal will be owed.
The change in the amount of money over a given time period
is called time value of money; it is the most important
concept in engineering economy.

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Interest
Interest is the manifestation of the time value of money
Rental fee that one pays to use someone elses money; the
cost of money
Difference between an ending amount of money and a
beginning amount of money
Always two perspectives to an amount of interest:
From the view of the borrower, it is the interest paid
From the view of the lender, it is the interest earned

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Interest
View of borrower:
= ( )
% =

100%

View of lender:
= ( )
% =

100%

Interest Rate (IR) and Rate of Return (ROR) involve the same
computations; however IR is the term more appropriate for the
borrowers perspective, and ROR is better for the investors perspective
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Interest Examples
The Oracle investment group invested $200,000 on May 1 and
withdrew a total of $220,000 exactly one year later
Interest earned = $220,000 $200, 000 = $20,000
ROR = ($20,000 / $200,000) 100 = 10%

Another Oracle group borrowed $100,000 on May 1 and paid

a total of $105,000 exactly one year later
Interest paid = $105,000 $100, 000 = $5,000
Interest rate = ($5,000 / $100,000) 100 = 5%

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Simple and Compound Interest

Interest can be either simple or compound.
With simple interest, in each period one pays interest on the
principal (the amount borrowed) itself only (rarely used).
With compound interest, in each period, one pays interest on
the principal and on the interest accumulated from previous
periods.
That is, one pays interest on interest

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Simple and Compound Interest

Suppose you borrow an amount P and pay interest for n years
at a rate of i per year.
Then, the amount, F, you pay back n years later is
With simple interest,
F = P + iP +.+ iP = P + niP.
Then, F = P(1+ ni)
With compound interest,
F = P(1+ i)(1+ i)......(1+ i).
Then, F = P(1+ i)n

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Simple and Compound Interest

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Interest Example

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Terminology and Symbols

i: interest
P: present value
t: a particular year/time increment
n: total number of interest periods; years, months, days
An: a series of consecutive, equal, end of period amounts of
money.
F: future value

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Example

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Example

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Cash Flows
Cash Inflows - amount of funds flowing into the firm
Cash Outflows - amount of funds flowing out of the firm
Example of cash inflows
Sales Revenue
Asset salvage value
Borrowed money

Example of cash outflows

Paybacks
Labor cost
Maintenance and operating costs
Lending money
Income taxes

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Cash flow diagram

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Cash Flow Diagrams

$800
i = 4%
$400

$350

$400

N (years)

$400

$600
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Cash Flow Example

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Economic Equivalence
Definition: cash flows that have the same economic effect
when compared in the same time period.
Different sums of money at different times may be
equivalent in economic value.
For the Oracle group doing the investment, $200 K now are
equivalent to $220 K a year later.

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Equivalence Example 1
You want to replace your study desk. The new desk is now
$125 and estimated to be worth $135 for the next year.
At a market interest rate of 12%, would you replace your desk
now or the next year?
$135 next year are equivalent to 135/1.12 = $120.54 < $125.
Then, its better to buy the desk next year because this saves
you around $5.
This is a Present Worth analysis

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Equivalence Example 2
Example: You have a choice between receiving $1500 today
and $3000 in 4 years. What interest rate would you have to
earn on the $1500 to make it equivalent to the $3000 at year
4?

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Equivalence Example 3

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Minimum Attractive Rate of Return

(MARR)
For any investment to be profitable, investors expect to
receive more money than the amount of capital invested.
MARR is a reasonable ROR established for the evaluation and
selection of alternatives.
A project is not economically viable unless it is expected to
return at least the MARR.
The company management establishes the MARR

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Minimum Attractive Rate of Return

(MARR)
Before we can talk about how MARR is established, we need
to understand cost of capital.
It almost always costs money in the form of interest to raise
capital.
The interest rate is the called the cost of capital.

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Minimum Attractive Rate of Return

(MARR)
Example: you want to purchase a new widescreen HDTV, but
dont have sufficient money (capital). To generate this money,
you could:
Obtain a credit union loan at i = 9% and pay for the TV in cash now; or
Use your credit card and pay off the balance on a monthly basis at i =
18% per year; or
Use funds from your savings account that earns 5% per year.

The 9%, 18%, and 5% rates are your cost of capital estimates
to raise the capital for the TV.
In similar ways, firms estimate the cost of capital from
different sources to raise funds for engineering projects.
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Minimum Attractive Rate of Return

(MARR)
Capital or funds can be generated in two ways:
1. Equity financing

Firm using its own funds from cash on hand, stock sales, or retained
earnings.
Individuals use their own cash or savings.
e.g. using money from the 5% savings account.

2. Debt financing

Firm borrowing money from outside sources and repaying later or over
time.
Sources of capital may be: taking loans, mortgage, etc.
e.g. credit union loan and credit card options.

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Minimum Attractive Rate of Return

(MARR)
MARR is estimated based on the weighted average of the cost
of capital (WACC) of sources of funding.
Example: TV purchased with: 40% credit card money at i = 18%
per year; and 60% savings account funds earning 5% per year.
WACC = (0.4)(18) + (0.6)(5) = 10.2% per year

MARR will be set to be greater than the WACC.

MARR is used as a criterion to accept or reject an investment
alternative.
To be considered financially viable, a projects expected ROR
must meet or exceed the MARR.
If ROR MARR, accept project.
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Summary on MARR
Determine the different funding
sources and their associated cost of
capital (interest).
Estimate a WACC depending on how
the investment will be funded.
Establish a MARR to be greater than
the WACC (MARR > WACC)
If the expected ROR on the investment
is greater or equal to MARR, then
accept the investment decision.
If ROR MARR, then accept project
If ROR < MARR, then reject project
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Rule of 72
This rule (approximately) estimates the number of time
periods, n, it takes for an amount of money to double under a
ROR of i (%):
72
=

Note: i is entered as a percentage in the formula.

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Rule of 72

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