Engineering Economics PDF

CHEMICAL ENGINEERING DEPARTMENT
GADJAH MADA UNIVERSITY

TKK 2105
ENGINEERING ECONOMICS
(2 SKS)
INSTRUCTOR:
Budhijanto
REFERENCES:
a. Sullivan, W.G., Wicks, E.M., and Luxhoj,
J.T., 2003, Engineering Economy, 12 ed.,
Pearson Education, Inc., New Jersey.
b. Garrett, D.E, 1989, Chemical Engineering
Economics, Van Nostrand Reinhold, New
York.
c. Peters, M.S. and Timmerhaus, K.D., 2003,
Plant Design and Economics for Chemical
Engineers, 5 ed., McGraw-Hill, Inc., New
York.
d. Turton, R., Bailie, R.C., Whiting, W.B., and
Shaeiwitz, 2003, Analysis, Synthesis, and
Design of Chemical Processes, 2 ed, Pearson
Education, Inc. Publishing as Prentice Hall
PTR.
Budhijanto,TeknikKimiaUGM,2012
Page1
e. Aries, R.S. and Newton, R.D., 1955, Chemical

Engineering Cost Estimation, McGraw-Hill
Book Company, New York.
Goal:
Students are able to do calculation based on the
time value of money, to analyze profit and
profitability, and to choose among several
investment alternatives.
Topics:
a. Introduction to Engineering Economics
b. Cost Concepts
c. Time Value of Money Concept
d. Applications of the Time Value of Money
Concept
e. Comparing Alternatives
f. Depreciation and Profit Analysis
g. Cost Estimation Techniques
h. Uncertainty
Grade:
Midterm Exam
Final Exam
Homeworks/Projects
45 %
45 %
10 %
Page2
A 75
75 > B 60
60 > C 45
45 > D 30
30 > E
Policy:
Closed book exams
No exam remedy
Questions regarding exam/homework/project
grades/scores must be submitted in a week after
students received their grades/scores
No late-homework
A minimum of 75% class attendance to get a
final grade
Page3
I. Introduction to Engineering Economics

What will we learn?
Systematic evaluation of the economic merits of
proposed solutions to engineering problems.
To be economicaly acceptable, the solutions
must demonstrate a positive balance of long
term benefits over a long term costs, and also
fulfils other criteria, such as safety, reliability,
etc.
Fundamental question:
Does the income exceed all the costs?
Why do we learn Engineering Economics?
Chemical Engineering Profession is the
profession in which knowledge of mathematics,
chemistry, and other natural science gained by
study, experience, and practice is applied with
judgment to develop economic ways of using
materials and energy for the benefit of mankind.
(Turton et al., 2003 p. 729)
Point: Chemical Engineers develop economic
ways.
Page4
More economic way: less cost higher profit.

Profit: the excess of income over expenditure
Engineering (regardless of the engineering
discipline), without economy, makes no sense
at all.
Example (Barir Kurniawan`s Final Project):
Methyl mercaptan (CH3SH):
Gas industry: leakage detector in gas
pipelines
Polymer industry: terminator to control
molecular weight
Feed industry: raw material in methionin
synthesis
etc.
Methods:
1. CO2 + S + 4 H 2 CH 3 SH + 2 H 2O
(250 400oC, 30 70 atm)
2. CS 2 + 3H 2 CH 3 SH + H 2 S
(catalytic, 150 350oC, 10 50 atm)
3. CH 4 + H 2 S CH 3 SH + H 2
(new process)
Page5
4. CH 3OH + H 2 S CH 3 SH + H 2 O
(catalytic, 200 500oC, 1 25 atm)
All these methods are different one from the
others in:
1. Raw Materials
2. Side products
3. Process equipments
4. Energy consumption
5. New/old process
6. etc.
Which one? the most economical one.
How? economic evaluation.
Engineering Economics : a tool to assist in
decision making
a. Is an investment plan economically
attractive?
b. Among several investment alternatives,
which one is the most economically
attractive?
Economics is one of the Chemical Engineering
Tools.
Chemical Engineering Tools:
1. Mass balance
Page6
2.
3.
4.
5.
6.
Energy balance
Equilibria
Rate processes
Economics
Humanity
Is economy the only aspect to be considered

in a feasibility study of an investment plan?
NO.
Other aspects such as ethics, professionalism,
welfare, safety, and environment.
Principles of Engineering Economics
Principle 1: Develop the alternatives.
Doing nothing is one of the possible
alternatives.
Principle 2: Focus on the differences.
Consider relevant differences only.
Principle 3: Use a consistent viewpoint.
Viewpoints: the firm owner interest, employee
satisfaction, customer satisfaction, etc.
Principle 4: Use a Common Unit of
Measurement.
Purpose: direct comparison among all the
prospective outcomes.
Page7
The common measurement unit: monetary unit.

Principle 5: Consider all relevant criteria.
Decision making should consider all the criteria.
Example of a criterion: alternative that gives the
most attractive interest.
Principle 6: Make uncertainty explicit.
Outcome estimation of an alternative always
contains uncertainty.
Principle 7: Revisit your decision.
The real outcome is different from what was
predicted. The difference is the base for the
necessary revision on the decision.
Engineering Economic Analysis Procedure

1. Problem
recognition,
definition,
and
evaluation.
2. Development of the feasible alternatives.
3. Development of the outcomes and cash flows
for each alternative.
4. Selection of a criterion (or criteria)
5. Analysis and comparison of the alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post-evaluation
of results.
Page8
II. Cost Concepts

Costs related to the implementation of an
investment plan need to be estimated. The
purposes include:
1. To provide information used in settling a
selling price for quoting, bidding, or
evaluating contracts.
2. To determine whether a proposed product is
profitable.
3. To evaluate how much capital needed for the
process changes or other improvements, and
4. To establish benchmarks for productivity
improvement programs
Two fundamental aproaches in cost estimation:
a. Top-down approach: use historical data
from similar engineering projects
b. Bottom-up approach: break down a project
into small, manageable units and estimate
their economic consequences
HOMEWORK # 1:
Explain the following cost terminologies
(References : 1. Sullivan, et. al. (2003); 2.
Aries and Newton (1955)). Compare your
Page9
answers based on reference #1 to those based

on reference #2.
1. a. Fixed costs.
b. Variable costs.
c. Incremental cost (or incremental revenue).
2. a. Recurring costs.
b. Nonrecurring costs.
3. a. Direct costs.
b. Indirect costs.
c. Overhead.
d. Standard cost.
4. a. Cash costs.
b. Noncash costs (= book cost).
5. Sunk costs.
6. Opportunity costs.
7. a.Life-Cycle cost.
b. Investment cost (=capital investment).
c. Working capital.
d. Operation and maintenance cost.
e. Disposal cost.
General economic concepts

1. Consumer and Producer Goods and Services.
Page10
Consumer goods and services: products or

services that are directly used by people to
satisfy
their
wants.
Example:
food,
entertainment.
Producer goods and services: products or
services that are used to produce consumer
goods and services or other producer goods.
Example: machine tools, factory buildings.
2. Measures of Economic Worth
Why are goods and services produced and
desired?
Because they have utility.
Utility : the power to satisfy human wants and
needs expressed as the price that must be paid
to obtain the goods or services.
Utility (value) of materials and products could
be increased by changing their form or location.
Example:
Iron ore stainless steel razor blades
3. Necessities, Luxuries, and Price Demand
Goods and services may be categorized into:
necessities and luxuries relative to the users.
Example:
Page11
A sophisticated camera a necessity for a

photographer; a luxury for others.
General price-demand relationship:
where
p = the selling price per unit
D = the demand
a
0 D , and a > 0, b > 0.
b
The price of luxuries is greatly increased the
demand can readily decrease.
The price of true necessities is greatly increased
the consumers find it difficult to reduce their
consumption the money saved from not
buying luxuries is used to pay the increased cost
of necessities.
Page12
4. Competition
Perfect competition : a situation in which any
given product is supplied by a large number of
vendors and there is no restriction on additional
suppliers entering the market there is
assurance of complete freedom on the part of
buyer and seller.
Perfect monopoly : a unique product or service
is available from only a single supplier and the
vendor can prevent the entry of all others into
the market. The buyer is at the complete mercy
of the supplier in terms of the availability and
price of the product.
Perfect monopolies rarely occur in practice,
because: (i) any product can usually be
substituted by other products with satisfactory
performance; (ii) governmental regulations
prohibit monopolies.
5. Total Revenue (TR) Function
Total revenue = TR = (selling price per unit)
(the number of units sold) = pD
If: p = a bD, then:
Page13
TR = (a bD)D = aD bD2 for 0 D
a
, and
b
a > 0, b > 0.
)
) a
dTR
where:
= a 2 bD = 0 D =
2b
)dD
D = the demand that will produce maximum TR.
6. Cost, Volume, and Breakeven Point

Relationships
Assuming linear relationship between variable
cost and demand, total cost is:
CT = CF + CV = CF + cV D
where:
CT = total cost
CF = fixed cost
CV = variable cost
cV = variable cost per unit
Profit/loss = TR CT
At breakeven point, TR = CT.
Scenario 1: p = a bD
Profit/loss = (aD bD2) (CF + cV D)
= bD2 + (a cV)D CF
Page14
a
for 0 D , dan a > 0, b > 0.
b
In order for a profit to occur, two conditions
must be met:
a. (a cV) > 0;
b. TR > CT
The relationship is shown in the following
figure.
D* is the optimum D that maximizes profit.

d(Pr ofit )
= 2bD* +(a c V ) = 0
dD
a cV
D* =
2b
D1 and D2 are breakeven points.
Profit/loss = bD2 + (a cV)D CF = 0
Page15
D1' , D '2 =
(a c V ) (a c V ) 4( b )( C F )
2( b )
2
12
6.2. Scenario 2: p constant

TR = pD
Profit/loss = pD (CF + cV D) = (p cV)D CF
In order for a profit to occur, two conditions
must be met:
a. (p cV) > 0;
b. TR > CT
The relationship is shown in the following
figure.
CF
Profit/loss = (p cV)D CF = 0 D ' =
p cV
Page16
Case study:
Data of an engineering consulting firm: Variable
cost (cV) = $62 per standard service hour;
Charge-out rate (p) = $85.56 per hour;
Maximum output of the firm = 160,000 hours
per year; Fixed cost (CF) = $2,024,000 per year.
Calculate:
a) Breakeven point (BEP)
b) Sensitivity analysis by calculating the
percentage reduction of BEP if CF is reduced
10%; if cV is reduced 10%; if CF and cV are
reduced 10% each; and if p is increased 10%.
Answer:
a) At breakeven point:
Total revenue = total cost
CF
pD' = C F + c V D' D ' =
p cV
$2,024,000
D' =
= 85,908 hours per year
$85.56 $62
85,908
D' =
= 0,537 or 53,7% of maximum
160,000
capacity.
D ' = $85,56(85,908 ) = $7,350,288
Page17
b) 1. 10% reduction in CF:

0,9($2,024,000)
D' =
$85,56 $62
D' 85,908 77,318
=
= 0,10
D'
85,908
2. 10% reduction in cV:
$2,024,000
D' =
$85,56 0,9($62 )
D' 85,908 68,011
=
= 0,208
D'
85,908
3. 10% reduction in CF and 10% reduction in cV:
0,9($2,024,000 )
D' =
$85,56 0,9($62 )
D' 85,908 61,210
=
= 0,287
D'
85,908
4. 10% increase in p:
$2,024,000
D' =
1,1($85,56 ) $62
D' 85,908 63,021
=
= 0,266
D'
85,908
Summary:
Change
Decrease in BEP, %
10% reduction in CF
10,0
Page18
10% reduction in cV
10% reduction in CF,
10% reduction in cV
10% increase in p
20,8
28,7
26,6
Conclusion:
1. BEP is very sensitive to the change in p.
2. BEP is more sensitive to the change in cV
than to the change in CF, but reduction in
both CF and cV should be sought.
Lower BEP is desired because:
1. The lower BEP, the less likely that a loss
will occur during market fluctuations.
2. If the selling price remains constant (or
increases), at any level of operation, the
lower BEP, the larger profit.
Cost-driven design optimization

Two main tasks:
1. The optimum value for a certain
alternatives design variable.
2. The best alternative, each with its own
unique value for the design variable.
Case study: Study Example 2-9
Page19
Case study:
Without insulation, heat loss through the roof of
a single-story home (2400 ft2) is:
Q = 99,9 10 6 Btu / year
The cost of several insulation alternatives and
associated space heating loads (Q) for the house
are:
Investment cost,
$
Annual heating
load (Btu/year)
Insulation
R19
R30
900
1,300
R11
600
74106
69,8106
67,2106
R38
1,600
66,2106
The cost of electricity = $21.6818 / 106 Btu

The life of the insulation = 25 years.
What is the most economical insulation?
Answer:
A. Investment cost,
$
B. Annual heating
load (Btu/year)
C. Cost of heat loss
per year (=
21.681810-6B), $
D. Cost of heat loss
over 25 years (=
25C), $
R11
Insulation
R19
R30
R38
600
900
1,300
1,600
74106
69,8106
67,2106
66,2106
1,604.45
1,513.39
1,457.02
1,435.34
40,111.33 37,834.74 36,425.42 35,883.38
Page20
E. Total life cycle

costs (A+D), $
40,711.33 38,734.74 37,725.42 37,483.38
Without insulation:
Annual heating load = 99,9106 Btu/year
The cost of heat loss over 25 years
= (99,9106)(21.681810-6)(25) = $54,150.30
Total life cycle costs = $54,150.30 + 0 =
$54,150.30
R38 has the minimum total life cycle cost
choose R38 insulation.
Another Solution: examine the incremental ()
differences among the alternatives (The 2nd
Principle of Engineering Economics: Focus on
the differences)
a. R19 vs R11:
(R19 R11)
investment = $(900 600) = $300
savings/year = $[1,513.39 ( 1,604.45)] =
$91.06
Remark: negative because these are costs.
Page21
Cost R19 Cost R11 has a positive value

means saving.
savings over 25 years = 25($91.06) =
$2,276.59
Net savings = $2,276.59 $300 = $1,976.59
positive R19 is more economical than R11.
b. R30 vs R19:
(R30 R19)
Analogous:
Net savings = $1,009.32 positive R30 is
more economical than R19.
c. R38 vs R30:
(R38 R30)
Analogous:
Net savings = $242.05 positive R38 is
more economical than R30.
Thus, the most economical one is R38.

Please notice that in this case, we ignored the
time value of money (interest rate = 0). If we
consider the time value of money, the
conclusion might be different.
Page22
Present Economy Studies.

engineering economic analyses when
alternatives for accomplishing a specific task are
being compared over one year or less and the
influence of time on money can be ignored.
Rule 1: When revenues and other economic
benefits are present and vary among alternatives,
choose the alternative that maximizes overall
profitability based on the number of defect-free
units of a product or service produced.
Rule 2: When revenues and other economic
benefits are not present or are constant among
all alternatives, consider only the costs and
select the alternative that minimizes total cost
per defect-free unit of product or service output.
Case study:
Two machines are being considered for the
production of a part. The capital investment
associated with the machines is about the same.
The important differences between the machines
are their: 1) production capacity (= production
Page23
rate x available production hours); 2) reject rates

(percentage of parts produced that cannot be
sold). The following data are available.
Machine A
Machine B
Production rate
100 parts/hr 130 parts/hr
Hours available
7 hr/day
6 hr/day
for production
% parts rejected
3%
10%
The material cost = $6.00/part
Price = $12.00/defect-free part
Price of rejected part = 0
The operator cost = $15.00/hour (the same for
machine A and B)
The variable overhead cost = $5.00/hour
a. Assume that all defect-free parts can be sold.
Which machine should be selected?
b. What would the percent of parts rejected
have to be for Machine B to be as profitable
as Machine A?
Answer:
a. Total revenue per day:
Machine A:
parts hr $12
(1 3% ) = $8148
7
100
hr day part
Analogous Machine B = $8424

Page24
There is difference in revenue use Rule 1.

Total cost per day:
Machine A:
parts $6.00 $15.00 $5.00 hours

100 hour part + hour + hour 7 day
= $4340
Analogous Machine B = $4800
Profit per day
Machine A: $8148 $4340 = $3808
Machine B: $8424 $4800 = $3624
Select machine A.
b. Let X = % parts rejected for machine B.
Profitability machine B = machine A. Thus:
parts hours $12
130
(1 X ) $4800
6
hour day part
= $3808
(3808 + 4800)
X = 1
= 0.08
(130)(6)(12)
Thus, percent of parts rejected for Machine B
can be no higher than 8%.
Homework: Study Sullivan et. al, 2003, pp. 56
61.
Page25
Time Value of Money

Investment:
an agreement between two parties, whereby, one
party, the investor, provides money, P, to a
second party, the producer, with the expectation
that the producer will return money, F, to the
investor at some future specified date, where
F>P.
P
F
n
: Principal/Present Value
: Future Value
: Years between F and P
The amount of money earned from the

investment = E = F P.
In general:
F
= f (n , i )
P
where
i = interest rate
For example:
F
= (1 + i s n )
P
Page26
The yearly earnings rate = simple interest rate =

E FP
=
is =
Pn
Pn
Capital: wealth in the form of money or property
that can be used to produce more wealth.
The time value of money concept:
Money today is worth more than money in
the future.
How:
Invest the money to earn more money.
The time value of money is different from
inflation.
Two basic categories of capital:
a. Equity capital: capital that is owned by
individuals who have invested their money
or property in a business project or venture
in the hope of receiving a profit. The owners
of equity capital are also the owners of the
project and fully participate in the risks of
the project. Example: stockholders.
b. Debt capital (= borrowed capital): capital
that is obtained from lenders, and the lenders
earn interest as the incentive for their
Page27
investment on the project. The owner of debt

capital are not owners of the project and do
not participate as fully as the owners in the
risks of the project. Interest and repayment
of the debt capital are assured by the owners
of the project. Example: bonds holder.
If capital is invested in a project, investors
would expect, as a minimum, to receive a return
at least equal to the amount they have sacrificed
by not using it in some other available
opportunity of comparable risk. This interest or
profit available from an alternative investment is
the opportunity cost of using capital in the
proposed undertaking. Of course if the
alternative investment has lower risk than the
proposed project, the project must produce much
more profit than the alternative investment to be
attractive for the investors.
Profitability of a project can be evaluated from
the future value of the capital invested on the
project the concept of interest Interest:
compensation paid for debt capital.
Page28
Types of Interest
1. Simple interest
the amount of interest paid is based solely on
the initial investment. Thus,
I = Pin
where
P : principal or Present Value
i : interest rate based on length of one period
Pi : interest earned during one period
n : the number of interest periods
I : total simple interest earned during n
periods
The total amount of money after n periods is Fn.
Fn = P + I = P(1 + in )
Example:
Someone puts his money as much as $1000 in a
bank. After 2 years, his investment will become
$1150. The length of one interest period is 1
year. What are the values of P, Fn, i, and n?
Answer:
P = $1000; Fn = $1150; n = 2.
Fn = P(1 + in )
(Fn P ) 1 (1150 / 1000 ) 1

i=
=
= 0,075
n
2
Page29
In common industrial practice, the length of the

interest period is taken to be 1 year, and the
interest rate i is based on 1 year. However, there
are cases where other time periods are used.
Even though the actual interest period is not 1
year, the interest rate is often expressed on an
annual basis.
Let the length of the actual interest period is d
days (< 1 year), and i is the annual interest rate.
There are two types of simple interest, i.e.:
a. Ordinary simple interest 1 year = 360
days. The amount of interest paid per period
is:
d
Ordinary simple interest = Pi
360
b. Exact simple interest 1 year = 365 days.
The amount of interest paid per period is:
d
Exact simple int erest = Pi
365
In practice, it is commonly assumed 1 year =
360 days.
2. Compound interest
Page30
The time value of interest that is not paid is

accounted in compound interest.
Period Principal
at the
beginning
of a
period
Interest
earned
per
period (i =
interest rate
based on the
length of one
period)
Investment
value at the
end of a
period
P+Pi = P(1+i)
P(1+i) + P(1+i)i
= P(1+i)2
P(1+i)2+ P(1+i)2i
= P(1+i)3
Fn = P(1+i)n
1
2
P
P(1+i)
Pi
P(1+i)i
P(1+i)2
P(1+i)2i
P(1+i)n
P(1+i)n-1i
(1+i)n : thediscreet single-payment compoundamount factor.

Example:
How much money must be invested to earn
$5,000 in 5 years if the annual interest rate
(compound interest) is 6%?
Answer:
F5 = $5000; n = 5 years, i = 6%.
Page31
P=
Fn
(1 + i )
$5,000
(1 + 0.06)
= $3,736.29
Remark:
- If interest rate changes each period:
n
Fn = P (1 + i j ) = P(1 + i1 )(1 + i 2 )...(1 + i n )

j=1
- Even though the actual interest period is not 1

year, the interest rate is often expressed on an
annual basis.
- If 1 interest period < 1 year, there are two types
of annual interest rate in compound interest:
a. Nominal annual interest rate (inom)
b. Effective annual interest rate (ieff)
- Let:
m = the number of interest periods per year
Then:
Interest rate per period =
Total amount of money after 1 year =
m
i
Fafter1 year = Fm = P1 + nom = P(1 + ieff )

m
Thus:
Page32
i eff = 1 + nom 1
m
i eff utk periode 1 thn

- The length of interest period less than 1 year
could be 1 month, 1 day, 1 hour, 1 second, etc. If
the length of interest period 0, m and
the coumpund interest in this case is called
continuous interest.
m
i
i eff = lim 1 + nom 1

m
m
(m i nom )i nom
i
1
= lim 1 + nom
m
m
From calculus:
mi
i nom nom
lim 1 +
= e = 2,71828...
m
m
Hence:
i eff = ei nom 1
Fafter 1 year = Fm = Pe i nom

In general,
Fafter n years = P(1 + i eff )n
For continuous interest:
Fafter n years = Pei nom n
Page33
Case study:
Money as much as $100 will be invested with
nominal annual interest rate 20%. Calculate the
total amount of money after 1 year and the
effective annual interest rate if the length of
interest period =
a. 1 year (20% compounded annually)
b. 0,5 year (20% compounded semiannually)
c. 1 day if 1 year = 365 days (20%
compounded daily)
d. 0 (20% compounded continuously)
Answer:
P = $100, inom = 0,2
a. m = 1/1 = 1;
m
1
i nom
0,2
i eff = 1 +
1 = 1 +
1 = 0,2
1
m
Fafter1 year = P(1 + ieff ) = $100(1 + 0,2) = $120

b. m = 1/0,5 = 2;
m
2
i
0
,
2
i eff = 1 + nom 1 = 1 +
1 = 0,21
m
2
Fafter1 year = P(1 + ieff ) = $100(1 + 0,21) = $121

c. m = 365/1 = 365;
Page34
365
0,2
i eff = 1 + nom 1 = 1 +
1 = 0,2213
m
365
Fafter1 year = P(1 + ieff ) = $100(1 + 0,2213) = $122.13

d. m ; i eff = ei nom 1 = e0,2 1 = 0,2214
Fafter1 year = P(1 + i eff ) = $100(1 + 0,2214) = $122.14
Some conclusions:
- ieff inom
- The maximum value of ieff is obtained when
the compound interest is continuous interest .
In comparing alternatives, we compared the
effective annual interest rates, NOT the nominal
annual interest rates.
The Concept of Equivalence

Economic equivalence all alternatives are
equally desirable Mathematically: total
interest paid divided by total money borrowed at
early years (total dollar-years of borrowing) is a
constant ratio among alternatives.
Case study:
Page35
We borrow $8,000 and agree to repay it in 4

years at an interest rate of 10% per year. There
are 4 plans by which the principal and its interest
can be repaid as shown in the following table.
(1)
(2)
Amount
Owed at
Year Beginning
of Year
(3) =
10% x
(2)
Interest
Accrued
for Year
(4) = (2)
(5)
(6) = (3) + (5)
+ (3)
Principal Total End-ofTotal
Payment
Year
Money
Payment
Owed at
(Cash flow)
End of
Year
Plan 1: At end of each year, we pay $2000

principal plus interest due
1
2
3
4
$8,000
$6,000
$4,000
$2,000
_______
20,000$yr
$800
$600
$400
$200
_______
$2,000
(total
interest)
$8,800
$6,600
$4,400
$2,200
$2,000
$2,800
$2,000
$2,600
$2,000
$2,400
$2,000
$2,200
_______ ___________
$8,000
$10,000
(total amount
repaid)
Plan 2: We pay interest due at end of each year

and principal at end of 4 years.
1
2
3
4
$8,000
$8,000
$8,000
$8,000
_______
32,000$yr
$800
$800
$800
$800
_______
$3,200
(total
interest)
$8,800
$8,800
$8,800
$8,800
0
$800
0
$800
0
$800
$8,000
$8,800
_______ ___________
$8,000
$11,200
(total amount
repaid)
Page36
Plan 3: We pay in 4 equal end-of-year payments

1
2
3
4
$8,000
$6,276
$4,380
$2,294
_______
20,960$-yr
$800
$628
$438
$230
_______
$2,096
(total
interest)
$8,800
$6,904
$4,818
$2,524
$1,724
$2,524
$1,896
$2,524
$2,086
$2,524
$2,294
$2,524
_______ ___________
$8,000
$10,096
(total amount
repaid)
Plan 4: We pay principal and interest in one

payment at end of 4 years (in this plan, column 6
column 3 + column 5).
1
2
3
4
$8,000
$8,800
$9,680
$10,648
_______
$800
$880
$968
$1,065
_______
37,130 $yr
$3,713
(total
interest)
$8,800
$9,680
$10,648
$11,713
0
0
0
0
0
0
$8,000
$11,713
_______ ___________
$8,000
Summary
Plan Total dollar- Total interest
years (sum paid (sum of
of column column (3) in
the above
(2) in the
table)
above table)
1
$20,000
$2,000
2
$32,000
$3,200
$11,713
(total amount
repaid)
Total
interest /
total
dollaryears
0.10
0.10
Page37
3
4
$20,960
$37,130
$2,096
$3,713
0.10
0.10
Because the ratio is constant at 0,10 for all plans,

all the 4 repayment methods are equivalent.
Cash-Flow Diagrams and Tables

Cash flow diagrams:
1. The horizontal line is a time scale.
2. The arrows show cash flows and are placed
at the end of the periods. Downward arrows
represent expenses (negative cash flow or
cash outflows); Upward arrows represent
receipts (positive cash flow or cash inflows).
3. The cash-flow diagram is dependent on the
point of view. Cash inflows for the lender is
cash outflows for the borrower.
Cash flow tables basically have the same usage
as cash flow diagrams.
Example: Draw a cash flow diagram from the

corporations viewpoint.
Investment = $10,000
Annual revenue = $5,310 for 5 years
Page38
Recovery value at the end of the 5th year =

$2,000
Annual expenses = $3,000
Answer:
Table cash flow: study example 3-2, p. 79,

Sullivan
Cash flow and interest analysis

Present worth (= present value = initial principal
= P) is a certain amount of money that must be
deposited at a certain interest rate to earn a
certain amount of money at a certain time in the
future.
Page39
The amount of money at a certain time in the

future is called the future value (= future worth
= F) of the initial principal.
Discount = F P
For discrete compound interest:
1
P=F
;
n
(1 + i )
1
is called discrete single-payment presentn
(1 + i )
worth factor (= P/F,i,n).
(1+i)n is called single-payment compoundamount factor (= F/P,i,n).
For continuous interest:
1
P=F i n
e nom
Case Study:
Maturity value of a bond is $ 1,000 with the
effective annual interest rate 3%. Determine:
a. Present worth at 4 years before the bond
reaches its maturity value
Page40
b. Discount
c. The effective annual interest rate, if the
present price of the bond is $700.
d. Repeat question a) for continuous interest in
which the nominal annual interest rate is 3%.
Answer:
F
$1,000
a. P =
=
= $888
n
4
(1 + i eff ) (1 + 0.03)
b. Discount = F P = $1,000 - $888 = $112
1n
14
F
1000
c. i eff = 1 =
1 = 0,0935
P
700
F
F
$1,000
d. P =
=
=
= $869
(
n
i nom n
0,03 )(4 )
e
(1 + i eff ) e
ANNUITIES
Annuity: a series of equal payments occurring at
equal time intervals.
Types of annuity:
1. Ordinary annuity: payments occur at the end
of each interest period.
2. Annuity due: payments are made at the
beginning of each interest period
Page41
3. Deferred annuity: the first payment is due

after a definite number of years.
Annuity term: the time from the beginning of the
first payment period to the end of the last
payment period.
The amount of an annuity: the sum of all the
payments plus interest if allowed to accumulate
at a definite rate of interest from the time of
initial payment to the end of the annuity term.
Relation between the amount of ordinary

annuity (= F) and annuity (= A):
F = A(1 + i )n 1 + A(1 + i )n 2 + A(1 + i )n 3 + ... +
A(1 + i ) + A
where
i : the interest rate based on the payment period
n : the number of discrete periods
F(1 + i ) F = Fi = A(1 + i )n A
(1 + i )n 1
F = A
Page42
(1 + i )n 1
= (F/A,i,n) : the discrete uniform
series compound-amount factor (= the series

compound-amount factor= future worth of
annuity).
(1 + i )n 1 = (A/F,i,n) : sinking fund factor
Let,
m : the number of interest periods per year;
n : annuity term (years);
A : the total of all ordinary annuity payments
occurring regularly and uniformly throughout a
year
Then,
Annuity = A / m
Total number of annuity payment periods over n
years = mn
A [1 + (i nom m )]mn 1
F=
(i nom m )
m
If the length of a payment period 0, then m

. We call it continuous cash flow.
Page43
A [1 + (i nom m )](m i nom )(i nom n ) 1

F = lim
(i nom m )
m m
e(i nom n ) 1
= A
i
nom
If cash flows occcur at discrete intervals, but

compounding is continuous throughout the
interval, the equation is:
e (i nom n ) 1
F = A i
e nom 1
Proof:
If we compare the equations for continuous
compounding to the equations for discrete
compounding, we may conclude that
e
1 i i e
1
1
1
1 i
e
F A
A
i
1
e
The present worth of an annuity : the principal
(P) which would have to be invested at the
present time at compound interest rate i to yield
Page44
a total amount at the end of the annuity term

equal to the amount of the annuity (F).
(1 + i )n 1
= P(1 + i )n
F = A
(1 + i )n 1
P = A
i(1 + i )n
(1 + i )n 1
= (P/A,i,n) : the discrete uniform
n
i(1 + i )
series present-worth factor (= the series presentworth factor = present worth of annuity).
i(1 + i )n
= (A/P,i,n) : capital recovery factor

(1 + i )n 1
For the case of continuous cash flow:

e(i nom n ) 1
= Pei nom n
F = A
i
nom
e(i nom n ) 1
P = A
i ei nom n
nom
If cash flows occcur at discrete intervals, but
compounding is continuous throughout the
interval, the equation is:
Page45
e
e
1 e
Discrete Compounding-Interest Factors

(i, effective interest rate per interest period; n,
number of interest periods; A, uniform series
amount (occurs at the end of each interest
period); F, future equivalent; P, present
equivalent)
Conversion Symbol Common
Formula
Name
(F/P, i, n) single(1+i)n
P to F
payment
compoundamount
factor
(P/F, i, n) discrete
1
F to P
single(1 + i )n
payment
presentworth factor
(F/A, i, n) discrete
A to F
(1 + i )n 1
uniform
series
compoundBudhijanto,TeknikKimiaUGM,2012
Page46
F to A
P to A
A to P
amount
factor, future
worth of
annuity
(A/F, i, n) sinking fund
factor
(1 + i )n 1
(A/P, i, n) capital
i(1 + i )n
recovery
(1 + i )n 1
factor
(P/A, i, n) discrete
(1 + i )n 1
uniform i(1 + i )n
series
presentworth factor,
present
worth of
annuity
Continuous Compounding and Discreet Cash

Flows: Interest Factors
(inom, nominal annual interest rate; n, number of
periods (years); A, annual equivalent amount
(occurs at the end of each year); F, future
equivalent; P, present equivalent)
Page47
Conversion
Symbol
P to F
(F/P,inom, n)
F to P
(P/F, inom, n)
A to F
(F/A, inom, n)
F to A
(A/F, inom, n)
P to A
(A/P, inom, n)
Common
Formula
Name
Continuous
e
compounding
compoundamount
factor (single
cash flow)
Continuous
e
compounding
present
equivalent
factor (single
cash flow)
Continuous
e
1
compounding e
1
compound
amount
(uniform
series)
Continuous
e
1
compounding e
1
sinking fund
factor
e
1 e
Continuous
e
1
compounding
capital
recovery
Page48
A to P
factor
(P/A, inom, n) Continuous
compounding
present
equivalent
(uniform
series)
e
e
1
1 e
Continuous Compounding Continuous

Uniform Cash Flows: Interest Factors
(inom, nominal annual interest rate; n, number of
periods (years); A , amount of money flowing
continuously and uniformly during each period;
F, future equivalent; P, present equivalent)
Conversion
A to F
F to A
Symbol
Common
Formula
Name
(F/, inom, n) Continuous
e
1
compounding
i
compound
amount
factor
(continuous,
uniform cash
flows)
i
(/F, inom, n) Continuous
compounding e
1
sinking fund
Page49
P to A
A to P
factor
(continuous,
uniform cash
flows)
(/P, inom, n) Continuous
compounding
capital
recovery
factor
(continuous,
uniform cash
flows)
(P/, inom, n) Continuous
compounding
present
equivalent
(continuous,
uniform cash
flows)
i
e
e
i
e
1
1
e
Case Study:
A saving account pays a nominal interest rate of
6% per year compounded monthly. Someone
opens an account with a deposit of $1000 and
then deposits $50 at the end of each month for a
period of two years followed by a monthly
deposit of $100 for the following three years.
Page50
What will the value of his savings account be at

the end of the five-year period?
Answer:
Discrete Cash Flow Diagram (CFD)
First method of solution:

Break the CFD down into 3 subproblems:
1. The initial investment of $1,000
2. The 24 monthly investments of $50
Each of these investments is brought forward to
the end of month 60.
.
The effective monthly interest rate is
0.005.
Page51
F = ($1000)(F/P,0.005,60) +
{($50)(F/A,0.005,24)}(F/P,0.005,60-24) +
($100)(F/A,0.005,36)
F = ($1000 )(1 + 0.005 )60 +
(1 + 0.005 )24 1
36
(
)
(
)
1
0
.
005
$
50
+
+
0.005

(1 + 0.005 )36 1
($100 )
0
.
005
F = $6,804.16
Second method of solution:

The CFD is broken down into 3 subproblems:
1. The initial investment of $1,000
F = ($1000)(F/P,0.005,60) +
($50)(F/A,0.005,60) + ($50)(F/A,0.005,36)
Page52
F = ($1000 )(1 + 0.005)60 +

(1 + 0.005)60 1
+
($50)
0
.
005
(1 + 0.005)36 1
= $6,804.16
($50)
0.005
PERPETUITIS AND CAPITALIZED COST

Perpetuity: an annuity in which the periodic
payments continue indefinitely. This type of
annuity is of particular interest, for example in a
case where it is desired to determine a total cost
for a piece of equipment or other asset under
conditions which permit the asset to be replaced
perpetually without considering inflation or
deflation.
F = P(1 + i )n
Here, n is the number of interest periods during
service-life of the asset.
Page53
If perpetuation to occur, F minus the cost for the

replacement must equal P. Let CR represent the
replacement cost. Therefore,
F CR = P
Combining the two equations, we get
P + C R = P(1 + i )n
CR
P=
(1 + i )n 1
Capitalized cost is defined as the original cost of
the equipment plus the present value of the
renewable perpetuity.
Let, K = capitalized cost, and CV = the original
cost of the equipment. Then,
CR
K = Cv +
(1 + i )n 1
Case Study:
A new piece of completely installed equipment
costs $12,000, and will have a scrap value of
$2,000 at the end of its useful life. If the usefullife period is 10 years and the interest is
compounded at 6% per year, what is the
capitalized cost of the equipment?
Page54
Answer:
CV = $12,000; SV = $2,000
Assuming no inflation or deflation, the
replacement cost of the equipment at the end of
its useful life is CR = CV SV = $12,000 $2,000 = $10,000
Other data,
i = 0.06
n = 10
Then,
$10,000
K = $12,000 +
= $12,000 + $12,650
10
(1 + 0.06) 1
= $24,650
Hence, if the equipment is to perpetuate itself,
the amount of total capital necessary at the start
would be $24,650, which consists of $12,000 for
the equipment plus $12,650 for the replacement
fund. After 10 years, the $12,650 replacement
fund becomes $12,650(1.06)10 = $22,650. The
scrap value of the equipment is $2,000. Thus,
the total amount of money available at the end of
the 10th year is $24,650 (= K, capitalized cost).
Page55
Alternative derivation of the capitalized cost

equation:
K = C R + R + SV
where
R is residual. The purpose of this residual is to
earn sufficient interest during the service life of
the asset to pay for its replacement. Hence, the
relation between CR and R is:
C R = R (1 + i )n R = R (1 + i )n 1
Combining the two equations:
1
K = CR + CR
+ SV
n
(1 + i ) 1
(1 + i )n
K SV
=
= capitalized cost factor
n
CR
(1 + i ) 1
Interest Formulas Relating a Uniform

Gradient of Cash Flows (an Arithmetic
Sequence of Cash Flows)
Page56
Please notice that the first cash flow occurs at

the end of period two.
The G is known as the uniform gradient amount.
Break the case down into several subproblems:
1. Annuity G in (n-1) interest periods.
.
.
.
Page57
(n-3). Annuity G in (3) interest periods.

(n-2). Annuity G in (2) interest periods.
(n-1). Annuity G in (1) interest period.
The future equivalent, F, of the arithmetic
sequence of cash flows is
F = G(F/A, i, n-1) + G(F/A, i, n-2) + G(F/A, i, n-3) +
... + G(F/A, i, 3) + G(F/A, i, 2) + G(F/A, i, 1)
1
F
G 1
i
G 1
i
1
i
i
1
1 i
i
i
1
1 i
1
i
1
1 i
nG
i
G
i
1
1
i
1
n
i
1
1
i
i
i
i
i
i
1
1
i
1
i
1
1
i
i
i
nG
i
Page58
1
1
1
F
1
1
i
1
G
FA , i, n
i
i
i
nG
i
FA , i, n
The ordinary annuity, A, equivalent to the

arithmetic sequence of cash flows is
A
F AF , i, n
G
F A, i, n
nG
i
1
A G
i
AG , i, n
nG
i
AF , i, n
n
1 in 1
AF , i, n
G
i
nG
i
i
1 in 1
G AG , i, n
Gradient to uniform
series conversion factor.

The present equivalent, P, of the arithmetic
sequence of cash flows is
P
F PF , i, n
Page59
F A, i, n
G
1 in
i 1 i
i
PG , i, n
nG
i
1
1 in
1
i 1 i n
G PG , i, n
n
Gradient to
present equivalent conversion factor.

1 1 i
1
1
PG , i, n
n
i 1 i n
1 i
i
PG , i, n
1
i
PA , i, n
n PF , i, n
Please notice that all the equations above were

derived for the case in which there is no cash
flow at the end of period one. If cash flow at the
end of period one 0, it is treated separately.
Interest Formulas Relating a Geometric

Sequence of Cash Flows to Its Present and
Annual Equivalents
Page60
Please notice that the first cash flow occurs at

the end of period one.
1 f , 2 k n
A
A
the rate of change of cash flows
f can be positive or negative.

A
A 1
A 1
A 1
A 1
The present equivalent of this geometric

gradient series is:
P
A PF , i, 1
A PF , i, 2
A PF , i, n
Page61
A PF , i, k
A 1
1
A
1
f
i
A
1 f
1
1
f
i
i
1
f
f
Let:
1 i
1 i
i R
1
1 f
1
= convenience rate
1 i
i R 1
1 f
Thus,
A
1
P
1 i R
1 f
1
1 i
i
1
1
1 i
1
1 i
1
1 i
1
i R
1
1 i
1
1 i
1 i
i R 1
1
f
Page62
When f
,i R
when n is finite.
P
P
PF, i
R, k
A
1 f
1
1 i
PF , i
A
1 f
1
1
R, k
Special case: When i

P
1 i
A
1 f i R 1
A
1
1 i R
1 f
A
PA , i R , n
1 f
We know that
0, this equation is valid only
f, i
nA
1 f
The end-of-period uniform annual equivalent, A,

of this geometric gradient series is:
A P AP , i, n
Lets define
Page63
A
P AP , i R , n = the year zero base of
annuity, which increases at a constant rate of f
per period.
Thus,
A
A1
PA , iCR , n
A 1
A 1
AP , i
A 1
R, n
A1
The difference between A and A0 can be seen in

the following figure.
Page64
The future equivalent of this geometric gradient

series is:
F P FP , i, n
HOMEWORK: Study examples in Chapter 3,

Sullivan.
Applications of the Time Value of Money
Concept
Minimum Attractive Rate of Return (MARR) =
hurdle rate
MARR is determined by the top management of
an organization.
MARR determination involves numerious
considerations, such as:
1. The amount of money available for
investments, and the source and cost of these
funds.
2. The number of good alternatives for the
investments and their purpose.
3. The amount of perceived risk associated
with investment alternatives and their
estimated costs.
4. The type of organization involved.
Page65
One popular approach in MARR determination

is opportunity cost principle. Example:
There are 7 possible investments. The maximum
capital that the company can afford is $6
million.
The
cumulative
investment
requirements of the seven acceptable projects
are plotted against the prospective annual rate of
profit of each as follows.
In view of the capital limitation, the last funded

project would be E, with a prospective rate of
profit of 19% per year, and the best rejected
project is F. In this case, the MARR by the
opportunity cost principle would be 16% per
year.
Page66
Figure 4 also shows the approximate cost of

obtaining the $6 million. The project E is
acceptable only as long as its annual rate of
profit exceeds the cost of raising the last $1
million (capital investment of E).
Example 4.1:
The following table shows prospective annual
rates of profit for a companys portfolio of
capital investment projects.
Expected Annual Investment
Cumulative
Rate of Profit
Requirements
Investment
(Thousands of Dollars)
40% and over
$2,200
$2,200
30-39.9%
3,400
5,600
20-29.9%
6,800
12,400
10-19.9%
14,200
26,600
Below 10%
22,800
49,400
Note: All projects with a rate of profit of 10% or

greater are acceptable
The supply of capital obtained from internal and
external sources has a cost of 15% per year for
the first $5,000,000 invested and then increases
1% for every $5,000,000 thereafter. What is the
companys MARR?
Answer:
Page67
Using the opportunity cost viewpoint, the

companys MARR = 18% per year.
The Present Worth Method (the PW Method)
In this method, all cash inflows and outflows are
discounted to the present point in time at an
interest rate equals to the MARR.
N
PW
F 1
where
i = effective interest rate, or MARR, per
compounding period
k = index for each compounding period (0kN)
Fk = future cash flow at the end of period k
Page68
N = number of compounding periods in the

study period
Here, it is assumed that the interest rate is
constant throughout the life of the project.
The project is economically acceptable if PW0.
Example 4.2:
An investment of $10,000 in a project will
produce a uniform annual revenue of $5,310 for
five years. At the end of the fifth year, the
salvage value of the project is $2,000. If the
annual expenses are $3,000 each year and
MARR is 10% per year, show whether this is a
desirable investment by using the PW method.
Answer:
Page69
PW
PW
10,000
5,310 3,000 PA , 0.1,5
2,000 PF , 0.1,5
1
1.1
2,000
10,000 2,310
0
0.1 1.1
1.1
Thus, the project is marginally acceptable.
The Future Worth Method (The FW Method)

This method is based on the equivalent worth of
all cash inflows and outflows at the end of study
period at an interest rate equals to the MARR.
N
FW
P 1
The project is economically acceptable if FW0.
Example 4.5:
To increase the productivity of a certain manual
welding operation, a piece of new equipment
will be installed. The investment cost is $25,000.
At the end of the fifth year, the market value of
the equipment is $5,000. Using the new
equipment, the annual saving is $8,000. If the
firms MARR is 20% per year, is this proposal a
sound one? Use the FW and PW methods.
Answer:
Page70
$8,000
$8,000
$8,000
2
3
i = 20% per year
$8,000
$5,000
$8,000
$25,000
Using the FW method:
The investment is economically justified.

Using the PW method:
The investment is economically justified.
The Annual-Worth
Method)
Method
(The
AW
Page71
The Annual Worth (AW) of a project is an equal

annual series of dollar amounts, for a stated
study period that is equivalent to the cash
inflows and outflows at an interest rate equals to
the MARR.
AW = R E CR
where
R is annual equivalent revenues or savings.
E is annual equivalent expenses.
CR is annual equivalent Capital Recovery
amount, which is defined as
where
I = initial investment for the project
S = salvage (market) value at the end of the
study period
N = project study period
Page72
The project is economically attractive if AW0.

If AW = 0, the annual return exactly equals to
the MARR.
EUAC = Equivalent Uniform Annual Cost = E +
CR. A low-valued EUAC is preferred to a highvalued EUAC.
Example 4.6:
Use the AW method to solve example 4.5.
Answer:
R E = the annual saving = $8,000
I = $25,000
S = $5,000
AW = R E CR
Page73
The investment is economically attractive
The Internal Rate of Return Method (The

IRR Method)
The IRR method = the investors method = the
discounted cash flow method = the profitability
index.
For a single alternative, from the lenders
viewpoint, the IRR is not positive unless (1)
both receipts and expenses are present in the
cash flow pattern and (2) the sum of receipts
exceeds the sum of all cash outflows.
Using a PW formulation:
where
Rk = net revenues or savings for the kth year
Ek = net expenditures including any investment
costs for the kth year
N = project life (or study period)
i'% = the IRR
Page74
Alternatively, using a FW formulation:
Thus, in this method, we calculate the IRR

(i%). The alternative is acceptable if iMARR.
Example 4.7:
A capital investment of $10,000 in a project will
produce a uniform annual revenue of $5,310 for
five years. The salvage value of the project is
$2,000. Annual expenses will be $3,000. The
company is willing to accept any project that
will earn at least 10% per year on all invested
capital. Determine using the IRR method
whether it is acceptable.
Answer:
Check:
The sum of cash inflows = 5($5,310) + $2,000 =
$28,550 > the sum of cash outflows = 5($3,000)
+ $10,000 = $25,000. Thus, i% is positive.
Page75
Trial and error:

i% = 10.5% > MARR = 10% the project is
acceptable.
Note:
The difference between a projects IRR and the
required return (i.e. MARR) is viewed by
management as a measure of investment safety.
A large difference signals a wider margin of
safety (or less relative risk).
The External Rate of Return Method (The

ERR Method)
Page76
In the IRR method, it is assumed that net cash

proceeds are reinvested at interest rate = IRR. In
practice, this assumption may not be valid. For
example, if a firms MARR is 20% per year and
the IRR of a project is 42.4%, it may not be
possible for the firm to reinvest the net cash
proceeds from the project at much more than
20% the ERR method can remedy this
weakness.
The ERR method takes into account the interest
rate ( ) external to a project at which net cash
flows generated (or required) by the project over
its life can be reinvested (or borrowed).
Steps of calculation:
1. All net cash outflows are discounted to time 0
per compounding period.
(the present) at
2. All net cash inflows are compounded to period
.
N at
3. The interest rate that establishes equivalence
between the two quantities (the external rate of
return) is determined.
Graphically:
Page77
Mathematically:
The ERR is the i% at which
where
Rk = excess of receipts over expenses in period k
Ek = excess of expenditures over receipts in
period k
N = project life or number of periods for the
study
= external reinvestment rate per period
A project is acceptable when ERR MARR.
Example 4.8:
The following diagram shows a total cash flow
diagram of a project. When = 15% and MARR
Page78
= 20% per year, determine whether the project is

acceptable.
$6,000
$6,000
$6,000
$6,000
$6,000
$1,000
$1,000
$1,000
$1,000
$1,000
$5,000
$10,000
Answer:
E0 = $10,000
E1 = $5,000
Rk = $5,000
Thus,
(k = 0)
(k = 1)
for k = 2,3,4,5,6
ERR = i% = 15,3% < MARR = 20%

The project is unacceptable according to the
ERR method.
The Payback (Payout) Period Method (The

Simple Payout Method)
Page79
This method shows how fast an investment can

be recovered a measure of a projects
riskiness.
A low-valued payback period is desirable.
For a project where all capital investment occurs
at time 0, we have
where
= the simple payback period, the smallest
value of for which this relationship is satisfied.
Here, the time value of money and all cash flows
that occur after is ignored.
Only when = N (the last time period of the
projects life) is the salvage value included in
the determination of a payback period.
This method is recommended as supplemental
information only in conjunction with one or
more of the five methods previously discussed.
In the discounted payback period method, the
time value of money is considered.
Page80
where
i% = MARR
I = the capital investment made at the present
time (k = 0)
' = the discounted payback period, the smallest
value of for which this relationship is
satisfied.
Payback periods of three years or less are often
desired in U.S. industry.
Using the payback period methods to make
investment decisions should be generally be
avoided except as a measure of how quickly
invested capital will be recovered, which is an
indicator of project risk.
Example 4.9: = Example 4.5

Cash flow diagram:
Page81
$8,000
$8,000
$8,000
$8,000
2
3
4
MARR = 20% per year
$5,000
$8,000
$25,000
Cash flow table:
Investment Balance Diagram

Example 4.10: = Example 4.7
Here, MARR = 5% per year.
Page82
Answer:
The investment balance diagram:
The diagram gives the following information: '

= 5 years; FW = $2,001. The project has a
negative investment balance until the end of the
fifth year thus the investor is at risk until the
last year of the study period not a
comfortable situation.
Comparing Alternatives
Rule:
Page83
The alternative that requires the minimum

investment of capital and produces satisfactory
functional results will be chosen unless the
incremental capital associated with an
alternative having a larger investment can be
justified with respect to its incremental benefits.
The base alternative: the acceptable alternative

that requires the least investment of capital.
This rule will keep as much capital as possible
invested at a rate of return equal to or greater
than the MARR.
Case study:
Alternatives A and B are two mutually exclusive
investment alternatives. (Two or more
alternatives are mutually exclusive when the
selection of one of these alternatives excludes
the choice of any of the others. Investment
alternatives are those with initial (or front-end)
capital investment(s) that produce positive cash
flows from increased revenue, savings through
reduced costs, or both.) The estimated net cash
flows of the alternatives are as follows.
Page84
Alternative
A
-$60,000
22,000
B
-$73,000
26,225
Capital investment
Annual revenues less
expenses
The useful life of each alternative is 4 years.
The cash flow diagram of alternative A:
The cash flow diagram of alternative B:

A = $26,225
0
1
4=N
$73,000
The cash flow diagram of alternative B

alternative A (year by year):
Page85
At MARR = 10% per year:
Alternative A has lower capital investment than

B, and PWA > 0 at i = MARR alternative A is
the base alternative and would be selected unless
the additional (incremental) capital associated
with alternative B ($13,000) is justified.
The extra benefits obtained by investing the
additional $13,000 of capital in B have a present
= $10,131
worth =
$9,738 = $393, or
>0
the additional capital invested in B is justified

alternative B is preferred to A.
Page86
Case study: Cost alternatives

(Cost alternatives are those with all negative
cash flows, except for a possible positive cash
flow element from disposal of assets at the end
of the projects useful life.
This situation occurs when the organization
must take some action, and the decision involves
the most economical way of doing it (e.g. the
addition of environmental control capability to
meet new regulatory requirements).)
Alternatives C and D are two mutually exclusive
cost alternatives with estimated net cash flows as
follows.
Alternative
End of year
C
D
0
$380,000
$415,000
1
38,100
27,400
2
39,100
27,400
3
40,100
27,400
3a
0
26,000
a
Market value.
Cash flow diagram of alternative C:
Page87
Cash flow diagram of alternative D:
The cash flow diagram of alternative D

alternative C (year by year):
The base alternative in this must take action

situation is alternative C (alternative which has
Page88
the lesser capital investment). It would be

selected unless the aditional (incremental)
capital associated with alternative D ($35,000) is
justified.
With the greater capital investment, alternative
D must have smaller annual expenses to be a
feasible alternative. (It would not be logical to
invest more capital in an alternative without
obtaining additional revenues or savings).
MARR = 10% per year.
.
.
Alternative D is preferred to C because it has the
less negative PW (minimizes costs).
The lower annual expenses obtained by
investing the additional $35,000 of capital in
alternative D have a present worth =
= $463,607 (
$477,077) = $13,470, or
>0
the additional capital invested in D is

justified alternative D is preferred to C.
The Study (Analysis) Period
Page89
The study (analysis) period = the planning

horizon = the selected time period over which
mutually exclusive alternatives are compared.
Factors that may influence the determination of
the study period are the service period required,
the useful lives of the alternatives, company
policy, and so on.
The useful life of an asset is the period during
which it is kept in productive use in a trade or
business.
Case 1: Useful lives are the same for all
alternatives and equal to the study period
1.1. Equivalent Worth Methods.
There are 3 methods in this category that we
have learned, i.e. the PW, AW, and FW
methods. When these 3 methods are used, the
conclusion will be the same. Thus, if and only if
PW(i%)A < PW(i%)B, then AW(i%)A <
AW(i%)B and FW(i%)A < FW(i%)B.
Proof:
a. PW(i%)A < PW(i%)B
< PW(i%)B
PW(i%)A
AW(i%)A < AW(i%)B
b. PW(i%)A < PW(i%)B
Page90
PW(i%)A
< PW(i%)B
FW(i%)A < FW(i%)B
Among the alternatives:
a. For investment alternatives, the one with the
greatest positive equivalent worth is selected.
b. For cost alternatives, the one with the least
negative equivalent worth is selected.
Example 5.1.
There are 3 mutually exclusive alternatives. The
differences that exist among them are in the
capital investments and the benefits (cost
savings).
Alternative
A
B
C
Capital
$390,000 $920,000 $660,000
investment
Annual cost
69,000 167,000 133,500
savings
The study period is 10 years, and the useful lives
of all 3 alternatives are also 10 years. Market
values of all alternatives at the end of their
useful lives are assumed to be zero. If the firms
Page91
MARR is 10% per year, which alternative

should be selected?
Answer:
Using PW method:
Thus, the order of preference is C > B > A.
Using AW method:
Using FW method:

1.2. Rate of Return Methods.
Guidelines:
a. Each increment of capital must justify itself
by producing a sufficient rate of return
(greater than or equal to the MARR) on that
increment.
Page92
b. Compare a higher investment alternative

against a lower investment alternative only
when the latter is acceptable.
c. Select the alternative that requires the largest
investment of capital as long as the
incremental investment is justified by benefits
that earn at least the MARR.
d. Do not compare the IRRs of mutually
exclusive alternatives (or IRRs of the
differences between mutually exclusive
alternatives) against those of other
alternatives. Compare an IRR only against the
MARR (IRR MARR) in determining the
acceptability of an alternative.
Case study: an inconsistent ranking problem
There are two investment alternatives, A and B.
Alternative
Difference
A
B
(B A)
Capital
$60,000 $73,000
$13,000
investment
Annual revenue 22,000 26,225
4,225
less expense
The useful life of each alternative = the study
period = 4 years.
Page93
MARR = 10% per year

A:
i' = 0,173 = 17,3%

B:
i' = 0,163 = 16,3%

A:
B:
Summary:
Alternative
IRR
PW(10%)
A
17.3%
$9,737.04
B
16.3%
$10,129.72
Based on maximizing the IRR A is selected.
Based on maximizing the PW B is selected.
there is inconsistency.
The incremental cash flow analysis:
Alternative A has lower capital investment than
B, PWA at MARR > 0, and IRRA > MARR
alternative A is the base alternative.
(B A):
Page94
i' = 0,114 = 11,4% > MARR = 10% OK
OK
Thus: alternative B is preferred to A.
Note: it is always true that if PW 0, then IRR
MARR.
The Incremental Investment Analysis Procedure
The incremental investment analysis procedure
is recommended to avoid incorrect ranking of
mutually exclusive alternatives when using rate
of return methods.
1. Arrange (rank order) the feasible alternatives
based on increasing capital investment.
2. Establish a base alternative.
a. Cost alternatives the least capital
investment (LCI) is the base.
b. Investment alternatives if the LCI is
acceptable (IRR MARR; PW, FW, or AW
at MARR 0), select the LCI as the base. If
Page95
the LCI is not acceptable, choose the next

alternative in order of increasing capital
investment and check the profitability
criterion (PW, etc) values. Continue until an
acceptable alternative is obtained. If none is
obtained, the do-nothing alternative is
selected.
3. Use iteration to evaluate differences
(incremental cash flows) between alternatives
until all alternatives have been considered.
a. If the incremental cash flow between the
next (higher capital investment) alternative
and the current selected alternative is
acceptable, choose the next altenative as the
current best alternative. Otherwise, retain
the last acceptable alternative as the current
best.
b. Repeat, and select as the preferred
alternative the last one for which the
incremental cash flow was acceptable.
Example 5.3:
We will analyze 6 mutually exclusive
alternatives that have been arranged by
increasing capital investment as follows.
Page96
Alternative Capital
Annual revenues
investment
less expenses
A
$900
$150
B
$1,500
$276
C
$2,500
$400
D
$4,000
$925
E
$5,000
$1,125
F
$7,000
$1,425
Useful life of each alternative = 10 years
MARR = 10% per year
Study period = 10 years
Market values = 0
Using the IRR method, determine which
alternative should be chosen.
Answer:
A:
i' = 0,106 = 10,6% > MARR = 10% OK

Similarly, we do the same calculations for
alternatives B, C, D, E, and F.
A
B
C
D
E
F
IRR 10.6% 13.0% 9.6% 19.1% 18.3% 15.6%
OK
OK
NOT OK
OK
OK
Page97
Only alternative C is unacceptable and can be

eliminated from the comparison because its IRR
is less than the MARR.
A is acceptable (its IRR MARR) and has the
lowest capital investment A is the base
alternative.
Incremental Analysis:
(B A):
Capital investment = $(1,500 900) = $600
Annual revenues less expenses = $(276 150)
= $126
i' = 0,164 = 16,4% > MARR = 10% OK

Similarly, we do the same calculations for (D
B), (E D), and (F E).
Increment Capital Annual revenues
Considered investment less expenses
A
$900
$150
(B A)
$600
$126
(D B)
$2,500
$649
(E D)
$1,000
$200
(F E)
$2,000
$300
IRR
10.6%
16.4%
22.6%
15.1%
8.1%
Is increment
justified?
Yes
Yes
Yes
Yes
No
Thus, alternative E will be chosen (NOT D,

although IRRD is the largest) because it requires
Page98
the largest investment for which the last

increment of capital investment is justified.
Case 2: Useful lives are different among the
alternatives and at least one does not match the
study period
The principle: Compare the mutually exclusive
alternatives being considered in a decision
situation over the same study period.
There are two types of assumptions used in the
comparisons.
a. The repeatability assumption
This assumption involves two main conditions:
a.1. The study period over which the alternatives
are being compared is either indefinitely long or
equal to a common multiple of the lives of the
alternatives.
a.2. The economic consequences that are
estimated to happen in an alternatives initial
useful life span will also happen in all
succeeding life spans (replacements).
b. The coterminated assumption
Page99
This assumption uses a finite and identical study

period for all alternatives needs appropriate
adjustments to the estimated cash flows. The
guidelines:
b.1. (Useful life) < (study period)
b.1.1. Cost alternatives: Because each cost
alternative has to provide the same level of
service over the study period, contracting for the
service or leasing the needed equipment for the
remaining years may be appropriate. Another
potential course of action is to repeat part of the
useful life of the original alternative, and then
use an estimated market value to truncate it at
the end of the study period.
b.1.2. Investment alternatives: The first
asumption is that all cash flows will be
reinvested in other opportunities available to the
firm at the MARR to the end of the study period.
A second assumption involves replacing the
initial investment with another asset having
possibly different cash flows over the remaining
life.
b.2. (Useful life) > (study period)
The most common technique is to truncate the
alternative at the end of the study period using
Page100
an estimated market value. This assumes that the

disposable assets will be sold at the end of the
study period at that value.
Example 5.7:
The estimation for two mutually exclusive
investment alternatives, A and B, is presented in
the following table.
A
B
Capital investment
$3,500 $5,000
Annual cash flow
$1,255 $1,480
Useful life (years)
4
6
Market value at end of useful life
0
0
If the MARR = 10% per year, which alternative
is more desirable? Use equivalent worth
methods in your analysis.
Answer:
1. Using the repeatability assumption.
The least common multiple of the useful lives of
alternatives A and B is 12 years.
Three cycles of alternative A:
A1
A2
A3
0
4
8
Two cycles of alternative B:
12 years
Page101
B1
0
B2
6
12 years
The solution must be based on the total study

period (12 years).
Using the PW method:
Because PWB > PWA, alternative B is selected.

2. Using the coterminated assumption.
We will use the first asumption in b.1.2. : All
cash flows will be reinvested in other
Page102
opportunities available to the firm at the MARR

to the end of the study period this assumption
is applied to alternative A, which has a 4-year
useful life (2 years less than the study period).
A
0
4
6 years
Assumed reinvestment of
cash flows at the MARR
for 2 years
B
6 years
Using the FW method:
Page103
Because FWB > FWA, alternative B is selected.

How to estimate market value of an asset at time
T < (useful life)?
The imputed market value technique:
MVT = [PW at end of year T of remaining
capital recovery amounts] + [PW at end of year
T of original market value at end of useful life]
Example 5-12:
Data of pump model HEPS9:
Capital investment = I = $47,600; Useful life =
N = 9 years; Market value at end of useful life =
S = $5,000.
Page104
Use the imputed maket value technique to

estimate market value of the pump at the end of
year 5. MARR = 20% per year.
Answer:
CR = Capital Recovery amount
[PW at end of year 5 of remaining capital

recovery amounts]
[PW at end of year 5 of original market value at

end of useful life]
The estimated market value at the end of year 5:
Comparison of Alternatives Using the
Capitalized Worth Method
In the Capitalized Worth (CW) method, we
determine the PW of all revenues or expenses
Page105
over an infinite length of time. This method is

used in comparing mutually exclusive
alternatives when the period of needed service is
indefinitely long and the repeatability
assumption is applicable.
Example 5-14:
A selection is to be made between two structural
designs, M and N. Revenues do not exist (or can
be assumed to be equal). Estimation:
Structure M Structure N
Capital investment
$12,000
$40,000
Market value
0
$10,000
Annual expenses
$2,200
$1,000
Useful life (years)
10
25
Using the repeatability assumption and the CW
method of analysis, determine which structure is
better if the MARR is 15% per year.
Answer:
Page106
Because CWM > CWN, structure M is selected.

Defining Mutually Exclusive Investment
Alternatives in Terms of Combinations of
Projects
There are three major groups of investment
opportunities:
1. Mutually exclusive: at most one project out of
the group can be chosen.
2. Independent: the choice of a project is
independent of the choice of any other project
in the group, so that all or none of the projects
may be selected or some number in between.
3. Contingent: the choice of a project is
conditional on the choice of one or more other
projects.
Page107
For example, we have three projects A, B, and

C. The projects are all mutually exclusive. Then,
we have four possible mutually exclusive
combinations as shown in the following table.
Here, the value 0 indicates that project is
rejected; the value 1 indicates that project is
accepted.
Mutually Exclusive
Combination
1
2
3
4
A
0
1
0
0
Project
B
0
0
1
0
Explanation
C
0
0
0
1
Accept none
Accept A
Accept B
Accept C
If, for some reason, it is not permissible to turn

down all projects, then mutually exclusive
combination 1 is eliminated from the table.
If the three projects are independent, there are
eight mutually exclusive combinations as
follows.
Mutually Exclusive Project Explanation
Combination
A B C
Page108
1
2
3
4
5
6
7
8
0
1
0
0
1
1
0
1
0
0
1
0
1
0
1
1
0
0
0
1
0
1
1
1
Accept none
Accept A
Accept B
Accept C
Accept A and B
Accept A and C
Accept B and C
Accept A, B and C
Let s suppose that A is contingent on the

acceptance of both B and C and that C is
contingent on the acceptance of B. Now there
are four mutually exclusive combinations as
follows.
Mutually Exclusive
Combination
1
2
3
4
Project
A B C
0 0 0
0 1 0
0 1 1
1 1 1
Explanation
Accept none
Accept B
Accept B and C
Accept A, B and C
Suppose that we are considering two

independent sets of mutually exclusive projects
Page109
(A1, A2) and (B1, B2). Then, all mutually

exclusive combinations are as follows.
Mutually
Exclusive
Combination
1
2
3
4
5
6
7
8
9
Project
Explanation
A1 A2 B1 B2
0
1
0
0
0
1
1
0
0
0
0
1
0
0
0
0
1
1
0
0
0
1
0
1
0
1
0
0
0
0
0
1
0
1
0
1
Accept none
Accept A1
Accept A2
Accept B1
Accept B2
Accept A1 and B1
Accept A1 and B2
Accept A2 and B1
Accept A2 and B2
Example 5-16:
The following are five proposed projects.
Cash Flow ($000s) for End of Year
Project
0
1
2
3
4
B1
$50
$20
$20
$20
$20
B2
30
12
12
12
12
C1
14
4
4
4
4
C2
15
5
5
5
5
D
10
6
6
6
6
Page110
The interrelationships among the projects are as

follows.
B1 and B2 are mutually exclusive and
independent of C set.
C1 and C2 are mutually exclusive and dependent
(contingent) on the acceptance of B2.
D is contingent on the acceptance of C1.
Using the PW method and MARR = 10% per
year, determine what combination of project is
best if the capital to be invested is (a) unlimited,
and (b) limited to $48,000.
Answer:
The mutually exclusive project combinations are
presented in the following table.
Mutually Exclusive
Project
Combination
B1 B2 C1 C2 D
1
0 0 0 0 0
2
1 0 0 0 0
3
0 1 0 0 0
4
0 1 1 0 0
5
0 1 0 1 0
6
0 1 1 0 1
The combined project cash flows and PWs are
as follows.
Mutually
Cash Flow ($000s) for
CI*)
PW**)
Page111
Exclusive
Combination
1
2
3
4
5
6
0
$0
50
30
44
45
54
End of Year
1
2
3
$0 $0 $0
20 20 20
12 12 12
16 16 16
17 17 17
22 22 22
($000s)
($000s)
$0
50
30
44
45
54
$0
13.4
8.0
6.7
8.9
15.7
4
$0
20
12
16
17
22
*) CI = Capital Investment
**) PW at MARR = 10% per year
For example:
(a) PW combination 6 is the highest

unlimited available capital combination 6
is selected.
(b) The maximum capital to be invested is
$48,000 combinations 2 and 6 are not
feasible of the remaining, combination 5
is the best combination 5 (B2 and C2) is
selected.
Depreciation
Page112
Depreciation is the decrease in value of physical

properties with the passage of time and use.
More specifically, depreciation is an annual
deduction against before-tax income such that
the effect of time and use on an assets value can
be reflected in a firms financial statement.
Depreciation is a noncash cost that affects
income taxes.
In general property is depreciable if:
1. It must be used in business or held to produce
income.
2. It must have a determinable useful life, and
the life must be longer than one year.
3. It must be something that wears out, decays,
gets used up, becomes obsolete, or loses
value from natural causes.
4. It is not inventory, stock in trade, or
investment property.
Examples of depreciable properties: machinery,
vehicles, equipment, furniture, buildings,
copyright, patent, franchise, etc.
Depreciation Methods
a. Straight-Line (SL) Method
Let:
Page113
N = depreciable life of the asset in years =

estimated period that a property will be used in a
trade or business to produce income. It is not
how long the property will last, but how long the
owner expects to productively use it.
B = cost basis, including allowable adjustments.
Cost basis = the initial cost of acquiring an asset
(purchase price plus any sales taxes), including
transportation expenses and other normal costs
of making the asset serviceable for its intended
use. Example of allowable adjustments: cost of
any improvement to a capital asset with a useful
life greater than one year increases the original
cost basis.
dk = annual depreciation deduction in year k (1
k N)
BVk = book value at end of year k = adjusted
cost basis minus total depreciation deduction
until end of year k.
SVN = estimated salvage value at end of year N.
Page114
= cumulative depreciation through year k
for 1 k N
Example 6.1:
A new electric saw has a cost basis of $4,000
and a 10-year depreciable life. SV10 = 0.
Tabulate the annual depreciation amounts and
the book value at the end of each year using SL
method.
Answer:
N = 10; B = $4,000; SV10 = 0;
for 1 k N
EOY, k
dk
BVk
0
$4,000
1
$400
3,600
2
400
3,200
3
400
2,800
4
400
2,400
5
400
2,000
6
400
1,600
Page115
7
8
9
10
400
400
400
400
1,200
800
400
0
b. Declining-Balance (DB) Method = the

Constant-percentage method = the Matheson
formula
Annual cost of depreciation = fixed percentage
of the BV at the beginning of the year.
Fixed percentage = R (0 R 1)
For example:
200% DB Method
150% DB Method
for 1 k N
Notice that none of the above equations do not

contain a term for SVN.
Example 6.2:
Rework Example 6.1 with 200% DB method.
Answer:
Page116
EOY, k
0
1
2
3
4
5
6*)
7
8
9
10
dk
$800
640
512
409.60
327.68
262.14
209.72
167.77
134.22
107.37
BVk
$4,000
3,200
2,560
2,048
1,638.40
1,310.72
1,048.58
838.86
671.09
536.87
429.50
*)
c. Sum-of-the-Years-Digits (SYD) Method
Page117
Example 6.3
Rework Example 6.1 with SYD method.
Answer:
BVk
EOY, k
dk
0
$4,000
1
$727.27
3,272.73
2
654.55
2,618.18
3
581.82
2,036.36
*)
4
509.09
1,527.27
5
436.36
1,090.91
6
363.64
727.27
7
290.91
436.36
8
218.18
218.18
9
145.45
72.73
10
72.73
0
*)
Page118
d. DB with Switchover to SL
DB method never reaches BV = SVN. It is
permissible to switch from DB to SL method, so
that BVN = SVN. The switchover occurs in the
year in which a larger depreciation amount is
obtained from the SL method.
Illustration: Rework Example 6.1
Year,
(1)
k
Beginning-ofYear BVa
Depreciation Method
(2)
(3)
200% DB
SL Methodc
Methodb
1 $4,000.00 $800.00
2
3,200.00
640.00
3
2,560.00
512.00
4
2,048.00
409.60
5
1,638.40
327.68
6
1,310.72
262.14
7
1,048.58
209.72
8
786.44
167.77
9
524.30
134.22
10
262.16
107.37
Total
$3,570.50
a
Column (1) year k + 1 =
column (4) year k.
b
2/10 of column (1)
(4)
Depreciation
Amount
Selectedd
>$400.00
> 355.56
> 320.00
> 292.57
> 273.07
= 262.14
< 262.14
< 262.14
< 262.14
< 262.14
$800.00
640.00
512.00
409.60
327.68
262.14
262.14
262.14
262.14
262.14
$4,000.00
column (1) year k
Page119
c
d
Select the larger amount in column (2) or (3)
Depletion
the decrease in value of natural resources
because they are being consumed in producing
products or services.
In the case of depreciation, the property
involved usually may be replaced with similar
property when it has become fully depreciated.
In the case of depletion of mineral or other
natural resources, such replacement usually is
not possible. The depletion funds may be used to
acquire new properties, such as new mines and
oil-producing properties, etc.
Methods to compute depletion allowances
Read p. 276 and 277, Sullivan.
Uncertainty
Both risk and uncertainty in decision-making
activities are caused by lack of precise
knowledge regarding future business conditions,
technological developments, synergies among
funded projects, and so on.
Page120
Decisions under risk: decisions in which the

analyst models the decision problem in terms of
assumed possible future outcomes, or scenarios,
whose probabilities of occurrence can be
estimated.
Decisions under uncertainty: decision problems
characterized by several unknown futures for
which probabilities of occurrence can not be
estimated.
In dealing with risk/uncertainty, we do
sensitivity analysis to determine how sensitive
the situation is to the several factors of concern
so that proper consideration may be given to
them in the decision process.
Techniques used in the sensitivity analysis:
1. Break-even analysis
used when the selection among project
alternatives or the economic acceptability of an
engineering project is heavily dependent upon a
single factor, which is uncertain.
Example 10-1:
There are two alternative electric motors that
provide 100-hp output.
Alpha motor Beta motor
Page121
Capital Investment, $
Efficiency, %
Useful life, years
Maintenance
expense, $/year
Taxes and insurance
expenses, % of the
investment
12,500
74
10
500
16,000
92
10
250
1.5
1.5
Electricity cost, $/kWh
0.05
0.05
Market Value, $
0
0
Assume that revenues are equal for both motors.
MARR = 15% per year. If the best estimate of
hours of operation per year is 600 hours, which
motor is preferred?
Answer:
Let: X = number of hours of operation per year
The equivalent annual worth of Alpha motor
= the equivalent uniform annual cost
(
Page122
Beta motor:
At the break-even point,

hours/year
Plot:
Page123
If best estimate hours of operation per year is <

508.08, choose the Alpha motor. Otherwise,
choose the Beta motor. So, in this case, choose
the Beta motor.
2. Sensitivity graph (spiderplot)
This approach makes explicit the impact of
uncertainty in the estimates of each factor of
concern on the economic measure of merit.
Example 10-4:
Page124
The best cash flow estimates of a new

equipment are as follows:
Capital investment, I = $11,500
Revenues = R = $5,000/year
Expenses = E = $2,000/year
Market value = MV = $1,000
Useful life = N = 6 years
Because this is a new technology, it is desired to
investigate its PW over a range of 40%
changes in the estimates for (a) I, (b) annual net
cash flow, (c) MV, and (d) N. MARR = 10%.
Answer:
(a)
(b)
(c)
(d)
Page125
The steeper the slope of a curve, the more

sensitive the PW is to the factor.
Conclusion: the PW is insensitive to MV, but
quite sensitive to changes in I, A, and N.
If we are going to use the sensitivity graph
technique to compare two mutually exclusive
project alternatives, a spiderplot based on the
incremental cash flow between the alternatives
can be used to aid in the selection of the
preferred alternative. Extending this approach to
three or more alternatives, two sequential paired
Page126
comparisons can be used. Another approach is to

plot in the same figure a sensitivity graph for
each alternative.
3. Combination of factors
concerned about the combined effects of
uncertainty in two or more project factors on the
economic of merit.
Read Sullivan p. 459-465.
Cost Estimation Techniques
Read Chapter 7 Sullivan
Read Peters and Timmerhaus.
Read Aries, R.S. and Newton, R.D., 1955,
Chemical Engineering Cost Estimation,
McGraw-Hill Book Company, New York.
Page127

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Engineering Economics PDF

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CHEMICAL ENGINEERING DEPARTMENT

GADJAH MADA UNIVERSITY

e. Aries, R.S. and Newton, R.D., 1955, Chemical

I. Introduction to Engineering Economics

More economic way: less cost higher profit.

Is economy the only aspect to be considered

The common measurement unit: monetary unit.

Engineering Economic Analysis Procedure

II. Cost Concepts

answers based on reference #1 to those based

General economic concepts

Consumer goods and services: products or

A sophisticated camera a necessity for a

TR = (a bD)D = aD bD2 for 0 D

6. Cost, Volume, and Breakeven Point

D* is the optimum D that maximizes profit.

6.2. Scenario 2: p constant

b) 1. 10% reduction in CF:

Cost-driven design optimization

The cost of electricity = $21.6818 / 106 Btu

40,111.33 37,834.74 36,425.42 35,883.38

E. Total life cycle

40,711.33 38,734.74 37,725.42 37,483.38

Cost R19 Cost R11 has a positive value

Thus, the most economical one is R38.

Present Economy Studies.

rate x available production hours); 2) reject rates

Analogous Machine B = $8424

There is difference in revenue use Rule 1.

parts $6.00 $15.00 $5.00 hours

Time Value of Money

The amount of money earned from the

The yearly earnings rate = simple interest rate =

investment on the project. The owner of debt

(Fn P ) 1 (1150 / 1000 ) 1

In common industrial practice, the length of the

The time value of interest that is not paid is

(1+i)n : thediscreet single-payment compoundamount factor.

Fn = P (1 + i j ) = P(1 + i1 )(1 + i 2 )...(1 + i n )

- Even though the actual interest period is not 1

Fafter1 year = Fm = P1 + nom = P(1 + ieff )

i eff utk periode 1 thn

i eff = lim 1 + nom 1

Fafter 1 year = Fm = Pe i nom

Fafter1 year = P(1 + ieff ) = $100(1 + 0,2) = $120

Fafter1 year = P(1 + ieff ) = $100(1 + 0,21) = $121

Fafter1 year = P(1 + ieff ) = $100(1 + 0,2213) = $122.13

The Concept of Equivalence

We borrow $8,000 and agree to repay it in 4

Plan 1: At end of each year, we pay $2000

Plan 2: We pay interest due at end of each year

Plan 3: We pay in 4 equal end-of-year payments

Plan 4: We pay principal and interest in one

Because the ratio is constant at 0,10 for all plans,

Cash-Flow Diagrams and Tables

Example: Draw a cash flow diagram from the

Recovery value at the end of the 5th year =

Table cash flow: study example 3-2, p. 79,

Cash flow and interest analysis

The amount of money at a certain time in the

3. Deferred annuity: the first payment is due

Relation between the amount of ordinary

series compound-amount factor (= the series