Economy Lecture Handout

ENGINEERING ECONOMICS
MOST IMPORTANT CONCEPT IN ENGINEERING ECONOMY

 It is a well-known fact that money makes money. The time value of money explains the
ENGINEERING ECONOMICS change in the amount of money over time for funds that are owned (invested) or owed
 Previously known as engineering economy, is a subset of economics concerned with the use and (borrowed).
"application of economic principles" in the analysis of engineering decisions.
 As a discipline, it is focused on the branch of economics known as microeconomics in that it
studies the behavior of individuals and firms in making decisions regarding the allocation of limited ACCOUNTING VS. ENGINEERING ECONOMY
resources.
 Engineering economy involves the systematic evaluation of the economic merits of proposed
solutions to engineering problems.
 People make decisions; computers, mathematics, concepts, and guidelines assist people in their
decision-making process.
 Since most decisions affect what will be done, the time frame of engineering economy is primarily
the future.
 Therefore, the numbers used in engineering economy are best estimates of what is expected to
occur.
 The estimates and the decision usually involve four essential elements:
 Cash flows
FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS
 Times of occurrence of cash flows
 Interest rates for time value of money
 Measure of economic worth for selecting an alternative
 The criterion used to select an alternative in engineering economy for a specific set of estimates is
called a measure of worth.
 The measures developed and usually used are:
Present worth (PW)
Future worth (FW)
Annual worth (AW)
Rate of return (ROR)
Benefit/cost (B/C)
Capitalized cost (CC)
Payback period
Economic value added (EVA)
Cost Effectiveness
CONCEPT OF THE TIME VALUE OF MONEY

 All these measures of worth account for the fact that money makes money over time.
Prepared by: Engr. Evangelyn C. Samson

PRINCIPLE 3: Use a Consistent Viewpoint

PERFORMING AN ENGINEERING ECONOMY STUDY  The prospective outcomes of the alternatives, economic and other should be consistently
 An engineering economy study involves many elements: developed from a defined viewpoint (perspective).
 problem identification  The perspective of the decision maker, which is often that of the owners of the firm, would
 definition of the objective normally be used.
 cash flow estimation  The viewpoint for the particular decision be first defined and then used consistently in the
 financial analysis description, analysis, and comparison of the alternatives.
 decision making
 Implementing a structured procedure is the best approach to select the best solution to the Principle 4:Use a Common Unit of Measure
problem.  For measuring the economic consequences, a monetary unit such as dollars is the common
measure.
The steps in an engineering economy study are as follows:  You should also try to translate other outcomes (which do not initially appear to be economic)
1. Identify and understand the problem; identify the objective of the project. into the monetary unit.
2. Collect relevant, available data and define viable solution alternatives.  Using more than one monetary unit for Economic Analysis will complicate the over all analysis
3. Make realistic cash flow estimates. of a project.
4. Identify an economic measure of worth criterion for decision making.
5. Evaluate each alternative; consider noneconomic factors; use sensitivity analysis as needed. Principle 5: Consider All relevant Criteria
6. Select the best alternative.  The decision maker will normally select the alternative that will best serve the long-term
7. Implement the solution and monitor the results. interests of the owners of the organization.
 In engineering economic analysis, the primary criterion relates to the long-term financial
interests of the owners.
ENGINEERING ECONOMICS PRINCIPLES  This is based on the assumption that available capital will be allocated to provide maximum
 The development, study, and application of any discipline must begin with a basic foundation. monetary return to the owners.
 The foundation for engineering Economy has been defined to be a set of principles that provide a  Often, though, there are other organizational objectives you would like to achieve with your
comprehensive doctrine for developing the methodology. decision, and these should be considered and given weight in the selection of an
alternative.
PRINCIPLE 1: Develop the Alternatives
 Carefully define the problem! Then the choice (decision) is among alternatives. PRINCIPLE 6: Make Risk and Uncertainty Explicit
 The alternatives need to be identified and then defined for subsequent analysis.  Risk and uncertainty are inherent in estimating the future outcomes of the alternatives and
 A decision situation involves making a choice among two or more alternatives. should be recognized.
 Developing and defining the alternatives for detailed evaluation is important because of the  The analysis of the alternatives involves projecting or estimating the future consequences
resulting impact on the quality of the decision.  Associated with each of them.
 Engineers and managers should place a high priority on this responsibility.  The magnitude and the impact of future outcomes of any course of action are uncertain.
 Creativity and innovation are essential to the process.  The probability is high that today’s estimates of, for example, future cash receipts and
expenses will not be what eventually occurs.
PRINCIPLE 2 :Focus on the Differences  Thus, dealing with uncertainty is an important aspect of engineering economic analysis.
 Only the differences in the future outcomes of the alternatives are important.
 Outcomes that are common to all alternatives can be disregarded in the comparison and PRINCIPLE 7: Revisit Your Decisions
decision.  A good decision-making process can result in a decision that has an undesirable outcome.
 For example, if your feasible housing alternatives were two residences with the same purchase  Other decisions, even though relatively successful, will have results significantly different from
(or rental) price, price would be inconsequential to your final choice. the initial estimates of the consequences.
 Instead, the decision would depend on other factors, such as location and annual operating  Learning from and adapting based on our experience are essential and are indicators of a
and maintenance expenses. good organization.

COSTS AND CONCEPTS FOR DECISION MAKING

Fixed / Variable Costs
If costs change appreciably with fluctuations in business activity, they are “variable.” Otherwise,
they are “fixed.”
A widely used cost model is:

Total Costs = Fixed Costs + Variable Costs
Some examples of fixed costs:

Insurance, taxes on facilities, administrative salaries, rental payments and initial setup or
installation.
Some examples of variable costs: direct labor, direct material, unit transportation.
The TOP cost concepts are:

1. Marginal Cost
Example Problem: 2. Out of Pocket Costs
FINANCIAL DATA REQUIRED TO MAKE AN ECONOMIC DECISION 3. Differential Costs
4. Sunk Costs
5. Opportunity Cost
6. Imputed Costs
7. Replacement Cost
8. Avoidable Cost and Unavoidable Cost
9. Relevant Cost and Irrelevant Cost
WHICH CAR TO LEASE? SATURN VS. HONDA

1. Recognize a decision problem
2. Define the goals or objectives
3. Collect all the relevant information
4. Identify a set of feasible decision alternatives
5. Select the decision criterion to use
6. Select the best alternative

a) Compare the two sites in terms of their fixed, variable, and total costs. Decision Making: Cost Concept # 5.
b) For the selected site, how much profit can be made if it is paid $8.05 per cubic meter delivered Opportunity Cost:
to the job site?  It is the maximum possible alternative earning that might have been earned if the productive
capacity or services had been put to some alternative use.
 It refers to the value of sacrifice made or benefit of opportunity foregone in accepting an
alternative course of action.
 For example, if an owned building is proposed to be used for a project, the likely rent of the
building is the opportunity cost which should be taken into consideration while evaluating the
profitability of the project.
Decision Making: Cost Concept # 6.

Imputed Costs:
Decision Making: Cost Concept # 1.  Notional costs or imputed costs are those costs which are notional in character and do not
Marginal Cost: involve any cash outlay, e.g., notional rent charged on business premises owned by the
 Marginal cost is the total of variable costs, i.e., prime cost plus variable overheads. proprietor, interest on capital for which no interest has been paid.
 It is based on the distinction between fixed and variable costs.  When alternative capital investment projects are being evaluated it is necessary to consider
 Fixed costs are ignored and only variable costs are taken into consideration for determining the imputed interest on capital before a decision is arrived as to which is the most profitable
the cost of products and value of work-in-progress and finished goods. project.
Decision Making: Cost Concept # 2. Decision Making: Cost Concept # 7.

Out of Pocket Costs: Replacement Cost:
 This is that portion of the costs which involves payment to outsiders, i.e., gives rise to cash  It is the cost at which there could be purchase of an asset or material identical to that which is
expenditure as opposed to such costs as depreciation, which do not involve any cash being replaced or revalued.
expenditure.  It is the cost of replacement at current market price.
 Such costs are relevant for price fixation during recession or when make or buy decision is to
be made. Decision Making: Cost Concept # 8.
Avoidable Cost and Unavoidable Cost:
Decision Making: Cost Concept # 3.  Avoidable costs are those which can be eliminated if a particular product or department, with
Differential Costs: which they are directly related, is discontinued. For example, salary of the clerks employed in a
 The change in costs due to change in the level of activity or pattern or technology or process particular department can be eliminated, if the department is discontinued.
or method of production is known as differential costs.  Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product
 If any change is proposed in the existing level or in the existing methods of production, the or department. For example, salary of factory manager or factory rent cannot be eliminated
increase or decrease in total cost as a result of this decision is known as differential cost. even if a product is eliminated.
 If the change increases the cost, it will be called incremental cost. If there is decrease in cost
resulting from decrease in output, the difference is known as decremental cost. Decision Making: Cost Concept # 9.
Relevant Cost and Irrelevant Cost:
Decision Making: Cost Concept # 4.  A cost that is relevant to a decision is called relevant cost.
Sunk Costs:  Past costs are not generally relevant costs because they are sunk costs or costs already
 A sunk cost is an irrecoverable cost and is caused by complete abandonment of a plant. incurred. Thus, the book value of an asset or depreciation charged in accounts in respect of an
 It is the written down value of the abandoned plant less its salvage value. asset is not relevant cost.
 Such costs are historical which are incurred in the past and are not relevant for decision-  On the other hand, the fall in the resale value of an asset as a result of using it, as also the
making and are not affected by increase or decrease in volume. running expenses incurred to make use of the asset are relevant costs.
 Thus, expenditure which has taken place and is irrecoverable in a situation is treated as sunk
cost.

 Similarly in the case of materials regularly in use, the relevant cost is its replacement cost and
not the book value or the realizable value. For material that is not in regular use; the realizable
value is the relevant cost.
 If it is possible to use this non-moving material in place of another material, the value of the
latter for which substitution is made is the relevant cost of the non-moving material.
 The relevant cost of any scarce resource (e.g., labour) is the direct cost of using the resource
plus any contribution earned by that resource on the most profitable alternative use of the
resource. In this sense the relevant cost is the opportunity cost. Generally relevant costs are
the expected future costs relevant to a decision and they differ among different alternatives.
PRESENT ECONOMY STUDIES
STUATIONS WHERE PRESENT ECONOMY STUDIES ARE INVOLVED

CHAPTER 1 INTEREST CASH FLOW TYPES
INTEREST AND TIME VALUE OF MONEY

 Money is invested or borrowed in thousands of transactions every day.
 When an investment is cashed in or when borrowed money is repaid, there is a fee that is collected
or charged. This fee is called interest.
In any financial transaction, there are two parties involved:

 an investor, who is lending money to someone
 and a debtor, who is borrowing money from the investor
 For the debtor, interest is the payment for the use of the borrowed capital while for the creditor, it is
the income from invested capital.
TIME VALUE OF MONEY

 P1 today is worth more than P1 next year.
 How much more depends upon the opportunities for using or investing that P1.
 If we invest in a government bond earning i% per year, then our P1 will be worth (1+i) at the end of
one year and (1+i)t at the end of t years.
 Likewise, earning P1 at the end of year t is worth 1/(1+i)t today
INTEREST
1. SIMPLE INTEREST
CASH FLOW 2. COMPOUNDING INTEREST
 SIMPLE INTEREST
Simple Interest ( I ) is defined as the interest on a loan or principal that is based only on the original
amount of the loan or principal.
I=Prt
Amount owed at the Interest amount for a Amount owed at the
Period beginning of the period period (x 10%) end of period
“P” “I” “F”
1 1,000 100 1,100
2 1,000 200 1,200
3 1,000 300 1,300
Where:
I = total interest earned by a principal
P = amount of the principal

r = rate of the interest expressed in decimal form SAMPLE PROBLEMS (SIMPLE INTEREST)
t = number of interest periods in years
1. If the rate of interest is 14 %, determine the ordinary simple interest on P 50,000 for 7 months and
10 days.
Where:
F = total amount to be repaid or sum of the principal and the interest
P = principal amount
I = total amount of interest earned by a principal
r = rate of the interest expressed in decimal form 2. Solve for the ordinary and exact simple interest on P 25,000 for the period from April 14 to
t = must be in years November 7, 2017. The rate of interest is 11%.
F=P+I F = P ( 1+ r t )
The factor (1 + rt) is called an accumulation factor at a simple interest rate r.

The process of calculating F from P is called accumulation at a simple interest rate r.
WHEN THE TIME IS GIVEN IN DAYS, THERE ARE TWO DIFFERENT VARIETIES OF
SIMPLE INTEREST IN USE:
3. A loan shark made a loan of P100 to be repaid with P120 at the end of one month. What was the
annual interest rate?
4. How long will it take P3000 to earn P60 interest at 6%?
 The general practice in Canada is to use exact interest

 The general practice in the United States and in international business transactions is to
use ordinary interest (also referred to as the Banker’s Rule).

5. A businessman borrowed P 175,000 from a lending firm at 10% simple interest. He received the EXERCISES:
borrowed money less the interest, but at the end of 1 year, he obliged to pay back P 175,000. What 1. A loan of P15 000 is taken out. If the interest rate on the loan is 7%, how much interest is due and
is the actual rate of the interest? what is the amount repaid if
a) The loan is due in seven months;
b) The loan was taken out on April 7 and is due in seven months?
2. Determine the exact and ordinary simple interest on a 90-day loan of P8000 at 8.5%.
DEMAND LOAN
 On a demand loan, the lender may demand full or partial payment of the loan at any time and the
borrower may repay all of the loan or any part at any time without notice and without interest
penalty.
6. What is the future worth of P 31,000 invested at 13% simple interest for 30 months?  Interest on demand loans is based on the unpaid balance and is usually payable monthly.
 The interest rate on demand loans is not usually fixed but fluctuates with market conditions.
JESSICA'S
BORROWED
DATE PAYMENT BALANCE
MONEY
AUG 16 1500
7. If the amount of interest is P 17,000 after 3.5 years and the rate of simple interest is 9%, what is SEPT 17 300 1200
the principal amount? OCT 7 500 700
NOV 12 400 300
DEC 15 300 0
Interest on the loan, calculated on the unpaid balance, is charged to her account on the 1st of
each month.
The rate of interest on the loan per annum
August 16 12%
8. A deposit of P1500 is made into a fund on March 18. The fund earns simple interest at 5%. On
September 25 11.5%
August 5, the interest rate changes to 4.5%. How much is in the fund on October 23?
November 20 12.5%.
Calculate the interest payments required and the total interest paid.
AUG 17 - SEPT 1 INTEREST MUST BE PAID (SEPT 1)

SEPT 2 - SEPT 17 PAYMENT OF 300 (SEPT 17)
SEPT 18 - SEPT 25 INTEREST RATE WAS CHANGED (SEPT 25)
SEPT 26 - OCT 1 INTEREST MUST BE PAID (OCT 1)
OCT 2 - OCT 7 PAYMENT OF 500 (OCT 7)
OCT 8 - NOV 1 INTEREST MUST BE PAID (NOV 1)
NOV 2 - NOV 12 PAYMENT OF 500 (NOV 12)
NOV 13 - NOV 20 INTEREST RATE WAS CHANGED (NOV 20)
NOV 21 - DEC 1 INTEREST MUST BE PAID (DEC 1)
DEC 2 - DEC 15 PAYMENT OF 300 (DEC 15)

 The difference between the amounts in cash smaller that the face value of the bond. The
difference between the amount he receives in cash (present worth) and the face value of the
RATE OF # OF bond or financial security (future worth) is known as discount.
BALANCE INTEREST
INTEREST DAYS  The process of converting a claim on a future amount of money in the present is called
discounting.
AUG 17 - SEPT 1
SEPT 2 - SEPT 17
SEPT 18 - SEPT 25
SEPT 26 - OCT 1
OCT 2 - OCT 7
OCT 8 - NOV 1
NOTE: The factor in is called a discount factor at a simple interest rate r and the
NOV 2 - NOV 12 process of calculating P from S is called discounting at a simple interest rate r, or simple
discount at an interest rate r.
NOV 13 - NOV 20
For a given interest rate r, the difference F− P has two interpretations.

NOV 21 - DEC 1 1. The interest I on P which when added to P gives F.
2. The discount D on F which when subtracted from F gives P.
DEC 2 - DEC 15
The rate of the discount is The rate of the interest is the

the discount on one unit of interest on one unit of
principal per unit of time principal per unit of time
DISCOUNT IN TERMS OF MARKETING
 MARKED PRICE
In big shops and departmental stores, every article is tagged with a card and its price is written on
it.
 DISCOUNT
 In order to increase the sale or clear the old stock, sometimes the shopkeepers offer a certain
percentage of rebate on the marked price.
 Discount on a negotiable paper is the difference between what it is worth in the future and its
present worth

SAMPLE PROBLEMS (DISCOUNT) 11. A dealer purchased a washing machine for P7660, then put it into market with a market price of x.
He allows a discount of 12% on its marked price and still gains 10%. Find the marked price of the
9. Jennifer wishes to have $1000 in eight months’ time. If she can earn 6%, how much does she need
machine.
to invest on September 15? What is the simple discount?
12. A man borrowed P2000 from a bank and promised to pay the amount for one year. He received
only the amount of P1920 after the bank collected an advance interest of P80. What was the rate of
10. The marked price of a ceiling fan is P1250 and the shopkeeper allows a discount of 6% on it. Find discount and the rate of interest that the bank collected in advance?
the selling price of the fan.

 COMPOUNDING INTEREST CONTINUOUS COMPOUNDING
 Compound Interest is defined as interest of loan or principal which is based not only on the Example: Nominal rate = 6%
original amount of the loan or principal but the amount of loan or principal plus the previous No. of years = 4
accumulated interest.
 Whenever the interest charge for any interest period ( a year, for example) is based on the
remaining principal amount plus any accumulated interest charges up to the beginning of that a. Compound annually e. Compounded bi-monthly
period, the interest is said to be compounded.
ί = 0.06 / 1 = 0.06 ί = 0.06 / 6 = 0.01
N = 4(1) = 4 N = 4(6) = 24
b. Compounded semi-annually f. Compounded daily

ί = 0.06 / 2 = 0.03 ί = 0.06 / 365 = 0.0001643
N = 4(2) = 8 N = 4(365) = 1460
c. Compounded quarterly g. Compounded Continuously

ί = 0.06 / 4 = 0.015 r = 0.06
N = 4(4) = 16 n=4
Amount owed at the Interest amount for a Amount owed at the end
Period beginning of the period period (x 10%) of period
“P” “I” “F” d. Compounded monthly
1 1,000 100 1,100 ί = 0.06 / 12 = 0.005
2 1,100 110 1,210 N = 4(12) = 48
3 1,210 121 1,331
EFFECTIVE RATE OF INTEREST

N mn  The effective rate of interest is the actual rate of interest on the principal for one year.
F = P ( 1 + ί) F=P(1+r/m)  It is equal to the nominal rate of interest if the interest is compounded annually, but greater than the
nominal rate if the number of interest periods per year exceeds one, such as for the interest
compounded semi-annually, quarterly, or monthly.
Where:
r = the nominal annual interest rate WHAT IS THE DIFFERENCE BETWEEN NOMINAL AND EFFECTIVE RATE OF INTEREST?
m = the number of interest periods each year
ί = r / m = interest rate per interest period Nominal rate of interest is defined as basic annual rate of interest
N = m*n = number of interest periods in N years Effective rate of Interest is defined as the actual or the exact rate of interest earned on the principal
during a one-year period.

4. You are planning to sell a 1 hectare (10,000 m2) lot which costs 200 per square meter at present. If
Principal amount of 10,000 gains an interest at a rate of 10% compounding every month for 1 you wish to sell it after 5 years, what will be the price of your lot if it is expected to appreciate at the
year. compounding rate of 20% per annum?
SAMPLE PROBLEMS (COMPOUND INTEREST) 5. A debt of 13,000 will amount to 27,000 after 3.5 years. What nominal rate is applied if the interest
is compounded bi-monthly? Quarterly?
1. Which is better, the interest earned by 46,800 for 10 years at 11% simple interest or that earned by
the same amount for 10 years at 11% compounded annually?
2. Determine the future worth of an investment of 25,000 after 3 years if invested at 11%
compounded bi-monthly?
6. A man deposited P100,000 in Coconut Bank. After 2 years, he withdrew P9,000. After another 2
years, he again withdrew P15,000. If he wishes to withdraw all his savings after 7 years from the time of
his deposit, what amount will he receive if annual interest rate is 7%?
3. If 10,000 will amount 70,000 in 8 years compounded annually, what is the amount after 16 years?

ANNUITIES 3. DEFERRED ANNUITY
 is a type of annuity where the first payment does not begin until some later date in the cash
 Annuity is defined as a series of equal payments occurring at equal interval of time.
flow.
 When an annuity has a fixed time span, it is known as annuity certain.
Annuities occur in the following instances:

1. Payments of a debt by a series of equal payments at equal intervals of time. This occurs when
goods are bought on the installment plan, the payments for which are usually of equal amounts
paid periodically, usually monthly.
2. Accumulation of a certain amount by setting equal amounts periodically. This occurs when a
person saves equal amounts and deposits these periodically in a bank; when equal amounts are
set aside at equal intervals of time to take care of the depreciation of equipment and to provide for
their replacement at a definite future time.
3. Substitution of a series of equal amount periodically in lieu of a lump sum at retirement of an

individual
4. PERPETUITY
TYPES OF ANNUITY:  When an annuity does not have a fixed time span but continues indefinitely, then it is referred
1. ORDINARY ANNUITY to as a perpetuity. The sum of perpetuity is an infinite value
 is a type of annuity where the payments are made at the end of each period beginning from
the first period.
P= A
ORDINARY ANNUITY PERPETUITY
ί
ANNUITY DUE PERPETUITY P=A+ A

ί
-J
DEFERRED ANNUITY PERPETUITY P= A(1+ί)
2. ANNUITY DUE ί
 is a type of annuity where the payments are made at the beginning of each period starting from
the first period.

SAMPLE PROBLEMS (FOR ORDINARY ANNUITY) SAMPLE PROBLEMS (FOR ANNUITY DUE)
1. What is the accumulated amount of the five year annuity paying 6,000 at the end of each school year, 1. A 12,000.00 loan is payable at the beginning of each month for 1 year. If the interest is 10%
with interest at 15% compounded annually? compounded monthly, how much is the monthly payment?
2. Under a company savings plan, each employee deposits 3,000 at the beginning of each quarter for
2. A 2001 model car can be purchased with a down payment of 109,000 and equal monthly installments 5 years. How much will each employee receive if the interest is compounded quarterly at the end of
of 12,000 for 20 months. If money is worth 11% compounded monthly, what is the equivalent cash price 5 years?
of the car?
3. A mother wish to earn 50,000 from an investment after 6 years so that she will have enough money 3. A warehouse can be leased at 50,000.00 a month for 5 years. However, with a 2M loan payable at
to celebrate her daughter’s 7th birthday. What equal amounts should the mother invest every year for 6 the beginning of each month for 5 years, the company could purchase a new warehouse. Should
years if interest on the investment is 9% compounded quarterly? the company lease or buy, considering that their expenses for the warehouse should not exceed
50,000.00 and the interest for a loan is 6% compounded monthly?

SAMPLE PROBLEMS (FOR DEFERRED ANNUITY)
1. Engr. Garcia deposited 100,000 now so that his 2 years old daughter will receive 5 equal amounts
of money yearly starting on her 17th birthday. If money earns 11% compounded annually, how
much will the girl receive yearly?
4. A man owes 10,000.00 with interest at 6% payable semi-annually. What equal payments at the
beginning of each 6 months for 8 years will discharge his debt?
2. A 100 m2 lot in a certain subdivision costs 120,000 in cash. On the installment basis, the seller
wants a 40,000 down payment and 12 monthly installments, the first due at the end of the first year
after purchase. Determine the amount of the monthly installments if money is worth 3%
compounded monthly.
5. How much equal deposit should you make at the beginning of each year for 10 years to be able to
withdraw 24,000.00 yearly for 8 years? The first withdrawal is a year after your last deposit. Interest
is 13% compounded annually.
3. Refer to problem #2. If in case the seller agrees to the buyer’s proposal to pay the supposedly
40,000 down payment on 12 monthly installments, what would be the amount of the monthly
payments using the same rate of interest. The first payment is to be made at the end of the first
month after the purchase.

SAMPLE PROBLEMS (FOR PERPETUITY)
4. A ten-wheeler secondhand truck is offered for sale. The owner offers two methods of payment. The
1. The maintenance of newly acquired equipment is estimated to cost P5,000.00 at the end of each
first method requires 200,000 down payment and 15,000 monthly installments for two years. The
month. If the money is worth 8% compounded monthly. What amount of money should be set aside
second method requires 100,000 down payment and monthly payments of 30,000 for the first year
now to take care of all the future maintenance cost?
and 15,000 for the second and third year. If the rate of interest for both methods of payment is 5%
compounded monthly, which method of payment is better for the buyer and how much?
2. What is the present worth of a pension of P10,000.00 monthly if money is worth 7% compounded
monthly?
5. A member of the cooperative loaned an amount of 80,000 payable in 12 equal quarterly

3. Find the present value in pesos of a perpetuity of P15,000.00 payable semi-annually if money is
installments. The first payment was made a year after the money was borrowed. How much is each
worth 8% compounded quarterly.
of the quarterly installments if the rate is 15% compounded bi-monthly?

ARITHMETIC AND GEOMETRIC GRADIENTS
In certain cases, engineering economy problems involve a series of disbursements or receipt that
increase or decrease in each succeeding period by varying amounts. For example, maintenance and
When i = g
repair expenses on specific equipment may increase by a relatively constant amount. If the change is
succeeding periods is constant, then the series is known as uniform arithmetic gradient.
1. UNIFORM ARITHMETIC GRADIENT When i ≠ g

 A collection of end-of-period, increasing cash payments or receipts arranged in a uniformly
increasing series. The uniform increase in each payment is called the gradient amount, G.
g uniform rate of cash flow increase / decrease from period to period, that is, the
geometric gradient
A value of cash flow at Year 1
i interest rate
SAMPLE PROBLEMS (FOR ARITHMETIC GRADIENT)

1. Our firm has purchased a photocopy machine that will require increasing service or maintenance
costs over the next six years (at which time we will sell it and buy a new one). Such costs at the
end of year 1 will be 100 and thereafter increase by 50 each subsequent year (total is 1350). Out
plan is to make these payments by using amounts based on an initial cash deposit in an investment
account in the local credit union paying 4% annual interest. What is the required initial deposit?
2. GEOMETRIC SERIES
 A collection of end-of-period, increasing cash payments or receipts arranged in a series that
increases at a uniform rate. The uniform rate increase, G, is applied to each successive
regular payment amount.
 Consider a 4 year period with costs increasing at 5% per year and given an initial cost in year
1 of 100.
Year Cash Flow

1 100 100.00
2 100 + 100 (5%) = 100 (1 + 0.05) 105.00
3 105 + 105 (5%) = 100 (1 + 0.05)2 110.25
4 110.25 + 110.25 (5%) = 100 (1 + 0.05)3 115.76

2. For the photocopy machine maintenance program previously investigated, let us now consider 4. Suppose that one has payments as follows:
what the equivalent uniform annual maintenance cost would be (assume the same 4% interest End of years Payments
rate). 1 10000.00
2 9000.00
3 8000.00
4 7000.00
5 6000.00
Given i = 14%, calculate the equivalent future worth at the end of the 5th year.
3. Maintenance cost for a new piece of manufacturing equipment is expected to be 5,000 in the first
year and increase 250 per year for every year thereafter. If the cost of funds is 10%, what is the
present worth cost of maintenance for the next 5 years?
SAMPLE PROBLEM (FOR GEOMETRIC GRADIENT)

1. The first-year maintenance cost for a new automobile is estimated to be $100, and it increases at a
uniform rate of 10%per year. Using an 8% interest rate, calculate the present worth of cost of the
first 5 years of maintenance.

CHAPTER 2 BASIC ECONOMY STUDY METHODS  A project is not economically viable unless it is expected to return at least the MARR.
ELEMENTS THAT CONTRIBUTE TO DETERMINING THE MARR:

TYPICAL CAPITAL BUDGETING DECISIONS  Amount, source, and cost of money available
 Number and purpose of good projects available
 Perceived risk of investment opportunities
 Type of organization
THE MOST-USED METHODS:

 Present Worth
The present worth (PW) is found by discounting all cash inflows and outflows to the present time
at an interest rate that is generally the MARR.
 Future Worth
Future worth (FW) is based on the equivalent worth of all cash inflows and outflows at the end of
the study period at an interest rate that is generally the MARR.
Decisions made using FW and PW will be the same.
TYPICAL CASH OUTFLOWS AND INFLOWS

 Annual Worth
Annual worth (AW) is an equal periodic series of dollar amounts that is equivalent to the cash
inflows and outflows, at an interest rate that is generally the MARR.
The AW of a project is annual equivalent revenue or savings minus annual equivalent expenses,
less its annual capital recovery (CR) amount.
 Capital recovery reflects the capital cost of the asset.

 CR is the annual equivalent cost of the capital invested.
 The CR covers the following items.
 Loss in value of the asset.
 Interest on invested capital (at the MARR).
THE MINIMUM ATTRACTIVE RATE OF RETURN  The CR distributes the initial cost (I) and the salvage value (S) across the life of the asset.
 If you’re in business at all, it’s because you think you can make more money from your investment
than the bank can.
 So, your MARR must be at least as great as the bank rate.
 If all the initial investment in the business is yours, your MARR is whatever you think it should be.
 If you’ve borrowed some of the money from the bank, your MARR must be enough to pay the
interest on the loan.
 The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return established for the
evaluation and selection of alternatives.
 MARR is also referred to as the hurdle rate, cutoff rate, benchmark rate, and minimum acceptable
rate of return.

Present Worth (PW) Method SAMPLE PROBLEMS:
If PW (MARR) ≥ 0, then the project is profitable.
1. Consider a project that has an initial investment of $50,000 and that returns $18,000 per year for
If PW (MARR) < 0, then the project is not profitable.
the next four years. If the MARR is 12%, is this a good investment?
Future Worth (FW) Method

If FW (MARR) ≥ 0, then the project is profitable.
If FW (MARR) < 0, then the project is not profitable.
Annual Worth (AW) Method

If AW (MARR) ≥ 0, then the project is profitable.
If AW (MARR) < 0, then the project is not profitable.
If PW ≥ 0, then FW ≥ 0 and AW ≥ 0
then the project is profitable.
2. A $45,000 investment in a new conveyor system is projected to improve throughput and increasing
revenue by $14,000 per year for five years. The conveyor will have an estimated market value of
EXAMPLE: $4,000 at the end of five years. Using FW and a MARR of 12%, is this a good investment?
Compute the present, future and annual equivalent of the estimated cash flows using the MARR as the
interest rate.
3. A project requires an initial investment of $45,000, has a salvage value of $12,000 after six years,
incurs annual expenses of $6,000, and provides an annual revenue of $18,000. Using a MARR of
10%, determine the AW of this project.

GOOD EXAMPLES OF PRESENT WORTH 4. Divide the AW obtained in step 3 by the interest rate i to obtain a CC value.
BOND 5. Add the CC values obtained in steps 2 and 4.
The commercial value of a bond is the PW of all future net cash flows expected to be received--the
period dividend [face value (Z) times the bond rate (r)], and the redemption price (C), all discounted to
the present at the bond’s yield rate, i%. In general, capital is developed in two very common ways for a project:
1. Equity financing:
CAPITALIZED WORTH The corporation uses its own funds from cash on hand, stock sales, or retained earnings.
 Capitalized worth is a special variation of present worth. Individuals can use their own cash, savings, or investments.
 Capitalized worth is the present worth of all revenues or expenses over an infinite length of time.
 If only expenses are considered this is sometimes referred to as capitalized cost. 2. Debt financing:
 The capitalized worth method is especially useful in problems involving endowments and public The corporation borrows from outside sources and repays the principal and interest according
projects with indefinite lives. to some schedule. Sources of debt capital may be bonds, loans, mortgages, venture capital
pools, and many others. Individuals, too, can utilize debt sources, such as the credit card (15%
CAPITALIZED COST (CC) rate) and bank options (9% rate).
 is the present worth of an alternative that is assumed to have a perpetual life.
 A perpetual or infinite life is the effective planning horizon.
 Public sector projects such as bridges, dams, irrigation systems, and railroads fall into this
category. CAPITALIZED COST = FIRST COST + REPLACEMENT COST + MAINTENANCE
 In addition, charitable organization endowments are evaluated using capitalized cost methods. COST + OPERATION COST
𝑨 𝑨𝑾
𝑪𝑪 = or 𝑪𝑪 =
𝒊 𝒊
 The application of this equation can become complicated with the presence of nonrecurring
cash flows.
 It is very important for you to know how to apply this equation.
The cash flows (costs, revenues, and savings) in a capitalized cost calculation are usually of FIRST COST
two types: - the sum of the initial expenditures involved in capitalizing a property or building a project;
includes items such as transportation, installation, preparation for service, as well as other
 RECURRING: also called periodic related costs. In the context of a building, first cost includes land acquisition costs in addition to
An annual operating cost of $50,000 and a rework cost estimated at $40,000 every 12 years are the cost of construction.
examples of recurring cash flows.
REPLACEMENT COST
 NONRECURRING - is the cost to replace an asset of a company at the same or equal value, and the asset to be
Examples of nonrecurring cash flows are the initial investment amount in year 0 and one-time cash replaced could be a building, investment securities, accounts receivable or liens. The
flow estimates at future times, for example, $500,000 in fees 2 years hence. replacement cost can change, depending on changes in market value of the asset and any
other costs required preparing the asset for use.
The procedure to determine the CC for an infinite sequence of cash flows is as follows:
1. Draw a cash flow diagram showing all nonrecurring (one-time) cash flows and at least two MAINTENANCE COST
cycles of all recurring (periodic) cash flows. - the cost incurred to keep an item in good condition and/or good working order. Examples of
2. Find the present worth of all nonrecurring amounts. This is their CC value. maintenance expenses for automobiles include gas, oil changes, alignment, tire replacement,
3. Find the A value through one life cycle of all recurring amounts. Add this to all other uniform brake fluid and car washes.
amounts (A) occurring in years 1 through infinity. The result is the total equivalent uniform
annual worth (AW).

OPERATING COST
- are expenses associated with the maintenance and administration of a business on a day-to-
day basis such as sales and marketing costs, travel expenses, rent, office supply cost, utility
expenses, repair and maintenance costs.
ANNUAL COST?
Annual cost of any structure or property is the sum of the annual depreciation cost, interest of 4. A manufacturing plant installed a new boiler at a total cost of 150,000.00 and is estimated to have a
the first cost and the annual operating and maintenance costs, or useful life of 10 years. It is estimated to have a scrap value at the end of its useful life of 5,000.00. If
interest in 12% compounded annually, determine its capitalized cost.
Annual Cost = annual depreciation cost interest of first cost + annual
operating cost + maintenance cost
SAMPLE PROBLEMS
1. A commercial buildings cost 1.5 M. At the end of each 25 years, it must be partially rebuilt at a cost
of 1M, at 7% interest rate, calculate the capitalized cost of the building.
2. A certain structure at a cost of 250,000.00 is expected to last 35 years. Maintenance and repairs
PREFERENCE DECISION – THE RANKING OF INVESTMENT PROJECTS
cost 8,000.00 annually. At the end of its 35th year, its renewal cost will be 200,000.00. Determine
the capitalized cost of the structure at 9% interest.
3. A machine will have a scrap value of 30,000.00 when retired at the end of 15 years. If money is
worth 10% and capitalized cost is 1.2 M. What is the original cost of the machine?

INTERNAL RATE OF RETURN When using the internal rate of return method to rank competing investment projects, the
preference rule is:
 The internal rate of return (IRR) method is the most widely used rate of return method for
“The higher the internal rate of return, the more desirable the project.”
performing engineering economic analysis.
 It is also called the investor’s method, the discounted cash flow method, and the profitability index.
 If the IRR for a project is greater than the MARR, then the project is acceptable. (IRR > MARR)
 The internal rate of return is the rate of return promised by an investment project over its useful life.
RANKING INVESTMENT PROJECTS
 It is computed by finding the discount rate that will cause the net present value of a project to be
zero.
 It works very well if a project’s cash flows are identical every year. If the annual cash flows are not
identical, a trial and error process must be used to find the internal rate of return.
 Solving for the IRR is a bit more complicated than PW, FW, or AW
 The method of solving for the i'% that equates revenues and expenses normally involves trial-
and-error calculations, or solving numerically using mathematical software.
 The use of spreadsheet software can greatly assist in solving for the IRR. Excel uses the
IRR(range, guess) or RATE(nper, pmt, pv) functions.
Challenges in applying the IRR method.

 It is computationally difficult without proper tools.
 In rare instances multiple rates of return can be found.
 The IRR method must be carefully applied and interpreted when comparing two more mutually
exclusive alternatives (e.g., do not directly compare internal rates of return).
How the IRR works SAMPLE PROBLEM:

 The IRR is the interest rate that equates the equivalent worth of an alternative’s cash inflows 1. Suppose you have the following cash flow stream. You invest $700, and then receive $100, $175,
(revenue, R) to the equivalent worth of cash outflows (expenses, E). $250, and $325 at the end of years 1, 2, 3 and 4 respectively. What is the IRR for your investment?
 The IRR is sometimes referred to as the breakeven interest rate.
The IRR is the interest i'% at which
Calculating Internal Rate of Return

Ways to find the IRR:
1. Compound Interest Tables (you may need to use interpolation)
2. Trial-and-error
3. Numerically (Excel’s IRR function, MATLAB, or other root finding methods)
4. Graphically

2. Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per REINVESTING REVENUE — THE EXTERNAL RATE OF RETURN
year in cash operating costs. The machine has a 10-year life.
(ERR)
 The IRR assumes revenues generated are reinvested at the IRR—which may not be an accurate
situation.
 The ERR takes into account the interest rate, ε, external to a project at which net cash flows
generated (or required) by a project over its life can be reinvested (or borrowed). This is usually
the MARR.
 If the ERR happens to equal the project’s IRR, then using the ERR and IRR produce identical
results.
The ERR procedure:

 Discount all the net cash outflows to time 0 at ε% per compounding period.
 Compound all the net cash inflows to period N at at ε%.
 Solve for the ERR, the interest rate that establishes equivalence between the two quantities.
ERR is the i'% at which
Where:
Rk = excess of receipts over expenses in period k,
Ek = excess of expenses over receipts in period k,
N = project life or number of periods, and
ε = external reinvestment rate per period.
General decision rule . . .
SAMPLE PROBLEM:
For the cash flows given below, find the ERR when the external reinvestment rate is ε = 12% (equal to
the MARR).
Year 0 1 2 3 4
When using the internal rate of return, the cost of capital acts as a hurdle rate that a project Cash Flow -$15,000 -$7,000 $10,000 $10,000 $10,000
must clear for acceptance.

OTHER APPROACHES TO CAPITAL BUDGETING DECISIONS  It doesn’t indicate anything about project desirability except the speed with which the initial
investment is recovered.
 Recommendation: use the payback period only as supplemental information in conjunction
Other methods of making capital budgeting decisions include:
with one or more of the other methods in this chapter.
1. SIMPLE RATE OF RETURN.
2. THE PAYBACK METHOD.

FINDING THE SIMPLE AND DISCOUNTED PAYBACK PERIOD FOR A SET OF CASH FLOWS.
 The payback period is the length of time that it takes for a project to recover its initial cost out
End of Net Cash Flow Cumulative PW at 0% Cumulative PW at 6%
of the cash receipts that it generates.
Year
 When the annual net cash inflow is the same each year, this formula can be used to compute
the payback period: 0 -$42,000 -$42,000 -$42,000
1 $12,000 -$30,000 -$30,679
2 $11,000 -$19,000 -$20,889
3 $10,000 -$9,000 -$12,493
4 $10,000 $1,000 -$4,572
 The method is simple, but possibly misleading. 5 $9,000 $2,153
 The simple payback period is the number of years required for cash inflows to just equal cash
outflows.
 It is a measure of liquidity rather than a measure of profitability.  The cumulative cash flows in the table were calculated using the formulas for simple and
discounted payback.
Measures of Liquidity  From the calculations θ = 4 years and θ' = 5 years.
 Simple Payback Period (Ø)
o how many years it takes to recover the investment (ignoring the time value of money).
 Discounted Payback Period (Ø')

o how many years it takes to recover the investment (including the time value of
money).
 Payback is simple to calculate. EVALUATION OF THE PAYBACK METHOD

 The payback period is the smallest value of θ (θ ≤ N) for which the relationship below is Short-comings of the payback period.
satisfied.  Ignores the time value of money.
 Ignores cash flows after the payback period.
Strengths of the payback period.

 Serves as screening tool.
 For discounted payback future cash flows are discounted back to the present, so the
 Identifies investments that recoup cash investments quickly.
relationship to satisfy becomes
 Identifies products that recoup initial investment quickly.
PAYBACK AND UNEVEN CASH FLOWS

 When the cash flows associated with an investment project change from year to year, the
Problems with the payback period method. payback formula introduced earlier cannot be used.
 It doesn’t reflect any cash flows occurring after θ, or θ'.  Instead, the un-recovered investment must be tracked year by year.

O&M = operating and maintenance costs of the proposed project.
B/C with salvage value
 For example, if a project requires an initial investment of $4,000 and provides uneven net cash
inflows in years 1-5 as shown, the investment would be fully recovered in year 4.
S = Salvage value (market value)

SAMPLE PROBLEM:
Management at The Daily Grind wants to install an espresso bar in its restaurant that
1. Costs $140,000 and has a 10-year life. EVALUATING PROJECT WITH B / C RATIO METHOD
2. Will generate annual net cash inflows of $35,000. Once we compute the B/C ratio for above formulation using the MARR as the interest rate.
Management requires a payback period of 5 years or less on all investments.  If B/C ≥1.0, then the project is profitable (acceptable)
What is the payback period for the espresso bar?  If B/C < 1.0, then the project is not profitable (rejected).
B / C RATIO EXAMPLE
BENEFIT / COST RATIO Apply the B/C ratio method with a study period of 20 years for MARR of 10% to determine whether the
project will be implemented or not without considering the salvage value.
 The benefit/cost ratio method involves the calculation of a ratio of benefits to costs.
 The B/C ratio is defined as the ratio of the equivalent worth of benefits to the equivalent worth of PW (cost) @ 10%
costs. = 1,200,000 + 197,500(P/A, 10%, 20)
 Generally, PW or AW is used as equivalent worth measure in B/C ratio. = $2,881,436
PW (benefit) @ 10%
B/C using PW method: = 490,000(P/A, 10%, 20)
= $4,171,664
B/C
= (4,171,664 / 2,881,436)
PW(x) = present worth of x = 1.45 > 1.0 the project is profitable
B = benefits of the proposed project
I = initial investment in the proposed project

CHAPTER 3 DECISION ANALYSIS

Course of Action (Ai)
Event (Ei) Sell Soft Drinks (A1) Sell Hot Dogs (A2)
MANAGEMENT AND DECISION MAKING
 The essence of management is decision making Cool Weather (E1) P 50 P 100
 Decision making is the process of selecting an alternative among two or more possible alternatives
 The right selection depends on the successful expectation of the outcomes of each alternative and Warm Weather (E2) P 200 P 125
matching these outcomes with the desired goal
 Decision Tree
Steps in Decision Making
1. Clearly define the problem
2. List all possible alternatives
3. Identify all possible outcomes for each alternative
4. Identify the payoff for each alternative & outcome combination
5. Use a decision modeling technique to choose an alternative
EXAMPLE:
1. Consider a food vendor determining what he could sell.
2. He is thinking whether to sell soft drinks or hot dogs.
3. He knew that soft drinks would be of more profit during warm weather, and hot dogs during cold
weather.
METHODS OF LISTING
 List Possible Actions or Events
 Payoff Table
Course of Action (Ai)
Event (Ei) Sell Soft Drinks (A1) Sell Hot Dogs (A2)
Cool Weather (E1) P 50 P 100
Warm Weather (E2) P 200 P 125

DECISION ANALYSIS  Expected Monetary Value (EMV) uses the probabilities to calculate the average payoff for
The Decision Process in Operations each alternative
1. Clearly define the problems and the factors that influence it
2. Develop specific and measurable objectives
3. Develop a model
4. Evaluate each alternative solution DECISION MAKING ALTERNATIVES
5. Select the best alternative
6. Implement the decision and set a timetable for completion  DECISION UNDER UNCERTAINTY
Maximax rule Minimax regret rule
Fundamentals of Decision Making  Determine worst potential regret associated with

1. Terms:  Identify best outcome for each each decision, where potential regret with any
a. Alternative—a course of action or strategy that may be chosen by the decision maker possible decision & choose decision decision & state of nature is the improvement in
b. State of nature—an occurrence or a situation over which the decision maker has little or with maximum payoff. payoff the manager could have received had the
no control  Pick the outcome with the maximum decision been the best one when the state of
number or the highest possible gain nature actually occurred. Manager chooses
2. Symbols used in a decision tree: decision with minimum worst potential regret.
a. —decision node from which one of several alternatives may be selected
b. —a state-of-nature node out of which one state of nature will occur Maximin rule Equal probability rule
 Identify worst outcome for each

decision & choose decision with  Assume each state of nature is equally likely to
TYPES OF DECISION MODELING ENVIRONMENTS maximum worst payoff. occur & compute average payoff for each.
The decision making process takes place under one of three conditions:  Pick the outcome with the minimum  Choose decision with highest average payoff.
 Under certainty number or the least possible loss
 Under risk
 Under uncertainty
State of Nature
Favorable Unfavorable
DECISION MAKING UNDER CERTAINTY Alternatives
Market Market
 The consequence of every alternative is known
 Usually there is only one outcome for each alternative Construct large plant P 200,000 - P 180,000
 This seldom occurs in reality
Construct small plant P 100,000 - P 20,000
DECISION MAKING UNDER UNCERTAINTY
Do nothing P 0 P 0
 Probabilities of the possible outcomes are not known
 Decision making methods:
1. Maximax
2. Maximin
3. Criterion of realism
4. Equally likely
5. Minimax regret
DECISION MAKING UNDER RISK

 Where probabilities of outcomes are available

 DECISION UNDER RISK  DECISION UNDER CERTAINTY
 Each possible state of nature has an assumed probability  Perfect Information would tell us with certainty which outcome is going to occur
 States of nature are mutually exclusive  Having perfect information before making a decision would allow choosing the best payoff for
 Probabilities must sum to 1 the outcome
 Determine the expected monetary value (EMV) for each alternative
 Is the cost of perfect information worth it?
Where probabilities of outcomes are available  Determine the expected value of perfect information (EVPI)
 Expected Monetary Value (EMV) uses the probabilities to calculate the average payoff for
each alternative
Expected Value of Perfect Information (EVPI)
EMV (for alternative i) = ∑(probability of outcome) x (payoff of outcome)  The amount by which perfect information would increase our expected payoff
 Provides an upper bound on what to pay for additional information
Example:  EVPI is the difference between the payoff under certainty and the payoff under risk
1. Decision: Whether or not to make and sell storage sheds
2. Alternatives: EVPI = EVwPI – EMV
• Build a large plant
• Build a small plant Where:
• Do nothing EVwPI = Expected value with perfect information
3. Outcomes: Demand for sheds will be high, moderate, or low EMV = the best EMV without perfect information
4. Payoffs
5. Apply a decision modeling method
Expected Value With Perfect Information (EVwPI)
 The expected payoff of having perfect information before making a decision
Outcomes (Demand)
Alternatives EVwPI = ∑ (probability of outcome) x ( best payoff of outcome)
High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0

DECISION TREE
 Information in decision tables can be displayed as decision trees
 A decision tree is a graphic display of the decision process that indicates decision alternatives,
states of nature and their respective probabilities, and payoffs for each combination of decision
alternative and state of nature
 Appropriate for showing sequential decisions
Steps in using decision tree

1. Define the problem
2. Structure or draw the decision tree
3. Assign probabilities to the states of nature
4. Estimate payoffs for each possible combination of decision alternatives and states of nature
5. Solve the problem by working backward through the tree computing the EMV for each state-of-
nature node
DECISION TREE IN ETHICAL DECISION MAKING
 Maximize shareholder value and behave ethically

 Technique can be applied to any action a company contemplates

CHAPTER 4 DECISIONS UNCER CERTAINTY  For independent projects one, two or more, in fact, all of the projects that are economically justified
can be accepted, provided capital funds are available.
FORMULATING ALTERNATIVES ANALYSIS OF ALTERNATIVES

 A future amount of money converted to its equivalent value now has a present worth (PW) value. 1. Present Worth
 This present value is always less than that of the actual future cash flow, for any interest rate  Equal Life
greater than zero, all P/F factors have a value less than 1.0.  Different Life
 For this reason, present worth values are often referred to as discounted cash flows (DCF).  LCM
 Similarly, the interest rate may be referred to as the discount rate. Besides PW, equivalent terms  Study Period
frequently used are present value (PV) and net present value (NPV). 2. Future Worth
 Different Life
 Present worth computations have been made for one project or alternative. 3. Capitalized Cost
 Alternatives are developed from project proposals to accomplish a stated purpose.
 Some projects are economically and technologically viable, and others are not.
 Once the viable projects are defined, it is possible to formulate the alternatives. 1.a. PRESENT WORTH ANALYSIS OF EQUAL-LIFE ALTERNATIVES
One alternative:
 Calculate the PW using the MARR.
TYPES OF ECONOMIC ALTERNATIVES  If PW > or = 0, the MARR is met or exceeded and the alternative is financially viable.
1. Mutually Exclusive Alternatives:
 Only one of the viable projects can be selected. Two or more alternatives:
 Each viable proposal is called an alternative  Calculate the PW of each alternative using the MARR.
 The viable projects compete against one another.  Select the alternative with the PW value that is numerically largest, that is, less negative and
more positive, indicating a lower PW of cost cash flows or larger PW of net cash flows of
2. Independent Alternatives: receipts minus disbursements.
 More than one viable project may be selected.
 Each viable proposal is called a project. For one of more independent projects, select all projects with PW > or = 0 using the MARR value.
 There may be dependent projects requiring a particular project to be selected before another. This compares each project with the do-nothing alternative.
 Contingent projects where one project may be substituted for another. The projects must have positive and negative cash flows to obtain a PW value that exceeds zero.
They must be revenue projects.
3. Do Nothing Alternative:
 Alternative or project means that the current approach is maintained; nothing new is  Convert all cash flows to PW using MARR
initiated. No new costs, revenues, or savings are generated.  Precede costs by minus sign; receipts by plus sign
 If it is absolutely required that one or more of the defined alternatives be selected, do nothing
is not considered. This may occur when a mandated function must be installed for safety, EVALUATION
legal, government, or other purposes.  For one project, if PW > 0, it is justified
 For mutually exclusive alternatives, select one with numerically largest PW
 For independent projects, select all with PW > 0
SAMPLE SCENARIO
 Mutually exclusive alternatives and independent projects are selected in completely different ways.
 A mutually exclusive selection takes place, for example, when an engineer must select the best Selection of Alternatives by PW
diesel-powered engine from several available models. Only one is chosen, and the rest are For the alternatives shown below, which should be selected if they are (a) mutually exclusive or (b)
rejected. independent?
 If none of the alternatives are economically justified, then all can be rejected and, by default, the
DN alternative is selected.

1.b. PRESENT WORTH ANALYSIS OF DIFFERENT-LIFE ALTERNATIVES
Project ID Present Worth
 When the present worth method is used to compare mutually exclusive alternatives that have
A 30,000 different lives, the equal-service requirement must be met.
 The procedure of PW analysis of equal life alternatives is followed, with one exception:
B 12,500
The PW of the alternatives must be compared over the same number of years and must end
C -4,000
at the same time to satisfy the equal-service requirement.
D 2,000
 A fair comparison requires that PW values represent cash flows associated with equal service.
In order to compare the alternatives over the same number of years, two approaches are used:
1. LCM: Compare the PW of alternatives over a period of time equal to the least common
SAMPLE PROBLEM: multiple (LCM) of their estimated lives.
PW Evaluation of Equal-Life ME Alts 2. Study Period: Compare the alternatives using a study period of length n years, which does
1. Alternative X has a first cost of $20,000, an operating cost of $9,000 per year, and a $5,000 not necessarily take into consideration the useful lives of the alternatives. This is also called
salvage value after 5 years. Alternative Y will cost $35,000 with an operating cost of $4,000 per the planning horizon approach.
year and a salvage value of $7,000 after 5 years. At an MARR of 12% per year, which should be
selected? The assumptions when using the LCM approach are that
X Y 1. The service provided by the alternatives will be needed for the LCM of years or more.
FIRST COST 20,000 35,000 2. The selected alternative will be repeated over each life cycle of the LCM in exactly the same
manner.
OPERATING COST 9,000/YR 4,000/YR
3. The cash flow estimates will be the same in every life cycle.
SALVAGE VALUE 5,000 7,000
YEARS 5 5  (Valid only when the cash flows are expected to change by exactly the inflation (or deflation)
MARR 12% 12% rate that is applicable through the LCM time period)
 If these assumptions cannot be applied to your particular analysis, then you should compare
the alternatives using a planning horizon approach.
SAMPLE PROBLEM:
National Homebuilders, Inc., plans to purchase new cut-and-finish equipment. Two manufacturers
offered the estimates below:
a) Determine which vendor should be selected on the basis of a present worth comparison, if the
MARR is 15% per year.
b) National Homebuilders has a standard practice of evaluating all options over a 5-year period. If
a study period of 5 years is used and the salvage values are not expected to change, which
vendor should be selected?

2. FUTURE WORTH (FW) ANALYSIS DEPRECIATION
Used to determine when to sell an asset before the expected life is reached.
1. Used for projects that will not come online until the end of the investment period. Electric
DEPRECIATION
generation facilities, toll roads and hotels are prime examples of this types of projects.
The decrease in the value of property such as machinery, cars equipment, building or other
2. FW > or = 0 indicates that the MARR has been met or exceeded for one alternative.
structures, due to passage of time
3. For two or more mutually exclusive alternatives, select the one with the numerically largest
FW value.
AMORTIZATION
Intangible assets constitute anything of value with no physical form, including copyrights,
patents, trademarks, brands, franchises and goodwill
DEPLETION
This method of writing off lost cost applies only to natural assets. For instance, if a company
purchases land for logging, this land loses all value when the company completely deforests it.
The same holds true for natural resources like oil and gas.
TYPES OF DEPRECIATION
1. Physical Depreciation
– due to deterioration caused by various chemical and mechanical factors on the materials
composing the property such as rusting of metal parts of machine or equipment.
2. Functional Depreciation
– due to the decrease in the demand for the equipment for which it was designed such as
obsolescence of the equipment or charges of methods of production.
SALVAGE VALUE
It is the estimated value of an asset at the end of its useful life.
BOOK VALUE
The value of an asset as it appears on a balance sheet, equal to cost minus accumulated
depreciation.

METHODS OF COMPUTING DEPRECIATION 3. Five years ago, ADMI Cocoa purchased a blending machine for 515,000.00. The said machine can
be sold for 118,000.00 at the end of its life of 10 years. The company now wishes to sell the
machine and replace it with a more efficient one. The new machine will cost 670,000.00. If the
1. STRAIGHT LINE METHOD company reserves the straight line accumulated depreciation cost of old machine, how much
In this method of computing depreciation, it is assumed that the loss in value is directly additional money will be required for the purchased of the new machine?
proportional to the age of the equipment or asset.
SAMPLE PROBLEMS
1. A filling machine has an initial cost of 280,000.00 after its useful life of 10 years, its salvage value is 4. An asset costs 101,000.00. Additional initial expenses amount to 3,900.00. Scrap value is 8% of
expected to be 95,000.00. Using straight line method of depreciation, determine its book value at the first cost and book value at the end of 2 years is 89,000.00. Determine the useful life of the
the end of the 7th year. assets in years, using the straight line method.
2. Calculate the total accumulated depreciation at the end of 3 years of an equipment costing 5. A 32 ounce can filling line comprises several machines and conveyors. The total cost of the
123,000.00 and with a salvage value of 45,000.00 at the end of 15 years. Use straight line method. machine is 3.01 M and the conveyors cost 0.8 M. Installation and other initial expenses amount to
170,000.00. The filling line will operate 4800 hours per year for 20 years. Electrical energy
consumption is P45.00 per hour and maintenance cost is 45,625.00 per year, salvage value at the
end of 20 years is 500,000.00. Using straight line method, how much is the total annual operating
cost of the filling line?

2. SINKING FUND METHOD 3. A commercial building costs 800,000.00. It has a life of 17 years and a salvage value of 85,000.00.
In this method of computing depreciation, it is assumed that a sinking fund is established in After 7 years, the owners of the building decided to sell it at a price equivalent to its book value at
which funds will accumulate for replacement purposes. the end of 7 years. Using sinking fund method at 14%, how much is the building offered for sale?
4. Semiconductor manufacturing equipment was purchased for 400,000.00. Its salvage value at the
end of its economic life of 9.5 years is 32,000.00. Using sinking fund method, how much is the total
SAMPLE PROBLEMS depreciation cost at the end of 5 years if money is worth 15%?
1. Ross products acquired a new delivery van for 650,000.00. the van a useful life of 28 years and a
scrap value of 30,000.00. Calculate the depreciation cost per year using sinking fund method at
12%.
3. SUM OF THE YEARS DIGIT METHOD

2. Abbot Laboratory was erected at a cost of 9M. It is estimated to have a useful life of 25 years with a YEAR IN DEPRECIATION DEPRECIATION CHARGE DURING
YEAR BOOK VALUE
REVERSE FACTOR THE YEAR
projected salvage value of 1M. Unfortunately, after 6 years or operation, a major explosion
happened that resulted to total destruction of the laboratory. Compute the amount needed to build
1 5 5 / 15 d1 = (5 / 15) (FC - SV) BV1 = FC - d1
a new laboratory costing 9.5 M if the annual depreciation cost for 6 years was reserved. Use
sinking fund method at 11% interest rate.
2 4 4 / 15 d2 = (4 / 15) (FC - SV) BV2 = FC - d2
3 3 3 / 15 d3 = (3 / 15) (FC - SV) BV3 = FC - d3
4 2 2 / 15 d4 = (2 / 15) (FC - SV) BV4 = FC - d4
5 1 1 / 15 d5 = (1 / 15) (FC - SV) BV5 = FC - d5
TOTAL = 15

SAMPLE PROBLEMS 4. DECLINING BALANCE METHOD
1. The Minow Country Highway Safety Department purchased electrical equipment for 234,000.00. In this method of computing depreciation, it is assumed that the annual cost of depreciation is
Freight and installation charges amounted to 5% of the purchased price. The equipment is a fixed percentage of the book value at the beginning of the year. This method is sometimes
expected to have a salvage value after 6 years of 12% of the initial cost. Compute the depreciation known as constant percentage method or the Matheson Formula.
charge during the second year using sum of the years digit method.
SAMPLE PROBLEMS
1. An agricultural structure costing 172,000.00 is projected to have a life of 10 years. Compute the
total depreciation cost at the end of its life using the declining balance method at 20% annual rate
of depreciation.
2. A special material handling device purchased for 38,000.00 is projected to have a salvage value for
12,000.00 at the end of 4 years. Solve for the book value at the end of the second year using the
sum of the year digit method.
3. An office furniture costs 18,000.00. It has no salvage value at the end of its life of 7 years. Use the
2. The price of the cellular phone is expected to decline at the rate of 11% annually because of
sum of the years digits method to compute the depreciation charge during the third year and the
obsolescence. If the current selling price is 24,000.00, how much will it cost after 5 years? Use the
total accumulated depreciation cost at the end of the fourth year.
declining balance method.

3. The estimated salvage value of a 1 M worth office building is 150,000.00 at the end of 28 years. REPLACEMENT
Using the declining balance method, calculate the annual rate of depreciation.
Replacement can be defined as the decision problems involving the replacement of existing obsolete or
worn out assets
CAUSES OF REPLACEMENT:
1. Deterioration
2. Obsolescence
3. Inadequacy
4. Working conditions
TYPES OF REPLACEMENT PROBLEM

1. Replacement of assets which deteriorate with time:
• Economic life of an asset.
• Replacement of an existing asset with a new asset.
4. Determine the depreciation charge for the third year, using the declining balance method of an
2. Simple probabilistic model for assets which fail completely.(replacement due to sudden failure)
asset costing 61,000.00. resale value at the end of its economic life of 6 years is 9,000.00
REASONS FOR REPLACEMENT ANALYSIS:

Decision:
Should an old, existing asset be kept in service or replace with a new asset
Reasons:
1. Physical impairment
2. Altered requirements
3. Technology
4. Financing
What to do:
1. Keep
2. Abandon
3. Replace but keep for backup
4. Change production capacity
5. Dispose and replace
Physical Impairment
 Efficiency loss resulting from continued use – again.
 Increased routine and corrective maintenance costs.
 Greater energy requirements.
 Increased need for operator intervention.
 Unanticipated problems leading to equipment deterioration.
Altered Requirements
 Significant change in demand for related products or services.
 Significant change in the composition or design of associated products or services.

 May be considered a form of obsolescence. The Breakeven Equation:
Revenue –Costs = Profit
Technology Revenue - Variable Cost - Fixed Cost = Profit
 Impact of technological change varies with associated industry.
 Technological changes typically reduce cost per unit and improve quality of output. Breakeven Point is where Profit = 0
 Results in earlier replacement of existing assets with improved asset. Revenue - Variable Cost - Fixed Cost = 0
 May be considered a form of obsolescence. Revenue = Variable Cost + Fixed Cost
Financing Revenue = #Units Sold * Selling Price $/Unit

 Considers economic opportunity changes external to the physical operation or use of the asset. Variable Cost = #Units Sold * Variable Cost $/Unit
 May involve income tax considerations( depreciation and after- tax analysis)
 May be considered a form of obsolescence. Graphic Depiction of Breakeven
BREAKEVEN
 The Point at which
Revenues = Costs
 Revenues above the breakeven point result in profit

 Revenues below the breakeven point result in loss
 May be measured in units of output or revenue dollars
 Represents a “Reality Check”

 Is this level of revenue reasonable?
 If not, what actions would yield a reasonable breakeven point?
SAMPLE PROBLEM
Review: Cost Terminology The following costs are incurred per show at Sebastian’s Dinner Theater:
 Fixed Costs: Costs that do not change in total with the volume produced or sold  Facilities cost $500
 Variable Costs: Costs that change in direct proportion with the volume produced or sold  Staff (actors who double as servers) 1000
 Mixed Costs: A combination of fixed and variable costs  Kitchen staff 200
 Semi-variable Cost: Costs that change with volume produced, but not in direct proportion  Stage crew 300
 Food cost (per ticket) 10
Identify Assumptions Ticket Price is $30

 The following are implied in the simple breakeven equation: Task: Calculate Breakeven number of tickets.
A single product or service
Clearly segregated fixed and variable costs SOLUTION:
Variable costs are linear on a per-unit basis  Identify the key variables in the equation
 What are the fixed costs?
 If analyzing multiple products is desired:  What are the variable costs?
Use “$1 of Revenue” as the Unit -or-  What is the revenue?
Use a weighted average unit

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ENGINEERING ECONOMICS

MOST IMPORTANT CONCEPT IN ENGINEERING ECONOMY

CONCEPT OF THE TIME VALUE OF MONEY

Prepared by: Engr. Evangelyn C. Samson

PRINCIPLE 3: Use a Consistent Viewpoint

Prepared by: Engr. Evangelyn C. Samson

COSTS AND CONCEPTS FOR DECISION MAKING

A widely used cost model is:

Some examples of fixed costs:

The TOP cost concepts are:

WHICH CAR TO LEASE? SATURN VS. HONDA

Prepared by: Engr. Evangelyn C. Samson

Decision Making: Cost Concept # 6.

Decision Making: Cost Concept # 2. Decision Making: Cost Concept # 7.

Prepared by: Engr. Evangelyn C. Samson

PRESENT ECONOMY STUDIES

STUATIONS WHERE PRESENT ECONOMY STUDIES ARE INVOLVED

Prepared by: Engr. Evangelyn C. Samson

CHAPTER 1 INTEREST CASH FLOW TYPES

INTEREST AND TIME VALUE OF MONEY

In any financial transaction, there are two parties involved:

TIME VALUE OF MONEY

Prepared by: Engr. Evangelyn C. Samson

The factor (1 + rt) is called an accumulation factor at a simple interest rate r.

4. How long will it take P3000 to earn P60 interest at 6%?

 The general practice in Canada is to use exact interest

Prepared by: Engr. Evangelyn C. Samson

AUG 17 - SEPT 1 INTEREST MUST BE PAID (SEPT 1)

Prepared by: Engr. Evangelyn C. Samson

For a given interest rate r, the difference F− P has two interpretations.

The rate of the discount is The rate of the interest is the

Prepared by: Engr. Evangelyn C. Samson

Prepared by: Engr. Evangelyn C. Samson

b. Compounded semi-annually f. Compounded daily

c. Compounded quarterly g. Compounded Continuously

EFFECTIVE RATE OF INTEREST

Prepared by: Engr. Evangelyn C. Samson

Prepared by: Engr. Evangelyn C. Samson

Annuities occur in the following instances:

3. Substitution of a series of equal amount periodically in lieu of a lump sum at retirement of an

ANNUITY DUE PERPETUITY P=A+ A

Prepared by: Engr. Evangelyn C. Samson

Prepared by: Engr. Evangelyn C. Samson

Prepared by: Engr. Evangelyn C. Samson

5. A member of the cooperative loaned an amount of 80,000 payable in 12 equal quarterly

Prepared by: Engr. Evangelyn C. Samson

1. UNIFORM ARITHMETIC GRADIENT When i ≠ g

SAMPLE PROBLEMS (FOR ARITHMETIC GRADIENT)

Year Cash Flow

Prepared by: Engr. Evangelyn C. Samson

SAMPLE PROBLEM (FOR GEOMETRIC GRADIENT)

Prepared by: Engr. Evangelyn C. Samson

ELEMENTS THAT CONTRIBUTE TO DETERMINING THE MARR:

THE MOST-USED METHODS:

TYPICAL CASH OUTFLOWS AND INFLOWS

 Capital recovery reflects the capital cost of the asset.

Prepared by: Engr. Evangelyn C. Samson

Future Worth (FW) Method

Annual Worth (AW) Method

Prepared by: Engr. Evangelyn C. Samson

Prepared by: Engr. Evangelyn C. Samson

Prepared by: Engr. Evangelyn C. Samson

Challenges in applying the IRR method.

How the IRR works SAMPLE PROBLEM: