Engineering Economics

CE 332

Page 1

Decision Making
We make decisions for many reasons,
but usually one of the biggest factors
is:

How do we decide the best option?

CE 332

Page 2

Considerations
When to buy or sell? Repair or rebuild?
Market conditions (interest rates-loans)
Rate of return on investment (ROI) (interest rate-savings)
Source of financing
Pay-back period
Product risks
Project risks
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Time Value of Money

Time value of money refers to the
change in the value of money over
time and is influenced by the
following three factors:

Interest rate
Time
Investment or Loan Amount

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Cash Terminology
P0 (PW) = value of the money at the present
(Present Worth)
Pt= value of the money at end of time t
n = number of interest periods
i = interest rate per period
F = future value of a present sum of money
A = Annuity, a series of consecutive, equal,
end-of-period amounts of money
G = gradient, uniform increase each year
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Interest Rate
Interest Rate can be defined in two
typical ways*:
1. money paid for the use of borrowed money..
2. the return obtainable by the productive
investment of capital..

Definition 2 is primarily used in Engineering

Economics and is another way of saying
return on investment (ROI).
* Principles of Engineering Economy, 5 th Ed., Grant and Ireson

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Cash Flow Diagrams

Graphical depiction of cash into
and out of an account
F= future income

F=salvage

Income
Monthly
?

+
0

A1=annual income
1

A2=annual cost of operation

End of
year
accrual

F= future cost

P = P0= initial purchase

Expense
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Time Value of Money

(example)
Suppose you deposit $1,000,000 in the
bank at an annual interest rate, i, of 8%
$1,080,000

$1,166,400

F1 = P0(1+i)
P0 = $1,000,000

$1,360,500

F3 = F2(1+i)

F2 = F1(1+i)

F4 = F3(1+i)

F4 = F3(1+i)= F2(1+i)(1+i)=F1(1+i)(1+i)(1+i)=P0(1+i)(1+i)(1+i)(1+i)=P0(1+i)4
In general,

Fn = P0(1+i)n
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Compound Interest
Compound interest includes interest on
the interest earned in pervious periods
The nominal interest rate per year is the
period interest rate times the number of
periods per year
The annual interest rate when
considering the time value of money for
rates quoted for a period (say one month)
is called the effective interest rate.
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Compound Interest (cont.)

Visa Card statement lists interest
as 2% per month
Nominal Interest Rate =
2%/mo x 12 mo = 24%
Effective Interest Rate =
ieff = (1+i)n -1 = (1.02)12 1 =
0.268 = 26.8%
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Compound Interest (cont.)

i = (1 + rt)t - 1
where
i = effective interest rate per period (year)
r = nominal interest rate per period (year)
t = number of compounding periods (per year)

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Effective Interest Rate

Example
A bank quotes the interest on a credit
card balance as 1.5% per month or a
nominal annual interest of 18%.
What is the effective interest?
i = (1 + 0.18 )12 - 1 = (1+.015)12 1 = 0.196
12

Thus, the effective annual interest

rate is 19.6%
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Equivalence
Different sums of money at different times can
be equal in economic value
For example, at i = 8%, $1,000,000 today is
equivalent to $1,360,500 at the end of 4 years
$1,080,000

$1,166,400

P1 = P0(1+i)
P0 = $1,000,000

$1,360,500

P3 = P2(1+i)

P2 = P1(1+i)
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P4 = P3(1+i)
Page 13

New School vs Old

School
New School:

F = P (1+i)n = $1,000,000(1.08)4
= $1,360,500

Old School:

F = P(F/P, i, n) = $1,000,000(F/P,8%,4)
= $1,000,000(1.360) = $1,360,000

See ANGEL for interest rate tables

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Interest Factors

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Future Value of Money

F = P (1+i)n = P (F/P,i%,n)
Example: if you have $1000 today,
what is it worth at the end of 7 years
at 10% annual effective interest?
F = 1000(1+.10)7 = $1000 (F/P,10%,7)
= $1000 (1.949) = $1949
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Present Value of Future

Money
P = F (1+i)-n = F (P/F,i%,n)
NOTE: thats minus
n
need
$1950 at the

Example: if you
end
of 7 years, how much will you need to
invest today at 10% annual effective
interest?
P = 1950(1+.10)-7 = 1950 (P/F,10%,7)
= 1950(0.5132) = $1000.74
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Annuity
(P/A,i%,n)= [(1+i)n]-1
i(1+i)n
Annuity A = P(A/P,i%,n) = P [i(1+i)n ]
[ (1+i)n]-1]
Present Value of an Annuity (fixed
payments:
{[(1+i)n]-1}
i(1+i)n
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P=A

Page 18

Equivalence Example
Consider four loan repayment plans for P
= $5,000, i = 0.15 per year, and n = 5
years

plan 1 - defer all payments until the end

plan 2 - pay interest each year and principal
at the end
plan 3 - pay interest plus $1,000 each year
plan 4 - make equal payments each year

Which is the best option?

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Equivalence (cont.)
Even though each payment plan is
different and the amount paid is
different, each is equivalent to
$5,000 at i = 0.15 and n = 5
Total Amount Repaid
Plan 1
Plan 2
Plan 3
Plan 4

$10,057
8,750
7,250
7,458
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Page 20

Amortization Table
n

Interest
Payment

Principal
Payment

Total
Payment

$750.00

$741.58

$1491.58

$638.76

$852.81

$1491.58

$510.84

$980.74

$1491.58

$363.73

$1127.85

$1491.58

$194.55

$1297.02

$1491.58

Total

$2457.89

$5000.00

$7457.89

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Assignment 3
Recreate the previous amortization
table using Microsoft Excel. Use
Excel for calculating the yearly
payment, interest, principal and
total payments.

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Assignment 3A
Recreate the previous amortization
table using Microsoft Excel. Use Excel
for calculating the monthly payment,
interest, principal and total payments.
Answers: A = $118.95; i (total) =
$2,136.98; Principal Total = $5,000; Total
Paid = $7,136.98
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Amortization Schedule
See example mortgage
spreadsheet

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Equivalence: Varying Interest

Rate and Time
Amount Invested =
Annual Interest Rate
Compounding
Period

$1,000,000

(one time)

8% = 0.08
No. Periods

Value at End of 4 Years

year

$1,360,488.96

month

48

$1,375,666.10

week

208

$1,376,789.17

day

1460

$1,377,079.48

hour

35040

$1,377,125.75

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Equivalence: Varying Interest

Rate and Time
Amount Invested (one time) =

$1,000,000

Annual Interest Rate =

Varies

Compounding Period =

Monthly

Rate

Value at End of
4 Years

5%

$1,220,895.36

8%

$1,375,666.10

10%

$1,489,354.10

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Equivalence: Varying Interest

Rate and Time
Amount Invested
(per month) =

$ 24,413.00

Annual Interest Rate =

8% = 0.08

Compounding Period =

Monthly

Value at 4 years

$1,375,670.48

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Assignment 4
Recreate the previous three slides
using Excel. Put them all on one
spreadsheet. Upload to the
specified Drop Box.

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Page 28

Assignment 5 - Credit Card

Debt
Assume you have $5,000 in credit card debt
Annual interest rate = 12%
How much will your monthly payment be if
you payback over 12, 24, 36 and 48 months?
What is the total amount repaid?
How much total interest is paid?
If you pay back only $100 per month, how
long will it take you to repay your debt?

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Assignment 5 Answers
12 months: A = $444.24; Total
$5,330.88; Total i = $330.88
24 months: A = $235.37; Total
$5,648.88; Total i = $648.88
36 months: A = $166.07; Total
$5,978.52; Total i = $978.52
48 months: A = $131.67; Total
$6,320.16; Total i = $1,320.16
Number of months = 69.7 +/-

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Payment =
Payment =
Payment =
Payment =

Page 30

Example
How much can you take a loan for in
2 years if you only want to repay
$400 each year for 5 years starting
3 years from now? i=10%
P2 = ?
0

F3=$400

F5=$400
F7=$400
F4=$400
F6=$400
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Example (contd)
P0 = ?
0

0
2

1
3

2
4

3
5

4
6

5
7

Shift time axis, so that P2 is now P0

Calculate the PV of each $400 payment.
$400 five years from now is $248.37
today
P=
= F(1+i)-n
P=F(P/F,10%,5)=400(1+.1)5
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=$248.37

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Example (contd)
To solve the entire problem move all FV to PV:
P= (P/F,10%,5)+ (P/F,10%,4)+ (P/F,10%,3)+
(P/F,10%,2)+ (P/F,10%,1)
P=$400[(1+.1)-5+ (1+.1)-4+(1+.1)-3+ (1+.1)-2
+(1+.1)-1]
=$1516.31
So you can take a $1516 loan.
This method derives the Annuity Equation!
P= A(P/A,I%,n)= A[(1+i)n-1]= 400[(1.15-1)] =
Watch this!
$1516.31
332
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5
i(1+i)nCE.1(1.1)

Example (contd)
How much could you take a loan
out for now, if you want to start
paying back $400 per year at the
end of
3?
P0 =year
?
0

F3=$400

F5=$400
F7=$400
F4=$400
F6=$400

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Example (contd)
We cant apply the annuity equation,
since we derived it as if the PV is only
one year before the first payment (at
t=2) and we want it at t=0 (3 years
before the first payment).
So we have to add another step.
First we find the PV at t=2
From previous calcs PV=$1516.31
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Example (contd)
Then we have to move the $1516.31 to t=0
The $1516.31 now becomes a future value
and we solve for P0.
P0= F(1+i)-n= $1516.31(1.1)-2= $1253.15
If you want the money now but dont want to
start paying back until the end of year 3, then
you get less money now.
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Useful Economic Formulas

(F/P,i%,n) = (1+i)n Future value of present money
F = P(1+i)n
(P/F,i%,n)= (1+i)-n Present value of future money
P = F(1+i)-n
(P/A,i%,n)= [(1+i)n]-1 Present value of fixed payments
i(1+i)n
P = A {[(1+i)n]-1}
i(1+i)n
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Page 37

Projects of Finite Life

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Page 38

Example
Your client wants to build a commercial
building and will have $1,000,000 in the bank
by the end of 2006. Assume that
construction will be completed by the end of
2009, when all money will be due the
contractor.
If the money is collecting 6.5% annual
interest until then, what should the final
budget cost of the building be?
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Future Value of Money

F = P (1+i)n = P (F/P,i%,n)

F= 1,000,000(1+.065)3=
(1,000,000,6.5%,3) =

$1,207,950

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Page 40

Background
Engineering economics is often used as a basis
for decision making.
Decisions can be to determine project
feasibility, determine long term project costs, or
to determine which alternative to choose.
Alternatives having the same economic life are
evaluated on the basis of their present worth.
Economic life is defined as the time in which
you want to recover your investment. It does
not have to be the actual life of the alternative.
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Page 41

Example 1
Suppose a developer wishes to construct
a building as office rental property.

The building will cost $5 million.

Rental income is forecast at $0.75 million
annually.
Maintenance cost will average $0.15 million
annually.
The developer plans to sell the building in 5
years. How much will the selling price need
to be for a $2 million profit if i = 8%? The
construction time frame is 1 year.

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Example 1 (contd)
Notice that the economic life is five
years even though the building will
last longer. The economic life is
often how long you want to take to
recover your investment.

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Example 1 (cont.)
Step 1: draw the cash flow diagram
$0.75 m
0

$5 m

F=?
5

$0.15 m

Step 2: time shift & find the PV of the income and expenses
$0.75 m
$5 m 10

2
1

3
2

4
3

5
4

$0.15 m

P0 = ?
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Example 1 (cont.)
P0 = -5.0 + (0.75 - 0.15) (P/A,8,4)=-5 + (0.60((1+.08)4-1 ))
0.08(1+0.08)4

P0 = -5.0 + 0.60 (3.3121) = -$3.013 m

Step 3: change time scale back
0
and transfer P1 to P0
P0 = P1 (P/F,8,1)= -3.013(1+0.08)-1 P0

3.013

P0 = -3.013 (0.9259) = -$2.789 m (loss)

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Example 1 (cont.)
Step 4: calculate selling price (include $2m profit!)

F0
$2m

2.789
Selling price = F0 + $2m
F = P0 (F/P,8,5) + 2.0 = 2.789(1+.08)5 + 2.0
F = 2.789 (1.4693) + 2.0
F = $6.099 m
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Page 46

Example 2
Suppose the same developer has an
option on property elsewhere that is for
sale for $3.5 million. A building could be
constructed on that site for $6.7 million.
The income would be $1.45 m/year and
maintenance of $0.20 m/year beginning
at the end of year 2. At the end of year
5, the sale price will be $8.5 million.
Which alternative is better?
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Page 47

Example 2 (cont.)

Profit
+F=?
$8.5 m

Step 1: draw cash flow diagram

$1.45 m
$3.5 m

$6.7 m

Sale price
5

$0.20 m

Step 2: find P1 (let F, Profit and $8.5m wait for

$1.45 m
later)
Step 1

$6.7 m

$0.20 m

P1 = ?
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Page 48

Example 2 (cont.)
P1 = -6.7 + 1.25 (P/A,8,4) = -6.7 + 1.25 (1+.08)4-1
.08(1+.08)4

P1 = -6.7 + 1.25 (3.3121)

P1 = -$2.560 m

Profit
+ F
$8.5 m

Step 3: find P0 (include $8.5m)

$3.5 m
P0 = ?

$2.560 m
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Page 49

Example 2 (cont.)
P0 = -3.5 + P1 (P/F,8,1)
P0 = -3.5 + (-2.560 (0.9259))
P0 = -$5.870 m
Step 4: find F and Profit
F = P0 (F/P,8,5)
F = -$5.870 (1.4693)
F = -$8.62 m
Profit = $8.5m - $8.62
Profit = -$0.12
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Page 50

Example Summary
If we compare the two examples as potential
alternatives for investment, we find that the first
alternative is the best economic alternative
because:

Alternative 1 Alternative 2
There is $2 m
profit at the
end of year 5

This is a
breakeven
proposition

The second alternative is at best a breakeven

proposition
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