TPD 501 Engr Economy Note
TPD 501 Engr Economy Note
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THE BEGINNING OF DECISION-MAKING
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CONSTRAINTS IN THE DECISION-MAKING PROCESS
• Some constraints are fixed
– physical laws
– government regulations
– standards and specs, etc
• Economic considerations are a major constraint in the planning and execution of projects.
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FORMS OF TECHNOLOGY-BASED BUSINESS INITIATIVES
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BASIS FOR COMPARING ALTERNATIVE INVESTMENTS
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CRITERIA FOR COMPARING ALTERNATIVE
INVESTMENTS
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• The majority of engineering economic studies
involves commitment of capital for extended
periods of time.
REVENUE F = Future
1 2 3 4 5
Expenditure Years
P = Present
NOTATIONS USED IN CASH FLOW DIAGRAMS
• i = Effective interest rate per interest period
• N = number of compounding periods.
• P = present sum of money; the equivalent worth of one
or more cash flows at a reference point in time called the
present
• F = future sum of money; the equivalent worth of one or
more cash flows at a reference point in time called the future
• A = end-of-period cash flows (or equivalent end-of- period
values) in a uniform series continuing for a specified number of
periods, starting at the end of the first period
CASH FLOW DIAGRAMS
• Consider an investment of N10,000
– Will produce uniform annual revenue of N5,310 for five years
– Have a positive salvage value of n2,000 at the end of year 5
– Annual operating & maintenance expenses at the end of each year is
N3,000 project
N2,000
1 2 3 4 5
N3,000 N3,000 N3,000 N3,000 N3,000
N10,000 Years
• The situation shown in for cash flow as seen by a lender/investor
N2,000
1 2 3 4 5
N3,000 N3,000 N3,000 N3,000 N3,000
N10,000 Years
SUMMARY
End of Year Net Cash Flow () Cumulative Cash Flow ()
0 -10,000 -10,000
1 2,310 -7,690
2 2,310 -5,380
3 2,310 -3,070
4 2,310 -760
5 4,310 +3,550
• Interest formulas for discrete To Given Factor Functional Symbol by which to Factor Name
compounding and discrete cash Find Multiply ‘Given’
flows For Single Cash Flow
– Summary of the six discrete
compound interest factors F P (F/P, i%, N) Single payment compound amount
• The formulas assume
P F (P/F, i%, N) Single payment present worth
discrete (i.e. Lump-
sum) cash flows paid or
received at the end of For Uniform Series (Annuities)
equal time intervals on
a cash flow diagram.
F A (F/A, i%, N) Uniform series compound amount
• Discrete compound
interest i is assumed to
remain constant during P A (P/A, i%, N) Uniform series present worth
the n compounding
periods.
A F (A/F, i%, N) Sinking fund
• Solution
• F = P(F/P, I%, N)
• The factor to use (F/P, 10%, 4) = 1.4641
• Hence, F = 8,000 x 1.4641 = N 11,712.80
• FINDING P WHEN GIVEN F
• TO FIND THE PRESENT VALUE OF FUTURE PAYMENTS
– USE SINGLE PAYMENT PRESENT WORTH
– USE THE FUNCTIONAL SYMBOL (P/F, i%, N) FOR THE FACTOR. HENCE P = F(P/F,
i%, N)
• Suppose an investor has an option to purchase a tract of land that will be worth n10,000 in
six years. If the value of the land increases at 8% each year, how much would the investor be
willing to pay now for this property?
•
• Solution
• P = F(P/F, i%, N)
• (P/F, 8%, 6) = 0.6302
• P = 10,000(P/F,8%,6)
• = 10,000(0.6302)
• P = N 6,302
• DEFERRED ANNUITIES (UNIFORM SERIES)
• All annuities (uniform series) discussed so far involved the first cash
flow being made at the end of the first period, and they are called
ordinary annuities
• If the cash flow does not begin until some later date, the annuity is
known as a deferred annuity
•
• If the annuity is deferred j periods (j < n), the entire ordinary
annuity has been moved forward from "time present," or "time 0,"
by j periods.
Years
1 2 17 18 19 20 21
i = 12%
P0 = ??? P17 = F17
• Solution
• In this problem, N = 21, and since the first A occurs at J+1, hence J
= 17.
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PROJECT SELECTION BASED ON THE EQUIVALENT
WORTH METHODS
• The equivalent worth methods convert all relevant cash flows into
their similar worth at the minimum attractive rate of returns
(MARR).
• The name of each method follows the time period being considered:
– present worth method,
– annual worth method and
– future worth
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THE DECISION CRITERIA (I)
• For two or more mutually exclusive alternatives with receipts AND expenditures
– the feasible alternative that has the highest net equivalent worth should be selected
as long as this is greater than or equal to zero.
OR
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THE DECISION CRITERIA (II)
• If
– only costs are known or are being considered, and
– the project revenues are the same for all the alternatives,
• Then
– the alternative which has the least negative equivalent
worth of costs should be selected.
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• Note: Although the same criteria largely apply for
all decision situations, our focus here is on
alternatives that have identical life-spans
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Problem 1
• Three mutually exclusive investment alternatives exist for
implementing an office automation plan in an engineering design firm.
A B C
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STEPS
• STEP 1: Cash Flow Diagrams for Alternatives
A, B and C
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ALTERNATIVE A
A A A A= N69,000
S = N60,000
0 1 2 9 10
N 390,000
ALTERNATIVE B
A A A A= N167,000
S = N75,000
0 1 2 9 10
N 920,000
ALTERNATIVE C
A A A A= N133,500
S = N87,000
0 1 2 9 10
N 660,000
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• Using the Present Worth Method (PW) for the three alternatives, where PWA,
PWB, PWC, represent Present Worth of A, B and C respectively, we obtain:
PWA = - 390,000 + 69,000 (P/A, 10%, 10) + 60,000 (P/F, 10%, 10)
= 57,107.00
PWB = - 920,000 + 167,000 (P/A, 10%, 10) + 75,000 (P/F, 10%, 10)
= 135,060.00
PWC = - 660,000 + 133,500 (P/A, 10%, 10) + 87,000 (P/F, 10%, 10)
= 193,842.00
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• Using the Future Worth Method (FW) for the three alternatives, where
FWA, FWB, FWC, represent Future Worth of A, B and C respectively, we
obtain:
FWA = [PWA (10%)] (F/P, 10%, 10) = [57,107:00] (F/P, 10%, 10)
= 148,118.00
FWB = [PWB (10%)] (F/P, 10%, 10) = [135,060] (F/P, 10%, 10)
= 350,305.00
FWC = [PWC (10%)] (F/P, 10%, 10) = [193,842] (F/P, 10%, 10)
= 502,768.00
• Here, we have the calculated the future worth from the present worth
previously obtained
• Again, alternative C will be chosen, as it is the one with the highest
equivalent worth.
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• Using the Annual Worth Method (AW) for the three alternatives, where AWA,
AWB, AWC, represent Annual Worth of A, B and C respectively, we obtain:
AWA = [PWA (10%)] (A/P, 10%, 10) = [57,107] (A/P, 10%, 10)
= 9,291.00
AWB = [PWB (10%)] (A/P, 10%, 10) = [135,060] (A/P, 10%, 10)
= 21,974.0
AWC = [PWC (10%)] (A/P, 10%, 10) = [193,842] (A/P, 10%, 10)
= 31,538.00
• Annual worth is also a multiple of present worth as shown, and again, the
choice is C.
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THANK YOU
FOR YOUR
ATTENTION!