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TPD 501 Engr Economy Note

This document provides an introduction to engineering economics. It defines engineering economics as using economic analysis techniques to systematically evaluate the costs and benefits of proposed technical or business ventures. Alternatives must be compared to determine the best option. Cash flow diagrams are used to illustrate the timing and amounts of cash inflows and outflows over the life of a project. The goal is to evaluate which alternative provides the highest return on the capital invested or maximizes recovery of costs and profits.

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0% found this document useful (0 votes)
69 views44 pages

TPD 501 Engr Economy Note

This document provides an introduction to engineering economics. It defines engineering economics as using economic analysis techniques to systematically evaluate the costs and benefits of proposed technical or business ventures. Alternatives must be compared to determine the best option. Cash flow diagrams are used to illustrate the timing and amounts of cash inflows and outflows over the life of a project. The goal is to evaluate which alternative provides the highest return on the capital invested or maximizes recovery of costs and profits.

Uploaded by

Tomisin Eniola
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 44

INTRODUCTION TO ENGINEERING ECONOMICS

Ibikunle O. OGUNDARI , M.TechMgt, PhD (Tech


Mgt)
COREN Registered Engineer

Senior Research Fellow

African Institute for Science Policy and


Innovation (AISPI)
1 Obafemi Awolowo University, Ile-Ife
Outline
• The Concept of Engineering Economy
• Why Consider Returns on Capital?
• The Concept of Equivalence
• Understanding Interest Formulas for Discrete
Compounding and Discrete Cash Flows.
• The Relationship between Present, Future and Annual
Worths
• Evaluation of Multiple Alternatives
• Comparing Alternatives with different Life Span
Engineering Economics
• Engineering economics can be defined as a
discipline concerned with the systematic
evaluation of the costs and benefits of
proposed technical and business ventures
through the application of economic analysis
techniques in the comparison of investment
alternatives.
• Salient points from the above definition:

– Engineering economics is a set of decision assistance tools.

– These tools comprise a set of mathematical techniques that


simplify economic comparison of alternatives.

– They also provide principles and logical framework for the


economic evaluation process.

– Engineering economic studies involve the gathering and


analysis of facts so that reason (objectivity) may be used to the
fullest extent in arriving at decisions.

– If there are not alternatives to compare, there is no need for


engineering economic studies.
• In technology-based business initiatives, occasions often
arise where there is need to make decisions relating to
choosing between alternative projects.

• These important decisions tend to have long-term effect


on the organisational performance.

5
THE BEGINNING OF DECISION-MAKING

• By developing and carefully examining possible alternatives,


the project analyst arrives at what he considers the best
option from other several options of achieving the objective.

• Certainly some constraints would arise in the process of


selection

6
CONSTRAINTS IN THE DECISION-MAKING PROCESS
• Some constraints are fixed
– physical laws
– government regulations
– standards and specs, etc

• Others are less rigid


– process/technology
– materials
– Equipment, etc

• Economic considerations are a major constraint in the planning and execution of projects.

7
FORMS OF TECHNOLOGY-BASED BUSINESS INITIATIVES

– modifications and additions to an existing project or


part of a project

– new production capacity to meet growing sales


demand for a product

– new process (or technology) for meeting customers’


satisfaction
8
What is an Alternative?

• An alternative is a stand-alone solution for a given situation.

• Each alternative may involve different investment patterns, that is,


commitment of resources (disbursement or costs), as well as
different streams of returns and economic benefits (receipts) over
the life of the project.

• In comparing alternatives, it is desirable to make consequences


commensurable with one another. That is, the consequences
should be expressed in numbers and the same units.

• Money unit is the only unit that meets the foregoing


specifications.
ALTERNATIVES
• Most technology-based projects and business ventures may be
accomplished by more than one feasible method or approach.

• Each method or approach is called an ALTERNATIVE

• Alternatives are MUTUALLY EXCLUSIVE when the selection of


one excludes the consideration of others.

• Only one of a set of MUTUALLY EXCLUSIVE alternatives can be


selected at any given time

10
BASIS FOR COMPARING ALTERNATIVE INVESTMENTS

• Different feasible alternatives require different levels of investment

• Different levels of investment usually produce different economic


outcomes or benefits;

• There is therefore the need to perform an engineering economy


study to
– determine which one of the mutually exclusive feasible alternatives is
the preferred option,
– know how much capital is required and
– how the capital would be invested.

11
CRITERIA FOR COMPARING ALTERNATIVE
INVESTMENTS

• The process of economic evaluation of alternative projects is eased


by adopting a simple set of criteria:

– the feasible alternative that requires the minimum investment of capital


and produces satisfactory functional results will be chosen

– unless the incremental capital associated with an alternative having a


larger investment can be justified with respect to its incremental
benefits, it will not be chosen.

12
• The majority of engineering economic studies
involves commitment of capital for extended
periods of time.

• Money units are not commensurate at


different times because of the time value of
money, hence, it is important to know the
timing of cash flows.
• In the final analysis, the two most important
questions engineering economics seeks answers to
regarding prospective investment concerns are:

– The likelihood of recovery of investment capital, and


– Adequacy of returns commensurate with the risk and of better
financial returns obtainable from alternative of the capital.

• Engineering economics should assist to determine


whether capital should be invested in a project, or
whether it should be utilized differently that it is
presently being used.
Engineering Economics for Business Output Analysis - WHY?

• The businesses are technology-based.

• Technology businesses tend to have long gestation


periods.

• The time value of money is critical to decision-


making.
WHY CONSIDER RETURNS TO CAPITAL?

• Capital available to an organisation may be in the form


of money, machines, materials, energy, and other
things needed for the operation

• Capital classified into two basic categories


– Equity – investment of owners
– Debt – borrowed funds
• Return to capital is important because interest and
profit pay the providers of capital some returns for
forgoing its use

• Investors must decide whether the expected return


on their capital is sufficient to justify buying into a
proposed project or venture
THE CONCEPT OF EQUIVALENCE

• Money must have effectively the same value over a


spectrum of time.
• To compare alternative options, or proposals, reduce
them to become equivalent.
• Different projects may be equivalent, and this is
reflected in the way the initial investments are
recovered and the profits are generated
• Consider:
• The interest rate
• The amounts of money involved,
• The timing of the monetary receipts and/or
disbursements, and
• The manner in which the interest, or profit, on
invested capital is repaid and the initial capital
recovered.
CASH FLOW DIAGRAMS
• Consists of:
– Horizontal line
• A time scale with progression of time moving from left to right
– Vertical lines
• Upward arrow - represent revenues (positive cash flows or cash inflows
• Downward arrow - represent expenses (negative cash flows or cash
outflows

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

N3,310 N3,310 N3,310 N3,310 N3,310

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

N3,310 N3,310 N3,310 N3,310 N3,310

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

A P (A/P, i%, N) Capital recovery


BASIC CALCULATIONS
• Finding F when given P
• To find the future value for a present investment
– Use single payment compound amount factor
– USE THE FUNCTIONAL SYMBOL (F/P, i%, N) FOR THE
FACTOR
• READ AS "FIND F GIVEN P AT i% INTEREST PER PERIOD
FOR N INTEREST PERIODS.”
– Hence (F/P, i%, N)
• Suppose N 8,000 is borrowed now, with the promise
to repay the loan, principal plus accumulated interest
in four years at i = 10% per year. How much would
you owe at the end of four years?'

• 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.

• Remember that in an annuity deferred for j periods, the first


payment is made at the end of period (j+1), (assuming that all
periods involved are equal in length).
• DEFERRED ANNUITIES (UNIFORM SERIES)

• For a deferred annuity whose cash flows of amount a occur


between j+1 and n periods, the present worth of all the cash flow at
the end of period j is given by A(P/A, i%, N-J)
• The present worth of the single amount A(P/A, i%, N-J) as of time 0
will then be A(P/A, i%, N-J)(P/F,i%,J).
A = N2,000

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.

• Figure 3 shows the ordinary annuity of four payments of 2,000


occurring at the end of periods 18, 19, 20 and 21.

• The present worth of this deferred annuity can be calculated at


the 17th birthday when a (P/A, i%, N-J) factor is utilised.

• It is often helpful to use a subscript with P or F to denote the


point in time.
• Hence P17 = A(P/A, 12%, 4) = 2,000(3.0373) = 6,074.60
• Note the dashed arrow in figure 3, denoting P17. Now that
P17 is known, the next step is to calculate P0.

• With respect to P0, P17 is a future worth, and hence it could


also be denoted F17.

• Money at a given point in time, such as end of period 17, is


the same regardless of whether it is called a present worth or
a future worth. Hence

• P0 = F17(P/F, 12%, 17) = 6,074.60(0.1456) = 884.46

• The amount that the father would have to deposit is N884.46.


EVALUATION OF MULTIPLE
ALTERNATIVES

32
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

• The conversion is implemented by selecting the course of action that


maximizes the equivalent worth computed at the MARR.

33
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.

∑ (cash inflow) - ∑ (cash outflow) ≥ 0

OR

∑ (cash inflow) ≥ ∑ (cash outflow)

34
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.

35
• Note: Although the same criteria largely apply for
all decision situations, our focus here is on
alternatives that have identical life-spans

• The examples that follow give further illustration.

36
Problem 1
• Three mutually exclusive investment alternatives exist for
implementing an office automation plan in an engineering design firm.

• Investment alternatives are those with initial capital investment that


produces positive cash flows from increased revenue and savings
through reduced costs.

• The study period is 10 years.

• Salvage (residual) values of all the alternatives are assumed to be zero


at the end of 10 years.

• If the firm’s MARR is 10% per year, which alternative should be


selected in view of the following estimates?
37
GIVEN DATA
Alternative

A B C

Investment (first) Cost N 390,000 N 920,000 N 660,000

Net Annual receipts less

Expenses N 69,000 N 167,000 N 135,500

Salvage value at end of

useful life N 60,000 N 75,000 N87,000

38
STEPS
• STEP 1: Cash Flow Diagrams for Alternatives
A, B and C

• STEP 2: Make Equivalent Worth Calculations

39
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
40
• 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

• The order of preference is C > B > A, where C > B implies C is preferred to B.


Alternative C is selected

41
• 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.

42
• 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.

43
THANK YOU
FOR YOUR
ATTENTION!

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