Lecture-1

Fundamentals of Engineering Economy

Books:
1. Fundamentals of Engineering Economics by Chan S.
Park
2. Basics of Engineering Economy by Leland Blank &
Anthony Tarquin
3. Engineering Economy “Applying Theory and Practice”
by Ted G. Eschenbach
Prepared by:
Engr. Mudassir Abbas
Department of Civil Engineering
NFC IET Multan
Contents of Course
Fundamentals of Engineering Economics
Capital Financing and Allocation
Business Organization and Industrial Relationship
Depreciation and Taxes
Selection between Alternatives
Introduction
The need for engineering economy is primarily motivated by the work that
engineers do in performing analysis, synthesizing, and coming to a
conclusion as they work on projects of all sizes.
In other words, engineering economy is at the heart of making decisions.
These decisions involve the fundamental elements of cash ows of money,
time, and interest rates.
This chapter introduces the basic concepts necessary for an engineer to
combine these three essential elements in organized, mathematically
correct ways to solve problems that will lead to better decisions.
Engineering Economy (Definition)
Engineering economy is a collection of techniques that simplify
comparisons of alternatives on an economic basis.
Engineering economy is not a method or process for
determining what the alternatives are.
On the contrary, engineering economy begins only after the
alternatives have been identi ed. If the best alternative is
actually one that the engineer has not even recognized as an
alternative, then all of the engineering economic analysis tools
will not result in its selection.
1.2 PERFORMING AN ENGINEERING ECONOMY STUDY

1.2.2 Cash Flows:

The estimated in ows (revenues) and out ows (costs) of money are called
cash ows. These estimates are truly the heart of an engineering
economic analysis.
They also represent the weakest part of the analysis, because most of the
numbers are judgments about what is going to happen in the future.
After all, who can accurately predict the price of oil next week, much less
next month, next year, or next decade?
Thus, no matter how sophisticated the analysis technique, the end result is
only as reliable as the data that it is based on.
1.2 PERFORMING AN ENGINEERING ECONOMY STUDY

1.2.3 Alternative Selection:

Every situation has at least two alternatives.
In addition to the one or more formulated alternatives, there is always the
alternative of inaction, called the do-nothing (DN) alternative. This is the
as-is or status quo condition.
In any situation, when one consciously or subconsciously does not take
any action, he or she is actually selecting the DN alternative.
Of course, if the status quo alternative is selected, the decision-making
process should indicate that doing nothing is the most favorable economic
outcome at the time the evaluation is made.
1.2 PERFORMING AN ENGINEERING ECONOMY STUDY

1.2.3 Alternative Selection:

When comparing two or more alternatives by the rate of return method, the rst
step is to classify them as either mutually exclusive or independent, and second
as either revenue or service-only alternatives, because their classi cation
determines what they are to be compared against. There are only three types
of alternatives based on these classi cations as shown in Table 8.1. The way
they are to be evaluated is also shown in the Table.
1.2 PERFORMING AN ENGINEERING ECONOMY STUDY

1.2.6 Time value of Money:

It is often said that money makes money.
The statement is indeed true, for if we elect to invest money today, we
inherently expect to have more money in the future.
If a person or company borrows money today, by tomorrow more than the
original loan principal will be owed.
This fact is also explained by the time value of money.
The change in the amount of money over a given time
period is called the time value of money; it is the most
important concept in engineering economy.
The term return on investment (ROI) is
used equivalently with ROR in di erent
industries and settings, especially where
large capital funds are committed to
engineering-oriented programs. The term
interest rate paid is more appropriate for
the borrower’s perspective, while rate of
return earned is better from the investor’s
perspective.
Example 1.1
An employee at LaserKinetics.com borrows $10,000 on May 1 and must
repay a total of $10,700 exactly 1 year later. Determine the interest amount
and the interest rate paid.
Minimum attractive rate of return (MARR)
Engineering alternatives are
evaluated upon the prognosis that
a reasonable rate of return (ROR)
can be realized.
A reasonable rate must be
established so that the accept/
reject decision can be made.
The reasonable rate, called the
minimum attractive rate of return
(MARR), must be higher than the
cost of money used to nance the
alternative, as well as higher than
the rate that would be expected
from a bank or safe (minimal risk)
investment.
Figure 1.1 indicates the relations
between di erent rates of return.
 Minimum attractive rate of return (MARR)
• An organization's minimum attractive rate of return (MARR) is just that,
the lowest internal rate of return the organization would consider to be a
good investment. The MARR is a statement that an organization is
con dent it can achieve at least that rate of return.
• Another way of looking at the MARR is that it represents the
organization's opportunity cost for investments. By choosing to invest in
some activity, the organization is explicitly deciding to not invest that
same money somewhere else. If the organization is already con dent it
can get some known rate.
• MARR is also referred to as the hurdle rate, cuto rate, benchmark rate,
and minimum acceptable rate of return.
Minimum attractive rate of return (MARR)
In general, capital is developed in two ways—equity nancing and debt
nancing. A combination of these two is very common for most projects.
Equity nancing: The corporation uses its own funds from cash on
hand, stock sales, or retained earnings. Individuals can use their own
cash, savings, or investments.
Debt nancing: The corporation borrows from outside sources and
repays the principal and interest according to some schedule. Sources
of debt capital may be bonds, loans, mortgages, venture capital pools,
and many others. Individuals, too, can utilize debt sources.
ROR>MARR
Minimum attractive rate of return (MARR)
Often there are many alternatives that are expected to yield a ROR that
exceeds the MARR as indicated in Figure (1–12), but there may not be
su cient capital available for all, or the project’s risk may be estimated as
too high to take the investment chance. Therefore, new projects that are
undertaken usually have an expected return at least as great as the return
on another alternative that is not funded. The expected rate of return on
the unfunded project is called the opportunity cost.
he opportunity cost is the rate of return of a forgone opportunity
caused by the inability to pursue a project. Numerically, it is the largest
rate of return of all the projects not accepted (forgone) due to the lack
of capital funds or other resources. When no speci c MARR is
established, the de facto MARR is the opportunity cost.
Pint:
a unit of liquid or dry
capacity equal to one
eighth of a gallon, in
Britain equal to 0.568
litre and in the US equal
to 0.473 litre (for liquid
measure) or 0.551 litre
(for dry measure).
Figure 1.2 indicates the amount of interest each year necessary to
make these three di erent amounts equivalent at 6% per year.