PART-II

4. Introduction to Engineering Economics

Daniel Ab.

Bahir Dar Institute of Technology (BiT)

Faculty of Mechanical and Industrial Engineering
 Introduction
▪ Engineering economics is the application of economic principles
to engineering problems, for example in comparing the
comparative costs of two alternative capital projects or in
determining the optimum engineering course from the cost
aspect, or the systematic evaluation of the economic merits of
proposed solutions to engineering problems.
▪ To be economically acceptable (i.e., affordable), solutions to
engineering problems must demonstrate a positive balance of
long term benefits over long term costs, and they must also;
• Promote the well-being and survival of an organization,
• Embody creative and innovative technology and ideas,
• Permit identification and scrutiny of their estimated outcomes, and
• Translate profitability to the “bottom-line” through a valid and
acceptable measure of merit. 2
 ….cont’d
▪ Engineering economics deals with the methods that enable
one to take economic decisions towards minimizing costs
and/or maximizing benefits to business organizations.
▪ It deals with the concepts and techniques of analysis useful
in evaluating the worth of systems, products, and services in
relation to their costs.
▪ In general, engineering economics is the application of
economic techniques to the evaluation of design and
engineering alternatives or projects.
▪ The role of engineering economics is then to:
✓Assess the appropriateness of a given project
✓Estimate its value
✓Justify it from an engineering standpoint 3
 Accounting vs. Engineering Economy

• Types of Strategic Engineering Economic Decisions in

Manufacturing Sector:
– Service Improvement
– Equipment and Process Selection
– Equipment Replacement
– New Product and Product Expansion
– Cost Reduction 4
 Types of Costs

• There are usually two types of costs/Benefits associated

with an engineering project, one-time costs, which
include first costs and salvage costs, and annual costs
(or benefits) that occur every year or several years of
the project.
One time costs:
• First Costs or Initial Costs are the costs necessary to
implement a project, including:
(Costs of new equipment, Costs of shipping and
installation, Costs of renovations, Cost of engineering, Cost
of permits, licenses, etc.)
5
 ….cont’d

• Salvage value is the money that can be obtained at the

end of the project by selling equipment. Salvage value is
a benefit rather than a cost.
Annual Costs/Benefits:
– Direct operating costs such as labor, supervision,
supplies, maintenance, material, electricity, fuel, etc.
– Indirect operating costs sometimes included, such as
a portion of building rent, a portion of secretarial
expenses, etc.
– Depreciation of equipment.
– Savings or profits from the project and tax.
6
Time Value of Money

7
 Basic Concepts and Definitions
▪ Money has the capacity to generate more money.
✓ If a given sum of money is deposited in a savings
account; it earns interest.
✓ If it is used to start a business, it earns profit
✓ If it is used to purchase a share in a business, it earns
dividends.
✓ If it is used to purchase an office building or apartment
house, it earns rent.
▪ Thus, the original sum of money expands as time elapses
through the accretion of these periodic earnings.

8
❖ Interest: It is the money earned by the original sum of
money, regardless of whether the earned money is
referred to as “interested”, “profits”, “dividends” ,
or “rent”.
❖ Interest rate (i): the time rate at which a sum of
money earns interest (it is usually expressed in
percentage per period of time). It measures the cost
or price of money.
❖ Investment: the productive use of money to earn
interest.
❖ Capital: the money that earns interest.
9
❖ Principal (P): The initial amount of money invested or
borrowed in transactions is called the principal (P).
❖ A specified length of time marks the duration of the
transaction and thereby establishes a certain number of
interest periods (N).
❖ A plan for receipts or disbursements (A) that yields a
particular cash flow pattern over a specified length of
time. (For example, we might have a series of equal
monthly payments that repay a loan.)
❖ A future amount of money (F) results from the
cumulative effects of the interest rate over a number of
interest periods. 10
❖Interest, then, may be defined as the
cost/benefit of having money available for use.
❖The way interest operates reflects the fact that
money has a time value.
❖The interest earned by the original capital can
itself be invested to earn interest, and this
process can be continued indefinitely.
❖This capacity of money to enlarge itself with the
passage of time is referred to as the time value of
money. 11
 Cash Flow and Cash-Flow Diagrams
▪ It is the graphic presentation of the costs and benefits over the
time is called the cash flow diagram.
▪ It is a presentation of what costs have to be incurred and what
benefits are received at all points in time. CFD illustrates the
size, sign, and timing of individual cash flows, and forms the
basis for engineering economic analysis.
▪ In the cash flow diagram:
▪ Time is plotted on a horizontal axis.
▪ The payments are represented by vertical bars.
▪ The amount of each payment is recorded directly above (for
revenue/benefits) or below (for costs) the bar representing
it. 12
E.g. Assume that a project has the following cash flow:
1) A disbursement of $ 50,000 now
2) A receipt of $ 10,000 after three years
3) A receipt of $ 15,000 after five years and
4) A receipt of $ 20,000 eight years hence

▪ Taking the unit of time one year, the cash flow diagram is
represented as in figure.

Receipts $ 10,000 $ 15,000 $ 20,000

Year

Disbursement
$ 50,000

13
 Interest Formulas
• Interest rate: is the rental value of money. It represents the
growth of capital per unit period. The period may be a
month, a quarter, semiannual or a year.
• The sum of money that is earning interest at a given instant
is known as the principal in the account.
• This process of converting interest to principal is referred to
as the compounding of interest; it represents an investment
of the interest in the same investment.

14
In general, let
P = sum deposited in savings account at the beginning of an
interest period
F = Principal in account at expiation of ‘n’ interest periods
i = interest rate
Simple interest: the interest is calculated, based on the
initial deposit for every interest period. In this case,
calculation of interest on interest is not applicable.

Note :Simple interest is commonly used with bonds.

Compound interest: the interest for the current period is
computed based on the amount (principal plus interest up
to the end of the previous period(at the beginning of the
current period)
Note: Engineering economic analysis uses the compounded-
interest 15
The principal at the end of the first period is P + Pi = P (1+i)
The principal at the end of the second period is:
=P (1+i) + P (1+i)i
= P (1+i) (1+i) = P (1+i)2
The principal at the end of the 3rd period is;:
= P (1+i) (1+i ) + P (1+i) (1+i)i
= P (1+i) (1+i) (1+i) = P(1+i)3

From this we conclude that the principal is multiplied by the

factor (1+i) during each period. Therefore, the principal at
the end of the nth period is
F = P (1+i) n

16
E.g. At the beginning of a particular year, the sum of $10,000 was
deposited in a savings account that earned interest of 10% per
annum. The growth of this sum during a three-year period is
explained as follows:
▪ During the first year, the principal is $10,000, and the interest
earned by the end of that year is 10,000(0.10) = $1,000
▪ At that time, the interest is compounded, there by increasing the
principal to 10,000 + 1,000 = $11,000.
▪ The interest earned by the end of the second year is
11,000(0.10) = $1,100
▪ At that time, this interest is compounded, there by increasing
the principal to 11,000 + 1,100 = $12,100
▪ The interest earned by the end of the third year is 12,100(0.10)
= $1,210
▪ At that time, this interest is compounded, there by increasing
the principal to 12,100 + 1,210 = $13,310

17
 Notation for Compound Interest Factors
❖ We shall define and apply several compound-interest
factors. Each factor will be represented symbolically
in the following general format:
➢ (A/B, n, i)
▪ A & B denoted two sums of money
▪ A/B denotes the ratio of A to B
▪ n denotes the number of interest periods
▪ i denotes the interest rate
➢ For brevity (shortness in time) the interest rate can
be omitted, and the expression will be given simply
as (A/B, n).
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 Calculations of Future Worth, Present Worth, Interest
Rate, and Required Investment Duration

F = P (1+i)n …….eq.(1)
▪ P is referred to as the present worth of the given sum of money
▪ F is referred to as the future worth of the given sum of money
▪ The terms “present” and “future” are applied in a purely relative sense as a
means of distinguishing between the beginning and end of the time
interval consisting of n periods.
▪ The factor (1+i)n is termed as the single-payment future-worth factor.
Conventionally we introduce the following notation.
(F/P, n, i) = (1+i) n ----- eq.(1a )
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❖ Thus, equation (1a) can be rewritten as:
F = P (F/P, n, i) ----eq.(1b)
Similarly P = F (1+i)-n
❖ The factor (1+i)-n is termed as the single-payment present-
worth factor.
❖ N.B when a future sum is converted to its present worth, it is
said to be discounted.

Figure: Cash flow diagram for single payment

compound amount
20
Example 1: If Birr 5,000 is invested at an interest rate of
10% per annum, what will be the value of this sum of money
at the end of 2 years?

Solution:
Given: P = 5,000 Birr, n = 2, i = 0.10
F = P (F/P, n, i) = 5,000 (F/P, 2, 10%)
= 5,000 (1.1)2
= 6,050 Birr

21
Example 2: Smith loaned Jones the sum of $2000 at the
beginning of year 1, $3000 at the beginning of year 2 and $
4000 at the beginning of year 4. The loans are to be
discharged by a single payment made at the end of year 6.
If the interest rate of the loans is 6% per annum, what sum
must Jones pay?
Solution:
❖ Refer to figure below. To maintain consistency and there by
simplify the calculation of time intervals, convert the date
of payment to the beginning of year 7.

22
23
Example 4: A person wishes to have a future sum of Birr 100,000 for his
son’s education after 10 years from now. What is the single-payment that
he should deposit now so that he gets the desired amount after 10 years?
The bank gives 15% interest rate compounded annually.
Solution
F= Birr. 100,000 P = ? i = 15%, compounded annually= 10 years
P= F/ (1 + i)n = F (P/F, i, n)
= 100,000 (P/F, 15%, 10)
= 100,000 * 0.2472
= Birr 24,720
The person has to invest Birr. 24,720 now so that he will get a sum of Birr
100,000 after 10 years at 15% interest rate compounded annually.

24
Example 5: An individual possesses two promissory notes. The first note has
a maturity value of $1000 and is due 2 years hence. The second note has a
maturity value of $1500 and is due 3 years hence. As this individual
requires cash for his immediate needs, he wishes to discount these notes
(i.e. to assign them to another individual or organization). If an investor
wishes to earn 7%, at what price should she offer to purchase the notes?
Solution
❖ The maturity value of a note is the amount of money that the holder of
the note is entitled to receive at the specified date. The proposed purchase
price is
P = 1000 (P/F, 2, 7%) + 1500 (P/F, 3, 7%)
= 1000 (0.87344) + 1500 (0.81630)
= $ 2098
25
 Meaning of Equivalence

❖ In general two alternative payments are equivalent to one

another if the monetary worth of the firm will eventually
be the same regardless of which payment is made.

❖ Consider that a firm received the sum of $10,000 at the

beginning of year 6 and immediately invested this at 8%,
by the beginning of year 9, this sum of money has
expanded to 10,000 (F/P, 3, 8%) = 12,597.

26
❖ Therefore, if the firm had received the sum of $12,597 at
the beginning of year 9 rather than the sum of $10,000 at
the beginning of year 6, its monetary worth at the
beginning of year 9 and at every instant thereafter would
have been the same.
❖ Thus, these two alternative events receipt of $10,000 at
the beginning of year 6, and receipt of $12,597 at the
beginning of year 9- yield an identical monetary worth if
money is worth 8%.
❖ We therefore can say that these two events are
equivalent to one another.

27
Example 6: If money is worth 10 percent, what single
payment made at the beginning of year 7 is equivalent to
the following set of payments: $600 at the beginning of
year 1, $3200 at the beginning of year 2, and $4000 at the
beginning of year 10.

Solution:

Equivalent payment= [600(F/P, 6) + 3200(F/P, 5)] + [4000(P/F, 3)]

=$9222

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 Comparison of Sets of Payments

Example 7: Given the following set of payments:

$800 at the beginning of year 2, and
$500 at the beginning of year 6
On the basis of an 8% interest rate, this set of payments is to
be transformed to an equivalent set consisting of the
following:
A Payment of X at the beginning of year 5, and
A payment of 2X at the beginning of year 9.
Find the payments under the second set, and verify the
values.

29
Solution:
❖ Refer to fig. below select the beginning of year 9 as the valuation date.

Value of the first set = 800 (F/P, 7) + 500 (F/P, 3)

= 800 (1.71382) + 500 (1.25971)
= $2001
Value of the second set = X (F/P, 4) + 2X = X (1.36049) +2X = $2001
Solving, X = $ 595, 2X = 1191
To verify these results, assume that a savings account has an interest rate of
8% & that the given payments represent withdrawals from the account.
Also arbitrarily assume that the account had a principal of $2000 at the end
of year 1.The history of the account is as follows:
30
First set of withdrawals:
➢ Principal at the beginning of year 2 = 2000-800 = $1200
➢ Principal at the beginning of year 5 = 1200 (1.36049)- 500 = $1133
➢ Principal at the beginning of year 9 = 1133 (1.25971) = $ 1427

Second set of withdrawals:

➢ Principal at the beginning of year 2 = $2000
➢ Principal at the beginning of year 5 = 2000 (1.25971) – 595 = $1924
➢ Principal at beginning of year 9 = 1924 (1.36049)- 1191 = $1427

The equivalence of the two sets of payments is thus established.

31
 Change of Interest Rate

▪ The interest rate changes at a particular date.

▪ This date serves to divide time into two intervals,
each characterized by a specific interest rate.
▪ If a given sum of money is to be carried from one
interval to the other, it is necessary to find its value at
the boundary point.

32
Example 8: The sum of $ 5000 will be required 10 years hence. To ensure
its availability, a sum of money will be deposited in a reserve fund at the
present time. If the fund will earn interest at the rate of 4% for the first
three years & 6% thereafter, what sum must be deposited?
Solution:
❖ The problem requires that we find the present worth of the specified sum
of money. We move this sum of $5000 backward 7 years at 6% and then
backward another 3 years at 4 %.Then
F = P(F/P, 7, 6%) (F/P, 3, 4%) = P (1+i)7 (1+i)3
5000 = P (1+i)7 (1+i)3 = P (1+0.06)7 (1+0.04)3
 P = $ 2956
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 Equivalent & Effective Interest Rates
❖ If a given rate applies to a period less than a year, its equivalent rate for an
annual period is referred to as its effective rate.
Consider that at the beginning of a given year the sum of $100,000 is
deposited in each of three funds designated A, B & C. The interest rates
are as follows.
➢ Fund A, 8% per year compounded quarterly
➢ Fund B, 8.08% per year compound semi-annually
➢ Fund C, 8.243% per year compounded annually
❖ The principal in each fund at the beginning of the following year is as
follows.

34
➢ Fund A: 100,000 (1.02) 4 = $ 108,243
➢ Fund B: 100,000 (1.0404) 2 = $ 108,243
➢ Fund C: 100,000 (1.08243) = $ 108,243
❖ Thus, the effective rate corresponding to a rate of 2 % per quarterly
period (or 8% per year compound quarterly) is 8.243%.

Where:
r- stated interest rate
m- number of compounding
periods per year
35
 Opportunity Costs and Sunk Costs

✓ Consider that an organization has a choice of two

alternative investments, A and B. If it undertakes

investment A, it forfeits the income that would accrue
under B. Therefore, the income associated with
investment B is referred to as an Opportunity Cost of
investment A.
✓ A Sunk Cost is an expenditure that was made in the past

and that exerts no direct influence on future cash flows.

Therefore, it is irrelevant in an economy analysis/ future
decision making. They are past opportunity costs.
36
 Effect of Taxes on Investment Rate
❖ If the rate of taxation varies according to the amount of
the income, it is necessary to establish the rate at which
the income from a specific venture will be taxed.
Definitions:
▪ Original income: income received by a firm before
taxation.
▪ Residual income: the income that remains after the
payment of taxes.
▪ Before-tax rate: investment rate calculated on the basis
of original income.
▪ After-tax rate: investment rate calculated on the basis of
residual income.
▪ Assume Q as the sum of money received & this income is
taxed at the rate t.
37
 The tax payment = Qt
Residual income = original income- tax payment
= Q – Qt = Q (1-t)

❖ We shall now develop the relationship between the before-tax & after-tax
investment rates.
❖ Assume that a given investment pays a constant annual dividend during its
life & that the firm recovers the money originally invested when the
venture terminates. Let
C = amount invested
I = annual income from investment rate
ib = before-tax investment rate
ia = after-tax investment rate
38
We have the following:
Original income = I, &
ib = I/C= original income/amount investment
Residual Income = Net taxable income – Tax payment
= I – It = I (1 – t),
& ia = I (1-t)/C = residual income/amount invested
Then ia = ib (1 –t)

Problem: A firm expended $560 to have an employee attend a seminar. If

this expenditure is tax deductible and the tax rate of the firm is 45%, what
was the after tax value of the expenditure?
39
 Inflation
❖ Inflation is the general increase of costs with the passage of time respect to
a given commodity. Let
Co = Cost of commodity at the beginning of the first year
Cr = Cost of commodity at the end of the r th year
q = (effective) rate of inflation of r th year
❖ The rate of inflation for a given year is taken as the ratio of the increase in
cost of the commodity during that year to the cost at the beginning of the
year. Expressed symbolically,

❖ If the annual rate of inflation remains constant for a year, the cost of
commodity at the end of that period is

40
 Uniform Series of Payments

❖ Uniform Series/Annuity: a set of payments each of equal

amount made at equal intervals of time.
❖ Payment Period: the interval between successive
payments.
❖ For example, if a corporation makes an interest payment
of $50,000 to its bondholders at 3-month intervals, these
interest payments constitute a uniform series, and the
payment period is 3 months.
Similarly, if a construction company rents equipment for
which it pays $4000 at the end of each month, these
rental payments constitute a uniform series, and the
payment period is 1 month. 41
❖ Ordinary Uniform Series: one in which a payment is made at
beginning or end of each interest period.
❖ The payment period and interest period coincide in all respects in
ordinary uniform series.

Origin date Terminal

date

❖ By convention, the origin date of a uniform series is placed one

payment period prior to the first payment, and the terminal date is
placed at the date of the last payment.
❖ The value of the entire set of payments at the origin date is called
the present worth of the series, and the value at the terminal date is
called the future worth. 42
 Calculation of Present Worth and Future Worth
(For uniform serious payment)

❖ Let equal amounts of money, A, be deposited in a savings

account (or placed in some other interest-bearing
investment) at the end of each year, as indicated in
figure.

❖ If the money earns interest at a rate i, compounded

annually, how much money will have accumulated after n
years?

43
❖ To answer this question, we note that after n years, the first year's deposit
will have increased in value to
Fl = A(1+ i)n-1
❖ Similarly, the second year's deposit will have increased in value to
F2 = A(1+ i)n-2
and so on. The total amount accumulated will thus be the sum of a
progression:
Fu = F1+F2 +F3+…………… + Fn
= A (1+ i)n-1 + A(1+ i)n-2 +……… + A
=A[(1+ i)n-1 + (1+ i)n-2 +……… +1 ]
Then, Fu = A
(1 + i ) n
−1
i
Fu = A( Fu / A, n, i )

where : ( Fu / A, n, i ) =
(1+ i)
n

−1
i
is called the uniform-series-future-worth factor.
44
Example: A person who is now 35 years old is planning for his
retired life. He plans to invest an equal sum of Birr. 10,000 at the
end of every year for the next 25 years starting from the end of
the next year. The bank gives 20% interest rate, compounded
annually. Find the maturity value of his account when he is 60
years old.
Solution:

A= Birr 10,000 F= ? i = 20% n= 25 years

F= A(F/A, i, n)
F= 10,000(F/A, 20%, 25)
F= 10,000 * 471.981
F= Birr. 4,719,810
The future sum of the annual equal payments after 25 years is equal to
Birr. 4,719,810. 45
Similarly, for present worth: evaluating all payments at the origin of the
series and summing the results, we obtain :

Pu = A[1 + (1 + i ) −1 + (1 + i ) −2 + ... + (1 + i ) − n ]
1
1 −
1 − (1 + i ) − n (1 + i ) n
Then : Pu = A[ ] = A[ ]
i i
Pu = A( Pu / A, n, i )
1 − (1 + i ) − n
where : ( Pu / A, n, i ) = [ ]
i
is called the uniform-series-present-worth factor.

46
Example: A company wants to set up a reserve which will help
the company to have an annual equivalent amount of Birr.
1,000,000 for the next 20 years towards its employee’s welfare
measures. The reserve is assumed to grow at the rate of 15%
annually. Find the single-payment that must be made now as the
reserve amount.
Solution:

A= Birr. 1,000,000P= ? i = 15% n= 20 years

= 1,000,000 (P/A, 15%, 20)

= 1,000,000 *6.2593
= Birr. 6,259,300
The amount of reserve which must be set-up now is equal to Birr. 6,259,300.
47
Equal-Payment Series Sinking Fund
In this type of investment mode, the objective is to find the
equivalent amount (A) that should be deposited at the end of
every interest period for n interest periods to realize a future
sum (F) at the end of the nth interest period at an interest rate
of i. The corresponding cash flow diagram is shown below.

The formula to get F is:

48
Example: A company has to replace a present facility after 15
years at an outlay of Birr. 500,000. It plans to deposit an equal
amount at the end of every year for the next 15 years at an
interest rate of 18% compounded annually. Find the equivalent
amount that must be deposited at the end of every year for the
next 15 years.
Solution:

F= Birr. 500,000 A= ? i = 18% n= 15 years

= 5, 00,000 (A/F, 18%, 15)
= 5, 00,000 * 0.0164
= Birr. 8,200
The annual equal amount which must be deposited for 15 years is Birr.
8,200. 49
Equal-Payment Series Capital Recovery Amount
The objective of this mode of investment is to find the annual
equivalent amount (A) which is to be recovered at the end of
every interest period for n interest periods for a loan (P) which is
sanctioned now at an interest rate of i compounded at the end of
every interest period.

The formula to compute for A is:

Where,

(A/P, i, n) is called equal-payment series capital recovery factor.

50
Example: A bank gives a loan to a company to purchase an
equipment worth Birr. 1,000,000 at an interest rate of 18%
compounded annually. This amount should be repaid in 15 yearly
equal installments. Find the installment amount that the
company has to pay to the bank.

Solution:

P= Birr. 1,000,000 A= ? i = 18% n= 15 years

= 1,000,000 * (A/P, 18%, 15)
= 1,000,000 * (0.1964)
= Birr. 196,400
The annual equivalent installment to be paid by the company to the bank is
Birr. 196,400.
51