Developed By:
Dr. Don Smith, P.E.
Department of Industrial
Engineering
Texas A&M University
College Station, Texas
Executive Summary Version
Chapter 1
Foundations Of
Engineering Economy
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Economy, 6th Edition, 2005
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© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
LEARNING OBJECTIVES
1. Questions
7. Symbols
2. Decision making
8. Spreadsheet
functions
3. Study approach
9. Minimum
attractive rate of
return
4. Interest rate
5. Equivalence
6. Simple and
compound
interest
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Economy, 6th Edition, 2005
10.Cash flows
11.Doubling time
12.Spreadsheets
1-2
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Sct 1: Why Engineering Economy is
Important to Engineers
 Engineers “design” and create
 Designing involves economic decisions
 Engineers must be able to incorporate
economic analysis into their creative efforts
 Often engineers must select and execute from
multiple alternatives
 A proper economic analysis for selection and
execution is a fundamental aspect of
engineering
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Engineering Economy
 The art and science that involves:
 Formulating,
 Estimating and
 Evaluating economic outcomes
 Always concerned with the selection and
possible execution of alternatives given the
economic parameters associated with the
project
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Sct 1.2 Role of Engineering Economy in
Decision Making
 Decision making involves the estimation of
future events/outcomes
 Engineering economy aids in quantifying past
outcomes and forecasting future outcomes
 Engineering Economy provides a framework
for modeling problems involving:
 Time
 Money
 Interest rates
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The Decision Making Process
1.
2.
3.
4.
5.
Understand the problem – define objectives
Collect relevant information
Define the set of feasible alternatives
Identify the criteria for decision making
Evaluate the alternatives and apply
sensitivity analysis
6. Select the “best” alternative
7. Implement the alternative and monitor
results
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Time Value of Money
 All firms make use of investment of funds
 Investments are expected to earn a return
 Investment involves money
 Money possesses a “time value”
 The “time value” of money is the most
important concept in engineering economy
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Sct 1.3 Performing An Engineering
Economy Study
 Engineering Economy Studies:
 Define Alternatives
Do-nothing alternative – maintain the status quo
Define feasible alternatives – that can solve the problem
 Define/estimate the current and future cash flows
 Perform the analysis
Apply the tools and methods of engineering economy
 Selection of the best alternative
 Implement and monitor
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Sct 1.4 Interest Rate and Rate of Return
 Interest – the manifestation of the time value of money
 Rental fee that one pays to use someone else’s
money
 Difference between an ending amount of money and a
beginning amount of money
 Interest rate (%) =
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interest accrued per time unit
x 100%
original amount
1-9
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Rate of Return
 Interest earned over a period of time is expressed as
a percentage of the original amount, specifically;
interest accrued per time unit
Rate of return (%) =
x 100%
original amount
 Borrower’s perspective – interest rate paid
 Lender’s perspective – interest rate earned
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Sct 1.5 Equivalence
 Different sums of money at different times
may be equal in economic value
$106 one
year from now
0
Interest rate = 6% per year
1
$100 now
$100 now is said to be equivalent to $106 one year from now, if
the $100 is invested at the interest rate of 6% per year.
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Sct 1.6 Simple and Compound Interest
 Simple Interest:
 Interest = (principal)(number of periods)(interest rate)
 Compound Interest:
 Interest earns interest on interest
 Compounds over time
 Interest = (principal + all accrued interest) (interest rate)
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Sct 1.7 Terminology and Symbols
 P = a present sum of money at a time
designated as t = 0 { t represents time}
 F = a future amount of money at some point in
time later than t = 0
 A = a series of equal, end-of-period cash
flows
 n = the number of interest periods
 i = the interest rate or rate of return per time
period, in percent
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Sct 1.8 Introduction To Solution By
Computer
 Application of Microsoft’s Excel© spreadsheet
program
 Excel financial functions
 Present Value P:
=PV(i%,n,A,F)
 Future Value F:
=FV(i%,n,A,P)
 Equal, periodic value:
=PMT(i%,n,P,F)
 No. of periods:
=NPER((i%,A,P,F)
 Compound interest rate: =RATE(n,A,P,F)
 Compound interest rate: =IRR(first_cell:last_cell)
 Present value of a series: =NPV(i%,second_cell:last_cell) + first_cell
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Sct 1.9 Minimum Attractive Rate of Return
 Investors expect to earn a return on their
investment (commitment of funds) over time
 We expect to see economic efficiencies greater
than 100%
 A profitable investment should earn (return)
funds in excess of the investment amounts
 Economic projects should earn a reasonable
return, which is termed:
 MARR – Minimum attractive rate of return
 Also termed the “hurdle” rate for an investment
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The MARR
 The MARR is established by the financial
managers of the firm
 The MARR is expressed as a percent value
 Most, if not all, projects should earn at a rate
equal to or greater than the established MARR
 MARR’s are set based upon:
 The cost of all types of capital
 Allowance for risk
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Types of Financing
 Equity Financing – the firm uses funds either
from retained earnings, new stock issues, or
owner’s infusion of money
 Debt Financing – the firm borrows funds from
outside sources
 The cost of debt financing = the interest rate
charged on the debt (loan) amounts
 The MARR is approximated from the weighted
average cost of all sources of capital to the
firm
 A firm’s ROR > MARR > cost of capital
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Sct 1.10 Cash Flows: Their Estimation and
Diagramming
 Definition of terms
 Cash Inflows - amount of funds flowing into the
firm
 Cash Outflows – amount of funds flowing out of the
firm
 Net Cash Flow equals
 cash inflows – cash outflows
 Assumption for analysis – end of period
 Funds flow at the end of a given (interest) period
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Cash Flow Diagrams
 A typical cash flow diagram might look like:
1. Draw a time line
0
1
2
… … …
n-1
n
One time period
2. Show the cash flows
Always assume end-of-period
cash flows!
0
1
2
… … …
n-1
n
Cash flows are shown as directed arrows (+ for up or – for down) --(+) inflow; (-) outflow
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Sct 1.11 Rule of 72: Estimating Doubling
Time or Interest Rate
 Common question:
 Estimate the number of time periods it takes for a
cash flow to double in size
 Given an interest rate i% per period
 The approximate time n for an investment at time
t = 0 to double in value is given by:
n = 72/i
 e.g., $10,000 at 7% per year doubles to $20,000 in
10.3 years
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Sct 1.12 Spreadsheet Application
 Reference Example 1.18
 Design a spreadsheet model to evaluate this
project
 Illustrates simple interest, compound interest and
inflation
 Focus on the overall design of the model and the
associated formatting
 Check appendix A for hints, formats, formulas to
use a spreadsheet effectively
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Chapter Summary
 Engineering Economy – application of economic
factors and criteria to evaluate alternatives
 Applies the time value of money
 Application of economic equivalence
 Introduction of the MARR
 Cash flow estimation
 Modeling – cash flow diagrams
 Difficulties in estimation
 Perspectives – viewpoints taken
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End of Slide Set
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