What is Engineering Economics?
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What is Engineering Economics?
 Subset
of General Economics
 Different from general economics situations
- project driven
 Analysis performed by technical
professionals (not economists)
 Requires advanced technical knowledge in
some cases
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Lots of Questions: Project/$ driven

Why do this at all?
 Is there a need for the project?
 Why do it now?
 Can it be delayed? Can we afford it now?
 Why do it this way?
 Is this the best alternative? Is this the optimal
solution?
 Will the project pay?
 Will we run a loss or make a profit?
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Sample Engineering Project


Hydro vs. Thermal power
Hydro:
 expensive initially
 far away from load
centres (high
transmission cost)
 no fuel required
 longer life
 no pollution

Thermal
 less expensive initially
 can be near load centres



require fuel
shorter life
can cause pollution
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Other examples
 Buy
vs. rent (car, house, equipment)
 Good
quality (expensive) but longer life vs.
poor quality (cheap) but shorter life
 car, shoes, computers
 Investments
decisions - GIC, RRSP, Bonds,
Stocks and Shares
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Steps in Engineering Economics Study
 Define
alternatives in physical terms
 Cost and revenue estimates
 All money estimates placed on a comparable basis
 appropriate interest rate used
 time horizon (economic life)
 Recommend choice among alternatives
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Engineering Economics on the Web
 The
discipline that translates engineering
technology into a form that permits evaluation by
businesses or investors.
 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.
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The Time Value of Money
Would you prefer to
have $1 million now or
$1 million 100 years
from now?
Of course, we would all
prefer the money now!
This illustrates that there
is an inherent monetary
value attached to time.
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What is Time Value?
 We
say that money has a time
value because that money can be
invested with the expectation of
earning a positive rate of return
 In other words, “a dollar received
today is worth more than a dollar
to be received tomorrow”
 That is because today’s dollar can
be invested so that we have more
than one dollar tomorrow
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What is The Time Value of Money?
 A dollar
received today is worth more than a
dollar received tomorrow
 This is because a dollar received today can
be invested to earn interest
 The amount of interest earned depends on
the rate of return that can be earned on the
investment
 Time value of money quantifies the value of a
dollar through time
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Uses of Time Value of Money

Time Value of Money, is a concept that
is used in all aspects of finance
including:




Stock valuation
Financial analysis of firms
Accept/reject decisions for project
management
And many others!
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The Terminology of Time Value
 Present Value
- An amount of money today, or
the current value of a future cash flow
 Future Value - An amount of money at some
future time period
 Period - A length of time (often a year, but can
be a month, week, day, hour, etc.)
 Interest Rate - The compensation paid to a
lender (or saver) for the use of funds expressed
as a percentage for a period (normally
expressed as an annual rate)
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Abbreviations
 PV
- Present value
 FV - Future value
 Pmt - Per period payment amount
 i - The interest rate per period
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Purchasing Power and Value
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Account Value
Case 1:
Inflation
exceeds
earning power
N = 0 $100
N = 1 $106
Case 2:
Earning power
exceeds
inflation
N = 0 $100
N = 1 $106
Cost of Refrigerator
N = 0 $100
N = 1 $108
(earning rate =6%) (inflation rate = 8%)
N = 0 $100
N = 1 $104
(earning rate =6%) (inflation rate = 4%)
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Timelines


A timeline is a graphical device used to clarify
the timing of the cash flows for an investment
Each tick represents one time period
PV
0
Today
FV
1
2
3
4
5
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Calculating the Future Value

Suppose that you have an extra $100 today that you
wish to invest for one year. If you can earn 10% per
year on your investment, how much will you have in
one year?
-100
?
0
1
2
3
4
5
FV1  1001  010
.   110
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Calculating the Future Value

Suppose that at the end of year 1 you decide to extend
the investment for a second year. How much will you
have accumulated at the end of year 2?
0
-110
?
1
2
3
4
5
FV2  1001  010
. 1  0.10  121
or
2
FV2  1001  010
.   121
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Generalizing the Future Value
 Recognizing the
pattern that is developing, we
can generalize the future value calculations
FVN  PV1  i
N
 If
you extended the investment for a third
year, you would have:
FV3  1001  010
.   13310
.
3
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Compound Interest

Note from the example that the future value is
increasing at an increasing rate
 In other words, the amount of interest earned each
year is increasing
 Year 1: $10
 Year 2: $11
 Year 3: $12.10
 The reason for the increase is that each year you
are earning interest on the interest that was earned
in previous years in addition to the interest on the
original principle amount
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Compound Interest Graphically
4500
3833.76
4000
5%
3500
10%
Future Value
3000
15%
2500
20%
2000
1636.65
1500
1000
672.75
500
265.33
0
0
1
2
3
4
5
6
7
8
9
10
Years
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12
13
14
15
16
17
18
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20
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The Magic of Compounding

On Nov. 25, 1626 Peter Minuit, purchased Manhattan
from the Indians for $24 worth of beads and other
trinkets. Was this a good deal for the Indians?
 This happened about 378 years ago, so if they could
earn 5% per year they would in 2005 have
$2,400,000,000  24(1.05) 378

If they could have earned 10% per year, they would now have:
$106,000,000,000,000,000  24(1.10)378
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Calculating the Present Value
 So
far, we have seen how to calculate the
future value of an investment
 But we can turn this around to find the
amount that needs to be invested to
achieve some desired future value:
PV 
FVN
1  i
N
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Present Value: An Example

Your five-year old daughter
has just announced her
desire to attend college.
After some research, you
determine that you will need
about $100,000 on her 18th
birthday to pay for four
years of college. If you can
100,000
earn 8% per year on your
PV 
 $36,769.79
13
. 
investments, how much do
108
you need to invest today to
achieve your goal?
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Continuous Compounding

There is no reason why we need to stop increasing the
compounding frequency at daily
 We could compound every hour, minute, or second
 We can also compound every instant (i.e.,
continuously):
F  Pe

rt
Here, F is the future value, P is the present value, r is the
annual rate of interest, t is the total number of years, and e
is a constant equal to about 2.718
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Continuous Compounding

Suppose that the Fourth National Bank is offering to
pay 10% per year compounded continuously. What is
the future value of your $1,000 investment?
F  1,000e


0 .10 1
 110517
, .
This is even better than daily compounding
The basic rule of compounding is: The more frequently
interest is compounded, the higher the future value
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Continuous Compounding
 Suppose
that the Fourth National Bank is
offering to pay 10% per year compounded
continuously. If you plan to leave the money
in the account for 5 years, what is the future
value of your $1,000 investment?
F  1,000e
0.10 5
 1,648.72
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Summary
 Engineering Economics
 The Time Value
of Money
 Calculating the Future/Present Value
 Simple/Compound Interest
 Self-Study: Simple
Interest P+P*N*5% 1+1=2
 Required: Slides/Book Chapter 2.1 2.2 2.3 2.5
 Feedback: Quiz
Review before Quiz
 Feedback: Book Library: waiting for answer
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