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MS-291: Engineering Economy

(3 Credit Hours)

Economic Equivalence

Different sums of money at different times may be equal in

economic value at a given rate
$110

Year

0
1
$100 now

Rate of return = 10% per year

$100 now is economically equivalent to $110 one year from

now, if the $100 is invested at a rate of 10% per year
Economic Equivalence: Combination of interest rate
(rate of return) and time value of money to determine
different amounts of money at different points in time
that are economically equivalent

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Minimum Attractive Rate

of Return (MARR)
Also termed hurdle rate,

Rate of return,
Per cent

benchmark rate and cutoff rate

Expected rate of
return on a new
proposal

MARR is a reasonable rate of

return (percent) established
for evaluating and selecting
alternatives
An investment is justified
economically if it is expected to
return at least the MARR

MARR is established by the

financial managers of the
firm

Range for the rate of

return on accepted
proposals, if other
proposals were
rejected for some
reasons
All proposals
must offer at
least MARR to
be considered

MARR

Rate of return on
safe investment

Size of MAAR relative to other rate of

return values

Sources of Capital for firms

Equity financing: uses of its own funds from cash on
hand, stock sales, or retained earnings. Individuals can use
their own cash, savings, or investments. In the example in
previous slide, using money from the 5% savings account is
equity financing.
Debt financing: borrowing from outside sources and repays
the principal and interest according to some schedule.
Sources of debt capital may be bonds, loans etc.
Individuals, too, can utilize debt sources, such as the credit
card (15% rate) and bank options (9% rate) described
above.

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Weighted Average Cost of

Capital (WACC)
If capital is used from more than one source .. Such as
combinations of debt-equity financing then the cost of
capital is a weighted average cost of capital (WACC)
If the HDTV is purchased with 40% credit card money at
15% per year and 60% savings account funds earning 5%
per year,
the Weighted Average Cost of Capital is:
0.4(15%) + 0.6(5%) = 9% per year.

Class Practice
A large multinational
corporation is considering
following six projects.
They are using 10% equity
financing costing 9% per year
and 90% debt financing with a
cost of debt capital of 16% per Solution
Return on project should
year, which projects should
be greater than Weighted
the company undertake in
average Cost of Capital
given projects Inventory,
(WACC)
technology, warehouse,
WACC = 10%(0.09) + 90%(0.16) = 15.3%
products, energy, shipping? Which one company should undertake ?
should undertake the inventory, technology, and
warehouse projects

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Simple
versus
Compound Interest

Commonly used Symbols

t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month

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Simple Interest
Interest is calculated using principal only
Mathematically:
Simple Interest = (principal) x (interest rate) x (number of periods)

I=

P= principle amount
n = number of period
i = interest rate

Example
GreenTree Financing lent an engineering
company $100,000 to retrofit an
environmentally unfriendly building. The loan
is for 3 years at 10% per year simple
interest. How much money will the firm
repay at the end of 3 years?
Solution

I=Pxixn
P= principle amount = $100,000
n = number of period = 3
i = interest rate = 10% or 0.1

I=Pxixn
I = $100,000 x 3 x 0.1
I = $30,000
Total due = $100,000 + 30,000= $130,000

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Compound Interest Rate

It must be noted that . Bank do not use Simple
Interest instead they use Compound Interest rate
Most of the time, we talk about interest we mean
compound interest rate
So when ever you are said to calculate interest rate
and it is not specified it will always mean
COMPOUND Interest rate. So be careful with this
distinction.

Compound Interest
With Compound Interest, you work out the interest for the first period,
add it to the principle, and then calculate the interest for the next period,
and so on ..., like this:
Let suppose You deposited $1000 in a bank with compound interest rate
of 10%

Period
1

Period
2

Period
3

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Compound Interest
Interest is based on principal plus all
accumulated interest
That is, interest compounds over time
Mathematically:
Compound Interest = (principal + all accumulated interest)
x (interest rate)

Simple and Compound Interest:

Comparison
Example: $100,000 lent for 3 years at interest rate i
= 10% per year. What is repayment after 3 years ?

Simple Interest

Compound Interest

Here

Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: F1 = 100,000 + 10,000
=$110,000

P=$100,000
n= 3
i= 10%
Simple interest = P X i x n

Interest = 100,000(3)(0.10)
= $30,000

Total due = 100,000 +

30,000

Interest, year 2: I2 = 110,000(0.10) = $11,000

Total due, year 2: F2 = 110,000 + 11,000
= $121,000

Interest, year 3: I3 = 121,000(0.10) = $12,100

Total due, year 3: F3 = 121,000 + 12,100
= $133,100

= $130,000
Simple: $130,000: Compounded: $133,100

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Comparison of Simple and

Compound Interest
Simple Interest Case

Compound Interest Case

Class Practice:
Time Five Minutes
If a company sets aside $1,000,000 (1 million $) now
into a fund, how much will the company have in 2
years, if it does not use any of the money and the
account grows at a rate of 10% per year?
Solution

F1 = 1,000,000 + 1,000,000(0.10)
= 1,100,000
F2 = 1,100,000 + 1,100,000(0.10)
= $1,210,000

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So for ..

What is Economics?
Why Economics for Engineers ?
What is Engineering Economy ?
How to Performing Engineering Economy Study ?
Some Basic Concepts
Utility & Various cost concepts
Time value of money (TVM)
Interest rate and Rate of Returns
Cash Flow
Economic Equivalence
Minimum Attractive Rate of Return
Cost of Capital and MARR
Simple and compound interest rates

Chapter 2
Factors: How Time and Interest
Affect Money

MS291: Engineering Economy

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Content of the Chapter

Single-Payment Compound Amount Factor (SPCAF)
Single-Payment Present Worth Factor (SPPWF)
Uniform Series Present Worth Factor (USPWF)
Capital Recovery Factor (CRF)
Uniform Series Compound Amount Factor
Sinking Fund Factor (SFF)
Arithmetic Gradient Factor
Geometric Gradient Series Factor

Simple and Compound Interest:

Comparison
Example: $100,000 lent for 3 years at interest rate i
= 10% per year. What is repayment after 3 years ?

Simple Interest

Compound Interest

Here

Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: F1 = 100,000 + 10,000
=$110,000

P=$100,000
n= 3
i= 10%
Simple interest = P X i x n

Interest = 100,0000(0.10) (3)

= $30,000

Total due = 100,000 +

30,000

Interest, year 2: I2 = 110,000(0.10) = $11,000

Total due, year 2: F2 = 110,000 + 11,000
= $121,000

Interest, year 3: I3 = 121,000(0.10) = $12,100

Total due, year 3: F3 = 121,000 + 12,100
= $133,100

= $130,000
Simple: $130,000: Compounded: $133,100

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Single Payment Compound

Amount Factor (SPCAF)
If an amount P is invested at time t=0 the amount accumulated after a year
is given as
F1 = P + Pi
= P(1 + i) . (1)
At the end of second year, the accumulated amount F2 is given as;

P = 1000@5%
After one year ?
F1 = 1000 + 50

After two year ?

F2 = 1050 + 52.5
F2 = F 1 + F 1 i
= P(1+i) + P(1+i)i
(from Eq. 1)
= P + Pi + Pi+ Pi2
= P(1+i)2 (2)
Similarly; F3 = F2 + F2 i
= P(1+i)3 ..(3)
to generalize the process for period n we can write as;

F = P(1+i)n

Single Payment Compound

Amount Factor (SPCAF)
F = P(1+i)n

The term (1+i)n is known as Single Payment

Compound Amount Factor (SPCAF)

It is also refer as F/P factor

This is a converting factor, when multiplied by P

yields the future amount F of initial amount P Do not forget
i .. Refers to
after n years at interest rate i
compound
interest rate

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Simple and Compound Interest

Example: $100,000 lent for 3 years at interest rate i
= 10% per year. What is repayment after 3 years ?

Simple Interest

Compound Interest
Now we have F = P(1+i)n

Here
P=$100,000
n= 3
i= 10%
Simple interest = P X i x n

P = $100,000
n=3
i=10%
So F = 100,000 (1+0.10)3

Interest = 100,000(0.103)(3)
= $30,000

Total due = 100,000 +

30,000

F= 100,000 (1.331)

F = 133100

= $130,000
Simple: $130,000: Compounded: $133,100

From SPCAF to SPPWF

Now we have the formula how to convert single
present amounts into future amount at a given
interest rate i.e. F = P(1+i)n
What if we are given a future amount (F) and we
are asked to calculate present worth (P) ?
F = P(1+i)n
=> P = F [1/(1+i)n]
or P = F(1+i)-n

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Single Payment Present

Worth Factor (SPPWF)

The term (1+i)n is known as Single Payment

Present Worth Factor (SPPWF)

It is also refer as P/F factor

This is a converting factor, when multiplied by F

yields the present amount P of initial amount F
after n years at interest rate i

Compounding and
Discounting
When we convert a P value into a F using some
rate we call this process . COMPOUNDING
and the rate use is called Interest rate
When we convert F into P using some rate we
call the process Discounting and the rate we
use is called Discount rate
Compounding increase your amount (as its
compounded).discounting decrease your amount
as its (discounted)

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THANK YOU

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