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UNIT-I

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Decisions made by engineers, managers, corporation presidents, and

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individuals are commonly the result of choosing one alternative over
another.

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Decisions often reflect a persons educated choice of how to best invest
funds; capital

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Amount of capital is usually restricted (how to invest to add value?)
Engineers play a major role in capital investment decisions based on their
analysis fundamentally, engineering economy involves formulating,
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estimating and evaluating the economic outcomes when alternatives to
accomplish a defined purpose are available.
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Engineering Economy
A collection of mathematical techniques that simplify economic
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comparison and assist people in making decisions Since decisions affect

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what will be done, the time frame of engineering economy is primarily

the future Numbers used in engineering economy analysis are best
estimates of what is expected to occur Estimates often involve three
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essential elements: cash flows time of occurrence interest rates

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Sensitivity Analysis
Stochastic nature of estimates will likely make the observed value in
future differ from the estimate made now. Sensitivity analysis is
performed during the engineering economic study to determine how the
decision might change based on varying estimates.

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Problem Identified; Objective Defined
Alternative 1 Alternative 2

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New Equipment

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Upgrade Old Equipment
Description & Information
Description &Information

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Cash Flows over time period
Cash Flows over time period

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Analysis by Eng.
Econ. Model
Analysis by Eng. no
Econ. Model
Income and Cost Estimates
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Financial Strategies
Tax Laws
Evaluated
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Alternative 1
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Evaluated
Alternative 2
Noneconomic attributes to be considered
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Implement
Alternative 1
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Time Value of Money

Interest Rate
Measure of Worth
Calculated Value of
Measure of Worth

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Cash Flows
The estimated inflows (revenues) and outflows (costs) of money

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Analysis

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Computations considering the time value of money on cash flows to
obtain a measure of worth

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Time Value of Money
Cash flows occur over a substantial period of time. How can we treat the
same amount of money available at different times?

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What is the value of this investment?
012345
Years no
$100 $100 $100 $100 $100$490
500 - 490 = $10?
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NO!!! DUE TO TIME VALUE OF MONEY

Economic Equivalence
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The observation that money has a time value leads us to: How do we
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compare various cash flows dispersed over the time horizon?

Economic equivalence exists between cash flows that have the same
economic effect and therefore be traded for one another in financial
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marketplace.
Economic Equivalence refers to the fact that: any cash flow - whether a
single payment or a series of payments - can be converted to an
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equivalent cash flow at any point in time.And that equivalence depends

on the interest rate.
Interest
1 Manifestation of time value of money
2 Computationally, Ending amount of money - Beginning amount of
oney

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3 Two perspectives to an amount of interest
1 Interest Paid: when money is borrowed and repaid as a larger amount

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2 Interest Earned: when money is invested and obtained back as a larger

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value
4 Interest Rate (%)= interest accrued per unit time/ original amount

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x100
5 The time unit of the rate is the interest period.
6 Interest period of the interest rate should always be stated (1 % per

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month).
Otherwise assume 1 year interest period.
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UNIT-II

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So far we know simple and compound interest; compound interest

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includes interest on the interest earned in the previous period When
interest is compounded more than once each year, the terms nominal and
effective must be considered.

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Nominal Interest Rate, r
Interest rate that does not include any consideration of compounding.

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r =interest rate per period x number of periods
A nominal rate r can be stated for any time period.
Nominal rate of r = 2% per month is equal to
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2% _ 12 months = 24% per year
2% _ 3 months = 6% per quarter
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2% _ 0.231 month = 0.462% per week

Effective interest rate is the actual rate that applies for a stated period of
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time. (The actual mount of interest that will accumulate in a stated period
of time.)
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The compounding of interest during the time period of the corresponding

nominal rate is accounted for by the effective interest rate.
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Effective interest rate is commonly expressed on an annual basis as the

effective rate, ia, but any time basis can be used.
Effective rate has the compounding frequency attached to the nominal
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rate statement (4% per year, compounded monthly)

If compounding frequency is not stated, it is assumed to be the Same as
the time period of r, i.e. compounding 1 time during the time period
All the interest formulas, factors, tabulated values must have the
effective interest rate to properly account for the time value of money.

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Therefore, we should know how to calculate the effective interest rate
value for any nominal or effective rate statement Annual Percentage Rate

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(APR) and Annual Percentage Yield (APY) can be used as instead of

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nominal and effective interest rates in practice.

There are always three time-based units associated with an interest rate

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statement.
Time Period- The period over which the interest is expressed. It is the t in

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the statement of r% per time period t (1% per month) Compounding
Period- the shortest time period over which interest is charged or earned.
(8% per year compounded monthly, therefore CP is month)
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Compounding frequency- the number of times that m compounding
occurs within the time period t. If the compounding period (CP) and the
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time period t are the same, the compounding frequency is 1 (1% per
month compounded monthly.)
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Example
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Consider the rate 8% per year compounded monthly.

Time period = 1 year
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Compounding period = 1 Month

Compounding frequency = 12 times per year

So far all the interest rates used have t and m as 1 year (8% per year).
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The effective and nominal rates were the same. It is common practice to
express the rates on the same time basis as the compounding period.

icp(Nominal Rate per CP) = r % per time period t/m compounding

per t =r/m

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Example

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Assume r = 9% per year, compounded monthly, then m = 12 and the effective

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rate per the compounding period is found as 9% 12 = 0.75% per month,
compounded monthly.

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NOTE: Changing the basic time period t does not alter the compounding
period, month in the previous example.

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Whenever time period = compounding period, stated nominal rate is an
effective rate. Therefore, icp is the effective rate per CP too.
For the Effective Annual Interest rate, time period t is year, and the
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compounding period can be any time unit less than a year.
Effective interest rate at any point during the year includes the interest
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rate of all previous compounding periods during the year.
Derivation of the effective annual interest rate formula directly parallels
the logic of the future worth relation F = P(1 + i)n.
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Rewrite the formula as F = P(1 + ia), since interest can be compounded

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many times a year.

The rate icp per CP must be compounded through all m years to find the
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total effect of compounding by the end of year.

Economic evaluation of an alternative requires cash flow estimates over a

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stated time period and a criterion for selecting the best alternative The
alternatives are developed from project proposals to accomplish a stated
purpose Some projects can be economically or technologically viable,
some are not After the viable projects stand out among the others, these
are the alternatives to evaluate In formulating alternatives;
1 Mutually Exclusive: Only one of the viable projects can be selected

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2 Independent: More than one viable project may be selected do-nothing (DN)
option can be another alternative; no new costs or revenues.

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Mutually exclusive alternatives compete with each other, best alternative

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is selected Independent projects compete with the do-nothing alternative
instead of another project

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If there are m independent projects; one, two or more of them can be
selected. (2m selections!)
Let we have m = 3, and three independent alternatives are {A, B,C}

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Then we have 23 = 8 possible selections: {DN, A, B,C, AB, AC, BC, ABC}
Assumption: No budget limit!
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It is important to recognize the nature or type of alternatives before
starting evaluation
Cash flows determine whether the alternatives are revenue-based or
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service-based
1 Revenue-Based: Each alternative generates cost and revenue cash flow
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estimates and possibly savings

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2 Service-Based: Each alternative has only cost cash flow estimates Revenues
or savings are not dependent on alternatives Revenues or savings are assumed to
be equal among alternatives
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Mostly public (government) initiatives Evaluation on based on cost

estimates All alternatives evaluated in an engineering economy study
must be of the same type
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Basic procedure for applying the Present Worth (PW) criterion:

1 Determine the interest rate (i) that the firm wishes to earn on its investments. i
= MARR is usually given to us.

2 Estimate the service life (n) of the project

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3 Estimate the cash inflow for each period over the service life

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4 Estimate the cash outflow for each period over the service life

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5 Determine the net cash flows (An) for each period (net cash flow = cash

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inflow - cash outflow)

6 Find the present worth of each net cash flow at MARR. Add up these present-

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worth figures; their sum is defined as the projects

The cash flows in a capitalized cost calculation are usually of two types:
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1 Recurring
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2 Nonrecurring

The following procedure assists in calculating the CC for an infinite

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sequence of cash flows.

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1 Draw a cash flow diagram for all nonrecurring cash flows and at
least two cycles of all recurring cash flows
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2 Find the present worth of all nonrecurring amounts. This will be

their CC value
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3 Find the equivalent uniform annual worth (A) through one life cycle of all
recurring amounts. Add this to all other uniform amounts occurring in years 1
through infinity and the result is total equivalent uniform annual worth (AW)

4 Divide the AW obtained at step 3 by i to obtain a CC value

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5 Add the CC values obtained in steps 2 and 4

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So far we learned PW and FW as comparison tools
AW analysis is said to be the best comparison tool.

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AW value is the equivalent uniform annual worth of all estimated receipts
and disbursements during the life cycle of the project or alternative AW

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value is equivalent to the PW and FW values at the MARR for n years
AW = PW(A/P, i, n) = FW(A/F, i, n)
where

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n is the number of years for equal-service comparison.

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When all cash flow estimates are converted to an AW value, this
value applies for: every year of the life cycle for each additional life cycle
The prime advantage of AW analysis is:
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1 AW value has to be calculated for only one life cycle

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2 not necessary to use the LCM of lives as it is for PW and FW.

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When alternatives being compared have different lives, the AW

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method makes the assumption that:

1 The service provided by alternatives will be needed for at least the
LCM of years or more
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2 The selected alternative will be repeated over each life cycle of the
LCM in exactly the same manner

3 The cash flow estimates will be the same in every life cycle Along with the
PW and AW criteria, the third primary measure of worth is rate of return

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Mostly preferred over PW and AW criteria. Ex: an alternatives
worth can be reported as:

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15% rate of return on the investment (EXACT!)

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will result in a net surplus of $10,000 in terms of PW at 10% MARR
(return > 10% is known only)

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ROR is also known as
Internal Rate of Return (IRR)
Return on Investment (ROI)

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UNIT-III

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Rate of Return: Definition 1

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is the rate (100% to 1) paid on the unpaid balance of borrowed
money

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The rate of return is calculated on the unrecovered balance not the
initial amount of investment.

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Resolution of Multiple Rates of Return
To understand the nature of multiple i_s, we need to understand the
investment situation represented by any cash flow. The net-investment test will
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indicate whether the computed i_ (by setting ROR equation equal to 0)
represents;
the true rate of return earned on the money invested in a project while the
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money isactually in the project.

Net-Investment Test
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The multiple i_s occurs only when the net-investment test fails. In such
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a case, none of the computed i_s is an IRR.

Therefore, only the investments with cash flow series that has a unique i_
may pass the net-investment test.
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Net-Investment Test
A project is said to a net-investment when
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1 the project balances computed at projects i_ values, PB(i_)n are

all less than or equal to zero throughout the life of the investment

2 with A0 < 0 (actually PB0 = A0)

The investment is net in the sense that the firm does not overdraw on
its return at any point and hence is not indebted to the project. These

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investments are called pure investments.

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Simple investments will always be pure investments

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If a Non-Simple investment passes the net-investment test
1 It is a pure investment

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2 Has a unique i_ values

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3 this i_ value = IRR of the investment

If any of the project balances computed at projects i_ is positive, the

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project is a mixed investment. A positive balance indicates that, at some point
during the projects life, the firm acts as a borrower [PB(i_)n > 0] rather than an
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investor [PB(i_)n < 0] in the project

Inflation is a reality that we deal with nearly everyday Inflation rate is

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sensitive to real, as well as perceived, factors of the economy Cost of

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energy interest rates political stability

The annual inflation rate is closely watched and historically analyzed by
overnment agencies and industrial corporations An engineering study can
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have different outcomes in an environment where inflation is significant

It is vital that the effects of inflation be integrated into an economic
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analysis.
Inflation
is an increase in the amount of money necessary to obtain the same
amount of product or service before the inflated price was present.
Sources of inflation are:

Money Supply: too much money in the system decrease its value

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Exchange rate: effects the profitability of international companies,

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prices may be raised in other markets to compensate.

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Cost-Push: Increase in cost is pushed" to the prices by the

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manufacturers.

Demand-Pull: With increase in demand, prices of the goods and

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services riser.

There are three important rates: no

1 Real or inflation-free interest rate: i Rate at which interest is earned when the
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effects of changes in the value of currency is removed Represents an actual gain
in purchasing power
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2 Inflation-adjusted interest rate: if is the interest rate that has been adjusted to
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take inflation into account also called market interest rate, the one we hear every
day is a combination of the real interest rate and inflation
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3 Inflation rate: f is a measure of the rate of change in the value of the currency
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UNIT-IV

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Deflation is the opposite of inflation.

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When deflation is present, the purchasing power of monetary unit is
greater in the future than at the present time.
Temporary price deflation may occur in specific sectors of the economy

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due to:
introduction of improved products cheaper technology imported materials

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or products However, if deflation occurs at a more general level,
nationally accompanied by the lack of money for new capital
fewer jobs, less credit, fewer loans tighter money situation prevails
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Tighter money brings less money commitment to industrial investments
And could and would bring Depression One of the most commonly performed
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engineering economy studies is that of replacement or retention of an asset or
system that is currently installed.
Differs from previous studies where all alternatives are new
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The question is "Should the current system or asset be replaced

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now or later?"
Replacement study is an application of AW method of comparing
unequal-life alternatives.
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The need for a replacement study can develop from several

resources:
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Reduced performance: due to physical deterioration

Altered requirements: New requirements for ac
The terminology that is used in Replacement Studies:
Defender: Currently installed asset
Challenger: Is the potential best alternative to replace the
defender

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AW values are used for both the defender and challenger. The term
EUAC (equivalent uniform annual cost) is also used instead of AW since

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often only the cost are used in the evaluation.

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Economic Service Life (ESL) for an alternative is the number of years at
which the lowest AW of cost occurs. The ESL establish the life n for the

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challenger and defender.
Defender first cost is the current market value (MV) for the
defender.

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Using the book value or the trade-in values as the first cost are incorrect
applications. If defender needs to be upgraded or augmented to make it
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equivalent to the challenger, this upgrade or augmentation cost must be
added to the defender first cost.
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A replacement study is performed from the viewpoint of an external
consultant:
Neither alternative is owned Services from defender is purchased now
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with an investment of defenders current Market Value.

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As mentioned, replacement study is an application of the annual worth

method. If the planning horizon is unlimited, the assumptions are as
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follows:
1 The services provided are needed for the indefinite future
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2 The challenger is the best challenger available now and in thefuture to replace
the defender

3 Cost estimates for every cycle of the challenger will be the

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Economic Service Life (ESL)
is the number of years n at which the equivalent uniform annual worth

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(EUAW) of costs is the minimum, considering the most current cost estimates

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over all possible years that the asset may provide a needed service.

ESL is also referred to as the minimum cost life.

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Once determined the ESL should be the estimated life for the asset.

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The ESL should be calculated for both the challenger and defender since
they are not provided mostly Some basic tax terms and relations useful in
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engineering economy studies are explained here.
Gross Income, GI: is the total income realized from: revenue-producing
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sources, and sale of assets, royalties, license fees.
Income tax: is the amount of taxes that must be delivered to the
government.
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Taxes are actual cash flows.

Operating Expenses, E: are all corporate costs incurred in the transaction
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of business.
These expenses are tax deductible for corporations.
Annual Operating Costs, Maintenance and Operations Costs are
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examples.
Taxable Income, TI: is the amount upon which taxes are based.
For corporations, depreciation is tax deductible.
TI = Gross Income Expenses Depreciation
= GI E D.
Dr. There are many other tax bases for taxes other than income:

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Sales Tax,
Value-added Tax,

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Import Tax,

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Property Tax
Net Cash Flow, NCF: was defined as cash inflows minus cash outflows

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for a period.
The annual NCF was used in PW, FW, AW and ROR methods.
Now we are expanding our terminology in the presence of taxes and

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depreciation.
NCF is replaced by the term Cash Flow Before Taxes, CFBT.
We will introduce the term Cash Flow After Taxes, CFAT.
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Both CFBT and CFAT are actual cash flows.
Analysis with CFAT
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Once CFAT estimates are developed, the economic evaluation is
performed using the same periods and selection guidelines applied previously,
only this time, CFAT estimates are utilized
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