Module 5 Lecture 3

ENGINEERING ECONOMY

Ma. Cecilia C. Carlos

Rene D. Estember
Fundamentals of Engineering Economy

• Introduction
• Money-Time Relationships and
Equivalence
 Introduction:

• Engineering Economy is the systematic evaluation of

the economic merits of proposed solutions to
engineering problems.

• Economically acceptable solutions to engineering

problems must:
– Demonstrate positive balance of long-term benefits over
long-term costs
– Promote the well-being and survival of the organization
– Embody creative and innovative technology
– Permit identification and scrutiny of estimated outcomes
– Translate profitability to the “bottom line”
 Money-Time Equivalence

• Capital refers to wealth in the form of money or property that

can be used to produce more wealth.
 Equity capital – investment made by individuals in a business in the
hope of receiving a profit.
 Debt or Borrowed capital – money obtained from lenders for
investment.
 Interest and profit are payments for the risk of the investor

• Money has time value. A peso today does not have the
same worth two years from today because of the interest it
can earn.
• Simple interest – total interest is linearly proportional to the
principal, interest rate and interest periods (I=Prt)
• Compound interest – interest based on the remaining
principal plus any accumulated interest charges up to the
 Concept of Equivalence
• The concept of equivalence is used to compare alternatives
by reducing them to an equivalent basis that is dependent
on interest rate, amount of money involved, timing of
receipts/expenses and manner in which the interest on
invested capital is paid and the initial investment recovered
• Notations
I = effective interest rate per interest period
N = number of compounding periods
P = present sum of money; equivalent value of cashflows at a
reference point in time called the present
F = future sum of money; equivalent value of cashflows at a reference
point in time called the future
A = end-of-period cashflows in a uniform series continuing for a
specified number of periods, starting at the end of the first period
and continuing through the last period.
• Time scale – horizontal line with progression moving from
left to right
 Time Scale

F
A or inflows

0 1 2 3 ……. N

P
 Formulae
• Single Cashflow
F = P(1+i)N P = F(1+i)-N
• Annuity (Uniform Series)
[
F = A (1+i)N – 1 ] ; F = A(F/A, i%, N)
i
P = A (1+i)N – 1 ; P = A (P/A, i%, N)
i(1+i)N
• Uniform Gradient
N-1

F = G/i [Σ (1+i)k] – NG/i

k=0

A = G [1/i – N/{(1 + i)N – 1}]

P = G/i [(1+i)N – 1- Ni]/ i (1+i)N

 Applications of Money-Time Relationships
Present Worth Method (PW) – all cash flows are discounted to
the present time at a desired interest rate
Future Worth Method (FW) – equivalent worth of all cash flows
at the end of a planning horizon at a desired interest rate.
Annual Worth Method (AW) – equal annual amounts for a
given period that is equivalent to the cash flows at a desired
interest rate; it is the annual equivalent revenues minus
expenses less the annual equivalent capital amount
recovery
Internal Rate of Return Method (IRR) – solves for the interest
rate that equates the equivalent worth of an alternative’s
cash inflows to the equivalent worth of cash outflows.
Payback Method – number of years required for cash inflows
to equal cash outflows.
 Sample Problems

1. An investment of P150,000 will yield the following cash returns:

Year 1 P60,000 Year 3 80,000

Year 2 70,000 Year 4 85,000
Year 5 90,000
The investment is on an equipment with no scrap value at the end of five
years. Desired rate is 10%. Determine the following:
a. Accounting rate of return
b. Payback period
c. Net or excess present value
. d. Time adjusted rate of return

2. A proposed product modification to avoid production difficulties will

require an immediate expenditure of P140,000 to modify certain dies.
What annual savings must be realized to recover this expenditure in
five years with interest at 15% per year?
 Sample Problems
3. It is estimated that a certain piece of equipment can save $6,000 per year
in labor and material costs. The equipment has an expected life of five
years and no salvage value. If the company must earn a 15% annual
return on such investments, how much could be justified now for the
purchase of this piece of equipment?

4. A debt of P20,000 was paid for as follows: P1,500 at the end of 3 months,
P3,000 at the end of 6 months, P4,500 at the end of 9 months, P4,500 at
the end of 15 months, P3,000 at the end of 18 months, and a final
payment F at the end of 21 months. If the rate of interest was 15%
compounded quarterly, find the final payment F.

5. Equal end-of-year payments of $263.80 each are being made on a

$1,000 loan at 10% effective interest per year. How many payments are
required to repay the entire loan? Immediately after the third payment,
what lump-sum amount would completely pay off the loan?