Basics of Engineering Economics

Contents
 What is Engineering Economics?
 Engineering Economic Decisions
 Engineering Projects & Decisions
 Fundamental Principles of Economics
Time Value of Money
Contents
- Time Value of Money
- Interest Calculations

Time Value of Money

Decision Dilemma—Take a Lump Sum or

Annual Installment
Which Repayment Plan?

The Interest Rate Cash Flow Diagram

Represent time by a horizontal line marked off with the
number of interest periods specified. Cash flow diagrams
give a convenient summary of all the important elements
of a problem.

Delaying Consumption
End-of-Period Convention Simple Interest

Elements of Transactions involve

Interest (terminology)

Simple Interest Formula

Interest Calculations
Compound Interest Compounding Process

Cash Flow Diagram

Compound Interest Formula

Practice Problem (1) Interest Rate Formulas

Solution

Example
Suppose $1,500 is deposited into an IRA with an
interest rate of 4%, compounded annually. How
much money will there be after 30 years?
Example Economic Equivalence
For an interest rate of 10% compounded annually The observation that money has a time value leads us to
find how much can be loaned now if $2,000 will be an important question: If receiving $100 today is not the
same as receiving $100 at any future point, how do we
repaid at the end of 3 years?
measure and compare various cash flows? How do we
know, for example, whether we should prefer to have
$20,000 today and $50,000 in 10 years from now, or
$8,000 each year for the next 10 years?

Definition and Simple Calculations

Example-Equivalence
Suppose you are offered the alternative of receiving Example-Equivalence Calculations
either $2,007 at the end of five years or $1,500
Consider the cash flow series given in Figure 2.6.
today. There is no question that the $2,007 will be
Compute the equivalent lump-sum amount at N = 3
paid in full (i.e., there's no risk of nonreceipt).
at 10% annual interest.
Assuming that the money will not be needed in the
next five years, you would deposit the $1,500 in an
account that pays i% interest. What value of I would
make you indifferent to your choice between $1,500
today and the promise of $2,007 at the end of five
years?
Example-Solving for i Example-Find N
Suppose you buy a share of stock for $10 and sell it for You have just purchased 200 shares of General Electric
$20; your profit is thus $10. If that happens within a year, stock at $15 per share. You will sell the stock when its
your rate of return is an impressive 100% ($10/$10 = 1). If market price doubles. If you expect the stock price to
it takes five years, what would be the rate of return on increase 12% per year, how long do you expect to wait
your investment? (See Figure 2.11.) before selling the stock? (See Figure 2.12.)
Uneven-Payment Series
A common cash flow transaction involves a series of
disbursements or receipts. Familiar examples of series
payments are payment of installments on car loans and
home mortgage payments, which typically involve
identical sums to be paid at regular intervals. When there
is no clear pattern over the series, we call the transaction
an uneven cash flow series.

EXAMPLE
Tuition Prepayment Option the Tuition Prepayment
Option (TPO) offered by many colleges provides savings by
eliminating future tuition increases. When you enroll in
the plan, you prepay all remaining undergraduate tuition
and required fees at the rate in effect when you enter the
plan. Tuition and fees (not including room and board) for
the 2011-2012 academic year are $37,489 at Harvard
University. Total undergraduate tuition for an entering
freshman at this rate is $149,956. Tuition, fees, room, and
board normally increase each year, but it is difficult to
predict by how much, since costs depend on future
economic trends and institutional priorities. The following
chart lists the tuition and required fee rates since 2007:

Suppose that you enrolled in the TPO for the academic

year 2008-2009. In 2012, looking back four years from the
time of enrollment, knowing now exactly what the actual
tuitions were, do you think your decision was justified in
an economic sense to prepay "when money saved or
invested was earning" at an interest rate of 6%?
Equal-Payment
We often encounter transactions in which a uniform
series of payments exists. Rental payments. bond interest
payments, and commercial installment plans are based on
uniform payment series. Our concern is to find the
equivalent present worth (P) or future worth (F) of such a
series, as illustrated in Figure 2.14.
Example-Handling Time Shifts in an
Equal-Payment Series
In previous Example, all five de posits we’re made at the
end of each period - the first deposit being made at the
end o f the first period. Suppose that all deposits we
remade at the beginning of each period instead or
commonly known as " annuity due.” How would you
compute the balance at the end of period 5?

Example-Equal Payment Series

Suppose you make an annual contribution of $5,000 to
your savings account at the end of each year for five
years. If your savings account earns 6% interest annually,
how much can be withdrawn at the end of five years? (See
Figure 2.16.)
Sinking-Fund Factor: Find A, Given F, i, Capital-Recovery Factor (Annuity
and N Factor): Find A, Given P, i, and N

The term within the brackets is called the equal-

payment-series sinking-fund factor, or just sinking-
fund factor, and is referred to with the notation (A/F,
Now we have an equation for determining the value
i, N). A sinking fund is an interest-bearing account
of the series of end-of-period payments, A, when the
into which a fixed sum is deposited each interest
present sum P is known. The portion within the
period; it is commonly established for the purpose of
brackets is called the capital-recovery factor, which is
replacing fixed assets.
designated (A/P, i, N). In finance, this A/P factors
referred to as the annuity factor. The annuity factor
indicates a series of payments of a fixed, or constant,
EXAMPLE-College Savings Plan
amount for a specified number of periods.
You want to set up a college savings plan for your
daughter. She is currently 10 years old and will go to
college at age 18. You assume that when she starts
college, she will need at least $100,000 in the bank.
How much do you need to save each year in order to
have the necessary funds if the current rate of
interest is 7%? Assume that end-of-year deposits are
made.
Example-Paying Off an Educational EXAMPLE-Deferred Loan Repayments
Loan: Find A Suppose, in previous Example, that you want to negotiate
with the bank to defer the first loan installment until the
You borrowed $21,061.82 to finance the educational
end of year 2. (But you still desire to make five equal
expenses for your senior year of college. The loan will be
installments at 6% interest.) If the bank wishes to earn the
paid off over five years. The loan carries an interest rate of
same profit, what should be the new annual installment?
6% per year and is to be repaid in equal annual
(See Figure 2.21.)
installments over the next five years. Assume that the
money was borrowed at the beginning of your senior year
and that the first installment will be due a year later.
Compute the amount of the annual installments (Figure
2.20).
EXAMPLE Equal-Payment Series: Find EXAMPLE Start Saving Money as Soon as
P, Given A, i,and N Possible: Composite Series That Requires
Both {F/P, i, N) and {FIA, i, N) Factors
A truck driver from Georgia won Powerball, a multistate
lottery game similar to the one introduced in the chapter
opening story. The winner could choose between a single
lump sum of $116.5 million or a total of $195 million paid
out over 20 annual installments (or $9.75 million per year
and the first installment being paid out immediately). The
truck driver opted for the lump sum. From a strictly
economic standpoint, did he make the more lucrative
choice?
Present Value of Perpetuities EXAMPLE 2.16 Present Value of
A perpetuity is a stream of cash flows that Perpetuities: Find P, Given A, i, and N
continues forever. A good example is a share Consider a perpetual stream of $1,000 per
of preferred stock that pays a fixed cash year, as depicted in Figure 2.24. If the interest
dividend each period (usually a quarter of a rate is 10% per year, how much is this
year) and never matures. An interesting perpetuity worth today?
feature of any perpetual annuity is that you
cannot compute the future value of its cash
now because it is infinite. However. It has a
well-defined present value. It appears
counterintuitive that a series of cash flows
that lasts forever can have a finite value
today. So what is the value of a perpetuity?
We know how to calculate the present value
for an equal-payment series with the finite
stream as shown in Eq. (2.10). If we take a
limit on this equation by letting N=∞, we can
find the closed-form solution as follows: