Department of Mechanical Engineering

Bangladesh University of Engineering and Technology

ME 310
Thermo-Fluid System Design
1.5 Credit Hours

ECONOMIC CONSIDERATION
Among the most important indicators of the success of an engineering
enterprise are the profit achieved and the return on investment. Therefore,
economic considerations play a very important role in the decision-making
processes that govern the design of a system.

Because of the crucial importance of economic considerations in most

engineering decisions, it is necessary to understand the basic principles of
economics and to apply these to the evaluation of investments, in terms of
costs, returns, and profits.

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 Basic Concepts
Time Value of Money

An important concept that is fundamental to economic analysis is the effect of time on the
worth of money. The value of money increases as time elapses due to interest added on
to the principal amount.
✓ If we assume
▪ That money can always be invested in the bank (or some other reliable source)
now to gain a return with interest later
▪ That as rational actors, we never make an investment which we know to offer less
money than we could get in the bank
✓ Then
▪ Money in the present can be thought as of “equal worth” to a larger amount of
money in the future
▪ Money in the future can be thought of as having an equal worth to a lesser
“present value” of money
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SIMPLE INTEREST

The rate of interest i is the amount added or charged per year to a monetary unit.

Frequently, the interest rate is given as a percentage, indicating the amount added per
one hundred of the monetary unit.

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 Basic Compounding

The interest may be calculated several times a year and then added to the amount on which
interest is computed in order to determine the interest over the next time period.
• Suppose we invest $x in a bank offering interest rate i
• If interest is compounded annually, asset will be worth:
– $x(1+i) after 1 year
– $x(1+i)2 after 2 years
– $x(1+i)3 after 3 years
– $x(1+i)n after n years

MacKay (2008)
0 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n

$x
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 Basic Compounding

This implies that for yearly compounding, the final sum F after n years is given by
the expression

If the interest is compounded m times a year, the interest on a unit amount in

the time between two compounding is i/m. Then the final sum F, which includes
the principal and interest, is obtained after n years as

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 Continuous Compounding

The number of times per year that the interest is compounded may be increased
beyond monthly or even daily compounding to reflect the financial status of a
company or an investment at a given instant. The upper limit on the frequency
of compounding is continuous compounding, which employs an infinite number
of compounding periods over the year.

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 Effective Interest Rate

It is often convenient and useful to express the compounded interest in terms of

an effective, or equivalent, simple interest rate

It is also possible to obtain an equivalent interest rate over a number of years n.

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 TASK-1

Calculate the resulting sum F for an investment of $100 after 1, 2, 5, 10, 20,
and 30 years at a nominal interest rate of 10%, using simple interest as well as
yearly, monthly, daily, and continuous compounding. From these results, calculate
the effective interest rates over a year and also 10 years.

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Solution Procedure

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 Solution

the effective interest rates for yearly, monthly, daily, and continuous compounding are
obtained as 15.937, 17.070, 17.179, and 17.183%, respectively
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 WORTH OF MONEY AS A FUNCTION OF TIME

If I know this is coming…

x

I can borrow this from the bank now

PV(x) t
0 I’ll pay this back to the bank later
-x

The net result is that I can convert a sure x at time t

PV(x) into a (smaller) PV(x) now! t

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 0 t

If I know this cost is coming… -x

I retrieve this back from the bank later

I can deposit this in the bank now x

PV(x) t

t
PV(x) The net result is that I can convert a sure cost x at time t
into a (smaller) cost of PV(x) now!
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 Present Worth
The present worth of a given sum F may be written, for yearly compounding

If the interest is compounded m times yearly

for continuous compounding

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 Future Worth
the future worth (FW) of P after n years with an interest rate of i,
compounded yearly or m times yearly

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 TASK-2

The design of the cooling system for a personal computer requires a fan. Three
different manufacturers are willing to provide a fan with the given specifications.
The first one, Fan A, is at $54, payable immediately on delivery. The second one,
Fan B, requires two payments of $30 each at the end of the first and second
years after delivery. The last one, Fan C, requires a payment of $65 at the end
of two years after delivery. Since a large number of fans are to be purchased,
the price is an important consideration. Consider three different interest rates, 6,
8, and 10%. Which fan is the best buy?

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 Solution Procedure

Discount rate 6.00%

Cash flow

$ -$30.00
$ -$30.00

NPV ($55.00)

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Solution

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 Inflation
Inflation refers to the decline in the purchasing power of money with time
due to increase in the price of goods and services. This implies that the
return on an investment must be considered along with the inflation rate in
order to determine the real return in terms of buying power.

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 Task-3

An engineering firm has to decide whether it should withdraw an investment that pays 8%
interest, compounded monthly, and use it on a new product. It would undertake the new
product if the real rate of increase in buying power from the current investment is less than
4%. The rate of inflation is given as 3.5%. Calculate the real rate of increase in buying
power. Will the company decide to go for the new product? What should the yield from the
investment be if the company wants a 5% rate of increase in buying power?

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Solution Procedure

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Solution

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 Series of Payments
A common circumstance encountered in engineering enterprises is that of a
series of payments. Frequently, a loan is taken out to acquire a given facility
and then this loan is paid off in fixed payments over the duration of the
loan.
FUTURE WORTH OF UNIFORM SERIES OF AMOUNTS

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INTEREST FORMULAS: SERIES

Uniform Series Compound Amount Factor (F=A×Factor)

 Factor that will make your annuity value future value in series payment

 (F/A, i, n) =[(1+i)n - 1]/ i

F=A
F
0 1 2 … n

A A A A

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INTEREST FORMULAS: SERIES

Uniform Series Compound Amount Factor (F=A×Factor)

 Factor that will make your annuity value future value in series payment

 (F/A, i, n) =[(1+i)n - 1]/ i

F = A+A(1+i)
F
0 1 2 … n

A A A A

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INTEREST FORMULAS: SERIES

Uniform Series Compound Amount Factor (F=A×Factor)

 Factor that will make your annuity value future value in series payment

 (F/A, i, n) =[(1+i)n - 1]/ i

F = A + A(1+i) + … + A(1 + i )n-1

0 1 2 … n

A A A A

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Uniform Series Compound Amount Factor (F=A×Factor)

 Factor that will make your annuity value future value in series payment

 (F/A, i, n) =[(1+i)n - 1]/ i

F
0 1 2 … n

A A A A

◼ Annuity occurs at the end of the interest period

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PRESENT WORTH OF UNIFORM SERIES OF AMOUNTS

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 Task-4

$ 20,000 equipment expected to last 5 years

$ 4,000 salvage value

Minimum attractive rate of return 15%

What are the?

 A - Annual Equivalent

 P - Present Equivalent

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SOLUTION PROCEDURE

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 SOLUTION
❑A = -20,000 * (A/P, 0.15, 5) + 4,000 * (A/F, 0.15, 5)

= -20,000 * (0.2983) + 4,000 * (0.1483)

= -5,373

❑P = -20,000 + 4,000 * (P/F, 0.15, 5)

= -20,000 + 4,000 * (0.4972)

= -18,011

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 SOLUTION
❑A = -20,000 * (A/P, 0.15, 5) + 4,000 * (A/F, 0.15, 5)

= -20,000 * (0.2983) + 4,000 * (0.1483)

= -5,373

❑P = -20,000 + 4,000 * (P/F, 0.15, 5)

= -20,000 + 4,000 * (0.4972)

= -18,011

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Excel Command for Discount factor

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CONTINUOUS COMPOUNDING IN A SERIES PAYMENT

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 DEPRECIATION
An important concept with respect to the calculation of taxes is that of
depreciation. Since a given facility has a finite useful life, after which it must be
replaced, at its salvage value. In essence, an amount is allowed to be put
aside each year for its replacement at the end of its useful life. This amount is
the depreciation and is taken as an expense each year, thus reducing the
taxes to be paid by the company.

There are several approaches to calculating depreciation:

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 There are several approaches to calculating depreciation:
•Straight line depreciation:

•The sum of-years digits (SYD) :

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•Modified accelerated cost recovery method :

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 Economic Consideration of Thermo-fluid System Design

❑Cost Comparison

❑Rate of Return

❑Payback Period

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 RATES
❑Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.

❑Interest Rate
 Contractual arrangement between a borrower and a lender

❑Discount Rate (real change in value to a person or group)

 Worth of Money + Risk
 Discount Rate > Interest Rate

❑Minimum Accepted Rate of Return (MARR)

 Minimum discount rate accepted by the market corresponding to the risks of a project (i.e., minimum
standard of desirability)

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 CHOICE OF DISCOUNT RATE
r = rf + ri + rr

Where:

r is the discount rate

rf the risk free interest rate. Normally government bond
ri Rate of inflation. It is measured by either by consumer price
index or GDP deflator.
rr Risk factor consisting of market risk, industry risk, firm
specific risk and project risk
Market Risk
rr = Industry Risk
Firm specific Risk
Project Risk

GDP = Gross Domestic Product 40

 NET PRESENT VALUE (NPV)
Suppose we had a collection (or stream, flow) of costs and revenues in the
future
The net present value (NPV) is the sum of the present values for all of these
costs and revenues
 Treat revenues as positive and costs as negative

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CALCULATION OF NET PRESENT VALUE
Total Revenue (R) (+) Various Costs (C) (-)

Calculate Gross Return

Tax (-)
Calculate Net Return
Discount Rate (r)
PV of Net Return
Initial Invest (-I)
NPV of the Project

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NET PRESENT VALUE DECISION RULE
Accept a project which has 0 or positive NPV
Alternatively,
Use NPV to choose the best among a set of (mutually exclusive)
alternative projects
 Mutually exclusive projects: the acceptance of a project precludes the acceptance of one or
more alternative projects.

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 Task-5
The cash flow profiles of four independent projects are shown below. Using a MARR of
20%, determine the acceptability of each of the projects on the basis of the net present
value criterion for accepting independent projects.

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 Excel Solution

Discount rate 20.00%

Cash flow
0 -75.3 investment

$ $28.00
$ $28.00
$ $28.00
$ $28.00
$ $28.00

NPV $8.44

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SOLUTION
[NPV1]20%
= -77 + (235)(P/F, 0.2, 5) = -77 + 94.4
= 17.4 $235 M

NPV1 – Cash Flow Year 0 1 2 3 4 5

-$77 M

[NPV2]20%
= -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7
= 8.4
$28 M each year

NPV2 – Cash Flow Year 0 1 2 3 4 5

-$75.3 M
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SOLUTION
[NPV3]20%
= -39.9 + (28)(P/A, 20%, 4) - (80)(P/F, 20%, 5)
= -39.9 + 72.5 - 32.2
= 0.4 $28 M each year

NPV3 – Cash Flow

Year 0 1 2 3 4 5

-$39.9 M
-$80 M
[NPV4]20%
= 18 + (10)(P/F, 20%, 1) - (40)(P/F, 20%, 2)
- (60)(P/F, 20%, 3) + (30)(P/F, 20%, 4)
+ (50)(P/F, 20%, 5)
= 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6 $50 M
$30 M
$18 M $10 M
NPV4 – Cash Flow
Year 0 1 2 3 4 5

-$40 M
-$60 M 47
Source: Hendrickson and Au, 1989/2003
SOLUTION

[NPV1] = 17.4
[NPV2] = 8.4
[NPV3] = 0.4
[NPV4] = -1.6

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Source: Hendrickson and Au, 1989/2003
 DISCOUNT RATE IN NPV
NPV (and PV) is relative to a discount rate

In the absence of risk or inflation, this is just the interest rate of the “reliable
source” (opportunity cost)

Correct selection of the discount rate is fundamental. If too high, projects

that could be profitable can be rejected. If too low, the firm will accept
projects that are too risky without proper compensation.

Its choice can easily change the ranking of projects.

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 TASK-6

NPV = -20,000 + 5,600 (P/A, i, 5) + 4,000 (P/F, i, 5)

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RELATIONSHIP BETWEEN NPV & IRR

IRR

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 IRR INVESTMENT RULE

r = IRR, r * = MARR

“Accept a
- project with IRR larger than MARR”

Alternatively,

“Maximize IRR across mutually exclusive projects.”

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 IRR VS. NPV
Oftentimes, IRR and NPV give the same decision/ranking among projects.
IRR only looks at rate of gain – not size of gain
IRR does not require you to assume (or compute) a discount rate.
IRR ignores capacity to reinvest
IRR may not be unique

NPV

Discount Rate

Link 53
 PAYBACK PERIOD
 Payback period (“Time to return”)
 Minimal length of time over which benefits repay costs
 Typically only used as secondary assessment

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 PAYBACK PERIOD
Payback period (“Time to return”)
Minimal length of time over which benefits repay costs
Typically only used as secondary assessment
Important for selection when the risk is extremely high
Drawbacks
Ignores what happens after payback period
Does not take into account discounting

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 COMPARING PROJECTS
Financing has major impact on project selection
 Suppose that one had to choose between 2 investment projects
How can one compare them?
 Use NPV
 Verify IRR
 Check payback period

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 PROJECT EVALUATION
For an equipment, there are TWO cost elements:

1) Initial Cost, and

2) Operation & Maintenance Cost

The identification of cost elements and their sub-division are based on

the purpose and scope of the LCC study.

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 COST ELEMENT
Initial Cost:
Design & development cost,
Investment on asset, or cost of equipment,
Installation cost or erection & commission cost.

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 COST ELEMENT
Operation & Maintenance Cost:
Labor cost,
Energy cost,
Spare & maintenance cost,
Raw material cost.

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 STEPS FOR COMPUTATION OF LCC
Step 1: Determine time for each cost element,
Step 2: Estimate value of each cost element,
Step 3: Calculate Net Present Value of each element, for every year (over its time
period),
Step 4: Calculate LCC by adding all cost element, at every year,
Step 5: Analyze the results.

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 ASSIGNMENT-1
Excess amount of heat from a 10 TPH boiler is exhausted to the atmosphere
which can be recovered by using an economizer. Annual energy savings by using
an economizer would be 12,50,000 BDT. A brand new economizer would cost
15,00,000 BDT and installation cost would be around 10% of the capital cost.
Yearly maintenance cost can be assumed as 1% of the capital cost and
expected life of the economizer is 15 years. The company can invest by
borrowing from a bank with an annual interest rate of 12%. Present the detailed
financial analysis for this project (NPV, IRR, Payback period). It is assumed that
the fuel cost may increase by 10% every 3 years.

Solve it in an excel spreadsheet and send to the email address before the next class

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Thank You!

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