Engineering Economics

Overview
Module II

Purpose of the Module

In this module the learners will understand and apply time value of money , the
economic techniques to the evaluation of design and engineering alternatives in order to
construct and implement a proper economic analysis in terms of engineering economic decision
making that refers to engineering projects.

Module title and Descriptions

The module entitles Engineering Economics that consist the topics, like Money-Time
Relationships and Equivalence, Interest and the Time Value of Money, The Concept of
Equivalence and Cash Flow Diagram. In order that the learner will fully understand in computing
problems and to apply in real situation.

Module Guide

In this module, the students will engage to read other books and practice solving
problems in every topics that was given by the instructor and use internet to sort some activities
and examples. Aside from the given examples and activities in this module.

Module Outcomes

Solve problem solving and create a cash flow diagram with the knowledge a of basic
foundation of engineering economics and application of formulas given.

Module Requirements
At the end of this module, you will solve problem solving and create a cash flow diagram
with the knowledge a of basic foundation of engineering economics and application of formulas
given.
Course Pre-assessment
I. Solve the following problems and create a cash flow diagram.

1. If the interest rate on an account is 11.5% compounded yearly, approximately how many
years will it take to triple the amount?

2. Fifteen years ago $1000 was deposited in a bank account, and today it is worth $2370.
The bank pays interest semi-annually. What was the nominal annual interest rate paid
on this account?

3. A piece of machinery can be bought for $10,000 cash or for $2000 down and payments
of $750 per year for 15 years. What is the annual interest rate for the time payments?

4. How long will it take P 5.00 to be four times its value if invested at the rate of 7%
compounded semi-annually? What is the effective rate of interest?

5. A company puts $25,000 down and will pay $5000 every year for the life of a machine
(10 years). If the salvage value is zero and the interest rate is 10% compounded
annually, what is the present value of the
machine?

Key Terms
Economics – the study of the wealth, its value, creation and distribution.

Interest – the amount of money paid for the use of money called the capital for a
certain period of time.

Simple Interest – the interest to be paid which is proportional to the length of time the
principal is used.

Principal – the amount of money used on which interest is charge.

Rate of Interest – the amount of interest earned by a unit of principle in a unit period of
time.

Ordinary Interest – an interest based on the exact number of one bankers year which
is equal to 12 months.

Exact Interest – an interest based on the exact number of days, 365 days for ordinary
year and 366 days for leaf year.

Compound Interest - the interest earned by the principal which is added to the
principal will also earn an interest for the succeeding periods.
Effective interest – is the only interest rate that should be used in equivalence
equations.

Nominal Interest – is encountered when compounding is more than once per year. The
nominal rate does not include the effect of compounding and is not be the same as the
effective rate.

Cash flow - is the sum of money recorded as receipts or disbursements in a project’s

financial records.

A cash flow diagram - a graphical presentation of cash flow drawn on a time scale.
This can be drawn to help visualized and simplify problems having diverse receipts and
disbursements.

Economic equivalence is a combination of interest rate and time value of

money to determine the different amounts of money at different points in time that are
equal in economic value.

Learning Plan

Let’s try this!

I. Please write your answers on the given space below.

1. How Time and Interest Affect Money?

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II. Please choose the letter of the correct answer.

1. If you borrow money from your friend with simple interest of 12%, find the present
worth of P20, 000, which is due at the end of nine months.
A. B. C. D.

2. A man wishes his son to receive P200, 000 ten years from now. What amount
should he invest if it will earn interest of 10% compounded annually during the
first 5 years and 12% compounded quarterly during the next 5 years?
A. B. C. D.

3. By the condition of a will the sum of P25, 000 is left to be held in trust by her
guardian until it amounts to P45, 000. When will the girl receive the money if the
fund is invested at 8% compounded quarterly?
A. B. C. D.

4. At a certain interest rate compounded semiannually P5, 000 will amount to P20,
000 after 10 years. What is the amount at the end of 15 years?
A. B. C. D.

5. A man borrowed P8000 at the rate of 12% , and lent the same sum to another
person at the rate of 15% what will be the gain after 7 year ?

A. B. C. D.

6. P 50,000.00 is barrowed for 75 days at 16% per annum simple interest. How
much will be the due at the end of 75days?

A. B. C. D.

7. Fred wanted to buy refrigerator which will have a price of P 13 ,000 for 90 days
from now due to the increase in prices of 12 percent simple interest. What is the
present worth of refrigerator?

A. B. C. D.
8. If the future amount is 50 percent more than the principal after 10 months, the
simple interest rate?

A. B. C. D.

9. How many years will it take money to be 3 times itself if invested at 12%
compounded semi-annually?

A. B. C. D.
 10. A businessman wants to have P100,000 after 10 years. What amount should be
deposit in the bank now if it will earned 12 percent compounded annually for 3
years and 16 compounded semi-annually for the next 7 years?

A. B. C. D.

Let’s Learn This!

Time Value of Money (TVM)

Description: TVM explains the change in the amount of money over time
for funds owed by or owned by a corporation (or individual)

• Corporate investments are expected to earn a return

• Investment involves money
• Money has a ‘time value’

The time value of money is the most important concept in

engineering economy

Engineering Economy

 Engineering Economy involves

 Formulating
 Estimating, and
 Evaluating
 expected economic outcomes of alternatives designed to accomplish a
defined purpose

 Easy-to-use math techniques simplify the evaluation

 Estimates of economic outcomes can be deterministic or stochastic in Nature

Interest and Interest Rate (borrower’s perspective - paid)

Interest – the manifestation of the time value of money

 Fee that one pays to use someone else’s money
 Difference between an ending amount of money and a beginning amount of
money

Interest = amount owed now – principal (initial amount)

Interest rate – Interest paid over a time period expressed as a percentage of principal
 Time unit = interest period (if no interest period is stated, a 1 year interest rate is
assumed

Example

Rate of Return – ROR / Return on Investment -ROI (saver / lender / investor’s

perspective - earned)

Interest earned over a period of time is expressed as a percentage of the original

amount (principal)

Rate of return (%) = interest accrued per time unit x 100%

original amount

 Borrower’s perspective – interest rate paid

 Lender’s or investor’s perspective – rate of return earned

Example

Interest paid Interest earned

Commonly used Symbols

t = time, usually in periods such as years or months3

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 mont

Economic Equivalence
Definition: 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

How it works: Use rate i and time t in upcoming relations to move money (values of P, F
and A) between time points t = 0, 1, …, n to make them equivalent (not
equal) at the rate i

Example of Equivalence

Different sums of money at different times may be equal in economic

value at a given rate

$110

Year

0
Rate of return = 10% per year

$100 now

$100 now is economically equivalent to $110 one year from now, if the
$100 is invested at a rate of 10% per year

Simple and Compound Interest

Simple Interest

Interest is calculated using principal only

Interest = (principal)(number of periods)(interest rate)

I=P.n.i

Example: $100,000 lent for 3 years at simple i = 10% per year. What is repayment after
3 years?
 Interest = 100,000(3)(0.10) = $30,000
Total due = 100,000 + 30,000 = $130,000
Simple Interest

Example 1.
What is the annual rate of interest if P265 is earned in four months on an investment of
P15, 000?

Solution:
Let ‘n’ be the number of interest periods. Thus, on the basis of 1 year (12 mo.), the
interest period will be,
n=4/12 = 1/3

Hence, the rate of interest given by the formula, i =1/Pn , is computed as

i = P265/ (P15,000 )(1/3 )= 0.053 or 5.3%

Thus, the annual rate of interest is 5.3%

Example 2.
A loan of P2, 000 is made for a period of 13 months, from January 1 to January 31 the
following year, at a simple interest of 20%. What is the future amount is due at the end of the
loan period?

Solution: F = P ( 1+ ni )
F = P2000 [ 1 + (13/12)(0.2)]
F = P2,2433.33

Answer: F = P2,2433.33

Example 3.
Determine the exact simple interest on P5, 000 for the period from Jan.15 to Nov.28,
1992, if the rate of interest is 22%.

Given:
P= P5, 000
i= 22%
Solution:
January 15 = 16 (excluding Jan.15)
February = 29
March = 31
April = 30
May = 31
June = 30
 July = 31
August = 31
September = 30
October = 31
November 28 = 28 (including Nov.28)
318 days

Exact simple interest = Pin

= 5000×318∕366×0.22
= P955.74
Answer: P955.74

Compound Interest

The interest earned by the principal which is added to the principal will also earn
an interest for the succeeding periods.

Interest Period Principal Interest Earned Compound Amount at the period

1 P Pi P + Pi = P ( 1+I )
2 P(1+i ) P ( 1+i ) i P ( 1+I )+P ( 1+I ) = P ( 1+I )2
3 P( 1+i )2 P ( 1+i )2 i P ( 1+i )2 + P ( 1+i )2 i = P ( 1+I )3

When n = 3 F = P ( 1+i )n

0 1 2 3 n

P F = P ( 1+i )n

P = present worth of principal

F = compound amount at the end of “n” periods
i = rate of interest
n = no. of periods
n
( 1+i ) = Single Payment Compound Amount Factor
n
F = P ( 1+i )

Compound Interest Example

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

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

Total due, year 1: T1 = 100,000 + 10,000 = $110,000
Interest, year 2: I2 = 110,000(0.10) = $11,000
Total due, year 2: T2 = 110,000 + 11,000 = $121,000

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

Total due, year 3: T3 = 121,000 + 12,100 = $133,100

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

Practical Solution for the amount due the stated time in the future

F = P. (1 + i)n
$133,100 = 100,000 (1.10)3

Example

INFLATION
1
Inflation Changing value of money that is forced upon a country’s currency by
inflation.
Cost and revenue cash flow estimates increase over time.

Inflation contributes:

 A reduction in purchasing power

 An increase in the CPI (consumer price index)
 An increase in the cost of equipment and its maintenance
 An increase in the cost salaried professionals and hourly employees
 A reduction in the real rate of return on personal savings and corporate investments

Cash Flows: Terms

Cash Inflows – Revenues (R), receipts, incomes, savings generated by projects and
activities that flow in.
Plus sign used

Cash Outflows – Disbursements (D), costs, expenses, taxes caused by projects and
activities that flow out.
Minus sign used

Net Cash Flow (NCF) for each time period:

NCF = cash inflows – cash outflows = R – D

End-of-period assumption:
 Funds flow at the end of a given interest period

Cash Flows: Estimating

Point estimate – A single-value estimate of a cash flow element of an alternative

Cash inflow: Income = $150,000 per month

Range estimate – Min and max values that estimate the cash flow

Cash outflow: Cost is between $2.5 M and $3.2 M

Point estimates are commonly used; however, range estimates with probabilities
attached provide a better understanding of variability of economic parameters used to
make decisions

Cash Flow Diagrams

What a typical cash flow diagram might look like

Draw a time line

Always assume end-of-end period cash flows

Time
0 1 2 ……… n-1 n
One time
period F = $100

Show the cash flows (to approximate scale)

0 1 2 n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
- (down) for outflow
P = $-80

Example 1.

Plot observed cash flows over last 8 years and estimated sale next year for $150. Show present
worth (P) arrow at present time, t = 0

End of Year Income Cost Net Cash flow

Example 2 :
What annual interest rate must you get if you need $7000 in 4 years and have $5000 to
invest now?
Given: P = $5000, F = $7000, N = 4 years, i = ?

4
7000 = 5000(1 + i)
4
7000 / 5000 = (1 + i)
1/4
(1.4) = 1 + i
1.0878 = 1 + i
0.0878 = i = 8.78% / year
Answer: i = 8.78%
Example 3:
 A merchants puts his P2,000 to a small business for a period of six years. With a given interest
rate on the investment of 15% per year, compounded annually, how much will he collect at the end of six
years?
Given: P = P2000 i = 15% n = 6 years F=?

F=?
i = 15%

0 1 2 3 4 5 n=6
P = 2000

Solutions:
n
F = P ( 1+i )
6
F = 2000 ( 1+ .15 )
Answer
F = P4,626.00

NOTE:
In solving problems, it is easy to solve problems regarding the Equivalence of Present (P) and
Future (F) values over time (N) with interest (i). The following steps will help:

1. Identify cash flows.

2. Identify P, F, i & n.
3. Determine the missing value.
4. Solve for missing value using equation.

Let’s try this!

I. Please choose the letter of the correct answer.

1. If you borrow money from your friend with simple interest of 12%, find the present
worth of P20, 000, which is due at the end of nine months.
B. C. D.

2. A man wishes his son to receive P200, 000 ten years from now. What amount
should he invest if it will earn interest of 10% compounded annually during the
first 5 years and 12% compounded quarterly during the next 5 years?
A. B. C. D.

3. By the condition of a will the sum of P25, 000 is left to be held in trust by her
guardian until it amounts to P45, 000. When will the girl receive the money if the
fund is invested at 8% compounded quarterly?
A. B. C. D.

4. At a certain interest rate compounded semiannually P5, 000 will amount to P20,
000 after 10 years. What is the amount at the end of 15 years?
 A. B. C. D.

5. A man borrowed P8000 at the rate of 12% , and lent the same sum to another
person at the rate of 15% what will be the gain after 7 year ?

A. B. C. D.

Let’s Try Once More!

Please write the appropriate answer in the Blank.

1. ______________________ is the only interest rate that should be used in equivalence

equations.

2. ______________________ is encountered when compounding is more than once per

year. The nominal rate does not include the effect of compounding and is not be the
same as the effective rate.

3. ______________________ is the sum of money recorded as receipts or disbursements

in a project’s financial records.

4. ______________________ a graphical presentation of cash flow drawn on a time

scale. This can be drawn to help visualized and simplify problems having diverse
receipts and disbursements.

5. ______________________ is a combination of interest rate and time value of

money to determine the different amounts of money at different points in time that are
equal in economic value.

6. ______________________ the amount of money used on which interest is charge.

7. ______________________ the amount of interest earned by a unit of principle in a unit
period of time.
8. ______________________ an interest based on the exact number of one bankers year
which is equal to 12 months.
9. ______________________ an interest based on the exact number of days, 365 days for
ordinary year and 366 days for leaf year.

10. ______________________ the interest earned by the principal which is added to the
principal will also earn an interest for the succeeding periods.
Suggested Reading

Suggested Reading

 https://akademik.adu.edu.tr/fakulte/muhendislik/personel/uploa
ds/gbozturk/enr-301-lecture-1-1459249947.pdf

 https://www.valpo.edu/student/asme/FE%20Slides/EngEconSl
ides.pdf

 http://engineeringandeconomicanalysis.blogspot.com/2013/12/
economic-equivalence.html


Assessment

Please send a copy or a power point presentation of your output that you will propose
and construct a plan in Process of Decision Making with the application and evaluation
of foundation of engineering economy in this module. Thank you and God Bless!!!

References

 Basics of Engineering Economy By: Leland Blank

 Engineering Economy By: Hipolito B. Sta. Maria
 Engineering Economics By: Besavilla
 Engineering Sciences By: Ronnie S. Alcorncon