Debre Markos University

Institute of Technology
Department of Construction Technology and
Management

Engineering Economics
CEng 4232
 CHAPTER - ONE
1. INTRODUCTION

ECONOMICS
 The study of how limited resources is used to
satisfy unlimited human wants/needs
 A sciences deals production and consumption of
goods, services and distribution.
 Eng Economics deals with economic decision of
how to minimize cost and maximize benefits.

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 What Kinds of Questions Can
Engineering Economics Answer?

• Engineering economics is needed for many

kinds of decision making
– Example: Buying a car
• Alternatives:
– Not buying
– Buying with $18,000 now, or
– Buying for $600 per month for 3 years
• Which is better?

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 What Kinds of Questions Can
Engineering Economics Answer?

• It will help you make good decisions:

• In your professional life
• (Regardless of whether you go into the
private or public sector)
• And in your personal life!
• Knowledge of engineering economics will have
a significant impact on you personally!

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 What Kinds of Questions Can
Engineering Economics Answer?

ENGINEERING ECONOMICS INVOLVES:

FORMULATING, ESTIMATING, AND
EVALUATING ECONOMIC OUTCOMES
WHEN CHOICES OR ALTERNATIVES ARE
AVAILABLE

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 How Does It Do This?

BY USING SPECIFIC
MATHEMATICAL RELATIONSHIPS
TO COMPARE THE CASH FLOWS OF THE
DIFFERENT ALTERNATIVES
(typically using spreadsheets)

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 Where Does Engineering Economics Fit?

Here is an approach to problem-solving:

• Understand the problem
• Collect all relevant data/information
• Define the feasible alternatives
• Evaluate each alternative
• Select the “best” alternative
• Implement and monitor the decision

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 Where Does Engineering Economics Fit?

1. Understand the Problem

2. Collect all relevant data/information (difficult!)
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor This is the major role of
engineering economics

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 Where Do I Get the Data?
• Engineering economics is based mainly on estimates of future costs and
benefits:
• So it has to deal with risk and uncertainty

• The costs, benefits, and other parameters are typically unknown, and can
vary over time:
• The values of these parameters will dictate a particular numerical
outcome
• And therefore a particular decision!
• Sensitivity analysis can be used to explore how the decision changes as
our estimates change

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 Project concept /Private or Public (state)
Project is an investment plan undertaken for
particular goal or objective to be achieved within a
limited period of time and with limited resources.
• A project is characterized by :
 A construction period
 An operational period
 Expected life time
 Specific desired output
 Use of scarce and valuable resources
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 Economic Decision Making
 Straight Cost Mthod: The total expense required
for an alternative.

• Pay Back Period: The pay back period for an

investment is the number of years it takes to
repay the original invested capital

• Average Annual Rate of Return: The alternatives are

evaluated on the basis of only the average rate of
return as expressed in terms of a percentage (of the
original capital).
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 EXAMPLES
1) Straight Cost Method
- A precast concrete factory has to produce 100,000
precast beams per year.
- An economic choice has to be made between using steel
and wooden molds.
- The life of steel mold is estimated to be one year, while
that of wooden mold is one month.
-The costs of preparing one set of steel mold and one set
of wooden mold are Birr. 40,000 and Birr 5,000
respectively.
- It is further estimated that the labor costs for assembling
and removing the steel and wooden molds are Birr. 1
Birr 0.9 per precast beam respectively. 12
 Choose the best mold.
Solution
- The out of pocket commitment for steel mold
= The total labor cost incurred for production of 100,000
precast beams/yr + the cost of the steel mold/yr
=Birr. 100,000 x 1 + Birr. 40,000= Birr. 140,000.
- Out of pocket commitment for wooden mold
= Birr 0.90x100,000 + Birr 5000x12 = Birr. 150,000.
- STEEL is our Engineering Decision.

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2) Pay Back Period
- A contractor want to choose from the two brands
of excavators A and B
- Suppose both the brands are available for a
down payment of Birr. 400,000. and Both brands
can be useful for a period of four years.
- Brand A is estimated to give a return of Birr.
50,000 for the first year, Birr. 150,000 for the
second year, and Birr.200,000 for the third and
fourth year.
- Brand B on the other hand is expected to give a
return of Birr. 150,000 for all each the four years.
Which brand of excavator is preferable? 14
 Solution
- The payback period for Brand A = 3 yrs,
As the initial investment of Birr. 400,000 is
recovered in 3 years
(50,000 + 150,000 + 200,000= 400,000)
- The method does not consider the returns after
the payback period.

- For Brand B, the return is

Birr. 300,000 up to the end of 2nd year and
Birr. 450,000 3rd year
Investment Birr. 400,000 recovered between 2nd
and 3rd yr, which can be found out by
interpolation.
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Interpolate

payback period for Brand B

= 2.67 yrs or 2 years and 8 months.

- Here also as in the first case we neglect the

return that is expected beyond the pay back
period.
- Brand B better why?????

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3) Average Annual Rate of Return
We use the previous example
- The average annual return from brand A
=(50,000+150,000+200,000+200,000)/4 = 600,000/4=
150,000.

- Average annual rate of return for brand A in %=

(150,000/400,000)*100= 37.5%. Here 400,000 is
the original invested capital.

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The average annual return for brand B
=(150,000+150,000+150,000+150,000)/4
=150,000.
- The average annual rate of return for equipment
B
- = (150,000/400,000)*100= 37.5%.
- Both are equal. Here we might go for B,
Because having high initial return.

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 .

Thank you!

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0
 Interest Formulas
Simple Interest

The interest payment each year is found by multiply

the interest rate I by the principal, P
I = Pi. After any n time periods,
The accumulated value of money owed under
simple interest, Fn, would be:
F1= P + Pi
Fn = P(1 + ni)
F1= P(1+i)
F1= Total accumulated after one year For n years
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 Compound Interest
The interest payment each year, or each
period, is found by multiplying the interest rate
i by the accumulated value of money, both
principal and interest.

For an amount P invested of n periods at i rate

of interest compound interest calculations
would be: F2= F1 + F1i
F2= P(1+i) + P(1+i)i
F2= P(1+i+i+i2)
F2= P(1+2i+i2) Fn = P( 1 + i )n
F2= P(1+i)2 25
Methods of Calculating Interest (𝑖)

Source: https://goo.gl/images/S7cvRi

Time Value of Money

 Interest Rates
• Interest rates are stated for some period, like a year, while
the computation of interest is based on shorter
compounding sub-periods such as months.
• 12% per year interest compounded yearly? Or 1% per month
interest compounded monthly?

• Nominal Interest Rate:

• Is the conventional method of stating the annual interest rate.
• It is calculated by multiplying the interest rate per compounding
period by the number of compounding periods per year.
• Suppose the nominal interest rate is 𝑟 and the time period is
divided into 𝑚 equal sub-periods, then the interest rate for each
sub-period is: 𝑖𝑠 = 𝑟/𝑚
• Example: Nominal interest rate of 18% per year, compounded
monthly, implies:
• 𝑖 𝑠 ,𝑚 𝑜 𝑛 𝑡 C𝑙 𝑦 , Time Value of Money
 Interest Rates
• Effective Interest Rate:
• Is the actual but not usually stated interest rate.
• It is determined by converting a given interest rate with an arbitrary
compounding period (normally less than a year) to an equivalent
interest rate with a one-year compounding period.
• The compound interest every sub-period will be:
𝐹 = 𝑃(1 + 𝑖𝑠 )𝑚
• The effective interest rate, 𝑖 𝑒 , that yields the same future amount 𝐹
at the end of the full period from the present amount 𝑃:
𝑃 1 + 𝑖𝑠 𝑚 = 𝑃(1 + 𝑖 𝑒 )
𝑚
1 + 𝑖𝑠 = (1 + 𝑖 𝑒 )
𝑖 𝑒 = 1 + 𝑖𝑠 𝑚 −1
• To convert from a nominal rate 𝑟 to an annual effective rate:
𝑟 𝑚
𝑖𝑒 = 1 + −1
𝑚
Time Value of Money
 Interest Rates
• Example A
• A local bank announces that a deposit over $1,000 will
receive a monthly interest of 0.5%. If you leave $10,000
in this account, how much would you have at the end of
one year?
• 𝐹 =𝑃 1+𝑖 𝑛 = 10,000 ∗ 1 + 0.005 12 = 10,000 ∗ (1.062) =
10,620

• This means that over a one-year period, $620 has been

added to our money, which is the same as a 6.2%
annual interest rate.
• We can see that this is not 12 times the monthly interest
rate of 0.5% which is 6%. The difference between the
6.2% and 6% rates is the result of compounding
monthly rather than annually. Time Value of Money
 Interest Rates
• Example B
• The annual rate is 6%, and the interest is
compounded
interest quarterly. What is the quarterly nominal
interest rate? What is the effective annual interest rate if
compounded quarterly and monthly?
• Nominal Interest Rate:
𝑟 P% 𝑟 P%
• = 1.5% 𝑖 𝑠,𝑚𝑜𝑛𝑡C𝑙𝑦 = = = 0.5%
𝑖 𝑠,𝑞𝑢𝑎𝑡𝑒𝑟𝑙𝑦 = 𝑚 = Q 𝑚 GI

• Effective Interest Rate, quarterly:

• 𝑖𝑒 = 1 + 𝑖𝑠,q 𝑚 − 1= 1 + 0.015 4 − 1 = 0.0613 =
6.13%
• Effective Interest Rate, monthly:
• 𝑖𝑒 = 1 + 𝑖𝑠,𝑀 𝑚 − 1= 1 + 0.005 12 − 1 = 0.0617 =
Time Value of Money
6.17%
 Interest Rates
• Example C
• A Credit Card company charges a nominal 24% interest
on overdue accounts, compounded daily? What is the
effective interest rate?
• Assuming 365 days per year:
𝑟
• 𝑖 𝑠 ,𝑑 𝑎i𝑙 𝑦 = = 24% = 0.0006575
𝑚 365

• The effective interest rate (per year):

𝑚
• 𝑖𝑒 =1 + 𝑖𝑠,𝐷 − 1= 1 + 0.0006575 365 − 1 = 0.271 =
27.1%

Time Value of Money

 Interest Rates
• Continuous Compounding:
• Compounding can be done yearly, quarterly, monthly, daily, or even
on smaller time sub-periods.
• If the period is made infinitesimally small, the interest
will be compounded continuously.
• Continuously compounding equation:

𝑟 𝑚 𝑟 𝑚
𝑖𝑒 = 𝑒 𝑟 − 1
𝑖𝑒 = 𝑚lim
→` 1+ −1 → 𝑚lim
→` 1+ = 𝑒𝑟 →
𝑚 𝑚
• Example D
• An investment in a new stock is expected to return a
nominal interest rate of 40%, compounded
continuously. What is the effective interest rate earned
by this stock?
• 𝑖𝑒 = 𝑒 𝑟 − 1 = 𝑒X.t − 1 = 1.492 − 1 = 0.492 𝑜𝑟 49.2% Time Value of Money
Methods of Calculating Interest (𝑖)

Source: https://goo.gl/images/YyMxde

Time Value of Money

 Inflation
Inflation:
Inflation reflects the purchasing power of money.
If one birr buys less of the special commodity, e.g., sugar, as time
passes, say today (𝑥) and a year from now (𝑦) → 𝑦 > 𝑥. Thus,
𝑦 -𝑥
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝑓 = 𝑥

If 𝑦 < 𝑥, then the change is called a

deflation.
The rate of inflation or deflation depends on the
particular item under consideration.

Taxes and
Inflation
 Inflation
For a constant rate of inflation,𝑓, the buying power
referred to the base year will be:
𝑅𝑁 = 𝐴 𝑛 (1 + 𝑓 ) - 𝑛 , where

𝐴 𝑛 = Actual dollar value after 𝑛 years

𝑅𝑁 = Real or Equivalent dollars at the base year (usually Year 0)

𝑓 = Rate of inflation

𝑅𝑁 represents the constant or real dollar value:

𝑅𝑁 = 𝐴𝑛 (P/F, f, n)
In effect inflation rate and interest rate work the same
way:
Inflation rate influences the buying power of money
Interest rate influences the earning power of money
Taxes and
Inflation
36
37
38
 Effect of Inflation on the IRR
• The effect of inflation on the IRR is that the actual IRR will be the real
IRR plus an upward adjustment that reflects the effect of inflation:
• 𝐼𝑅𝑅𝐴 = 𝐼𝑅𝑅𝑅 + 𝑓 + 𝐼𝑅𝑅𝑅 ∗ 𝑓

𝐼𝑅𝑅𝑅 = 1 + 𝐼𝑅𝑅𝐴 − 1
1+𝑓
where,
𝐼𝑅𝑅𝐴 = Actual IRR, rate of return on the project on the
basis of actual dollar cash flows.
𝐼𝑅𝑅𝑅 = Real IRR, rate of return on the project on the
basis of actual real dollar cash flows.

Taxes and
Inflation
Thank you!