1

1. ENGINEERING ECONOMICS ANALYSIS

 Engineering Economics Analysis

 Time Value Of Money

 Net Present Value (NPV)

 Internal Rate Of Return (IRR)

 Benefit-cost Analysis

 Incremental Analysis

 Depreciation

2
 1. ENGINEERING ECONOMICS ANALYSIS

Definition

The economic analysis of costs, revenues and benefits occurring over time is called
engineering economic analysis

Engineering economic analysis is used to answer many different questions like:

 Which engineering projects are worthwhile

 How to compare different ways to finance purchases (installments or upfront)

 How to make short and long-term investment decisions

3
 1. ENGINEERING ECONOMICS ANALYSIS

Cash flow The movement of money (in or out) of a project

Cash flow diagram Describes type, magnitude and timing of cash f lows
(graphical representation of cash flow)

Beginning of first year is traditionally defined as “Time 0”

In calculations
Receipts (Cash in): +ive sign
Expense (Cash out): -ive sign
Interest / Discount Used to move money through time for comparisons
Interest/ Discount rate(i) When interest is expressed as a percentage of the original
amount per unit time

The most common period or unit of time is one year

4
 1. ENGINEERING ECONOMICS ANALYSIS

Simple interest: The practice of charging an interest rate “ i ” only to an initial

sum (Principal amount “P”)
Total amount earned / due (F) = P (1 + i . n)

Compound interest: The practice of charging an interest rate to an initial sum

and to any previously accumulated interest that has not
been withdrawn
Total accrued Amount (F) =P(1+i)n

Where,
P = Value or amount of money at a time designated as the
Present or time 0
F = Compound amount (the future value of money after n periods
of time at i interest)
i = Interest rate or Discount rate (%)

n = Return period

5
 2. TIME VALUE OF MONEY
 Rs. 1,000 today will not be the same as Rs. 1,000 ten years from now
 Receiving a dollar today is always worth more to you than receiving a dollar tomorrow.

 REASONS:

1. Risk and Uncertainty :

Outflow of cash is in our control as payments to parties are made by us. Cash inflows is
dependent out on our Creditor etc.

2. Inflation:
The money received today, has more purchasing power than the money to be received in
future.

3. Consumption:
Individuals generally prefer current consumption to future consumption.

4. Investment opportunities:
An investor can profitably employ a rupee received today, to give him a higher value to be
received tomorrow or after a certain period of time.
you can use money to make more money!
6
 2. TIME VALUE OF MONEY

Identification of transaction / cash flow

Steps to solve a problem

1. Expense or Receipts
2. When it occurs (by the end of year or so)
3. Magnitude

7
 2. TIME VALUE OF MONEY

Example-1: Cash flow diagram

Starting a project with:

Initial investment = 10,000  (Expense)

Annual Return = 3,000  (Receipt)

Interest rate 6% Annual

Period = 4 Years

3,000 3,000 3,000 3,000

1 2 3 4

10,000
Total return = 3000 x 4 = 12,000 (Wrong)

Total return = 10,396 (Correct)

8
 2. TIME VALUE OF MONEY

Example-2: Suppose you invested $100,000, and withdraw total of $106,000

exactly one year later

Compute
 Interest
 Interest rate

9
 2. TIME VALUE OF MONEY

Example-3: Suppose you loan a friend $5,000 for five years at the rate 8% per
year. How much your friend Pay you in period of 5 years?

1. By Simple interest F = P ( 1 + i . n)
= 5000 ( 1+ 0.08 . 5)
= $ 7,000

2. By Compound interest F = P(1+i)n

= 5000 ( 1 + 0.08 ) 5
= $ 7,347

Comments
 The amount earned by Compound interest is $ 347 more than that of by Simple
interest

 This is the interest being earned on top of interest

10
 2. TIME VALUE OF MONEY

Simple interest vs. Compound interest

11
 2. TIME VALUE OF MONEY

Compounding vs. Discounting

12
 2. TIME VALUE OF MONEY

1. Single Payment Series

or (F/P, i %, n)

or (P/F, i %, n)

2. Equal / Uniform Payment Series

or (P/A , i %, n)

or (F/A , i %, n)

(“A” stands for Annuity, Uniform series)

Annuity—finite series of equal payments that occur at regular intervals 13

 2. TIME VALUE OF MONEY

Example-4: Finding future amount by Single Payment Series

Investment $12,000 now at 6% annual interest rate for 3 years.

 Present value = $12,000

 Interest rate = 6%
?
 Return period = 3 years
0
 Future value = ?
1 2 3
12,000

 F = 12,000 x ( 1 + 0.06 ) 3

 F = $ 14,292

14
 2. TIME VALUE OF MONEY

Example-5: Finding present amount by Single Payment Series

You will get $900 in 3 years, calculate today’s investment?
Annual Interest rate = 10%
 Future sum = $ 900

 Interest rate = 10%

 Return period = 3 years

900
 Present value = ? 0

1 2 3
?
 P = 900 / ( 1 + 0.10 ) 3

 P = $ 676.18

15
 2. TIME VALUE OF MONEY

Example-6: Finding present amount by (i) Single Payment Series

You will get $100 every year for 3 years, calculate today’s investment?
Annual Interest rate = 7%
100 100 100
 Annuity = $ 100 annually
0
 Interest rate = 7%
1 2 3
 Return period = 3 years

 Present value = ?

 Formula

 P = [100 / ( 1 + 0.07 )1] + [100 / ( 1 + 0.07 )2 ]+ [100 / ( 1 + 0.07 ) 3]

 F = $ 262.43

16
 2. TIME VALUE OF MONEY

Example-7: Finding present value by (ii) Equal / Uniform Payment Series

You will get $100 every year for 3 years, calculate today’s investment?
Annual Interest rate = 7%
100 100 100
 Annuity = $100 annually
0
 Interest rate = 7%
1 2 3
 Return period = 3 years

 Present value = ?

 Formula

 P = 100 x [ ( 1 + 0.07 )3 – 1 / 0.07( 1 + 0.07)3 ]

 F = $ 262.24

17
3. NET PRESENT VALUE (NPV)

18
 3. NET PRESENT VALUE (NPV)

NET PRESENT VALUE (NPV)

 To convert a series of cost and benefits over a period of time in a one Equivalent
time value

 If NPV (i%) > 0 then the project is deemed acceptable

 If NPV (i%) < 0 then the project is deemed unacceptable

 If the net present worth = 0 then, The project earns exactly i% return

 Its is also called Present Worth (PW), Present Value (PV), Discounted Cash Flow
(DCF)

19
 3. NET PRESENT VALUE (NPV)

Example:5 A friend needs $500 now, and will pay you back $570 in a year. Is
that a good investment when you can get 10% elsewhere?

 Present amount = 500

 Future amount = 570

 NPV = - 500 + [570 / ( 1 + 0.10 ) 1 ]

 NPV = - 500 + 518.18

570
0
 NPV = 18.18 > 0
1
500

 This investment adds $18 to the value of than a 10% investment, in today's money
market, therefore accepted

20
 3. NET PRESENT VALUE (NPV)
EXAMPLE-6: Project investment = $ 10,000
2,500 4,000 5,000 3,000 1,000
Savings (Year - 1) = $ 2,500 0
Savings (Year - 2) = $ 4,000 2 3 4
1 5
Savings (Year - 3) = $ 5,000 10,000
Savings (Year - 4) = $ 3,000
Savings (Year - 5) = $ 1,000
Discount rate = 6%
Solution: We have to discount it to Time “0”
Select Single Payment Series

PW = - 10,000 + 2,500(P/F, 6%, 1) + 4,000(P/F, 6%, 2) + 5,000(P/F, 6%, 3) + 3,000(P/F, 6%, 4)

+ 1,000(P/F, 6%, 5)
= -10,000 + 2,500 [1 / (1+0.06) 1] + 4,000 [1 / (1+0.06) 2 ] + 5,000 [1 / (1+0.06) 3 ] +
3,000 [1 / (1+0.06) 4 ] + 1,000 [1 / (1+0.06) 5 ]

= - 10,000+2,500(0.943)+4,000(0.890)+5,000(0.840) + 3,000(0.792) + 1,000(0.747)

= 3,240 > 0 (Accept this project)

Comments: This project will add the value of 3,240 more than if we invest this
amount somewhere else with the opportunity cost of 6%
21
 3. NET PRESENT VALUE (NPV)
17,000 25,000
Example:7
0
1 2 3 4 5 6 7 8 9 10 11 12
1,25,000
15,000
Select Uniform / Equal Payment Series
Investment = 1,25,000 Life span = 12 years
Savings = 17,000 Annually Interest = 8%
Maintenance = 15,000 Annually
Salvage = 25,000
Is it a beneficial investment

NPV = -1,25,000 + 17,000 (P/A, i%, n) – 15,000 (P/A, i%, n) + 25,000 (P/F, 8%, n)
NPV = - 125000 + (17000 x 7.5361) – (15000 x 7.5361) + (25000 x 0.3971)
NPV = -100,000 < 0

 This investment is $ -100,000 worst than a 8% investment, in today's money

market, therefore rejected
22
 3. NET PRESENT VALUE (NPV)

Three project categories:

 The Single Project:

NPV (i%) > 0 then the project is deemed acceptable

 Mutually Exclusive Set:

Only one of the feasible (viable) projects can be selected from the set.

 Independent Project Set:

More than one can be selected.
For one or more independent projects, select all projects with PW>0 at the MARR

Minimum Attractive Rate of Return (MARR): It is a minimum rate the company will
accept on the money it invests

23
 3. NET PRESENT VALUE (NPV)

TWO OR MORE ALTERNATIVES

 Calculate the PW of each alternative at the MARR.

 Select the alternative with PW value that is numerically largest, that is, less negative
or more positive.

 e.g. Present Worth of projects 1 and 2 are:

PW1 PW2 Selected

alternative
$ -1500 $ -500 2
-500 1000 2
2500 -500 1
2500 1500 1

24
 3. NET PRESENT VALUE (NPV)

Example:8 Electric Gas Powered(G) Solar Powered (S)

Powered (E)
Investment $ 2,500 3,500 6,000
Operating cost (Annual) $ 900 700 50

Salvage value $ 200 350 100

Life, years 5 5 5

200
Interest(i) = 10% 0

NPVE = - 2,500 – 900(P/A,10%,5) + 200(P/F,10%,5)

1 2 3 4 5
= - 2,500 – 900(3.79) + 200(0.621) 2,500 900 900 900 900 900
= - 5,786 350
0
NPVG = - 3,500 – 700(P/A,10%,5) + 350(P/F,10%,5) 5
= - 3,500 – 700(3.79) + 350(0.621) 3,500 1 2 3 4 700
= - 5,936 700 700 700 700 100
0
NPVS = - 6,000 – 50(P/A,10%,5) + 100(P/F,10%,5)
= - 6,000 – 50(3.79) + 100(0.621) 1 2 3 4 5
= -6,127 6,000 50 50 50 50 50

Result: Higher value of NPVE , therefore Electric Powered project is selected 25

 3. NET PRESENT VALUE (NPV)

DIFFERENT PROJECT LIFE

 Compare the alternatives over a period of time equal to the least common multiple
(LCM) of their lives

 E.g.

0 0

1 2 3
1 2
Project-1 Project-2

1st cycle for proj-1 2nd cycle for proj-1 3rd cycle for proj-1 1st cycle for proj-2 2nd cycle for proj-2
2 yrs 2 yrs 2 yrs 3 yrs 3 yrs
0 0

1 2 3 4 5 6 1 2 3 4 5 6
Project-1 Project-2

26
 3. NET PRESENT VALUE (NPV)

Example:9: Two lease options are available

Location-A Location-B
First cost $ 15,000 18,000
Annual lease cost $ 3,500 3,100
Deposit return $ 1,000 2,000
Lease term, years 6 9
Interest rate 15%
1,000 2,000
0 0

1 2 3 4 5 6 1 2 3 4 5 6 7 8 9
15,000 3,500 18,000
3,100
Location-A
Location-B

LCM = ? Years

= 18 years

27
 3. NET PRESENT VALUE (NPV)
Example:9: Two lease options are available

Location-A 1,000 1,000 1,000

0
1 2 3 4 5 7 8 9 10 11 13 14 15 16 17 18
6 12
15,000 15,000 15,000
3,500

NPVA = -15,000 – 15,000( P/F,15%,6) + 1,000 (P/F,15%,6) – 15,000 (P/F,15%,12)+1000(P/F,15%,12)+1000(P/F,15%,18) -

3500(P/A,15%,18)
NPVA = -15,000 – 15,000(0.4323) + 1,000 (0.4323) – 15,000(0.1869) + 1000(0.1869) + 1000(0.0808) – 3500(6.128)
NPVA = - 45,036
Location-B 2,000 2,000
0

1 2 3 4 5 6 7 8 10 11 12 13 14 15 16 17 18
18,000 9
18,000
3,100

NPVB = -18,000 + 2000(P/F,15%,9) – 18,000(P/F,15%,9) + 2000(P/F,15%,18) - 3,100(P/A,15%,18)

NPVB = -18,000 + 2000(0.2843) – 18,000(0.2843) + 2000(0.0808) - 3,100(6.128)
NPVB = - 41,384 NPVB is numerically larger therefore, lease of location B is selected 28
6. DEPRECIATION

29
 6. DEPRECIATION

 It is the reduction in value of an asset.



Methods used to calculate depreciation:

I. Straight line Method

II. Double declining balance

30
 6. DEPRECIATION

I. Straight line Method

 Most commonly used

 Each period has the same amount of depreciation expense

 Depreciation expense (Annual )= (Asset cost - Salvage value) / Useful Life

31
 6. DEPRECIATION

I. Straight line Method

Example-15
A company buys machinery for $20,000. The machinery has a salvage value of
$3,000 and an estimated useful life of 5 years.
Find a) Annual Depreciation, b) Book value after Year-1 & Year-3
Book value: Capital investment after total amount of depreciation to date have been subtracted

a) Depreciation expense = (Asset cost - Salvage value) / Useful Life

= ($20,000- $3,000) / 5 years

= $3,400 per year

b) Book value after Year-1 = 20,000 – 3400 = 16,600

Book value after Year-3 = 20,000 – [3 x 3400] = 9,800

32
 6. DEPRECIATION

II. Double declining balance

 Accelerated method

 In the beginning periods, it recognizes more depreciation but as the periods

continue it will produce less depreciation on the asset

 Depreciation expense (Year ) = (2/n) (C) (1-2/n) t – 1

 Book Value BV = C x (1-2/n) t

(where, n = useful life, C = capital cost, t = depreciation year)

33
 6. DEPRECIATION

II. Double declining balance

Example-16:
A fiber optic testing device is to be DDB depreciated. It has capital cost of $25,000
and an estimated salvage of $2,500 after 12 years
Calculate the depreciation and book value for years 1 and 4

Year-1: D1 = (2/n) (C) (1 - 2/n) t – 1

= (2/12) x (25,000) x (1 - 2/12) 1-1
= $4,167
BV1 = C x (1-2/n) t
= (25,000) x (1 - 2/12) 1
= $20,833
Year-4: D4 = (2/n) (C) (1-2/n) 4 – 1
= (2/12) x (25,000) x (1 - 2/12) 4-1
= $ 2,411
BV4 = C x (1-2/n) 4
= (25,000) x (1 - 2/12) 4
= $12,056 34
THANK YOU

35