Engineering Economics Fundamentals: Principles, Methods & Applications
Engineering Economics Fundamentals
Introduction
Engineering Economics is the science that deals with techniques of quantitative analysis useful for selecting a preferable alternative from several technically viable ones.
Four Fundamental Principles
The four fundamental principles that must be applied in all engineering economic decisions are:
- The time value of money
- Differential (incremental) cost and revenue
- Marginal cost and revenue
- The trade-off between risk and reward
Key Concepts
Ethics
Ethics: A set of principles that guide a decision maker to distinguish between right and wrong.
Cash Flow Analysis
Cash flow analysis: The cycle of cash inflows and cash outflows that determine a business’s solvency.
Interest Rates
Market Interest Rate: The interest rate quoted by financial institutions that refers to the cost of money to borrowers or the earnings from money to lenders.
Interest Rate: The cost or price of money expressed as a percentage rate per period of time.
Interest Period: A length of time (often a year, but can be a month, week, day, hour, etc.) that determines how frequently interest is calculated.
Cash Flow Diagram
A cash flow diagram is a graphical summary of the timing and magnitude of a set of cash flows.
Simple and Compound Interest
Simple interest: The practice of charging an interest rate only to an initial sum (principal amount).
Compound interest: The practice of charging an interest rate to an initial sum and to any previously accumulated interest that has not been withdrawn.
Economic Equivalence
Economic equivalence exists between individual cash flows and/or patterns of cash flows that have the same economic effect and could therefore be traded for one another.
Effective Interest Rate
Effective Interest Rate ieff: The true value of interest rate computed by equations for compound interest for a 1-year period, regardless of the length of the compounding period.
Investment Analysis Methods
Present Worth Analysis
Principle: Are the anticipated cash inflows from a proposed project sufficient to attract investors to invest in the project?
Method: The present worth of all cash inflows is compared to the present worth of all cash outflows. The difference between the present worth of these cash flows is net present worth (NPW).
Minimum Acceptable Rate of Return (MARR): A firm’s interest rate it wants to earn on its investment.
Decision Rule:
- If PW(i) > 0, accept the investment.
- If PW(i) = 0, remain indifferent to the investment.
- If PW(i) < 0, reject the investment.
Cost of Capital: The required return necessary to make an investment project worthwhile. It is viewed as the rate of return that a firm would receive if it invested its money someplace else with a similar risk.
Risk Premium: The additional risk associated with the project if you are dealing with a project with higher risk.
Future Worth Analysis
Principle of Future Worth Analysis: Future-worth analysis calculates the future worth of an investment undertaken.
Method of Future Worth Analysis: The future worth of all cash inflows is compared to the future worth of all cash outflows. The difference between the future worth of these cash flows is net future worth (NFW).
Net Future Worth Criterion: Measures the surplus in an investment project at the end of its investment period.
Decision Rule:
- If FW(i) > 0, accept the investment.
- If FW(i) = 0, remain indifferent to the investment.
- If FW(i) < 0, reject the investment.
Net-Present-Worth Method
Net-present-worth method compares projects on the basis of converting all cash flows to a present worth. A project is acceptable if its net present worth is greater than zero.
Amortized Loans
Amortized loan: Loans that are paid off in equal installments over time, and most of these loans have interest that is compounded monthly.
In a typical amortized loan, the amount of interest owed for a specified period is calculated on the basis of the remaining balance on the loan at the beginning of the period.
Examples of installment loans include automobile loans, loans for appliances, home mortgage loans, and the majority of business debts other than very short-term loans.
Payment Split
An additional aspect of amortized loans is calculating the amount of interest versus the portion of the principal that is paid off in each installment. In calculating the size of a monthly installment, two types of schemes are common:
- Conventional amortized loan, based on the compound interest method.
- Add-on loan, based on the simple-interest concept.
Mortgages
The term mortgage refers to a special type of loan used primarily for the purpose of purchasing a piece of property such as a home or commercial building.
The mortgage itself is a legal document in which the borrower agrees to give the lender certain rights to the property being purchased as security for the loan.
Types of Mortgages
Two types of mortgages are common:
Fixed-rate mortgages offer loans whose interest rates are fixed over the period of the contract.
Variable-rate mortgages offer interest rates that fluctuate with market conditions.
Bonds
Bonds are a specialized form of a loan in which the creditor – usually a business or the federal, provincial, or local government – promises to pay a stated amount of interest at specified intervals for a defined period and then to repay the principal at a specific date, known as the maturity date of the bond.
The concept of economic equivalence can be important in determining the worth of bonds.
Bond Terminology
Par value: The stated face value on the individual bond.
Maturity date: A specified date on which the par value is to be repaid.
Bonds can be classified into the following categories: short-term bonds (maturing within three years), medium-term bonds (maturing from three to 10 years), and long-term bonds (maturing in more than 10 years).
Coupon rate: The interest paid on the par value of a bond.
Discount or premium bond: A bond that sells below its par value is called a discount bond. When a bond sells above its par value, it is called a premium bond.
Bond prices change over time because of the risk of nonpayment of interest or par value, supply and demand, and the economic outlook. These factors affect the yield to maturity (or return on investment) of the bond.
Yield to Maturity: The interest rate that establishes the equivalence between all future interest and face-value receipts and the market price of the bond.
Current Yield: The annual interest earned as a percentage of the current market price.
Project Classifications
Independent: Costs and benefits of one project do not depend on whether another is chosen.
Mutually Exclusive: A project is excluded if another is chosen.
Payback Period Method
Advantages
- Easy to understand
- Adjusts for uncertainty of later cash flows
- Reduces time spent analyzing some alternatives
Disadvantages
- Fails to measure profitability
- Ignores the time value of money
- Biased against long-term projects
Discounted Payback Period Method
Principle: How fast can I recover my initial investment plus interest?
Method: Based on the cumulative discounted cash flow.
Screening Guideline: If the discounted payback period (DPP) is less than or equal to some specified payback period, the project would be considered for further analysis.
Weakness: Cash flows occurring after DPP are ignored.
Present Worth Analysis
Principle: Are the anticipated cash inflows from a proposed project sufficient to attract investors to invest in the project?
Method: The present worth of all cash inflows is compared to the present worth of all cash outflows. The difference between the present worth of these cash flows is net present worth (NPW).