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Engineering Orientation

Engineering Economics
Engineering Economics
 Value and Interest
 Cost of Money
 Simple and Compound Interest
 Cash Flow Diagrams
 Cash Flow Patterns
 Equivalence of Cash Flow Patterns
Value and Interest
 “Value” is not synonymous with
“amount”. The value of an amount of
money depends on when the amount is
received or spent.
 First Cost is what you pay for an item
when you buy it
Value and Interest
 The difference between the anticipated
amount in the future and its current value
is called interest.
 At an interest rate of 10% what is the
value now of the expectation of receiving
$1 in one year?
Cost of Money
 Interest that could be earned if the
amount invested in a business or
security was instead invested in
government bonds or in time deposit.
Cost of Money
 Buy a car for $20,000 of your own cash
vs. US bonds returning 5%/yr ($1,000
forever)
 In effect you are paying $1,000 for ever
(even after the car is a certifiable clunker
destined for destruction)
Simple and Compound Interest
 You have a business project costing $100,000
• You get a loan for 7.5% yearly for 5 years at
simple interest payable at the end of the loan
• The loan costs $7,500 for each of five years
for a total interest of $37,500
 Total cost over 5 years = $137,500
Simple and Compound Interest

 Is the banker really willing to lend you


money for 5 years? Isn’t he also lending
you
• $7,500 for four years,
• $7,500 for three years,
• $7,500 for two years,
• $7,500 for one year
Terms and formulae
 P or PV Principal is the amount borrowed
 N # of pay periods
 r Interest rate per period
 F or FV, Future worth, value in the future of
what you have to payback
 Formulae:
• Simple interest = P(1 + Nr) ( = $137,500)
• Compound interest = P(1 + r)N ( = $143,563)
Pay periods
 Calculate FV
 Assume your loan is compounded
quarterly, monthly or daily instead of
yearly.
 Student loan of $25,000 at 8% for
• Annually for two years,
• Quarterly for two years and
• Daily for two years
Pay periods

Yearly n=1 Quarterly n=4 Dayly n=365


PV 25000 PV 25000 PV 25000
r 8% r/n 2% r/n 0.0219%
N 2 n*N 8 n*N 730
FV ($29,160.00) FV ($29,291.48) FV ($29,337.26)
N=4 N = 365
Study Examples
 Compute the effective annual interest
rate ie equivalent to 8% nominal annual
interest compounded continuously.
 Calculate the PV
Example
 What amount must be paid in two years
to settle a current debt of $1,000 if the
interest rate is 6% Annually?
Cash Flow Diagrams
Cash Flow Patterns
Example
 A new widget twister, with a life of six years, would save $2,000
in production costs each year. Using a 12% interest rate,
determine the highest price that could be justified for the
machine. Although the savings occur continuously throughout
each year, follow the usual practice of lumping all amounts at
the ends of years.
Example
 A new widget twister, with a life of six years, would save $2,000
in production costs each year. Using a 12% interest rate,
determine the highest price that could be justified for the
machine. Although the savings occur continuously throughout
each year, follow the usual practice of lumping all amounts at
the ends of years.

PV -8,222.81
FV
A 2,000.00
n 6.00
i 12.00
Example
 How soon does money double if it is
invested at 8% interest?
Example 2
 Find the value in 2002 of a bond described
as “Acme 8% of 2015” if the rate of return set
by the market for similar bonds is 10%.

PV -852.67
FV 1,000.00
A 80.00
n 14.00
i 10.00
Example
 Compute the annual equivalent
maintenance costs over a 5-year life of a
laser printer that is warranted for two
years and has estimated maintenance
costs of $100 annually. Use i = 10%.
Return on Investment
 ROI = The ratio of annual return to the
cost of the investment
 If an investment of $500,000 produces
an income of $40,000 per year, its ROI
= $40,000/$500,000 = 0.08 = 8%.
 Many successful large companies
operate with ROI’s of 15% or more

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Return on Investment
Company ROI, annual %
DOW Chemical 10.5
Exxon Mobil 22.4
DuPont 18.5
PPG Industries 20.2
Air Products 11.0
Eastman Chemical 10.9
W.R. Grace 9.8

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 Unusual Cash Flows and Interest
Periods
PAYMENTS AT BEGINNINGS OF
YEARS
 Using a 10% interest rate, find the future
equivalent of:
Cost of losing one semester
 Two students, Frank and Mary start they
Engineering Studies on the same date and
they make the commitment of retiring thirty
years after their forecasted graduation date
(the date they would graduate if no delays
are introduced). This date will not change if
any delays make any of them graduate later.
 Calculate the difference in their earnings if for
some reasons Frank is required to graduate
one semester later than what was intended.
The Model
 Assumptions:
• We have a constant inflation
• You have a yearly Salary Increase greater
than what you loose because of inflation
• Salary increases and inflation are constant
• They work for the same company their entire
carrier
Study Examples
 Your perfectly reliable friend, Frank, asks for a loan and
promises to pay back $150 two years from now. If the
minimum interest rate you will accept is 8%, what is the
maximum amount you will loan him?
• a) $119 b) $126 c) $129 d) $139
 The annual amount of a series of payments to be made
at the end of each of the next twelve years is $500. What
is the present worth of the payments at 8% interest
compounded annually?
• a) $500 b) $3,768 c) $6,000 d) $6,480
Study Examples
 Maintenance expenditures for a structure with a twenty-
year life will come as periodic outlays of $1,000 at the end
of the fifth year, $2,000 at the end of the tenth year, and
$3,500 at the end of the fifteenth year. With interest at
10%, what is the equivalent uniform annual cost of
maintenance for the twenty-year period?
• a) $200 b) $262 c) $300 d) $325
 The purchase price of an instrument is $1 2,000 and its
estimated maintenance costs are $500 for the first year,
$1 500 for the second and $2500 for the third year. After
three years of use the instrument is replaced; it has no
salvage value. Compute the present equivalent cost of
the instrument using 1 0% interest.
• a) $14,070 b) $15,570 c) $15,730 d) $16,500
Study Examples
 If $10,000 is borrowed now at 6%
interest, how much will remain to be paid
after a $3,000 payment is made four
years from now?
• a) $7,000 b) $9,400 c) $9,625 d) $9,725

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