FUNDAMENTAL CONCEPTS

ENGINEERING ECONOMY
 the discipline concerned with the economic aspects of engineering, and involves
the systematic evaluation of the costs and benefits of proposed technical and
business projects and ventures.
 the analysis and evaluation of the factors that will affect the economic success of
engineering projects to the end that a recommendation can be made and will
ensure the best use of capital.

Engineering economy is used by engineers and managers to assist with decision

making in situations such as the following:
 selecting among alternative preliminary designs, or alternative detailed
designs, as part of the engineering design process
 estimating and analyzing the economic consequences of alternative
automation improvements in a factory operation.
 Selecting among proposed projects within the annual capital budget limits
established in a corporation.
 Choosing between asset lease or purchase options to support a new product
line within a company

PRINCIPLES OF ENGINEERING ECONOMY

(1) Develop the alternatives. A decision making situation involves making a
choice among two or more alternatives. Developing and defining the
alternatives for detailed evaluation is important because of the resulting
impact on the quality of the decision.
(2) Focus on the differences. Only the differences in expected future
outcomes among the alternatives are relevant to their comparison and
should be considered in the decision.
(3) Use a consistent viewpoint. The prospective outcomes of the
alternatives, economic and other, should be consistently developed from a
defined viewpoint.
(4) Use a common unit of measure. Using a common unit of measurement
to enumerate as many of the prospective outcomes as possible will make
the analysis and comparison of the alternatives easier.
(5) Consider all relevant criteria. Selection of a preferred alternative
requires the use of a criterion.
(6) Make uncertainty explicit. Uncertainty is inherent in projecting or
estimating the future outcomes of the alternatives and should be
recognized in their analysis and comparison.
(7) Revisit your decisions. Improved decision making results from an
adaptive process; to the extent practicable, initial projected outcomes of
the selected alternative and actual results achieved should be
subsequently compared.

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 THE ENGINEERING ECONOMIC ANALYSIS PROCEDURE

Performance monitoring and post-evaluation of results

Selection of the preferred alternative
Analysis and comparison of the alternatives
Selection of a criterion
Development for the net cash flow of each alternative
Development of the feasible alternatives
Problem recognition, formulation and evaluation

The Economic Environment

Consumer and Producer Goods and Services

Consumer goods and services are those products or services that are directly
used by people to satisfy their wants. Producer goods and services are used to
produce consumer goods and services or other producer goods.

Necessities and Luxuries

Necessities are those products or services that are required to support human
life and activities that will be purchased in somewhat the same quantity even though
the price varies considerably.
Luxuries are those products or services that are desired by humans and will
be purchased if money is available after the required necessities have been
obtained.

Competition, Monopoly and Oligopoly

Perfect competition occurs in a situation where a commodity or service is
supplied by a number of vendors and there is nothing to prevent additional vendors
entering the market.
Monopoly is the opposite of perfect competition. A perfect monopoly exists
when a unique product or service is available from a single vendor and that vendor
can prevent the entry of all others into the market.
Oligopoly exists when there are so few suppliers of a product or service that
action by one will almost inevitably result in similar action by the others.

The Law of Supply and Demand

Supply is the quantity of a certain commodity that is offered for sale at a
certain price at given place and time.
Demand is the quantity of a certain commodity that is bought at a certain price
at a given place and time. Elastic demand occurs when a decrease in selling price
result in a greater than proportionate increase in sales. Inelastic demand occurs
when a decrease in the selling price produces a less than proportionate increase in
sales.
The law of supply and demand states that under conditions of perfect
competition the price at which a given product will be supplied and purchased is the
price that will result in the supply and the demand being equal.
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INTEREST
Interest is the amount of money paid for the use of borrowed capital or the
income produced by money which has been loaned.

 Simple Interest is calculated using the principal only, ignoring any interest
that had accrued in preceding periods. In practice, simple interest is paid on
short-term loans in which the time of the loan is measured in days.

I = Pni
F =P+I = P+Pni
F =P(1+ni)
Where :
I = interest
P = principal or present worth
n = number of interest periods
i = rate of interest per interest period
F = accumulated amount or future worth

Ordinary simple interest is computed on the basis of 12 months of 30 days or

360 days in one year.
Exact simple interest is based on the exact number of days in a year, 365 days
for an ordinary year and 366 for a leap year.

Problems :
(1) Determine the ordinary simple interest on P27,000 for 8 months and 15
days if the rate of interest is 15%.
(2) If you borrow money from your friend with simple interest of 12%, find the
present worth of P25,000, which is due at the end of nine months.
(3) Determine the exact simple interest on P55,000 for the period from Jan. 15
to Nov. 28, 2012, if the rate of interest is 22%.

 Compound interest is calculated on the principal plus total amount of interest

accumulated in previous periods, thus compound interest means “ interest on
top of interest ”.

F = P (1+i )n

The quantity (1+i )n is called the single payment compound amount factor and
is designated by the functional symbol F/P, i%, n thus

F = P (F/P, i%, n )

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On the other hand,
P = F (1+i )-n

the quantity is called the single payment present worth factor and is
designated by the functional symbol P/F, i%, n thus

P = F (P/F, i%, n )

Rates of Interest
o Nominal rate of interest specifies the rate of interest and a number of
interest periods in one year.
i = r/m
where :
i = rate of interest per interest period
r = nominal interest rate
m = number of compounding periods per year

o Effective rate of interest is the actual or exact rate of interest on the principal
during one year.
If P1.00 is invested at a nominal rate of 15 % compounded quarterly,
after one year this will become P1.1586. The actual interest earned is P0.1586,
therefore the rate of interest after one year is 15.86%, hence
Effective rate = F1 – 1 = (1 + i) m - 1
where:
F1 = the amount P1.00 after one year

Problems :
(1) An engineer wishes to accumulate P100,000 in a savings account at the end
of 10 years. If the bank pays only 8% compounded quarterly, what should
be the initial deposit?
(2) By the conditions of a will, the sum of P250,000 is left to an heir to be held
in trust by her guardian until it amounts to P500,000. When will the girl
receive the money if the fund is invested at 9% compounded quarterly?
(3) Find the nominal rate which if converted quarterly could be used instead
of 12 % compounded monthly. What is the corresponding effective rate?

CASH-FLOW DIAGRAMS
It is a graphical representation of cash flows on a time scale. Cash flow
diagram for economic analysis problems is analogous to that of the free body
diagrams for mechanics problems.

receipt ( positive cash flow or cash inflow )

disbursement ( negative cash flow or cash outflow )

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A loan of P100 at simple interest of 10% will become P150 after 5 years.
P150

1 2 3 4
P100

Cash flow diagram on the viewpoint of the lender

P100

1 2 3 4
P150
Cash flow diagram on the viewpoint of the borrower

EQUATION OF VALUE
An equation of value is obtained by setting the sum of the values on a certain
comparison or focal date of one set of obligations equal to the sum of the values on
the same date of another set of obligations.

Illustrative Problem :
A man bought a lot worth P1,000,000 if paid in cash. On the installment basis,
he paid a downpayment of P200,000; P300,000 at the end of one year; P400,000 at the
end of three years and final payment at the end of five years. What was the final
payment if interest was 20%?

CONTINUOUS COMPOUNDING & DISCRETE PAYMENTS

In discrete compounding, the interest is compounded at the end of each finite
– length period, such as month, a quarter or a year. In continuous compounding, it is
assumed that cash payments occur once per year, but the compounding is
continuous throughout the year.

Continuous compounding ( lender’s viewpoint )

F

1 2 3 4 mn
P
n years

where :
r = nominal rate of interest per year
r/m = rate of interest per period
m = number of interest periods per year
mn = number of interest periods in n years

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 F = P ( 1 + r/m ) mn

Let m/r = k then m = rk, as m increases, so must k

( 1 + r/m )mn = ( 1 + 1/k )rkn = [ (1+ 1/k )k ]r n

the limit of ( 1 + 1/k )k as k approaches infinity is e

[ (1+ 1/k )k ]r n = e r n

thus F = Per n
P = Fe-r n

Illustrative Problem :
Compare the accumulated amounts after 5 years of P1000 invested at the rate
of 10% per year compounded (a) annually, (b) semi-annually, (c) quarterly, (d)
monthly, and (f) continuously.

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ANNUITIES
An annuity is a series of equal payments occurring at equal periods of time.
Symbols Used and their Meanings:
P = value or sum of money at present
F = value or sum of money at some future time
A = a series of periodic, equal amounts of money
n = number on interest periods
i = interest rate per interest period

Ordinary Annuity
An ordinary annuity is one where payments are made at the end of each
period.

 Finding P when A is given

1 - (1+i ) -n (1+i ) n - 1
P = A = A
i i ( 1+i ) n

The quantity in brackets is called the “uniform series present worth factor “
and is designated by the functional symbol P/A, i %, n , read as “ P given A at i
percent in n interest periods “, hence the equation can be expressed as P = A (P/A,
i%, n)

Illustrative Problem :
What is the present worth of P3500 deposited at the end of every three months
for 6 years if the interest rate is 12% compounded semi-annually?

 Finding F when A is given

(1+i ) n - 1
F = A
i

The quantity in brackets is called the “uniform series compound amount factor
“ and is designated by the functional symbol F/A, i %, n , read as “ F given A at i
percent in n interest periods “, hence the equation can be expressed as F = A (F/A,
i%, n)

Problem :
What is the accumulated amount of a 15-year annuity paying P23,000 at the
end of each year, with interest at 15% compounded annually?

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  Finding A when P is given

i
A = P
1 - (1+i ) -n

The quantity in brackets is called the “capital recovery factor “ and is

designated by the functional symbol A/P, i %, n , read as “ A given P at i percent in
n interest periods “, hence the equation can be expressed as A = P (A/P, i%, n)

Illustrative Problem :
Using a compound interest of 8%, find the equivalent uniform annual cost for
a proposed machine that has a cost of P160,000, an estimated salvage cost of P30,000
and an estimated economic life of 8 years. Annual maintenance will amount to
P2,500 a year and periodic overhaul costing P7,000 each will occur at the end of the
second and fourth year?

 Finding A when F is given

i
A = F
(1+i ) n - 1

The quantity in brackets is called the “sinking fund factor “ and is designated
by the functional symbol A/F, i %, n , read as “ A given F at i percent in n interest
periods “, hence the equation can be expressed as A = F (A/F, i%, n)

Illustrative Problem :
An engineer wishes to set up a special fund by making uniform semi-annual
end of period deposits for 20 years. The fund is to provide P100,000 at the end of
each of the last five years of the 20-year period. If interest is 8% compounded semi-
annually, what is the required semi-annual deposit to be made?

Supplementary Problems :

(1) A businessman needs P500,000 for his operations. One financial institution
is willing to lend him the money for one year at 12.5% interest per annum (
discounted ). Another lender is charging 14%, with the principal and
interest payable at the end of one year. A third financier is willing to lend
him P500,000 in 12 equal monthly installments of P46,000. Which offer is
best for him?

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 (2) The officers and board of directors of the PICE desire to award a P25,000
scholarship annually to deserving civil engineering students for as long as
its scholarship fund last. The fund was started July 1, 2000 by a donor in
the amount P180,000. The PICE invested this amount at that time at 8% per
annum and plans on adding P20,000 each year to the fund from its dues
starting July 1, 2003 for as long as awards are made.
(a) For how many years starting July 1, 2000 can scholarship be
awarded?
(b) What will be the balance in the fund after the last award is made

(3) A man purchased a house for P425,000. In the first month that he owned
the house, he spent P75,000 on repairs and remodeling. Immediately after
the house was remodeled, he was offered P575,000 to sell the house. After
some consideration, he decided to keep the house and have it rented for
P4,500 per month starting two months after the purchase. He collected
rent for 15 months and then sold the house for P600,000. If the interest rate
was 1.5% per month, how much extra money did he make or lose by not
selling the house immediately after it was remodeled?

(4) Today, you invest P100,000 into a fund that pays 25% compounded
annually. Three years later, you borrow P50,000 from a bank at 20%
annual interest and invest in the fund. Two years later, you withdraw
enough money from the fund to repay the bank loan and all interest due on
it. Three years from this withdrawal you start taking P20,000 per year out
of the fund. After five more years, you withdraw the balance in the fund.
How much was withdrawn?

Deferred Annuity
A deferred annuity is one where the first payment is made several periods
after the beginning of the annuity.

1 - (1+i ) -n
P = A (1+i )-m
i

Illustrative Problems:

(1) On the day his grandson was born, a man deposited to a trust company a
sufficient amount of money so that the boy could receive five annual payments of
P10,000 each for his college tuition fees, starting with his 18th birthday. Interest at
the rate of 12% per annum was to be paid on all amounts on deposit. There was also
a provision that the grandson could elect to withdraw no annual payments and
receive a single lump amount on his 25 th birthday. The grandson chose this option.
(a) How much did the boy receive as the single payment?
(b) How much did the grandfather deposit?
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(2) A debt of P40,000, whose interest rate is 15% compounded semiannually, is to
be discharged by a series of 10 semiannual payments, the first payment to be made
6 months after the consummation of the loan. The first 6 payments will be P6,000
each, while the remaining 4 payments will be equal and of such amount that the final
payment will liquidate the debt. What is the amount of the last 4 payments?

Perpetuity
A perpetuity is an annuity to which the payments continue indefinitely.

1 - (1+i ) -
P = A = A/i
i

Illustrative Problems :

(1) What amount of money invested today at 15% interest can provide the following
scholarships : P30,000 at the end of each year for 6 years; P40,000 for the next 6
years and P50,000 thereafter?

(2) A foundation was endowed with P10,000,000 in July 2000. In July, 2004,
P4,000,000 was expended for initial facilities, and it was decided to provide for
P1,000,000 of capital replacements at the end of every 5 th year thereafter. If all
money earns interest at 15% after the time of endowment, what annual end-of-year
perpetuity can be provided for operating expenses?

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