Unit V

Introduction to Engineering Economics, Fundamental

concepts, Time value of money, Cash flow and Time
Diagrams, Choosing between alternative investment
proposals, Methods of Economic analysis (Pay back, ARR,
NPV, IRR and B/C ratio)
Engineering economy involves formulating, estimating, and evaluating the

expected economic outcomes of alternatives designed to accomplish a

defined purpose.

Economics is a social science that focuses on the production, distribution,

and consumption of goods and services, and analyzes the choices that

individuals, businesses, governments, and nations make to allocate

resources.
The steps in an engineering economy study
1. Identify and understand the problem; identify the objective of
the project.
2. Collect relevant, available data and define viable solution
alternatives.
3. Make realistic cash flow estimates.
4. Identify an economic measure of worth criterion for decision
making.
5. Evaluate each alternative; consider noneconomic factors; use
sensitivity analysis as needed.
6. Select the best alternative.
7. Implement the solution and monitor the results.
Noneconomic factors
• Market pressures, such as need for an increased international presence

• Availability of certain resources, e.g., skilled labor force, water, power, tax incentives

• Government laws that dictate safety, environmental, legal, or other aspects

• Corporate management’s or the board of director’s interest in a particular alternative

• Goodwill offered by an alternative toward a group: employees, union, county, etc

Time Value of Money (TVM) is a fundamental financial concept, stating that

the current value of money is higher than its future value, given its potential to

earn in the years to come. Thus, it suggests that a sum of money in hand is

greater in value than the same sum of money received in the next couple of

years. The idea focuses on identifying the real value of cash flows expected in

the future due to the business or individual investment decisions made from

time to time.
The financial firms use this idea of TVM for the following purposes:
•It helps in comparing the investment alternatives available in the market.
Investors assess the returns and other conditions to make a final decision
on what option to choose.
•Investors choose the best investment proposals based on the evaluation,
considering the TVM.
•Lenders decide the interest rates for loans, mortgages, etc., based on the
present and future value of an amount.
•The value of money, when known, helps in fixing appropriate wages and
prices of products.
Investment Evaluation Criteria
The capital budgeting process begins with assembling of investment proposals of different
departments of a firm. The departmental head will have innumerable alternative projects
available to meet his requirements.
Steps involved in the evaluation of an investment:
1) Estimation of cash flows
2) Estimation of the required rate of return
3) Application of a decision rule for making the choice
Investment Process
Payback period Method : This method is popularly known as pay off, pay-out,

recoupment period method also. It gives the number of years in which the total investment

in a particular capital expenditure pays back itself. This method is based on the principle

that every capital expenditure pays itself back over a number of years.
Delta Company is planning to purchase a machine known as machine X. Machine X would cost Rs. 25,000
and would have a useful life of 10 years with zero salvage value. The expected annual cash inflow of the
machine is Rs.10,000.
Required: Compute payback period of machine X and conclude whether or not the machine would be
purchased if the maximum desired payback period of Delta company is 3 years.

Solution:
Since the annual cash inflow is even in this project, we can simply divide the initial investment by the
annual cash inflow to compute the payback period. It is shown below:
Payback period = Rs.25,000/Rs.10,000
= 2.5 years
According to payback period analysis, the purchase of machine X is desirable because its payback period
is 2.5 years which is shorter than the maximum payback period of the company.
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in
its production process. For this purpose, two types of machines are available in the market – Machine X
and Machine Y. Machine X would cost Rs.18,000 where as Machine Y would cost Rs. 15,000. Both the
machines can reduce annual labor cost by Rs. 3,000.
Required: Which is the best machine to purchase according to payback method of project analysis?
(Hint: Consider the reduction in cost as equivalent to cash inflow).
Solution:
Payback period of machine X: Rs. 18,000/ Rs. 3,000 = 6 years
Payback period of machine Y: Rs. 15,000/ Rs. 3,000 = 5 years
According to payback method, machine Y is more desirable than machine X because it has a shorter
payback period than machine X.
Payback method with uneven cash flow:

When projects generate inconsistent or uneven cash inflow (i.e., different cash inflow in different periods), In

such situations, we need to compute the cumulative cash inflow and then apply the following formula:
An investment of Rs.200,000 is expected to generate the following cash inflows in six years:
Year 1: Rs. 70,000
Year 2: Rs. 60,000
Year 3: Rs. 55,000
Year 4: Rs. 40,000
Year 5: Rs. 30,000
Year 6: Rs. 25,000
Required: Compute payback period of the investment. Should the investment be made if management wants
to recover the initial investment in 3 years or less?
Solution:
(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback
period.
We can compute the payback period by computing the cumulative net cash flow as follows:
 Year Cash Inflow Cumulative Cash Inflow
1 70,000 70,000
2 60,000 130,000
3 55,000 185,000
4 40,000 225,000
5 30,000 255,000
6 25,000 280,000

Payback period = 3 + (Rs. 15,000*/ Rs. 40,000)

= 3 + 0.375
= 3.375 Years
*Unrecovered investment at start of 4th year:
= Initial cost – Cumulative cash inflow at the end of 3rd year
= Rs.200,000 – Rs.185,000
= Rs. 15,000
The payback period for this project is 3.375 years which is longer than the maximum desired payback period
of the management (3 years). The investment in this project is therefore not desirable.
 Accounting Rate of Return Method – This method is known as Accounting Rate of

Return Method / Financial Statement Method/ Unadjusted Rate of Return Method also.

According to this method, capital projects are ranked in order of earnings. Projects which

yield the highest earnings are selected and others are ruled out.
ARR = Average Net Annual profits ÷ Net Average Investment in the Project

Where,

Average Annual profits = Total Profits from the Project ÷ Life of the Project in Years

Initial Investment – Scrap Value

Net Average Investment in the Project =[ ]+ Working Capital + Scrap
2
A machine costs Rs. 10,00,000 has a 5 years life and no scrap. It is depreciated on straight
line basis. The expected net earnings after depreciation and taxes are as follows
Determine the Average Rate of Return from the following data of two machines A and B
Net Present Value (NPV) – NPV is the present value of that surplus which the
investor can earn over and above the expected rate of return

NPV is determined in the following manner:

NPV= Total PV of Cash inflow-Total PV of Cash Outflow

• The present value of any future cash inflow will be obviously less than the cash flow
itself. Such present value is therefore also known as Discounted Cash flow.
• The rate of interest which is used for determining the present value of cash flow is also
known as Discounting Rate.
• The Discounting rate indicates the expected rate of return for the investor. It is also
known as cut-off rate which indicates the minimum rate of return that is expected.
• If the investment project is capable of generating rate of return higher than cut-off rate,
then investing is such project is definitely beneficial. It indicates positive NPV.
• When NPV is positive, it indicates that the project is capable of generating rate of return
which is higher than cut-off rate.
• If NPV is positive, it indicates that the investor is earning more than expected.
• If NPV is negative, it indicates that the investor is earning less than expected.
• If NPV is Zero, it indicates that the investor is earning exactly what is expected.
• If NPV is negative, the investment proposal should not be accepted because of
rate of return of the project is less than expected rate of return.
• If NPV is Zero, the investor should accept the investment proposal because the
investor still earns that rate of return which is expected by such investor.
ILLUSTRATION
COMPUTE the net present value for a project with a net investment of ₹ 1,00,000 and net
cash flows year one is ₹ 55,000; for year two is ₹ 80,000 and for year three is ₹ 15,000.
Further, the company’s cost of capital is 10%? [PVIF @ 10% for three years are 0.909,
0.826 and 0.751]

Calculation of net present value:

ILLUSTRATION
Internal Rate of Return (IRR)

The internal rate of return or IRR is a discounting cash flow method to determine the rate of

return earned by the project excluding the external factor. By definition, IRR is the

discounting rate at which the present value of all future cash inflows is equal to the initial

investment, that is the rate at which the company investments break even.
When the cash inflows are not uniform over the life of the investment, the determination of
the discount rate can involve trial and error and interpolation between discounting rates.
However, IRR can be found out by using the following procedure:
Step 1: Discount the cash inflow at any random rate, say 10%, 15% or 20%.
Step 2: If the resultant NPV is negative, then discount cash flows again by lower discounting
rate to make NPV positive. Conversely, if resultant NPV is positive, then again discount cash
flows by higher discounting rate to make NPV negative.
Step 3: Use the following interpolation formula to calculate IRR.

Where:
LR= Lower Discount Rate
HR = Higher Discount Rate.
Calculate the Internal Rate of Return of an investment of ₹ 1,36,000 which yields the

following cash inflows:

The Internal Rate of Return is more than 10% but less than 12 %. In order to know the

exact rate, IRR can be obtained by applying interpolation formula.

Type equation here.

Acceptance Rules
Profitability Index (PI) or Benefit Cost Ratio (B/C Ratio)

Profitability Index is one of the time-adjusted technique for evaluating investment proposals.

It is also known Benefit Cost Ratio because the numerator measures benefits and the

denominator measures costs. PI is the relation between present value of future net cash

flows and the initial cash outlays and is expressed either in per rupee or in percentage. It is

computed as under.
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
PI (per rupee)= 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 (𝑐𝑜𝑠𝑡)

𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
PI (%) = 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 (𝑐𝑜𝑠𝑡)
x100
From the following information calculate NPV and PI of the project assuming that the

discount factor is 10%

Initial Investment Rs. 25,000

Cash Inflows(End of the Year)

1 10,000

2 7,500

3 12,500

4 5,000
Calculation of NPV and PI of the project assuming that the discount factor is 10%
NPV Calculation
Discount factor @
Year Cash Inflows (Rs.) PV of NCF (Rs.)
10 %
1 10,000 0.909 9,090
2 7,500 0.826 6,195
3 12,500 0.751 9,388
4 5,000 0.683 3,415
Total 28,088
Initial Investment 25,000
NPV 3,088
 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
PI (%) = 𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 (𝑐𝑜𝑠𝑡)
x100

28,088
PI (%) = x100
25,000)

PI (%) = 1.12

Hence the project is accepted because the profitability index (PI) is greater than

one.
Economics is a science that studies human behavior which aims at allocation of scarce
resources in such a way that consumer can maximize their satisfaction, producers can maximize
their profits and society can maximize its social welfare. It is about making choice in the
presence of scarcity.
1.Study of Economics is divided into two branches:
(a) Microeconomics
(b) Macro economics
1.Microeconomics studies the behavior of individual economic units. Ex-Consumer
equilibrium, producers' equilibrium, product pricing, factor pricing etc. Microeconomics is
also called price theory.
2.Macro economics studies the behavior of the economy as a whole. Ex- National income,
aggregate demand, aggregate supply, general price level, Inflation etc. Macro economics is
also called theory of income and employment.
2. Economy is a system in which people earn a living to satisfy their wants through process of
production, consumption, investment and exchange.
3.Economic problem is the problem of choice arising from use of limited means which
have the alternative use for the satisfaction of various wants.
4. Cause of economic problems are :
(a) Unlimited Human Wants
(b)Limited Economic Resources
(c) Alternative uses of Resources.
5. Central Problems of an Economy

Types of Activities
1. Economic Activities 2. Non-Economics Activities
a. Production a. Social
b. Consumption b. Religious
c. Investment c. Political
d. Exchange d. Charitable
e. Distribution e. Parental