TOPIC 1 INTRODUCTION TO ENGINEERING ECONOMY

Introduction:

Engineering Economics is the application of economic techniques to the

evaluation of design and engineering alternatives. The role of engineering economics is to
assess the appropriateness of a given project, estimate its value, and justify it from an
engineering standpoint.

Definition

Engineering economy involves the systematic evaluation of the economic merits

of proposed solutions to engineering problems (Sullivan et.al.)

Engineering economy involves formulating, estimating, and evaluating the

expected economic outcomes of alternatives designed to accomplish a defined purpose
(Blank et.al.)

Engineering economics, previously known as engineering economy, is a subset of

economics concerned with the use and application of economic principles in the analysis
of engineering decisions. As a discipline, it is focused on the branch of economics known
as microeconomics in that it studies the behavior of individuals and firms in making
decisions regarding the allocation of limited resources. It is pragmatic by nature,
integrating economic theory with engineering practice. But it is also a simplified
application of microeconomic theory in that it avoids a number of microeconomic
concepts such as price determination, competition and demand/supply. Fundamentally,
engineering economics involves formulating, estimating, and evaluating the economic
outcomes when alternatives to accomplish a defined purpose are available (Wikipedia)

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Principles of Engineering Economy

Principle 1: Develop the Alternatives

Carefully define the problem! Then the choice (decision) is among
alternatives. The alternatives need to be identified and then defined for
subsequent analysis.

Principle 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.

Principle 3: Use a Consistent Viewpoint

The prospective outcomes of the alternatives, economic and other, should be
consistently developed from a defined viewpoint (perspective).

Principle 4: Use a Common Unit of Measure

Using a common unit of measurement to enumerate as many of the
prospective outcomes as possible will simplify the analysis of the
alternatives.

Principle 5: Consider All Relevant Criteria

Selection of a preferred alternative (decision making) requires the use of a
criterion (or several criteria). The decision process should consider both the
outcomes enumerated in the monetary unit and those expressed in some
other unit of measurement or made explicit in a descriptive manner.

Principle 6: Make Risk and Uncertainty Explicit

Risk and uncertainty are inherent in estimating the future outcomes of the
alternatives and should be recognized in their analysis and comparison.

Principle 7: Revisit Your Decisions

Improved decision-making results from an adaptive process; to the extent
practicable, the initial projected outcomes of the selected alternative should
be subsequently compared with actual results achieved.

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Importance of Engineering Economics in ABE

The accreditation Board for Engineering and Technology defines engineering as

“the profession in which a knowledge of the mathematical and natural resources gained
by study, experience, and practice is applied with judgment to develop ways to utilize,
economically, the materials and forces of nature for the benefit of mankind. This
definition emphasizes not only the physical aspects of engineering, but its economic
aspects as well. As shown, engineers are confronted with the two important
interconnected environments – the physical and the economic. Engineers must be able to
manipulate the physical elements to create value in the economic environment. Any
engineering project must be not only physically realizable but also economically feasible.

Physical Economic
Environment Environment

Production
Engineering Want
or
Proposals Satisfaction
Construction

Will it work? Will it pay?

Figure 1. The bi-environmental nature of engineering

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 MONEY – TIME RELATIONSHIP

Time Value of Money

It is a well-known fact that money makes money. This is true because if we invest
money today (e.g. deposit money in a bank, or design a product, machine or structure that
will sell at a value more than what it costs), by tomorrow we will have accumulated more
money than what we had originally invested. This change in the amount of money over a
given time period is called the time value of money. The time value of money also
explains why, if you borrow money today you will have to pay in the future an amount
that is larger than what you have originally owed.

Simple and Compound Interests

Interest is the manifestation of the time value of money. It is a fee that is charged
for the use of someone else’s money. Computationally, it is a measure of the increase
between the original sum borrowed or invested, also called principal, 𝑃, and the final
amount owed or accrued, or the future sum of money, 𝐹. There are always two
perspectives to an amount of interest—interest paid and interest earned.

When money is borrowed, the interest paid is the fee charged to the borrower for
the use of the lender’s money.

When money is loaned or invested, the interest earned is the lender’s gain from
providing a good to another.

Figure 2. (a) Interest paid over time to lender. (b) Interest earned over time by investor

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Interest, then, may be defined as the cost of having money available for use (Park, 2004).
The cost of money is established and measured by an interest rate. It is the percentage of
money charged as interest.

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑢𝑛𝑖𝑡

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑟 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 (%) = 𝑥100%
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

The time unit of the rate is called the interest period. By far the most common
interest period used to state an interest rate is 1 year. For shorter time periods, the interest
period is always necessary to include, say, 1% per month. If only the rate is stated, for
example, 8.5%, a 1-year interest period is assumed.

The term interest rate paid is more appropriate for the borrower’s perspective,
while the term rate of return (ROR) earned applies for the investor’s perspective.

There are two ways to calculate the interest charged or earned: (1) simple interest
and (2) compound interest.

Simple Interest
Simple interest is defined as a fixed percentage of the principal multiplied by the
life of the loan (or the number of interest periods for which the principal is committed).
𝐼 = 𝑃𝑛𝑖
Where:
𝐼 = Simple interest
𝑃 = Principal
𝑛 = Number of interest periods (e.g. years)
𝑖 = Interest rate per interest period (expressed as decimal)

The future amount of money charged or earned after 𝑛 interest periods, 𝐹, is the sum of
the principal 𝑃 and the interest earned. Thus,

𝐹 = 𝑃+𝐼
𝐹 = 𝑃 + 𝑃𝑛𝑖
= 𝑃(1 + 𝑛𝑖)
𝐹

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Ordinary simple interest is computed on the basis of one banker’s year equivalent to 360
days (12 months, each month consisting of 30 days).
𝑑
𝐼 = 𝑃( )𝑖
360

Exact simple interest is based on the exact number of days, 365 for an ordinary and 366
for a leap year.
𝑑
𝐼 = 𝑃( )𝑖
365

Where: d= number of days in the interest period

Figure 3. Knuckles Trick Figure 4. Leap Year Test

Sample Problem 1.
Engr. Agarrado borrowed ₱60,000 from a lending firm. If the firm charges 16% simple
interest per year, how much must Engr’s payment be after: a. 15 months? b. 3 years?

Solution: Interest is expressed on a per year basis, therefore

15 𝑛 should be number of years
a. 𝐹 = 60,000 [1 + (12) 0.16] = ₱72,000

b. 𝐹 = 60,000[1 + (3)0.16] = ₱88,800

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Sample Problem 2.
Determine the exact and ordinary simple interest on ₱100,000 for the period Jan. 10 to
Aug. 25, 2018, if the rate of simple interest is 14% per year.
Solution:
d
Jan. 10-31 21
Feb 28
Mar 31
Apr 30
May 31
Jun 30
Jul 31
Aug 1-25 25
Total 227

𝑑 227
Ordinary simple interest, 𝐼 = 𝑃 ( ) 𝑖 = 100,000 ( ) 0.14 = ₱8,827.78
360 360

𝑑 227
Exact simple interest, 𝐼 = 𝑃 (365) 𝑖 = 100,000 (365) 0.14 = ₱8,706.85

Compound Interest
Whenever the interest charged for any interest period is based on the remaining principal
amount plus any accumulated interest charges up to the beginning of that period, the
interest is said to be compound. In general, if there are 𝑛 interest periods, the total
amount of money accumulated or owed (𝐹) after 𝑛 interest periods at an 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑖
compounded each period is:
𝐹 = 𝑃 (1 + 𝑖 )𝑛

Thus, compound interest means interest on top of interest.

Sample Problem 3.
Siena has one savings account with a simple interest rate of 4.5% in a credit cooperative
and one money market account with the same interest compounded annually. If she
deposits ₱60,000 for each account, how much money will she have after 3 years?

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Solution:
Savings account, 𝐹 = 𝑃(1 + 𝑛𝑖 ) = 60,000(1 + (3)(0.045)) = ₱68,100
Money market account, 𝐹 = 𝑃(1 + 𝑖 )𝑛 = 60,000(1 + 0.045)3 = ₱68,470

Valley Rendering, Inc. is considering purchasing a new flotation system for grease
recovery. The company can finance a ₱150,000 system at 5% per year compound interest
or 5.5% per year simple interest. If the total amount owed is due in a single payment at
the end of 3 years, (a) which interest rate should the company select, and (b) how much is
the difference in interest between the two schemes?

Solution:
•
𝐹 = 𝑃(1 + 𝑛𝑖 ) = 150,000(1 + (3)(0.055)) = ₱174,750
𝐹 = 𝑃(1 + 𝑖 )𝑛 = 150,000(1 + 0.05)3 = ₱173,644
∴ The company must select 5% compound interest
• ₱174,750 − ₱173,644 = ₱1,106

Cash Flow Diagram

Analogous to the free-body diagram in mechanics, a cash flow diagram is a

graphical representation of the cash flows drawn on a time scale. To conveniently clarify
or visualize situations involving the time value of money, construction of a cash flow
diagram is strongly recommended. The horizontal line represents the time scale, with
marks corresponding to time periods. Time 0 is considered to be the present time and
time 1 is the end of the first time period. Cash flows are represented by arrows: upward
pointing arrows for receipts (positive cash flows) and downward pointing arrows for
disbursements (negative cash flows). The length of the arrow is drawn proportionately
with the magnitude of the cash flow. In reality, the cash flows can occur at the beginning,
or in the middle, or at the end of an interest period, or at practically any point in time. The
end-of-period convention means that all cash flows are assumed to take place at the end
of the interest period in which they actually occur. When several inflows and outflows
occur within the same period, the net cash flow is assumed to occur at the end of the
period. The cash flow diagram is dependent on the point of view (e.g. lender versus
borrower viewpoint).

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Figure 5.(a)A typical cash flow time scale for 5 years (b) Pointing up is positive cash
flow while pointing down is negative cash flow. We will use a bold, colored arrow to
indicate what is unknown and to be determined. The arrow for the unknown value is
generally drawn in the opposite direction from the other cash flows; however, the
engineering economy computations will determine the actual sign on the F value.

Sample Problem 4.

Before evaluating the economic merits of a proposed investment, the XYZ Corporation
insists that its engineers develop a cash-flow diagram of the proposal. An investment of
₱10,000 can be made that will produce uniform annual revenue of ₱5,310 for five years
and then have a market (recovery) value of ₱2,000 at the end of year (EOY) five. Annual
expenses will be ₱3,000 at the end of each year for operating and maintaining the project.
Draw a cash-flow diagram for the five-year life of the project. Use the corporation’s
viewpoint.

Solution:

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The Concept of Equivalence

Economic equivalence is a combination of interest rate and time value of money to

determine the different amounts of money at different points in time that are equal in
economic value.
Time value of money and interest rate utilized together generate the concept of
equivalence. Equivalence means that different sums of money at different times can be
equal in economic value. Even though the amounts and the timing of the cash flows may
differ, the appropriate interest rate makes them equal. Economic equivalence is
established, in general, when we are indifferent between a future payment, or series of
future payments, and a present sum of money. Listed below are the principles of
equivalence:
1. Equivalent cash flows have the same economic value at the same point in time.
2. Cash flows that are equivalent at one point in time are equivalent at any other
point in time.
3. If cash flow A is equivalent to cash flow B and cash flow C is equivalent to cash
flow B, then cash flow A must be equivalent to cash flow C.
4. As a cash flows are converted to their equivalence from one time period to the
next, the interest rate associated with each time period must be reflected in the
calculation.
5. The actual interest rate received or paid is the interest rate that sets the equivalent
receipts equal to the equivalent disbursement.
6. If cash flow has receipts and disbursement, a point may be selected on the time
line that partitions the cash flow into two parts. At the interest rate that equates
the receipts and disbursement for the entire cash flow, the equivalent at the
boundary of the two portions of the receipts and disbursement of the other
partition (the remaining partition) with the sign reverse.

As an illustration, if the interest rate is 6% per year, ₱100 today (present time) is
equivalent to ₱106 one year from today.

𝐴𝑚𝑜𝑢𝑛𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 = 100 + 100(0.06) = 100(1 + 0.06) = ₱106

If someone offered you a gift of $100 today or $106 one year from today, it would make
no difference which offer you accepted from an economic perspective. In either case you
have ₱106 one year from today. However, the two sums of money are equivalent to each

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other only when the interest rate is 6% per year. At a higher or lower interest rate, ₱100
today is not equivalent to ₱106 one year from today.

Sample Problem 5.
Shane invested to a company which is expected to make a 28% rate of return on his
investment. (a) If he invested ₱8 million the first year, what was the amount of its profit
in that year? (b) What amount would have to be invested to realize the same monetary
amount of return if the rate decreases to 15% per year?
Solution:

𝐼 = 𝑃𝑛𝑖
= 8(1)(0.28)
= ₱2.24 million

𝑃 = 𝐼/𝑛𝑖
= 2.24
(1 × 0.15)
= ₱14.93 million

Sample Problem 6.

What is the annual rate of interest if P265 is earned in four months on an investment of
P15,000?
I=Pni, i=I/Pn = 265/ {(15000)(4/12)} = 5.3%

Sample Problem 7.

If you borrow money from your friend with a simple interest of 12%, find the present
worth of P20,000, which is due at the end of nine months.

F=P(1+ni)
P=F/(1+ni) = 20,000/{1+(9/12)0.12%} = 18,348.62

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MONEY DISCOUNTING UNDER NORMAL AND INFLATIONARY
CONDITION

Inflation is an increase in the amount of money necessary to obtain the same amount of
goods or services before the inflated price was present.

Purchasing power, or buying power, measures the value of a currency in terms of the
quantity and quality of goods or services that one unit of money will purchase. Inflation
decreases the purchasing ability of money in that less goods or services can be purchased
for the same one unit of money. The opposite of inflation is deflation.

Three different rates in understanding inflation:

1. Real or inflation-free interest rate i. This is the rate at which interest is earned
when the effects of changes in the value of currency (inflation) have been
removed. Thus, the real interest rate presents an actual gain in purchasing power.
This is the risk-free or “safe investment” rate.
2. Inflation-adjusted or market interest rate if. The interest rate that has been
adjusted to take inflation into account. This is the interest rate we hear every day.
It is a combination of the real interest rate i and the inflation rate f, and, therefore,
it changes as the inflation rate changes. It is also known as the inflated interest
rate.
3. Inflation rate f. This is a measure of the rate of change in the value of the
currency.

Inflation calculation using Constant-Value is

1
𝑃=𝐹 𝑛 , 𝑤ℎ𝑒𝑟𝑒 𝑖𝑓 = 𝑖 + 𝑓 + 𝑖𝑓
(1 + 𝑖𝑓 )

Sample Problem 8.
You expect to receive an inheritance of ₱50,000 six years from now. What is the present
worth at a real interest rate of 4% per year and an inflation rate of 3% per year?

Solution:
1 1
𝑃=𝐹 𝑛 = 50,000 = ₱33,094
(1 + 𝑖𝑓 ) (1 + (0.04 + 0.03 + (0.04 × 0.03)))6

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Sample Problem 9.
A 15-year $50,000 bond that has a dividend rate of 10% per year, payable semiannually,
is currently for sale. If the expected rate of return of the purchaser is 8% per year,
compounded semiannually, and if the inflation rate is expected to be 2.5% each 6-month
period, what is the bond worth now (a) without an adjustment for inflation, and (b) when
inflation is considered? Show both hand and spreadsheet solutions.

Solution:

(a) Without inflation adjustment: The semiannual dividend is I = [(50,000)(0.10)]∕2 =

$2500. At a nominal 4% per 6 months for 30 periods, PW = 2500(P∕A,4%,30) +
50,000(P∕F,4%,30) = $58,645
(b) With inflation: Use the inflated rate if. if = 0.04 + 0.025 + (0.04)(0.025) = 0.066 per
semiannual period PW = 2500(P∕A,6.6%,30) + 50,000(P∕F,6.6%,30) = 2500(12.9244) +
50,000(0.1470) = $39,660

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ACCOUNTING STANDARDS

Accounting Principles

For communicating the results of business to outside world, it should be based on certain
uniform and scientifically laid down principles or postulates.
Accounting principles mean those rules of conduct or procedures which are adopted by
accountants universally while recording the accounting transactions to ensure uniformity,
clarity and understanding while recording transactions.

Accounting Concepts
Accounting Concepts are those basic assumptions or conditions upon which accounting is
based. Important accounting concepts are:

• Business Entity Concept – Entity is different from its owner for accounting
purposes. Dual
• Aspect Concept – Recording simultaneously debits credits.
𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝐴𝑠𝑠𝑒𝑡𝑠
• Cost Concept – Assets are normally recorded basis of historical cost i.e.
acquisition cost. Market value immaterial, except on concepts of revaluation.
• Going Concern Concept – Always on anticipation that a business will continue for
long and will not be liquidated.
• Accounting Period Concept – Though business continues indefinitely, life of
business sub-divided into accounting periods (generally of 1 year).
• Money Measurement Concept – Those transactions which are expressed in money
terms are only recorded.
• Realization Concept - Revenue is recognized only when, an agreement is reached
or sale is made. Exceptions may be on certain businesses such on HP/sale on
contract etc.
• Constant Value Concept - Assumption of constant value of currency e.g. rupee.
• Accrual Concept - Under this concept, the effects of transactions and other events
are recognized on mercantile basis i.e. when they occur (and not as cash received
or paid).
• Consistency – In order to achieve comparability of the financial statements of an
enterprise through time, the accounting policies are followed consistently from the
one period to another. A change in accounting policy is made only in certain
exceptional circumstances.
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Fundamental Accounting Assumptions are: Going Concern, Consistency, and Accrual. If
nothing has been mentioned about fundamental accounting assumptions in the financial
statements then it is assumed that they have already been followed in the preparation of
financial statements. However, if any of the above-mentioned fundamental accounting
assumption is not followed then this fact should be disclosed.

Accounting Standards

Accounting Standards (Ass) are written policy document issued by expert accounting
body or by government or regulatory body covering the aspects of recognition, treatment,
measurement, presentation and disclosure of accounting transaction and events in the
financial statements. It provides framework and standard accounting policies so that
financial statements of different enterprises become comparable. It seeks to ensure that
the financial statements of an enterprise should give a true and fair view of its financial
position and working results. It does not only prescribe appropriate accounting treatment
of complex business transactions but also foster greater transparency and market
discipline.

Accounting Standards promote: Uniformity. Rationalization. Comparability.

Transparency.

International Accounting Standards (IAS)

International Accounting Standards (IAS) were the first international accounting

standards. Its goal is to make businesses comparison easier even across countries,
increase transparency and trust in financial reporting, and foster global trade and
investment.
• International Accounting Standards Committee (IASC) was constituted in 1973 to
formulate accounting standards.
• Barring Canada, Japan and US all countries have accepted these standards.
• To give proper direction and interpretations Standards Interpretations Committee
was formed in 1997.
• IASB was constituted in 2001 to prescribe norms for treatment of several items on
preparation and presentation of financial statements.

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 • ISAB adopted all 41 standards issued by IASC.
• The US Financial Accounting Standards Board (FASB) and IASB are in process
of eliminating differing in some standards. IASB publishes its Standards in a
series of pronouncements called International Financial Reporting Standards
(IFRSs). It has also adopted the body of Standards issued by the Board of the
International Accounting Standards Committee (IASC).
• Those pronouncements are designated "International Accounting Standards"
(IASs).

International Financial Reporting Standards (IFRS) of IAS

IAS # DESCRIPTION IAS # DESCRIPTION

1 Presentation of Financial 26 Accounting and Reporting by
Statements. Retirement Benefit Plans.
2 Inventories 27 Consolidated and Separate Financial
Statements
7 Cash Flow Statements 28 Investments in Associates
8 Accounting Policies, Changes in 29 Financial Reporting in
Accounting Estimates and Errors Hyperinflationary Economies
10 Events After the Balance Sheet 31 Interests in Joint Ventures.
Date
11 Construction Contracts 32 Financial Instruments: Presentation
12 Income Taxes 33 Earnings per Share
16 Property, Plant and Equipment 34 Interim Financial Reporting.
17 Leases 36 Impairment of Assets
18 Revenue 37 Provisions, Contingent Liabilities
and Contingent Assets.

19 Employee Benefits 38 Intangible Assets

20 Accounting for Government Grants 39 Financial Instruments: Recognition
and Disclosure of Government and Measurement.
Assistance.
21 The Effects of Changes in Foreign 40 Investment Property
Exchange Rates
23 Borrowing Costs 41 Agriculture
24 Related Party Disclosures

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Generally Accepted Accounting Principles (GAAP)

• To avoid confusion and to achieve uniformity, accounting process is applied within the
conceptual framework of ‘Generally Accepted Accounting Principles’ (GAAP).
• The Financial Statements of entity cannot be said to be showing a true and fair view,
unless these Financial Statements have been drawn up on GAAP.
• GAAP consist of four components.
o The requirements of law.
o The judgments by courts of law.
o Pronouncement by the governing bodies (Like ICAI, FASB in US).
o Requirements of regulatory authority (Like RBI, SEBI, SEC in US).
• GAAPs are the backbone of the accounting information system, without which whole
system cannot even stand erectly.
• GAAPs and Accounting Standard are considered as the theory base of accounting.

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USE OF FEASIBILITY ANALYSIS SOFTWARE ADOPTING IAS STANDARDS

Bytex Feasibility Analyzer, version 5.18

A Software for Quick Preparation of Any Feasibility Study Employing International

Accounting Standards (IAS)

Software Features: User-friendly with tutorial, help in all windows, prints inputs & outputs,
PSAE award-winner

Major Software Inputs: 1. Project information and assumptions 2. Quantities, units,

descriptions, unit prices and shadow prices of (a) investments, (b) operating costs and (c)
benefits 3. Software-guided inputs to feasibility discussions

Major Software Outputs: 1. Values of the financial and economic feasibility indicators (Net
Present Value, Internal Rate of Return, Benefit-Cost Ratio, Return on Investment, Payback
Period) Annuity and remark which specifies if project is feasible or not 2. Life cycle cash flow
3. Financial and economic sensitivity analyses 4. Amortization schedule 5. Project feasibility
discussions – Project Summary, Market Feasibility, Technical Feasibility, Financial
Feasibility, Socio-Economic Feasibility and Management Feasibility

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