AASTU, Engineering Economics Chapter 1

Course name:
• Engineering Economics (CEng5201)

The Course objectives are to:
• Understand the basic concepts of Engineering
economics.
• Understand the time value of money.
• Understand the concepts behind benefit-cost
analysis.
• Understand the concept of depreciation.
AASTU, Engineering Economics chapter 1 1

Lecture One

CHAPTER ONE
Basic Principles in
Engineering Economics

Introduction to Engineering Economics.
• Economics
• Mankiw’s definition
• is the study of how society manages its scarce resources
• Hedrick’s definition
• ……is how society chooses to allocate its scarce resources among
competing demands to improve human welfare
• McConnell
• concerned with the efficient use limited to achieve maximum satisfaction
of human wants
• Alternative definitions
• … concerned with doing the best with what we have
• … how best to use limited means in the pursuit of unlimited ends
• … is the study of choice.
• Economics is a social science that studies how to allocate
scarce resources in the production and distribution of goods
and services so as to attain the maximum fulfillment of
society’s material wants.
• Engineering is the profession in which a knowledge of the

mathematical and natural sciences gained by study,
experience, and practice is applied with judgment to develop
ways to utilize, the materials and forces of nature
economically for the benefit of mankind.
• 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.
• Engineering economics is entirely involved with evaluating

the comparison of alternatives that involve spending money
in hopes of earning more.
.

 The purpose of engineering economics is to study whether any

project or investment is financially desirable.
Suppose you are an engineer(PM) setting up a new Asphalt plant

in A.A. Then
 There are various problems that are related to the money.
 For instance, you can lease or buy the land, quarry site, and you
can make or purchase machines.
 These monetary problems constitute the engineering economics.

• Engineering Economy is about making decisions
• It is based on the systematic evaluation of the costs and

benefits of proposed technical projects
• The principles and methodology of engineering economy are

utilized to analyze alternative uses of financial resources,
particularly in relation to the physical assets and the
operation of an organization.

Decision making process
The decision-making process for engineering project

development includes the following basic steps:
1. Defining the problem
2. Establishing objectives and criteria
3. Generating alternative plans and designs
4. Evaluation and choice
5. Implementation and control

Role of Engineering Economy in Decision Making
• Engineering economy is just a set of tools:

• It can help in decision making but it will not make the
decision for you
• However, which alternative is “best” is up to you
 Understand the Problem

 Collect all relevant data/information
 Define the feasible alternatives
 Evaluate each alternative
 Select the “best” alternative
 Implement and monitor

• Typical decision situations encountered
 Selection of one design out of several competing designs
 Selection of one construction methodology out of several
construction methodologies.
 Replacement decisions
 Investment decisions ? Risky investment with high returns vs
safe investment with low returns
 Allocation of funds for few public projects out of several
competing projects
 Selection of a project out of several competing projects
• A set of estimates are made based on selection criteria that is

numerically valued and called “Measure of Worth” such as:
 Present worth: amount of money at the current time
 Future worth: amount of money at some future time
 Payback period: Number of years to recover the initial
investment and a stated rate of return
 Rate of return: Compound interest rate on unpaid or
unrecovered balances
 Benefit/cost ratio
Time Value of Money
•

Time value of money
• Change in the amount of money (due to the

impact of interest or cost of money) over time
is called time value of money.
• The “value” of money depends on the

amount and when it is received or spent.
Interest
Interest is the difference between an ending amount of money and

the beginning amount
There are two types of interest:

 Interest paid: when a person borrows money and repays a larger
amount
 Interest revenue/earned: when a person saved, invested, or lent
money and obtains a return of a larger amount
Numerical values are the same for both yet they are different in
interpretation
Interest paid Interest earned
Interest rate Rate of return
AASTU, Engineering Economics chapter 1 1-16

Interest Paid
•

Interest Earned
• Interest earned = total amount now – original amount
• Interest earned over a specific period of time is

expressed as a percentage of the original amount and is
called rate of return (ROR) and is computed from the
following:
Interest accrued per time unit

Rate of Return (%) = Original amount x 100%

Examples:
•

Example:
2. A company plans to borrow 20,000 birr from a bank for 1
year at 9% interest for a new recording equipment.
Compute the interest and the total amount due/owing after
1 year.
Soln:
Interest = 20,000 x 0.09 = 1,800 Birr
Total amount due = 20,000 + 1,800 = 21,800 Birr
3. Calculate the amount deposited 1 year ago to have 1,000
birr now at an interest rate of 5% per year and also
calculate the amount of interest earned during this time
period.
Soln:
P=952.38 and
I=47.62 AASTU, Engineering Economics chapter 1 20
Simple Interest
Interest that is computed only on the original sum
or principal
Total interest earned(I)
I=P*i*n
Where
P – present sum of money
i – interest rate
n – number of periods (years)
Eg. P=100 ETB, i=7%, n=2 years what is I?
Answer:
I = 100 ETB x .07/yr period x 2 yr periods = 14
ETB
Examples:
•

Future Value of a Loan with Simple Interest
•
Interest
F = 100 ETB(1 + 0.07 x 2) = 114 ETB

• Would you accept payment with simple interest terms?
• Would a bank?

Compound Interest
Interest that is computed on the original unpaid debt and the
unpaid interest
 Interest = (principal + all accrued interest) (interest rate)
Total interest earned = In = P (1+i)n - P
Where
P – present sum of money, i – interest rate
n – number of periods (years)
P at time 0 increases to P(1+i)n at the end of time n.
Or a Future sum = present sum (1+i)n
Year Beginning balance Interest for Ending

period balance
1 P iP P(1+i)
2 P(1+i) iP(1+i) P(1+i)2
3 P(1+i)2 iP(1+i)2 P(1+i)3
n P(1+i)n-1 iP(1+i)n-1
AASTU, Engineering Economics chapter 1
P(1+i)n 24
Simple and Compound Interest
• In the previous examples, the interest period was 1 year and
the interest amount was calculated at the end of one period
• When more than one interest period is involved (e.g. after 3
years), it is necessary to state whether the interest is accrued
on a simple or compound basis from one period to the next
• In simple interest:
Interest = (principal) × (number of periods) × (interest rate)
I=Pxnxi  Total amount due = P + I =P(1+ni)
• Compound interest: it is the interest that accrued for each
interest period and is calculated on the principal plus the total
amount of interest accumulated in all previous periods
 Total amount due = P(1 + i)n

Example
1. If an engineer borrows 1,000 ETB at 10% per year
compound interest, compute the total amount due after 3
years
Soln:
• Year 1 interest: 1,000 × 0.1 = 100
Total amount due after year 1 = 1,000 + 100 = 1,100
• Year 2 interest: 1,100 × 0.1 = 110
Total amount due after year 2 = 1,100 + 110 = 1,210
• Year 3 interest: 1,210 × 0.1 = 121
Total amount due after year 3 = 1210 + 121 = 1331
Total amount due = 1,000x(1 + 0.10)3 = 1,331 ETB
Compounded: 1,331 Simple: 1000+1000*0.1*3=1,300

Effective Interest Rates
• Suppose that you deposited 1,000 Birr in a savings account at
the beginning of a year where the annual interest rate is 18%
• What would be the future worth?

• What would be the future worth if the interest is compounded
monthly?
 Compounding yearly
F = P(1+i)n = 1000(1+0.18)1 = 1180Birr

 When compounding monthly
 For each month, we have an interest rate of 0.18/12 = 1.5%
F = P(1+i)12 = 1,000(1+0.015)12 = 1,195.61Birr
Thus, the annual effective interest rate =in/p

= {(1,195.61 – 1,000)/1000}*100
= (195.65/1000)*100% = 19.565%
Thus,
 We have an annual interest rate of 18% compounded monthly
Or
 We have monthly interest rates of 1.5% for 12 months
Or
 We have a 19.56% interest rate compounded annually

Nominal interest rate: this is the annual interest rate. It does
not consider any compounding
Effective interest rate: the actual rate that should be
considered for the payment period
Let
r = nominal interest rate per year (or per payment period)
m = number of compounding periods per year (or per
payment period)
i = effective interest rate per compounding period
ia = effective interest rate per year (or per payment period)


Example:
• Find the amount after 10 years for the given cash flow
diagram if the interest rate is 12% per year compounded semi
annually
Solution
• r=12%, m=2  ia=(1+12/2)2-1 = 12.36%
• F = 1,000(F/P,12.36%,10)+3,000(F/P,12.36%,6)
+1,500(F/P,12.36%,4) = $11,634
An alternative way is as follows:
• F = 1,000(F/P,6%,20)+3,000(F/P,6%,12)+1,500(F/P,6%,8)
= $11,634
Inflation
• Inflation represents a decrease in the value of a given

currency
For instance, 1 Ethiopian birr (ETB) now will not

purchase the same number of mangoes as 1 ETB did 15
years ago
• Interest rates reflect two things: real rate of return plus the
expected inflation rate

Example:
• You have 10,000 birr and you want to buy a 10,000 birr
machine
• Suppose that you can invest money at 6% interest, but the price
of the machine increases only at an annual rate of 4% due to
inflation. In a year, you can still buy the machine and you will
have 200 birr left over (earning power exceeds inflation)
• If the price of the machine increases at an annual rate of 8%

instead, you will not have enough money to buy the machine a
year from today. In this case, it is better to buy it today
(inflation exceeds earning power)

Equivalence
 Different sums of money at different times can be
equal in economic value.
 For example: if the interest rate is 6% per year, a
100 ETB today (present time) would be equivalent to
106 ETB one year from today.
 Also, 100 ETB today is equivalent to 94.34 ETB one
year ago.
 Therefore, 94.34 ETB last year, 100 ETB now, and
106 ETB one year from now are equivalent when
the interest rate is 6% per year
How soon does your money double if it is saved at bank
at 8% interest?

Lecture Two

Cash Flows
• The sums of money recorded as receipts or disbursements in a
project's financial records are called cash flows.
• Cash flows represent the flow or movement of money at some
specific time over some period of time.
• To financially analyze engineering projects, we need to model
the projects in terms of cash flows.
• Cash Outflows – Disbursements (D), costs, expenses, taxes
caused by projects and activities that flow out. Minus sign used
• Cash Inflows – Revenues (R), receipts, incomes, savings
generated by projects and activities that flow in. Plus sign used
• Net Cash Flow (NCF) for each time period:
NCF = Cash inflows – cash outflows = R – D
• An engineering project can be viewed as an account with
outflows and inflows
• Cash flow movements can be visually displayed through use of
a cash flow diagram
Cash Flow Diagram [CFD]
• A cash flow diagram is a picture of a financial problem that
shows all cash inflows and outflows plotted along a
horizontal time line
• The cash flows over time are represented by arrows at
relevant periods: upward arrows denote positive flows and
downward arrows denote negative flows
• Arrows represent net cash flows since two or more values at
the same time are summed and shown as a single arrow

CFD
• Generally, the start of the diagram represents the beginning of
the interest period
 When t = 0, this is the present

 When t = 1, this is the end of the first year
A typical cash flow time scale for 5 years

CFD
• The figure illustrates a receipt (cash inflow) at the end of year 1 and
equal disbursements (cash outflows) at the end of years 2 and 3
Example of positive and negative cash flows

Cash flows are shown as directed arrows:
• Positive (+) or (up) for inflow
• Negative (-) or (down) for outflow

Fig. Cash flow diagram Fig. Simplified cash flow diagram

Exercises:
1. You borrowed 10,000 ETB from a bank to purchase a laptop.
The bank requires you to make 12 equal monthly payments
of 950birr to pay off the loan. Draw a cash flow diagram
2. A company spent 2,500 ETB on a new compressor 7 years

ago. The annual income from the compressor has been 750
ETB. Additionally, the 100 ETB spent on maintenance during
the first year has increased each year by 25 ETB. The
company plans to sell the compressor at the end of next year
for 150 ETB. Construct the cash flow diagram from the
company’s perspective.

Types of Cash Flows
 Cash flow transactions can be generally classified into five
general categories:
1. Single cash flow
2. Uniform series
3. Linear gradient series
4. Geometric gradient series, and
5. Irregular series

P-Pattern “present”
1 2 3 n
F-Pattern “future”
1 2 3 n
A-Pattern “annual”
1 2 3 n
G-Pattern “gradient”
1 2 3 n
 Compounding Future value of money
 Discounting Present value of money
1. Single Cash Flow
• The simplest case involves the equivalence of a single

present amount and its future worth
• Thus, the single-cash-flow formulas deal with only two
amounts: a single present amount P and its future worth F

Single-Payment Factors
• We know that the amount of money F accumulated after n years

from a present worth P with interest compounded one time per
year is given by the following equation
► F = P(1+i)n
 The factor (1+i)n is called the single-payment compound amount
factor (SPCAF) (compounding factor) and is usually referred to
as the F/P factor
► P=F(1+i)-n
 The factor (1+i)-n is known as the single-payment present worth
factor (SPPWF) (Discounting factor) or P/F factor
• Note that single payment means that only one payment or receipt
is involved

Single…cont
• A standard notation has been adopted for all factors and is
always in the general form (X/Y,i,n)
• The letter X represents what is sought, while the letter Y
represents what is given
• For example, F/P means find F when given P
• Thus, (F/P, 6%, 20) represents the factor that is used to calculate
the future amount F accumulated in 20 periods if the interest
rate is 6% per period. P is given

Examples:
1. 2,500 ETB at time zero is equivalent to how much
after six years if the interest rate is 8% per year?
2. 3,000 ETB at the end of year seven is equivalent to
how much today (time zero) if the interest rate is 6%
per year?
Soln:
1. F=2500(F/P,8%,6)=2500(1+0.08)6 = 3967 ETB
2. P=3000(P/F,6%, 7)=3000(1+0.06)-7 = 1995 ETB

Example:
3. The office supplies for an engineering firm for different years
were as follows: Year 0: 600 ETB; Year 2: 300 ETB; and Year 5:
400 ETB
• What is the equivalent future value in year 10 if the interest
rate is 5% per year?
Soln:
• Draw the cash flow diagram for the values 600, 300, and 400
ETB. Use F/P factors to find F in year 10
• F = 600(F/P,5%,10) + 300(F/P,5%,8) + 400(F/P,5%,5)
= 600×(1.6289) + 300×(1.4775) + 400×(1.2763) = 1931.11 ETB

Exercise:
1. A company wishes to set aside money now to invest over the
next four years. The company can earn 10% on a lump sum
deposited now, and it wishes to withdraw the money in the
following increments: Year 1: $25,000, Year 2: $3,000, Year
3: No expenses, Year 4: $5,000
• How much money must be deposited now to cover the
anticipated payments over the next 4 years?
• To see if the needed lump sum deposited now is sufficient,
calculate the balance at the end of each year.

2. Uniform Series
A. Present-Worth Factor
• What would you have to invest now P in order to withdraw A
birrs at the end of each of the next n periods?
• In this case, it is the P/A factor used to calculate the equivalent
P value in year 0 for a uniform series of A values beginning at
the end of period 1 and extending for n periods
• The term in bracket is the conversion factor known as the

uniform-series present worth factor (USPWF) or P/A factor,
(P/A, i, n)

B. Capital Recovery Factor
• To reverse the situation, the present worth P is known and the
equivalent uniform-series amount A is sought/required.
• The first A value occurs at the end of period 1, that is, one
period after P occurs.
• The term in bracket is called the capital recovery factor (CRF),

or A/P factor, (A/P, i, n)

C. Sinking Fund Factor
• Suppose we are interested in the future amount F of a fund
to which we contribute A birrs each period and on which we
earn at a rate of i per period.
• Which annual deposit should be made to yield a given
amount after a definite number of years?
• The expression in bracket is the A/F factor or sinking fund

factor(SFF), (A/F, i, n)

D. Uniform Series Compound Amount
• Suppose over a period of n years, a constant annual deposit, A
is made at the end of each year. What is the total value, F
after n years?
• The above equation can be rearranged to find F for a stated A
series in periods through n
• The expression in bracket is the F/A factor or uniform series

compound amount factor(USCAF), (F/A, i, n)

Examples:
1. How much money should you be willing to pay now for a
guaranteed $600 per year for 9 years starting next year, at a
rate of return of 16% per year?
Soln:
ᴆ Finding P when given A.
• The present worth is:
P = 600(P/A,16%,9) = 600×(4.6065) = $2763.90

Examples:
2. If you had 500,000 ETB today in an account
earning 10% each year, how much could you
withdraw each year for 25 years?
Soln.
ᴆ Finding A when given P.
A=500,000(A/P, 10%, 25)

=500,00(0.1102)= 55,100 ETB
Examples:
3. How much would you need to set aside each year for 25
years, at 10% interest, to have accumulated 1,000,000
ETB at the end of the 25 years?
Soln:
ᴆ Finding A when given F.
A=1,000,000(A/F, 10%, 25)

=1,000,000(0.0102)= 10,200 ETB

Examples
4. What is the equivalent future worth of a one million dollar of
investment each year for 8 years starting 1 year from now
with an interest rate of 14%?
Soln:
ᴆ Finding A when given F.
• The cash flow diagram shows the annual payments (per $1,000)
F = 1,000,000×(F/A,14%,8) = $13,232,800

3. Arithmetic (Linear) Gradient Series
• An arithmetic gradient is a cash flow series that
either increases or decreases by a constant amount
• The cash flow, whether income or disbursement,
changes by the same arithmetic amount each
period
• The amount of the increase or decrease is the
gradient (G)
• For example, if an engineer predicts that the cost of
maintaining a machine will increase by 5000birr per
year until the machine is retired, a gradient series is
involved and the amount of the gradient is 5000birr

Present Worth Factor – P/G Factor
• The Present worth factor (P/G) can be expressed in the
following form:
P = G(P/G,i,n)
Gradient series
present-worth fact

Annul Series Factor – A/G Factor
• The equivalent uniform annual series (A value) for an
arithmetic gradient G is found by the following formula:
A = G(A/G,i,n) ► Arithmetic-gradient
uniform-series factor

Future Worth Factor – F/G Factor
• The Future worth factor (F/G) can be expressed in the following
form:
F = G(F/G,i,n) ►
Arithmetic-gradient
future worth factor

Examples:
1. A construction firm has just purchased a dump truck that has
a useful life of five years. The engineer estimates that
maintenance costs for the truck during the first year will be
1,000 ETB. As the truck ages, maintenance costs are
expected to increase at a rate of 250 ETB per year over the
remaining life. Assume that the maintenance costs occur at
the end of each year. The firm wants to set up a maintenance
account that earns 12% annual interest. All future
maintenance expenses will be paid out of this account. How
much does the firm have to deposit in the account now?
Soln:
• P = A1(P/A,12%,5) + G(P/G,12%,5)
= 1,000(3.6048) + 250(6.397) = 5,204 ETB

Examples:
2. You want to deposit 1,000 ETB in your saving account at the
end of the first year and increase this amount by 300 ETB for
each of the next five years
• Then what should be the size of an annual uniform deposit that
yields an equal balance with the above by the end of six years?
Soln:
A = 1,000 + 300(A/G,10%,6)
= 1,000 + 300(2.22236) = 1,667.08 ETB

4. Geometric Gradient Series
• In geometric gradient series, cash flow increases or
decreases from period to period by a constant percentage
• This uniform rate of change defines a geometric gradient
series of cash flows
• We will use the term g which is the constant rate of change
by which amounts increase or decrease from one period to
the next

Cont…

Cont…
• We need to find the value of the present worth at time = 0

based on geometric gradient series cash flows starting in
period 1 in the amount A1 and increasing by a constant rate
of g each period
• P = A1(P/A,g,i,n)

Examples
1. Engineers at a specific company need to make
some modifications to an existing machine. The
modification costs only 8,000 ETB and is expected
to last 6 years with a 1,300 ETB salvage value. The
maintenance cost is expected to be high at 1,700
ETB the first year, increasing by 11% per year
thereafter. Determine the equivalent present
worth of the modification and maintenance cost.
The interest rate is 8% per year.
Soln:
Draw CFD

Cont…
•

5. Irregular (Mixed) Series
• A series of cash flows may be irregular, in that it does not

exhibit a regular overall pattern
500br
400br
300br
200br
100br
0 1 2 3 4 5
Years

Introduction to Spreadsheet Functions
Excel financial functions
Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%, second_cell:last_cell) +
first_cell
Example: Estimates are P = 4212.35 ETB . n = 5 years i = 6% per

year
Find A in ETB per year
Function and display: =AASTU,
PMT(6%, 5, 4212.35)
Engineering Economics chapter 1
displays A = 1000.00 ETB
72
Assignment 1
Using an excel spread sheet prepare a cash flow factor table of four
decimal digit for i=1%,4%,5%,6%,7%,8%,10%,11%,12% 15% and for
n=1 to 100 as shown in the table below.
• Be a group of 4 to ten students
• Submission date

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Course name:

• Engineering Economics (CEng5201)

AASTU, Engineering Economics chapter 1 1

AASTU, Engineering Economics chapter 1 2

AASTU, Engineering Economics chapter 1 3

• Engineering is the profession in which a knowledge of the

• Engineering Economics is the application of economic

• The role of engineering economics is to assess the

• Engineering economics is entirely involved with evaluating

AASTU, Engineering Economics chapter 1 6

 The purpose of engineering economics is to study whether any

Suppose you are an engineer(PM) setting up a new Asphalt plant

 There are various problems that are related to the money.

 These monetary problems constitute the engineering economics.

AASTU, Engineering Economics chapter 1 7

• Engineering Economy is about making decisions

• It is based on the systematic evaluation of the costs and

• The principles and methodology of engineering economy are

AASTU, Engineering Economics chapter 1 8

The decision-making process for engineering project

1. Defining the problem

2. Establishing objectives and criteria

3. Generating alternative plans and designs

4. Evaluation and choice

5. Implementation and control

AASTU, Engineering Economics chapter 1 9

• Engineering economy is just a set of tools:

 Understand the Problem

AASTU, Engineering Economics chapter 1 10

• A set of estimates are made based on selection criteria that is

AASTU, Engineering Economics chapter 1 13

• Change in the amount of money (due to the

• The “value” of money depends on the

Interest is the difference between an ending amount of money and

There are two types of interest:

Interest rate Rate of return

AASTU, Engineering Economics chapter 1 1-16

AASTU, Engineering Economics chapter 1 17

• Interest earned over a specific period of time is

Interest accrued per time unit

AASTU, Engineering Economics chapter 1 18

AASTU, Engineering Economics chapter 1 19

AASTU, Engineering Economics chapter 1 22

F = 100 ETB(1 + 0.07 x 2) = 114 ETB

AASTU, Engineering Economics chapter 1 23

Year Beginning balance Interest for Ending

AASTU, Engineering Economics chapter 1 25

Compounded: 1,331 Simple: 1000+1000*0.1*3=1,300

• What would be the future worth?

AASTU, Engineering Economics chapter 1 27

Thus, the annual effective interest rate =in/p

AASTU, Engineering Economics chapter 1 28

AASTU, Engineering Economics chapter 1 29

AASTU, Engineering Economics chapter 1 30

• Inflation represents a decrease in the value of a given

For instance, 1 Ethiopian birr (ETB) now will not

AASTU, Engineering Economics chapter 1 33

• If the price of the machine increases at an annual rate of 8%

AASTU, Engineering Economics chapter 1 34

Compounded: 1,331 Simple: 1000+10000.13=1,300