LECTURE NO.

3
INTRODUCTION TO
ENGINEERING ECONOMICS

NML adapted from RSM

Lecture 2 - Review
 Introduction to Engineering Economics
 Time Value of Money
 Simple Interest
 Cash Flow Diagrams
 Compound Interest
 Nominal and Effective Interest Rates
 Present Worth
 Uniform Series Payments
 Capital Recovery Factor
 Interest Tables
 Overview of Lecture No. 3
3

 Uniform Gradient Series

 Economic Comparison
 Process of Economic Comparison
 Methods of Economic Comparison
 Single criterion methods
 Multi criteria methods
 Non-discounting methods
 Discounting methods
 Gradients
4

 Gradients are special cases where a series of cash

flows consists of regular, unequal amounts that
increase or decrease following a specific pattern
Gradient factors are the factors used to calculate
equivalent P, A and F for such series of cash flows.
 Arithmetic (Uniform) Gradient
5

 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 constant amount each period.
 The amount of the increase or decrease is the gradient
“G”.
 For example, if a manufacturing engineer predicts that
the cost of maintaining a machine will increase by
$500 per year until the machine is retired, a gradient
series is involved and the amount of the gradient is
$500.
 Uniform Gradient
6
 Geometric Gradient
7

 It is also common for cash flow series, such as

operating costs, construction costs, and revenues, to
increase or decrease from period to period by a
constant percentage, for example, 5% per year.
 This uniform rate of change defines a geometric
gradient series of cash flows. In addition to the
symbols i and n used thus far, we now need the
term g. g = constant rate of change, in decimal
form, by which amounts increase or decrease from
one period to the next .
8
 Uniform gradient series
 Consider the following cash flow
(n-1)G
(n-2)G
2G
G

0 1 2 3 n
n-1

F=?
 Uniform gradient series
 Consider the following cash flow
(n-1)G
(n-2)G
2G
G

0 1 2 3 n
n-1

F=?
 Uniform gradient series (contd..)
 G represents equal uniform increment yearly
 The first increment will have a compound amount

 n 1 

G

 1  i  1 



i 

 
 Uniform gradient series (contd..)

 based on uniform series compound amount factor.

 The second increment will have a compound amount

of:
 n 2 

G
1  i 


1




i 

 
 Uniform gradient series (contd..)
 square brackets contain the uniform series
compound amount factor, therefore the uniform
gradient future worth factor is:

é
ê
n
(1 + i ) - 1 úú - n
ù
= ê
ê i2 ú i
ë û
 Uniform
Uniform gradient
gradient series
Present (contd..)
Worth Factor
14
 Geometric gradient series formula
15

 Short Task:
 Search for formulae and give practical examples of
each.
 Assignment example
16

 A contractor has an offer to rent a large warehouse for

storage of materials for ten years at TZS 12 million per
month in the initial year. However, the owner of the
warehouse requires that the rent increases by 250,000
every year until the end of the last year.
1. Compute the present worth of the rental charges.

2. What will be the PV if the owner wishes to increase

the rent by 5% every year for the next ten years?
3. What will be the equivalent annual rental charges?

4. What would be the equivalent amount at the end of

year 10?
 17

ECONOMIC COMPARISONS

Lecture No. 3
 Introduction
18

 Economic studies are made to

evaluate:
 whether an investment should be

made at all; and

 when a decision to invest has been

made, which alternative should be

selected.
 Process of economic appraisal
19

 preceded by establishing estimates of the

various cash flows associated with the
project.
 Positive of negative cash flows are

projected.
 Estimates are expressed in terms of

MONEY (Tshs, USD, EURO, Pounds,

etc).
 Process of economic appraisal
20

 Calculation: Positive and negative cash

flows are put in an appropriate sequence
and their relative time scheduling
established. Where necessary, a
sensitivity study is performed to establish
the sensitivity of the projects outcome to
possible changes in the values of the
principle variables in the project.
 Process of economic appraisal
21

 Evaluation: Consideration of factors

that cannot be expressed in quantitative
form (intangibles such as social
obligation, political considerations etc.).
The detailed treatment of these can be
considered further when we shall discuss
multi-criteria project appraisal
techniques.
 Classifications of methods of economic
appraisal
22

 Project appraisal can be performed using two broad

methods:
 Single criterion – projects compared on the basis

of a single Criterion.
 Multi-criteria - projects compared on the basis of

several Criteria,
 In practice, the second method is employed and
criteria are given different weights. A project
(or projects) that have a higher combined
aggregate weights is selected.
 Single criterion Technique
23

 Classified into two broad categories:

 Non-discounting criteria: – criteria that
does not put into consideration the time
value of money; and
 Discounting criteria: – criteria that puts
into consideration the time value of
money.
 Non-discounting criteria
24

 Urgency Method
 According to this criterion, projects that are
considered to be more urgent get priority over those
considered less urgent.
 How does one establish the degree of ‘urgency’?

 Use methods that reduce the level of subjectivity in

the decision; for example:
 Public opinion survey;
 Main stakeholder’s views; etc
 Major disadvantage – can be very subjective
especially if not all stakeholders views are considered.
 Non-discounting criteria
25

 Rate of Return on Capital Method (RRC)

 RRC = Annual Net Profit
Capital Invested
Project A Project B
Annual Net Profit $ 1,200 $ 400
Capital $ 12,000 $ 3,600
RRC 10% 11.1%
Conclusion: B is favourable
Advantage: Simple to understand
Disadvantage: Does not consider the size of the Investment and
No time Value of Money
 Non-discounting criteria (Contd..)
26

 Payback period
 The principle of the method is to determine
how quickly the gross capital invested in a
project can be recovered.
 Advantages: -
 Easily understood – both the concept and its
application.
 Rough and ready method of dealing with risk,
as the longer the project lasts the more exposed
it is to risk.
 Non-discounting criteria (Contd..)
27

 Payback period
Advantages: -
Favours projects that generate more
money in earlier years;
Risks tend to increase with time.
Disadvantages:
Ignores time value of money
Ignores cash flows beyond the payback
period.
 Non-discounting criteria (Contd..)
28

 Average Annual Profits:

 Projects that have highest average
annual profit are favourable.
 Example:
 Consider 3 projects with similar
initial capital outlay:
 Year Projects
Alpha Beta Gamma
0 £ -20,000 £ -20,000 £ -20,000
1 3,000 6,500 7,000
2 4,000 6,500 6,000
3 6,000 6,500 7,000
4 8,000 6,500 5,000
5 8,000 - 3,000
6 8,000 - 1,000
Total Profits: £ 37,000 £ 26,000 £ 29,000
Average Annual 6,170 6,500 4833
Profit
Return of Capital 30.85% 32.50% 24.17%
Payback period 3.87yrs 3.08 yrs 3 yrs

Project Beta is selected on the basis of both Average Annual Profit

and Return on Capital. However on the basis of Payback Period,
Project Gamma would be selected. However, it is very tempting to
select project Alpha due to highest total profits (without considering
time value of money).
29
 Discounting Methods
30

 Discounting methods are project

appraisal techniques that put into
consideration the timing of the
cash flows – time value of
money.
 Discounting Methods (Contd…)
31

 These include:
 Equivalent Annual Cost (EAC) method;
 Present Worth (PW) or Net Present
Value (NPV) Method;
 Internal Rate of Return (IRR) Method;
and
 Benefit Cost Ratio (BCR) Method.
 Equivalent Annual Cost Method (EACM)
32

 This method takes into account the

time value of money by expressing
costs occurring over the life of the
investment into equivalent uniform
annual costs, using selected
discounting rate, i.
 See example on EACM method
 Example on EACM
33

 The current cost of maintaining a strip of road to a mine

using labour is £108,000 per annum for the next six years.
 Two alternatives are being considered:
 Alt. 1: Buy a motor grader for £ 70,000 that will cost on average
£ 3,000 per year for the six years after which it will have a
salvage value of £ 15,000 the average annual cost of labour will
be reduced to £ 60,000.
 Alt.2: Strengthen the road with an initial investment of £60,000
followed by £30,000 and £28,000 after 2 and 4 years
respectively. Labour cost for this scheme is £ 48,000 per year.
If the return on the investment desirable is 10% per annum,
which scheme is favourable?
 Solution
34

 Essentially, the first question the investor would have

to answer is whether to invest at all – this alternative is
always there and it is normally referred to as “Do
nothing alternative”
 Alt. 0- Do nothing (using existing method – leave
thing as they are)

0 1 2 3 4 5 6

108,000
Annual Cost is 108,000
 Solution
35

Alt. 1- Buy a motor grade 15,000

Cash flow
60,000 +
1 2 3 4 5 6 3,000 per
year
70,000

Annual cost recovery of grader 70,000 x 0.2296 = 16,072

Sinking fund – of salvage value 15,000 x 0.1296 = -1,944

Annual Maintenance of Grader 3,000

Annual cost of Labour 60,000

Equivalent Annual Cost 77,128

 Solution
36 Alt. 2- Strengthen the road initially
Cash flow
1 2 3 4 5 6 48,000 per
year

60,000 30,000 28,000

Annual Recovery of initial 60,000(A/P,10%,6 = 60,000 x 16,072
cost 0.2296
Annual cost recovery for the 30,000(P/F,10%,2)(A/P, 10%,6) = 5,693
investment at year 2 30,000 (0.8265)(0.2296)
Annual cost recovery for the 28,000(P/F,10%,4)(A/P, 10%,6) = 4,391
investment at year 4 28,000 (0.6830)(0.2296)
Annual cost of Labour 48,000
Equivalent Annual Cost 71,860
Conclusion: Select Alternative 2 with min. Equivalent Annual Cost of $ 71,860
Assumption: All alternatives will result into an equal level of service on the road.
 Example 2 on EACM
37

A company has two alternatives for a storage structure:

R.C. Steel
Initial Cost: USD 2,000,000 1,350,000
Estimated life: 60 yrs 20 yrs
Annual Nil (first 10 yrs 30,000
Maintenance 25,000 thereafter
 60,000
Alt 1. Concrete structure – Cash flow:

11

10 20 30 40 50 60

2,000,000

25,000 p.a.

Annual Recovery of initial 2,000,000(A/P,10%,60) = 2,000,000 200,600

cost x 0.10032
Sinking fund – of salvage 60,000(A/F,10%,60) = 60,000 x -18
value 0.0003
Annual Maintenance costs 25,000(F/A,10%,50)(A/F,10%,60) = 8,729
25,000(1163.9085)(0.0003)
Equivalent Annual Cost $ 209,311

38
 Alt 2. Steel structure – Cash flow:
20,000

10 20 30 40 50 60

1,350,000

30,000 p.a.

Annual Recovery of initial 1,350,000(A/P,10%,20) = 1,350,000 158,558

cost x 0.11745
Sinking fund – of salvage 20,000(A/F,10%,20) = 20,000 x -1,157
value 0.0579
Annual Maintenance costs 30,000
Equivalent Annual Cost =187,400
Conclusion: Select Option 2- However note that lives of two alternatives differ
39
 Example 2 on EACM
40

 Questions that arise:

 What happens at the end of year 20 for alternative 2?
Replacement! What about effect of inflation?
 Suppose the two alternatives were equal in Equivalent
Annual Cost, which one would be chosen?
 What are the risk considerations?
 Technological choices – efficiency increases.
 Suppose replacements are made at the end of years 20
+ 40 respectively at 50% additional cost increase each
time?
 Despite of all these possible circumstances, in the following
cash-flow diagram it is assumed that the structure will be
replaced after 20 years and at the 40th year and that there
will not be inflation.

20,000 20,000 20,000

10 20 30 40 50 60
30,000 30,000 30,000

1.35 m 1.35 m 1.35 m

41
 Present Worth Method
42

 This is also known as the Net Present

Value Method (NPV)
 This method takes into account the time
value of money by expressing costs
occurring over the life of the investment
into net present value (NPV), using
selected discounting rate, i.
 Present Worth Method
43

 The basis of the Present worth Method is

that all future receipts and payments are
converted into present worth using an
interest rate, which represents the cost of
money involved or the acceptable rate of
return on the investment.
 Example (PW Method)
A contractor who owns a quarry wishes to buy either one
Bulldozer or two excavators, both can do what he wants done.
Compute and compare the NPV of the two options if the desired
rate of return is 10% p.a. Given the information in Table below

Bulldozer Excavator

Initial cost (mill Tshs) (per 750 300

unit)
Maintenance costs p.a. (per 50 22
unit)
Useful life (years) 8 4

Salvage value (per unit) 45 27

44
 Alt 1. Bulldozer – Cash flow:
45

0 1 2 3 4 5 6 7 8

750
50 per annum

Initial Cost 750

Present Worth of Annual 50(P/A,10%,8)= 50(5.3349) 266.745
Maintenance Cost
Present Worth of Salvage 45(P/F, 10%,8) = 45(0.4665) -20.9925
value
Net Present Worth 995.75

45
 Alt 2. Excavator– Cash flow:

2 x 27 2 x 27

0 1 2 3 4 5 6 7 8

2 x 300
2 x 22 per annum

2 x 300

Present Worth of Initial 2 x 300 + 600(P/F,10%,4) = 600 + 1,009.8

Cost 600(0.6830)
Present Worth of Annual 2 x 22(P/A,10%,8)= 44(5.3349) 234.73
Maintenance Cost
Present Worth of Salvage 54(P/F, 10%,4) + 54(P/F,10%,8) = -62.07
value 54(0.6830) + 54(0.4665)
Net Present Worth 1,182.5
46 Conclusion: Select Option 1
 Internal rate of Return Method (IRR)
47

 In both equivalent annual cost method and the present worth

method , it is necessary to assume the desired rate of return of
an investment. In the IRR method one is concerned with the
calculation of the actual rate of return.
 The Internal rate of return (IRR) method employs the
discounted cash flow method to compare between
alternatives. The alternative with the highest IRR is selected
(higher than the min acceptable rate of return).
 IRR (Contd…)
48

 Other names for the same method are: yield

method, profitability index, interest rate of
return, marginal efficiency of capital and
discounted cash flow method.
 The IRR method of investment appraisal is a means
of arriving at a rate of interest that will discount all
future cash flows associated with the investment,
both negative and positive into equality with the
initial investment. (discount all future cash flows
into PW)
 See example on IRR
 Example on IRR Method:
Suppose an investor is expecting to get £150,000 from a
fixed deposit account after 10 years after an initial
investment of £100,000. What is the internal rate of
return (IRR) on the investment?

Solution: Cash flow

F=$ 150,000

10 yrs

P=$ 100,000

49
  1 
P  F n 
 1  i  
The problem: P= 100,000, F = 150,000
Find i if n= 10
n
150,000 x [1/(1+i) ] = 100,000 what
is i
n
i.e. PW = 100,000 -150,000 x [1/(1+i) ] = 0
Soln: By trial and error method
If i=10, PW Factor = -42,175
If i=3%, PW Factor = 11,615
50
 From Similar triangles
+16,615-(-42,175) 42,175)
=
3 - 10 i - 10
+40,000
53790i – 537,900 = - 295,225

+11,615 i = 4.5%
10

PW = 0
3

- 40,000

- 42,175

51
 Example 2: Homework
An investment has the following cash flow:
a) Determine the net cash flow.
b) Compute the internal rate of return of the
investment (is an internal rate of return of 10% p.a. met?)

Year Receipts Payments Net cash flow

0 - 15,000 ?
1 £ 6000 2000 ?
2 7500 3500 ?
3 6500 2500 ?
4 8000 3000 ?
5 5000 2500 ?
6 2000 500 ?

52
 Benefit Cost Ratio (BCR)
53

 The benefit cost ratio is a ratio of the present worth

of net project benefits and the net project costs.
 The method is used to evaluate the extent to which
society will benefit from an investment.
 Used also to rank alternatives where projects may
not be mutually exclusive. i.e more than one
project may be undertaken. Often used in public
projects!
 BCR (Contd..)
54

 Procedure:
 1. Identify project alternatives.
 2. Quantify as much as possible all costs
and all benefits.
 3. Develop ‘cash flow’ considering costs as
negative cash flows and benefits as
positive cash flows.
 4. Convert both costs and benefits into PW
 BCR (Contd..)
55

 5. Determine the ratio of PW of benefits to the PW of

costs

PVB
BCR 
PVC

 in principle, a project A has no benefits if the ratio is 1

 BCR (Contd..)
56

 Sometimes referred to as Net Benefit Cost Ratio

PVB
NBCR  1
 PVC

 → should be greater than 0.

 If more than one project can be undertaken, then

projects are arranged in descending value of NBCR
to sort in order of priority.
 Lecture summary
57

 Uniform Gradient Series

 Economic Comparison
 Process of Economic Comparison
 Methods of Economic Comparison
 Single criterion methods
 Multi criteria methods
 Non-discounting methods
 Discounting methods
58

 Thank you.