What is Engineering Economics?

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What is Engineering Economics?
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What is Engineering Economics?

• Subset of General Economics
• Different from general economics situations -
  project driven
• Analysis performed by technical professionals
  (not economists)
• Requires advanced technical knowledge in some
  cases

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Lots of Questions Project/ driven

• Why do this at all?
• Is there a need for the project?
• Why do it now?
• Can it be delayed? Can we afford it now?
• Why do it this way?
• Is this the best alternative? Is this the optimal
  solution?
• Will the project pay?
• Will we run a loss or make a profit?

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Sample Engineering Project

• Hydro vs. Thermal power

• Hydro
• expensive initially
• far away from load centres (high transmission
  cost)
• no fuel required
• longer life
• no pollution

• Thermal
• less expensive initially
• can be near load centres
• require fuel
• shorter life
• can cause pollution

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Other examples

• Buy vs. rent (car, house, equipment)
• Good quality (expensive) but longer life vs. poor
  quality (cheap) but shorter life
• car, shoes, computers
• Investments decisions - GIC, RRSP, Bonds, Stocks
  and Shares

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Steps in Engineering Economics Study

• Define alternatives in physical terms
• Cost and revenue estimates
• All money estimates placed on a comparable basis
• appropriate interest rate used
• time horizon (economic life)
• Recommend choice among alternatives

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Engineering Economics on the Web

• The discipline that translates engineering
  technology into a form that permits evaluation by
  businesses or investors.
• The application of economic principles to
  engineering problems, for example in comparing
  the comparative costs of two alternative capital
  projects or in determining the optimum
  engineering course from the cost aspect.

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The Time Value of Money

• Would you prefer to
• have 1 million now or
• 1 million 100 years
• from now?

Of course, we would all prefer the money
now! This illustrates that there is an inherent
monetary value attached to time.
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What is Time Value?

• We say that money has a time value because that
  money can be invested with the expectation of
  earning a positive rate of return
• In other words, a dollar received today is worth
  more than a dollar to be received tomorrow
• That is because todays dollar can be invested so
  that we have more than one dollar tomorrow

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What is The Time Value of Money?

• A dollar received today is worth more than a
  dollar received tomorrow
• This is because a dollar received today can be
  invested to earn interest
• The amount of interest earned depends on the rate
  of return that can be earned on the investment
• Time value of money quantifies the value of a
  dollar through time

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Uses of Time Value of Money

• Time Value of Money, is a concept that is used in
  all aspects of finance including
• Stock valuation
• Financial analysis of firms
• Accept/reject decisions for project management
• And many others!

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The Terminology of Time Value

• Present Value - An amount of money today, or the
  current value of a future cash flow
• Future Value - An amount of money at some future
  time period
• Period - A length of time (often a year, but can
  be a month, week, day, hour, etc.)
• Interest Rate - The compensation paid to a lender
  (or saver) for the use of funds expressed as a
  percentage for a period (normally expressed as an
  annual rate)

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Abbreviations

• PV - Present value
• FV - Future value
• Pmt - Per period payment amount
• i - The interest rate per period

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Purchasing Power and Value
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Timelines

• A timeline is a graphical device used to clarify
  the timing of the cash flows for an investment
• Each tick represents one time period

PV
FV
Today
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Calculating the Future Value

• Suppose that you have an extra 100 today that
  you wish to invest for one year. If you can earn
  10 per year on your investment, how much will
  you have in one year?

-100
?
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Calculating the Future Value

• Suppose that at the end of year 1 you decide to
  extend the investment for a second year. How
  much will you have accumulated at the end of year
  2?

-110
?
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Generalizing the Future Value

• Recognizing the pattern that is developing, we
  can generalize the future value calculations

• If you extended the investment for a third year,
  you would have

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Compound Interest

• Note from the example that the future value is
  increasing at an increasing rate
• In other words, the amount of interest earned
  each year is increasing
• Year 1 10
• Year 2 11
• Year 3 12.10
• The reason for the increase is that each year you
  are earning interest on the interest that was
  earned in previous years in addition to the
  interest on the original principle amount

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Compound Interest Graphically
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The Magic of Compounding

• On Nov. 25, 1626 Peter Minuit, purchased
  Manhattan from the Indians for 24 worth of beads
  and other trinkets. Was this a good deal for the
  Indians?
• This happened about 378 years ago, so if they
  could earn 5 per year they would in 2005 have

• If they could have earned 10 per year, they
  would now have

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Calculating the Present Value

• So far, we have seen how to calculate the future
  value of an investment
• But we can turn this around to find the amount
  that needs to be invested to achieve some desired
  future value

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Present Value An Example

• Your five-year old daughter has just announced
  her desire to attend college. After some
  research, you determine that you will need about
  100,000 on her 18th birthday to pay for four
  years of college. If you can earn 8 per year on
  your investments, how much do you need to invest
  today to achieve your goal?

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Continuous Compounding

• There is no reason why we need to stop increasing
  the compounding frequency at daily
• We could compound every hour, minute, or second
• We can also compound every instant (i.e.,
  continuously)

• Here, F is the future value, P is the present
  value, r is the annual rate of interest, t is the
  total number of years, and e is a constant equal
  to about 2.718

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Continuous Compounding

• Suppose that the Fourth National Bank is offering
  to pay 10 per year compounded continuously.
  What is the future value of your 1,000
  investment?

• This is even better than daily compounding
• The basic rule of compounding is The more
  frequently interest is compounded, the higher the
  future value

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Continuous Compounding

• Suppose that the Fourth National Bank is offering
  to pay 10 per year compounded continuously. If
  you plan to leave the money in the account for 5
  years, what is the future value of your 1,000
  investment?

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Summary

• Engineering Economics
• The Time Value of Money
• Calculating the Future/Present Value
• Simple/Compound Interest
• Self-Study Simple Interest PPN5 112
• Required Slides/Book Chapter 2.1 2.2 2.3 2.5
• Feedback Quiz Review before Quiz
• Feedback Book? Library waiting for answer