CH-8 Engineering Economics

Anishek Poudel
 Engineering Economics
• Engineering economics is the application of economic principles and
calculations to engineering projects.
• It is defined as the set of principles, concepts, techniques and methods by
which alternatives within a project can be compared and evaluated for the best
monetary return.

Types of Engineering Economics Decision

• Service or Quality Improvement
• New Product Development or Product Expansion
• Equipment and Process Selection
• Cost Reduction
• Equipment Replacement
 Time Value of Money
• The time value of money (TVM) is a fundamental concept in finance and
economics that states that money's value changes over time.
• It recognizes that receiving or paying a certain amount of money today is
different from receiving or paying the same amount in the future due to various
factors such as inflation, interest rates, and the opportunity cost of money.
• The underlying principle of TVM is that a sum of money available today is
worth more than the same amount in the future because money has the
potential to earn returns or interest if invested.
• Conversely, money received in the future is considered less valuable because it
cannot be put to work immediately, and there is an opportunity cost associated
with not having the money available today.
 Simple Interest
• Simple interest is a straightforward method of calculating interest on a principal
amount over a specific period.
• The interest is only calculated on the original principal, and there is no
compounding involved.
• The formula for calculating simple interest is:
• Simple Interest (SI) = Principal (P) × Rate of Interest (R) × Time (T)
• The total amount (A) after simple interest can be calculated as:
A=P+S
Where:
• P is the principal amount (initial amount of money).
• R is the interest rate per period (usually expressed as a decimal).
• n is the number of compounding periods per year (e.g., annually, semi-annually,
quarterly).
• T is the time duration for which the interest is calculated (usually in years).
• The total amount (A) after compound interest can be calculated as: A = P + CI.
Effective Interest rate
• The effective interest rate (EIR) is the true or actual interest rate earned or paid
on an investment or loan after considering the effect of compounding. • It takes
into account the compounding frequency and gives a more accurate measure of the
interest rate's impact over time.
• To find the effective interest rate when given the nominal interest rate (i.e., the
stated interest rate per period) and the compounding frequency, you can use the
following formula:
Where:
• R is the nominal interest rate per period (as a decimal).
• n is the number of compounding periods per year.
• The effective interest rate is always higher than the nominal interest rate when
compounding is involved, as it reflects the impact of earning interest on
previously earned interest.
• It is crucial for comparing different financial products or investments to see
their true returns or costs over time.
 Depreciation
• The reduction in the value and efficiency of the plant, equipment or any fixed
asset because of wear and tear, due to passage of time, use and climatic
conditions is known as depreciation.
• The most common depreciation methods include:
– Straight line method
– Declining balance method

Straight line method

• In this method every year a fixed amount is put aside as depreciation charges
during the economical life of the equipment.
• Let, C = Initial cost of the machine in rupees • S = Scrap value (salvage value)
in rupees • N = Estimated life of the machine in years • Then,
A machine costing Rs. 24,000 was purchased on 1 st Dec. 1985. The installation
and erection charges were Rs. 1,000 and its useful life is expected to be 10 years.
The scrap value of the machine at the end of the useful life is Rs. 5,000. Calculate
the yearly depreciation by straight line method.
• Solution:
Declining balance method
• The machine or equipment depreciates rapidly in the early years and later on
slowly.
• Therefore according to this method the depreciation fund is more during the
early years, when repairs and renewals are not costly.
• Let X = Fixed percentage for calculating yearly depreciation
• C = Initial cost
• S = Scrap Value
• N = Estimated life
 Project Evaluation Techniques
• Project evaluation is a systematic and objective assessment of an ongoing or
completed project. The aim is to determine the relevance and level of achievement
of project objectives, development effectiveness, efficiency, impact and
sustainability.
• Different techniques of project evaluation include:
– Simple payback period
– NPV
– IRR
– MARR
1. Payback period
• The Payback period refers to the expected length of time to recover the
investment of project.
• As per this technique project with shorter PBP are preferred over project with
longer PBP.
• The value of NPV may be positive, negative or zero.
• A positive NPV (i.e NPV > 0) means that the project is profitable and worth
investing in. – A negative NPV (i.e NPV < 0) means that the project is
unprofitable and should be rejected.
• A zero NPV (i.e NPV =0) means that the project is indifferent and does not
affect the value of the business.
Minimum Attractive Rate of Return (MARR)
• The Minimum Attractive Rate of Return (MARR) is a financial threshold used
in capital budgeting and investment analysis.
• It represents the minimum rate of return or the minimum level of
profitability that a company or investor requires before they consider an
investment or a project financially acceptable.
• When evaluating investment opportunities or projects, the MARR serves as a
benchmark for comparing the expected returns. Any investment or project
that can deliver a rate of return equal to or higher than the MARR is
considered viable and worth pursuing. On the other hand, if the projected rate
of return falls below the MARR, the investment is generally rejected because
it does not meet the required profitability standard.
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