ENGINEERING ECONOMY
Chapter 2: Money-Time Relationships and Equivalence
Topics:
1. Interest and the Time Value of Money
2. The Concept of Equivalence
3. Cash Flows
Learning Outcomes
At the end of this lesson, students should be able to:
1. Explain why money has a time value.
2. Differentiate simple interest from compound interest.
3. Calculate interest, present value, and future value.
4. Explain the concept of economic equivalence.
5. Draw and interpret cash flow diagrams.
6. Apply money-time relationships in engineering decision-making.
7. Solve engineering economy problems involving present and future values.
I. INTRODUCTION
Imagine two job offers after graduation.
Offer A
• Receive ₱100,000 today
Offer B
• Receive ₱100,000 after two years
Question:
Which would you choose?
Most people prefer Offer A because receiving money today allows them to:
• Invest it
• Earn interest
• Use it immediately
• Avoid uncertainty
This simple example illustrates the Time Value of Money (TVM).
II. TIME VALUE OF MONEY
Definition
The Time Value of Money (TVM) is the principle that:
Money available today is worth more than the same amount received in the future because it
can earn interest.
This is the foundation of Engineering Economy.
Why Does Money Have Time Value?
There are several reasons.
1. Investment Opportunity
Money can generate more money.
Example
Deposit:
₱10,000
Interest:
5%
After one year
₱10,500
2. Inflation
Prices increase over time.
Example
Today
Rice = ₱50/kg
After one year
Rice = ₱55/kg
The purchasing power of money decreases.
3. Risk
Future payments may never be received.
Examples
• Company bankruptcy
• Natural disasters
• Business failure
4. Preference for Current Consumption
People generally prefer enjoying money today rather than later.
Reflection:
"If someone offers you:
Option A:
₱1,000 today
Option B:
₱1,100 after one year
Which will you choose?"
III. INTEREST
Definition
Interest is the cost of borrowing money or the reward for investing money.
Interest Formula
Interest
I=P×r×t
Where
I = Interest
P = Principal
r = Interest rate
t = Time
Example
Principal = ₱20,000
Interest Rate = 8%
Time = 2 years
Interest
I = 20,000 × 0.08 × 2
I = ₱3,200
Total Amount
₱23,200
Types of Interest
A. Simple Interest
Interest is computed only on the original principal.
Formula
F = P(1 + rt)
Where
F = Future value
P = Present value
Example
Borrow
₱50,000
Interest
10%
Time
3 years
Interest
₱15,000
Future Value
₱65,000
Characteristics
✔ Easy to compute
✔ Used in short-term loans
✔ Interest remains constant
B. Compound Interest
Interest is computed on
• Principal
• Previous interest earned
Interest earns interest.
This is the most common type used in
• Banks
• Investments
• Credit cards
• Mortgages
Example
Deposit
₱50,000
Interest
8%
Time
5 years
Solution
FV
= 50,000(1.08)^5
= ₱73,466.40
Interest Earned
₱23,466.40
Simple vs Compound Interest
Simple Interest Compound Interest
Interest only on principal Interest on principal and accumulated interest
Linear growth Exponential growth
Less earnings Higher earnings
Short-term loans Banks and investments
IV. MONEY-TIME RELATIONSHIPS
Engineering Economy studies how money changes over time.
Three important values:
Present Value (P)
Money today.
Example
₱10,000 now
Future Value (F)
Money after a future period.
Example
₱12,000 after three years
Interest Rate (i)
Growth rate of money.
Example
6% annually
Time (n)
Number of interest periods.
Relationship
Money grows through time because of interest.
Present Value
Interest
Future Value
V. CONCEPT OF EQUIVALENCE
Definition
Economic equivalence means
Different sums of money occurring at different times can have the same economic value.
Example
Receiving
₱1,000 today
may be equivalent to
₱1,100 next year
if the interest rate is 10%.
Although the amounts differ, their economic worth is the same.
Importance
Engineers compare alternatives occurring at different times.
Examples
Buying machines
Repairing equipment
Constructing buildings
Selecting software systems
Renewing licenses
Illustration
Alternative A
Receive ₱100,000 today
Alternative B
Receive ₱110,000 after one year
Interest
10%
Since
100,000(1.10)
110,000
Both are economically equivalent.
VI. ENGINEERING APPLICATION OF EQUIVALENCE
Examples
Choosing between
Machine A
₱500,000 now
Machine B
₱100,000 every year for six years
Which is better?
Engineering Economy converts all values into one point in time.
Usually
Present Value
or
Future Value
VII. CASH FLOWS
Definition
Cash Flow is the movement of money into and out of a project.
Types
Cash Inflow
Money received
Examples
Salary
Sales
Savings
Investment return
Cash Outflow
Money spent
Examples
Tuition
Equipment
Maintenance
Taxes
Repairs
VIII. CASH FLOW DIAGRAM
A graphical representation of money over time.
Rules
Time moves left to right.
Outflows are downward arrows.
Inflows are upward arrows.
Equal spacing represents equal time intervals.
Example
↑ ₱8,000
--------|--------|--------|-------->
Year1 Year2 Year3
↓ ₱20,000
Today
Interpretation
Invest ₱20,000 today.
Receive ₱8,000 annually.
IX. WHY ENGINEERS USE CASH FLOW DIAGRAMS
They help
Visualize projects
Identify inflows and outflows
Avoid mistakes
Compare alternatives
Perform present worth analysis
X. REAL-LIFE ENGINEERING APPLICATIONS
Example 1
Buying Laboratory Computers
Today
₱800,000
Maintenance
₱50,000/year
Salvage Value
₱150,000
Cash flow analysis determines whether purchasing is economical.
Example 2
Solar Power Installation
Initial Cost
₱2 million
Annual Savings
₱400,000
Life
10 years
Determine if the investment is worthwhile.
Example 3
Computer Server Upgrade
Upgrade Cost
₱1.5 million
Annual Maintenance Savings
₱300,000
Life
7 years
Engineering Economy evaluates profitability.
XI. COMPUTER ENGINEERING APPLICATIONS
Cloud Computing
Compare
Monthly subscription
vs
Building an in-house server
Software Development
Compare
Immediate development cost
versus
Future maintenance expenses
Artificial Intelligence Projects
Investment
GPU hardware
Future
Research outputs
Income
Patents
Network Installation
Installation
Today
Maintenance
Every year
Replacement
After 8 years
IoT Systems
Initial sensors
Annual calibration
Battery replacement
Future savings
XII. COMMON MISTAKES OF STUDENTS
Ignoring time value
Mixing simple and compound interest
Wrong interest rate
Wrong number of periods
Drawing incorrect cash flow arrows
Ignoring inflation
XIII. SUMMARY
Engineering Economy is founded on the principle that money changes value over time. Interest
enables money to grow, making present and future amounts economically comparable. By
understanding time value of money, interest, equivalence, and cash flow diagrams, engineers
can make informed financial decisions about projects, investments, equipment purchases, and
technology adoption.
XIV. Key Takeaways
• Money today is worth more than money tomorrow.
• Interest is the price of using money.
• Simple interest is based only on the principal.
• Compound interest earns interest on both principal and accumulated interest.
• Economic equivalence allows engineers to compare cash amounts occurring at
different times.
• Cash flow diagrams visually represent inflows and outflows over time.
• Engineering Economy provides quantitative tools for selecting the most economically
beneficial alternative.
XV. Practice Problems
Problem 1
Compute the simple interest on ₱80,000 invested at 9% per year for 4 years.
Problem 2
Find the future value of ₱100,000 invested at 8% compounded annually for 6 years.
Problem 3
If the interest rate is 12%, determine whether ₱50,000 today is economically equivalent to
₱56,000 one year from now.
Problem 4
Draw a cash flow diagram for the following project:
• Initial investment: ₱120,000 today
• Annual income: ₱40,000 for 5 years
• Salvage value: ₱20,000 at the end of Year 5
Problem 5
A company can purchase a new computer server for ₱600,000, which is expected to generate
savings of ₱150,000 per year for 5 years. Sketch the cash flow diagram and identify all inflows
and outflows.