Debre Markos University
Institute of Technology
Department of Civil Engineering
Engineering Economics
CHAPTER - ONE
1. INTRODUCTION
ECONOMICS
▪ The study of how limited resources is used
to satisfy unlimited human wants/needs
▪ A sciences deals production and
consumption of goods, services and
distribution.
▪ Eng Economics deals with economic
decision of how to minimize cost and
maximize benefits.
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Resources:- Land, Labor, Capital
Land(natural)
All natural gifts, such as: water, air, minerals,
sunshine, plant and tree growth, as well as the
land itself.
Labor
The efforts, skills, and knowledge of people which
are applied to the production process.
Capital
A) Real Capital (Physical Capital ):Tools, buildings,
machinery- things which have been produced
which are used in further production
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B) Financial Capital: Assets and money which are
used in the production process
C) Human Capital: Education and training applied
to labor in the production process
Relationship between Engineering and Economics
very close
Engineers are not only expected to create technical
alternatives but also evaluate them for economic
efficiency.
Incase of Construction projects , ECONOMICS
affects Decision making in many ways.
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Project concept /Private or Public (state)
Project is an investment plan undertaken for
particular goal or objective to be achieved within a
limited period of time and with limited resources.
A project is characterized by :
✓ A construction period
✓ An operational period
✓ Expected life time
✓ Specific desired output
✓ Use of scarce and valuable resources
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2. Economic Decision Making
▪ Out of Pocket Commitment:The total
expense required for an alternative.
Pay Back Period:The pay back period for
an investment is the number of years it
takes to repay the original invested capital
Average Annual Rate of Return: The alternatives
are evaluated on the basis of only the average
rate of return as expressed in terms of a
percentage (of the original capital).
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EXAMPLES
1) Out of Pocket Commitment
- A precast concrete factory has to produce
100,000 railway sleepers per year.
- An economic choice has to be made between
using steel and wooden molds.
- The life of steel mold is estimated to be one year,
while that of wooden mold is one month.
-The costs of preparing one set of steel mold and
one set of wooden mold are Birr. 40,000 and Birr
5,000 respectively.
- It is further estimated that the labor costs for
assembling and removing the steel and wooden
molds are Birr. 1 Birr 0.9 per sleeper respectively.7
Choose the best mold.
Solution
- The out of pocket commitment for steel mold
= The total labor cost incurred for production of
100000 sleepers/yr + the cost of the steel mold/yr
=Birr. 100,000 x 1 + Birr. 40,000= Birr. 140,000.
- Out of pocket commitment for wooden mold
= Birr 0.90x100,000 + Birr 5000x12 = Birr. 150,000.
- STEEL is our Engineering Decision.
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2) Pay Back Period
-A contractor want to choose from the two brands
of excavators A and B
-Suppose both the brands are available for a down
payment of Birr. 400,000. and Both brands can be
useful for a period of four years.
-Brand A is estimated to give a return of Birr.
50,000 for the first year, Birr. 150,000 for the second
year, and Birr.200,000 for the third and fourth year.
- Brand B on the other hand is expected to give a
return of Birr. 150,000 for all the four years.
Which brand of excavator is preferable?
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Solution
-The payback period for Brand A = 3 yrs,
As the initial investment of Birr. 400,000 is
recovered in 3 years
(50,000 + 150,000 + 200,000= 400,000)
-The method does not consider the returns after
the payback period.
-For Brand B, the return is
Birr. 300,000 up to the end of 2nd year and
Birr. 450,000 3rd year
Investment Birr. 400,000 recovered between 2nd
and 3rd yr, which can be found out by
interpolation.
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Interpolate
payback period for Brand B
= 2 + (3 – 2) * (400,000-300,000)/ (450,000 –
300,000)) = 2.67 yrs or 2 years and 8 months.
-Here also as in the first case we neglect the
return that is expected beyond the pay back
period.
-Brand B better why???
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3) Average Annual Rate of Return
We use the previous example
- The average annual return from brand A
=(50,000+150,000+200,000+200,000)/4 =
600,000/4= 150,000.
- Average annual rate of return for brand A
in %= (150,000/400,000)*100= 37.5%. Here
400,000 is the original invested capital.
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The average annual return for brand B
=(150,000+150,000+150,000+150,000)/4
=150,000.
- The average annual rate of return for
equipment B
- = (150,000/400,000)*100= 37.5%.
- Both are equal. Here we might go for B,
Because having high initial return.
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[Link] Value of Money
(Change in the value of money with time)
In most decisions the change in the value
of money needs to be accounted
The manifestation of time value of money
is called interest.
Interest ; Money paid by Borrower for the
use of funds provided by the lender
Therefore time value of money is the
relationship between time and money.
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Interest and Interest Rate
Interest – the manifestation of the time value of money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money and
a beginning amount of money
• Interest = amount owed now – principal
• Interest rate – Interest paid over a time period
expressed as a percentage of principal
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It is clearly explained in quote;
“A bird in hand is more than two in bush”
the reason for the time value of money is
inflation, risk and cost of money.
Interest could be simple or compound
Simple;The interest doesn't attract any
interest during the repayment period
Compound;The interest amount it self also
attracts further interest.
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Consider the following statement by a Bank
“Interest on the deposit will be payable at the rate of
eight percent compound quarterly”
A year for Quarterly compounding of interest:-
Four periods ( 3 months of each)
- If the amount was 100 Birr
1st period = 100 + (100*8%/4)
= 102
2nd Period = 102 + (102*8%/4)
= 104.04
3rd Period = 104.04 + (104.04*8%/4)
=106.12
4th Period = 106.12 + (106.12*8%/4)
= 108.24
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From the Example it is clear that Birr 8.24 can be
seen as the interest amount attracted by 100 Birr
in one year period under a given rate ( 8% ) and
condition of quarterly compounding.
NOMINAL & EFFECTIVE RATES
Nominal and Effective Interest rates are common
in business, finance, and engineering economy
Nominal Interest Rate, i (inom)
A Nominal Interest Rate, i, is an interest Rate that does
not include any consideration of compounding
i = (interest rate per period)(No. of Periods)
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The Effective Interest Rate /ieffe
It is a rate that applies for a stated period of time
It is conventional to use the year as the time standard
So, the EIR is often referred to as the Effective Annual
Interest Rate (EAIR)
ieffe = (1 + i/m)m – 1
where:
m = number of compounding periods per year
i = nominal interest rate per year
ieffe = effective interest rate per year
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From the above example Calculate ieff for the given inom
Quarterly 5% & 10% - inom , answer 5.09 and 10.38
Respectively
Monthly 5% & 10% - inom ,answer 5.12 and 10.47 Respectively
Eg. inom M period ieffe
5 2 5.06
10 4 10.38
Please 15 6 15.97
Check 20 12 21.94
All 5 12 5.12
10 6 10.43
15 4 15.87
20 2 21.00
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E.g. An engineer deposits $1,000 in a savings
account at the end of each year. If the bank pays
interest at the rate of 6% per year, compounded
quarterly, how much money will have
accumulated in the account after 5 years?
ieffe = (1 + i/m)m – 1 = (1 + 0.06/4)4 – 1
= 0.06136 = (6.136%)
F = $1,000 (F/A,6.136%,5) ????
Using formula: F = $5,652 ????
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Interest Formulas
Simple Interest
The interest payment each year is found by multiply
the interest rate I by the principal, P
I = Pi. After any n time periods,
The accumulated value of money owed under
simple interest, Fn, would be:
F1= P + Pi Fn = P(1 + ni)
F1= P(1+i)
For n years
F1= Total accumulated after one year
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Compound Interest
The interest payment each year, or each
period, is found by multiplying the interest rate
i by the accumulated value of money, both
principal and interest.
For an amount P invested of n periods at i rate
of interest compound interest calculations
would be: F2= F1 + F1i
F 2= P(1+i) + P(1+i)i
F 2= P(1+i+i+i2)
F 2= P(1+2i+i2)
Fn = P( 1 + i )n
F 2= P(1+i)2 23
Quiz 1
Calculate ieff for the given inom compounded
monthly?
A. 15%?
B. 13.5%?
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Thank you !!
Any Question ???