AMERICAN UNIVERSITY OF BEIRUT
MAROUN SEMAAN FACULTY OF ENGINEERING AND ARCHITECTURE
DEPARTMENT OF INDUSTRIAL ENGINEERING & MANAGEMENT
INDE 301: ENGINEERING ECONOMY
FALL 2024-2025
Chapter 1: Foundations of Engineering Economy
AUB MSFEA | INDE 301 | Nadim Khater
What is Engineering Economy?
• Estimating, formulating, and evaluating financial outcomes of
alternatives
• Collection of mathematical techniques for economic comparison
• Provides criteria for decision-making
AUB MSFEA | INDE 301 | Nadim Khater
Decision-Making Process in Engineering Economy
Steps of the Decision-Making Process:
• Understand the problem and define the objective
• Collect relevant information
• Define alternatives and estimate relevant costs
• Identify the criteria
• Evaluate each alternative
• Select the best alternative
• Implement the solution
• Monitor the results and refine the solution
AUB MSFEA | INDE 301 | Nadim Khater
Importance of Engineering Economy to Engineers
• Engineers design and create, which involves economic decisions
• Essential to incorporate economic analysis into creative efforts
• Proper economic analysis is crucial for selecting and executing alternatives
AUB MSFEA | INDE 301 | Nadim Khater
Examples of Engineering Economy Questions
Should we:
• Replace old equipment?
• Introduce a new product?
• Build a new plant?
• Invest in Project A or Project B?
AUB MSFEA | INDE 301 | Nadim Khater
The Time Value of Money
$1 today is not equivalent to $1 a year later
“Money makes money “
Worst alternative is to deposit (invest) the $1 in a bank and gain “interest”
(or dividend)
Basic Principle: Money has a time value
• Interest as a return on investment
• All firms invest funds expecting returns
• Investments are expected to earn a return
• Money possesses a “time value”
AUB MSFEA | INDE 301 | Nadim Khater
Interest and Rate of Return (ROR)
• Interest is the manifestation of the time value of money
• Rental fee that one pays to use someone else’s money
• Difference between an ending amount of money and a beginning amount of money
• Interest rate = (interest accrued per time unit) / (original amount)
• From the lender perspective, the “earned” interest rate is a “rate of return” (ROR)
Final loan amount − Original amount borrowed
Interest rate (%) = 100
Original amount
Final investment value − Original amount invested
ROR (%) = 100
Original amount
AUB MSFEA | INDE 301 | Nadim Khater
Interest rate and Rate of Return Examples
• An investment group invested $200,000 and withdrew a total of $220,000 exactly one year
later
o Interest earned = $220,000 – $200, 000 = $20,000
o ROR = ($20,000 / $200,000) × 100 = 10%
• Another investment group borrowed $100,000 and paid a total of $105,000 exactly one
year later
o Interest paid = $105,000 – $100, 000 = $5,000
o Interest rate = ($5,000 / $100,000) × 100 = 5%
AUB MSFEA | INDE 301 | Nadim Khater
The Concept of Equivalence
• Different sums of money at different times may be “equivalent” in
economic value.
• For the investment group doing the investment, $200 K now are
equivalent to $220 K a year later
$220 K one
year from now
0 1
Interest rate = 10 % per year
$200 K now
AUB MSFEA | INDE 301 | Nadim Khater
An Example on Equivalence
• You want to replace your study desk. The new desk is now $125 and
estimated to be worth $135 for the next year. At a market interest rate
of 12%, would you replace your desk now or the next year?
• $135 next year are equivalent to 135/1.12 = $120.54 < $125.
• Then, it’s better to buy the desk next year because this saves you around $5.
• This is a “Present Worth” analysis
AUB MSFEA | INDE 301 | Nadim Khater
Simple and Compounded Interest
With simple interest, in each period one pays interest on the principal (the amount
borrowed) itself only
With compounded interest, in each period, one pays interest on the principal and on
the interest accumulated from previous periods. That is, one pays “interest on interest”
Suppose you borrow an amount P and pay interest for n years at a rate of i per year.
Then, the amount, F, you pay back n years later is
With simple interest, With compounded interest,
F = P + iP + + iP = P + niP. F = P(1 + i )(1 + i ) (1 + i ).
Then, Then,
F = P (1 + ni ) F = P(1 + i)n
AUB MSFEA | INDE 301 | Nadim Khater
Example of Simple vs. Compounded Interest
Here's a diagram
showing the growth
of $10,000 at a 10%
interest rate over 10
years, comparing
simple interest and
compound interest.
AUB MSFEA | INDE 301 | Nadim Khater
Cash Flows
• Cash Inflows - amount of funds flowing into the firm/project
• Cash Outflows – amount of funds flowing out of the firm/project
Example of cash inflows Cash flow diagram
o Sales Revenue
o Asset salvage value
o Borrowed money
o Income tax savings
0 1 2 … … … n─1
Example of cash outflows n
o Paybacks
o Labor cost
o Maintenance and operating costs Cash flows are shown as directed arrows
o Loans (from the lender’s perspective) (+ for up or – for down) ---
o Income taxes (+) inflow; (-) outflow
AUB MSFEA | INDE 301 | Nadim Khater
Minimum Attractive Rate of Return (MARR)
Investors expect to earn a return on their investment (commitment of funds) over time
MARR is estimated based on the weighted average of the “cost of capital” of sources of funding available to the firm
(simply termed cost of capital for the firm).
• MARR is set in such a way that MARR > cost of capital
• To be considered financially viable, a project’s expected ROR must meet or exceed the MARR. That is, a project
should be undertaken if and only if its ROR ≥ MARR
Rule of 72 - This rule (approximately) estimates the number of time periods, n, it takes for an amount of money to
double under a ROR of i (%)
72
n=
i
AUB MSFEA | INDE 301 | Nadim Khater