Chapter 9

Engineering Economic Analysis

Chemical Engineering Department
West Virginia University

Copyright R.Turton and J. Shaeiwitz - 2012

Definitions

P Principal or Present Value (of an investment)

Fn Future Value (of an investment)
n Years (or other time unit) between P and F
i Interest Rate (based on time interval of n) per anum

Basic premise: Money when invested earns money

$1 today is worth more than $1 in the future
Copyright R.Turton and J. Shaeiwitz - 2012

Interest
Simple Interest Annual Basis
Interest paid in any year = Pis
Pis Fraction of investment paid as interest per
year
After n years total interest paid = Pisn
Total investment is worth = P + Pisn
Total investment after 1 year (n = 1) = P (1+is)
What is the drawback of simple interest?

We can earn interest on earned interest

Copyright R.Turton and J. Shaeiwitz - 2012

Interest
Compound Interest
At time 0 we have P
At the end of Year 1, we have F1 = P (1 + i )
At the end of Year 2, we have F2 = P (1 + i )2
At the end of Year n, we have Fn = P (1 + i )n
or P = Fn / (1 + i )n

Copyright R.Turton and J. Shaeiwitz - 2012

Example
How much would I need to invest at 8
% p.a. to yield $5000 in 10 years?

i 0.08
n 10
F10 5000
P

5000

1 0.08

10

$2315.97

Copyright R.Turton and J. Shaeiwitz - 2012

What if Interest Rate Changes with

Time?

Fn P (1 i j ) P 1 i1 1 i2 ....... 1 in
j 1

Copyright R.Turton and J. Shaeiwitz - 2012

Eq. (7.7)

Different Time Basis for Interest

Calculations
Relates to statement Your loan is 6 % p.a.,
compounded monthly
Define actual interest rate per compounding
period as r
inom = Nominal annual interest rate
m = Number of compounding periods per year (12)

Copyright R.Turton and J. Shaeiwitz - 2012

Different Time Basis for Interest

Calculations cont.
ieff = effective annual interest rate

inom
r
m

Look at condition after 1 year

inom
F1 P 1 ieff P 1

m
inom
ieff 1
1
m

Copyright R.Turton and J. Shaeiwitz - 2012

Example
I invest $1000 at 10 % p.a. compounded
monthly. How much do I have in 1 year, 10
years?
m

12

0.10
inom

F1 P 1
1000 1

m
12

$1104.71

12

ieff

0.10

12

F10 P 1 ieff

10

1 0.1047
$2707.04

Copyright R.Turton and J. Shaeiwitz - 2012

Example cont.
As m decreases ieff increases
Is there a limit as m goes to infinity
Yes continuously compounded interest
Derivation pp. 265-266
ieff (continuous) = e inom 1

Copyright R.Turton and J. Shaeiwitz - 2012

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Cash Flow Diagram (CFD)

Represent timings and approximate
magnitude of investment on a cfd
x-axis is time and y-axis is magnitude
both positive and negative investments are
possible.

In order to determine direction (sign) of cash

flows, we must define what system is being
considered.
Copyright R.Turton and J. Shaeiwitz - 2012

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Consider a Discrete Cash Flow Diagram

Discrete refers to individual CFDs that are

plotted

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12

Example
I borrow $20 K for a car and repay as a $400
monthly payment for 5 years.
$20,000

For Bank

For Me

$400
123
12 3

60

60
$400

$20,000
Copyright R.Turton and J. Shaeiwitz - 2012

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Cumulative CFD
Cumulative CFD

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14

Annuities

1 2

Uniform series of equally spaced, equal value cash flows

Note: The first payment is at the beginning of year 1 not
at t = 0

Copyright R.Turton and J. Shaeiwitz - 2012

15

Annuities
What is future value Fn?

Fn A 1 i

n 1

A 1 i

n 2

..... A

Geometric progression

1 i n 1

Fn Sn A
i

Copyright R.Turton and J. Shaeiwitz - 2012

16

Discount Factors
Just a shorthand symbol for a formula in i and
n
P

See Table 9.1

1 i

1
P

, i, n
F
1 i n

1
P

P F , i, n F
n
1 i
F

P
1 i 1
A P , i, n
A
i 1 i n
n

Copyright R.Turton and J. Shaeiwitz - 2012

17

Discount Factors
n

F
1

i
1

, i, n
i
A

1
P

, i, n
n
F

1 i
therefore
P
1 i 1
, i, n
A
i 1 i n

Table 9.1 has six

versions of these
Three are reciprocals
of the other three

Copyright R.Turton and J. Shaeiwitz - 2012

18

Calculations with Cash Flow Diagrams

$5,000
$1,000

$2,000

4
0

$3,000
Invest 5K, 1K, 2K at end of Years 0, 1, 3, and take 3K at end of
Year 4
Note that annuity payments are all at the end of the year
Copyright R.Turton and J. Shaeiwitz - 2012

19

Example 1
How much in account at end of Year 7 if i = 8%
p.a.?
F7 5,000 1 0.08 1000 1 0.08 2000 1 0.08
7

3000 1 0.08

F7 $9097.84

What would investment be at Year 0 to get this

amount at Year 7?
P

9097.84

1.08

5308.50
Copyright R.Turton and J. Shaeiwitz - 2012

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Example 2
What should my annual monthly car payment
be if interest rate is 8% p.a. compounded
monthly?
A

$20,000
Copyright R.Turton and J. Shaeiwitz - 2012

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Example 2 (contd)
Compare at n = 60
0.08 60
1
1
12

73.47 A
F60 A
0.08

12

0.08 60
F60 20,000 1
29,796.90
12

73.47 A 29,796.90 0
A $405.53

Interest paid = $4,331.20

Copyright R.Turton and J. Shaeiwitz 2012

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Example 2 (contd)
Another method
i
i
1
m m

mn

0.08 0.08
1

12
12

60

,
0
.
08
,
60

0.020276

mn
60
P

i
0.08
1

1
1
12
m

A P ,0.08,60 20,000(0.020276) $405.52

P

interest paid 60(405.52) 20,000 $4331.20

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 3
You buy a house where you finance $200 K
at 6% p.a. interest, compounded monthly.
What is your monthly payment, and how
much interest do you pay over the lifetime
of the loan for a 15-year and a 30-year
mortgage in current dollars?

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 3 (contd)
mn

i
i
1
n
A
i (1 i )
m m

mn
n
P (1 i ) 1
i
1 1
m
15 - year mortgage m 12, n 15
30 - year mortgage m 12, n 30
Copyright R.Turton and J. Shaeiwitz - 2012

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Example 3 (contd)
For 15-year mortgage
$1687.71/month
total of $303,788 paid
$103,788 interest

For 30-year mortgage

$1199.10/month
total of $431,676 paid
$231,676 interest

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 4
You invest $5000/year (the maximum, for
now) in a Roth IRA, starting at age 25 for 40
years. Assuming a return of 8% p.a., how
much will you have at age 65 in future
dollars?

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 4 (contd)
F (1 i ) 1

A
i
n

F (1 0.08) 1

A
0.08
F
259.06
A
A 5000
40

F $1,295,283
Copyright R.Turton and J. Shaeiwitz - 2012

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Example 5
Repeat the previous calculation, assuming that you
do not start investing until age 35 or age 45.
F (1 i ) n 1

A
i
F (1 0.08) n 1

A
0.08
A 5000
if n 30
if n 20

F
113.28
A
F
45.76
A

F $566,400
F $228,800

Copyright R.Turton and J. Shaeiwitz - 2012

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Depreciation
Total Capital Investment = Fixed Capital +
Working Capital
Fixed Capital All costs associated with new
construction, but Land cannot be depreciated
Working Capital Float of material to start
operations cannot depreciate

TCI FCI L Land WC

Copyright R.Turton and J. Shaeiwitz - 2012

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Definitions
Salvage Value, S
Value of FCIL at end of project
Often = 0

Life of Equipment
n set by IRS
Not related to actual equipment life

Total Capital for Depreciation

FCIL - S
Copyright R.Turton and J. Shaeiwitz - 2012

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4 Basic Methods for Depreciation

Straight Line
Sum of Years Digits (SOYD)
Double Declining Balance (DDB)
Modified Accelerated Cost Recovery System
(MACRS)

Copyright R.Turton and J. Shaeiwitz - 2012

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Straight Line
d kSL

FCI L S

n = # of years over which depreciation is taken

Copyright R.Turton and J. Shaeiwitz - 2012

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Sum of Years Digits (SOYD)

d kSOYD

n 1 k FCI L S

1
n n 1
2
SOYD

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Double Declining Balance (DDB)

DDB
dk

k 1

2
FCI L
d j
n

Copyright R.Turton and J. Shaeiwitz - 2012

35

MACRS
Current IRS-approved method
Year

Depreciation Percentage

1
2
3
4
5
6

20.00
32.00
19.20
11.52
11.52
5.76

See Chapter 9
Based on combination
of DDB and SL

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 9.21
FCI L $150 10
S $10 10

n7
1st Year d SL ?
150 10
d SL
20
7
Same for Years 1-7
Copyright R.Turton and J. Shaeiwitz - 2012

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Example 9.21 (contd)

Sum of Years Digits

7 1 1

7
d SOYD ,1
150 10 150 10 35

1
28
7 8
d SOYD ,2

2
7 1 2

150 10 150 10 30

1
28
7 8
2

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 9.21 (contd)

Double Declining Balance

2
d DDB,1 150 42.9
7
2
d DDB,2 150 42.9 30.6
7

Copyright R.Turton and J. Shaeiwitz - 2012

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Example 9.21 (contd)

MACRS
d MACRS , yr 1 0.20(150) 30
d MACRS , yr 2 0.32(150) 48
d MACRS , yr 3 0.192(150) 28.8
d MACRS , yr 4 0.1152(150) 17.28
d MACRS , yr 5 0.1152(150) 17.28
d MACRS , yr 6 0.0576(150) 8.64

Copyright R.Turton and J. Shaeiwitz - 2012

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Taxation, Cash Flow, and Profit

Tables 9.3 9.4

Expenses = COMd + dk
Income Tax = (R COMd - dk)t
After Tax (net)Profit =
(R COMd dk)(1 t)
After Tax Cash Flow =
(R COMd dk)(1 t) + dk (+ other cash flows)
Other cash flows might include working capital return,
salvage value, etc.
Copyright R.Turton and J. Shaeiwitz - 2012

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Inflation
$ Net Worth Now vs. $ Next Year

CEPCI j n 1 f CEPCI j
n

f = Average inflation rate between years j and n

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Inflation
Example
CEPCI 1993 359
CEPCI 2003 402

1 f

10

402

359

402
f

359

0.1

1 0.0114 or 1.14%
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Inflation
What is inflation rate since 2003? The current
CEPCI is 600 (2011).
600
(1 f )
1.4925
402
8

f 1.49250.125 1 0.0513
5.13%

Copyright R.Turton and J. Shaeiwitz - 2012

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Inflation
Effect of inflation on interest rate
f affects the purchasing power of the $
Look at the purchasing power of future worth, then
F'

F
(1 f )n

If this future worth was obtained by investing at a rate i,

then the inflation adjusted interest rate, i is given by
F'

1 i
F
(1 i )
' n

P
(1

i
)
1 f
n
n
(1 f )
(1 f )

i'

1 i
1 i f
1 f

Copyright R.Turton and J. Shaeiwitz - 2012

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