Engineering economics helps engineers choose between project alternatives using both technical performance and financial value. A design that works well may still be a poor choice if its costs arrive too early, its benefits arrive too late, or another option creates more value. The central idea is that money has a time value, so a dollar today is worth more than a dollar received in the future.
This matters in decisions about equipment, energy systems, construction projects, manufacturing upgrades, and product design.
Key Facts
- Future worth with compound interest: F = P(1 + i)^n
- Present worth of a future amount: P = F/(1 + i)^n
- Net present value: NPV = present value of benefits - present value of costs
- Choose the alternative with the largest positive NPV when projects have the same study period and risk level.
- Simple payback period = initial investment / annual net cash inflow
- Example: If a project costs 3000 per year for 4 years at 8%, NPV = -10000 + 3000(P/A, 8%, 4) = -10000 + 3000(3.312) = -$64, so it is slightly unattractive by NPV.
Vocabulary
- Time Value of Money
- The principle that money available today is worth more than the same amount of money received in the future because it can earn interest.
- Present Worth
- The value today of a future cost or benefit after discounting it using an interest rate.
- Future Worth
- The value at a future date of money invested or borrowed today after interest has accumulated.
- Net Present Value
- The total present value of all benefits minus the total present value of all costs for a project.
- Payback Period
- The time required for a project’s cash inflows to recover its initial investment.
Common Mistakes to Avoid
- Adding future dollars directly to present dollars, because cash flows at different times must be converted to a common point in time before comparison.
- Using the wrong sign for costs and benefits, because costs should reduce value and revenues or savings should increase value in an NPV calculation.
- Choosing the shortest payback automatically, because payback ignores cash flows after recovery and often ignores the time value of money.
- Comparing alternatives over unequal study periods without adjustment, because different lifetimes can bias the result unless repeated lives, annual worth, or a common study period is used.
Practice Questions
- 1 A machine costs 2500 per year for 4 years. Using an interest rate of 6%, calculate the NPV. Use (P/A, 6%, 4) = 3.465.
- 2 You deposit $5000 in an account earning 7% annual compound interest. How much will it be worth after 5 years? Use F = P(1 + i)^n.
- 3 Two design alternatives have the same initial cost. Alternative A has large savings in the first two years, while Alternative B has larger savings in years 8 through 10. Explain how a higher interest rate affects which alternative is more attractive.