Modul 1: Pendahuluan

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Outline Modul 1

What is Economics? What is Engineering Economy? The Role of Engineering in Shaping the Economic Environment Project Life Cycle Some Concepts, Definitions and Terminologies Time Value of Money Interest and Interest Rate Cash Flow

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

What is Economics?

The study of how limited resources are used to satisfy unlimited human wants. The study of how individual and societies choose to use and utilize scarce resources Resources:

LAND all gifts of nature that can be applied to the process (production) LABOR efforts, skills, expertise, knowledge of people which can be applied to the process CAPITAL human, tools/machineries, financial

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

What is Engineering Economy?

Engineering and the Economy

Any endeavor, including engineering, will always have consequences Engineering endeavor

Add value betterment of effectiveness, efficiency, changing conditions Add economic value the most common comparable measurement

Example:

Economic decisions

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A piece of equipment has been used for 10 years as part of important process. Current condition indicates that service level is slightly decrease, often breaks down. On the other hand the demand for product is in constant increase, at least for the next 5 years. Alternatives:

Replaced with a new one or to be repaired SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D. Current and future technology (?)

Engineering Economy

Deals with the concepts and techniques of analysis useful for evaluating the worth of goods, services, system in relation to cost For engineers, it is used to answer questions such as:

Which engineering projects are worthwhile? Which engineering projects should have higher priority? How should an engineering project be designed? Cash flows Interest rate and time value of money Equivalent techniques
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

The answers based on the concepts of:

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The Role of Engineering in Shaping the Economic Environment

Engineering Options

There are many (engineering) alternative solution for any problem or challenge What solution is best to satisfy? For now or anytime in the future How do we compare one to another? Determine objectives Identification of strategic factors Determine means engineering proposals Evaluation of engineering proposals cash flow of alternatives Decision making economic evaluation
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Engineering Steps
1. 2. 3.

4.
5.
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Project Life Cycle

Concept & Definition Phase

Design Phase Construction Phase

Next Cycle

Level of Change

Operation & Maintenance Phase

scope

cost

Time
1-7 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Time Value of Money

Purchasing or earning power of money

Funds borrow for the prospects of gain are commonly exchanged for goods, services or instruments of production, that ultimately leads to increase earning What you could buy with Rp. 1 million a year ago will not be the same with the ones you buy today. Rp. 1 million you invested in a bank a year ago will yield more when you draw today. Rp 1 million today is worth more than a year latter. Concept of equivalence different sums of money at different time can be equal in economic value.
P F
Rp. 1 Mill + interest

Time value of money

Rp. 1 Mill

0
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SI-4251 Ekonomi Teknik

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Muhamad Abduh, Ph.D.

Interest and Interest Rate

Interest is defined as a rental amount charged by financial institution of the use of money Interest rate (also known as rate of capital growth) is defined as the rate gain received from an investment measured in % Interest rate is determined mutual agreement between the borrower and the lender, or by market forces involving supply and demand market value. From lenders point of view:

Involves risk of default Compensate for not taking other alternative (including for own use) Cost of investigating borrower and other administrative expenses To make up for inflation Based in ones utility, for personal use Based on expected return, for financing operation or investment
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

From borrowers point of view:

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Basic Calculation of Interest

Rp. 1 Mill

P 0 1 2 3 n-1

Rp. 1 Mill + interest

Original investment present value (P) Total accumulated amount future value (F) Interest , I = F P Interest rate, i = (interest accrued per unit time) / (original amount)

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Simple Interest

Simple interest = (principal)(number of periods)(interest rate), I = P.n.i Accumulated amount, F = P + I = P(1+ni)

End of Period (A) 1 2 3 4

Amount Owed at Beginning of Period (B) Rp. 1.000.000,Rp. 1.000. 000,Rp. 1.000.000,Rp. 1.000.000,-

Interest Charged (C) = (B) x i Rp. 120.000,Rp. 120.000,Rp. 120.000,Rp. 120.000,-

Amount Owed at End of Period (D) = (B) + (C) Rp. 1.120.000,Rp. 1.120.000,Rp. 1.120.000,Rp. 1.120.000,-

Amount Paid at End of Period Rp. 120.000,Rp. 120.000,Rp. 120.000,Rp. 1.120.000,-

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Compound Interest

Compound interest interest will be charged for all unpaid amount Accumulated amount, F = P(1+i)n
Amount Owed at Beginning of Period (B) = (C)n-1 Interest Charged (C) = (B) x i Amount Owed at End of Period (D) = (B) + (C) Amount Paid at End of Period (E)

End of Period (A)

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2 3 4

Rp. 1.000.000,Rp. 1.120. 000,Rp. 1.254.400,Rp. 1.404.928,-

Rp. 120.000,Rp. 134.400,Rp. 150.528,Rp. 168.592,-

Rp. 1.120.000,Rp. 1.254.400,Rp. 1.404,928Rp. 1.573.519,-

Rp. 0,Rp. 0,Rp. 0,Rp. 1.573.519,-

End of Period
1 2 3

Amount Owed at Beginning of Period

P P(1+i) P(1+i) 2

Interest Charged
Pi P(1+i) 1 P(1+i) 2i

Amount Owed at End of Period

P + Pi P(P+i) 1 + P(1+i)i P(1+i) 2 + P(1+i) 2.i = P (1+i)1 = P (1+i) 2 = P (1+i) 3

P(1+i) n-1

P(1+i) n-1i

P(1+i) n-1 + P(1+I) n-1i

= P(1+i) n

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Exercise for Concept of Equivalence

Loan: $ 5,000, i = 8%, n = 5 Repayment plans:

Plan 1: Simple interest, pay all at end. Plan 2: Compound interest, pay all at end. Plan 3: Simple interest paid annually, principal repaid at end. Plan 4: Compound interest and portion of principal repaid annually. Plan 5: Equal payments of compound interest and principal made annually.

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Cash Flows

Any undertaking and/or business endeavor (including engineering projects) generally have economic consequences that occur over an extended period of time. Each project is described as cash received (inflow cash in) or disbursement or expenses (outflow cash out) at different point in time. Cash Flow Diagram (CFD) summarizes the costs and benefits of engineering project over time. CFD illustrates the size, sign and timing of individual cash flows and form as the basis for engineering economic analysis

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Cash Flows Diagram

In a CFD the end of period t is the same as the beginning of next period t+1 The choice of time 0 is arbitrary. It can be when the project is analyzed, when funding is approved or when the construction begins

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SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.

Homework #1
1. What will be the accumulated amount of Rp 750.000,compounded annually for three years at the rate of 10% p.a?

2. How much do you have to save now if youd like to have

Rp. 15.500.000,- to start a new company 2 years from now at the interest rate of 1.5% compounded monthly?

3. What is the rate of return of an initial investment worth

Rp. 35 millions that yield Rp. 42.500.000,- after 18 months?

4. An initial investment of Rp. 50 millions is being

considered. The revenues from this investment are Rp 25 millions at the end of first year, Rp 20 millions and Rp 15 millions at the end of second and third years. If the alternative will give a revenue of Rp 57,5 millions at the end of the third year, which investment would you recommend? The interestAbduh, Ph.D. 1-16 SI-4251 Ekonomi Teknik Muhamad rate is set at 11% annually.