Engineering Economic Analysis

62 INTERESTAND EQUIVALENCE

In the first chapter, we discussed the engineering economic decision process. In Chapter 2

we described models used to estimate the costs and benefits that are summarized in cash

flow diagrams. For many of the situations we examined, the economic consequences of an

alternative were immediate or took place in a very short period of time, as in Example 1-2,- ~ .'. --.

(the decision on the design of a concrete aggregate mix) or Example 1-3 (the change of

manufacturing method). In such relatively simple situations, we total the various positive

and negative aspects, compare our results, and quickly reach a decision. But can we do the

same if the economic consequencesoccur over a considerable period of time?

No we cannot, becausemoney has value over time.Would you rather: (1) receive

$1000 today or (2) receive $1000 ten years from today? Obviously, the $1000 today has

more value. Money's value over time is expressed by an interest rate. In this chapter, we

describe two introductory concepts involving thetime value of money:interest and cash

flow equivalence.

COMPUTING CASH FLOWS

Installing an expensivepiece of machinery in a plant obviouslyhas economic consequences

that occuroveran extendedperiod of time.If the machinerywere bought on credit,the simple

process of paying for it may take severalyears. What about the usefulness of the machinery?

Certainly it was purchased because it would be a beneficial addition to the plant. These

favorable consequences may last as long as the equipment performs its useful function.

In these circumstances, we do not add up the various consequences; instead, we describe

each alternativeas cash receipts or disbursements at different points in time. In this way,

each alternative is resolved into a set of cash flows. This is illustrated by Examples 3-1

and 3-2.

The manager has decided to purchase a new $30,000 mixing machine. The machine may be paid

for in one of two ways:

1. Pay the full price nowminusa 3% discount.


2. Pay $5000 now; at the end of one year, pay $8000; at the end of each of the next four
   years, pay $6000.
   List the alternatives in theform of a table of cash flows.

In this problem the two alternatives represent different ways to pay for the mixing machine.

While the first plan represents a~lumpsum of $29,100 now, the second one calls for payments

cOhtinuinguntilthe end of the fifthyear.The problemis to convertan alternativefnto cash receipts

or disbursements and show the tirn,ingof each.receipt or disbursement.The result is called a cash

I flQwtable or, more simply,a set ofcashflows.

.. III_ - - - -- - -- - - - .. - - - ...-.. - -.. ..