Engineering Economics Fundamentals: Cash Flow & Interest
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Key Concepts in Engineering Economics
Engineering Economics is the science dealing with quantitative analysis techniques for selecting the most preferable alternative from several technically viable options.
Fundamental Principles
Four fundamental principles must be applied in all engineering economic decisions:
- The time value of money
- Differential (or incremental) cost and revenue
- Marginal cost and revenue
- The trade-off between risk and reward
Core Terminology Explained
- Ethics
- A set of principles that guides a decision-maker in distinguishing between right and wrong.
- Market Interest Rate
- The interest rate quoted by financial institutions, which refers to the cost of money for borrowers or the earnings from money for lenders.
- Interest Rate
- The cost, or price, of money expressed as a percentage rate per period.
- Interest Period
- A length of time (e.g., year, month, week) that determines the frequency of interest calculation.
- Simple Interest
- The practice of charging an interest rate only on an initial sum (the principal amount).
- Compound Interest
- The practice of charging an interest rate on an initial sum and on any previously accumulated interest that has not been withdrawn.
- Economic Equivalence
- A state that exists between cash flows or patterns of cash flows that have the same economic effect and can, therefore, be traded for one another.
- Effective Interest Rate (ieff)
- The true interest rate computed using compound interest equations for a one-year period, regardless of the compounding period's length.
Understanding Cash Flow
- Cash Flow Analysis
- The cycle of cash inflows and outflows that determines a business's solvency.
- Cash Flow Diagram
- A graphical summary of the timing and magnitude of a set of cash flows. These diagrams are particularly useful for detecting patterns.
Five Categories of Cash Flows
Cash flows can be categorized into five main patterns:
- Single Cash Flow: A single present or future cash flow.
- Equal (Uniform) Series: A series of cash flows of equal amounts at regular intervals.
- Linear Gradient Series: A series of cash flows increasing or decreasing by a fixed amount at regular intervals.
- Geometric Gradient Series: A series of cash flows increasing or decreasing by a fixed percentage at regular intervals.
- Irregular Series: A series of cash flows exhibiting no overall pattern, although portions of the series might have detectable patterns.