lecture 1 chap 1 foundations of engineering economy

Chap. 1 Foundations of Engineering Economy

Lecture 1

Dr. Jin-Lee Kim, P.E., LEED AP BD+C

Learning Outcomes:

1. Role in decision making2. Study approach3. Ethics and economics4. Interest rate5. Terms and symbols6. Cash flows7. Economic equivalence8. Simple and compound interest9. Minimum attractive rate of return10. Spreadsheet functions

Why Engineering Economy is

Important to Engineers

Engineers design and create

Designing involves economic decisions

Engineers must be able to incorporate economic analysis

into their creative efforts

Often engineers must select and implement from multiple

alternatives

Understanding and applying time value of money, economic

equivalence, and cost estimation are vital for engineers

A proper economic analysis for selection and execution is a

fundamental task of engineering

A Sea of Problems

Simple Problems

Should I buy metro-rail pass or pay every time?

Should our company pay the vendor cash or credit?

Intermediate Problems

Should I buy or lease my next car?

Which computer numerical control (CNC) machine

should the company purchase?

Complex Problems

Feasibility study of a new automobile plant

Planning for new highways

Time Value of Money (TVM)

TVM explains the change in the amount of money over time

for funds owed by or owned by a corporation (or individual)

Corporate investments are expected to earn a return

Investment involves money

Money has a time value

The time value of money is the most important concept in

engineering economy

Time Value of Money

Money has purchasing power

Money has earning power

Money is a valuable asset

People are will to pay some charges (interests) to have

money available for their use

Engineering Economy

Engineering Economy involves

Formulating

Estimating, and

Evaluating

expected economic outcomes of alternatives designed to

accomplish a defined purpose

Easy-to-use math techniques simplify the evaluation

Estimates of economic outcomes can be deterministic or

stochastic in nature

Decision-Making Process

1. Recognize Problem / Opportunity

2. Define Goals/Objectives

3. Assemble Relevant Data

4. Identify Feasible Alts

7. Predict Alts Outcomes

8. Choose the Best Alt.9. Audit the Results

Overall Mission / Objectives

5. Select the Criterion

6. Construct a Model


1. Recognize Problem / Opportunity

Needs for New Products, Processes, or Facilities

Improvement of Products, Processes, or Facilities (Total

quality management (TQM), Continuous improvement (CI))

SWOT (Strengths, Weaknesses, Opportunities, and

Threats) Analysis

Investment/Financing


2. Define Goals/Objectives

General or specific goals

Systems perspective

Limiting factors

Multiple goals

Conflicting goals



Importance of Data Collection

Relevance of Information

Dollar Amount and Time Horizon

Sources of Information

Financial Accounting System

Cost Accounting Records

Market Research

Quotations

Economic Indicators

Other Published Information


3. Assemble Relevant DataEx. 1: Assemble Relevant Data

Vast information

What is relevant?

From whos viewpoint?

From the Manager of Shipping Dept.

Alt. 1 $793.00 /30,000 copies (Printing Dept.) vs.

Alt. 2 $688.00 /30,000 copies (Comm. Printer)

From General Manager

Alt. 1 $793.50 / mo (Printing Dept.) vs.

Alt. 2 ($793.50-$294.00)+688.50 / mo (Comm. Printer)



Financial Consequences (Costs & Benefits):

Market Consequences: has established prices

Extra-Market Consequences: prices could be assigned by

indirect means

Intangible Consequences: Social impacts, environmental

impacts, etc.


4. Identify Feasible Alternatives

Include as many as possible alternatives:

Do-Nothing option

Simple solutions

Bounded rationality Number of alternatives


5. Select the Criterion

Multiple criteria

Conflicting criteria

Integrating criteria

Most common criterion Maximize profit

Category Economic Criterion

Fixed input Maximize the benefits or other outputs

Fixed output Minimize the costs or other inputs

Neither input nor output fixed

Maximize the profits (Value of outputs

cost of inputs)


6. Construct Models

Real Systems and Models

A model describes the interrelationships among the

relevant data and predicts the outcomes of various

alternatives.


7. Predict Alternatives Outcomes

Comparable outcomes

Single criterion

Single composite criterion

Risk and uncertainty

Search for more information (loop)

Modification of alternatives (loop)


8. Choose Best Alternative(s)

Selection criterion

Other intangible considerations


9. Audit the Results

Reality vs. prediction

Learn from mistakes

Replacement Analysis

Ethics

The concept of distinguishing between right and wrong in

decision making.

Ethics includes:

Establishing systems of beliefs and moral obligations

Defining values and fairness

Determining duty and guidelines for conduct

Ethics Different Levels

Universal morals or ethics Fundamental beliefs: stealing, lying, harming or murdering another are wrong

Personal morals or ethics Beliefs that an individual has and maintains over time; how a universal moral is

interpreted and used by each person

Professional or engineering ethics Formal standard or code that guides a person in work activities and decision

making

Code of Ethics

National Society of Professional Engineers (NSPE)

All disciplines have a formal code of ethics. National Society of

Professional Engineers (NSPE) maintains a code specifically for

engineers; many engineering professional societies have their own

code

Code of Ethics

National Society of Professional Engineers (NSPE)

Engineers, in the fulfillment of their professional duties, shall:

1. Hold paramount the safety, health, and welfare of the public.

2. Perform services only in areas of their competence.

3. Issue public statements only in an objective and truthful manner.

4. Act for each employer or client as faithful agents or trustees.

5. Avoid deceptive acts.

6. Conduct themselves honorably, responsibly, ethically, and

lawfully so as to enhance the honor, reputation, and usefulness

of the profession.

(http://www.nspe.org/ethics/eh1-code.asp)

Ethical Dimensions in

Engineering Decision Making

Decision Process Step Example Ethical Lapses

1. Recognize the problem Looking the other way, or not to recognize the problem due to bribes or

fear of retribution

2. Define goals/objectives Favoring one group of stakeholders by focusing on their objective

3. Assemble relevant data Using faulty or inaccurate data

4. Identify feasible alts. Leaving legitimate alts out of consideration

5. Select criterion to

determine best alt

Considering only monetary consequences when other significant consequences exist

Ethical Dimensions in

Engineering Decision Making

Decision Process Step Example Ethical Lapses

6. Construct a model Using a short horizon that favors one alt over another

7. Predict alts outcomes Using optimistic estimates for one alt. and pessimistic ones for the other alts

8. Choose the best alt Choosing an inferior alt, one that is unsafe, adds unnecessary cost for user,

harms the environment

9. Audit the result Hiding past mistakes

Ethics in

Engineering Economic Analysis

How well and how honestly the decision-making process is

conducted the data, method of analysis, recommendations, and follow-up

Recognize ethical issues exist and make them an explicit

part of decision making process

Interest and Interest Rate

Interest the manifestation of the time value of money

Fee that one pays to use someone elses money

Difference between an ending amount of money and a

beginning amount of money

Interest = amount owed now principal

Interest rate Interest paid over a time period expressed as a percentage of principal

Rate of Return

Interest earned over a period of time is expressed as a

percentage of the original amount (principal)

Borrowers perspective interest rate paid

Lenders or investors perspective rate of return earned

interest accrued per time unitRate of return (%) = x 100%

original amount

Rate of Return

Interest paid Interest earned

Interest rate Rate of return

Commonly used Symbols

t = time, usually in periods such as years or months

P = value or amount of money at a time t

designated as present or time 0

F = value or amount of money at some future

time, such as at t = n periods in the future

A = series of consecutive, equal, end-of-period

amounts of money

n = number of interest periods; years, months

i = interest rate or rate of return per time period; percent per

year or month

Cash Flows: Terms

Cash Inflows Revenues (R), receipts, incomes, savings generated by projects and activities that flow in. Plus sign

used

Cash Outflows Disbursements (D), costs, expenses, taxes caused by projects and activities that flow out. Minus

sign used

Net Cash Flow (NCF) for each time period:

NCF = cash inflows cash outflows = R D

End-of-period assumption:

Funds flow at the end of a given interest period

Cash Flows: Estimating

Point estimate A single-value estimate of a cash flow element of an alternative

Cash inflow: Income = $150,000 per month

Range estimate Min and max values that estimate the cash flow

Cash outflow: Cost is between $2.5 M and $3.2 M

Point estimates are commonly used; however, range

estimates with probabilities attached provide a better

understanding of variability of economic parameters used to

make decisions

Cash Flow Diagrams

What a typical cash flow diagram might look like

0 1 2 n - 1 n

Draw a time line

One time period

0 1 2 n-1 n

Show the cash flows (to approximate scale)

Cash flows are shown as directed arrows: + (up) for inflow

- (down) for outflow

Always assume end-of-period cash flows

Time

F = $100

P = $80

Ex. 2: Cash Flow Diagram

Plot observed cash flows over last 8 years and estimated sale next year

for $150. Show present worth (P) arrow at present time, t = 0

Ex. 3: Cash flows of 2 payment options

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 now minus a 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 the form of a table of cash flows.

Ex. 3: Cash flows of 2 payment options

End of Year Cash Flow

0 (now) -$29,100

1 0

2 0

3 0

4 0

5 0

Pay in full

40 1 2 3 5

Pay in 5 years

End of Year Cash Flow

0 (now) -$5,000

1 -8,000

2 -6,000

3 -6,000

4 -6,000

5 -6,000

40 1 2 3 5

$29,100

$5,000$8,000

Ex. 4: Cash flow for repayment of a loan

A man borrowed $1000 from a bank at 8% interest. He

agreed to repay the loan in two end-of-year payments. At

the end of each year, he will repay half of the $1000

principal amount plus the interest that is due. Compute the

borrowers cash flow.

Yr Interest Balance Repayment

Cash

Flow

0 1000 1000

1 80 500 500 -580

2 40 0 500 -540

0 1 2

$1000

$580$540

Economic Equivalence

Definition: Combination of interest rate (rate of return) and

time value of money to determine different amounts of

money at different points in time that are economically

equivalent

How it works: Use rate i and time t in upcoming relations to

move money (values of P, F and A) between time points t =

0, 1, , n to make them equivalent (not equal) at the rate I

Using the concept of equivalence, one can convert different

types of cash flows at different points of time to an

equivalent value at a common reference point

Equivalence is dependent on interest rate

Ex. 5: Equivalence

Different sums of money at different times may be equal in

economic value at a given rate

$100 now is economically equivalent to $110 one year from

now, if the $100 is invested at a rate of 10% per year

0 1

$100 now

$110

Rate of return = 10% per year

Year

Simple Interest

Interest is computed only on the original sum, and not on accrued interest

niP (Eq. 3-1)Total interest earned =

Where P = Principali = Simple annual interest raten = Number of years

niPPF

Where F = Amount due at the end of n years

(Eq. 3-2)

Ex. 6: Simple Interest Calculation

You have agreed to loan a friend $5000 for 5 years at a

simple interest rate of 8% per year. How much interest will

you receive from the loan? How much will your friend pay

you at the end of 5 years?

Total interest earned = $5000(8%)(5) = $2000

Amount due at end of loan = $5000 + 2000 = $7000

Compound Interest

Interest is computed on the unpaid balance, which includes

the principal and any unpaid interest from the preceding

period

Common practice for interest calculation, unless specifically

stated otherwise

Ex. 7: Compound Interest Calculation

To highlight the difference between simple and compound

interest, rework Example 6 using an interest rate of 8% per

year compound interest. How will this change affect the

amount that your friend pays you at the end of 5 years?

Ex. 7 Compound Interest Calculation

Year

Balance at the

Beginning of the year Interest

Balance at the end

of the year

1 $5,000.00 $400.00 $5,400.00

2 $5,400.00 $432.00 $5,832.00

3 $5,832.00 $466.56 $6,298.56

4 $6,298.56 $503.88 $6,802.44

5 $6,802.44 $544.20 $7,346.64

Repaying a Debt

Plan #1: Constant Principal

Repay of a loan of $5000 in 5 yrs at interest rate of 8%

Plan #1: Constant principal payment plus interest due

Yr

Balance at

the

Beginning

of year Interest

Balance at

the end of

year

Interest

Payment

Principal

Payment

Total

Payment

1 $5,000.00 $400.00 $5,400.00 $400.00 $1,000.00 $1,400.00

2 $4,000.00 $320.00 $4,320.00 $320.00 $1,000.00 $1,320.00

3 $3,000.00 $240.00 $3,240.00 $240.00 $1,000.00 $1,240.00

4 $2,000.00 $160.00 $2,160.00 $160.00 $1,000.00 $1,160.00

5 $1,000.00 $80.00 $1,080.00 $80.00 $1,000.00 $1,080.00

Subtotal $1,200.00 $5,000.00 $6,200.00

Repaying a Debt

Plan #2: Interest Only

Repay of a loan of $5000 in 5 yrs at interest rate of 8% Plan #2: Annual interest payment and principal payment at end of 5 yrs

Yr

Balance at

the

Beginning

of year Interest

Balance at

the end of

year

Interest

Payment

Principal

Payment

Total

Payment

1 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00

2 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00

3 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00

4 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00

5 $5,000.00 $400.00 $5,400.00 $400.00 $5,000.00 $5,400.00

Subtotal $2,000.00 $5,000.00 $7,000.00

Repaying a Debt

Plan #3: Constant Payment


Plan #3: Constant annual payments

Yr

Balance at

the

Beginning

of year Interest

Balance at

the end of

year

Interest

Payment

Principal

Payment

Total

Payment

1 $5,000.00 $400.00 $5,400.00 $400.00 $852.28 $1,252.28

2 $4,147.72 $331.82 $4,479.54 $331.82 $920.46 $1,252.28

3 $3,227.25 $258.18 $3,485.43 $258.18 $994.10 $1,252.28

4 $2,233.15 $178.65 $2,411.80 $178.65 $1,073.63 $1,252.28

5 $1,159.52 $92.76 $1,252.28 $92.76 $1,159.52 $1,252.28

Subtotal $1,261.41 $5,000.00 $6,261.41

Repaying a Debt

Plan #4: All at Maturity


Plan #4: All payment at end of 5 years

Yr

Balance at

the

Beginning

of year Interest

Balance at

the end of

year

Interest

Payment

Principal

Payment

Total

Payment

1 $5,000.00 $400.00 $5,400.00 $0.00 $0.00 $0.00

2 $5,400.00 $432.00 $5,832.00 $0.00 $0.00 $0.00

3 $5,832.00 $466.56 $6,298.56 $0.00 $0.00 $0.00

4 $6,298.56 $503.88 $6,802.44 $0.00 $0.00 $0.00

5 $6,802.44 $544.20 $7,346.64 $2,346.64 $5,000.00 $7,346.64

Subtotal $2,346.64 $5,000.00 $7,346.64

A Closer Look at the 4 Repayment

Differences:

Repayment structure (repayment amounts at various

points in time)

Total payment amount

Similarities:

All interest charges were calculated at 8%

They all achieved the same purpose of repaying the loan

within 5 years

Minimum Attractive Rate of Return

MARR is a reasonable rate of

return (percent) established for

evaluating and selecting

alternatives

An investment is justified

economically if it is expected to

return at least the MARR

Also termed hurdle rate,

benchmark rate and cutoff rate

MARR Characteristics

MARR is established by the financial managers of the firm

MARR is fundamentally connected to the cost of capital

Both types of capital financing are used to determine the

weighted average cost of capital (WACC) and the MARR

MARR usually considers the risk inherent to a project

Selecting a

Minimum Attractive Rate of Return

Minimum Attractive Rate of Return (MARR)

should be equal to the largest of:

Cost of borrowed money

Cost of capital

Opportunity cost

Adjusting MARR to Account for

Risk and Uncertainty

Risk: Probabilities could be assigned to a set

of possible future outcomes

Uncertainty: Probabilities are unknown

If projects are under normal business risk, no

need to adjust MARR

For projects with greater risk or uncertainty,

MARR should be increased

Most companies use risk-adjusted rates

Ex. 8: Risk-Adjusted Interest Rates for Manufacturing

Rate (%) Applies to:

6% Equipment replacement

8% New equipment

10% New product in normal market

12% New product in related market

16% New product in new market

20% New product in foreign market

Representative Values of MARR

MARR should be equal to the largest of:

Cost of borrowed money

Prime interest rate (lowest)

Cost of capital

Composite value of the capital structure

After-tax return on total capital

0% ~ 40%, average 8%

After-tax return on common stock and retained

earnings

0% ~ 65%, average 14%

Opportunity cost

Representative Values of MARR

MARR used by enterprises

25~30% for high-tech start-ups, petroleum and mining

12~15% for companies with normal risk level

Usually decided by opportunity cost

Much higher than MARR by individuals

Diminished competition

Higher risk

Types of Financing

Equity Financing Funds either from retained earnings, new stock issues, or owners infusion of money.

Debt Financing Borrowed funds from outside sources loans, bonds, mortgages, venture capital pools, etc. Interest

is paid to the lender on these funds

For an economically justified project

ROR MARR > WACC

Opportunity Cost

Definition: Largest rate of return of all projects not accepted

(forgone) due to a lack of capital funds

If no MARR is set, the ROR of the first project not

undertaken establishes the opportunity cost

Example: Assume MARR = 10%. Project A, not funded due

to lack of funds, is projected to have RORA = 13%. Project

B has RORB = 15% and is funded because it costs less

than A

Opportunity cost is 13%, i.e., the opportunity to make an

additional 13% is forgone by not funding project A

Introduction to Spreadsheet Functions:Excel financial functions

Present Value, P: = PV(i%,n,A,F)

Future Value, F: = FV(i%,n,A,P)

Equal, periodic value, A: = PMT(i%,n,P,F)

Number of periods, n: = NPER((i%,A,P,F)

Compound interest rate, i: = RATE(n,A,P,F)

Compound interest rate, i: = IRR(first_cell:last_cell)

Present value, any series, P:

= NPV(i%,second_cell:last_cell) + first_cell

Ex. 9: Estimates are P = $5000 n = 5 years i = 5% per year

Find A in $ per year

Function and display: = PMT(5%, 5, 5000) displays A = $1154.87

Chapter Summary

Engineering Economy fundamentals

Time value of money

Economic equivalence

Introduction to capital funding and MARR

Spreadsheet functions

Interest rate and rate of return

Simple and compound interest

Cash flow estimation

Cash flow diagrams

End-of-period assumption

Net cash flow

Perspectives taken for cash flow estimation

Ethics

Universal morals and personal morals

Professional and engineering ethics (Code of Ethics)

lecture 1 chap 1 foundations of engineering economy

Documents

power money

money available

economic decisions engineers

economic equivalence8

proper economic analysis

engineers engineers

relevant data vast information

relevant data4