Intro to engineering economy

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Intro to engineering economy

  1. 1. ENGINEERING ECONOMY Introduction
  2. 2. IMPORTANCE OF ENGINEERING ECONOMY -1 <ul><li>Individuals, small-business owners, large corporation presidents, and government agency heads are routinely faced with the challenge of making decisions when selecting one alternative over another. </li></ul><ul><li>These are decisions of how to best invest the funds, or capital, of the company and its owners. </li></ul>
  3. 3. IMPORTANCE OF ENGINEERING ECONOMY - 2 <ul><li>Engineering economy, quite simply, is about determining the economic factors and the economic criteria utilized when one or more alternatives are considered for selection. </li></ul><ul><li>Another way to define engineering economy is a collection of mathematical techniques that simplify economic comparisons. </li></ul>
  4. 4. Importance of Engineering Economy - 3 <ul><li>With the techniques of Engineering Economy, a rational and meaningful approach to evaluating the economic aspects of different methods (alternatives) of accomplishing a given objective can be developed. </li></ul>
  5. 5. Corporations and Businesses <ul><li>Will we make the required return if we install this new manufacturing technology in the plant? </li></ul><ul><li>Do we build or lease space for the new branch in Burkina Faso? </li></ul><ul><li>Is it economically better to make in‑house or buy component part on a new product line? </li></ul>
  6. 6. Government Units Which Serve the Public <ul><li>How much new tax revenue does the city need to generate to pay for new public school. </li></ul><ul><li>Is it cost-effective for the city to construct a new stadium for major sports events? </li></ul><ul><li>Should the university contract with part time lecturers to teach foundation-level undergraduate courses or have full time university faculty teach them? </li></ul>
  7. 7. Individuals <ul><li>What are graduate studies worth financially over my professional career? </li></ul><ul><li>Exactly what rate of return did we make on this stock investment? </li></ul><ul><li>Should I buy or lease my next car or keep the one I have now and continue to pay on the loan? </li></ul>
  8. 8. ROLE OF ENG. ECONOMY IN DECISION MAKING -1 <ul><li>Engineering Economy is the application of economic factors and criteria to evaluate alternatives considering the time value of money by computing a specific measure of worth of estimated cashflows over a specific period of time. </li></ul>
  9. 9. Steps to Problem Solving <ul><li>1. Understand the problem and goal. </li></ul><ul><li>2. Collect relevant information. </li></ul><ul><li>3. Define the alternative solutions. </li></ul><ul><li>4. Evaluate each alternative. </li></ul><ul><li>5. Select the best alternative using some criteria. </li></ul><ul><li>6. Implement the solution and monitor the results. </li></ul>
  10. 10. ROLE OF ENG. ECONOMY IN DECISION MAKING -2 <ul><li>Engineering economy has a major role in steps 2, 3, and 5. Steps 2 and 3 set up the alternatives, and engineering economy helps structure the estimates of each one </li></ul><ul><li>It is the primary technique in step 4 to perform the economic‑based analysis of each alternative. </li></ul><ul><li>Step 4 utilizes one or more engineering economy models discussed here to complete the economic analysis upon which a decision is made. </li></ul>
  11. 11. Example 1 <ul><li>The presidents of two small businesses play racquetball each week. After several conversations, they have decided that, due to their frequent commercial- airline travel around the region, they should evaluate the purchase of a plane jointly owned by the two companies. What are some of the typical economic‑based questions the two presidents should answer as they evaluate the alternatives to </li></ul><ul><li>(1) co-own a plane or </li></ul><ul><li>(2) continue as is? </li></ul>
  12. 12. Solution <ul><li>Some questions (and what is needed to respond to them) might be: </li></ul><ul><li>How much will it cost each year? (Estimates needed here) </li></ul><ul><ul><li>How do we pay for it? (A financing plan needed here) </li></ul></ul><ul><ul><li>Are there tax advantages? (Tax law information needed here) </li></ul></ul><ul><ul><li>Which alternative is more cost-effective? (Selection criteria needed here) </li></ul></ul><ul><ul><li>What is the expected rate of return? (Equations needed here) </li></ul></ul><ul><ul><li>What happens if we use different amounts each year than we estimated? (Sensitivity analysis needed here) </li></ul></ul>
  13. 13. Step 4 Step 4: This is the heart of engineering economy. The technique result in numerical values called measures of worth, which inherently consider the time value of money. Some common measures of worth are, Present worth (PW) Future worth (FW) Annual worth (AW) Rate of return (ROR) Benefit/cost ratio (B/C) Capitalised cost (CC)
  14. 14. Solution <ul><li>Assume that the problem and goal are the same for each president - available, reliable transportation which minimizes total cost. </li></ul><ul><li>Engineering economy assists in several ways. Using the problem‑solving approach as a framework. </li></ul>
  15. 15. Solution - continued <ul><li>Steps 2 and 3: The framework of estimates necessary for an engineering economy analysis assists in structuring what data should be estimated and collected. </li></ul><ul><li>For example, for alternative 1 (buy the plane), these include estimated purchase cost, financing methods and interest rates, annual operating costs, possible increase in annual sales revenue, and income tax deductions. </li></ul>
  16. 16. Solution - continued <ul><li>For alternative 2 (maintain the status quo), these include observed and estimated commercial transportation costs, annual sales revenue, and other relevant data. </li></ul><ul><li>Note that engineering economy does not specifically include the estimation; it helps determine what estimates and data are needed for the analysis (step 4) and decision (step 5). </li></ul>
  17. 17. Step 5: <ul><li>For the economic portion of the decision, some criterion based on one of the measures of worth is used to select only one of the alternatives. </li></ul><ul><li>Additionally, there are so many non-economic factors‑social, environmental, legal, political, personal, to name a few‑that the result of the engineering economy analysis may seem, at times, to be used less than the engineer may wish. But this is exactly why the decision-maker must have adequate information for all factors ‑economic and non-economic‑to make an informed selection. </li></ul>
  18. 18. Solution - continued <ul><li>In our case, the economic analysis may significantly favor the co‑owned plane (alternative 1). But because of non-economic factors, one or both presidents may decide to remain with the current situation by selecting alternative 2. </li></ul>
  19. 19. The time value of money <ul><li>Any future cash flows have less value to us than current cash flows. </li></ul><ul><li>Cash Flows over Some Time Period </li></ul><ul><li>Evaluated Alternative </li></ul><ul><li>Evaluation or Selection Criteria </li></ul>
  20. 20. INTEREST CALCULATIONS <ul><li>Interest = total amount now ‑ </li></ul><ul><li>original principal </li></ul><ul><li>Interest = amount owed now ‑ </li></ul><ul><li>original principal </li></ul><ul><li>Percent = interest accrued per </li></ul><ul><li>interest rate time unit x 100% </li></ul><ul><li> original amount </li></ul>
  21. 21. SIMPLE AND COMPOUND INTEREST <ul><li>Interest = (principal) (number of periods) (interest rate) </li></ul><ul><li>Interest = (principal + all accrued interest) (interest rate) </li></ul>
  22. 22. EQUIVALENCE <ul><li>EQUIVALENCE </li></ul><ul><li>means that different sums of money considered at different times are equal in economic value. </li></ul><ul><li>For example, if the interest rate were 6% per year, GH¢100 today (present time) would be equivalent to GH¢106 one year from today. </li></ul><ul><li>Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = GH¢106 </li></ul>
  23. 23. SYMBOLS AND THEIR MEANING <ul><li>P = value or amount of money at a time denoted as the present, called the present worth or present value; currency, dollars ($), Ghana cedis (GH¢), pound sterling (£), etc. </li></ul><ul><li>F = value or amount of money at some future time, called future worth or future value; dollars ($), Ghana cedis (GH¢), pound sterling (£), etc </li></ul>
  24. 24. SYMBOLS AND THEIR MEANING <ul><li>A = series of consecutive, equal, end‑of‑period amounts of money, called the equivalent value per period or annual worth , dollars per year ($/yr.), Ghana cedis per year (GH¢/yr.), pound sterling per year (£/yr.) </li></ul><ul><li>n = number of interest periods; years, months, days </li></ul>
  25. 25. SYMBOLS AND THEIR MEANING <ul><li>i = interest rate per interest period; percent per year, percent per month </li></ul><ul><li>t = time stated in periods; years, months, days </li></ul>
  26. 26. INTEREST CALCULATIONS <ul><li>F 1 = P + iP = P (1+ i ) </li></ul><ul><li>If we divide the above equation by (1 + i ) n , we will have </li></ul>
  27. 27. MINIMUM ATTRACTIVE RATE OF RETURN <ul><li>For any investment to be profitable, the investor (corporate or individual) must expect to receive more money than the amount invested. </li></ul><ul><li>In other words, a fair rate of return, or return on investment must be realizable. </li></ul>
  28. 28. MINIMUM ATTRACTIVE RATE OF RETURN <ul><li>Over a stated period of time, the rate of return (ROR) is calculated as </li></ul><ul><li>ROR = Current amount ‑ original investmen t x100% </li></ul><ul><li>original investment </li></ul><ul><li>The numerator may be called profit, net income, or a variety of other terms. The term rate of return is commonly used when estimating the profitability of a proposed alternative or when evaluating the results of a completed project or investment. This and interest rate are both represented by the symbol i. </li></ul>
  29. 29. MINIMUM ATTRACTIVE RATE OF RETURN <ul><li>Some reasonable rate must, therefore, be stated and utilized in the selection criteria phase of the engineering economy study approach. </li></ul><ul><li>The reasonable rate is called the Minimum Attractive Rate of Return (MARR) and is higher than the rate expected from a bank or some safe investment, which involves minimal investment risk. </li></ul>
  30. 30. CASH FLOWS: THEIR ESTIMATION AND DIAGRAMMING <ul><li>Samples of Cash Inflows </li></ul><ul><li>Revenues (usually incremental due to the alternative). </li></ul><ul><li>Operating cost reductions (due to the alternative). </li></ul><ul><li>Asset salvage value. </li></ul><ul><li>Receipt of loan principal. </li></ul><ul><li>Income‑tax savings. </li></ul><ul><li>Receipts from stock and bond sales. </li></ul><ul><li>Construction and facility cost savings. </li></ul><ul><li>Savings or return of corporate capital funds. </li></ul>
  31. 31. CASH FLOWS: THEIR ESTIMATION AND DIAGRAMMING <ul><li>Samples of Cash Outflows </li></ul><ul><li>First cost of assets (with installation and delivery). </li></ul><ul><li>Operating costs (annual and incremental). </li></ul><ul><li>Periodic maintenance and rebuild costs. </li></ul><ul><li>Loan interest and principal payments. </li></ul><ul><li>Major, expected upgrade costs. </li></ul><ul><li>Income taxes. </li></ul><ul><li>Bond dividends and bond payment. </li></ul><ul><li>Expenditure of corporate capital funds. </li></ul>
  32. 32. CASH FLOWS: THEIR ESTIMATION AND DIAGRAMMING <ul><li>Net cash flow = receipts ‑ disbursements </li></ul><ul><li>= cash inflows ‑ cash outflows </li></ul><ul><li>end‑of‑period convention is used </li></ul><ul><li>A cash‑flow diagram is simply a graphical representation of cash flows drawn on a time scale. </li></ul>
  33. 33. A typical cash‑flow time scale for 5 years.
  34. 34. CASH FLOWS: THEIR ESTIMATION AND DIAGRAMMING <ul><li>Make a neat diagram to approximate scale for both time and cash‑flow magnitude. </li></ul><ul><li>The direction of the arrows on the cash‑flow diagram is important. Throughout this text, a vertical arrow pointing up will indicate a positive cash flow. Conversely, an arrow pointing down will indicate a negative cash flow. </li></ul>
  35. 35. Example of positive and negative cash flows.
  36. 36. RULE OF 72: ESTIMATING DOUBLING TIME AND INTEREST RATE <ul><li>Sometimes it is important to estimate the number of years n, or the rate of return i, that is required for a single cash‑flow amount to double in size. </li></ul><ul><li>The rule of 72 for compound‑interest rates can be used to estimate i or n, given the other value. </li></ul>
  37. 37. ESTIMATION n GIVEN i <ul><li>The estimation is simple; the time required for an initial single amount to double in size with compound interest is approximately equal to 72 divided by the rate of return value (in percent). </li></ul><ul><li>Estimated n = 72 </li></ul><ul><li>i </li></ul>
  38. 38. Estimation i given n <ul><li>Alternatively, the compound rate i in percent required for money to double in a specified period of time n can be estimated by dividing 72 by the specified n value. </li></ul><ul><li>Estimated i = 72 </li></ul><ul><li> n </li></ul>

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