Ch 01 slides

Chapter 1Chapter 1
Foundations Of Engineering EconomyFoundations Of Engineering Economy
Developed by Dr. Don Smith, P.E., Texas A&M University
& Dr. Michael Bennett, P.Eng., PMP, UOIT, Oshawa, Ontario

Slide Sets to accompany Blank, Tarquin &
Iverson, Engineering Economy, Canadian Edition
© 2008 McGraw-Hill Ltd.
1-2
LEARNING OBJECTIVESLEARNING OBJECTIVES
1. Questions
2. Decision making
3. Study approach
4. Interest rate
5. Equivalence
6. Simple and
compound
interest
7. Symbols
8. Spreadsheet
functions
9. Minimum
attractive rate of
return
10.Cash flows
11.Doubling time
12.Spreadsheets

1-3
Sct 1: Why Engineering Economy isSct 1: Why Engineering Economy is
Important to EngineersImportant 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 execute from
multiple alternatives
 A proper economic analysis for selection and
execution is a fundamental aspect of
engineering

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Engineering EconomyEngineering Economy
 The art and science that involves:
Formulating,
 Estimating and
 Evaluating economic outcomes
 Always concerned with the selection and
possible execution of alternatives given the
economic parameters associated with the
project

1-5
Sct 1.2 Role of Engineering Economy inSct 1.2 Role of Engineering Economy in
Decision MakingDecision Making
 Decision making involves the estimation of
future events/outcomes
 Engineering economy aids in quantifying past
outcomes and forecasting future outcomes
 Engineering Economy provides a framework
for modeling problems involving:
Time
Money
Interest rates

1-6
The Decision Making ProcessThe Decision Making Process
1. Understand the problem – define objectives
2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply
sensitivity analysis
6. Select the “best” alternative
7. Implement the alternative and monitor
results

1-7
Time Value of MoneyTime Value of Money
 All firms make use of investment of funds
 Investments are expected to earn a return
 Investment involves money
 Money possesses a “time value”
 The “time value” of money is the most
important concept in engineering economy

1-8
Sct 1.3 Performing An EngineeringSct 1.3 Performing An Engineering
Economy StudyEconomy Study
 Engineering Economy Studies:
 Define Alternatives
Do-nothing alternative – maintain the status quo
Define feasible alternatives – that can solve the problem
 Define/estimate the current and future cash flows
 Perform the analysis
Apply the tools and methods of engineering economy
 Selection of the best alternative
 Implement and monitor

1-9
Sct 1.4 Interest Rate and Rate of ReturnSct 1.4 Interest Rate and Rate of Return
 Interest – the manifestation of the time value of money
 Rental fee that one pays to use someone else’s money
 Difference between an ending amount of money and a
beginning amount of money
 Interest rate (%) =
interest accrued per time unit
x 100%
original amount

1-10
Rate of ReturnRate of Return
 Interest earned over a period of time is expressed as
a percentage of the original amount, specifically;
interest accrued per time unit
Rate of return (%) = x 100%
original amount
 Borrower’s perspective – interest rate paid
 Lender’s perspective – interest rate earned

1-11
Sct 1.5 EquivalenceSct 1.5 Equivalence
 Different sums of money at different times
may be equal in economic value
0 1
$100 now
$106 one
year from now
Interest rate = 6% per year
$100 now is said to be equivalent to $106 one year from now, if
the $100 is invested at the interest rate of 6% per year.

1-12
Example 1.6Example 1.6
AC-Delco makes auto batteries available to General Motors dealers
through privately owned distributorships. In general, batteries
are stored throughout the year, and a 5% cost ownership is
added each year to cover the inventory carrying charge for the
distributorship owner. Assume that you own the City Centre
Delco facility. Make the calculations necessary to shoe which of
the following statements are true and which are false about
battery costs.

1-13
True or FalseTrue or False
a) The amount of $98 now is equivalent to $105.60 one year from now
b) A truck battery cost of $200 one year ago is equivalent to $205 now
c) A $38 cost now is equivalent to $39.90 one year from now
d) A $3000 cost now is equivalent to $2887.14 one year ago
e) The carrying charge accumulated in 1 year on an investment of
$2000 worth of batteries is $100

1-14
True or FalseTrue or False
a) The amount of $98 now is equivalent to $105.60 one year from now
FALSE
b) A truck battery cost of $200 one year ago is equivalent to $205 now
FALSE
c) A $38 cost now is equivalent to $39.90 one year from now
TRUE
d) A $3000 cost now is equivalent to $2887.14 one year ago
FALSE
e) The carrying charge accumulated in 1 year on an investment of
$2000 worth of batteries is $100
TRUE

1-15
Sct 1.6 Simple and Compound InterestSct 1.6 Simple and Compound Interest
 Simple Interest:
Interest = (principal)(number of periods)(interest rate)
 Compound Interest:
Interest earns interest on interest
 Compounds over time
 Interest = (principal + all accrued interest) (interest rate)

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Sct 1.7 Terminology and SymbolsSct 1.7 Terminology and Symbols
 P = a present sum of money at a time
designated as t = 0 { t represents time}
 F = a future amount of money at some point
in time later than t = 0
 A = a series of equal, end-of-period cash
flows
 n = the number of interest periods
 i = the interest rate or rate of return per time
period, in percent

1-17
On July 1, 2008, your new employer Canadian
Pacific Railways deposits $5000 into your
money market account, as part of you
employment bonus. The account pays interest
at 5% per year. You expect to withdraw an
equal annual amount for the following 10
years. Identify the symbols and their values.
P? A? i ? n = ?

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On July 1, 2008, your new employer Canadian Pacific
Railways deposits $5000 into your money market
account, as part of you employment bonus. The
account pays interest at 5% per year. You expect to
withdraw an equal annual amount for the following
10 years. Identify the symbols and their values.
P= $5000 A = ? Per year i = 5% per year
n = 10 years

1-19
Sct 1.8 Introduction To Solution BySct 1.8 Introduction To Solution By
ComputerComputer
 Application of Microsoft’s Excel©
spreadsheet
program
 Excel financial functions
 Present Value P: =PV(i%,n,A,F)
 Future Value F: =FV(i%,n,A,P)
 Equal, periodic value: =PMT(i%,n,P,F)
 No. of periods: =NPER((i%,A,P,F)
 Compound interest rate: =RATE(n,A,P,F)
 Compound interest rate: =IRR(first_cell:last_cell)
 Present value of a series: =NPV(i%,second_cell:last_cell) + first_cell

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Sct 1.9 Minimum Attractive Rate of ReturnSct 1.9 Minimum Attractive Rate of Return
 Investors expect to earn a return on their
investment (commitment of funds) over time
 We expect to see economic efficiencies greater
than 100%
 A profitable investment should earn (return)
funds in excess of the investment amounts
 Economic projects should earn a reasonable
return, which is termed:
MARR – Minimum attractive rate of return
Also termed the “hurdle” rate for an investment

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The MARRThe MARR
 The MARR is established by the financial
managers of the firm
 The MARR is expressed as a percent value
 Most, if not all, projects should earn at a rate
equal to or greater than the established MARR
 MARR’s are set based upon:
 The cost of all types of capital
 Allowance for risk

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The MARR in CanadaThe MARR in Canada
The Prime Rate of the Bank of Canada is usually
used as the benchmark SAFE rate
If you cannot do better than this, put your money
in a sock!

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Types of FinancingTypes of Financing
 Equity Financing – the firm uses funds either
from retained earnings, new stock issues, or
owner’s infusion of money
 Debt Financing – the firm borrows funds from
outside sources
The cost of debt financing = the interest rate
charged on the debt (loan) amounts
 The MARR is approximated from the weighted
average cost of all sources of capital to the
firm
 A firm’s ROR > MARR > cost of capital

1-24
Sct 1.10 Cash Flows: Their Estimation andSct 1.10 Cash Flows: Their Estimation and
DiagrammingDiagramming
 Definition of terms
Cash Inflows - amount of funds flowing into the
firm
Cash Outflows – amount of funds flowing out of the
firm
 Net Cash Flow equals
 cash inflows – cash outflows
 Assumption for analysis – end of period
Funds flow at the end of a given (interest) period

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Cash Flow DiagramsCash Flow Diagrams
 A typical cash flow diagram might look like:
0 1 2 … … … n-1 n
1. Draw a time line
One time period
0 1 2 … … … n-1 n
2. Show the cash flows
Cash flows are shown as directed arrows (+ for up or – for down) ---
(+) inflow; (-) outflow
Always assume end-of-period
cash flows!

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Sct 1.11 Rule of 72: Estimating DoublingSct 1.11 Rule of 72: Estimating Doubling
Time or Interest RateTime or Interest Rate
 Common question:
Estimate the number of time periods it takes for a
cash flow to double in size
Given an interest rate i% per period
The approximate time n for an investment at time
t = 0 to double in value is given by:
n = 72/i
e.g., $10,000 at 7% per year doubles to $20,000 in
10.3 years

1-27
Sct 1.12 Spreadsheet ApplicationSct 1.12 Spreadsheet Application
 Reference Example 1.18
 Design a spreadsheet model to evaluate this
project
Illustrates simple interest, compound interest and
inflation
Focus on the overall design of the model and the
associated formatting
Check appendix A for hints, formats, formulas to
use a spreadsheet effectively

1-28
Chapter SummaryChapter Summary
 Engineering Economy – application of economic
factors and criteria to evaluate alternatives
 Applies the time value of money
 Application of economic equivalence
 Introduction of the MARR
 Cash flow estimation
 Modeling – cash flow diagrams
 Difficulties in estimation
 Perspectives – viewpoints taken

1-29
End of Chapter 1End of Chapter 1

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