Chapter 1 Foundations Of Engineering Economy

Lecture slides to accompany

Engineering Economy
7th edition Leland Blank Anthony Tarquin

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LEA !"!# O$TCO%E&

1. Role in decision making 2. Study approach 3. Ethics and economics 4. Interest rate 5. Terms and symbols . !ash "lo#s $. Economic e%ui&alence '. Simple and compound interest (. )inimum attracti&e rate o" return 1*. Spreadsheet "unctions

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'hy Engineering Economy is "mportant to Engineers

O Engineers design and create O (esigning in)ol)es economic decisions O Engineers must *e a*le to incorporate economic analysis into their creati)e efforts O Often engineers must select and implement from multiple alternati)es O $nderstanding and applying time )alue of money+ economic equi)alence+ and cost estimation are )ital for engineers O A proper economic analysis for selection and e,ecution is a fundamental task of engineering
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Time -alue of %oney .T-%/

(escription0 T-% e,plains the change in the amount of money o)er time for funds o1ed *y or o1ned *y a corporation .or indi)idual/

Corporate in)estments are e,pected to earn a return "n)estment in)ol)es money %oney has a 2time )alue3

The time &alue o" money is the most important concept in engineering economy
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Engineering Economy
K Engineering Economy in)ol)es
Formulating Estimating+ and E)aluating e,pected economic outcomes of alternati)es designed to accomplish a defined purpose

K Easy4to4use math techniques simplify the e)aluation K Estimates of economic outcomes can *e deterministic or stochastic in nature
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#eneral &teps for (ecision %aking 5rocesses

16 96 :6 ;6 <6 $nderstand the pro*lem 7 define o*8ecti)es Collect rele)ant information (efine the set of feasi*le alternati)es "dentify the criteria for decision making E)aluate the alternati)es and apply sensiti)ity analysis =6 &elect the >*est? alternati)e 76 "mplement the alternati)e and monitor results
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&teps in an Engineering Economy &tudy

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Ethics 7 (ifferent Le)els

$ni)ersal morals or ethics 7 Fundamental *eliefs0 stealing+ lying+ harming or murdering another are 1rong 5ersonal morals or ethics 7 Beliefs that an indi)idual has and maintains o)er time@ ho1 a uni)ersal moral is interpreted and used *y each person 5rofessional or engineering ethics 7 Formal standard or code that guides a person in 1ork acti)ities and decision making
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Code of Ethics for Engineers

All disciplines ha)e a formal code of ethics6 !ational &ociety of 5rofessional Engineers .!&5E/ maintains a code specifically for engineers@ many engineering professional societies ha)e their o1n code

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"nterest and "nterest ate

K "nterest 7 the manifestation of the time )alue of money Fee that one pays to use someone else3s money (ifference *et1een an ending amount of money and a *eginning amount of money
G

"nterest A amount o1ed no1 7 principal

K "nterest rate 7 "nterest paid o)er a time period e,pressed as a percentage of principal
G

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ate of eturn
K "nterest earned o)er a period of time is e,pressed as a percentage of the original amount .principal/
interest accrued per time unit Rate of return (%) = x 100% original amount
O (orrower)s *ers*ective + i,terest rate *ai O -e, er)s or i,vestor)s *ers*ective + rate o. ret/r, ear,e

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"nterest paid

"nterest earned

Interest rate
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Rate of return
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Commonly used &ym*ols

t A time+ usually in periods such as years or months 5 A )alue or amount of money at a time t designated as present or time B F A )alue or amount of money at some future time+ such as at t = n periods in the future A A series of consecuti)e+ equal+ end4of4period amounts of money n A num*er of interest periods@ years+ months i A interest rate or rate of return per time period@ percent per year or month
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Cash Flo1s0 Terms

K Cash "nflo1s 7 e)enues . /+ receipts+ incomes+ sa)ings generated *y pro8ects and acti)ities that flo1 in6 5lus sign used K Cash Outflo1s 7 (is*ursements .(/+ costs+ e,penses+ ta,es caused *y pro8ects and acti)ities that flo1 out6 %inus sign used K !et Cash Flo1 .!CF/ for each time period0 !CF A cash inflo1s 7 cash outflo1s A 7 ( K End4of4period assumption0
Funds flo1 at the end of a gi)en interest period
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Cash Flo1s0 Estimating

5oint estimate 7 A single4)alue estimate of a cash flo1 element of an alternati)e
Cash inflo10 "ncome A C1<B+BBB per month

ange estimate 7 %in and ma, )alues that estimate the cash flo1
Cash outflo10 Cost is *et1een C96< % and C:69 %
5oint estimates are commonly used@ ho1e)er+ range estimates 1ith pro*a*ilities attached pro)ide a *etter understanding of )aria*ility of economic parameters used to make decisions
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Cash Flo1 (iagrams

'hat a typical cash flo1 diagram might look like
(ra1 a time line
B 1
One time period
Always assume end-of-period cash flows

0i1e D D D

n41
2 3 4100

&ho1 the cash flo1s .to appro,imate scale/

B
5 3 4-&0

D D D

n41
4 .do1n/ for outflo1

Cash flo1s are sho1n as directed arro1s0 E .up/ for inflo1 1-1$
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Cash Flo1 (iagram E,ample

5lot observe cash .lows over last & years a, esti1ate sale ,e6t year .or 41#0. 7how *rese,t worth 859 arrow at *rese,t ti1e, t 3 0

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Economic Equi)alence
(efinition0 Com*ination of interest rate .rate of return/ and time )alue of money to determine different amounts of money at different points in time that are economically equi)alent Fo1 it 1orks0 $se rate i and time t in upcoming relations to mo)e money .)alues of 5+ F and A/ *et1een time points t A B+ 1+ D+ n to make them equi)alent .not equal/ at the rate i
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E,ample of Equi)alence
(ifferent sums of money at different times may *e equal in economic )alue at a gi)en rate
4110
Year

Rate o. ret/r, 3 10: *er year

4100 ,ow C1BB no1 is economically equi)alent to C11B one year from no1+ if the C1BB is in)ested at a rate of 1BG per year6
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&imple and Compound "nterest

K &imple "nterest
"nterest is calculated using principal only "nterest A .principal/.num*er of periods/.interest rate/ I A Pni

E,ample0 C1BB+BBB lent for : years at simple i A 1BG per year6 'hat is repayment after : yearsH
"nterest A 1BB+BBB.:/.B61B/ A C:B+BBB Total due A 1BB+BBB E :B+BBB A C1:B+BBB

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&imple and Compound "nterest

K Compound "nterest
"nterest is *ased on principal plus all accrued interest That is+ interest compounds o)er time "nterest A .principal E all accrued interest/ .interest rate/

"nterest for time period t is

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Compound "nterest E,ample

E,ample0 C1BB+BBB lent for : years at i A 1BG per year compounded6 'hat is repayment after : yearsH
;,terest, year 1< ;1 3 100,00080.109 3 410,000 0otal /e, year 1< 01 3 100,000 = 10,000 3 4110,000 ;,terest, year 2< ;2 3 110,00080.109 3 411,000 0otal /e, year 2< 02 3 110,000 = 11,000 3 4121,000 ;,terest, year !< ;! 3 121,00080.109 3 412,100 0otal /e, year !< 0! 3 121,000 = 12,100 3 C1::+1BB
>o1*o/, e < 41!!,100
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7i1*le< 41!0,000
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%inimum Attracti)e ate of eturn

O %A is a reasona*le rate of return .percent/ esta*lished for e)aluating and selecting alternati)es O An in)estment is 8ustified economically if it is e,pected to return at least the %A O Also termed hurdle rate, benchmark rate and cutoff rate

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%A

Characteristics

K %A is esta*lished *y the financial managers of the firm K %A is fundamentally connected to the cost of capital K Both types of capital financing are used to determine the 1eighted a)erage cost of capital .'ACC/ and the %A K %A usually considers the risk inherent to a pro8ect
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Types of Financing
K Equity Financing 7Funds either from retained earnings+ ne1 stock issues+ or o1ner3s infusion of money6 K (e*t Financing 7Borro1ed funds from outside sources 7 loans+ *onds+ mortgages+ )enture capital pools+ etc6 "nterest is paid to the lender on these funds For an economically 8ustified pro8ect O I %A
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J 'ACC
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Opportunity Cost
l (efinition0 Largest rate of return of all pro8ects not accepted .forgone/ due to a lack of capital funds
l "f no %A is set+ the O of the first pro8ect not undertaken esta*lishes the opportunity cost

E,ample0 Assume %A A 1BG6 5ro8ect A+ not funded due to lack of funds+ is pro8ected to ha)e O A A 1:G6 5ro8ect B has O B A 1<G and is funded *ecause it costs less than A Opportunity cost is 1:G+ i6e6+ the opportunity to make an additional 1:G is forgone *y not funding pro8ect A
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"ntroduction to &preadsheet Functions

E,cel financial functions
5resent -alue+ 50 A 5-.iG+n+A+F/ Future -alue+ F0 A F-.iG+n+A+5/ Equal+ periodic )alue+ A0 A 5%T.iG+n+5+F/ !um*er of periods+ n0 A !5E ..iG+A+5+F/ Compound interest rate+ i0 A ATE.n+A+5+F/ Compound interest rate+ i0 A " .firstKcell0lastKcell/ 5resent )alue+ any series+ 50 A !5-.iG+secondKcell0lastKcell/ E firstKcell E,ample0 Estimates are 5 A C<BBB n A < years i A <G per year Find A in C per year Function and display0 A 5%T.<G+ <+ <BBB/ displays A A C11<;6L7
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Chapter &ummary
K Engineering Economy fundamentals

Time )alue of money Economic equi)alence "ntroduction to capital funding and %A &preadsheet functions &imple and compound interest Cash flo1 diagrams End4of4period assumption !et cash flo1 5erspecti)es taken for cash flo1 estimation $ni)ersal morals and personal morals 5rofessional and engineering ethics .Code of Ethics/
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2012 by McGraw-Hill, New York, N.Y All Rights Reserve

K "nterest rate and rate of return

K Cash flo1 estimation

K Ethics