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1 INTRODUCTION Section 1

Why the Economy Perspective


is Important to Engineers
Ir. HaerySihombing (IP)
Pensyarah Fakulti Kejuruteraan Pembuatan (and other professionals)
Universiti Teknologi Malaysia Melaka

MANUFACTURING
ECONOMY

• Engineers “Design”
Design” • Engineers must work within the realm of
•Engineers must be concerned with the economics and justification of engineering
economic aspects of designs and projects projects
they recommend and perform •Work with limited funds (capital)
•Analysis •Capital is not unlimited – rationed
•Design •Capital does not belong to the firm
•Synthesis •Belongs to the Owners of the firm
•Capital is not “free”…
free”…it
it has a “cost”
cost”
Technical Perspective Economic Considerations
„ Technical Feasibility: „ Economic Feasibility:
„ In order to ensure the implementation of „ The solutions provided must not exceed
the design, the solution provided must obey monetary budget limits
the laws of nature and science
„ Technical Efficiency: „ Economic Efficiency:
„ Because there may be many solutions to a „ The most economical of the many technical
problem, the best technical solution should be solution to a problem should be choosen
sought. Examples include designing solutions that
generate the least waste, consume the lest
energy, perform reliably in adverse conditions,
and allow for easy production or maintenance

Definition Definition

ENGINEERING ECONOMY IS INVOLVED WITH


THE FORMULATION, ESTIMATION, AND ENGINEERING ECONOMY IS INVOLVED WITH
EVALUATION OF ECONOMIC OUTCOMES WHEN THE APPLICATION OF DEFINED MATHEMATICAL
ALTERNATIVES TO ACCOMPLISHED A DEFINED RELATIONSHIPS THAT AID IN THE COMPARISON
PURPOSE ARE AVAILABLE. OF ECONOMIC ALTERNATIVES
Role of Engineering Economy
Questions in Decision Making

•Knowledge of Engineering Economy will have • Remember:


Remember: People make decisions – not “tools”
tools”
a significant impact on you, personally.
• Engineering Economy is a set of tools that aid in
•Make proper economic comparisons decision making – but will not make the decision for
•In your profession you
•Private sector • Engineering economy is based mainly on
estimates of future events – must deal with the future
•Public sector and risk and uncertainty
•In your personal life

Role of Engineering Economy Role of Engineering Economy

¾ The parameters within an engineering ¾ Sensitivity Analysis plays a major role in


economy problem can and will vary over time the assessment of most, if not all,
engineering economy problems
¾Parameters that can vary will dictate a
numerical outcome – apply and understand ..
¾ The use of spreadsheets is now common
and students need to master this valuable
¾Sensitivity Analysis tool as an analysis aid
DECISION CATEGORIES DECISION CATEGORIES (Cont’
(Cont’)

1. Profit-
Profit-Enhancing Program 2. Cost-
Cost-Control Program
„ A company may expand production, its „ Engineers are often asked to correct errors in

product line, or service, in order to systems-


systems-errors that cost money. Designing and
increase sales. These ventures generally implementing solutions also costs money,
take considerable investment, with hope including, at a minimum, the time and effort
of increasing revenues spent by the engineer in finding a solution to the
problem. The expectation is that the engineer will
a. New Product Development provide solution that will save money in the long
b. New product Acquisition
run a. Improving Efficiency
c. Production Capacity Expansion
d. Service Capacity Expansion b. Streamlining Operations
e. Improved Customer Service c. Eliminating Waste
d. Reducing Liabilities

DECISION CATEGORIES (Cont’


(Cont’) DECISION CLASSIFICATION

3. Public-
Public-Improvement Program 1. EXPANSION
„ Government entities often make investments, „ This can take many forms, including expanding he
the goals of which is not to increase profits, but production capacity of a current and expanding
rather to increase some measure of public into new markets with new products or services.
satisfaction
a. New product design and development
a. Increased public satisfaction b. Expansion of current development
b. Increased public safety c. Construction of new facility
c. Improved infrastructure d. Acquiring capacity
e. Equipment, process, or technology selection
DECISION CLASSIFICATION (Cont’
(Cont’) DECISION CLASSIFICATION (Cont’
(Cont’)

2. REPLACEMENT 3. ABANDONMENT
„ A company may want to continue operations or „ Although it may not seem like an investment
services in some sector, but may want to do so in a decision, the decision to walk away from a project,
more economical manner. This may lead to replacing such as closing a facility, is a very important
equipment, changing processes, or changing locations. economic decision. It also represents the final
a. Equipment, process, or technology selection stage in our decision-
decision-making process.
b. In house versus outsourcing a. Cease production
b. Cease product line
c. Close a facility
d. Retire equipment

DECISION RESULTS Problem Solving Approach


„ INVEST 1. Understand the Problem (Recognition and definition
„ This “accept”
accept” or “go”
go” decision releases the necessary funding
of problem or opportunity)
to undertake a project
2. Collect all relevant data/information (Generation
„ DELAY of solution alternatives)

„ This “wait”
wait” decision provides time to gather more information 3. Define the feasible alternatives (Development of
about the prospects of an investment or merely for the feasible alternative cash flows and information gathering)
investment climate to change. On the one hand, the decision
to delay may occur before a “go”
go” decision 4. Evaluate each alternative
„ DO NOT INVEST 5. Select the “best”
best” alternative (Selection and
„ This “reject”
reject” or “no go”
go” decision eliminates a proposal from implementation the best alternative)
further consideration. This decision also encompasses halting
for a project, as in the abandonment decision just described 6. Implement and monitor (Post-
(Post-implementation
analysis and evaluation)
Problem Solving Approach Problem Solving Approach
1. Understand the Problem
1. Understand the Problem
2. Collect all relevant data/information
2. Collect all relevant data/information
3. Define the feasible alternatives
3. Define the feasible alternatives
4. Evaluate each alternative
4. Evaluate each alternative
5. Select the “best” alternative
5. Select the “best” alternative
6. Implement and monitor
6. Implement and monitor

Major Role of One of the more


Engineering difficult tasks
Economy

Problem Solving Approach Problem Solving Approach

1. Understand the Problem 1. Understand the Problem


2. Collect all relevant data/information 2. Collect all relevant data/information
3. Define the feasible alternatives 3. Define the feasible alternatives
4. Evaluate each alternative 4. Evaluate each alternative
5. Select the “best” alternative 5. Select the “best” alternative
Where the major tools
6. Implement and monitor of Engineering 6. Implement and monitor Tools
Present Worth, Future Worth
Economy are applied Annual Worth, Rate of Return
Benefit/Cost, Payback,
Capitalized Cost, Value Added
Time Value of Money Performing a Study

• Time Value of Money „ To have a problem, one must have


• Money can “make” money if Invested alternatives (two or more ways to solve a
• Centers around an interest rate
problem)
„ Alternative ways to solve a problem must

The change in the amount of money over a first be identified


given time period is called the time value of „ Estimate the cash flows for the alternatives
money; by far, the most important concept
„ Analyze the cash flows for each alternative
in engineering economy

Alternatives Needed Parameters

• To analyze must have: ™ First cost (investment amounts)


• Concept of the time value of $$
• An Interest Rate ™ Estimates of useful or project life
• Some measure of economic worth
™ Estimated future cash flows (revenues and
• Evaluate and weigh expenses and salvage values)
• Factor in non-
non-economic parameters ™ Interest rate
• Select, implement, and monitor
™ Inflation and tax effects
Cash Flows Alternatives

• Estimate flows of money coming into the Each problem will have at least one
firm – revenues salvage values, etc. alternative – DO NOTHING
(magnitude and timing) – positive cash flows
• May not be free and may have future
• Estimates of investment costs, operating costs associated
costs, taxes paid – negative cash flows
• Do not overlook this option!

Alternatives Mutually Exclusive

•Goal: Define, Evaluate, Select and Execute • Select One and only one from a set of
feasible alternatives

The Question:
• Once an alternative is selected, the
Do remaining alternatives are excluded at
Alt. 1 Which One do
Nothing that point.
we accept?
More Alternatives Default Position

•Goal: Define, Evaluate, Select and Execute ¾ If all of the proposed alternatives are not
economically desirable then…

Do ¾ One usually defaults to the DO-NOTHING


Alt. 1 ………... Alt. j
Nothing alternative

Which one do we accept?

Taxes Taxes

¾ Taxes represent a significant negative cash ¾ A Before-Tax cash flow analysis (while
flow to the for-profit firm. not as accurate) is often performed as a
¾ A realistic economic analysis must assess the preliminary analysis
impact of taxes
¾ A final, more complete analysis should
•Called and AFTER-TAX cash flow analysis be performed using an After-Tax analysis
¾ Not considering taxes is called a BEFORE-
¾ Both are valuable analysis approached
TAX Cash Flow analysis
Interest Rate Interest Rates and Returns

•Interest can be viewed from two perspectives:


„ INTEREST RATE - INTEREST PER TIME
UNIT 9 Lending situation
9 Investing situation
INTEREST PER TIME UNIT
INTEREST RATE
ORIGINAL AMOUNT

Interest - Lending Interest – Lending Example 1

9 You borrow money (renting someone •Example


else's money) •You borrow $10,000 for one full year
9 The lender expects a return on the •Must pay back $10,700 at the end of one year
money lent •Interest Amount (I) = $10,700 - $10,000
9 The return is measured by application of •Interest Amount = $700 for the year
an interest rate
•Interest rate (i) = 700/$10,000 = 7%/Yr
Interest Rate - Notation Interest – Borrowing (Example)
•The interest rate (i) is 7% per year
•For example 1 the interest rate is..
•The interest amount is $700 over one year
•Expressed as a per cent per year
•The $700 represents the return to the lender for
•Notation this use of his/her funds for one year
• I = the interest amount is $ •7% is the interest rate charged to the borrower
• i = the interest rate (%/interest period) •7% is the return earned by the lender
• N = No. of interest periods (1 for this problem)

Interest – Example Interest – Example


•Borrow $20,000 for 1 year at 9% interest per year •Note the following
• i = 0.09 per year and N = 1 Year •Total Amount Due one year hence is
• Pay $20,000 + (0.09)($20,000) at end of 1 year • ($20,000) + 0.09($20,000)
• Interest (I) = (0.09)($20,000) = $1,800 • =$20,000(1.09) = $21,800
• Total Amt Paid one year hence • The (1.09) factor accounts for the repayment
•$20,000 + $1,800 = $21,800 of the $20,000 and the interest amount
• This will be one of the important interest
factors to be seen later
Interest – Investing Perspective Inflation Effects

•Assume you invest $20,000 for one year in a •A social-economic occurrence in which
venture that will return to you, 9% per year. there is more currency competing for
constrained goods and services
•At the end of one year, you will have:
•Where a country’s currency becomes
•Original $20,000 back
worth less over time thus requiring more of
•Plus…….. the currency to purchase the same amount
of goods or services in a time period
•The 9% return on $20,000 = $1,800

We say that you earned 9%/year on the investment!


This is your RATE of RETURN on the investment

Inflation Rate(s) EQUIVALENCE

Inflation impacts: •Example


9 Purchasing Power (reduces) •You travel at 68 miles per hour
9 Operating Costs (increases) •Equivalent to 110 kilometers per hour
9 Rate of Returns on Investments (reduces) •Thus:
• 68 mph is equivalent to 110 kph
• Using two measuring scales
• Miles and Kilometers
EQUIVALENCE ECONOMIC EQUIVALENCE

•Is “68” equal to “110”? Economic Equivalence


•No, not in terms of absolute numbers • Two sums of money at two different points in
time can be made economically equivalent if:
•But they are “equivalent” in terms of the two
measuring scales 9We consider an interest rate and,
•Miles 9No. of Time periods between the two sums
•Kilometers
Equality in terms of Economic Value

Equivalence Illustrated Equivalence Illustrated

•Return to Example Diagram the loan (Cash Flow $20,000 is


received here
Diagram)
•The company’s perspective is shown T=0 t = 1 Yr

$20,000 is $21,800 paid


received here back here

T=0 t = 1 Yr $20,000 now is economically equivalent to $21,800


one year from now IF the interest rate is set to
$21,800 paid
back here equal 9%/year
Equivalence Illustrated Equivalence Illustrated

• $20,000 now is not equal in magnitude to • If you were told that the interest rate is 9%....
$21,800 1 year from now
•Which is worth more?
• But, $20,000 now is economically equivalent to
•$20,000 now or
$21,800 one year from now if the interest rate in
9% per year. •$21,800 one year from now?
•Another way to put it is …….. •The two sums are economically equivalent but
not numerically equal!

Equivalence Illustrated Simple and Compound Interest

•To have economic equivalence you must specify: •Two “types” of interest calculations
•Timing of the cash flows 9 Simple Interest
•An interest rate (i% per interest period) 9 Compound Interest
•Number of interest periods (N) • Compound Interest is more common worldwide
and applies to most analysis situations
Simple and Compound Interest Simple and Compound Interest

• Simple Interest • Example


•Calculated on the principal amount only • Borrow $1000 for 3 years at 5% per year
•Easy (simple) to calculate • Let “P” = the principal sum
•Simple Interest is: • i = the interest rate (5%/year)

(principal)(interest rate)(time) • Let N = number of years (3)

$I = (P)(i)(n)

Simple and Compound Interest Simple and Compound Interest

•Simple Interest •Year by Year Analysis Simple Interest


•DEFINITION •Year 1
•I = P(i)(N) •I1 = $1,000(0.05) = $50.00
•For : •Year 2
•I = $1000(0.05)(3) = $150.00 •I2 = $1,000(0.05) = $50.00
•Total Interest over 3 Years •Year 3
•I3 = $1,000(0.05) = $50.00
Accrued Interest Year 1 Accrued Interest Year 2
•“Accrued” means “owed but not yet paid” •Year 2
•First Year:
P=$1,000 P=$1,000

1 2 3 1 2 3

I1=$50.00 I1=$50.00 I2=$50.00

$50.00 interest accrues but not paid $50.00 interest accrues but not paid

End of 3 Years Simple Interest: Summary

•$150 of interest has accrued • In a multiperiod situation with simple


P=$1,000
interest:
•The accrued interest does not earn interest
1 2 3 during the succeeding time period
I1=$50.00 I2=$50.00 I3=$50.00 •Normally, the total sum borrowed (lent) is paid
Pay back $1000 back at the end of the agreed time period PLUS
The unpaid interest did not + $150 of the accrued (owed but not paid) interest.
interest
earn interest over the 3-year
period
Compound Interest Compound Interest

•Compound Interest is much different • To COMPOUND – stop and compute the


associated interest and add it to the unpaid
•Compound means to stop and compute
balance.
•In this application, compounding means to •When interest is compounded, the interest that
compute the interest owed at the end of is accrued at the end of a given time period is
the period and then add it to the unpaid added in to form a NEW principal balance.
balance of the loan •That new balance then earns or is charged
•Interest then “earns interest” interest in the succeeding time period

Compound Interest Compound Interest: Example

• To COMPOUND – stop and compute the • Assume:


associated interest and add it to the unpaid
balance. •P = $1,000
•When interest is compounded, the interest that • i = 5% per year compounded annually
is accrued at the end of a given time period is (C.A.)
added in to form a NEW principal balance.
•N = 3 years
•That new balance then earns or is charged
interest in the succeeding time period
Compound Interest Cash Flow Compound Interest: Calculated

• For compound interest, 3 years, we have: • For the example:


P=$1,000 •P0 = +$1,000
Owe at t = 3
years: •I1 = $1,000(0.05) = $50.00
1 2 3
$1,000 + 50.00 + •Owe P1 = $1,000 + 50 = $1,050 (but, we don’t
I1=$50.00 52.50 + 55.13 =
I2=$52.50 pay yet!)
$1157.63
I3=$55.13 •New Principal sum at end of t = 1: = $1,050.00

Compound Interest: t = 2 Compound Interest: t = 3


• New Principal sum: $1,102.50
• Principal and end of year 1: $1,050.00
•I3 = $1102.50(0.05) = $55.125 = $55.13
•I1 = $1,050(0.05) = $52.50 (owed but not paid)
•Add to the beginning of year principal yields:
•Add to the current unpaid balance yields:
•$1102.50 + 55.13 = $1157.63
•$1050 + 52.50 = $1102.50
•This is the loan payoff at the end of 3 years
•New unpaid balance or New Principal Amount
•Note how the interest amounts were added to
•Now, go to year 3……. form a new principal sum with interest calculated
on that new amount
Example Example : 5 Plans
• Plan 5. Equal Payments of the compound
• Five plans are shown that will pay off a loan of
interest and principal reduction over 5 years with
$5,000 over 5 years with interest at 8% per year.
end of year payments.
•Plan1. Simple Interest, pay all at the end
Note: The following tables will show the five
•Plan 2. Compound Interest, pay all at the end approaches. For now, do not try to understand
•Plan 3. Simple interest, pay interest at end of how all of the numbers are determined (that will
come later!) Focus on the methods and these
each year. Pay the principal at the end of N = 5
table illustrate economic equivalence
•Plan 4. Compound Interest and part of the
principal each year (pay 20% of the Prin. Amt.)

Plan 1: @ 8% Simple Interest Plan 2: Compound Interest 8%/yr


• Simple Interest: Pay all at end on $5,000 Loan • Pay all at the End of 5 Years
Plan 3: Simple Interest Pd. Annually Plan 4 Compound Interest

• Principal Paid at the End (balloon Note) • 20% of Principal Paid back annually

Plan 5: Equal Repayment Plan Comparisons – 5 Plans


• Plan 1 Simple interest = (original principal)(0.08)
Equal Annual Payments (Part Principal and Part Interest
• Plan 2 Compound interest = (total owed previous
year)(0.08)
• Plan 3 Simple interest = (original principal)(0.08)
• Plan 4 Compound interest = (total owed previous
year)(0.08)
• Plan 5 Compound interest = (total owed previous
year)(0.08)
Analysis Terminology and Symbols

• Note that the amounts of the annual payments ‰ Specific symbols and their respective
are different for each repayment schedule and definitions has been developed for use in
that the total amounts repaid for most plans are engineering economy
different, even though each repayment plan ‰ Symbols tend to be standard in most
requires exactly 5 years. engineering economy texts world-wide
•The difference in the total amounts repaid can ‰ Mastery of the symbols and their respective
be explained (1) by the time value of money, (2) meanings is most important in understanding of
by simple or compound interest, and (3) by the the subsequent material!
partial repayment of principal prior to year 5.

Terminology and Symbols Terminology and Symbols

•P = value or amount of money at a time • F = value or amount of money at some future


designated as the present or time 0. time.

•Also P is referred to as present worth (PW), •Also F is called future worth (FW) and future
present value (PV), net present value (NPV), value (FV); dollars
discounted cash flow (DCF), and capitalized
cost (CC); dollars
Terminology and Symbols Terminology and Symbols

™ A = series of consecutive, equal, • i = interest rate or rate of return per


end-of-period amounts of money. time period; percent per year, percent
per month
™ Also A is called the annual worth (AW) and
equivalent uniform annual worth (EUAW); • t = time, stated in periods; years,
dollars per year, dollars per month months, days, etc
™ n = number of interest periods; years,
months, days

P and F P and F:

• The symbols P and F represent one-time ‰ It should be clear that a present value
occurrences: $F P represents a single sum of money at
•Specifically: some time prior to a future value F
‰This is an important basic point to
0 1 2 … … n-1 n remember
t=n

$P
Annual Amounts Annual Amounts

Cash Flow diagram for annual amounts


• It is important to note that the symbol A might look like the following:
always represents a uniform mount (i.e.,
the same amount each period) that $A $A $A $A $A
extends through consecutive interest
…………
periods.
0 1 2 3 .. N-1 n

A = equal, end of period cash flow amounts

Interest Rate – i% per period Terminology and Symbols

• The interest rate i is assumed to be a For many engineering economy problems:


compound rate, unless specifically stated 9Involve the dimension of time
•As “simple interest”
9At least 4 of the symbols { P, F, A, i% and n }

•The rate i is expressed in percent per interest 9At least 3 of 4 are either estimated or
period, for example, 12% per year. assumed to be know with certainty.
Intro to Solution by Computer Spreadsheets
• Use of a spreadsheet similar to Microsoft’s
Excel is fundamental to the analysis of • Excel supports (among many others) six built-
engineering economy problems. in functions to assist in time value of money
analysis
•Appendix A of the text presents a primer on
spreadsheet use •Master each on your own and set up a variety
of the homework problems (on your own)
•All engineers are expected by training to know
how to manipulate data, macros, and the
various built-in functions common to
spreadsheets

Excel’s Financial Functions Financial Functions - continued

• To find the present value P: PV(i%,n,A,F) • To find the number of periods n:


NPER(i%,A,P,F)
•To find the future value F: FV(i%,n,A,P) •To find the compound interest rate i:
RATE(n,A,P,F)
•To find the compound interest rate i:
•To find the equal, periodic value A:
PMT(i%,n,P,F) IRR(first_ cell:last_ cell)
Financial Functions - continued
Minimum Attractive Rate
of Return (MARR)
¾ Firms will set a minimum interest rate that the
• To find the present value P of any series: financial managers of the firm require that all
NPV(i%,second_cell_last cell) + first cell accepted projects must meet or exceed.

• These built-in Excel functions support a wide ¾The rate, once established by the firm is termed
variety of spreadsheet models that are useful in the Minimum Attractive Rate of Return (MARR)
engineering economy analysis. ¾The MARR is expressed as a per cent per year
¾Numerous models exist to aid the financial
managers is estimating what this rate should be in
a given time period.

Minimum Attractive Rate of Return MARR – Hurdle Rate

™ An investment is a commitment of funds


• In some circles, the MARR is termed the Hurdle
and resources in a project with the expectation
Rate
of earning a return over and above the worth
of the resources that were committed. • Capital (investment funds) is not free
™ Economic Efficiency means that the returns •It costs the firm money to raise capital or to use
should exceed the inputs. the owners of the firm’s capital.
™ In the for profit enterprise, economic •This cost is often expressed as a % per year
efficiencies greater than 100% are required!
Cost of Capital: Personal Example Cost to a Firm

• Firm’s raise capital from the following sources


• Assume you want to purchase a new computer
• Equity – using the owner’s funds (retained
• Assume you have a charge card that carries a
earnings, cash on hand )belongs to the owners)
18% per year interest rate.
• Owners expect a return on their money and
• If you charge the purchase, YOUR cost of capital
hence, there is a cost to the firm
is the 18% interest rate.
•DEBT – the firm borrows from outside the firm and
•Very high!
pays an interest rate on the borrowed funds

Costing Capital Setting the MARR: Safe Investment

9 Financial models exist that will approximate • First, start with a “safe” investment possibility
the firm’s weighted average cost of capital for a
• A firm could always invest in a short term CD
given time period.
paying around 4-5%
9 Once this “cost” is approximated, then, new
• But investors will expect more that that!
projects up for funding MUST return at least the
cost of the funds used in the project PLUS some • The firm should compute it’s current weighted
additional per cent return. average cost of capital (See Chapter 10)
9 The cost is expressed as a % per year just •This cost will almost always exceed a “safe”
like an interest rate. external investment rate!
Setting the MARR - continued Setting a MARR

• Assume the weighted average cost of capital • Start with the WACC…
(WACC) is say, 10.25% (for the sake of
•Add a buffer percent (?? Varies from firm to
presentation)
firm)
• Certainly, the MARR must be greater than the
• This yields an approximation to a reasonable
firms cost of capital in order to earn a “profit” or
MARR
“return” that satisfies the owners!
•This becomes the Hurdle Rate that all
•Thus, some additional “buffer” must be
prospective projects should earn in order to be
provided to account for risk and uncertainty!
considered for funding.

Graphical Presentation: MARR Opportunity forgone


RoR - %

• Assume a firm’s MARR = 12%


Acceptable range for new
projects
•Two projects, A and B
• A costs $400,000 and presents an estimated
MARR - % 13% per year.
• B cost $100,000 with an estimated return of
Safe Investment WACC - %
14.5%

0%
Opportunity Forgone Cash Flow Diagramming

• What if the firm has a budget of say $150,000 • Engineering Economy has developed a
graphical technique for presenting a problem
•A cannot be funded – not sufficient funds!
dealing with cash flows and their timing.
•B is funded and earns 14.5% return or more
• Called a CASH FLOW DIAGRAM
•A is not funded, hence, the firm looses the
• Similar to a free-body diagram in statics
OPPORTUNITY to earn 13%
• First, some important TERMS . . . .
•This often happens!

Important TERMS Cash Flows

• CASH INFLOWS For many practical engineering economy


problems the cash flows must be:
•Money flowing INTO the firm from outside
• Assumed know with certainty
•Revenues, Savings, Salvage Values, etc
• Estimated
• CASH OUTFLOWS
• A range of possible realistic values provided
•Disbursements
• Generated from an assumed distribution and
• First costs of assets, labor, salaries, taxes paid, simulated
utilities, rents, interest, etc
Net Cash Flows End of Period Assumption

• A NET CASH FLOW is • END OF PERIOD convention


• Cash Inflows – Cash Outflows
•(for a given time period) ALL CASH FLOWS ARE ASSUMED TO OCCUR AT
THE END OF AN INTEREST PERIOD EVEN IF THE
• We normally assume that all cash flows occur: MONEY FLOWS AT TIMES WITHIN THE
INTEREST PERIOD.
•At the END of a given time period
THIS IS FOR SIMPLIFICATION PURPOSES
•End-of-Period Assumption

The Cash Flow Diagram: CFD Example Cash Flow diagrams

• Extremely valuable analysis tool • Assume a 5-year problem


• First step in the solution process • The basic time line is shown below
• Graphical Representation on a time scale
• Does not have to be drawn “to exact scale”
•But, should be neat and properly labeled
•Required on most in class exams and part •“Now” is denoted as t = 0
of the grade for the problem at hand
Displaying Cash Flows Sample CF Diagram
Positive CF at t = 1

• A sign convention is applied


• Positive cash flows are normally drawn
upward from the time line
• Negative cash flows are normally drawn
downward from the time line

Negative CF’
CF’s at t = 2 & 3

Problem Perspectives Lending – Borrowing Example

• Before solving, one must decide upon the • Assume $5,000 is borrowed and payments are
perspective of the problem $1100 per year.
•Most problems will present two perspectives •Draw the cash flow diagram for this
•Assume a borrowing situation for example •First, whose perspective will be used?
•Perspective 1: From the lender’s view •Lender’s or the Borrower’s ? ? ?
•Perspective 2: From the borrower’s view •Problem will “infer” or you must decide….
•Impact upon the sing convention
Lending - Borrowing Lending - Borrowing

• From the Lender’s Perspective • From the Lender’s Perspective

P = +$5,000
A = +$1100/yr

0 1 2 3 4 5 0 1 2 3 4 5

A = -$1100/yr
-$5,000

Example Example CF Diagram

• A father wants to deposit an unknown


lump-sum amount into an investment
opportunity 2 years from now that is large
enough to withdraw $4000 per year for state
university tuition for 5 years starting 3 years
from now.
•If the rate of return is estimated to be 15.5%
per year, construct the cash flow diagram.
Rule of 72: Estimating Doubling Time
and Interest Rate
Rule of 72’s for Interest

• A common question most often asked by • The Rule of 72 states:


investors is:
•The approximate time for an investment to
•How long will it take for my investment to double in value given the compound interest
double in value? rate is:
•Must have a known or assumed compound •Estimated time (n) = 72/i
interest rate in advance
•For i = 13%: 72/13 = 5.54 years
•Assume a rate of 13%/year to illustrate….

Rule of 72’s for Interest Chapter 1 Summary

• Likewise one can estimate the required • Engineering Economy:


interest rate for an investment to double in
value over time as: •Application of economic factors and
criteria to evaluate alternatives
•i approximate = 72/n
considering the time value of money
•Assume we want an investment to double in (interest and time)
say 3 years.
•Estimate i –rate would be: 72/3 = 24%
Chapter 1 Summary Chapter 1 Summary

• Engineering Economy Study: • The concept of equivalence helps


•Involves modeling the cash flows in understanding how different sums
of money at different times are equal
•Computing specific measures of
in economic terms
economic worth
•Using an interest rate(s)
•Over a specified period of time

Chapter 1 Summary Chapter 1 Summary

• Simple and Compound Interest • Compounding of Interest


•The differences between simple •The power of compounding is very
interest (based on principal only) and noticeable, especially over long periods
compound interest (based on principal of time.
and interest upon interest) have been
•Notion of computing interest on
described in formulas, tables, and
interest
graphs
Chapter 1 Summary Chapter 1 Summary

• The MARR • Attributes of Cash Flows


•The MARR is a reasonable rate of •Difficulties with their estimation.
return established as a hurdle rate to •Difference between estimated and
determine if an alternative is actual value.
economically viable.
•End-of-year convention for cash flow
•The MARR is always higher than a location.
return from a safe investment.

Chapter 1 Summary

• Attributes of Cash Flows


•Net cash flow computation.
•Different perspectives in determining
the cash flow sign convention.
THE END
•Construction of a cash flow diagram.
•Introduction to spreadsheet analysis