INEN 2273 Engineering Economics

Dr. Alberto Marquez Lamar University

amarquez@my.lamar.edu Industrial Engineering Department

Introduction
Time value of Money

Time value of money
Opportunity cost Not the same as inflation

Section 2.1
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Project economic valuation
Fundamentally, project valuation includes the formulation, estimation and valuation of economic outcomes when the alternatives for the achievement of objectives are available It is founded on a collection of mathematical techniques that simplify the economic comparison
Section 2.1
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Section 2.1 8/26/2010 Dr.Cash flow A cash flow represents the money that will come out of or into the investor as a consequence of the development of the project. Alberto Marquez 5 .

Section 2.Financial Science FS is the application of scientific tools to investments There is an art to the investment as well. Alberto Marquez 6 .1 8/26/2010 Dr.

Alberto Marquez 7 .Some relevant terms Capital Interest Present value Future Value Annuity Internal rate of return Minimum acceptable rate of return Simple interest Compounded Interest Inflation Taxes Depreciation Bonds Section 2.1 8/26/2010 Dr.

Cash flow diagrams Section 2. They could be periodic or not.2 8/26/2010 Dr.Cash flow series A series is a chain of flows that can be represented by a diagram. Alberto Marquez 8 .

future value. annuities.Main formulae Present value. equivalences .

2 8/26/2010 Dr. Alberto Marquez 10 .Simple interest F ! P (1  in) Section 2.

Alberto Marquez .Compound interest n n ! n 1 (1  r ) n ! (1  r ) ! Dr.

n 11 Section 2. i. .4 8/26/2010 .

Single Amount: Factor Notation and Formula: .

.

4 8/26/2010 . n ! . i. Section 2.

i. n ! © © .1  i n ¨ 1 ¸ ¹ .

 i n ¹ ª1 º Dr. Alberto Marquez 12 .

Sample Cash Flow Diagram: Single Amount t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 Section 2.4 8/26/2010 Dr. Alberto Marquez 13 .

Series of cash flows P ! § At (1  i ) ! § At .

P F . t t t !1 t !1 n t n n F ! § At (1  i ) t !1 n !§ At . i.

Alberto Marquez 14 .F P.5 8/26/2010 Dr. i. n  t t !1 n Section 2.

Uniform Series: Factor Notation and Formula: Present Worth Capital Recovery « (1  i )  1» A.

n ! A¬ n ¼ ­ i (1  i ) ½ n « i (1  i ) » P. i.P | A.

1 8/26/2010 . n ! P ¬ ¼ n ­ (1  i )  1½ n Dr. Alberto Marquez 15 Section 2.5. i.A | P.

5. Alberto Marquez 16 .1 8/26/2010 Dr.Sample Cash Flow Diagram: Uniform Flows t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 Section 2.

Uniform Series: Factor Notation and Formula ! ! Section 2.1 8/26/2010 (1  i )  1 i i n (1  i )  1 Dr. Alberto Marquez 17 n .5.

Internal rate of return=IRR 0 ! § At 1 i t !0 n .

.

* n t j 0 ! § At 1 i t !0 8/26/2010 Dr. Alberto Marquez n * t j 18 .

end of years 1 through 3     . Alberto Marquez 19 Example at 10% $1.  402. end of years 1 and 2.8 8/26/2010 Dr.Equivalence Two cash flow series are equivalent at some specified interest rate k% if their present worth are equal using an interest rate of k% Section 2.210 in two years $576.000 today $1.1905 in each year.100 in one year $1.1 in each year.

Mathematical relationships 1 .

n ! .F P. i.

i. n 1 .P F .

i. n ! .A P.

i. n 1 .P A.

A F . i. n ! .

i. n Section 3.A F . Alberto Marquez 20 .6 8/26/2010 Dr.

.

.

i. n ! . .

n  i t !1 n t !1 . . i. n ! 1 ! . n n . i. i.

.

. t 1 . n . i. i.

Mathematical relationships .

n  m ! . i.P F .

i. n v .P F .

P F . m . i.

i.P F . n .

P F . n  m ! . i.

i.P F . m .

i.P F . m v n ! .

P F . m ! . i.

P F . n n m Section 3. i.6 8/26/2010 Dr. Alberto Marquez 21 .

: anticipated paid interest Section 2.Multiple compounding periods Nominal interests Effective interest Actual (real) interest  Ex. Alberto Marquez 22 .6 8/26/2010 Dr.

Effective interest rate ¨ rnominal ¸ i effective ! ©1  ¹ 1 m º ª m Section 2.6 8/26/2010 Dr. Alberto Marquez 23 .

9 8/26/2010 Dr.A.F) Internal rate of return based on flows (i): IRR(Range) Section 2.P.F) Periods (n): NPER(i%.A.n. Range) Future Value: FV(i%.A.F) Internal rate of return based on parameters (irr): RATE(n.P.P.F) Present value: NPV( i%. Alberto Marquez 24 .P) Annuity (A): PMT(i%.Solutions using MS Excel Present value: PV(i%.n.A.n.

Building a spreadsheet 8/26/2010 Dr. Alberto Marquez 25 .

Bonds. Measuring the worth of investments . Project comparison.Applications Loan payment.

Loan payments Principal amount Payoff ! A  U ! A  A.

n  t t t 1 Payoff t ! A.P A. i.

 ( P A. i. n  t ) I t ! iU t 1 U t ! A.

n  t Interest amount A 1 I t ! A?  .P A. i.

n  t  1 Et ! A  I t Et ! A. i.P A.

n  t  1 Section 3.4 8/26/2010 Dr.P A. Alberto Marquez 27 . i.

17 $3.097.60 $1.48 $0.47 $23.002.52 2 $81.097.097.48 $21.095.947.00 $19.900. Alberto Marquez 28 .4 8/26/2010 Dr.48 $42.997.902.00 $81.097.145.17 3 $62.48 $62.099.097.00 Section 3.88 $21.997.000.48 Total payment $23.69 4 $42.60 $23.147.097.952.52 $4.997.48 New Balance 1 $5.38 $20. n=5 Period Beginning Balance $100. i=5%. Interest Principal Payment $18.12 $19.947.35 $23.950.902.60 5 $21.10 $23.Amortization schedule P=100K.69 $2.900.000.

Bond Problems Pbond ! Vr .

i. n  F .P A.

P F . i. n Section 3. Alberto Marquez 29 .5 8/26/2010 Dr.

FW.AW.CW .SIR.Measuring the Worth of Investments PW. IRR.PBP. ERR.

A project can be financed by:  Debt  Capital  A combination 8/26/2010 Dr. Alberto Marquez 31 . Related to the financial cost.MARR: Minimum acceptable rate of return MARR.

Alternative Evaluation Criteria Net present value Future Value Annuity Internal rate of return Section 2. Alberto Marquez 32 .9 8/26/2010 Dr.

NPV comparison Same project life time.One alternative

1. Calculate the NPV with MARR. 2. Si NPV>0 then MARR is achieved and the project is accepted

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NPV comparison Same project lifetime. Multiple alternatives

1. Calculate the NPV of each alternative with MARR 2. Select the alternative with the highest NPV 3. If selecting more than one, select all those where NPV>0.

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NPV for projects with different lifetimes
To compare using NPV, the same project lifetime should be used across all the alternatives 
A) Use the same period using a minimum common multiple of the alternative periods  B) Use a period of n years that will not necessarily be the equivalent of the lifetime of all the alternatives. This method is know as planning horizon.

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Present Worth - PW

PW j

i ! § A jt (1  i ) t !0 n t 8/26/2010 Dr. Alberto Marquez 36 .

AW « W j .Annual Worth .

i ! ¤ jt .

­ t !0 W j .

i ! W j .

i .

n » . n . i.

¼ ½ . i. i. n 8/26/2010 Dr. Alberto Marquez 37 . n .

Future Worth .FW W j .

i ! § t !0 n jt (1  i ) n t 8/26/2010 Dr. Alberto Marquez 38 .

It is called ³internal´ because it does not depend of other rates/ In the practical mathematical solution there could be more than one real positive IRR. Alberto Marquez 39 .Internal rate of return IRR is the rate that turns the value of the project to cero. 8/26/2010 Dr.

IRR n 0!§ t !0 jt (1  i ) * n t j 8/26/2010 Dr.Internal rate of return . Alberto Marquez 40 .

IRR u MARR " apital cost MARR vs. TIR IRR future pro ects IRR current pro ects MARR Zero risk investment return 8/26/2010 Dr. Alberto Marquez 41 .

Alberto Marquez 42 . similar as IRR. Alternative when there could is more than one real positive IRR. Separates positive cash flows (R for revenue) from negative cash flows (C for costs) 8/26/2010 Dr.External rate of return ERR. is the rate that turns the value of the project to cero.

ERR §R t !0 n jt n (1  rt ) * n t ! § C jt (1  i ' ) t !0 n t n n t 0 ! § ( R jt  C jt )(1  i ' ) t !0 8/26/2010 Dr. Alberto Marquez 43 .External rate of return .

Alberto Marquez 44 .Savings/investment ratio .SIR §R SIR j (i ) ! n jt (1  i ) (1  i ) n t §C t !0 t !0 n n t jt 8/26/2010 Dr.

Alberto Marquez 45 .Payback period .PBP mj R jt u C jt !0 § t !0 8/26/2010 Dr.

CW A P! i 8/26/2010 Dr. Alberto Marquez 46 .Capitalized worth .

Capital Recovery Formula CR ! .

i. . n  .

i. . n 8/26/2010 Dr. Alberto Marquez 47 .

continuous compounding .Further Mathematical Developments Gradient.

Alberto Marquez 49 n .2 8/26/2010 Dr.5.Arithmetic Gradient (1  i )  in  1 P!G 2 n i (1  i ) ¨1 ¸ n ¹ A ! G©  © i (1  i ) n  1 ¹ ª º Section 2.

Geometric Gradient: Factor Notation and Formula ® « ¨ 1  g ¸n » ± 1 ¬1  © ¹ ¼ ± ¬ ª 1 i º ¼ ­ ½ ± ig !¯ ± ± n ±1 ° 1 i Dr. Alberto Marquez g {i g g !i 50 Section 2.2 8/26/2010 .5.

r .7/2.Continuous compounding r¸ ¨ lim ©1  m ¹ º m pg ª rn F! e mn !e rn ! ( ieff ! e  1 Section 2. Alberto Marquez 51 . n) g r Dr.71 8/26/2010 .

7 8/26/2010 Dr. Alberto Marquez 52 .Rule of 70% Used to calculate the required period to duplicate capital Approximated formula: 0.7 n! 70 ! r n i Section 2.

Reality issues Changing interest rates Inflation Taxes Depreciation Section 3.1 .

2 8/26/2010 Dr.Changing interest rates Section 3. Alberto Marquez 54 .

Inflation i=combined interest rate d=desired return j=inflation rate 1  i ! .

 d .

 j 1 1 i ! d  j  dj Section 3. Alberto Marquez 55 .3 8/26/2010 Dr.

Alberto Marquez 56 .Corporation Theory and Costs Concepts Cost terminology Break-even point Estimation Section 8.2/8.3 8/26/2010 Dr.1/8.

Cost terminology Life cycle costs Past and sunk costs Future and opportunity costs Direct. Alberto Marquez 57 . indirect and overhead costs Fixed and variable costs Average and marginal costs Section 8.1 8/26/2010 Dr.

Alberto Marquez 58 .Cost terminology Life cycle costs First cost Working capital Operating and maintenance costs Disposal costs Market or trade-in value Salvage value Book value Scrap value 8/26/2010 Dr.

Alberto Marquez 59 Prime costs Cost of goods manufactured Cost of goods sold Factory Overhead costs .Cost structure for manufacturing Direct material Direct labor Conversion costs Selling price Indirect material Indirect labor Fixed and miscellaneous General and Administrative Selling Profit 8/26/2010 Dr.

Break-even point Revenue Profit Fixed + Variable costs Variable costs Fixed costs Breaking even Section 8.2 8/26/2010 Break even point Dr. Alberto Marquez 60 .

3 8/26/2010 Dr.Estimation Section 8. Alberto Marquez 61 .

General Accounting principles Balance sheet Income statement Ratio analysis Section 8.4 8/26/2010 Dr. Alberto Marquez 62 .

once on the left Section 8.General Accounting Principles ASSETS CUSTOMERS SUPPLIERS + - A=L+NW LIABILITIES + - + NET WORTH Everything should be recorded twice: once on the right. Alberto Marquez 63 .4 8/26/2010 Dr.

0 0 0 .0 0 0 C o m p a n y $ $ $ $ $ $ 2 5 .0 0 0 .0 0 0 1 5 0 .Sample balance sheet J a x to o l a n d E n g in e e r in g B a la n c e S h e e t a s o f d a te A s s e ts C u rre n t a s s e ts C a s h A c c o u n t s r e c e iv a b le R a w m a t e r ia ls W o r k in p r o c e s s F in is h e d g o o d s in v e n t o r y S m a ll t o o l in v e n t o r y T o ta l c u rre n t a s s e ts F ix e d a s s e t s L a n d B u ild in g L e s s E q u ip m e n t L e s s O ffic e e q u ip m e n t T o t a l fix e d a s s e t s T o ta l a s s e t L ia b ilit ie s a n d N e t W o r t h C u r r e n t lia b ilit ie s A c c o u n t s p a y a b le T a x p a y a b le T o t a l c u r r e n t lia b ilit ie s F ix e d lia b ilit ie s M o r t g a g e lo a n p a y a b le E q u ip m e n t lo a n p a y a b le T o t a l fix e d lia b ilit ie s T o t a l L ia b ilit ie s N e t w o rth C o m m o n s to c k R e t a in e d e a r n in g s E a r n e d s u r p lu s T o t a l e q u it y T o t a l lia b ilit ie s a n d e q u it y $ $ $ $ 2 0 0 .4 8/26/2010 $ $ $ 3 2 5 .0 0 0 .0 0 0 1 7 1 .0 0 0 .0 0 0 5 0 .5 0 0 0 0 0 0 0 0 0 0 0 0 $ $ 3 0 .0 0 0 .0 0 0 .0 1 1 5 .0 0 8 0 .0 0 9 6 1 .0 0 0 D e p r e c ia t io n re s e rv e $ 1 5 0 .0 0 0 .0 0 0 $ $ 7 9 0 .0 0 $ $ 4 3 4 .0 0 0 .0 0 5 2 7 .0 0 $ $ 4 8 0 .0 0 0 $ $ 3 2 .0 0 0 D e p r e c ia t io n re s e rv e $ $ 6 0 0 .0 0 0 . Alberto Marquez 64 .0 0 Section 8.0 3 .0 0 0 1 0 .0 0 Dr.0 0 0 .0 0 0 .0 0 0 .0 0 0 9 6 1 .0 1 2 .0 0 2 9 .0 8 .0 0 3 5 0 .0 0 $ $ 1 3 0 .0 0 0 7 5 0 .0 0 1 5 .0 0 $ 4 7 .5 7 .

. tr t t t r r ) . . . . . . . Alberto Marquez 65 . . t r t I t r t N t r ft f r t N t r ft ( t t . . . . . . . . . . in In om tat m nt p riod from dat 1 to dat 2 S t f Dr t r Dr t t r I r t r t D r R r Ut t t Gr r ft t r A f t r . Section 8.Sample Income Statement Manufacturing Jax Tool and Engin ring ompan .4 8/26/2010 Dr. . . . . .

000 29.000 10.000 $ $ 414.700 Section 8.800 1.Sample Income Statement Commercial Jax Tool and Engineering company inc Income statement period from date1 to date 2 Sales Less cost of good sold Initial Inventory Plus purchases Final Inventory Gross profit Less expenses Direct labor Depreciation building Depreciation equipment Repars and maintenance Indirect labor Utilities Supplies Tooling Net profit before taxes Less income taxes Net profit (posted to earned surplus) $ $ $ $ 26.000 26.000 432.000 44.500 218.000 41.000 $ $ $ $ $ $ $ 420.200.000 1.000 9. Alberto Marquez 66 .4 8/26/2010 $ $ $ $ 731.000 Dr.000 30.000 786.000 55.

4 8/26/2010 Dr.Ratio Analysis Net income Total Average Assets Net income ROE ! Average Owner' s Equity Current assets CR ! Current liabilitie s cash  receivable s  short . Alberto Marquez 67 .term markeatabl e securities TR ! current liabilitie s Net sales RT ! Average Account Receivable ROA ! IT ! Cost of goods sold Average inventory Total Liabilitie s Total Capital Worth Net Incomer before income taxes and interest TI R ! Interest Charges Net Operating Income OIT ! Total Assets DER ! Section 8.

500 650.000 $ 109.000 $ 320.570 108.750 305.287.500 19X5 $ 83.950 147. Alberto Marquez ¡ Section 8.000 $ 1.080 $ 580.000 $ 31.920 ¢ ¥¥ ¥¥ ¥ ASSETS Current assets Cash Acc unts Recei le In entory Prepaid Expenses T tal current assets Fixed assets M chienry Furniture Other T tal Fixed Assets T tal assets Net s les Cost of goods s ld Beginning In entory Direct M teri ls Direct Labor F ctory O erhead T tal Less ending in entory Cost of goods s ld Gr ss pr fit Other oper ting expenses Selling expenses Gener l and Ad inistr ti e T tal Other Oper ting Expenses Net Oper ting Inc e Less Interest Expenses Net inc e before taxes Less Inc e T xes Net Inc e     ¡   Okie anufacturing Co parative Balance Sheets ¤¡ ¤¡ ¡ ¤¡£ ¤¡ ¢ ¢ ¢ ¤¡ ¤¡ ¤¡ ¢ ¢ ¤¡ ¢ ¡ ¢   Okie Manufacturing Co parative inco e State ents $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ ¤¡ ¡ ¢ ¢ ¤¡   ¢ 19X6 1.973 40.920 $ 261.000 $ 90.000 .000 $ 187.987 .030 $ 228.900 $ 295.600 92.000 $ 50.603 1.188 51.Ratio Analysis $ $ $ $ $ $ $ $ $ $ 8/26/2010 Dr.000 1.000 74.427 51.8293 9.000 $ $ $ $ $ $ $ $ 37.370 211.7038 5.520 $ 130.750 $ 284.600 100.400 650.180.000 $ 40.347 43.17502 68 .400 51.17% 1.161 40.000 409.830 $ 72.000 $ 700.000 ¢ £ £ ¡ ¡ £ ¢ ¡ 19X6 61.000 100.750 344.450.352.438 309.586 113.000 $ 87.430 39.427 $ 580.000 90.573 $ 90.625.606 4.000 $ 90.500 94.653 $ 64.980 180.000 $ 1.000 Return on assets Return on Owners Equity Current R ti Acit Test R ti Acc unts recei le turno er In entory Turno er Debto to equity r ti Ti es interest earned r ti Oper ting inc e to T tal Assets ¥ ¥¥ ¡ £¡ ¦ ¦¢ ¢ ¦¢ ¡ ¦¢ ¦¢ ¡ ¡ ¡ ¢ ¢ 08.000 $ 350.430 18.130.000 406.397 $ 51.000 88.973 19X5 $ 1.500 $ 50.212 69.000 65.600 100.500 $ 23.750 195.45% .573 $ 100.761 1.000 801.103 338.2667 0.030 ¡ £ ¢ 8.750 .3844 1.450 50.000 $ 351.200 174.4 ¥¥ ¥¥ £ ¢ ¦¢ ¢¡ ¢¡ £ ¤¡£ ¢¡ ¢¡ ¢ ¦ £ ¥ LIABILITIES & CAPITAL Current li ilities N tes pay le Acc unts pay le T xes pay le T tal current li ilities Fixed li ilities Loans T tal fixed li ilities T tal li ilities Capital Stock Retained earnings Earned surplus T tal c pital T tal li ilities and c pital $ $ $ $ $ $ $ $ $ $ $ $ 92.000 $ 77.103 65.1127 0.

specifying MARR. replacement analysis . Cost of capital. planning horizon.Comparison of Alternatives Investment alternatives. cash flow profiles. comparing methods.

2 8/26/2010 Dr. Alberto Marquez 70 .Developing investment alternatives Section 5.

Alberto Marquez 71 .Defining the planning horizon Section 5.3 8/26/2010 Dr.

Alberto Marquez 72 .Developing cash flow profiles Section 5.4 8/26/2010 Dr.

IRR u MARR " apital cost MARR vs. TIR IRR future pro ects IRR current pro ects MARR Zero risk investment return Section 5.5 8/26/2010 Dr. Alberto Marquez 73 .

1 8/26/2010 Dr.The cost of capital Section 5.5. Alberto Marquez 74 .

Alberto Marquez 75 .Comparing investment alternatives Ranking approach Incremental approach Section 5.6 8/26/2010 Dr.

11 8/26/2010 Dr.Replacement analysis Section 5. Alberto Marquez 76 .

Alberto Marquez 77 .Optimum replacement interval Section 5.11.3 8/26/2010 Dr.

Effects of interest on borrowed money .Income Taxes and Depreciation Depreciation. Income taxes.

Depreciation 8/26/2010 Dr. Alberto Marquez 79 .

Taxes 8/26/2010 Dr. Alberto Marquez 80 .

8/26/2010 Dr. Alberto Marquez 81 .