Ch 1 Foundations

8/12/2019 Ch 1 Foundations

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2012 by McGraw-Hill, New York, N.Y All Rights Reserve1-1

Lecture slides to accompany

Engineering Economy7th edition

Leland Blank

Anthony Tarquin

Chapter 1

Foundations Of

Engineering

Economy


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LEA!"!# O$TCO%E&

1. Role in decisionmaking

2. Study approach

3. Ethics andeconomics

4. Interest rate

5. Terms and symbols. !ash "lo#s

$. Economice%ui&alence

'. Simple andcompound interest

(. )inimum attracti&erate o" return

1*. Spreadsheet"unctions


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'hy Engineering Economy is "mportant

to Engineers

Engineers design and create

(esigning in)ol)es economic decisions

Engineers must *e a*le to incorporate economicanalysis into their creati)e efforts

Often engineers must select and implement frommultiple alternati)es

$nderstanding and applying time )alue of money+economic equi)alence+ and cost estimation are )italfor engineers

A proper economic analysis for selection ande,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 oed *y

or oned *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 themost important concept in

engineering economy


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Engineering Economy

Engineering Economy in)ol)es Formulating

Estimating+ and

E)aluating

e,pected economic outcomes of alternati)es

designed to accomplish a defined purpose

Easy4to4use math techniques simplify the

e)aluation Estimates of economic outcomes can *e

deterministic or stochastic in nature


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#eneral &teps for (ecision %aking 5rocesses

16 $nderstand the pro*lem define o*8ecti)es96 Collect rele)ant information

:6 (efine the set of feasi*le alternati)es

;6 "dentify the criteria for decision making

*est? alternati)e76 "mplement the alternati)e and monitor

results


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&teps in an Engineering Economy &tudy


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Ethics (ifferent Le)els

$ni)ersal morals or ethics Fundamental

*eliefs0 stealing+ lying+ harming or murdering

another are rong

5ersonal morals or ethics Beliefs that an

indi)idual has and maintains o)er time@ ho auni)ersal moral is interpreted and used *y

each person

5rofessional or engineering ethics Formalstandard or code that guides a person in ork

acti)ities and decision making

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Code of Ethics for EngineersAll disciplines ha)e a formal code of ethics6 !ational &ociety of

5rofessional Engineers .!&5E/ maintains a code specifically forengineers@ many engineering professional societies ha)e their on code

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"nterest and "nterest ate

"nterest the manifestation of the time )alue of money

Fee that one pays to use someone else3s money

(ifference *eteen an ending amount of money

and a *eginning amount of money

"nterest amount oed no principal

"nterest rate "nterest paid o)er a time period

e,pressed as a percentage of principal


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ate of eturn

"nterest earned o)er a period of time is e,pressed as a

percentage of the original amount .principal/

interest accrued per time unitRate of return (%) = x 100%original amount

(orrower)s *ers*ective + iterest rate *aieer)s or ivestor)s *ers*ective + rate o ret/r eare


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"nterest paid "nterest earned


Interest rate Rate of return


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Commonly used &ym*ols

t time+ usually in periods such as years or months5 )alue or amount of money at a timet

designated as present or time

F )alue or amount of money at some future

time+ such as at t = n periods in the future

A series of consecuti)e+ equal+ end4of4period

amounts of money

n num*er of interest periods@ years+ months i interest rate or rate of return per time period@

percent per year or month


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Cash Flos0 Terms

Cash "nflos e)enues ./+ receipts+incomes+ sa)ings generated *y pro8ects andacti)ities that flo in6 5lus sign used

Cash Outflos (is*ursements .(/+ costs+

e,penses+ ta,es caused *y pro8ects andacti)ities that flo out6 %inus sign used

!et Cash Flo .!CF/ for each time period0

!CF cash inflos cash outflos (

End4of4period assumption0

Funds flo at the end of a gi)en interest period


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Cash Flos0 Estimating

5oint estimate A single4)alue estimate of acash flo element of an alternati)e

Cash inflo0 "ncome 1


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Cash Flo (iagrams

'hat a typical cash flo diagram might look like

1 9 D D D n 4 1 n

(ra a time line

One time

period

1 9 D D D n41 n

&ho the cash flos .to appro,imate scale/

Cash flos are shon as directed arros0 .up/ for inflo

4 .don/ for outflo

Always assume end-of-period cash flows

ie

3 4100

5 3 4-&0


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Cash Flo (iagram E,ample

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5lot observe cash lows over last & years a estiate sale e6t

year or 41#0. 7how *reset worth 859 arrow at *reset tie, t 3 0


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Economic Equi)alence

(efinition0 Com*ination of interest rate .rate ofreturn/ and time )alue of money to determine

different amounts of money at different points

in time that are economically equi)alent

o it orks0 $se ratei and time tin upcoming

relations to mo)e money .)alues of 5+ F and A/

*eteen time points t + 1+ D+ n to makethem 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

1

4100 ow

4110

Rate o ret/r 3 10: *er year

1 no is economically equi)alent to 11 one year from

no+ if the 1 is in)ested at a rate of 1G per year6

Year


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&imple and Compound "nterest

&imple "nterest"nterest is calculated using principal only

"nterest .principal/.num*er of periods/.interest rate/

I Pni

E,ample0 1+ lent for : years at simple i 1G

per year6 'hat is repayment after : yearsH

"nterest 1+.:/.61/ :+

Total due 1+ :+ 1:+


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&imple and Compound "nterest

Compound "nterest

"nterest is *ased on principal plus all accrued interest

That is+ interest compounds o)er time

"nterest .principal all accrued interest/ .interest rate/

"nterest for time periodt is



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Compound "nterest E,ample

E,ample0 1+ lent for : years at i 1G per

year compounded6 'hat is repayment after :yearsH

;terest, year 1< ;1 3 100,00080.109 3 410,000

otal /e, year 1< 1 3 100,000 = 10,000 3 4110,000 ;terest, year 2< ;2 3 110,00080.109 3 411,000

otal /e, year 2< 2 3 110,000 = 11,000 3 4121,000

;terest, year !< ;! 3 121,00080.109 3 412,100 otal /e, year !< ! 3 121,000 = 12,100 31::+1

>o*o/e< 41!!,100 7i*le< 41!0,000



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%inimum Attracti)e ate of eturn

%A is a reasona*le rate ofreturn .percent/ esta*lished fore)aluating and selectingalternati)es

An in)estment is 8ustified

economically if it is e,pectedto return at least the %A

Also termed hurdle rate,benchmark rate and cutoff rate


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%A Characteristics

%A is esta*lished *y the financialmanagers of the firm

%A is fundamentally connected to the cost

of capital

Both types of capital financing are used to

determine theeighted a)erage cost of capital

.'ACC/ and the %A

%A usually considers the riskinherent to a

pro8ect


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Types of Financing

Equity FinancingFunds either fromretained earnings+ ne stock issues+ oroner3s infusion of money6

(e*t FinancingBorroed funds fromoutside sources loans+ *onds+ mortgages+)enture capital pools+ etc6 "nterest is paid tothe lender on these funds

For an economically 8ustified pro8ect

O I %A J 'ACC


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Opportunity Cost(efinition0 Largest rate of return of all pro8ects not

accepted .forgone/ due to a lack of capital funds "f no %A is set+ the O of the first pro8ect not undertaken

esta*lishes the opportunity cost

E,ample0 Assume %A 1G6 5ro8ect A+ notfunded due to lack of funds+ is pro8ected to

ha)e OA 1:G6 5ro8ect B has OB 1


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"ntroduction to &preadsheet Functions

E,cel financial functions5resent -alue+ 50 5-.iG+n+A+F/

Future -alue+ F0 F-.iG+n+A+5/

Equal+ periodic )alue+ A0 5%T.iG+n+5+F/

!um*er of periods+ n0 !5E..iG+A+5+F/Compound interest rate+ i0 ATE.n+A+5+F/

Compound interest rate+ i0 ".firstKcell0lastKcell/

5resent )alue+ any series+ 50 !5-.iG+secondKcell0lastKcell/ firstKcell

E,ample0 Estimates are 5


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Chapter &ummary Engineering Economy fundamentals

Time )alue of money Economic equi)alence "ntroduction to capital funding and %A &preadsheet functions

"nterest rate and rate of return &imple and compound interest

Cash flo estimation Cash flo diagrams End4of4period assumption

!et cash flo 5erspecti)es taken for cash flo estimation

Ethics $ni)ersal morals and personal morals 5rofessional and engineering ethics .Code of Ethics/

Ch 1 Foundations

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