Economic

Analysis of
Engineering
Projects

ISEN 302-502

Copyright 2013 John Wiley & Sons, Inc.

Before the formal lecture

Syllabus
Other benefit of taking this course?
Prepare your FE/PE exams. You may take
FE exam during your senior year if you
choose to do so

Copyright 2013 John Wiley & Sons, Inc.

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 Chapter 1

An Overview of
Engineering
Economic
Analysis

Copyright 2013 John Wiley & Sons, Inc.

What is engineering economy?
DEFINITION: Techniques that simplify comparison of
alternatives on an economic basis

Other Names:
Economic analysis;
Economic justification;
Capital investment analysis;
Economic decision analysis

Copyright 2013 John Wiley & Sons, Inc.

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Engineering economy problems

Personal
Should I buy or lease a new car?
Should I pay off my credit card balance with borrowed
money?
What rate of return did I make with this stock investment?
How much should I save for my retirement?

Corporations and Businesses

Should we produce or sub-contract parts?
Do we build or lease a facility for a new plant?
Should we replace existing machines?
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1-1 Time value of money

Time value of money (TVOM)

Four discounted cash flow (DCF) rules

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Example: You get a tax-free gift of $ 1,000

You are provided with two choices:

$1,000 today or $X a year from today?
(For purposes of this example, assume that the guarantee
is risk-free.)

Which would you choose if X equals

(1) $1,000, (2) $1,050, (3) $1,100, (4) $1,500, (5) $2,000,
(6) $5,000, (7) $10,000, (8) $100,000?

Copyright 2013 John Wiley & Sons, Inc.

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Example 1.1 The Time Value of
Money Illustrated (cont.)

some value (or range of values) of $X exists for which you are
indifferentthat is, has no preferenceabout receiving $1,000
today versus receiving $X a year from today.

If you are indifferent when X equals $1,200, then we would

conclude that $1,200 received 1 year from now has a present
value or present worth of $1,000 in your current circumstance.
In this case, yourTVOM is 20 percent.

Copyright 2013 John Wiley & Sons, Inc.

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Time Value of Money (TVOM)

The value of a given sum of money depends on

both the amount of money and the point in time
when the money is received or paid.
Money has time of value even in absence of
inflation
Other terms used to express the TVOM
Interest rate
Discount rate
Minimum Attractive Rate of Return (MARR)
Cost of capital
Copyright 2013 John Wiley & Sons, Inc.
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Leaning Objective of Time value of
money

Apply the four discounted cash flow (DCF) rules

to simple time value of money (TVOM) situations

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Four DCF Rules

Rule 1: Money has a time value.

$1 $1 + interest

$1

Today 1 year later

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 Four DCF Rules

Rule 2. Quantities of money cannot be added or

subtracted unless they occur at the same points
in time.
$1 today + $ 1 tomorrow (Wrong!)
Rule 3. To move money forward one time unit,
multiply by 1 plus the discount or interest rate.
(1+i)
Rule 4. To move money backward one time unit,
divide by 1 plus the discount or interest rate.
(1+i) Copyright 2013 John Wiley & Sons, Inc.
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Example 1.2 Applying the Four DCF
Rules

Recall the previous tax-free $1,000 gift example,

where your TVOM was 20 percent.

Suppose you are guaranteed to receive $1,100

one year from today, and nothing thereafter, if
$1,000 is invested today in a particular venture.
What is the return on this investment?
Is this a good investment?

Copyright 2013 John Wiley & Sons, Inc.

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 Example 1.2 Applying the Four DCF
Rules (cont.)

Rule 1 establishes that money has a time value; in

previous example, it can be represented by a 20
percent annual/discount rate.
It would be a mistake to subtract the $1,000
investment from the $1,100 return and conclude
that the investment yielded a net positive return of
$100. Why?
Because Rule 2 establishes that the $1,000 investment
cannot be subtracted from the $1,100 return, because they
occur at different points in time.
Copyright 2013 John Wiley & Sons, Inc.
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Example 1.2 Applying the Four DCF Rules
(cont.) Net Future Value approach

Using Rule 3, based on a 20% discount rate, the future

value or future worth of the $1,000 investment
= $1,000(1+0.2) = $1,200 one year later.
Thus,
negative cash flow = $1,200 (spend outflow)
positive cash flow = $1,100 (receive inflow)
The net future worth of the investment
= $1,200 + $1,100
=$100.
Because the future worth is negative, the investment
would not be considered a good one by the student.

Copyright 2013 John Wiley & Sons, Inc.

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Example 1.2 Applying the Four DCF
Rules (cont.) Net Present Value approach
Using Rule 4,
the present value or present worth of $1,100 a year
from now = $1,100/(1+0.2)= $916.67.
Therefore,
negative cash flow= $1000
positive cash flow = $ 916.67
The net present worth of the investment
= $1,000 (outflow) + $ 916.67(inflow) =$ 83.33.
Again, the student should conclude that the investment
was not a good one.
Q: What if your TVOM is 8% instead of 20%?
A: It becomes a good investment. WHY?
Copyright 2013 John Wiley & Sons, Inc.
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1-2 Engineering Economy Principles

Learning Objective:
Identify the 10 principles of engineering
economic analysis that can be used by all
engineers in analyzing the economic performance
of the products, processes, and systems they
design.

Copyright 2013 John Wiley & Sons, Inc.

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Principle 1

Money has a time value

Due to the TVOM, we prefer to receive a fixed sum of
money sooner rather than later; likewise, we prefer to pay
a fixed sum of money later, rather than sooner.

A dollar today is worth more than a dollar in the future

Because the money can earn interest up until the time the
future dollar is received

Copyright 2013 John Wiley & Sons, Inc.

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Principle 2

Make investments that are economically justified

If you need a new machine and dont buy it, you pay for
it without ever getting it --- Henry Ford

Need means: saving > price paid

Copyright 2013 John Wiley & Sons, Inc.

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Principle 3

Choose the mutually exclusive investment

alternative that maximizes economic worth
Mutually exclusive: multiple investment alternatives
exist, but only one can be chosen.
Consider only monetary aspects of the alternatives.
Nonmonetary considerations may cause an alternative
to be chosen that does not maximize economic worth.

Copyright 2013 John Wiley & Sons, Inc.

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Principle 4

Two investment alternatives are equivalent if they

have the same economic worth

The fourth principle is an extension of the third

For well-behaved cash flow profiles, the equivalence
holds only for the TVOM that equates their economic
worths.
More about this in Chapters 2 and 6.

Copyright 2013 John Wiley & Sons, Inc.

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Principle 5

Marginal revenue must exceed marginal cost

One should not make an investment unless the added
revenues are greater than the added costs.

Based on the first principle, the TVOM must be used in

comparing marginal revenues and marginal costs if they
occur at different points in time.

Copyright 2013 John Wiley & Sons, Inc.

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Principle 6

Principle 6: Continue to invest as long as each

additional increment of investment yields a return
that is greater than the investors TVOM
Use someone elses money if you can earn more by
investing it than you have to pay to obtain it.
Corollary of Principle 5
More about this principle in Chapters 6 and 9.

Copyright 2013 John Wiley & Sons, Inc.

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Principle 7

Consider only differences in cash flows among

investment alternatives

Option Monthly Monthly Cash Monthly Salvage

Fuel Mainten outlay at payment Value at
Cost ance signing end of
year 3
Buy $960 $550 $6,500 $350 $9,000

Lease $960 $550 $2,400 $550 0

Irrelevant items in decision making

Copyright 2013 John Wiley & Sons, Inc.
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Principle 8

Compare investment alternatives over a common

period of time
**This principle is often violated**
It is important to compare the alternatives over the same
length of time.
More about this principle in Chapters 4, 5 and 6.

Copyright 2013 John Wiley & Sons, Inc.

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Principle 9

Risks and returns tend to be positively correlated

The higher the risks associated with an investment, the
greater the anticipated returns must be to justify the
investment.
Investment Class Potential Risk Expected Return

Savings account Low/None 1.5%

(cash)
Bond (debt) Moderate 4.8%

Stock (equity) High 11.5%

Copyright 2013 John Wiley & Sons, Inc.

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Principle 10

Past costs are irrelevant in engineering economic

analysis, unless they impact future costs

Past costs that have no carryover effect in the future,

also called sunk costs, must be ignored when performing
an engineering economic analysis.

Copyright 2013 John Wiley & Sons, Inc.

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1-3 Economic Justification of Capital Investments

Learning Objective :
Identify the seven steps of the systematic
economic analysis technique (SEAT) used to
perform engineering economic analysis.

Copyright 2013 John Wiley & Sons, Inc.

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 Step 1

Identify the Investment Alternatives

mutually exclusive: either/or but not both
collectively exhaustive: consider all possible investments
Very Critical
The do nothing alternative is often considered
Baseline
Doesntmean nothing will be done
Extreme care taken not to underestimate the cost of doing nothing

Copyright 2013 John Wiley & Sons, Inc.

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Step 2

Define the Planning Horizon

The period of time or width of the window over which
the economic performance of each investment
alternative will be viewed.
8th principle requirement over a common period of time

Copyright 2013 John Wiley & Sons, Inc.

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Step 2 (cont.)

When the lives of the investment alternatives differ, consider

the following approaches to make them equal:
1. The shortest life among the alternatives.
2. The longest life among the alternatives.
3. The least common multiple of the lives of the various alternatives.
-- may be quite long
4. A standard length horizon.
identical replacement
5. Infinitely long planning horizon reasonable approx.
Key: make all investments end at the same time

Copyright 2013 John Wiley & Sons, Inc.

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Step 3

Specify the Minimum Attractive Rate of Return

(MARR) (or the Discount Rate)
Minimum rate of return on an investment that a decision
maker is willing to accept given the associated risk and
the opportunity cost of other forgone investments.
Weighted Average Cost of Capital (WACC) used to
establish a lower bound for the MARR.

Copyright 2013 John Wiley & Sons, Inc.

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Step 3 Formula (cont.)

WACC = (E /V ) ie + (D /V ) id (1 itr )
where
E = a firms total equity, expressed in dollars
D = a firms total debt and leases, expressed in dollars
V = E + D, a firms total invested capital
ie = cost of equity or expected rate of return on equity,
expressed in percent
id = cost of debt or expected rate of return on borrowing,
expressed in percent
itr = corporate tax rate

Copyright 2013 John Wiley & Sons, Inc.

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Step 4
Estimate the Cash Flows

Once the planning horizon is determined, a cash flow

diagram (CFD) need to be drawn for each alternatives at
each year of the horizon
Not an exact science
Best estimates based on historical data, personal
judgement and experiences of the estimator, etc.
Annual based
Cost (consider risk and uncertainties) and Revenues
More about this is in Chapter 2.
Copyright 2013 John Wiley & Sons, Inc.
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Step 5

Compare the Alternatives

After alternative identified, planning horizon determined,
MARR specified and cash flow estimated
Select criterion such as present value, future value,
payback period, or rate of return
Depreciation, income tax, replacement, and inflation
may need to be considered depending on the
investment type and the investors country

-This course focus is Step 5 (chapter 3-9)

Copyright 2013 John Wiley & Sons, Inc.

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Step 6

Perform Supplementary Analysis

Answer as many what if questions as possible such as
Are the cash flow estimates correct?
Is the timing of the cash flows correct?
What happens if the planning horizon changes?
What happens when I vary my MARR?

Copyright 2013 John Wiley & Sons, Inc.

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Step 7
Select the Preferred Investment
The preferred investment may not always be the one that
performs best when considering only the economic criteria
In practice, multiple (intangible) criteria typically exists
such as
(improved) Safety
(improved) Quality
(increased) Customer service
(improved) Employee morale
Being first in the industrial to adopt a new technology

Copyright 2013 John Wiley & Sons, Inc.

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Assignments

Homework 1
Online, untimed, ungraded, for practice only
Will be announced on eCampus by the end of today
There is no due date for homework, you can always
go back and try the old problems as you wanted

Copyright 2013 John Wiley & Sons, Inc.

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