EMP5102B - Week 6 Presentation

EMP5102B: Introduction to Engineering Management
WEEK 6
Agenda
Midterm # 1 Review Economic Decision Making Models
EMP5100 - WEEK 5 - RIDHIMA SHARMA
Economic Decision Making

Time value of Money
$1 today is worth more than $1 tomorrow
Interest and Interest Formulas
Interest Rate: The ratio of borrowed money to the fee charged for its use over a period. The ratio is usually expressed as a percentage
Money Flow Over Time

P 1 2 3 ... A A n F
i = nominal annual interest rate n = number of interest periods, usually annual P = principal amount at a time assumed to be the Present A = single amount in a series of n equal amounts at the end of each interest period F = amount, n interest period hence, equal to the compound amount of P, or the sum of the compound amounts of A, at the interest rate i
Single Payment Compound Amount Formula
When interest is permitted to compound, the interest earned during each interest period is added to the principal amount at the beginning of the next interest period. We can show how this applied using the following table:
Single Payment Compound Amount Formula

Single Payment Compount-Amount Formula Yr
Amount at Beginning of Year
Interest Earned During the Year
Compound Amount at end of Year
1 2
P P (1+i)
Pi P(1+i)i
P + Pi = P (1+i) P(1+i) + P(1+i)i = P(1+i)2
3
4
P(1+i)2
P(1+i)n-1
P(1+i)2i
P(1+i)n-1i
P(1+i)2 + P(1+i)2i = P(1+i)3

P(1+i)n-1 + P(1+i)n-1i = P(1+i)n = F
Single Payment Compound-Amount Formula

Referred to as (F/P, i, n) Used to express the equivalence between a present amount, P, and a future amount, F, at an interest rate I for n years
Eqn 1
= (1 + )
Single Payment Compound-Amount Factor
Eqn 2

= ( , , )
i = nominal annual interest rate n = number of interest periods, usually annual P = principal amount at a time assumed to be the Present F = amount, n interest period hence, equal to the compound amount of P, or the sum of the compound amounts of A, at the interest rate i
Single Payment Present-Amount Formula

Also referred to as (P/F,i,n) We can express Eqn 1 in terms of the PV
Eqn 3
1 = (1 + )
Single Payment Present-Amount Factor
Eqn 4

= ( , , )
i = nominal annual interest rate n = number of interest periods, usually annual P = principal amount at a time assumed to be the Present F = amount, n interest period hence, equal to the compound amount of P, or the sum of the compound amounts of A, at the interest rate i
10
Ordinary Annuity
In some situations, a series of receipts or payments occurring uniformly at the end of each period may be encountered. These are called ordinary annuities The sum of the compound amounts can be determined as follows:
1 + 1 =
For derivation: http://www.mathalino.com/reviewer/derivation-formulas/derivation-formula-future-amount-ordinary-annuity
11
Ordinary Annuity
We can also express the relationship as:
F = A(F/A,i,n)
We can also express the relationship in terms of A as:
=
or A=F(A/F,i,n)
1 + 1
12
Ordinary Annuity
We can also express the relationship in terms of the Present Value, P
= (1 + )
We can also express the relationship in terms of A as:
1+ 1 (1+) 1+ 1
= (1 +
or
A=P(A/P,i,n)
13
Ordinary Annuity
Rearranging and solving for P, we get
1 + 1 = (1 + )
or P=P(P/A,i,n)
14
Equivalence Calculations
Allows us to compare 2 or more situations In terms of money, two monetary amounts are equivalent when they have the same value in exchange. There are three factors involved in equivalence of sums of money: (1) the amount of the sums (2) the time of occurrence of the sums (3) the interest rate
15
Example:
At an interest rate of 10% with n = 8 years, a P of $1 is equivalent to an F of what amount?
16
F = P(F/P,i,n) = $1(F/P,10,8) = $2.144 Practically, this can mean that $1 today, is equivalent to $2.144 8 years from now given an interest rate of 10% compounded annually.
17
Example:
At an interest rate of 12% with n = 10 years, a F of $1 is equivalent to a P of what amount?
18
P = F(P/F,i,n) = $1(P/F,12,10) = $0.322 Practically, this can mean that $1 10 years from now, is equivalent to $0.322 today given an interest rate of 12% compounded annually. So if we dont want to exceed a total cost of $1, 10 years from now, we should not spend more than $0.32 today
19
Example:
At an interest rate of 8% with n = 20 years, and an A of $1 is equivalent to a F of what amount?
20
F = A(F/A,i,n) = $1(F/A,8,20) = $45.762 Practically, this means that $1 spent each year for 20 years will result in a total cost of $45.76 20 years from now given an interest rate of 8%
21
Example:
At an interest rate of 12% with n = 6 years, and an F of $1 is equivalent to an A of what amount?
22
A = F(A/F,i,n) = $1(A/F,12,6) = $0.1232 This means that $0.1232 must be received each year for 6 years to be equivalent to the receipt of $1, 6 years hence.
23
Example:
At an interest rate of 9% with n = 10 years, and an A of $1 is equivalent to a P of what amount?
24
P = A(P/A,i,n) = $1(P/A,9,10) = $6.4177 This means that an investment of $6.4177 today must yield an annual benefit of $1 each year for 10 years if the interest rate is 9%.
25
Example:
At an interest rate of 14% with n = 7 years, and an P of $1 is equivalent to a A of what amount?
26
A = P(A/P,i,n) = $1(A/P,14,7) = $0.233 This means that $1 can be spent today to capture an annual savings of $0.233 per year over 7 years if the interest rate is 14%
27
Evaluating a Single Alternative

Sometimes we have situations where we need to accept or reject a single alternative (i.e. do we proceed with this design). In such a case, the decision will be based on the relative merit of the alternative We will assume that all costs/savings will occur at the end of the year
28
Present Equivalent Evaluation

Disbursements and Savings for a Single Alternative Item Initial Cost Savings, First Year Savings, Second Year Overhaul Cost Date 1-1-2005 1-1-2005 1-1-2007 1-1-2007 Disbursements $28,000 $2,500 Savings $9,500 $9,500
Savings, Third Year

Savings, Fourth Year Salvage Value
1-1-2008
1-1-2009 1-1-2009
$9,500
$9,500 $8,000
29
$8,000
$9,500
$9,500
$9,500
$9,500 $9,500
$28,000
$25,000
30

Present Value = PV of Initial Cost + PV of Savings (Yr 1) + PV of Savings (Yr 2) + PV of Overhaul Cost + PV of Savings (Yr 3) + PV of Savings (Yr 4) + PV of Salvage Value Present Value = -28,000(P/F,12,0) + $9,500(P/F,12,1) + $9,500(P/F,12,2) - $2,500(P/F,12,2) + $9,500(P/F,12,3) + $9,500(P/F,12,4) + $8,000(P/F,12,4)
31

Present Value = -28,000(P/F,12,0) + $9,500(P/F,12,1) + $7,000(P/F,12,2) + $9,500(P/F,12,3) + $17,500(P/F,12,4) Present Value = -28,000(1.00) + $9,500(0.8929) + $7,000(0.7972) + $9,500(0.7118) + $17,500(0.6355) Present Value = $3,946
Because the PV is greater than $0, this is a desirable undertaking at an interest rate of 12%
32

In general, the present value can be given by: =
=0
(1 + )
33
Annual Equivalent Evaluation

We know that the relationship between the present and the annual value is given by: A = P(A/P,i,n) Or (1 + ) = 1 + 1 So using the present equivalent value that we calculated, we can form an annual equivalent amount =
=0
(1 +
(1+) 1+ 1
34
Annual Equivalent Evaluation
=
=0
(1 + )
(1 + ) 1 + 1
Annual Equiv= ($3,946)(A/P,12,4) Annual Equiv= $1,299 What this tells us is that if $28,000 is invested on Jan 1, 2005, a 12% return will be received plus an equivalent of $1,299 on Jan 1,2006, 2007, 2008, and 2009.
35
Future Equivalent Evaluation

We know that the relationship between the present and the future value is given by: = ( , , ) Or = (1 + ) So using the present equivalent value that we calculated, we can form a future equivalent amount
=0
(1 + ) (1 + ) =
=0
(1 + )
36
Future Equivalent Evaluation
=
=0
(1 + )
Future Equiv= ($3,946)(F/P,12,4) Future Equiv= $6,211 What this tells us is that there will be a difference of $6,211 between future equivalent savings and future equivalent costs. Because this amount is great than zero, it is a desirable venture at 12%
37
Annual Equivalent Cost of an Asset

A useful application of the annual equivalent cost pertains to the cost of an asset. The cost of an asset is made up of two components: (1) The cost of depreciation (2) The cost of interest on the undepreciated balance We will assume straight line depreciation this means that the asset will depreciate by a fixed amount every year
38

Example: An asset has a first cost of $5,000, a salvage value of $1,000, and a service life of 5 years, and the interest rate is 10%. What is the present cost?
39

Example: An asset has a first cost of $5,000, a salvage value of $1,000, and a service life of 5 years, and the interest rate is 10%. What is the annual equivalent cost?
40

Calculate the Depreciation Cost: = $5,000 $1,000 = = $800 5
We know that:
cost of any asset = cost of depreciation + cost of interest on undepreciated balance
At the beginning of year 1: Cost of Depreciation = $800 Undepreciated Balance = $5000 Cost of Asset = $800 + $5,000(0.1) = $800 + $500 = $1,300
41

At the beginning of year 2: Cost of Depreciation = $800 Undepreciated Balance = $4,200 Cost of Asset = $800 + $4,200(0.1) = $800 + $420 = $1,220 At the beginning of year 3: Cost of Asset = $800 + $3,400(0.1) = $800 + $340 = $1,140 At the beginning of year 4: Cost of Asset = $800 + $2,600(0.1) = $800 + $260 = $1,060 At the beginning of year 5: Cost of Asset = $800 + $1,800(0.1) = $800 + $180 = $980
42

Find Present Value: Present Value = 1,300(P/F,10,1) + 1,220(P/F,10,2) + 1,140(P/F,10,3) - $1,060(P/F,10,4) + $980(P/F,10,6) Present Value = $4,379
To find Annual Equivalent Cost: =
(1
=0
+ )
(1 + ) 1 + 1
Annual Equiv= ($4,379)(A/P,10,5) Annual Equiv= $1,155
43

Alternatively, Annual Equivalent Cost can be expressed as such: = ( )( , , ) + ()
44
Break-Even Economic Evaluation

Break-Even Analysis may be graphical or mathematical in nature Useful in relating FC and VC to the number of hours of operation, the number of units produced, or other measures of operational activity. It identifies the range of the decision variable within which the most desirable economic outcome may occur Especially useful when the cost of two or more alternatives is a function of the same variable.
45
Make or Buy Evaluation

Often, a manufacturing firm has the choice of making or buying a certain component for use in the product being produced. In this case, the firm faces a make-or-buy decision
46

Example: Suppose that a firm finds that it can buy from a vendor the electric power supply for the system that it produces for $8/unit. Alternatively, suppose that it can manufacture an equivalent unit for a variable cost of $4/unit. It is estimated that the additional fixed cost in the plant would be $12,000 per year if the unit is manufactured.
Finding the number of units/year for which the cost of the two alternatives breaks would help in making the decision.
47

Make Alternative:
Given: Fixed Costs: $12,000 in plant Variable Costs: $4/unit

Let N be the number of units produced
48

Total Cost = Fixed Costs + Variable Costs = + = $12,000 + $4
49

Buy Alternative:
Given: Fixed Costs: $0 (there are no fixed costs for the Buy option) Variable Costs: $8/unit
Let N be the number of units produced
50

Total Cost = Fixed Costs + Variable Costs = + = $0 + $8 = $8
51

Break Even Mathematical Analysis
Break Even occurs when TCbuy = TCmake

$12,000 + $4N = $8N $12000 = $4 = 3,000 units
52

Which Option is Better?
= $12,000 + $4 = $12,000 + $4 3,001 = $24,004

= $8 = $8(3,001) = $24,008
From the above, we can see that in excess of the break even quantity, the Make Option is better
53
Lease-or-Buy Evaluation
Often, a company has to consider the decision to lease or buy a piece of equipment. In this case, the firm faces a lease-or-buy decision
54
Lease-or-Buy Evaluation
Example:
Assume that a small electronic computer is needed for data processing in an engineering office. Suppose that the computer can be leased for $50/day, which includes the cost of maintenance. Alternatively, the computer can be purchased for $25,000. The computer is estimated to have a useful life of 15 years with a salvage value of $4,000 at the end of that time. It is estimated that the annual maintenance costs will be $2,800. If the interest rate is 9% and it costs $50/day to operate the computer, how many days of user per year are required for the two alternatives to break even?
55
Lease or Buy Evaluation

Lease Alternative:
Given: Fixed Costs: $0 (no fixed costs) Variable Costs: $50/unit to lease computer $50/unit to operate computer
Let N be the number of computer units required
56

Total Cost = Fixed Costs + Variable Costs = + = $0 + $50 + $50 = $100
57

Buy Alternative:
Given: Initial Cost of Computer = $25,000 Salvage Value = $4,000 Useful life = 15 years Interest Rate = 9% Variable Costs: $50/day to operate Let N be the number of units produced
58

Total Cost = Fixed Costs + Variable Costs
= + +
= ( )( , , ) + () + +
= 25,000 4,000 0.1241 + 4,000 0.09 + 2,800 + $50
= 5,766 + $50
59

Break Even occurs when TCbuy = TClease
$100N = $5,766 + $50N

$5,766 = $50 = 115 So, for levels of use exceeding 115 days/year, it would be more economical to purchase the computer. IF the level of use is anticipated to be below 115 days per year, the computer should be leased
60
Equipment Selection Evaluation

Example:
Suppose that a fully automatic controller for a machine center can be fabricated for $140,000 and that it will have an estimated salvage value of $20,000 at the end of four years. Maintenance costs will be $12,000/year, and the cost of operation will be $85/hour As an alternative, a semiautomatic controller can be fabricated for $55,00. This device will have no salvage value at the end of a 4-year service life. The cost of operation and maintenance is estimated to be $140/hour. Assume an interest rate of 10% - which machine should we select?
61

Machine A
Given: Fabrication Cost: $140,000 Salvage Value: $20,000 Maintenance Cost: $12,000 $80/unit to operate machine
Let N be the number of operating hours
62

Machine B
Given: Fabrication Cost: $55,000 Salvage Value: $0 Maintenance Cost: $12,000 $80/unit to operate machine
Let N be the number of operating hours
63
Equipment Selection Evaluation - Machine A

Total Cost = Fixed Costs + Variable Costs = + + = ( )( , , ) + () + + = 140,000 20,000 0.3155 + 20,000 0.10 + 12,000 + $85 = 51,800 + $85
64
Equipment Selection Evaluation - Machine B

Total Cost = Fixed Costs + Variable Costs = + = ( )( , , ) + () + = 55,000 0 0.3155 + 0 0.10 + $140 = 17,400 + $140
65

Break Even occurs when TCA = TCB
$51,800 + $85N = $17,400 + $140N

$34,400 = $55 = 625 So, for levels of use exceeding 625 hours, it would be more economical to produce the automatic controller. If the level of use is anticipated to be below 625 hours per year, the semiautomatic should be produced
66

EMP5102B - Week 6 Presentation

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EMP5102B: Introduction to Engineering Management

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Economic Decision Making

Time value of Money

$1 today is worth more than $1 tomorrow

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Interest and Interest Formulas

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Money Flow Over Time

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Single Payment Compound Amount Formula

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Single Payment Compound Amount Formula

Amount at Beginning of Year

Interest Earned During the Year

Compound Amount at end of Year

P + Pi = P (1+i) P(1+i) + P(1+i)i = P(1+i)2

P(1+i)2 + P(1+i)2i = P(1+i)3

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Single Payment Compound-Amount Formula

Single Payment Present-Amount Formula

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

At an interest rate of 10% with n = 8 years, a P of $1 is equivalent to an F of what amount?

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

At an interest rate of 12% with n = 10 years, a F of $1 is equivalent to a P of what amount?

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

At an interest rate of 8% with n = 20 years, and an A of $1 is equivalent to a F of what amount?

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

At an interest rate of 12% with n = 6 years, and an F of $1 is equivalent to an A of what amount?

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

At an interest rate of 9% with n = 10 years, and an A of $1 is equivalent to a P of what amount?

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

At an interest rate of 14% with n = 7 years, and an P of $1 is equivalent to a A of what amount?

EMP5100 - WEEK 5 - RIDHIMA SHARMA

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Evaluating a Single Alternative

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Present Equivalent Evaluation

Savings, Third Year

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Present Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Present Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Present Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Present Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Annual Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Annual Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Future Equivalent Evaluation

EMP5100 - WEEK 5 - RIDHIMA SHARMA

Future Equivalent Evaluation