BKF3142 - PROCESS ENGINEERING ECONOMICS

Chapter 1.0 :
Fundamentals of Engineering
Economics

FAKULTI KEJURUTERAAN KIMIA & SUMBER ASLI,

UNIVERSITI MALAYSIA PAHANG, KUANTAN.
 BASIC OUTLINES:
Fundamentals of Engineering Economics
What's and Why?
The Concept of Supply and Demand
Scarcity and Resources
Financial Markets
Fund Resources/ Project Financing
Banking and Financial Institutions
Monetary System
Business Plan
Financial Statements & Budgeting
 1.1 Fundamentals of Economics
 ECONOMICS is social science that studies how
individuals, governments, firms, and nations make
optimal choices on allocating scarce resources to
satisfy their unlimited wants.

 Economics is the social science that analyzes the

production, distribution, and consumption of
goods and services. (wikipedia, 2011)
 Scarcity
SCARCITY is the basic economic problem that
arises because people have unlimited wants
but resources are limited. Because of scarcity,
various economic decisions must be made to
allocate resources efficiently.
 Economics Marginal
 In economics, marginal means “extra”, “additional”
or a “change in”.
 Marginal Benefit (MB)
 Refers to what people are willing to give up in
order to obtain one more unit of a goods.
 Marginal Cost (MC)
 Refers to the value of what is given up in order to
produce the additional unit.
 1.2 The Concept of Supply and Demand

SUPPLY AND DEMAND IS PERHAPS ONE OF THE

MOST FUNDAMENTAL CONCEPTS OF ECONOMICS AND
IT IS THE BACKBONE OF A MARKET ECONOMY.

Demand refers to how much (quantity) of a product or service is

desired by buyers. The quantity demanded is the amount of a product
people are willing to buy at a certain price; the relationship between
price and quantity demanded is known as the demand relationship.
Supply represents how much the market can offer. The quantity
supplied refers to the amount of a certain goods producers are willing
to supply when receiving a certain price.

 The correlation between price and how much of a goods or service is

supplied to the market is known as the supply relationship.
 Price, therefore, is a reflection of supply and demand.
 Supply and Demand

 The Law of Demand

 The law of demand
states that, if all other
factors remain equal, the
higher the price of a
good, the less people
will demand that good.
In other words, the
higher the price, the
lower the quantity
demanded.
 Supply and Demand

 The Law of Supply

 the law of supply
demonstrates the
quantities that will
be sold at a certain
price.
 the higher the price,
the higher the
quantity supplied.
Read
 Supply and Demand

 Equilibrium
 When supply and demand are equal
(i.e. when the supply function and
demand function intersect) the
economy is said to be at equilibrium.
 At this point, the allocation of goods is
at its most efficient because the
amount of goods being supplied is
exactly the same as the amount of
goods being demanded.
 Supply and Demand
 Disequilibrium (Excess supply)
 If the price is set too high, excess
supply will be created within the
economy and there will be allocative
inefficiency.

 Disequilibrium (Excess
demand)
 Excess demand is created when
price is set below the equilibrium
price. Because the price is so low,
too many consumers want the
good while producers are not
making enough of it.
 1.3 Financial Markets

What is Financial Markets?

Any marketplace where buyers and sellers participate in the trade
of assets such as equities, bonds, currencies and derivatives.
Financial markets are defined by having transparent pricing, basic
regulations on trading, costs and fees and market forces determining
the prices of securities that trade.
Channel funds from savers to investors, thereby
 Promoting economic efficiency
 Affect personal wealth and behavior of business firms
Major Financial Markets

Bond Market

Stock Market

Foreign Exchange
Market
 Bond Market
 Bonds are an example of a debt contract.
 A debt contract is simply a promise to repay an
amount in the future in exchange for funds now.
 A bond is a kind of a debt contract that is
marketable, that it can be bought and sold in a
market.
 For example, to raise funds, Proton Holdings might
sell a bond, which is a promise to repay the money
plus interest some time in the future.
 Stock Market

 Stock represents share/ownership in the company so that

stockholders can vote on who manages the company.
 Owner of stocks may buy or sell their share in the stock
market (e.g. London Stock Exchange, KLSE)
 Firms/company may raise their fund through Initial Public
Offerings (IPO)
 Stock Price volatility
 Stock Price “Bubbles”
 Technology bubble in 1990’s?
 Foreign Exchange Market

 It is the activity of funds transfer from one country

to another
 There are a variety of different currencies in the
world: dollars (US), Yen (Japan), Euros (13 nations of
the European Community) among many others.
 The value of currencies differs from one another and
subject to international trade.
 The market where currencies are exchanged is called
the foreign exchange market.
 Classification of Financial Markets
1. Primary Market
 New security issues sold to initial buyers (often behind closed doors)
 Investment banks typically underwrite securities (i.e. guarantees a price for the
security and then sells it to the public)
2. Secondary Market
 Securities previously issued are bought and sold. E.g.: NASDAQ, Futures,
Options, Foreign Exchange
 Exchanges
 Trades conducted in central locations (e.g., New York Stock Exchange, NYSE; London Stock
Exchange, LSE)
 Over-the –Counter Markets
 Dealers at different locations buy and sell
 Funding Sources
Sources:
Internal Sources
Retained earnings
Reserves
External Sources
Debt
Stockholders’ Equity
 Methods of Raising Private Sector Funds
• Debt Markets
 Short-term (maturity < 1 year): Money Market
 Intermediate-term (1year < maturity < 10 years)
 Long-term (maturity > 10 years)
• Equity Markets
 Common stocks: claims to share in assets and net income
 No maturity date; periodic payments known as dividends
• Capital Market
 Intermediate + Long Term Debt + Equity
 Examples: Bonds, mortgages
 Internal Sources: Retained Earnings

Retained earning
= after tax earning – dividends paid
to stockholders

(used for research, development expenditures, or

capital outsource)
 Internal sources: Reserves
Provide for depreciation, depletion and
obsolescence
Cover for the replacement costs of
equipment because improved
technology results in more expensive,
sophisticated equipment
Face inflation
Provide dividends to stockholders
 External sources: Debt
I. Current debt
- maturing up to 1 year
- options: commercial loan, commercial
paper, banker’s acceptance

II. Intermediate debt

- maturing between 1 and 10 years
- options: deferred-payment contract,
revolving credit, term loans
 External sources: Debt (cont.)
III. Long term debt/ bond
Is a negotiable certificate, issued at par values
of $1000
Types: mortgage, debenture, income bonds,
convertible bond
External sources : Stockholders’ Equity
…..is defined as the total equity interest that
stockholders have in a corporation.

Classifications of Stocks:
1. Common Stock
2. Preferred Stock
3. Golden Stock
 Common stock
Includes:
 the right to receive dividend payments typically from earnings
-- if authorized by the board of directors
 the power to sell the stock (liquidity rights) and realize capital
gains on public trading markets or in private transactions-- if
there are willing buyers
 the right to receive consideration in a merger or other
fundamental transaction -- if approved by the board and the
shareholders
 the right to vote to elect directors and to approve
fundamental transactions (mergers, sale of assets,
amendments to articles, dissolutions)
 the right to receive a proportionate distribution of assets on
corporate liquidation -- if the board and shareholders
approve a dissolution
Preferred stock
features:
 Preference in dividends.
 Preference in assets in the event of
liquidation.
 Convertible into common stock.
 Callable at the option of the
corporation.
 Nonvoting.
 Financial Market Instruments

What are the kinds of securities traded in financial markets?

• Money Market Instruments
 Because of short term to maturity, debt instruments traded in the money
market do not have much fluctuation in their prices, and hence are the least
risky
• Capital Market Instruments
 Debt and equity instruments with maturities greater than a year; these have
much greater fluctuations in their prices (compared to money market
instruments) and as such are considered more risky
 Examples: Money Market Instruments

• Treasury Bills
 Issued by US govt, with 1, 3, and 6 month maturities.
 Pay a set amount at maturity, and have no interest payments; effectively pay
interest by selling at a discount.
• Negotiable Bank Certificates of Deposit
 CD’s are debt instruments sold by banks to depositors that pays an annual
interest of a given amount, and pays back the original purchase price at
maturity
• Commercial Paper
 Short term debt instrument issued by large banks and well known
corporations (e.g. Microsoft, GM).
 Examples: Money Market Instruments

• Repurchase Agreements
 Reposes are effectively short term loans (usually with a
maturity of less than 2 weeks) for which T-bills serve as
collateral. The most important lenders in this market are
usually large corporations.

• Federal (Fed) Funds

 These are typically overnight loans of reserves between
banks, of their deposits at the Federal Reserve.
 Examples: Capital Market Instruments
• Stocks
 These are equity claims on net income and assets of a corporation.
 Issue of new stocks in any given year is typically quite small, although the
total value of stocks exceed that of any other type of security in the capital
markets.
• Mortgages
 Mortgage market is the largest debt market in the US
 Residential mortgages are approximately 4 times the amount of commercial
and farm combined.
• Corporate Bonds
 Long term bonds issued by corporations with very strong credit ratings.
 Typical corporate bond sends the holder an interest payment twice a year and
pays off the face value when the bond matures.
 Some “convertible” corporate bonds allows the holder to convert them into a
specified number of shares of stock at any time up to the maturity date.
 Examples: Capital Market Instruments

• Government Securities
 These are long term debt instruments issued by the Treasury to finance the
government’s deficits.
• Government Agency Securities
 Issued by various agencies such as Ginnie Mae, the Federal Farm Credit Bank,
etc, to finance such items as mortgages, farm loans or power generating
equipment.
 Many of the securities are guaranteed by the federal government.
• State and Local bonds
 Also called municipal bonds, which are long term debt instruments issued by
the state and local governments to finance expenditures on roads, schools,
and other programs.
 Interest payments from these bonds are exempt from federal income tax and
generally from the state taxes issuing the bond.
• Consumer and Bank loans
 Money Exchange Rate
 Purchasing Power Parity Theory
 A method of calculating exchange rates that
attempts to value currencies at rates such that
each currency will buy an equal basket of goods.
 Creates a balance in trade. When a country has an
inflation, its currency depreciates.
 Money Exchange Rate

Import Export
demand demand

Tariffs and
Productivity
quotas Other factors
affecting
exchange
rates
 Modern Monetary System

 In the 19th and early 20th centuries gold played a key role in
international monetary transactions.
 The gold standard was used to back currencies; the international value
of currency was determined by its fixed relationship to gold.
 19th Century Gold Standard
1 oz of gold = $20 = £4
 £1 = $5

 Liberty Gold Dollar (1849-1854)

 Modern Monetary System
 Bretton Woods Agreement 1944
 Established a system of fixed exchange rates.
 Modern Monetary System

 1960’s inflation hit US resulted

in President Nixon Closes the
Gold Window in year 1971
 Nixon refuses to honor
agreement signaling the
beginning of the end of fixed
exchange rates.
 Modern Monetary System

 The Effect of Exchange Rate Interventions

 Central Banks enters into forex market to
influence value of currency. Tendency of
competition to keep value high.
 Central Banks enter into forex market and
then conducts open market operation to
keep money supply constant.
 The speculative activities of world
currencies
 Some Basic Definitions
1. Debt Instrument:
Contractual agreement by borrower to pay holder of
the instrument a fixed dollar amount at regular intervals
(principal + interest), until a specified date
 Example: Car loan

2. The maturity of a debt instrument is the number of

years (term) until the instrument expires

3. Liquidity
The degree to which an asset or security can be bought
or sold in the market without affecting the asset's price.
Liquidity is characterized by a high level of trading activity.
Assets that can be easily bought or sold, are known as liquid
assets.
 Some Basic Definitions (Cont.)
4. Volatility
 Volatility refers to the amount of uncertainty or risk about the size of changes
in a security's value.
 A higher volatility means that a security's value can potentially be spread out
over a larger range of values. This means that the price of the security can
change dramatically over a short time period in either direction.
 A lower volatility means that a security's value does not fluctuate dramatically,
but changes in value at a steady pace over a period of time.
 Commonly, the higher the volatility, the riskier the security.
 1.4 The Business Plan
“A good business idea will always find a backer”
Capital/Operation budgeting and planning is crucial
important to both entrepreneurs and investors.
Is structured along with a projected timetable
Perceived goals and objectives of the company
Provide benchmark to monitor business progress
Help entrepreneur to raise finance
 Business Plan
What makes a good business?
 Profitability
 Feasibility
 Viability
ELEMENTS OF A GOOD BUSINESS PLAN

PART 1: INDUSTRIAL OVERVIEW

Introductions
Products overview
Market overview
Resources and raw materials
 BUSINESS PLAN - MARKET
PART 2: MARKET ANALYSIS

 International/ Regional/ Local industry

Descriptions & Overview
 Target Market Information - Test & Data
 Projected share of the market
 Market Prices & Market Growth
 Competitors Evaluation - Domestic and Global
 Project and Product
 BUSINESS PLAN (cont.)
PART 3: COMPANY DESCRIPTION
Year of Establishment
Nature/Type of Business
Organization and Management
Location of Operation
Specialisation
Strength of the Company - Personality
 BUSINESS PLAN (cont.)
PART 4: OPERATION DESCRIPTION
Services or Products
Processes (the chain value process flow
of the company)
Technology profile
Human Resource Engagement
Investment
 BUSINESS PLAN (cont.)
PART 5: FINANCIALS
1. Funding request
Required amount of money needed (capital budgets)
Provide different funding scenario (worst and best case
scenario) based on payback period analysis
Outline current and future funding requirement
The funding type preferred (e.g. equity, debt etc)
2. Prospective financial data
Forecast income statement for at least five years
Cash Flow Statement for at least five years
Profit and Lost Statement for at least five years
Balance Sheet
Financial Ratios; IRR-Sensitivity, Breakeven; Acid Test; Leverage
(Equity/Debt) etc.
PART 5: FINANCIALS
Ratios
oProfit Margin – Before and After Tax
oCash flow Analysis – Break-Even
oPayback period
oRate of Return
oReturns on equity and assets
oEconomic value added
 BUSINESS PLAN (cont.)
PART 6: RISK ANALYSIS
Industry risk
Market risk
Operation risk
Social and Economic Risk
Health and Safety Risk
a. Product safety
b. Raw Material safety i.e. MSDS etc.
PART 6: RISK ANALYSIS
Projected risk
 Effect of changes in revenue
 Effect of changes in direct and indirect expenses
 Effect of capital cost
 Effect of potential changes in market competition

Project life
 Estimated life cycle of the product or venture
 BUSINESS PLAN (cont.)
PART 7: CONCLUSIONS & RECOMMENDATIONS
Viability of the project:
Technical
Cost (ROI)
Manpower (Skill or semi-skill)
Social & Environmental
Political influence/ will
1.5: FINANCIAL
STATEMENTS & Accounting Concepts and Conventions

BUDGETING
Journal and Ledger
Financial Reports
Financial Ratios
 Accounting Concept & Convention

 Assets = Equities
 Assets = Liabilities + Owner’s equity
 Assets are the economic resources of company
which expected to benefit future operations.
Maybe in tangible or intangible forms.
 Equities are the value of ownership interest in
company and may be in the form of liabilities or
owner’s equity
 Liabilities are outside claims against the asset of
company
 Debits and Credits
 The fundamental concept of double-entry bookkeeping system
 Debits and credits form two opposite aspects of every financial
transaction based upon the perspective of parties involved.
 Data Recording
 The General Ledger
 Record of all transactions in chronological
sequence
 The Ledger
 A ledger journal extracted from general ledger
 The number of accounts in the ledger depends on
the information required by management
 Basic ledger contains at least Asset and Liability
accounts
FINANCIAL STATEMENTS
A written report which quantitatively
describes the financial health of a company.
This includes an income statement and a
balance sheet, and often also includes a cash
flow statement.
Financial statements are usually compiled on
a quarterly and annual basis.
 BALANCE SHEET
 The following formula summarizes what a balance
sheet shows:

ASSETS =
LIABILITIES + SHAREHOLDERS‘ EQUITY

 A company's assets have to equal, or "balance," the

sum of its liabilities and shareholders' equity.
 INCOME STATEMENTS
An income statement is a report that shows
how much Revenue a company earned over a
specific time period (usually for a year or
some portion of a year). An income statement
also shows the Costs and Expenses associated
with earning that revenue.

A Profit and Loss Statement is another name

for the Income Statement.
 Cash Flow Statements
 Cash flow statements report a company’s inflows and
outflows of cash. This is important because a company needs
to have enough cash on hand to pay its expenses and
purchase assets.
 While an income statement can tell you whether a company
made a profit, a cash flow statement can tell you whether the
company generated cash.
 Cash flow statements are divided into three main
activities:
(1) operating activities;
(2) investing activities; and
(3) financing activities.
 Financial Ratios
A measure of company performance
Common Financial Ratios:
Liquidity ratios: A measure of the
company’s ability to pay its short-term
debts when due
Leverage ratios: A measure of the
company’s overall debt burden
Activity ratios: A measure of how effectively
a company manages its assets
Profitability ratios: An indication of a firm’s
total operating performance
 Financial Statement Ratios and Calculations
Use to evaluate a company- desirable ratios vary by industry.
 Debt-to-equity ratio compares a company’s total debt to shareholders’
equity. Both of these numbers can be found on a company’s balance
sheet. To calculate debt-to-equity ratio, you divide a company’s total
liabilities by its shareholder equity, or
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
 Inventory turnover ratio compares a company’s cost of sales on its income
statement with its average inventory balance for the period.
Inventory Turnover Ratio = Cost of Sales / Average Inventory for the
Period
 Operating margin compares a company’s operating income to net
revenues.
Operating Margin = Income from Operations / Net Revenues Operating
margin is usually expressed as a percentage.
 P/E ratio compares a company’s common stock price with its earnings per
share.
P/E Ratio = Price per share / Earnings per share
 Working capital is the money leftover if a company paid its current
liabilities from its current assets.
Working Capital = Current Assets – Current Liabilities
 Summary of Selected Financial Ratios
Ratio Equation for calculation Industry average

Liquidity
Current Current assets/current liabilities 1.5 – 2.0 times
Cash or quick cash Current assets – inventory/current liabilities 1.0 – 1.5 times

Leverage
Debt-to-total assets Total debt/total assets 30 – 35%
Times interest earned Profit before taxes plus interest charges/interest 7.0 – 8.0 times
charges
Fixed-charge coverage Income available for meeting fixed charges/fixed 5.5 times
charges

Activity
Inventory turnover Sales or revenue/inventory 7.0 times
Average collection period Receivables/sales per day 45 – 60 days
Fixed assets turnover Sales/fixed assets 2 – 3 times
Total assets turnover Sales/total assets 1 – 2 times
 Summary of Selected Financial Ratios (cont)

Ratio Equation for calculation Industry average

Profitability
Gross profit margin Net sales – cost of goods sold/sales (revenue) Varies
Net operating profit before taxes/sales (revenue)
Net operating margin Net profit after taxes/sales (revenue) Varies
Net profit after taxes/net worth
Profit margin on sales 5–8%
Return on net worth Net profit after taxes/total assets 15%
(return on equity)
Return on total assets 10%
 Financial Reports - Summary
 An annual report contains a large amount of
financial information to tell reader how well a
company perform in the previous year.
 Contents:
 Balance sheet
 Income statement
 Accumulated retained earnings
 Changes in working capital
 Statement of consolidated stockholder’s equity