1 What is this course about? Time value of money Importance of interest, inflation, etc. Cash flow...

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What is this course about? Time value of money Importance of interest, inflation,

etc. Cash flow comparisons Project and Investment Analysis Making good economic decisions

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Some interesting questions Buy or lease? Buy car or land for an investment? Buy a bond, stock, keep money in

bed? Which investment to make?

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Cash flow comparisons Needed for all kinds of decision

making Example: Buying a car

Alternatives: $18,000 now, or $600 per month for 3 years(= $21,600 total)

Which is better?

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Cash flow comparisons Needed for all kinds of decision

making Example: Buying a car

Alternatives: $18,000 now, or $600 per month for 3 years (= $21,600 total)

Which is better? It depends!

Issue: how much is money now worth compared to money in the future?

Leads to idea of Time value of money!

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Time value of money Would you rather have:

$100 today, or $100 a year from now?

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Time value of money Would you rather have:

$100 today, or $100 a year from now?

Basic assumption: Given a fixed amount of money, and a

choice of having it now or in the future,

Most people would prefer to have it sooner rather than later

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Time value of money Basic assumption:

Given a fixed amount of money, and a choice of having it now or in the future, most people

would prefer to have it sooner

Reasons: Security ? Interests ? Currency strength ? Uncertainty ?

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Time value of money A consequence:

Suppose you are willing to exchange a certainamount now for some other amount later

Then the later amount has to be _______ ?

A bird at hand is better than two birds in the bush. But how many birds in the bush is worth a bird at

hand?

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What this means for us In this course, we will learn methods to:

Compare different cash flows over time Using the interest rate or discount rate:

How much more a dollar today is worth, compared to a dollar in the future

For example, if the interest rate is 5% per year: Then $1 today is worth as much as $1.05

next year

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Interest rates Interest factor: The ratio between an

amount one period in the future and an equivalent amount now. Example: If you are indifferent between

$5 now and $6 one period in the future, the interest factor is 6/5 = 1.20 (per period)

Interest rate = interest factor - 1 In above example, it’s 0.20 = 20%

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Chapter 1Engineering Economic Decisions

Rational Decision-Making Process Economic Decisions Predicting Future Role of Engineers in Business Large-scale engineering projects Types of strategic engineering

economic decisions

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Rational Decision-Making Process1. Recognize a decision

problem2. Define the goals or

objectives3. Collect all the relevant

information4. Identify a set of feasible

decision alternatives5. Select the decision

criterion to use6. Select the best

alternative

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Which Car to Lease?1. Recognize a decision

problem2. Define the goals or

objectives3. Collect all the relevant

information4. Identify a set of feasible

decision alternatives5. Select the decision

criterion to use6. Select the best

alternative

Need a car

Want mechanical security

Gather technical as well as financial data

Choose between Toyota and Honda

Want minimum total cash outlay

Select Honda

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Engineering Economic Decisions

Planning Investment

Marketing

ProfitManufacturing

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Predicting the Future Required

investment Forecasting

product demand Estimating selling

price Estimating

manufacturing cost Estimating product

life

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Role of Engineers in Business Participate in a variety

of decision-making processes, ranging from manufacturing, through marketing, to financing decisions

Plan for the acquisition of equipment

Design products from the concept to shipping

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Create & Design

• Engineering Projects

Evaluate

• Expected Profitability• Timing of Cash Flows• Degree of

Financial Risk

Analyze

• Production Methods• Engineering Safety

• Environmental Impacts• Market Assessment

Evaluate

• Impact on Financial Statements• Firm’s Market Value

• Stock Price

Role of Engineers in Business

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PresentFuturePast

Engineering EconomyAccounting

Evaluating past performance Evaluating and predicting future events

Accounting Vs. Engineering Economy

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A Large-Scale Engineering Project Requires a large

sum of investment Takes a long time

to see the financial outcomes

Difficult to predict the revenue and cost streams

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A Large-Scale Engineering Project

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Types of Strategic Engineering Economic Decisions Equipment and Process Selection Equipment Replacement New Product and Product

Expansion Cost Reduction Service Improvement

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Equipment & Process Selection How do you choose between Plastic

Sheet Molding Compound (glass fiber reinforced polymer) and Steel sheet stock for the auto body panel?

The choice of material will dictate the manufacturing process for the body panel as well as manufacturing costs.

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Which Material to Choose?

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Equipment Replacement Now is the time to

replace the old machine?

If not, when is the right time to replace the old equipment?

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New Product and Product Expansion Shall we build or acquire a new

facility to meet the increased demand?

Is it worth spending money to market a new product?

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Example - MACH 3 Project

R&D investment: $750 million Product promotion through

advertising: $300 million Priced to sell at 35% higher than

Sensor Excel (about $1.50 extra per shave).

Question 1: Would consumers pay $1.50 extra for a shave with greater smoothness and less irritation?

Question 2: What would happen if the blade consumption dropped more than 10% due to the longer blade life of the new razor?

Gillette’s MACH3 Project

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Cost Reduction Should a company

buy equipment to perform an operation now done manually?

Should spend money now in order to save more money later?

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Service/Quality Improvement

Make-to-order Levi’s for women How many more jeans would Levi’s need to sell to justify the cost

of additional robotic tailors?

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Principle 1: A nearby dollar is worth more than a distant dollar

Today 6-month later

Fundamental Principles in Engineering Economics

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Principle 2: All it counts is the differences among alternatives

Option

Monthly Fuel Cost

Monthly Maintenance

Cash outlay at signing

Monthly payment

Salvage Value at end of year 3

Buy $960 $550 $6,500

$350 $9,000

Lease $960 $550 $2,400

$550 0Irrelevant items in decision making

Fundamental Principles in Engineering Economics

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Principle 3: Marginal revenue must exceed marginal cost

Manufacturing cost

Sales revenueMarginal revenue

Marginal cost

1 unit

1 unit

Fundamental Principles in Engineering Economics

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Principle 4: Additional risk is not taken without the expected additional returnInvestment

ClassPotential

RiskExpected

Return

Savings account (cash)

Low/None 1.5%

Bond (debt) Moderate 4.8%

Stock (equity)

High 11.5%

Fundamental Principles in Engineering Economics