Lecture 1 Ekotek 2006

8/6/2019 Lecture 1 Ekotek 2006

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INTRODUCTION TOINTRODUCTION TO

ENGINEERING ECONOMYENGINEERING ECONOMY

Engineering EconomyEngineering Economy

Lecture no. 1Lecture no. 1Thursday, May 19, 2011Thursday, May 19, 2011


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Why Engineering Economy is ImportantWhy Engineering Economy is Important

to Engineers (and other professionals)to Engineers (and other professionals)

Engineers Design

Engineers must be concerned with the

economic aspects of designs andprojects they recommend and perform

Analysis

Design

Synthesis


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Engineers must work within the realm

of economics and justification of

engineering projectsWork with limited funds (capital)

Capital is not unlimited rationed

Capital does not belong to the firm Belongs to the Owners of the firm

Capital is not freeit has a cost


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DefinitionDefinition

ENGINEERING ECONOMY IS INVOLVED WITHTHE FORMULATION, ESTIMATION, AND

EVALUATION OF ECONOMIC OUTCOMES

WHEN ALTERNATIVES TO ACCOMPLISH ADEFINED PURPOSE ARE AVAILABLE.

ENGINEERING ECONOMY IS INVOLVED WITHTHE APPLICATION OF DEFINED

MATHEMATICAL RELATIONSHIPS THAT AIDIN THE COMPARISON OF ECONOMIC

ALTERNATIVES


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Knowledge of Engineering Economy

will have a significant impact on you,

personally. Make proper economic comparisons

In your profession

Private sector

Public sector

In your personal life


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Role of Engineering Economy inRole of Engineering Economy in

Decision MakingDecision MakingRemember: People make decisions not tools

Engineering Economy is a set of toolsthat aid in decision making but willnot make the decision for you

Engineering economy is based mainly

on estimates of future events mustdeal with the future and risk anduncertainty


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Decision MakingDecision MakingThe parameters within an engineering

economy problem can and will vary

over timeParameters that can vary will dictate a

numerical outcome apply and

understand

Sensitivity Analysis


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Decision MakingDecision MakingSensitivity Analysis plays a major role

in the assessment of most, if not all,

engineering economy problems

The use of spreadsheets is now

common and students need to master

this valuable tool as an analysis aid


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ProblemProblem--Solving ApproachSolving Approach

1. Understand the Problem

2. Collect all relevant data/information

3. Define the feasible alternatives

4. Evaluate each alternative

5. Select the best alternative6. Implement and monitor


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5. Select the best alternative

6. Implement and monitor

Major Role ofEngineeringEconomy


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6. Implement and monitor

One of the moredifficult tasks


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6. Implement and monitor Where the majortools of Engr.Economy are

applied


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6. Implement and monitor ToolsPresent Worth, Future Worth

Annual Worth, Rate of ReturnBenefit/Cost, Payback,

Capitalized Cost, Value Added


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Time Value of MoneyTime Value of Money

Time Value of Money

Money can make money if Invested

Centers around an interest rate

The change in the amount of money over agiven time period is called the time value ofmoney; by far, the most important conceptin engineering economy


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Performing a StudyPerforming a Study

To have a problem, one must havealternatives (two or more ways to solve aproblem)

Alternative ways to solve a problem mustfirst be identified

Estimate the cash flows for thealternatives

Analyze the cash flows for eachalternative


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AlternativesAlternatives

To analyze, one must have:

Concept of the time value of $$

An Interest Rate Some measure of economic worth

Evaluate and weigh

Factor in noneconomic parameters

Select, implement, and monitor


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Needed ParametersNeeded Parameters

First cost (investment amounts)

Estimates of useful or project life

Estimated future cash flows (revenuesand expenses and salvage values)

Interest rate

Inflation and tax effects


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Cash FlowsCash Flows

Estimate flows of money coming into thefirm revenues salvage values, etc.(magnitude and timing) positive cashflows

Estimates of investment costs, operatingcosts, taxes paid negative cash flows


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Each problem will have at least onealternative DO NOTHING

May not be free and may have futurecosts associated

Do not overlook this option!


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Goal: Define, Evaluate, Select and Execute

DoNothing

Alt. 1

The Question:

Which One dowe accept?


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Mutually ExclusiveMutually Exclusive

Select One and only one from a set offeasible alternatives

Once an alternative is selected, theremaining alternatives are excluded atthat point.


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More AlternativesMore Alternatives

Goal: Define, Evaluate, Select and Execute

DoNothing

Alt. 1 Alt. j...

Which one do we accept?


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Default PositionDefault Position

If all of the proposed alternatives are noteconomically desirable then

One usually defaults to the DO-NOTHINGalternative


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TaxesTaxes

Taxes represent a significant negativecash flow to the for-profit firm.

A realistic economic analysis must assessthe impact of taxes.

Called andAFTER-TAX cash flowanalysis

Not considering taxes is called a BEFORE-TAX Cash Flow analysis.


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TaxesTaxes

A Before-Tax cash flow analysis (while notas accurate) is often performed as apreliminary analysis.

A final, more complete analysis should beperformed using an After-Tax analysis

Both are valuable analysis approaches


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Interest RateInterest Rate

INTERESTINTEREST -- MANIFESTATION OF THEMANIFESTATION OF THETIME VALUE OF MONEY. THE AMOUNTTIME VALUE OF MONEY. THE AMOUNT

PAID TO USE MONEY.PAID TO USE MONEY.

INVESTMENTINVESTMENT

INTEREST = VALUE NOWINTEREST = VALUE NOW -- ORIGINAL AMOUNTORIGINAL AMOUNT

LOANLOAN

INTEREST = TOTAL OWED NOWINTEREST = TOTAL OWED NOW -- ORIGINALORIGINAL

AMOUNTAMOUNT

RENTAL FEE PAID FOR THE USE OF SOMEONEELSES MONEYEXPRESSED AS A %


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Inflation EffectsInflation Effects

A social-economic occurrence in whichthere is more currency competing forconstrained goods and services

Where a countrys currency becomesworth less over time, thus requiring more ofthe currency to purchase the same amount

of goods or services in a time period


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EQUIVALENCEEQUIVALENCE

Example

You travel at 68 miles per hour

Equivalent to 110 kilometers per hour

Thus:

68 mph is equivalent to 110 kph

Using two measuring scales

Miles and Kilometers


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EQUIVALENCEEQUIVALENCE

Is 68 equal to 110?

No, not in terms of absolute numbers

But they are equivalent in terms of thetwo measuring scales

Miles

Kilometers


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ECONOMIC EQUIVALENCEECONOMIC EQUIVALENCE

Economic Equivalence

Two sums of money at two different

points in time can be made economicallyequivalent if:

We consider an interest rate and,

No. of time periods between the twosums

Equality in terms of Economic Value


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Terminology and SymbolsTerminology and Symbols

Specific symbols and their respectivedefinitions have been developed for use inengineering economy.

Symbols tend to be standard in mostengineering economy texts world-wide.

Mastery of the symbols and their respectivemeanings is most important in understanding the

subsequent material!


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F = value or amount of money at somefuture time.

Also, F is called future worth (FW) andfuture value (FV); dollars


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A = series of consecutive, equal,end-of-period amounts of money.

Also, A is called the annual worth (AW) andequivalent uniform annual worth (EUAW);dollars per year, dollars per month

n = number of interest periods; years,months, days


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i = interest rate or rate of return pertime period; percent per year, percent permonth

t = time, stated in periods; years,months, days, etc


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Computer SolutionsComputer Solutions

Use of a spreadsheet similar toMicrosofts Excel is fundamental to the

analysis of engineering economyproblems.

All engineers are expected by training toknow how to manipulate data, macros,and the various built-in functions commonto spreadsheets.


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Important TERMSImportant TERMS

CASH INFLOWS

Money flowing INTO the firm from outside

Revenues, Savings, Salvage Values, etc.

CASH OUTFLOWS

Disbursements

First costs of assets, labor, salaries, taxespaid, utilities, rents, interest, etc.


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Cash FlowsCash Flows

For many practical engineering economyproblems the cash flows must be:

Assumed known with certainty

Estimated

A range of possible realistic values provided

Generated from an assumed distribution and

simulated


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Net Cash FlowsNet Cash Flows

A NET CASH FLOW is

Cash Inflows Cash Outflows

(for a given time period)

We normally assume that all cash flowsoccur:

At the END of a given time period

End-of-Period Assumption


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EndEnd--ofof--Period AssumptionPeriod Assumption

END-OF-PERIOD Convention

ALL CASH FLOWS ARE ASSUMED TO OCCUR ATTHE END OF AN INTEREST PERIOD EVEN IF THEMONEY FLOWS AT TIMES WITHIN THE

INTEREST PERIOD.

THIS IS FOR SIMPLIFICATION PURPOSES


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The Cash Flow Diagram: CFDThe Cash Flow Diagram: CFD

Extremely valuable analysis tool

First step in the solution process

Graphical Representation on a time scale

Does not have to be drawn to exact scale

But, should be neat and properly labeled

Required on most in-class exams and part ofthe grade for the problem at hand


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SummarySummary

Engineering Economy Study:

Involves modeling the cash flows

Computing specific measures of economic worth

Using an interest rate(s)

Over a specified period of time

The concept ofequivalence helps in

understanding how different sums of money

at different times are equal in economic

terms

Lecture 1 Ekotek 2006

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Transcript of Lecture 1 Ekotek 2006