ME 195A FALL 2012NICOLE OKAMOTO

Overview of Engineering Economics

Outline

Market Analysis – for your ME 195a reportsTime Value of MoneyPresent Worth Analysis/Cost-Benefit AnalysisDepreciationTaxes

Revision of J. Rhee slide -- Engineering Economics and Business

Market Research

Market research backs up the project motivation. A typical analysis includes: Target Market Size (size in $$, large >

$50M) Growth (aggressive growth > 20%) Current Major Players in the Market Trends Your Competitive Advantages CustomersAll claims should be backed up by reliable and reputable information sources. This kind of information will bolster your sections on “Motivation” and “Significance of your Project” for your Chapter 1’s.

Revision of J. Rhee slide -- Engineering Economics and Business

Market Research - Example

Target Market/Segment: Corporate data centers (spent $2.25B on electricity for AC in 2006)

Growth: Projected to double from 2006 to 2011Major Players: Commercial HVAC (Trane, Honeywell,

etc…)Trends: RE<C (Google, 2007); Sustainable IT Lab (HP,

2008); Ice Energy (2008)Competitive Advantage: very little electricity required;

very few moving parts, no emissions/consumables during operation

Customers: Data center owners

Solar Icemaker – Dr. Rhee, Fall 2010

Time Value of Money

Funds placed in a secure investment will increase in value, depending on the time elapsed and interest rate.

$1000 placed in a bank account at the beginning of the year with a 5% interest rate, compounded at the end of the year, will give you $1050 at the end of the year.

This understanding is important to choose the best design, from an economic perspective. For example, product x may be more expensive but

also more efficient than product y. Which is better in the long run?

Important Definitions/Terms

F: future worth; the amount in the future a certain cash value today will be worth

P: present value; the value today of a certain cash amount at some point

i: market interest rate; percent added per year to a transaction

ir: real interest rate; interest rate with inflationary effects removed, showing the real earning power of your money

f: annual inflation rate

Important Definitions/Terms, cont.

m: number of compounding periods per yearn: number of yearsMARR: minimum acceptable (or attractive)

rate of return; minimum expected rate of return that a company will accept before beginning a project; often is the rate at which they can invest money

Compound Interest

Interest is compounded at specified periods and is added to the principal.

May be compounded yearly, quarterly, daily, continuous, etc.

Future Worth/Present Worth Equations

n

n

iFP

iPF

1

1

mn

m

iPF

1

If interest is compounded multiple (m) times per year:

If interest is compounded once per year:

Uniform Payments

We can also consider the present value or future worth of a uniform series of payments (annual or other time frame)

Terminology is often in the form of (P/A, i, n)If interest is compounded multiple times per

year, replace i with i/m and n with mn

n

n

n

ii

i

A

P

i

i

A

F

1

11

11

Table Example (from EIT review manual)

PW Example

What is the present worth of payments of $500/year for 10 years with an interest rate of 6%?

from previous slide (P/A, 6%, 10)=7.3601

Multiply your annual payments (A) by P/A

7.3601*$500=$3680.50

Monthly Compounding Example.

Consider a 10-year mortgage where the principal amount P is $200,000 and the annual interest rate is 6%, compounded monthly. Find the monthly payment.

The number of monthly payments is 120 and the monthly interest rate is 6/12=0.5%.

We can use our equation with n=120 and i=0.005.A=P*A/P=$200,000*0.0110=$2200

n

n

ii

i

A

P

1

11

What if prices escalate at an annual rate?

Real interest rate must take this into accountInflation: general rise in price levels

associated with increase in available currency and credit without increase in goods and services; f

Escalation: changes in cost due to increase in demand, resource depletion, and technology advances; rr

Nominal escalation rate rn: includes both inflation and escalation rate

Additional equations that we won’t get into here can take these effects into account.

Present Worth Analysis

This is one example of a cost-benefit analysis to compare alternatives and see which investment choice is best. Estimate and total the “Equivalent Money Value” of

the BENEFITS and COSTS to the planned projects or investments to establish whether they are worthwhile

Step 1: Determine interest rate firm wishes to earn on investments; MARR – minimum attractive (or acceptable) rate of return

Step 2: Estimate service life of projectStep 3: Estimate cash inflow for each period over

service lifeStep 4: Estimate cash outflow for each period over

service lifeStep 5: Determine net cash flows for each period (inflow

minus outflow)

Present Worth Analysis, cont.Step 6: Find the present worth, P, of each period

An= net cash flow at the end of period n N=lifetime n=year i=MARR (or interest rate)

Step 7: Decide P>0 accept P=0 indifferent P<0 reject

N

nn

n

i

AP

0 1Or use P/F for each period

Choosing Between Alternatives

If you have multiple alternatives Select the one with the highest P if the service lives

are the same length, all else being equal. If revenues are the same, choose the one with the

smallest P of costs.

Example

Tiger Machine Tool Company is considering the acquisition of a new metal-cutting machine. The required initial investment of $75000 and projected cash benefits over a three-year project life are as follows:

Evaluate the economic merit of the acquisition assuming MARR=15%.

So we should accept this opportunity!

3553$3%,15,55760

2%,15,27340$1%,15,24400$75000%)15(

FP

FP

FPP

Reference: Chan Park, Fundamentals of Engineering Economics, Prentice-Hall, 2004.

End of Year Net Cash Flow0 -$75,0001 $24,0002 $27,3403 $55,760

Cash Flow Diagram Example

Here’s another way to look at the analysis, with a cash flow diagram:

P (15%)inflow=$24,400(P/F, 15%, 1)+$ 27,340(P/F, 15%,2)+ $55,760(P/F, 15%,3)=$78553

P (15%)outflow=$75000P (15%)=$78553-$75000>0 accept!

$55,760

$27, 340$24,400

$75,000

Year

0

1 2 3

Here’s how P

changes with

MARR

Reference: Chan Park, Fundamentals of Engineering Economics, Prentice-Hall, 2004.

Another Example

By replacing a condenser on a building’s AC system with a more efficient one, you can save 10,000 kWh/year over its 15 year life. It needs replacing anyway. How much more can you afford to pay for the more efficient one? Assume that the company can get a 15-year loan at i=6%, and electricity costs 5¢/kWh.

Solution: Set the present worth of condenser A equal to the present work of condenser B to find the break-even point.

Solution

Cost A + present worth of electricity cost=Cost B + present worth of electricity cost

Cost B-Cost A=difference in present worth of electricity costs=10,000 kWh*$0.05/kWh*(P/A, 6%, 15)=$500*9.7122=$4856

If you spend less than $4856 on the more efficient condenser, you will come out ahead.

The big uncertainty in this analysis is the stability of long-term electricity costs.

Other considerations – a more efficient system could help you get LEED certification, which may have benefits.

Cash Outflow Sources

Cash outflow (costs) sources:• Initial planning cost• Capital investment• Operating (both direct and indirect costs)• Maintenance• Marketing and promotion• Taxes • Quality assurance and warranty• Depreciation • Others

Depreciation

Value of equipment decreases with timeDepreciation can be deducted from income as a

business expense for tax purposes.Book value = original cost – depreciationThree common ways to calculate depreciation

Straight line

z=year of interest C0=purchase price S=salvage value at end of lifetime N=lifetime (years)

N

SCDPz

0

Depreciation, cont.Other ways to calculate depreciation:Sum-of-Years

Digits, Declining Balance, Modified Accelerated Cost Recovery System (MACRS)

Burmeister, Elements of Thermal-Fluid System Design, Prentice Hall

Income Taxes

Percentage can vary widely CA is a very high tax state Many companies incorporate in NV instead, and a

lot of manufacturing has been moving to surrounding states

Local taxes may be negotiableProperty taxes 1-4% of assessed valueTax deductible expenditures include

Fuel costs O&M Interest on debt Depreciation State income taxes (for federal) Federal income taxes (for state)

For more information:

Take ISE 102 Engineering Economic Systems as an elective

Get approval from your advisor firstCourse Description: Systems analysis applied

to economic decisions in engineering; comparison of alternatives based on cost breakdown structure and time value of money; system life-cycle process; life-cycle economic concepts, costing methodology and applications. Corequisite: MATH 31 and ENGR 10 or equivalent.