Unit 01 lecture 01

ENGR 3360UUnit 1

General Introduction to Engineering Economics

Dr. J. Michael Bennett, P. Eng., PMP,

UOIT,

Version 2013-I-01

Unit 1 – General Introduction to Engineering Economics

2013-I-01 Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco1-2

Change Record

2013-I-01 Initial Creation

2013-I-09 small edits


Course Outline

1. Engineering Economics

2. General Economics

1. Microeconomics

2. Macroeconomics

3. Money and the Bank of Canada

3. Engineering Estimation

4. Interest and Equivalence

5. Present Worth Analysis

6. Annual Cash Flow

7. Rate of Return Analysis

8. Picking the Best Choice

9. Other Choosing Techniques

10. Uncertainty and Risk

11. Income and Depreciation

12. After-tax Cash Flows

13. Replacement Analysis

14. Inflation

15. MARR Selection

16. Public Sector Issues

17. What Engineering should know about Accounting

18. Personal Economics for the Engineer




Learning Objectives

Why should you take this course?

This course is a bird, right?

Engineering and economy



Mottos

Time is money

An engineer is someone who can build for a dime, what any damn fool can build for a dollar

There are three kinds of economists; those who count and those who don’t



Observation

How many filthy rich economists do you know?

Do you think that Bill Gates would pass this course? Would he even take it?


Economics

The “dismal” science (Carlyle)

“founded” by Scottish philosopher Adam Smith

“Wealth of Nations”

The “invisible hand” of the market place



Carlyle’s snide quote

“Teach a parrot to say “supply and demand” and you’ve got an economist”

“Give me a one-handed economist; all of the others say <<on one hand…on the other hand>>” Harry S. Truman

Is a Nobel category




Roadmap for Chapter 11. Options and

Questions

2. Decision Making

3. Macro and Micro Economics

4. Fundamental Business Structures

5. Interest Rates

6. Spreadsheet functions

7. Minimum attractive rate of return

8. Cash flows

9. Doubling times


What is the most important Engineering Variable?


$ £ € ¥



Why Engineering Economy is Important to Engineers

Engineers “design” and create Designing involves economic decisions Engineers must be able to incorporate economic analysis into their creative efforts Often engineers must select and execute from multiple alternatives A proper economic analysis for selection and execution is a fundamental aspect of engineering



Engineering Economy

The art and science that involves:Formulating,

Estimating and

Evaluating economic outcomes

Always concerned with the selection and possible execution of alternatives given the economic parameters associated with the project



Role of Engineering Economy in Decision Making

Decision making involves the estimation of future events/outcomes Engineering economy aids in quantifying past outcomes and forecasting future outcomes Engineering Economy provides a framework for modeling problems involving:

TimeMoneyInterest rates



Two Concerns of Engineering

Engineers have the dual task of determining:

1. What society wants (its needs), and

2. How best to combine econo

mic resources, processes, etc. to produce the goods and services desired by society.

Efficiency: economic and physical efficiency must be considered.



Physical and Economic Efficiency

Physical efficiencyMeasure of the success of engineering activity in the physical environment; ratio of outputs to inputs

Maximum physical efficiency ratio is 1 (or 100%)

Physical units include BTUs, kw-hours, etc.



Economic efficiencyRatio of value or worth to cost; must exceed 1 or 100%

Engineer must produce outputs that are most-valued (of greatest satisfaction) by society (economic efficiency)



ENGINEERING SPHERE

1950s

ECONOMIC SPHERE

1970s+

ECONOMIC SPHERE

ENGINEERING SPHERE

Evolution of Economic & Physical Efficiency

(Physical efficiency)(Economic

efficiency)

Economic Efficiency

Independent decision makingSignificant overlap

Physical efficiency



2 The Decision Making Process1. Understand the problem – define objectives

2. Collect relevant information

3. Define the set of feasible alternatives

4. Identify the criteria for decision making

5. Evaluate the alternatives and apply sensitivity analysis

6. Select the “best” alternative

7. Implement the alternative and monitor results



2.1 Understand the problem - define objectives

Problems can be simple, complex or intermediate

Are referred to as “opportunities”Build a new model

Replace an old plant

Open up in a new territory

Must refine opportunities into metrics (objectives)



Project ObjectivesDevelop expertise in some area.

Become competitive

Improve productivity

Reduce costs

Modify an existing facility

Develop a new sales strategy

Develop a new product



SMART Objectives

S = Specific

M = Measurable

A = Achievable

R = Realistic

T = Time-Limited



Minor Characteristics of ObjectivesThey should be

verifiablealignedcast in terms of deliverablescomprehensiblesingle-ended



Priorities of ObjectivesHand rank

Matrix



Scoring Models

Can build various objectives into a scoring model



2.2 Collect Relevant Information

Objectives are metricized so start there

Money is a biggy

As is Interest Rates, Inflation Rate, etc

May need customer surveys (consider Microsoft launching Windows-8)



Example: Gassing up in Oshawa

Need to evaluate all prices on a daily basis plus weekly plus monthly plus “externals”

Observations of a Shrewd Gas-upperMorning BAD

Later in the evening best

South side normally lower than north end



2.3 Define the Set of Feasible Alternatives

Do nothing (always a possibility)

Alternative A

Alternative B

………

Alternative n


Opportunity Cost

What will it cost you by NOT doing something?

Can be 1 thing: can be 1,000 things

For example, going to FEAS/UOIT

OC is flipping burgers at MickeyDs



OC of going to Class

You could be flipping burgers at MickyDs

6*8*10 = $480/wk

35 week = 35*480 = 17,000

Your OPPORTUNITY COST IS $17,000




2.4 Identify the Criteria for Decision Making

What is the most important criterion?

Normally, money but can be other things

(protection of the environment, exclusion of a competitor into a new market, etc.)



2.5 Evaluate the Alternatives (apply sensitivity analysis)

Some parameters are keyInterest rates

Inflation rate

Canadian dollar rate

Demand expectation

Price of oil

SA varies these to see how the chosen model reacts



2.6 Select the “Best” Alternative

Be sure to state all assumptions and constraints

When the project is done, we will do a post-mortem

Needs these to justify decisions

For example, Tar Sands development: assumed price of oil critical



2.7 Implement the Best and Monitor

Do it

Check it

Do root cause analysis



Time Value of Money

All firms make use of investment of funds

Investments are expected to earn a return

Investment involves money

Money possesses a “time value”

The “time value” of money is the most important concept in engineering economy



Performing An Engineering Economy Study

Engineering Economy Studies: Define Alternatives

Do-nothing alternative – maintain the status quo Define feasible alternatives – that can solve the problem

Define/estimate the current and future cash flows

Perform the analysis Apply the tools and methods of engineering economy

Selection of the best alternative

Implement and monitor



3 Macro and Microeconomics

Fundamental approach of EconomicsDraw a circleInside, Microeconomics describes

Actions of individuals and groups in individual markets (choice under scarcity, implications on prices and demand)

Outside, Macroeconomics describesPerformance of national economies and their policies (unemployment rate, overall level of prices, GDP, prime rate, price of oil etc).



Microeconomics

Comparative advantage

Supply and demand

Competition and the invisible hand

Efficiency and exchange

Profit



Macroeconomics

Global supply and demand

Economic growth and living standards

Productivity

Recessions and expansions

Unemployment

Inflation

Money, Banks and Central Banking



4 Fundamental Business Structures

1. Sole proprietorship

2. Partnership

3. Limited partnership

4. Corporation



4.1 Sole Proprietorship

Business owned by one person

Easiest to start, least regulated

Owner keeps all of the profits BUT is responsible for all debts

Owner has unlimited liability which means that Loophole and Loophole can foreclose on your house, Mercedes, wifey’s diamonds, hubby’s Hummers, etc



Characteristics of Sole Proprietorships

Cheapest and fastest to set up

All business profits are taxed as personal income

Owner has unlimited liability, extending to all of her assets

Life of the firm is limited to the life of the owner

Transfer of ownership requires the sale of the whole business to the new owner

Equity financing is limited to personal wealth of the owner



4.2 Partnership

Involves two or more owners. Here partners run the company together

They also share all profits and losses, under a pre-existing agreement



Characteristics of Partnerships

Inexpensive, easy to form

General partners have full liability for debts

Partnership is dissolved when a partner dies or withdraws

Difficult for partners to raise money

Management control resides only with the partners



4.3 Limited Partnership

Some of the partners are involved only as investors

These are called limited partners

Are liable only up to the amount of their investment

The daily running of the business is not their concern



Characteristics of Limited Partnerships

Limited partners have limited liability

LPs can withdraw at any time

LPs have no control over management of the group



4.1 Corporations

Corporations are owned by shareholders

Set up as an independent business entity with clearly specified rights and obligations

Shareholders elect a Board of Directors which is responsible for picking managers to run the business in the best interests of the shareholders

The corporation is a separate legal entity which is responsible for its debts



Corporations cont.

Humans and other legal entities (other corporations, trusts) can hold shares in the corporation

If no stockholders exist, can be a “non-stock corporation”

Also a “membership corporations” Not-for-profit corps such as churches, charities etc.



Stocks

Can be closely held (private) or publicly traded

“Traded” means traded on a stock exchange or an “over-the-counter” market



Characteristics of Corporations

Ownership of the corp is easily transferredThe corporation has unlimited life (oldest is a Japanese company, 800 years old)Shareholders’ liability is limited to amount of shares heldIs almost the only way to run large organizations (J exception!)Is the easiest form to raise large amounts of capital quickly (e.g.. Google)



Corporate Finance (for all 4)

Capital Budgeting – what are the long-term strategies the company should undertake?

Capital Structure – what is the best way to raise long-term financing to make new products

Working Capital Management – how does the company manage its short-term cash flow in order to pay people, suppliers etc



Corporate Financing

Primary goal is to ensure that the return on capital exceeds the cost of capital without taking big risks

Goal is to enhance corporate value



5 Interest Rates and Rate of Return

Interest – the manifestation of the time value of money

Rental fee that one pays to use someone else’s money

Difference between an ending amount of money and a beginning amount of money

Interest rate (%) =

in te re s t a c c ru e d p e r t im e u n it x 1 0 0 %

o rig in a l a m o u n t



Rate of Return

Interest earned over a period of time is expressed as a percentage of the original amount, specifically;

Borrower’s perspective – interest rate paid

Lender’s perspective – interest rate earned

interest accrued per specific time periodRate of return (%) =

original amount X100%



Economic Equivalence Different sums of money at different times may be equal in economic value

0 1

$100 now

$106 one

year from now

Interest rate = 6% per year

$100 now is said to be equivalent to $106 one year from now, if the $100 is invested at the interest rate of 6% per year.



Simple and Compound Interest

Simple Interest:Interest = (principal)(number of periods)(interest rate)

Compound Interest:Interest earns interest on interest

Compounds over time

Interest = (principal + all accrued interest) (interest rate)



Terminology and Symbols P = a present sum of money at a time designated as t = 0 { t represents time}

F = a future amount of money at some point in time later than t = 0

A = a series of equal, end-of-period cash flows

n = the number of interest periods

i = the interest rate or rate of return per time period, in percent



6. Introduction To Solution By Computer

Application of Microsoft’s Excel© spreadsheet program

Excel financial functionsPresent Value P: =PV(i%,n,A,F)

Future Value F: =FV(i%,n,A,P)

Equal, periodic value: =PMT(i%,n,P,F)

No. of periods: =NPER((i%,A,P,F)

Compound interest rate: =RATE(n,A,P,F)

Compound interest rate: =IRR(first_cell:last_cell)

Present value of a series: =NPV(i%,cell2:last_cell) + cell1



7. MARR (Minimum Attractive Rate of Return) Investors expect to earn a return on their investment (commitment of funds) over time We expect to see economic efficiencies greater than 100% A profitable investment should earn (return) funds in excess of the investment amounts Economic projects should earn a reasonable return, which is termed:

MARR – Minimum Attractive Rate of ReturnAlso termed the “hurdle” rate for an investment



The MARR

The MARR is established by the financial managers of the firm

The MARR is expressed as a percent value

Most, if not all, projects should earn at a rate equal to or greater than the established MARR

MARR’s are set based upon: The cost of all types of capital

Allowance for risk



Types of Financing Equity Financing – the firm uses funds either from retained earnings, new stock issues, or owner’s infusion of money Debt Financing – the firm borrows funds from outside sources

The cost of debt financing = the interest rate charged on the debt (loan) amounts

The MARR is approximated from the weighted average cost of all sources of capital to the firm A firm’s ROR > MARR > cost of capital



8 Cash Flows: Their Estimation and Diagramming

Definition of termsCash Inflows - amount of funds flowing into the firmCash Outflows – amount of funds flowing out of the firm

Net Cash Flow equals Cash inflows – cash outflows

Assumption for analysis – end of periodFunds flow at the end of a given (interest) period



Cash Flow DiagramsA typical cash flow diagram might look like:

0 1 2 … … … n-1 n

1. Draw a time line

One time period

0 1 2 … … … n-1 n

2. Show the cash flows

Cash flows are shown as directed arrows (+ for up or – for down) ---

(+) inflow; (-) outflow

Always assume end-of-period

cash flows!


9 Course Assumptions

Fallacy of linearity

Show me a linearity in nature!

Pointy-Haired-Boss and St Dilbert

PHB e.g.One woman creates a baby in 9 months

Nine women create one in 1 month!

Assumption of homo economicus



Guestimation

Engineers must do this all the time

How many dogs are there in Canada?

Interpolation si; extrapolation non!

Rule-of-six

Estimation accuracy

Estimation of SD




Rule of 72: Estimating Doubling Time

Common question:Estimate the number of time periods it takes for a cash flow to double in size

Given an interest rate i% per period

The approximate time n for an investment at time

t = 0 to double in value is given by:

n = 72/ie.g., $10,000 at 7% per year doubles to $20,000 in 10.3 years


Economists you should Know

Adam Smith (invisible hand man)

Karl Marx (boo-hiss)

Alfred Marshall (2 blades of the scissors)

John Maynard Keynes (when in doubt, SPEND)

Milton Friedman (Chicago - yea)

Paul Samuelson (ol’ guns and butter)

Ben Bernanke (chair of the US Fed)

Paul Krugman (contrarian)

Mark Carney (gov, Bank of Canada)




Chapter Summary

Engineering Economy – application of economic factors and criteria to evaluate alternatives

Applies the time value of money

Application of economic equivalence

Introduction of the MARR

Cash flow estimationModeling – cash flow diagrams

Difficulties in estimation

Perspectives – viewpoints taken

Unit 01 lecture 01

Documents

Transcript of Unit 01 lecture 01