Chan s park fundamentals of engineering economics chan s park pearson education (2012)
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Fundamentals of
Engineering Economics
THIRD EDITION
Chan S. Park
Summ:tr) or lntc rc!'> t faclors and Or h er Useful Formulas
Flem T) pc
Single
payment
Equal
payment
series
Linear
gradient
series
Geometric
gradient
series
Factor Notation
Gou)
Future worth
(Fil~ i, N)
Find: I
Given: I'
Formulu
P( I
F
F:quhulenl Cash Flow Diagnun"
~
+ i) ,.
I-"
Find: I'
Given: I
Futun; worth
(FIA. i, \I)
Fiml: F
Given: A
Sinking fund
(All·, i, N)
Find: A
Given: /·
A-[-+
Present worth
(PIA. i. V)
Find: P
Gi,en: A
p
Find: A
Given: I'
Present worth
Find: P
(PG,i. V)
Given: G
Equal paynu.:nt
Finu: A
Given: (i
(A/G, i, N)
Pres<.:nt worth
(P A 1. g.
1. \ '}
+
1)'
I
I
I
0
Present \\orrb
(Pl!·: i. V)
Capital recovery
(Ami, N)
/'(I
P
F(I
+ i)
1
I
i)''
= r( I
-t i)''
• i( I
0::.:7
II
(1
-
-]
l
~]
+ i)'
(I t i)'
H \
I
T
T
T
T
Y
I
I
I
I
·I
,\
,\
I
I
tI t, L_Li
I \'
l
l
,. -
®
l]
( I -r i)" - iN - ~]
[
G
i( I 1- i}.\ i
\.....,,,. '.(.;1. . .0
,, - ! '·
0
A
0 •I
I
I
I
(I+ i)' iN r
G
f(l+i)'
p
\
---
I
o
A -[~(~)'_]
-
N
I
I
I
,.
~
I
1
-
-·
1 ,\
I \
"'""
®
Find: P
Gi\'<.:n:g
Continuous Ca'ic
Effect ivc interest rate per
payment period
~larkct
interest rate
j
= i' f
Net present worth
LA,,( I + i)
"
Capital recovery with return
i
\
PW(i) -
Capitalized equivalent worth
i'f
1
I
CE(i)
CR(i)
"
()
A
(/ -
S}(A /I~
i. N)
+ iS
= i' +1
Internal rate of return
PW(t)
Benefit-cost ratio
BC(i)
Profitability index
Pl(i)
=
Ao
o+ n
+
=I:
A,
<1 + n
+ ... +
AN
<1 + n
=0
C'
=B-
I
C'
Summary of Project Analysis Methods
Payback period
pp
A method for determining the length
of time required to recover the cost
of an investment. Management
sets the benchmark PP".
PP< pp"
Select the one with
shortest PP
Discounted
payback period
PP(i)
A variation of payback period when
PP(i)
Management sets the benchmark pp•.
Select the one with
shortest PP(i)
Present worth
PW(i)
A method that translates a project's
cash flows into an equivalent net
present value.
A variation of the PW: A project's
cash flows are translated into an
equivalent net future value.
PW(i) >0
Select the one with Select the one with
the largest PW
the least negative
PW
FW(i) >0
Select the one with Select the one with
the largest FW
the least negative
FW
Future worth
FW(i)
A variation of the PW: A perpetual
or very long-lived project that
generates a constant stream of
annual net cash flow.
A variation of the PW: A project's
Annual
cash flows are translated into an
equivalence
annual equivalent sum.
AE(i)
A relative percentage method that
Internal rate of
measures the yield as a percentage
return
of investment over the life of a
IRR
project: The IRR must exceed the
minimum required rate of return
(MARR).
Benefit-cost ratio A relative measure to evaluate
public projects by finding the ratio
BC(i)
of the equivalent benefits over the
equivalent costs.
Capitalized
· equivalent
CE(i)
Profitability
index
PI(i)
A relative measure to evaluate
projects by calculating the ratio of
the equivalent net benefits over the
equivalent net investment.
CE(i) > 0
AE(i) > 0
IRR>MARR
Select the one with Select the one with
the largest CE
the least negative
CE
Select the one with Select the one with
the largest AE
the least negative
AE
Incremental analysis:
If IRRA2·AI >MARR,
select the higher cost
investment project, A2.
Incremental analysis:
BC(i) > 1
If BC(i)A2·At > 1, select
the higher cost
investment project, A2.
Incremental analysis:
Pl(i) > 1
If PI(i)A2-A 1 > 1, select
the higher cost
investment project, A2.
fundamentals of
Enginee~ing
Economics
THIRD lDITION
Chan S. Park
Department of Industrial and Systems Engineering
Auburn University
International Edition contributions by
Pravin Kumar
Department of Mechanical Engineering
Delhi Technological University
Nand Kumar
Department of Humanities
Delhi Technological University
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Authori:etl adaptation from the United States editio11, entitled Fundamentals of Engineering Economics, 3rd edition, ISBN 978-0-13-277542-7 by Cl1t111 S Park
published by Pearson Education 11:> 2013.
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ISBN 10: 0-273-77291-0
ISBN 13:978-0-273-TI291-0
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
10911765432
1413
'l)'Jlesel in limes Ten 10/12 by Jouve India Private Limited.
Printed and bound by Courier Kendallville in The United Stales of America
The publisher's policy is lo use paper manufactured from sustainable forests.
PEARSON
ISBN 13: 978-0-273-77291-0
ISBN 10:
0-273-77291-0
To my mentors: James R. Buck (late),
Gerald j. Thuesen, and
Vernon E. Unger
PREFACE
Why Fundamentals of Engineering Economics?
Engineering economic'> i!, one of the most practical subject mailers in the engineering curriculum. but it is an always challenging. ever-changing discipline. Contemporary
Engineering Economics ( C £ £). now in its fifth edition. was first published in 1993.
and since then. we have tried to renect changes in the business world in each new
edi tion along with the latest innovations in education and publishing. These changes
have resulted in a belier. more complete textbook, but one that is much longer than ii
was or iginally inwndcd. This may present a problem: Today, covering the tex tbook in
n single term is increasingly difficult. Therefore, we decided to crea te F1111rla111entals of
Engineering J::co110111ic.1· (FEE) for those who like co11te111porary but thin k a smaller,
more concise tex tbook would better serve tbeir needs.
Goals of the Text
This text aims not only to provide sound and comprehensive coverage of the concepts
of engi neering economics but also to add ress the practical concerns o f engineering
economics. More specifically. this text has the following goa ls:
I. To build n thorough understanding of the theoretical and conceptual basis upon
which the practice of financial project anal ysis is built.
2. To satisfy the very pract ical needs of the engi neer toward making informed
finnncial decisions when acting as a ream member or project manager for an
t!ngineering project.
3. To incorporate nil critical decision-n1aking tools -including the most contcn1porary. computer-oriented ones that engineers bring to the task o f making informed
fin ancial decisions.
4. To appea l to the rull range of engineering discip lin es for which th is course is
orten required: ind ustrial. civil , mechanica l, electrica l, computer, aerospace,
chemical. n11 d manu fac turing engineering as well ns engin eering lcch11ology.
Intended Market and Use
This tl:Xt is intended for use in introductory engineering economics courses. U nl ike the
larger textbook (CEH). it is possible to cover FEE in a single term and perhaps even to
supplement it with a few outside readings or case studies. Although the chapters in FEE
are arrangl:d logically, they arc written in a flexible, modular format. allowing instructors
to cover the material inn different sequence.
5
6 PREFACE
New to This Edition
Much of rhe conte nt has been s tre amlined lo provide m a te ria ls in depth and to reflect
the cha lle nges in conte m pora ry e ngineering econo mics. Some of the high lighted
cha nges are as follows:
• A ll ch apte r opening vigne ttes- a tradem ark of F1111damentnls of E11gi11eeri11g
Eco110111ics-bave been revised o r comple te ly re placed with more current and
thought-provoking exa mples fro m both ser vice a nd ma n ufacturi ng sectors.
Chapte rs
Chapte r Opening
Vigne ttes
Company
Sector
Industry
1
• Socia l networking
Face book
Technology
st!rvices
Internet
software/Services
2
• Powe rball lollery
Pe rsona l
Consumer
Gaming
3
• Cred it cards
Pe rsonal
Financial
Banklng
4
• Dallas Cowboys
Da llas Cowboys
E ntertainment
Sports
5
• LCD glass
ma nufacturing
Corning G lass
Manufacwring
Electronic
componen ts
6
• Owning
a corpora te je t
Hawker
Beech craft
Corpora tio n
E lectro nic
techno logy
Aerospace/
Defense
7
• What's a degree
reaUy worth?
Personal
Consume r
Education
8
• High-speed
Tm e rne t
Australian
Government
Public
Computer
communication
9
• Obama lo pro pose
tax write-off for
business
U.S.
Governme nt
Public
Taxation
:IO
• Coke leveraging its
investment in plantbased packaging
Coca Cola
Consume r
nondurables
Beverages/
Packaging
11
• Japanese oil
company looks
to the rising sun
Solar Frontie r
KK's
E nergy
In tegrated oil
12
• Finding a fix fo r
the Tappan Zee
Bridge
State of New
York
Public
Construction
13
• Warren BuCfe tt
Be rkshire
Hathaway
Finance
Property/
Ins urance
• Self-Test Q u es1ions have been added a l the end of each chapte r (131 problems
in to tal), and worked-out solutions to the question s a re provided in Appendix A.
These questions are fo rma tted in a style suitable for Fundamentals Engineering
E xam revie w a nd were created to he lp stude nts prepare for a typical class exam
common to in tro ducto ry en gineering econo mic cou rses.
PREFACE
• The Benefit-Cost Analysis section has been moved to Chapter 8 as a part of measure of investment chapters. The profitability index is included in this chapter.
• Most of the end-of-chapter problems are revised to reflect the changes in the main
text. There are 708 problems, including 131 self-test questions, 43% of which are
new or updated.
ã Various Excelđ spreadsheet modeling techniques are introduced throughout
the chapters, and the original Excel files are provided online at the Companion
Website. Most worksheets have been redesigned with graphical outputs.
• Some other specific content changes made in the third edition are as follows:
• In Chapter 1, a cost reduction (Apple's iPadđ) project is introduced.
ã In Chapter 2, a new retirement planning example is introduced.
• In Chapter 4, all CPI- and inflation-related data have been updated.
• In Chapter 5, an example of comparing mutually exclusive revenue projects is
provided.
• In Chapter 6, a section on capital cost has been expanded with an automobile
ownership example.
• In Chapter 8, benefit-cost contents have been streamlined, and a new section on
the profitability index has been created.
• In Chapter 11, the section on risk-adjusted discount rate approach is expanded
in which the risk element is incorporated through the cost of capital.
• In Chapter 13, all financial statements for Lam Research Corporation have
been updated, and a new set of financial ratio analysis is provided. Investment
strategics have been added as a part of managing personal financial asset under
uncertainty.
Features of the Book
FEE is significantly different from CEE, but most of the chapters will be familiar to
users of CEE. Although we pruned some material and clarified, updated, and otherwise improved all of the chapters, FEE should still be considered an alternative and
streamlined version of CEE.
We did retain all of the pedagogical elements and supporting materials that helped
make CEE so successful. For example:
• Each chapter opens with a real economic vignette describing how an individual decision maker or actual corporation has wrestled with the issues discussed in the chapter.
These opening cases heighten students' interest by pointing out the real-world relevance and applicability of what might otherwise seem to be dry technical material.
• In working out each individual chapters example problems, students are encouraged to highlight the critical data provided by each question, isolate the question
being asked, and outline the correct approach in the solution under the headings
Given, Find, Approach, and Comments, respectively. This convention is employed
throughout the text. This guidance is intended to stimulate student curiosity to look
beyond the mechanics of problem solving to explore "what-if' issues, alternative
solution methods, and the interpretation of the solutions.
• There are a large number of end-of-chapter problems and exam-type questions varying in level of difficulty; these problems thoroughly cover the book's various topics.
7
8 PREFACE
• Most chapters contain a section titled "Short Case Studies with Excel," enabling
students to use Excel to answer a set of questions. These problems reinforce the
concepts covered in the chapter and provide students an opportunity to become
more proficient with the use of an electronic spreadsheet.
• All Excel spreadsheets now contain easy-to-follow call-out formulas. The integration of Excel is another important feature of FEE. Students have increased access to and familiarity with Excel, and instructors have more inclination either to
treat these topics explicitly in the course or to encourage students to experiment
independently. One could argue that the use of Excel will undermine true understanding of course concepts. This text does not promote the trivial or mindless
use of Excel as a replacement for genuine understanding of and skill in applying
traditional solution methods. Rather, it focuses on Excel's productivity-enhancing
benefits for complex project cash flow development and analysis.
To Student: How to Prepare for the Fundamentals
of Engineering (FE) Exam
The set of self-study questions at the end of each chapter is designed primarily to help
you develop a working knowledge of the concepts and principles of engineering economics. However, the questions are also perfect resource to help you prepare the Fundamentals of Engineering (FE) exam. All questions are structured in multiple-choice
format because these types of exam questions are used in the FE exam and, increasingly, in introductory engineering economics courses.
The FE exam typically consists of 180 multiple-choice questions. During the morning session (120 questions), all examinees take a general exam common to all disciplines. During the afternoon session (60 questions), examinees can opt to take a general
exam or a discipline-specific (Chemical, Civil, Electrical, Environmental, Industrial, or
Mechanical) exam.
The general exam includes four questions related to engineering economics in the
morning session and five in the afternoon session. The specific engineering economics
topics covered in the FE exam are
•
•
•
•
•
Discounted cash flow (e.g., equivalence, PW, equivalent annual, FW, and rate of return)
Cost (e.g., incremental, average, sunk, estimating)
Analyses (e.g., breakeven, benefit-cost)
Uncertainty (e.g., expected value and risk)
Valuation and depreciation
Some sample questions are also provided by the National Council of Examiners for
Engineering and Surveying (www.ncees.org/exams).
Companion Book Website
A Companion Website (www.pearsoninternationaleditions.com/park) has been
created and maintained by the publisher. This text takes advantage of the Internet
as a tool that has become increasingly important in accessing a variety of information. The website contains a variety of resources for both instructors and students,
PREFACE 9
including various online financial calculators. There are three main links on the
Companion Website:
• Instructor Resources: This is a password-protected link for registered instructors
where the Instructor's Manual and PowerPoint slides for lecture notes can be
found. A comprehensive Instructor's Manual in Word® format includes answers to
end-of-chapter problems and Excel® solutions to all complex problems.
• St11dent Resources: This is where students can access online financial tools such as
( l) Interest Factor Tables, (2) Cash Flow Analyzer, (3) Depreciation Analysis, and
(4) Loan Analysis. The Cash Flow Analyzer is an integrated computer software
package written in Java®. The software includes the most frequently used methods of economic analysis. It is menu-driven for convenience and flexibility, and it
provides ( l) a flexible and easy-to-use cash flow editor for data input and modifications and (2) an extensive array of computational modules and user-selected
graphic outputs.
• Awhor's Resource Website: This content has been created and maintained by the
author and contains several pieces of information useful in conducting engineering
economic analyses.
• Tax Information: This section will serve as a clearinghouse for disseminating
ever-changing tax information, personal as well as corporate. Links are provided
to various tax sites on the Web, so you will find the most up-to-date information
on depreciation schedules as well as capital gains taxes.
• Money and Investing: This section provides a gateway to a variety of information useful in conducting engineering economic analysis. For example, a direct
link is provided to the most up-to-date stock prices, options, and mutual fund
performances.
• Economic Tracks: This section includes cost and price information as well as the
most recent interest rate trends. In particular, the consumer price indices, productivity figures, and employment cost indices are some of the representative economic data provided.
• Financial News: This section provides access to various financial news outlets
on the Web. The site divides news outlets into online news and daily, weekly, and
monthly publications.
Acknowledgments
This book reflects the efforts of a great many individuals over a number of years. In
particular, I would like to recognize the following individuals whose reviews and comments for the previous editions have contributed to this edition. Once again, I would
like to thank each of them:
•
•
•
•
•
•
Roland K. Arter, Summit College- University ofAkron
Kandace Ballard, Quorum Business Solutions, Inc.
John L. Evans, Auburn University
Dolores Gooding, University of South Florida
Bruce Hartsough, University of California at Davis
Kyongsun Kim, Republic of Korea Army
10 PREFACE
•
•
•
•
•
•
•
•
•
•
•
Hwansik Lee, Republic of Korea Army
Matthew Marshall, Rochester /nstilllte of Technology
Bruce McCann, University of Texas at Austin
Michael Park, Mckinsey & Company
Richard V. Petitt, United States Military Academy
Linda Ann Riley, Roger Williams University
Iris V. Rivero, Texas Tech University
Bhaba R. Sarker, Loul'>it1tu1 State University
James R. Smith, Tennessee Technological University
Donald R. Smith, Texas A &M University
Stan Uryasev, University of Florida
I also wish to thank the following individuals for their additional input to the
new edition: Kandace Ballard, John Evans, Linda Ann Riley, and Bhaba Sarker who
offered numerous comments to improve the presentation of the materials. Thanks also
go to Edward Park who read the entire manuscript from a student's point of view
and made many constructive comments; Daphne Ku, Seungbae Park, and Wonsuk
Kang who helped me develop the Instructor's Manual; Orhan Dengiz who helped me
develop the book Website; Holly Stark, my editor, and Scott Disanno, senior managing
editor, both at Prentice Hall, who assumed responsibility for the overall project; and
Maheswari PonSaravanan at Jouve, India, the project manager, who oversaw the entire
book production.
CHAN
S. PARK
AUBURN, ALABAMA
CONTENTS
s
Preface
PART I UNDERSTANDING MONEY AND ITS
MANAGEMENT t9
Chapter I
1.1
1.2
1.3
1.4
2.2
2.3
20
The Rational Decision-Making Process
1.1.1 How Do We Make 'JYpical Personal Decisions?
1.1.2 How Do We Approach an Engineering Design Problem?
1.1.3 What Makes Economic Decisions Different from
Other Design Decisions?
The Engineer's Role in Business
1.2.1 Making Capital-Expenditure Decisions
1.2.2 Large-Scale Engineering Economic Decisions
1.2.3 Impact of Engineering Projects on Financial Statements
Types of Strategic Engineering Economic Decisions
1.3.1 New Products or Product Expansion
1.3.2 Equipment and Process Selection
1.3.3 Cost Reduction
1.3.4 Equipment Replacement
1.3.5 Service or Quality Improvement
Fundamental Principles in Engineering Economics
Summary
Self-Test Questions
Problems
Chapter 2
2.1
Engineering Economic Decisions
Time Value of Money
22
22
25
27
28
28
28
30
31
32
32
33
34
34
35
36
37
37
38
Interest: The Cost of Money
2.1.1 The Time Value of Money
2.1.2 Elements of Transactions Involving Interest
2.1.3 Methods of Calculating Interest
Economic Equivalence
2.2.1 Definition and Simple Calculations
2.2.2 Equivalence Calculations Require a Common
lime Basis for Comparison
Interest Formulas for Single Cash Flows
2.3.1 Compound-Amount Factor
2.3.2 Present-Worth Factor
2.3.3 Solving for lime and Interest Rates
40
40
42
44
46
47
50
51
51
53
56
11
12 CONTENTS
2.4
2.5
2.6
2.7
Uneven-Payment Series
Equal-Payment Series
2.5.1 Compound-Amount Factor: Find F, Given A, i, and N
2.5.2 Sinking-Fund Factor: Find A, Given F, i, and N
2.5.3 Capital-Recovery Factor (Annuity Factor):
Find A, Given P, i, and N
2.5.4 Present-Worth Factor: Find P, Given A, i, and N
2.5.5 Present Value of Perpetuities
Dealing with Gradient Series
2.6.1 Handling Linear Gradient Series
2.6.2 Handling Geometric Gradient Series
More on Equivalence Calculations
Summary
Self-Test Questions
Problems
Chapter 3
3.1
3.2
3.3
3.4
60
60
64
66
69
74
76
76
82
86
92
93
97
112
Market Interest Rates
3.1.1 Nominal Interest Rates
3.1.2 Annual Effective Yields
Calculating Effective Interest Rates Based on Payment Periods
3.2.1 Discrete Compounding
3.2.2 Continuous Compounding
Equivalence Calculations ~ith Effective Interest Rates
3.3.1 Compounding Period Equal to Payment Period
3.3.2 Compounding Occurs at a Different Rate than
That at Which Payments Are Made
Debt Management
3.4. l Borrowing with Credit Cards
3.4.2 Commercial Loans-Calculating Principal
and Interest Payments
3.4.3 Comparing Different Financing Options
Summary
Self-Test Questions
Problems
Chapter 4
4.1
Understanding Money Management
58
Equivalence Calculations under Inflation
114
114
115
118
118
119
121
121
124
128
128
131
134
139
141
144
1ss
Measure of Inflation
4.1.1 Consumer Price Index
4.1.2 Producer Price Index
4.1.3 Average Inflation Rate
4.1.4 General Inflation Rate (f) versus Specific Inflation Rate(!;)
159
160
161
163
164
CONTENTS 13
4.2
4.3
Actual Versus Constant Dollars
4.2.l Conversion from Constant to Actual Dollars
4.2.2 Conversion from Actual to Constant Dollars
Equivalence Calculations under Inflation
4.3.1 Market and Inflation-Free Interest Rates
4.3.2 Constant-Dollar Analysis
4.3.3 Actual-Dollar Analysis
4.3.4 Mixed-Dollar Analysis
Summary
Self-Test Questions
Problems
166
167
168
172
173
173
174
178
181
182
184
PART 2 EVALUATING BUSINESS AND ENGINEERING
ASSETS
Chapter 5
5.1
5.2
5.3
5.4
6.2
192
Loan versus Project Cash Flows
Initial Project Screening Methods
5.2.1 Benefits and Flaws of Payback Screening
5.2.2 Discounted-Payback Period
Present-Worth Analysis
5.3.1 Net-Present-Worth Criterion
5.3.2 Guidelines for Selecting a MARR
5.3.3 Meaning of Net Present Worth
5.3.4 Net Future Worth and Project Balance Diagram
5.3.5 Capitalized-Equivalent Method
Methods to Compare Mutually Exclusive Alternatives
5.4.1 Doing Nothing Is a Decision Option
5.4.2 Service Projects versus Revenue Projects
5.4.3 Analysis Period Equals Project Lives
5.4.4 Analysis Period Differs from Project Lives
Summary
Self-Test Questions
Problems
Chapter 6
6.1
Present-Worth Analysis
191
Annual Equivalence Analysis
194
195
197
198
200
200
205
206
210
211
213
214
214
215
219
225
225
228
248
Annual-Equivalent Worth Criterion
6.1.1 Benefits of AE Analysis
6.1.2 Capital (Ownership) Costs versus Operating Costs
Applying Annual-Worth Analysis
6.2.1 Unit-Profit or Unit-Cost Calculation
6.2.2 Make-or-Buy Decision
250
254
254
259
259
263
14 CONTENTS
6.3
Comparing Mutually Exclusive Projects
6.3.1 Analysis Period Equals Project Lives
6.3.2 Analysis Period Differs from Project Lives
Summary
Self-Test Questions
Problems
Chapter 7
7.1
7.2
7.3
7.4
Rate-of-Return Analysis
266
266
271
274
274
277
294
Rate of Return
7.1.1 Return on Investment
7.1.2 Return on Invested Capital
Methods for Finding Rate of Return
7.2.1 Simple versus Nonsimple Investments
7.2.2 Computational Methods
Internal-Rate-of-Return Criterion
7.3.1 Relationship to the PW Analysis
7.3.2 Decision Rule for Simple Investments
7.3.3 Decision Rule for Nonsimple Investments
Incremental Analysis for Comparing Mutually
Exclusive Alternatives
7.4.1 Flaws in Project Ranking by IRR
7.4.2 Incremental-Investment Analysis
7.4.3 Handling Unequal Service Lives
Summary
Self-Test Questions
Problems
Chapter 7A
Resolution of Multiple Rates of Return
296
296
297
298
298
300
307
307
307
311
313
313
314
320
322
322
326
342
7A-1 Net-Investment Test
7A-2 The Need for an External Interest Rate
7A-3 Calculation of Return on Invested Capital for Mixed Investments
Chapter 8
8.1
8.2
Benefit-Cost Analysis
Evaluation of Public Projects
8.1.1 Valuation of Benefits and Costs
8.1.2 Users' Benefits
8.1.3 Sponsor's Costs
8.1.4 Social Discount Rate
Benefit-Cost Analysis
8.2.1 Definition of Benefit-Cost Ratio
8.2.2 Incremental B/C-Ratio Analysis
342
344
345
350
352
353
353
353
354
355
355
358
CONTENTS
8.3
8.4
Profitability Index
8.3. l Definition of Profitability Index
8.3.2 Incremental PI Ratio Analysis for Mutually Exclusive Alternatives
Highway Benefit-Cost Analysis
8.4.1 Define the Base Case and the Proposed Alternatives
8.4.2 Highway User Benefits
8.4.3 Sponsors' Costs
8.4.4 Illustrating Case Example
Summary
Self-Test Questions
Problems
PART 3 DEVELOPMENT OF PROJECT CASH FLOWS
Chapter 9
9.1
9.2
9.3
9.4
Accounting Depreciation
9.1.1 Depreciable Property
9.1.2 Cost Basis
9.1.3 Useful Life and Salvage Value
9.1.4 Depreciation Methods: Book and Tax Depreciation
Book Depreciation Methods
9.2.1 Straight-Line Method
9.2.2 Declining-Balance Method
9.2.3 Units-of-Production Method
Tax Depreciation Methods
9.3. l MACRS Recovery Periods
9.3.2 MACRS Depreciation: Personal Property
9.3.3 MACRS Depreciation: Real Property
Corporate Taxes
9.4.l How to Determine "Accounting Profit"
9.4.2 U.S. Corporate Income Tax Rates
9.4.3 Gain Taxes on Asset Disposals
Summary
Self-Test Questions
Problems
Chapter I0
10.1
10.2
Accounting for Depreciation and Income Taxes
Project Cash-Flow Analysis
362
362
364
366
366
367
367
368
372
372
375
383
384
386
386
387
388
388
390
390
392
396
397
397
398
401
403
403
405
407
411
412
414
426
Understanding Project Cost Elements
10.1.1 Classifying Costs for Manufacturing Environments
10.1.2 Classifying Costs for Financial Statements
10.1.3 Classifying Costs for Predicting Cost Behavior
Why Do We Need to Use Cash Flows in Economic Analysis?
428
428
430
431
435
15
16 CONTENTS
10.3
10.4
Income-Tax Rate to Be Used in Project Evaluation
Incremental Cash Flows from Undertaking a Project
10.4. l Operating Activities
10.4.2 Investing Activities
10.4.3 Financing Activities
436
439
439
442
443
10.5
Developing Project Cash Flow Statements
10.5.1 When Projects Require Only Operating and Investing Activities
10.5.2 When Projects Are Financed with Borrowed Funds
443
443
447
10.6
Effects of Inflation on Project Cash Flows
10.6.1 Depreciation Allowance under Inflation
10.6.2 Handling Multiple Inflation Rates
Summary
Self-Test Questions
Problems
449
449
453
455
456
459
Chapter 11
Handling Project Uncertainty
480
11.l
Origins of Project Risk
483
11.2
Methods of Describing Project Risk
11.2.1 Sensitivity Analysis
11.2.2 Sensitivity Analysis for Mutually Exclusive Alternatives
11.2.3 Break-Even Analysis
11.2.4 Scenario Analysis
Probabilistic Cash Flow Analysis
11.3.1 Including Risk in Investment Evaluation
11.3.2 Aggregating Risk over lime
11.3.3 Estimating Risky Cash Flows
483
483
488
491
492
495
496
497
500
Considering the Project Risk by Discount Rate
11.4.1 Determining the Company Cost of Capital
11.4.2 Project Cost of Capital: Risk-Adjusted Discount Rate Approach
Summary
Self-Test Questions
Problems
504
504
509
511
512
514
11.3
11.4
PART 4 SPECIAL TOPICS IN ENGINEERING
ECONOMICS s29
Chapter 12
12.1
12.2
Replacement Decisions
530
Replacement-Analysis Fundamentals
12.1.l Basic Concepts and Terminology
12.1.2 Approaches for Comparing Defender and Challenger
Economic Service Life
532
533
535
539
CONTENTS
12.3
12.4
Replacement Analysis When the Required Service Period Is Long
12.3.1 Required Assumptions and Decision Frameworks
12.3.2 Handling Unequal Service Life Problems
in Replacement Analysis
12.3.3 Replacement Strategics under the Infinite Planning Horizon
Replacement Analysis with Tax Considerations
Summary
Self-Test Questions
Problems
Chapter 13
13.1
13.2
13.3
13.4
Understanding Financial Statements
545
545
546
546
552
559
560
561
574
Accounting: The Basis of Decision Making
Financial Status for Businesses
13.2.1 The Balance Sheet
13.2.2 The Income Statement
13.2.3 The Cash-Flow Statement
Using Ratios to Make Business Decisions
13.3.1 Debt Management Analysis
13.3.2 Liquidity Analysis
13.3.3 Asset Management Analysis
13.3.4 Profitability Analysis
13.3.5 Market-Value Analysis
13.3.6 Limitations of Financial Ratios in Business Decisions
13.3.7 Where We Get the Most Up-to-Date Financial Information
Principle of Investing in Financial Assets
13.4.1 Trade-Off between Risk and Reward
13.4.2 Broader Diversification Reduces Risk
13.4.3 Broader Diversification Increases Expected Return
Summary
Self-Test Questions
Problems
576
577
579
584
586
592
592
595
596
597
599
601
603
603
603
603
605
607
608
612
Appendix A
Answers to the Self-Test Questions
Appendix B
Interest Factors for Discrete Compounding
Appendix C
How to Read the Cumulative Standardized Normal
Distribution Function 679
Index
683
621
649
17
Understanding
Money and Its
Management
_CH
_ A_PT_E_R ONE ~~~~~~~~~-
Engineering Economic
Decisions
Facebook: From College Startup to Online Trailblazer In
February 2004 , college student Mark Zuckerberg launched Facebook,
a social networking site. With presently 800 million individual users,
what started as a networking site for Harvard students quickly grew
in scope and functionality and evolved into a must-have form of
communication for people and businesses around the world. It has
consistently out periormed its competitors and has fast become the
pre-eminent social networking site in country after country.
Through content sharing, recommendations and reviews, Facebook puts emphasis on on lin e personal and professional relationships, not on abscr-act data, database driven metrics, or the algorithm ic
use of search terms.With users able to "like" something within the
framework of Facebook itself. Facebook has propagated itself across
other websites. It is thus blazing new territory in terms of Internet
advertising. sales. and the notion of consumer privacy.
11 11 11
T his has the po tential to put Facebook in direct competition with
Google, with recommendations within the Facebook environment potent ially having more impact on personal choice than algorithm-based search
resu lts conventionally secured through Google.
Moreover, Facebook only continues to grow, in users and in valu e. Early
in 20 I I , t he value of Facebook was raised to nearly $50 billion owing to investm ents from Goldman Sac hs and an unnamed Russian investo r. And with
rumo rs circulating that the company w ill be going publi c in the nea r future,
th ere's no telling how that value may increase in the coming monthsposing a threat to t he impersonal search-based results Internet mogul
Google has to offer.
O f cour se, Google can't afford to sit idle and watch Facebook make
inroads into their key business model, i.e., making money from pay per
click on advertising banner s.To overcome its past miscues in the social
networking space, Google ca me up w ith its own social netwo rking site
named Google+ . In July 20 I I, Google+ launched and already had more than
60 million subscribers with in only a half year of inception. If this trend continues, some analysts expect to see nearly 400 million users by 20 13. W ho
know what will happen? A lthough, there are sti ll plenty of questions left
about th e fate and future of Google+ , Zuckerberg has to watch Google+
closely, w hich cou ld yet prove to be a sizable alter native to Facebook for the
techn ology and advertising industries alike.
he slory of how a college student was motivated to inven1 a social netwo rk and
eve nlua lly transform his invention into a multibillion-d. ollar business is not an
uncommon one in today's market. Companies like Google 1". DellM. Microsoft®.
:ind Yahoo!" produce compu ter-related products and have market va lues of
several billion dollars. ·1111.:se companies were all founded by highly motivated young colkgc students ju-.1 like t\ Ir. Zuckerberg. Also common among these successful businesses
b their capable and imaginative engineers who cons1an1ly generate sound ideas for capital im e!\tmcnt. e\ccutc them well. and obrain good results. You might wonder" hat role
these engineer~ play in making such business decisions: What spccilic task'> arc assigned
10 these engineer-.. and" hat tools and techniques arc available Lo them for making uch
capital-i11\c~tmcnt decisions'! In this book. we will consider many inve<,tn11.:nt sit uations.
personal as \\ell as business. ·nie focus will be 10 evaluate engineering projects based on
the merits of economic <.ksirability and the respective firm's in\'es1111cn1 climate.
T
21
22 CHAPTER I Engineering Economic Decisions
1111
The Rational D ecision-M aking Process
We, as individuals or busin ess-persons. consta ntly make decisions in our daily lives.
Most are made automatically witho ut rea lizing that we a re actua lly followin g some
sort of logical decision fl owchart. Rati o na l decision making is often a complex process
that includes a numbe r of essential c le me nts. This chapter will provide examples of
how two engineering stude nts approache d their financial and engineering design proble ms using fl exible, rational decisio n mak ing. By reviewing these examples, we will be
able to identify some essential e le me nts common to any rational decision-making process. The first example ill ustrates how a s tude nt na me d Jane narrowe d down he r cho ice
be tween two competing a lte rna tives wh e n leasing an automobile. The second exmnple
illustrates how a typica l class project idea evolves and how a student named Sonya a pproached the design proble m by foll owing a logical me thod of analysis.
1. 1.1 How Do We Make Typical Personal Decisions ?
For Jane Williams, a senio r a l the University of Arizona. the future ho lds a new car.
f-I e r 2002 Saturn has clocked a lmost 150.000 miles. a nd she wa nts to replace it soon.
But how to do ii- sho uld s he buy or lease? In e ither case. "Car payme nts would be
difficult." said the e ngineering major, who works as a part-rime cashie r a t a local s upe rmarket. ··1 have never leased before. but l am lea ning toward it this time to save o n
the down paym e nt. I also don't want 10 worry about major repairs." For Ja ne. leasing
would provide the warranty protection she wants, a long with a new car every three
years. On the othe r hand , s he would be li mite d to driving only a specified numbe r of
miJes, about 12,000 per year, afte r whic h she would have to pay 20 cents or mo re per
mile. Jane is we ll aware that choosing the rig ht vehicle and the best possible finan cing
are important decision. Ye l, al this po int , Jane is unsure of the implicatio ns of buying
vers us leasing.
Establishing the G oal or Object ive
Jane decided to research the local papers and the Inte rnet for the latest lease programs. including factory-subsidized ··sweetheart'' deals and special ince mi ve packages.
Of Lhe cars that were within her budget. the 20 I1 Ford Focus and the 201 1 Honda Civic
Coupe DX appeared to be equally attractive in te rms of style. price. a nd options. Jane
decided to visit the dea le rs · lo ts to sec how both mode ls looked and to lake th e m for
a test drive. Both cars gave he r very sa tisfacto ry driving experiences. Ja ne thought tha t
it would be prude nt to tho ro ug hly examine the many technical and safety fea tures o f
both vehjcles. Afte r he r exa mination, it seemed that both models we re virtua lly ide ntical in te rms of re liabilily. sa fe ly features. a nd quality.
Evaluation of Feasible A lternatives
Jane estimated that he r 2002 Saturn could be traded in for around $2,200. This amount
would be just e nough lo make any down payment required for leasing the new a ut omobile. Th rough he r research, Jane learned that the re are two types of leases: openend and closed-e nd. The most popular by fa r was closed-end because ope n-end leases
potentially expose the consumer 10 highe r payme nts at the e nd of the lease if th e car
I. I The Rational Decision-Making Process 23
depreciates faster than expected. If Jane were to take a closed-end lease, she could
just return the vehicle at the end of the lease and "walk away" to lease or buy another
vehicle; however, she would still have to pay for extra mileage or excess wear or damage. She thought that since she would not be a "pedal-to-the-metal driver," closed-end
charges would not be a problem for her.
To get the best financial deal, Jane obtained some financial facts from both dealers
on their best offers. With each offer, she added up all the costs of leasing from the down
payment to the disposition fee due at the end of the lease. This sum would determine
the total cost of leasing that vehicle, not counting routine items such as oil changes and
other maintenance. (See Table 1.1 for a comparison of the costs of both offers.)
It appeared that by leasing the Ford Focus, Jane could save about $1,010 in total
payments [(47 x $60 monthly lease payment savings less $1,810 total due at signing
(including the first month's payment savings)] over the Honda Civic. But, she has to
pay $250 on the disposition fee (which leasing the Honda did not require), for a total
savings of $760. 2 However, if she were to drive any additional miles over the limit,
TABLE I. I
Financial Data for Auto Leasing: Focus versus Honda
$16,640
$16,155
48
48
48,000
48,000
4. Monthly lease payment
$215
$275
-$60
5. Mileage surcharge over
$0.20
$0.15
+ $0.05
$250
$0
+$250
$215
$275
-$60
$1,500
$0
+$1,500
• Administrative fee
$495
$0
+$495
• Refundable security deposit
$200
$325
-$125
Total
$2,410
$600
+ $1,810
L Manufacturer's suggested
retail price (MSRP)
2. Lease length (months)
3. Allowed mileage (miles)
+$485
48,000 miles
6. Disposition fee at lease end
7. Total due at signing:
• First month's lease payment
• Down payment
•Models compared: The 2011 Focus and the 2011 Honda Civic Coupe DX. both with automatic
transmission and A/C.
• Disposition fee: This is a paperwork charge for getting the vehicle ready for resale after the
lease ends.
2 If Jane
considered the time value of money in her comparison, the amount of actual savings would be
less than $760, which we demonstrate in Chapter 2.
24
CHAPTER I Engineering Economic Decisions
her savings would be reduced by 5 cents (the difference between the two cars' mileage
surcharges) for each additional mile. Jane would need to drive about 15.200 extra miles
over the limit in order to lose all the savings. Because she could not anticipate her exact
driving needs after graduation and it was difficult to come up with $2,410 due at lease
signing, she decided to lease the Honda Civic DX. Certainly, any monetary savings would
be important, but she preferred having some flexibility in her future driving needs.
Knowing Other Opportunities
If Jane had been interested in buying the car, it would have been even more challenging to determine precisely whether she would be better off buying than leasing.
To make a comparison of leasing versus buying, Jane could have considered what she
likely would pay for the same vehicle under both scenarios. If she would own the car
for as long as she would lease it, she could sell the car and use the proceeds to pay off
any outstanding loan. If finances were her only consideration, her choice would depend
on the specifics of the deal. But beyond finances, she would need to consider the positives and negatives of her personal preferences. By leasing, she would never experience
the joy of the final payment-but she would have a new car every three years.
Review of Jane's Decision-Making Process
Now let us revisit the decision-making process in a more structured way. The analysis
can be thought of as including the six steps summarized in Figure 1.1.
These six steps are known as the rational decision-making process. Certainly, we
do not follow all six steps in every decision problem. Some decision problems may not
require much time and effort. Quite often, we base our decisions solely on emotional
reasons. However, for any complex economic decision problem, a structured framework proves to be worthwhile.
Step2
----~-/
•Recognize
a decision
problem
•Need a car
Figure I. I
•Define the
goals and
objectives
•Want
mechanical
security and
lower cost
•Collect all
the relevant
information
•Gather
technical
and financial
data
•Identify a
set of
feasible
decision
alternatives
•Choose
between
Focus and
Honda
•Select the
decision
criterion to
use
•Want
minimum
total cash
outlay and
driving
nexibility
•Select the
best
alternative
•Select
Honda
Logical steps to follow in a car-leasing decision
