Lecture 1 Ekotek 2006
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Transcript of 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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Why Engineering Economy is ImportantWhy Engineering Economy is Important
to Engineers (and other professionals)to Engineers (and other professionals)
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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Why Engineering Economy is ImportantWhy Engineering Economy is Important
to Engineers (and other professionals)to Engineers (and other professionals)
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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Role of Engineering Economy inRole of Engineering Economy in
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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Role of Engineering Economy inRole of Engineering Economy in
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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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 alternative
6. Implement and monitor
Major Role ofEngineeringEconomy
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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 alternative
6. Implement and monitor
One of the moredifficult tasks
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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 alternative
6. Implement and monitor Where the majortools of Engr.Economy are
applied
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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 alternative
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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AlternativesAlternatives
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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AlternativesAlternatives
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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Terminology and SymbolsTerminology and Symbols
F = value or amount of money at somefuture time.
Also, F is called future worth (FW) andfuture value (FV); dollars
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Terminology and SymbolsTerminology and Symbols
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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Terminology and SymbolsTerminology and Symbols
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