Fundamentals of Engineering Economics

PART 1 UNDERSTANDING MONEY AND ITS MANAGEMENT 1
Chapter 1 Engineering Economic Decisions 2
1.1 The Rational Decision-Making Process 4
1.1.1 How Do We Make Typical Personal Decisions? 4
1.1.2 How Do We Approach an Engineering Design Problem? 7
1.1.3 What Makes Economic Decisions Different from Other Design Decisions? 9
1.2 The Engineer's Role in Business 10
1.2.1 Making Capital-Expenditure Decisions 10
1.2.2 Large-Scale Engineering Economic Decisions 10
1.2.3 Impact of Engineering Projects on Financial Statements 12
1.3 Types of Strategic Engineering Economic Decisions 13
1.3.1 New Products or Product Expansion 14
1.3.2 Equipment and Process Selection 14
1.3.3 Cost Reduction 15
1.3.4 Equipment Replacement 16
1.3.5 Service or Quality Improvement 16
1.4 Fundamental Principles in Engineering Economics 17
Summary 18
Self-Test Questions 19
Problems 19

Chapter 2 Time Value of Money 20
2.1 Interest: The Cost of Money 22
2.1.1 The Time Value of Money 22
2.1.2 Elements of Transactions Involving Interest 24
2.1.3 Methods of Calculating Interest 26
2.2 Economic Equivalence 28
2.2.1 Definition and Simple Calculations 29
2.2.2 Equivalence Calculations Require a Common Time Basis for Comparison 32
2.3 Interest Formulas for Single Cash Flows 33
2.3.1 Compound-Amount Factor 33
2.3.2 Present-Worth Factor 35
2.3.3 Solving for Time and Interest Rates 38
2.4 Uneven-Payment Series 40
2.5 Equal-Payment Series 42
2.5.1 Compound-Amount Factor: Find F , Given A , i , and N 42
2.5.2 Sinking-Fund Factor: Find A , Given F , i , and N 46
2.5.3 Capital-Recovery Factor (Annuity Factor):
Find A , Given P , i and N 48
2.5.4 Present-Worth Factor: Find P , Given A , i , and N 51
2.5.5 Present Value of Perpetuities 56
2.6 Dealing with Gradient Series 58
2.6.1 Handling Linear Gradient Series 58
2.6.2 Handling Geometric Gradient Series 64
2.7 More on Equivalence Calculations 68
Summary 74
Self-Test Questions 75
Problems 79

Chapter 3 Understanding Money Management 94
3.1 Market Interest Rates 96
3.1.1 Nominal Interest Rates 96
3.1.2 Annual Effective Yields 97
3.2 Calculating Effective Interest Rates Based on Payment Periods 100
3.2.1 Discrete Compounding 100
3.2.2 Continuous Compounding 101
3.3 Equivalence Calculations with Effective Interest Rates 103
3.3.1 Compounding Period Equal to Payment Period 103
3.3.2 Compounding Occurs at a Different Rate than That at Which Payments are Made 106
3.4 Debt Management 110
3.4.1 Borrowing with Credit Cards 110
3.4.2 Commercial Loans-Calculating Principal and Interest Payments 113
3.4.3 Comparing Different Financing Options 116
Summary 121
Self-Test Questions 123
Problems 126

Chapter 4 Equivalence Calculations under Inflation 140
4.1 Measure of Inflation 141
4.1.1 Consumer Price Index 142
4.1.2 Producer Price Index 143
4.1.3 Average Inflation Rate 145
4.1.4 General Inflation Rate ( f ) versus Specific Inflation ( f j ) 146
4.2 Actual versus Constant Dollars 148
4.2.1 Conversion from Constant to Actual Dollars 149
4.2.2 Conversion from Actual to Constant Dollars 150
4.3 Equivalence Calculations under Inflation 154
4.3.1 Market and Inflation-Free Interest Rates 155
4.3.2 Constant-Dollar Analysis 155
4.3.3 Actual-Dollar Analysis 156
4.3.4 Mixed-Dollar Analysis 160
Summary 163
Self-Test Questions 164
Problems 166

PART 2 EVALUATING BUSINESS AND ENGINEERING ASSETS 173
Chapter 5 Present-Worth Analysis 174
5.1 Loan versus Project Cash Flows 176
5.2 Initial Project Screening Methods 177
5.2.1 Benefits and Flaws of Payback Screening 179
5.2.2 Discounted-Payback Period 180
5.3 Present-Worth Analysis 182
5.3.1 Net-Present-Worth Criterion 182
5.3.2 Guidelines for Selecting a MARR 187
5.3.3 Meaning of Net Present Worth 188
5.3.4 Net Future Worth and Project Balance Diagram 192
5.3.5 Capitalized-Equivalent Method 193
5.4 Methods to Compare Mutually Exclusive Alternatives 195
5.4.1 Doing Nothing Is a Decision Option 196
5.4.2 Service Projects versus Revenue Projects 196
5.4.3 Analysis Period Equals Project Lives 197
5.4.4 Analysis Period Differs from Project Lives 201
Summary 207
Self-Test Questions 207
Problems 210

Chapter 6 Annual-Equivalence Analysis 230
6.1 Annual-Equivalent Worth Criterion 232
6.1.1 Benefits of AE Analysis 236
6.1.2 Capital (Ownership) Costs versus Operating Costs 236
6.2 Applying Annual-Worth Analysis 241
6.2.1 Unit-Profit or Unit-Cost Calculation 241
6.2.2 Make-or-Buy Decision 245
6.3 Comparing Mutually Exclusive Projects 248
6.3.1 Analysis Period Equals Project Lives 248
6.3.2 Analysis Period Differs from Project Lives 253
Summary 256
Self-Test Questions 256
Problems 259

Chapter 7 Rate-of-Return Analysis 276
7.1 Rate of Return 278
7.1.1 Return on Investment 278
7.1.2 Return on Invested Capital 279
7.2 Methods for Finding Rate of Return 280
7.2.1 Simple versus Nonsimple Investments 280
7.2.2 Computational Methods 282
7.3 Internal-Rate-of-Return Criterion 289
7.3.1 Relationship to the PW Analysis 289
7.3.2 Decision Rule for Simple Investments 289
7.3.3 Decision Rule for Nonsimple Investments 293
7.4 Incremental Analysis for Comparing Mutually Exclusive Alternatives 295
7.4.1 Flaws in Project Ranking by IRR 295
7.4.2 Incremental-Investment Analysis 296
7.4.3 Handling Unequal Service Lives 302
Summary 304
Self-Test Questions 304
Problems 308
Chapter 7A Resolution of Multiple Rates of Return 324
7A-1 Net-Investment Test 324
7A-2 The Need for an External Interest Rate 326
7A-3 Calculation of Return on Invested Capital for Mixed Investments 327

Chapter 8 Benefit-Cost Analysis 332
8.1 Evaluation of Public Projects 334
8.1.1 Valuation of Benefits and Costs 335
8.1.2 Users' Benefits 335
8.1.3 Sponsor's Costs 335
8.1.4 Social Discount Rate 336
8.2 Benefit-Cost Analysis 337
8.2.1 Definition of Benefit-Cost Ratio 337
8.2.2 Incremental B/C-Ratio Analysis 340
8.3 Profitability Index 344
8.3.1 Definition of Profitability Index 344
8.3.2 Incremental PI Ratio for Mutually Exclusive Alternatives 346
8.4 Highway Benefit-Cost Analysis 348
8.4.1 Define the Base Case and the Proposed Alternatives 348
8.4.2 Highway User Benefits 349
8.4.3 Sponsors' Costs 349
8.4.4 Illustrating Case Example 350
Summary 354
Self-Test Questions 354
Problems 357

PART 3 DEVELOPMENT OF PROJECT CASH FLOWS 365
Chapter 9 Accounting for Depreciation and Income Taxes 366
9.1 Accounting Depreciation 368
9.1.1 Depreciable Property 368
9.1.2 Cost as Basis 369
9.1.3 Useful Life and Salvage Value 370
9.1.4 Depreciation Methods: Book and Tax Depreciation 370
9.2 Book Depreciation Methods 372
9.2.1 Straight-Line Method 372
9.2.2 Declining-Balance Method 374
9.2.3 Units-of-Production Method 378
9.3 Tax Depreciation Methods 379
9.3.1 MACRS Recovery Periods 379
9.3.2 MACRS Depreciation: Personal Property 380
9.3.3 MACRS Depreciation: Real Property 383
9.4 Corporate Taxes 385
9.4.1 How to Determine "Accounting Profit" 385
9.4.2 U.S. Corporate Income Tax Rates 387
9.4.3 Gain Taxes on Asset Disposals 389
Summary 393
Self-Test Questions 394
Problems 396

Chapter 10 Project Cash-Flow Analysis 408
10.1 Understanding Project Cost Elements 410
10.1.1 Classifying Costs for Manufacturing Environments 410
10.1.2 Classifying Costs for Financial Statements 412
10.1.3 Classifying Costs for Predicting Cost Behavior 413
10.2 Why Do We Need to Use Cash Flows in Economic Analysis? 417
10.3 Income-Tax Rate to Be Used in Project Evaluation 418
10.4 Incremental Cash Flows from Undertaking a Project 421
10.4.1 Operating Activities 421
10.4.2 Investing Activities 424
10.4.3 Financing Activities 425
10.5 Developing Project Cash Flow Statements 425
10.5.1 When Projects Require Only Operating and Investing Activities 425
10.5.2 When Projects Are Financed with Borrowed Funds 428
10.6 Effects of Inflation on Project Cash Flows 431
10.6.1 Depreciation Allowance under Inflation 431
10.6.2 Handling Multiple Inflation Rates 435
Summary 437
Self-Test Questions 438
Problems 441

Chapter 11 Handling Project Uncertainty 462
11.1 Origins of Project Risk 465
11.2 Methods of Describing Project Risk 465
11.2.1 Sensitivity Analysis 465
11.2.2 Sensitivity Analysis for Mutually Exclusive Alternatives 470
11.2.3 Break-Even Analysis 473
11.2.4 Scenario Analysis 474
11.3 Probabilistic Cash Flow Analysis 477
11.3.1 Including Risk in Investment Evaluation 478
11.3.2 Aggregating Risk over Time 479
11.3.3 Estimating Risky Cash Flows 481
11.4 Considering the Project Risk by Discount Rate 486
11.4.1 Determining the Company Cost of Capital 486
11.4.2 Project Cost of Capital: Risk-Adjusted Discount Rate Approach 491
Summary 493
Self-Test Questions 494
Problems 496

PART 4 SPECIAL TOPICS IN ENGINEERING ECONOMIC 511
Chapter 12 Replacement Decisions 512
12.1 Replacement-Analysis Fundamentals 514
12.1.1 Basic Concepts and Terminology 515
12.1.2 Approaches for Comparing Defender and Challenger 517
12.2 Economic Service Life 521
12.3 Replacement Analysis when the Required Service Period is Long 527
12.3.1 Required Assumptions and Decision Frameworks 527
12.3.2 Handling Unequal Service Life Problems in Replacement Analysis 528
12.3.3 Replacement Strategies under the Infinite Planning Horizon 528
12.4 Replacement Analysis with Tax Considerations 534
Summary 541
Self-Test Questions 542
Problems 543

Chapter 13 Understanding Financial Statements 556
13.1 Accounting: The Basis of Decision Making 558
13.2 Financial Status for Businesses 559
13.2.1 The Balance Sheet 561
13.2.2 The Income Statement 566
13.2.3 The Cash-Flow Statement 568
13.3 Using Ratios to Make Business Decisions 574
13.3.1 Debt Management Analysis 574
13.3.2 Liquidity Analysis 577
13.3.3 Asset Management Analysis 578
13.3.4 Profitability Analysis 579
13.3.5 Market-Value 581
13.3.6 Limitations of Financial Ratios in Business Decisions 583
13.3.7 Where We Get the Most Up-to-Date Financial Information 585
13.4 Principle of Investing in Financial Assets 585
13.4.1 Trade-Off between Risk and Reward 585
13.4.2 Broader Diversification Reduces Risk 585
13.4.3 Broader Diversification Increases Expected Return 587
Summary 589
Self-Test Questions 590
Problems 594

Appendix A Self-Test Questions with Answers 603
Appendix B Interest Factors for Discrete Compounding 631
Appendix C How to Read the Cumulative Standardized Normal
Distribution Function 661
Index 664