System Engineering

1
System Engineering Economy Analysis
Lecturer Maha Muhaisen

• College of Applied Engineering Urban Planning

2
System Engineering Economy Analysis
Lecturer Maha Muhaisen

• College of Applied Engineering Urban Planning

3
Course outline

• Introduction to making economic decision
• Interest and equivalence
• Present worth analysis
• Cash flow analysis
• Rate of return
• Deprecation
• Cost benefit analysis
• Risk, and uncertainly
• Sensitivity analysis

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Grading

• Research Projects homework 30
• Midterm Exam. 30
• Final Exam. 40

5
Resources

• Engineering Economic analysis, by Donald G.
  Newnan. , Ted G. Eschenbach, J.P. Lavelle.
• Civil and Environmental Systems Engineering,
  Charles S. Revelle, Earl Whitlatch , Jeff Wright
• Class Notes and Handouts
• Course material will be made available through
  the web site

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Introduction
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Engineering

• Engineers provide answers.
• Ability to solve problems or take advantage of
  opportunities through the application of science.
• Must meet certain criteria.
• Technical feasibility/efficiency meet or exceed
  specifications.
• Economic feasibility/efficiency meet budgets and
  return.

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Engineering Economy

• Every technical solution has financial
  consequences.
• Engineering economic analysis determines whether
  a proposed solution is financially viable.
• Will it pay?
• Is this the minimum cost solution?
• Will it generate an acceptable return?

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Engineering Economic Decisions

• Profit Enhancing Programs projects designed to
  generate revenues.
• New product development
• New product acquisition
• Product/service capacity expansion
• Improved customer service

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Engineering Economic Decisions

• Cost Control Programs projects designed to
  generate savings.
• Improving efficiency
• Streamlining operations
• Eliminating waste
• Reducing liabilities

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Engineering Economic Decisions

• Public Improvement Programs government entities
  also make capital expenditures.
• Increased public satisfaction
• Increased public safety
• Improved infrastructure

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Investment Categories

• Expansion
• Products, services, capacity can expand
• Often requires choice of technology
• Replacement
• Technology selection
• Outsourcing versus in-house choice
• Abandonment
• Eliminating products, services, or capacity

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Investment Decisions

• Invest
• Releases funds to start a project
• Do Not Invest
• Eliminates the project from further consideration
• Wait (Delay)
• Time to gather information about the future can
  aid in decision-making

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Making an Economic Decision

• Problem or opportunity recognition and definition
• Generation of Solution Alternatives
• Development of Feasible Solution Alternative Cash
  Flows and Information Gathering
• Evaluation of Solution Alternatives
• Selection and Implementation of Best Alternative
• Post-implementation Analysis and Evaluation

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The Role of engineering Economic analysis

• Engineering economic analysis is most suitable
  for intermediate problems and economic aspects of
  complex problem, they have those qualities
• 1) the problem is important enough to justify
  our giving it serious thought and effort.
• 2) careful analysis requires that we recognize
  the problem and all various consequences, and
  this is just too much to be done all at once.
• 3) the problem has economic aspects important in
  reaching a decision.

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Engineering Design Decisions

• Problem or opportunity recognition and definition
• Generation of Solution Alternatives
• Assess the Feasibility of Each Approach.
• 4 Selection of Best Alternative According to
  Technical and Economic Constraints
• 5 Detailed Design, Testing, and Analysis. If
  Successful, Implement, Else, Goto 2.
• Post-implementation Analysis and Evaluation

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Decisions in Design

• The design process is generally embedded in the
  second step of the decision-making process.
• Designs Solution Alternatives
• Design decisions are generally discipline
  specific.
• But the economics surrounding design decisions
  are for all engineers.

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Engineering Economic Decision Analysis Importance

• Companies must invest to grow.
• Companies must invest to improve.
• Investments cost (lots of) money!
• Economic Analysis considers the economic
  viability of each and every investment project
  such that money is made, not lost.

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Engineering Economic Decision Analysis Difficulty

• Investments carry risk.
• Money spent now for expected savings or returns
  in the future.
• As future is uncertain, so are returns or
  savings.
• Money spent can be lost. If too often, could
  lead to bankruptcy.
• While economics are paramount, many other factors
  influence decision.

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Why YOU, the Engineer?

• Those who generate solutions are most intimate
  with the details and best suited to analyze them
  financially.
• To be heard, engineers must be able to speak
  financially
• It is generally assumed that the engineering
  solution will work -- must justify financially.
• Understanding the financials will help you move
  up the corporate ladder.
• This analysis provides the link to other
  departments, such as accounting and finance.

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In this course, you will learn

• The fundamentals of engineering economy (time
  value of money, interest, economic equivalence)
• To perform the economic decision making process
• To financially evaluate engineering projects
  under certainty, risk, uncertainty, and multiple
  options
• Numerous methods in which to determine the best
  choice from a feasible set with multi-attributes
• To solve a variety of problems dealing with
  capital investments

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• Engineering economic analysis is used to answer
  many different questions
• Which engineering projects are worthwhile ?
• Which engineering project should give higher
  priority?
• How should the engineering project be design?
• Engineering economic analysis can also used to
  answer questions that are personally important
• How to achieve long-term financial goal.
• How to compare different ways to finance
  purchases.
• How to make short and long term investment
  decision.

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Decision making process

• Decision making process, include
• - Rational Decision making
• - Decision making for current cost
• - Examples

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Decision making process

• It is the choosing from alternatives, but is this
  enough for definition?

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Rational Decision Making

• Rational decision making is a complex process
  that contain nine essential elements.
• Although those nine steps are shown sequentially
  it is common for decision making to repeat the
  steps.
• All those steps is required and shown in a
  logical order.

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1- Recognize the problem

• Recognition of the problem is obvious and
  immediate
• Many firms establish programs for total quality
  management (TQM) or continuous improvement that
  are designed to identify the problems, so that
  they can be solved.

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2- Define the Goal or objective

• The goal can be a grand, overall goal of a person
  or a firm.
• The presence of multiple goal is often foundation
  of complex problem.
• But the objective need not to be a grand but the
  overall objective may be specific and narrow. I
  want to pay a load by may
• So defining the objective is the act of exactly
  describing the task and goal

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3- Assemble of relevant data

• Good decision good
  information
• Some data are available immediately at little or
  no cost, but still other require survey, or
  consulting with specific knowledgeable people
• Time horizon is part of data as how long
  equipment, building will last?
• Accounting system is of important source of data
• Financial and cost accounting are designed to
  show accounting values and the flow of money
  (cost benefit)
• What are the cost that related to specific
  operation , those indirect (overhead) cost, that
  usually allocated to operations, those may be
  satisfactory for cost accounting purposes, but
  may be unreliable for economic analysis.
• To understand the meaningful analysis see the
  following example

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Example

• The cost accounting records of a large company
  show the avg. monthly costs for the three persons
  printing dep. The wages of the three dep. members
  and benefits such as vacation, sick leave, make
  up the first category of the direct labor. The
  companys indirect or overhead costs such heat
  , electricity, etc must be distributed to its
  various departments in some manner , this one
  uses floor space as basis for its allocations
• Direct labor cost 6000
• Material and supplies consumed 7000
• Allocated overhead costs
• 200m2 of the floor area at 25/m2
  5000
• The total 18000
• The printing dep. charges other dep. for its
  services to cover 18,000 monthly cost. For
  example , the charge to run 1000 copies of an
  announcement is
• Direct labor 7.6
• Material and supplies 9.8
• Over head 9.05
• Cost to other dep.s 26.45

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Cont.

• The shipping dep. checks with a commercial
  printer which would print 1000 copies for 22.95
  although the shipping dep. needs only about
  30,000 copies printed a month, its Forman
  decision to stop printing dep. and have work done
  by outside printer. The manger has asked to study
  situation and recommend what should be done.
• Solution

Printing dep. Printing dep. Outside Printer Outside Printer
1000 copies 30,000 copies 1000 copies 30,000 copies
Direct cost 7.6 228.00
Material and supplies 9.8 294.00 22.95 688.5
overhead 9.05 271.5
Total 26.45 793.5 22.95 688.5
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Cont.

• The firm will save 294 in material and may or
  may not save 228 in direct labor if printing
  dep. no longer does the shipping dep. work.
• The max. saving will be 294 228 522
• But if the shipping dep. Is permitted to obtain
  its printing from outside, the firm will be
  688.5 a month.
• The saving from not doing the shipping dep. work
  in printing de. Would not exceed 522 and it is
  probably would be 294
• The result would be a net increase in cost to
  firm. For this reason it is not encouraged to
  print outside.
• Data cost gathering present other difficulty.
  One way to look at financial consequences ,
  cost-benefit, of various alternative
• Market consequences raw material, machinery
  cost, ..etc.
• Extra market consequences (shadow prices) as
  cost of employee injury,ect.
• Intangible consequences numerical analysis
  probably never fully describe the difference
  between alternative.
• As how does one evaluate the potential loss of
  workers job due to automation ?

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4. Identify feasible alternative

• There is no way to ensure the best alternative is
  listed among the alternatives considered.
• Sometime a group of people considering
  alternative in an innovative atmosphere (
  brainstorming) can be helpful
• Any good listing of alternative will produce
  both practical and impractical solutions.
• Only feasible alternative are retained for
  further analysis.

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5. Select the criterion to determine the best
alternative

• To choose the best alternative , we must define
  what we mean by best.
• Criterion or set of criteria must be judged.
• Worst Bad Fair Good Better Best
• Several possible criteria are
• create the least disturbance to the environment
• Improve the distribution of the wealth among
  people.
• Minimize the expenditure
• Ensure that benefit greater that losses
• Minimize the time to achieve the goal
• Minimize unemployment
• Maximize profit
• Maximize profit is normally selected in
  engineering decision . When it is used all
  problems fall into one of the three categories
• fixed output , fixed input, or neither input
  nor output.

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Cont.

• Fixed input the amount of money or other input
  resources (like labor, material, or equipment) .
  The objective is no effectively utilize them.
• Example
• A project engineer has a budget of 350,000 to
  renovate a portion of petroleum refinery.
• For ecom\nomic efficiency, the appropriate
  criterion is to maximize benefits or outputs.
• Fixed output there is a fixed task (or other
  output objectives / results) to be accomplished
• Example
• Civil engineer firm has been given a job of
  surveying land and preparing a record of survey
  map.
• purchasing a car without any optional equipment.

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Cont.

• Neither input nor output fixed It is the
  general situation, whereas the amount of money or
  inputs is not fixed, nor is the amount of
  benefits or other output.
• Example
• A consulting eng. Firms has a lot of work, and
  paying for the staff for evening works to
  increase the amount of design work.
• In this category, maximize the benefit is the
  criterion, since the difference between input and
  output is simply the profit.

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Cont.
Category Economic Criterion
Fixed input Maximize benefit or other outputs
Fixed output Minimize the costs or other inputs
Neither input nor output Maximize (benefits or, other output minus costs or other input) or stated another way, maximize profit.
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6. Constructing the model

• Putting various elements together (objective,
  relevant data, feasible alternatives, and
  selection criteria)
• Relationship between the elements called model
  building or constructing model.
• To an engineer, the model is a mathematical
  equations.

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7. Predicting the outcomes for each alternative.

• Each alternative might produce a variety of
  outcomes. Studying each alternative and outcomes
  for everyone.

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8. Choose the best alternative

• The selection of the feasible alternative may be
  key item, with the rest of the analysis a
  methodical process leading to predictable
  decision.

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9. Audit the results

• It the comparison of what happened against
  predication.
• Do the results of decision agree with its
  predications?
• The audit help ensure that projected operating
  advantages are ultimately obtained.
• On other hand, the economic decision may be
  unjustifiably optimistic.

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Example

• A concrete aggregate mix is required to contain
  at least 31 sand by volume for proper batching.
  One source of material, which has 25 sand and
  75 coarse aggregate, sells for 3 per cubic
  meter (m3). Another source, which has 40 sand
  and 60 coarse aggregate, sells for 4.40/m3.
• Determine the least cost per cubic meter of
  blended aggregates.
• Solution
• The least cost of blended aggregates will result
  from maximum use of the lower-cost material. The
  higher-cost material will be used to increase the
  proportion of sand up to the minimum level (3 1)
  specified.
• Let x Portion of blended aggregates from
  3.00/m3 source
• 1 - x Portion of blended aggregates from
  4.40hi3 source
• Sand Balance
• X(0.25) (1 -x)(0.40) 0.31
• 0.25x 0.4-0.4x 0.31
• 0.31 0.4 -0.09 0.6
• 0.25 - .04 -0.15
• Thus the blended aggregates will contain 60
  of 3.0m3 material, 40 of 4.40/m3 material
• The least cost per cubic meter of blended
  aggregates is
• 0.6(3.00) 0.4(4.4) 1.81.76 3.56 / m3

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Summary

• Classifying to solve. Others problems
• Many problems are simple and thus easy to solve,
  others are of intermediate difficulty and need
  considerable thought / calculation to properly
  evaluate. There intermediate problems tends to
  have a substantial economic component, hence, are
  good candidates for economic analysis. Complex
  problems, on other hand, often contain people
  elements along with political and economic
  components.
• Economic analysis is still very important but the
  best alternative must be selected considering all
  criteria not just the economic.

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Cont.

• The Rational decision making process
• Rational Decision Making Process uses a logical
  method to select the best alternative from among
  the feasible alternatives. The following nine
  steps can be followed sequentially, but decision
  makers often repeat some steps undertake some
  simultaneously, and skip others altogether.
• 1- recognize the problem
• 2- define goal or objective. What is the task?
• 3- assemble relevant data What are the facts?
  Are more data needed, and is it worth more than
  the cost to obtain it ?4- Define feasible
  alternative.
• 5- Select the criterion for choosing the best
  alternative, possible criteria include political,
  economic, environmental, and humanitarian. The
  single criterion may be a composite or several
  criteria.

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Cont.

• 6 - Mathematically model the various
  interrelations.
• 7- Predict the outcomes for each alternative.
• 8- choose best alternative.
• 9- audit the alternative.
• Engineering DM refers to solving substantial
  engineering problems in which economic aspects
  dominate and economic efficiency is the criteria
  for choosing from among possible alternatives. It
  is particular case of general decision making
  process, some of unusual aspects of engineering
  decision making are as follows
• 1- cost accounting systems, while an important
  source of cost data, contain allocations of
  indirect costs that may be incorporate for use in
  economic analysis.
• 2- the various consequences costs benefits-
  of an alternative may be of three types
• Market consequences there are established
  market prices.
• Extra market consequences there are no direct
  market process, but prices can be assigned by
  indirect costs.
• Intangiable consequences valued by judgment ,
  not by monetary prices.

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Cont.

• 3- the economic criteria for judging alternatives
  can be reduced to three cases
• For fixed input maximize the benefits or other
  outputs.
• For fixed output minimize the costs or other
  outputs.
• When neither input or output is fixed, maximize
  the differences between benefits, and costs or
  more simply stated, maximize profit.
• The third case states the general rule from which
  both first and second cases may derived.
• 4- to choose among the alternatives, the market
  consequences and extra market consequences are
  organized into a cash flow diagram, we will see
  in the next chapter, that engineering economic
  calculation can be used to compare differing cash
  flows.. These outcomes are compared against the
  selection criteria. From this comparison plus the
  consequences not included in Monterey analysis,
  the best alternative is selected.
• 5- an essential part of engineering decision
  making is post audit of results. This step helps
  to ensure that projected benefits are obtained
  and to encourage realistic estimates in analysis.

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Principles of Engineering Economy
48
Cash Flows
49
Cash flow

• Cash flow diagram (CFD) summarized the cost and
  benefit of the project occur over time.
• CFD is created by first drawing a segmented time
  based horizontal line, divided onto appropriate
  time units.
• At each time at which cash flow will occur a
  vertical arrow is added. Pointing down for cost ,
  pointing up for revenues or benefit.

50
Key Concepts

• Cash Flow Diagram the financial description
  (visual) of a project
• Time Value of Money the value of money changes
  with time
• Money provides utility (value) when spent
• Value of money grows if invested
• Value of money decreases due to inflation
• Interest used to move money through time for
  comparisons

51
Cash Flow

• Movement of money in (out) of a project
• Inflows revenues or receipts
• Outflows expenses or disbursements
• Net Cash Flow receipts - disbursements

52
Cash Flows

• Discrete Movement of cash to or from a project
  at a specific point in time.
• Continuous Rate of cash moving from or to a
  project over some period of time.

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Cash Flow Diagram

• Financial representation of a project.
• Describes type, magnitude and timing of cash
  flows over some horizon.

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Cash Flow Diagram

• Describes type, magnitude and timing of cash
  flows over some horizon

0
1
2
3
4
5
Time Periods over the Horizon
55
Cash Flow Diagram

• Describes type, magnitude and timing of cash
  flows over some horizon

0
1
2
3
4
5
50
100
500
Discrete Cash Outflow (Disbursement,
Expense) Note the direction of the arrow!
56
Cash Flow Diagram

• Describes type, magnitude and timing of cash
  flows over some horizon

500
200
200
200
0
1
2
3
4
5
Discrete Cash Inflow (Revenue)
57
Cash Flow Diagram

• Describes type, magnitude and timing of cash
  flows over some horizon

500
200
200
200
0
1
2
3
4
5
50
100
500
58
Cash Flow Diagram

• Net cash flows add expenses and disbursements at
  same point in time.

500K
200K
200K
200K
0
1
2
3
4
5
50K
100K
Can write as net cash flow
500K
59
Cash Flow Diagram

• Net cash flows add expenses and disbursements at
  same point in time.

500
200
200
100
0
1
2
3
4
5
50
500
60
Cash Flow Diagram

• Continuous cash flows define a rate of movement
  of cash over time.

500
200
200
0
1
2
3
4
5
Continuous Cash Inflow (Revenue) 200 Rate of
Flow per unit time
500
61
Cash Flow Diagram

• Continuous cash flows define a rate of movement
  of cash over time.
• While good for analysis, not used often.

500
200
200
0
1
2
3
4
5
Continuous Cash Inflow (Revenue) 200 Rate of
Flow per unit time
500
62
Cash Flow Diagram

• Can describe any investment opportunity.
• Typical investment

63
Cash Flow Diagram

• Can describe any investment opportunity.
• Typical investment

0
P
Make an initial investment (purchase)
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Cash Flow Diagram

• Can describe any investment opportunity.
• Typical investment

0
1
2
N
3
P
Receive revenues over time.
65
Cash Flow Diagram

• Can describe any investment opportunity.
• Typical investment

0
1
2
N
3
P
Pay expenses over time.
66
Cash Flow Diagram

• Can describe any investment opportunity.
• Typical investment

Receive salvage value at time N.
F
0
1
2
N
3
P
67
Cash Flow Diagram

• Can describe any investment opportunity.
• Typical investment

AN
A3
A2
0
1
2
N
3
A1
P
Write as a NET cash flow in each period.
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Example (Nothing to Sneeze At!)

• Tissue paper company Svenska Cellulosa announced
  an investment of 490 million for a new tissue
  machine at its Valls, Spain plant to expand
  capacity by 60,000 tons/year. Most product is
  for retail private labels.
• Assume Investment in 2006 with operations
  beginning in 2007. The machine has a service
  life of 10 years and a salvage value of 25M.
  Fixed OM costs are 10 million in year 1,
  increase 8 per year. Revenues are 6,400/ton
  against costs of 4,600/ton.
• Draw the cash flow diagram.

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Cash Flow Diagram

• Timeline

0
1
2
10
3
70
Cash Flow Diagram

• Individual cash flows Investment Cost

0
1
2
10
3
490M
71
Cash Flow Diagram

• Individual cash flows Per Unit Revenues

384M
384M
384M
384M
0
1
2
10
3
490M
72
Cash Flow Diagram

• Individual cash flows Per Unit Costs

384M
384M
384M
384M
0
1
2
10
3
276M
276M
276M
276M
490M
73
Cash Flow Diagram

• Individual cash flows Fixed Costs

384M
384M
384M
384M
0
1
2
10
3
276M
276M
276M
276M
10M
10.8M
11.7M
20M
490M
74
Cash Flow Diagram

• Individual cash flows Salvage Value

25M
384M
384M
384M
384M
0
1
2
10
3
276M
276M
276M
276M
10M
10.8M
11.7M
20M
490M
75
Cash Flow Diagram

• Net Cash Flow Diagram

113M
98.0M
97.2M
96.4M
89.5M
0
1
2
10
3
9
490M
76
Cash Flow Diagram

• Net Cash Flow Diagram

113M
98.0M
97.2M
96.4M
89.5M
0
1
2
10
3
9
This is a typical investment. (Invest at zero,
returns later.)
490M
77
Cash Flow Diagram

• Net Cash Flow Diagram

113M
98.0M
97.2M
96.4M
89.5M
0
1
2
10
3
9
This is a typical investment. (Invest at zero,
returns later.) Can also use a spreadsheet!
490M
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Spreadsheet Basics

• Sheet defined by rows and columns of cells.

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Spreadsheet Basics

• Can enter the following into a cell
• Data Input that is fixed.
• Variables Input that can change.
• Accomplished by references.
• Absolute references are fixed when copied.
• Relative references change when copied.
• Functions Accept input (arguments) and return
  pre-defined output.
• Combinations Data, Variables, and Functions.
• Labels Formatting that makes it easy to read!

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Good Spreadsheet Form

• Give your spreadsheet a title.
• Put data in a data center and reference it (so
  you can change it easily).
• Label units, scales, time, etc.
• Use formatting to make it easy to read.

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Good Spreadsheet Form

• Give your spreadsheet a title.
• Put data in a data center and reference it (so
  you can change it easily).
• Label units, scales, time, etc.
• Use formatting to make it easy to read.
• If you dont, you will just end up doing it
  again!

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Return to our Example
83
Return to our Example
Data Center with Data
84
Return to our Example
Relative Reference A13 Copies relative distance
between cell and copied cell to the new
cell. Absolute Reference G4 Copies the cell
reference exactly (fixed).
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Return to our Example
Function Call SUM(argument1, argument2,)
argument1argument2
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Return to our Example
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Engineering Costs and Cost Estimating

• Costs
• Fixed and Variable
• Direct and Indirect
• Marginal and Average
• Sunk and Opportunity
• Recurring and Non-Recurring
• Incremental
• Cash and Book
• Life-Cycle

Cost Indices Estimating Benefits Cash Flow
Diagrams
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Engineering Costs and Cost Estimating

• Fixed Costs
• are constant and unchanging regardless of the
  level of the activity over a feasible range of
  operations for the capacity or capability
  available.
• Variable costs
• operating costs that vary in total with the
  quantity of output or other measures of activity
  level.
• Direct Costs
• cost that can be reasonably measured and
  allocated to a specific output or work activity.
• Indirect/Overhead Cost
• cost that it is difficult to attribute or
  allocate to a specific output or work activity.

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Engineering Costs and Cost Estimating

• Average cost dividing the total cost for all
  units by the total number of units. DM use cost
  to attain an overall cost picture of the
  investment on a per unit analysis.
• Marginalized cost is used to decide whether the
  additional unit should be made, purchase, or
  enrolled in
• (for full time student, marginal cost of another
  credit is 0 or 120 depend in how many credits
  has already signed up.

90
Engineering Costs and Cost Estimating

• Key Question Where do the numbers come from that
  we use in engineering economic analysis?
• Cost estimating is necessary in an economic
  analysis
• When working in industry, you may need to
  consult with professional accountants to obtain
  such information

91
Engineering Costs and Cost Estimating

• Example 2-1.
• an industrialist DK was considering the money
  making potential plans to charter a bus to take
  people to see a wrestling match show in
  Jacksonville. His wealthy uncle will reimburse
  him for his personal time, so his time cost can
  be ignored.

• Item Cost Item Cost
• Bus Rental 80 Ticket 12.50
• Gas Expense 75 Refreshments
  7.50
• Other Fuel Costs 20
• Bus Driver 50
• Total Costs 225.00 Total Costs
  20.00
• Which of the above are fixed and which are
  variable costs?
• How do we compute total cost if he takes n people
  to Jacksonville?

92
DKs Charter Bus Venture (example)

• Answer Total Cost 225 20 per person. 
• Graph of Total Cost Equation  

Total cost
n
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DKs Charter Bus Venture (example)

• marginal cost -The cost to take one more person
• average cost
• - Average cost the cost per person
• Avg. Cost TC/n
• Avg. Cost (22520n)/n
• For n 30, TC 885
• Avg. Cost 885/30 29.50
• Total cost cannot be calculated
• from an average cost value
• For n 35, TC ? 35(29.50) 1,032.50

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DK Charter Bus Venture (example)

• Question Do we have enough information yet to
  decide how much money he will make on his
  venture? What else must we know?
• he needs to know his total revenue
• he knows that similar ventures in the past have
  charged 35 per person, so that is what he
  decides to charge
• Total Revenue 35n (for n people)
• Total profit
• Total Revenue Total Cost
• 35n (225 20n) 15n 225
• Question
• How many people does
• DK need to break even?
• (not lose money on his venture)
• Solve 15 n 225 0 gt n15

95

• Break-even point the level of business activity
  at which the total costs provide the product,
  good, or services are equal to revenue (or
  saving) generated by providing services. This is
  he level at which one just break even)
• Profit region the output level of the variable
  x (or n) greater than the breakeven point, where
  the total revenue is greater than the total cost.
• Loss region the output level of variable x (n)
  less than the breakeven point, where total cost
  are greater than the total revenue.

96
DKs Charter Bus Venture (example)

• Where is the Loss Region?
• Where is the Profit Region? 
• Where is the Breakeven point?
• Can you make this chart in Excel?

97
Sunk Costs

• A sunk cost is money already spent due to a past
  decision.
• As engineering economists we deal with present
  and future opportunities
• We must be careful not to be influenced by the
  past
• Disregard sunk costs in engineering economic
  analysis
• Example
• Suppose that three years ago your parents bought
  you a laptop PC for 2000.
• How likely is it that you can sell it today for
  what it cost?
• Suppose you can sell the laptop today for 400.
  Does the 2000 purchase cost have any effect on
  the selling price today?
• The 2000 is a sunk cost. It has no influence on
  the present opportunity to sell the laptop for
  400

98
Opportunity Cost

• An opportunity cost is the benefit that is
  foregone by engaging a business resource in a
  chosen activity instead of engaging that same
  resource in the foregone activity.
• Example Suppose your wealthy uncle gives you
  75,000 when you graduate from high school. It
  is enough to put you through college
• (5 years at 15,000 per year). It is also
  enough for you to open a business making web
  pages for small companies instead of going to
  college. You estimate you would make 20,000 per
  year with this business.
• If you decide to go to college you give up the
  opportunity to make 20,000 per year
• Your opportunity cost is 20,000
• Your total cost per year is 35,000

99
Sunk and Opportunity Cost

• Example 2-3. A distributor has a case of
  electric pumps. The pumps are unused, but are
  three years old. They are becoming obsolete.
  Some pricing information is available as follows.
• Item Amount Type of Costs

Price for case 3 years ago 7,000
Sunk cost
Sunk cost
Storage costs to date 1,000
List price today for a case of new and up to
date pumps 12,000
Can be used to help determine what the lot is
worth today.
Amount buyer offered for case 2 years ago
5,000
A foregone opportunity
Case can currently be sold for 3,000
Actual market value today
100
Recurring and Non-Recurring Costs

• Recurring costs are those expenses that are
  known, anticipated, and occur at regular
  intervals. These costs can be modeled as cash
  flows.
• Non-recurring costs are one-of-a-kind and occur
  at irregular intervals. They are difficult to
  plan for or anticipate.
• Example. You decide to landscape a lot of ground
  and then care for it. Which are recurring and
  which are non-recurring costs you incur? 
• Remove existing trees, vegetation
• Have land graded with bulldozer
• Have yard planted with grass
• Plant vegetation, trees
• trim grass
• Fertilize grass, shrubs
• Water grass, shrubs 

101
Incremental Cost

• Incremental Cost is the additional cost that
  results from
• Increasing the output of a system by one (or
  more) units
• Selecting one alternative over another
• Example 2-4. Philip can choose between model A
  or model B. The following information is
  available.
• Cost Items Model A Model B Incremental
  Cost of
  B

Purchase price 10,000 17,500
7,500
Installation cost 3,500 5,000
1,500
Annual maintenance cost 2,500 750
-1,750/yr
800/yr
Annual utility expense
1,200 2,000
-200
Disposal cost after useful life 700 500

• Can we conclude that model B is more expensive
  than model A?

102

• Notice that the cost for the cost categories
  given, the incremental costs of B are both ()
  and (-). Positive incremental costs mean that B
  costs more than A and negative incremental costs
  indicate that there would be a saving (reduction
  of the cost) if B were chosen.
• Because B has more features, a decision would
  also have to reflect consideration the
  incremental benefits offered by model.

103
Cash Costs vs. Book Costs

• Cash costs
• require the cash transaction of dollars from
  one pocket to another.
• Book costs
• are cost effects from past decisions that are
  recorded in the books (accounting books) of a
  firm
• Do not represent cash flows
• Not included in engineering economic analysis
• One exception is for asset depreciation (used for
  tax purposes).
• Example You might use Edmonds Used Car Guide to
  conclude the book value of your car is 6,000.
  The book value can be thought of as the book
  cost. If you actually sell the car to a friend
  for 5,500, then the cash cost to your friend is
  5,500.

104
Life-Cycle Costs

• Life-cycle costs are the summation of all costs,
  both recurring and nonrecurring, related to a
  product, structure, system, or service during its
  life span
• Products go through a life cycle, just like
  people
•  
• Assessment Justification Phase
• Conceptual or Preliminary Design Phase
• Detailed Design Phase
• Production or Construction Phase
• Operational Use Phase
• Decline and Retirement Phase  

105
Life-Cycle Costs
106
Life-Cycle Costs

• Comments
• The later design changes are made in the
  life-cycle, the higher the costs.
• Decisions made early in the life-cycle tend to
  lock in costs incurred later in the life cycle
• Nearly 70 to 90 of all costs are set during
  the design phases, while only 10 to 30 of the
  cumulative life-cycle costs have been spent.
• Bottom Line. Engineers should consider all
  life-cycle costs when designing products and the
  systems that produce them.

107
Estimating Benefits

• For the most part, we can use exactly the same
  approach to estimate benefits as to estimate
  costs
• Fixed and variable benefits
• Recurring and non-recurring benefits
• Incremental benefits
• Life-cycle benefits
• Rough, semi-detailed, and detailed benefit
  estimates
• Difficulties in estimation
• Segmentation and index models
• Major differences between benefit and cost
  estimation
• Costs are more likely to be underestimated
• Benefits are most likely to be overestimated
• Benefits tend to occur further in the future than
  costs

108
System Engineering Economy Analysis
Lecturer Maha Muhaisen

• College of Applied Engineering Urban Planning

109
Discussion

• Chapter (1)

110
Q-27

• A farmer must decide what combination of seed,
  water, fertilizer, and pest control will be most
  profitable, for the coming year. The local
  agricultural college did a study of this
  farmer's situation and
• prepared the following table.
• Plan Cost/acre income/acre
• A 600 800
• B 1500 1900
• C 1800 2250
• D 2100 2509
• the last page of the college's study was torn
  off, and hence the farmer is not sure which plan
  the agricultural college recommends. Which plan
  should the farmer adopt? Explain.

111
Solution

• Plan Cost/acre income/acre Profit
• A 600 800 200
• B 1500 1900 400
• C 1800 2250 450
• D 2100 2509 400
• To maximize profit, choose alternative C.

112
Q-33

• Marie., a college student, is getting ready for
  three final examination at the end of the school
  year. Between now and the start of exams, she has
  15 hours of study time available. She would like
  to get as high a grade average as possible in her
  math, physics, and engineering economy classes.
• She feels she must study at least 2 hours for
  each course and if necessary, will settle for low
  grade that limited study would yield.
• How much time should Maria devote to each class
  if she estimate her grade in each subject as
  follows

113
Solution

• The question here is how to apportion the
  available 15 hrs of study among the courses. One
  might begin for example, assuming 5hrs of study
  for each course. The combined total score would
  be 190.
• Further study would show that the best use of
  time is
• Math 4hrs 44
• Physics 7 hrs 77
• Eng. Economy 4 hrs 71
• Total 192 hrs

114
Q-31

• On her first engineering job, Joy Hayes was given
  the responsibility of determining the production
  rate for a new product. She has assembled data as
  indicated
• (a) Select an appropriate economic criterion and
  estimate-the production rate based upon it
• Joy's boss told Joy "I want you to maximize
  output with minimum input, Joy wonders if it is
  possible to achieve her boss's criterion.
• She asks your advice. What would you tell her?

115
(No Transcript)
116
solution

• The suitable criterion is to maximize net profit
• The date from graphs may be tabulated as follows
• The best production rate is 150 unit/hr
• B. minimum input is zero max. output is 250
  units/hr. since one can not achieve max. output
  at minimum input, the statement makes no sense.

117
Q. 40

• a firm is planning t manufacture a new product.
  The sales dep. estimates that the quantity that
  can be sold deponds on the selling price. As the
  selling price is increased, the quantity that can
  be sold decreases, numerically they estimate
• P 35 0.02 Q
• Where P selling price per unit.
• Q quantity sold per year.
• On the other hand, the management estimates that
  the average cost of manufacturing and selling the
  product will decrease as the quantity sold
  increases. They estimate
• C 4Q - 8000, where C cost to product and
  sell Q per year.

118

• The firms management wishes to produce and sell
  the product at rate that will be a maximum.
• What quantity should the decision makers plan to
  produce and sell each year?
• Solution
• Profit income cost PQ C , where,
• PQ 35Q 0.02Q2
• C 4Q 8000
•  
• Profit 35Q 0.02Q2-4Q-8000
• 31Q 0.02Q2 8000
•  D (profit) / dq 31 0.04Q solve for Q
•  Q 775 units /year

119

• Solution
• Profit income cost PQ C , where,
• PQ 35Q 0.02Q2
• C 4Q 8000
•  Profit 35Q 0.02Q2-4Q-8000
• 31Q 0.02Q2 8000
•  D (profit) / dq 31 0.04Q solve for Q
•  Q 775 units /year
•  

120
Interest and Equivalence

• Time Value of Money
• Simple and Compound Interest

121
Cash Flow Diagrams

• Cash flow diagrams (CFD) summarize the costs and
  benefits of projects
• A CFD illustrates the size, sign,
• and timing of individual cash flows
• Periods may be months, quarters, years, etc.

Example Time Period Size of Cash Flow 0
(today) Receive 100 (positive CF) 1 Pay 100
(negative CF) 2 Positive CF of 100
3 Negative CF of 150 4 Negative CF of 150
5 Positive CF of 50

• COMMENTS
• The end of one period is the beginning of the
  next one
• Arrows point up for revenues or benefits, down
  for costs
• One persons payment (cash outflow w. neg. sign)
  is another persons receipt (cash inflow w. pos.
  sign)
• It is essential to use only one perspective in
  any CFD

122
Cash Flow Analysis

• Given that any investment opportunity can be
  drawn by a cash flow diagram, how can we select
  the best?
• Transform all cash flow diagrams into something
  similar for comparison.
• Use a Common Interest Rate
• Use Time Value of Money Calculations

123
Time Value of Money

• Money has value because it gives us utility.
• Generally, money is preferred now, as opposed to
  later (same amount)
• One can spend it now and get utility
• One can invest it and watch it grow with interest
  for greater future utility
• One can put it under the mattress and watch it
  lose purchasing power

124
Time Value of Money

• To describe the same amount of money at different
  periods of time requires the use of an interest
  rate. With a positive rate
• Money grows (compounds) into larger future sums
  in the future.
• Money is smaller (discounted ) in the past.

125
Time Value of Money

• Question Would you prefer 100 today or 100
  after 1 year?
• There is a time value of money. Money is a
  valuable asset, and people would pay to have
  money available for use. The charge for its use
  is called interest rate.
• Question Why is the interest rate positive?
• Argument 1 Money is a valuable resource, which
  can be rented, similar to an apartment.
  Interest is a compensation for using money.
• Argument 2 Interest is compensation for
  uncertainties related to the future value of the
  money.

126
Interest

• Cost of Money
• Rental amount charged by lender for use of money
• In any transaction, someone earns and someone
  pays interest
• Savings Account bank pays you
  1.5 fee to depositor
• Home/Auto Loan borrower pays bank
  7.5 fee to bank

127
Interest

• Interest Rate comprised of many factors
• Example Home Mortgage 7.5
• Prime Rate (Banks borrow money at this rate
  from the Federal Reserve banks when needed) 5
• Risk Factor 1
• Administration Fees 0.5
• Profit 1
• May raise more for higher risk client.

128
Definitions

• Principal (capital) P
• Amount invested or loaned
• Interest Rate i
• Rental charge for money defined as a percentage
  of principal per time period
• Compounding Period
• Defines how often interest is calculated (may not
  be paid, however)
• Length of loan/investment N periods

129
Simple Interest

• Interest earned/paid is directly proportional to
  capital involved.

130
Simple Interest

• Interest earned/paid is directly proportional to
  capital involved.
• (Principal)(Interest Rate)(Periods)

131
Simple Interest

• Simple interest is interest that is computed on
  the original sum.
• If you loan an amount P for n years at a rate of
  i a year, then after
• n years you will have 
• P n ? (i P) P n ? i ? P P (1 i n).
• Note Interest is usually compound interest, not
  simple interest.
• Example You loan your friend 5000 for five
  years at a simple interest rate of 8 per year.  
• At the end of each year your friend pays you 0.08
  ? 5000 400 in interest.
• At the end of five years your friend also repays
  the 5000.
• After five years your friend has paid you
• 5000 5 ? 400 5000 5 ? 0.08 ? 5000.
• Note The borrower has used the 400 for 4 years
  without paying interest on it.

132
Example

• Keystone Cement Co. announced a 165 million
  expansion of its Lehigh Valley PA plant. The
  state Machinery and Equipment Loan Fund is
  supplying a 4.5 million loan to be paid at a
  rate of 3.25 percent over 10 years and the
  states Development Authority is providing a 2
  million loan at 4.25 percent over 15 years.
• Consider the machinery loan. What is owed after
  10 years assuming simple annual interest?

4.5M (4.5M)(.0325)(10) 5.96M
133
Compound Interest

• Interest is paid on both the capital and accrued
  interest.
• Must compute interest owed periodically.

134
Revisit the Example

• Repeat example assuming 3.25 compounded
  annually. How much is owed after two years if no
  payments are made?

135
Compound Interest

• Compounded interest is interest that is charged
  on the original sum and un-paid interest.
• You put 500 in a bank for 3 years at 6 compound
  interest per year.
• At the end of year 1 you have (1.06) ? 500
  530. 
• At the end of year 2 you have (1.06) ? 530
  561.80. 
• At the end of year 3 you have (1.06) ? 561.80
  595.51. 
• Note  
• 595.51 (1.06) ? 561.80
• (1.06) (1.06) 530
• (1.06) (1.06) (1.06) 500 500
  (1.06)3

136
Revisit the Example

• Assuming 3.25 compounded annually
• After the first year
• Balance Interest
• 4.50M (.0325)(4.5M) 146,250
• After the second year
• Balance Interest
• 4.65M (.0325)(4.65M) 151,003
• 4,797,253 owed after two years.

137
Quarterly Compounded Interest Rates

• Example. You put 500 in a bank for 3 years at
  6 compound interest per year. Interest is
  compounded quarterly. 
• The bank pays you i 0.06/4 0.015 every 3
  months
• 1.5 for 12 periods (4 periods per year ? 3
  years). 
• At the end of three years you have
• F P (1i)n 500 (1.015)12 500 (1.19562) ?
  597.81
•   (598 in
  text due to rounding)
• Note. Usually the stated interest is for a
  1-year period. If it is compounded quarterly
  then an interest period is 3 months long. If the
  interest is i per year, each quarter the interest
  paid is i/4 since there are four 3-month periods
  a year.

138
Example

• Example. In 3 years, you need 400 to pay a
  debt. In two more years, you need 600 more to
  pay a second debt. How much should you put in
  the bank today to meet these two needs if the
  bank pays 12 per year?  
  
  
• Interest is compounded yearly
• P 400(P/F,12,3) 600(P/F,12,5)
• 400 (0.7118) 600 (0.5674)
• 284.72 340.44 625.16

• Interest is compounded monthly
• P 400(P/F,12/12,312) 600(P/F,12/12,512)
• 400(P/F,1,36) 600(P/F,1,60)
• 400 (0.6989) 600 (0.5504)
• 279.56 330.24 609.80

139
Example Points of view

• Borrower point of viewYou borrow money from the
  bank to start a business.
• Investors point of viewYou invest your money in
  a bank and buy a bond.

140
Concluding Remarks

• The Blue Pages in the text book tabulate
• Compound Amount Factor
• (F/P,i,n) (1i)n  
• Present Worth Factor
• (P/F,i,n) (1i)-n
•  
• These terms are in columns 2 and 3, identified as
   
• Compound Amount Factor Find F Given P F/P 
• Present Worth Factor Find P Given F P/F

141

• Present value
• Economic Equivalence

142
Present Value (PV)

• Example You borrowed 5,000 from a bank at 8
  interest rate and you have to pay it back in 5
  years. There are many ways the debt can be repaid.

• Plan A At end of each year pay 1,000 principal
  plus interest due.
• Plan B Pay interest due at end of each year and
  principal at end of five years.
• Plan C Pay in five end-of-year payments.
• Plan D Pay principal and interest in one payment
  at end of five years.

143
Example

• You borrowed 5,000 from a bank at 8 interest
  rate and you have to pay it back in 5 years.
• Plan A At end of each year pay 1,000 principal
  plus interest due.

a b c d e f
Year   Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment
Year   Amnt. Owed intb bc Princip. Payment Total Payment
1 5,000 400 5,400 1,000 1,400
2 4,000 320 4,320 1,000 1,320
3 3,000 240 3,240 1,000 1,240
4 2,000 160 2,160 1,000 1,160
5 1,000 80 1,080 1,000 1,080
SUM 15,000 1,200 16,200 5,000 6,200
144
Example (cont'd)

• You borrowed 5,000 from a bank at 8 interest
  rate and you have to pay it back in 5 years.
• Plan B Pay interest due at end of each year and
  principal at end of five years.

a b c d e f
Year   Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment
Year   Amnt. Owed intb bc Princip. Payment Total Payment
1 5,000 400 5,400 0 400
2 5,000 400 5,400 0 400
3 5,000 400 5,400 0 400
4 5,000 400 5,400 0 400
5 5,000 400 5,400 5,000 5,400
SUM 25,000 2,000 27,000 5,000 7,000
145
Example (cont'd)

• You borrowed 5,000 from a bank at 8 interest
  rate and you have to pay it back in 5 years.
• Plan C Pay in five end-of-year payments.

a b c d e f
Year   Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment
Year   Amnt. Owed intb bc Princip. Payment Total Payment
1 5,000 400 5,400 852 1,252
2 4,148 332 4,480 920 1,252
3 3,227 258 3,485 994 1,252
4 2,233 179 2,412 1,074 1,252
5 1,160 93 1,252 1,160 1,252
SUM 15,768 1,261 17,029 5,000 6,261
146
Example (cont'd)

• You borrowed 5,000 from a bank at 8 interest
  rate and you have to pay it back in 5 years.
• Plan D Pay principal and interest in one payment
  at end of five years.

a b c d e f
Year   Amnt. Owed Int. Owed Total Owed Princip. Payment Total Payment
Year   Amnt. Owed intb bc Princip. Payment Total Payment
1 5,000 400 5,400 0 0
2 5,400 432 5,832 0 0
3 5,832 467 6,299 0 0
4 6,299 504 6,802 0 0
5 6,802 544 7,347 5,000 7,347
SUM 29,333 2,347 31,680 5,000 7,347
?
COMPOUND INTEREST
147
Example (cont'd)
147
148
Example (cont'd)
148
149
Example (cont'd)
149
150
Example (cont'd)
150
151
Economic Equivalence

• What do we mean by economic equivalence?
• Why do we need to establish an economic
  equivalence?
• How do we establish an economic equivalence?

152
Economic Equivalence

• Economic equivalence exists between cash flows
  that have the same economic effect and could
  therefore be traded for one another.
• Even though the amounts and timing of the cash
  flows may differ, the appropriate interest rate
  makes them equal.

153
Equivalence from Personal Financing Point of View

• If you deposit P dollars today for N periods at
  i, you will have F dollars at the end of period N.

154
Alternate Way of Defining Equivalence
P

• F dollars at the end of period N is equal to a
  single sum P dollars now, if your earning power
  is measured in terms of interest rate i.

N
0

F
N
0
155
Example
At an 8 interest, what is the equivalent worth
of 2,042 now in 5 years?
If you deposit 2,042 today in a savings account
that pays an 8 interest annuall