Unit 01 lecture 01

ENGR 3360U
Unit 1

General Introduction to Engineering Economics

Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2013-I-01

Unit 1 – General Introduction to Engineering Economics

Change Record
2013-I-01 Initial Creation
2013-I-09 small edits

1-2 2013-I-01 Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco


Course Outline
1. Engineering Economics 10. Uncertainty and Risk
2. General Economics 11. Income and Depreciation
1. Microeconomics 12. After-tax Cash Flows
2. Macroeconomics 13. Replacement Analysis
3. Money and the Bank of 14. Inflation
Canada 15. MARR Selection
3. Engineering Estimation 16. Public Sector Issues
4. Interest and Equivalence 17. What Engineering should know
5. Present Worth Analysis about Accounting
6. Annual Cash Flow 18. Personal Economics for the
7. Rate of Return Analysis Engineer
8. Picking the Best Choice
9. Other Choosing Techniques



Learning Objectives
Why should you take this course?
This course is a bird, right?
Engineering and economy



Mottos
Time is money
An engineer is someone who can build for a
dime, what any damn fool can build for a dollar
There are three kinds of economists; those who
count and those who don’t



Observation
How many filthy rich economists do you
know?
Do you think that Bill Gates would pass this
course? Would he even take it?



Economics
The “dismal” science (Carlyle)
“founded” by Scottish philosopher Adam
Smith
“Wealth of Nations”
The “invisible hand” of the market place



Carlyle’s snide quote
“Teach a parrot to say “supply and demand”
and you’ve got an economist”
“Give me a one-handed economist; all of
the others say <<on one hand…on the other
hand>>” Harry S. Truman
Is a Nobel category



Roadmap for Chapter 1
1. Options and 6. Spreadsheet functions
Questions
7. Minimum attractive rate
2. Decision Making of return
3. Macro and Micro 8. Cash flows
Economics
9. Doubling times
4. Fundamental
Business Structures
5. Interest Rates



What is the most important
Engineering Variable?

$ £ € ¥



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



Engineering Economy
The art and science that involves:
Formulating,
Estimating and
Evaluating economic outcomes
Always concerned with the selection and
possible execution of alternatives given the
economic parameters associated with the
project



Role of Engineering Economy in Decision Making

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



Two Concerns of Engineering
Engineers have the dual task of
determining:
1. What society wants (its needs), and
2. How best to combine econo
mic resources, processes, etc. to produce the
goods and services desired by society.
Efficiency: economic and physical
efficiency must be considered.



Physical and Economic Efficiency
Physical efficiency
Measure of the success of engineering activity
in the physical environment; ratio of outputs to
inputs
Maximum physical efficiency ratio is 1 (or
100%)
Physical units include BTUs, kw-hours, etc.



Economic efficiency
Ratio of value or worth to cost; must exceed 1
or 100%
Engineer must produce outputs that are most-
valued (of greatest satisfaction) by society
(economic efficiency)



Evolution of Economic & Physical Efficiency

1950s 1970s+
Physical efficiency Economic Efficiency

ECONOMIC
SPHERE ECONOMIC
ENGINEERING SPHERE
(Economic SPHERE
efficiency) (Physical efficiency) ENGINEERING
SPHERE

Independent decision making
Significant overlap



2 The Decision Making Process
1. Understand the problem – define objectives
2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply sensitivity
analysis
6. Select the “best” alternative
7. Implement the alternative and monitor results



2.1 Understand the problem - define objectives
Problems can be simple, complex or
intermediate
Are referred to as “opportunities”
Build a new model
Replace an old plant
Open up in a new territory
Must refine opportunities into metrics
(objectives)



Project Objectives
Develop expertise in some area.
Become competitive
Improve productivity
Reduce costs
Modify an existing facility
Develop a new sales strategy
Develop a new product



SMART Objectives
S = Specific
M = Measurable
A = Achievable
R = Realistic
T = Time-Limited



Minor Characteristics of Objectives
They should be
verifiable
aligned
cast in terms of deliverables
comprehensible
single-ended



Priorities of Objectives
Hand rank
Matrix



Scoring Models
Can build various objectives into a scoring
model



2.2 Collect Relevant Information
Objectives are metricized so start there
Money is a biggy
As is Interest Rates, Inflation Rate, etc
May need customer surveys (consider
Microsoft launching Windows-8)



Example: Gassing up in Oshawa
Need to evaluate all prices on a daily basis
plus weekly plus monthly plus “externals”
Observations of a Shrewd Gas-upper
Morning BAD
Later in the evening best
South side normally lower than north end



2.3 Define the Set of Feasible Alternatives
Do nothing (always a possibility)
Alternative A
Alternative B
………
Alternative n



Opportunity Cost
What will it cost you by NOT doing
something?
Can be 1 thing: can be 1,000 things
For example, going to FEAS/UOIT
OC is flipping burgers at MickeyDs



OC of going to Class
You could be flipping burgers at MickyDs
6*8*10 = $480/wk
35 week = 35*480 = 17,000
Your OPPORTUNITY COST IS $17,000



2.4 Identify the Criteria for Decision Making
What is the most important criterion?
Normally, money but can be other things
(protection of the environment, exclusion of
a competitor into a new market, etc.)



2.5 Evaluate the Alternatives
(apply sensitivity analysis)
Some parameters are key
Interest rates
Inflation rate
Canadian dollar rate
Demand expectation
Price of oil
SA varies these to see how the chosen
model reacts



2.6 Select the “Best” Alternative
Be sure to state all assumptions and
constraints
When the project is done, we will do a post-
mortem
Needs these to justify decisions
For example, Tar Sands development:
assumed price of oil critical



2.7 Implement the Best and Monitor
Do it
Check it
Do root cause analysis



Time Value of Money
All firms make use of investment of funds
Investments are expected to earn a return
Investment involves money
Money possesses a “time value”
The “time value” of money is the most
important concept in engineering economy



Performing An Engineering Economy Study
Engineering Economy Studies:
Define Alternatives
 Do-nothing alternative – maintain the status quo
 Define feasible alternatives – that can solve the problem

Define/estimate the current and future cash flows
Perform the analysis
 Apply the tools and methods of engineering economy
Selection of the best alternative
Implement and monitor



3 Macro and Microeconomics
Fundamental approach of Economics
Draw a circle
Inside, Microeconomics describes
Actions of individuals and groups in individual
markets (choice under scarcity, implications on
prices and demand)
Outside, Macroeconomics describes
Performance of national economies and their
policies (unemployment rate, overall level of
prices, GDP, prime rate, price of oil etc).



Microeconomics
Comparative advantage
Supply and demand
Competition and the invisible hand
Efficiency and exchange
Profit



Macroeconomics
Global supply and demand
Economic growth and living standards
Productivity
Recessions and expansions
Unemployment
Inflation
Money, Banks and Central Banking



4 Fundamental Business Structures
1. Sole proprietorship
2. Partnership
3. Limited partnership
4. Corporation



4.1 Sole Proprietorship
Business owned by one person
Easiest to start, least regulated
Owner keeps all of the profits BUT is
responsible for all debts
Owner has unlimited liability which means
that Loophole and Loophole can foreclose on
your house, Mercedes, wifey’s diamonds,
hubby’s Hummers, etc



Characteristics of Sole Proprietorships
Cheapest and fastest to set up
All business profits are taxed as personal income
Owner has unlimited liability, extending to all of
her assets
Life of the firm is limited to the life of the owner
Transfer of ownership requires the sale of the
whole business to the new owner
Equity financing is limited to personal wealth of
the owner



4.2 Partnership
Involves two or more owners. Here partners
run the company together
They also share all profits and losses, under
a pre-existing agreement



Characteristics of Partnerships
Inexpensive, easy to form
General partners have full liability for debts
Partnership is dissolved when a partner dies
or withdraws
Difficult for partners to raise money
Management control resides only with the
partners



4.3 Limited Partnership
Some of the partners are involved only as
investors
These are called limited partners
Are liable only up to the amount of their
investment
The daily running of the business is not
their concern



Characteristics of Limited Partnerships
Limited partners have limited liability
LPs can withdraw at any time
LPs have no control over management of
the group



4.1 Corporations
Corporations are owned by shareholders
Set up as an independent business entity
with clearly specified rights and obligations
Shareholders elect a Board of Directors
which is responsible for picking managers
to run the business in the best interests of
the shareholders
The corporation is a separate legal entity
which is responsible for its debts


Corporations cont.
Humans and other legal entities (other
corporations, trusts) can hold shares in the
corporation
If no stockholders exist, can be a “non-
stock corporation”
Also a “membership corporations” Not-for-
profit corps such as churches, charities etc.



Stocks
Can be closely held (private) or publicly
traded
“Traded” means traded on a stock exchange
or an “over-the-counter” market



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



Corporate Finance (for all 4)
Capital Budgeting – what are the long-term
strategies the company should undertake?
Capital Structure – what is the best way to
raise long-term financing to make new
products
Working Capital Management – how does
the company manage its short-term cash
flow in order to pay people, suppliers etc



Corporate Financing
Primary goal is to ensure that the return on
capital exceeds the cost of capital without
taking big risks
Goal is to enhance corporate value



5 Interest Rates and Rate of Return

Interest – the manifestation of the time value of
money
Rental fee that one pays to use someone else’s
money
Difference between an ending amount of money and
a beginning amount of money
interest accrued per time unit
Interest rate (%) = x 100%
original amount



Rate of Return

Interest earned over a period of time is expressed as
a percentage of the original amount, specifically;
interest accrued per specific time period
Rate of return (%) = X100%
original amount

Borrower’s perspective – interest rate paid
Lender’s perspective – interest rate earned



Economic Equivalence
Different sums of money at different times
may be equal in economic value $106 one
year from now

0 1
Interest rate = 6% per year

$100 now

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



Simple and Compound Interest

Simple Interest:
Interest = (principal)(number of periods)(interest rate)
Compound Interest:
Interest earns interest on interest
Compounds over time
Interest = (principal + all accrued interest) (interest
rate)



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

F = a future amount of money at some
point in time later than t = 0
A = a series of equal, end-of-period cash
flows
n = the number of interest periods
i = the interest rate or rate of return per
time period, in percent


6. Introduction To Solution By Computer
Application of Microsoft’s Excel© spreadsheet
program
Excel financial functions
Present Value P: =PV(i%,n,A,F)
Future Value F: =FV(i%,n,A,P)
Equal, periodic value: =PMT(i%,n,P,F)
No. of periods: =NPER((i%,A,P,F)
Compound interest rate: =RATE(n,A,P,F)
Compound interest rate: =IRR(first_cell:last_cell)
Present value of a series: =NPV(i%,cell2:last_cell) + cell1



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



The MARR
The MARR is established by the financial
managers of the firm
The MARR is expressed as a percent value
Most, if not all, projects should earn at a
rate equal to or greater than the established
MARR
MARR’s are set based upon:
The cost of all types of capital
Allowance for risk


Types of Financing
Equity Financing – the firm uses funds
either from retained earnings, new stock
issues, or owner’s infusion of money
Debt Financing – the firm borrows funds
from outside sources
The cost of debt financing = the interest rate
charged on the debt (loan) amounts
The MARR is approximated from the
weighted average cost of all sources of
capital to the firm
A firm’s ROR > MARR > cost of capital


8 Cash Flows: Their Estimation and Diagramming

Definition of terms
Cash Inflows - amount of funds flowing into
the firm
Cash Outflows – amount of funds flowing out
of the firm
Net Cash Flow equals
Cash inflows – cash outflows
Assumption for analysis – end of period
Funds flow at the end of a given (interest)
period



Cash Flow Diagrams
A typical cash flow diagram might look like:
1. Draw a time line

0 1 2 … … … n-1 n
One time period

2. Show the cash flows
Always assume end-of-period
cash flows!

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows (+ for up or – for down) ---
(+) inflow; (-) outflow



9 Course Assumptions
Fallacy of linearity
Show me a linearity in nature!
Pointy-Haired-Boss and St Dilbert
PHB e.g.
One woman creates a baby in 9 months
Nine women create one in 1 month!
Assumption of homo economicus



Guestimation
Engineers must do this all the time
How many dogs are there in Canada?
Interpolation si; extrapolation non!
Rule-of-six
Estimation accuracy
Estimation of SD



Rule of 72: Estimating Doubling Time
Common question:
Estimate the number of time periods it takes for a
cash flow to double in size
Given an interest rate i% per period
The approximate time n for an investment at time
t = 0 to double in value is given by:
n = 72/i
e.g., $10,000 at 7% per year doubles to $20,000 in
10.3 years



Economists you should Know
Adam Smith (invisible hand man)
Karl Marx (boo-hiss)
Alfred Marshall (2 blades of the scissors)
John Maynard Keynes (when in doubt,
SPEND)
Milton Friedman (Chicago - yea)
Paul Samuelson (ol’ guns and butter)
Ben Bernanke (chair of the US Fed)
Paul Krugman (contrarian)


Chapter Summary
Engineering Economy – application of economic
factors and criteria to evaluate alternatives
Applies the time value of money
Application of economic equivalence
Introduction of the MARR
Cash flow estimation
Modeling – cash flow diagrams
Difficulties in estimation
Perspectives – viewpoints taken


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