Chapter 5 Engineering Economics 4th Edition

Engineering Economics How much will an engineering project cost? Simple and compound interest Cost of borrowing money for an engineering project Mathematical and Excel formulae Breakeven point Return on Investment Exploring Engineering

Engineering Economics “Money makes the world go around …” http://www.youtube.com/watch?v=rkRIbUT6u7Q True in engineering too! “Cost of Money”: Interest that could be earned if the amount invested in a business or security was instead invested in government or in time deposit. In other words, the business investment vs. a guaranteed return You can get it downloaded from Utube – it’s an attention getter if you want to go that extra mile. Exploring Engineering

The Cost of Money Should you buy a car for $20,000 using your own cash vs. US bonds returning 5%/yr ($600 … forever) In effect you are paying $1,000 for ever (even after the car is a certifiable clunker destined for destruction) Likewise, engineering economics looks beyond the first cost and adds the interest you have to pay to get the money to invest Exploring Engineering

Simple and Compound Interest You have a business project costing $100,000 You get a loan for 7.5% for 5 years at simple interest payable at the end of the loan The loan costs $7,500 for each of five years for a total interest of $37,500 Total cost over 5 years = $137,500 Is the banker really willing to lend you money for 5 years? Isn’t he also lending you $100,000 + 5% of $7,500 for four years, $15,000 for three years, $22,500 for two years, $30,000 for four years and $37,500 for five years? Exploring Engineering

Simple and Compound Interest Guess what? The banker does think you owe him interest on the interest (known as compound interest) He will charge you about $375 after year 1, $750 after year 2. $1,125 after year 3, $1,500 after year 4 and $1,875 after year 5 The cost of the 5 year project is thus about $142,125 Compound interest can be a significant part of an engineering project Exploring Engineering

Terms and Formulae Principal P is the amount borrowed # of pay periods, N Interest rate r per period Future worth, F, total of how much you have to payback Formulae: Simple interest = P(1 + Nr) ( = $137,500) Compound interest = P(1 + r)N ( = $143,563) Compound interest (CI) is higher than Simple interest (SI) because the CI also levied on the annual escalating interest. Exploring Engineering

Simple and Compound Interest SI is shown only for completeness – not commercially practiced. Exploring Engineering

Pay Periods Suppose your load is compounded quarterly, monthly or daily instead of yearly. Student loan of $25,000 at 8% for 1) annually for two years, 2) quarterly and 3) daily 1) r = 0.08 per yr, N = 2 and F = $29,160 2) r = 0.02 per qtr N = 8 and F = $29,291 r = 2.19 x 10-4 per day, N = 730 and F = $29,337 Morale: Watch the effect of increased compounding! Exploring Engineering

Excel Rides to the Rescue … Exploring Engineering

Example A nuclear reactor has cost $5 Billion when test trials start that take an additional 4 years to complete. If interest rates are 12% annually (payable quarterly), what’s the final reactor cost? Exploring Engineering

Example in Excel Exploring Engineering

Example Continued The $5B reactor ends up costing a cool $8 B Nuclear reactors are only economical if they are built during times of low cost of money! Exploring Engineering

When is an Investment Worth it? ‘Break Even Point’ (BEP) has a simple definition: BEP occurs when the project has earned back the cost it took to make it. Exploring Engineering

Example Cost of producing new widget is $1,000,000.  If profit per widget is $1.00 and we’re selling 1,000/day when is the BEP?.  Need: BEP = _____ years Know - How: Equate cost to total money stream. Solve: 1,000 [widgets/day]  1.00 [$/widget]  D [days] = $1,000,000. Solving for D gives: D = 1,000 days = 2.74 years. Most companies require BEP of 12 -18 months to fund a new widget Exploring Engineering

Return on Investment (ROI) ROI is the ratio of annual return to the cost of the investment If an investment of $500,000 produces an income of $40,000 per year, its ROI is: ROI = $40,000/$500,000 = 0.08 = 8%. Many successful large companies operate with ROI’s of 15% or more Exploring Engineering

Return on Investment Exploring Engineering

Summary Manufacturing businesses add to their costs the cost of borrowing Compound interest is the only way money is lent More payment periods is a more expensive loan Breakeven Point and Return on Investment are the principal business criteria for a successful investment BEP needs to be about 12 -18 months and ROI needs to be about 15% for a sturdy investment. Loan is a noun, lend is a verb! Exploring Engineering

Cost Estimating Construction Manufacturing Buyer vs. Seller RS Means Government Markets Manufacturing Waste Regulatory Investments Buyer vs. Seller Bid vs. Buy Loan is a noun, lend is a verb! Exploring Engineering

Engineering Business Models Consultants Mulitipliers No bids Embedded Free Lance Loan is a noun, lend is a verb! Exploring Engineering