Beginning Engineering Economics ©2011 Dr. B. C. Paul with significant revisions from an earlier version Please note – concepts presented in these slides are considered common knowledge to those schooled in Engineering Economics, however, these concepts were not developed by Dr. Paul.

The Big Picture Pattern  All the Problems are Done the Same Way  Two Most Important Questions  How Much Do I Get?  When Do I Get It?

How Much Do I Get?  More is better (at least when it comes to money)!  How Do I Determine How Much Money There Is?  A Good Project  For a Good Project You Get More Out of It than You Put Into It.

When Do I Get It?  You’d like to take a really nice spring break vacation  Then I offer you $3,000 to work through spring break  You get paid at the end of Spring Break  Someone Else Offers you $3,000 to work through spring break  You get paid in 5 years  Which offer motivates you more?

The When Reality  The Motivational Clout of Money is Influenced by when you get it.  Money now has more pull than money a long time in the future.  You might even be saying if I get it now I could invest it and grow more money for the future.

An Issue of Equivalence  Padro Plush has 2 one dollar bills and 23 Pesos  That must mean he has 25 monies!  Freddy Flush has 20 one dollar bills and 5 Pesos  He has 25 monies too!  They must both have the same amount of money because they both have 25 monies!  (You are buying this aren’t you?)

How Do I Fix an Equivalence Problem?  Since Pesos and Dollars do not have the same monetary power what do I have to do before I can count the money?

Meet the Cash Flow  Carbondale Sells its Water System to Soak-it-to-You Inc for $8,000,000  Due to the diligence and well managed maintenance programs of government bodies they spend $18,000,000 on fixing up the system the first year and then $6,000,000 the second.  After that Soak-It-To-You makes $4,000,000 per year for 10 more years  Then Sammy Socialist is elected Mayor on a promise to condemn and buy back the water system so that residents are not “screwed over” by high for profit system costs.  They pay Soak-It-To-You $21,000,000 for the system

A Cash Flow is a List Showing When Money Moves and How Much  Time 0 -$8,000,000  Time 1 -$18,000,000  Time 2 -$6,000,000  Time 3 $4,000,000  Time 4 $4,000,000  Time 5 $4,000,000  Time 6 $4,000,000  Time 7 $4,000,000  Time 8 $4,000,000  Time 9 $4,000,000  Time 10 $4,000,000  Time 11 $4,000,000  Time 12 $4,000,000  Time 13 $21,000, …………………………………………………… $8,000,000 $18,000,000 $6,000,000 $4,000,000 per year $21,000,000 A Cash Flow Can Also Be Represented With a Graphic

Making A Cash Flow  Making a Cash Flow is One of the First Things one does in an Engineering Economics Problem  Problem usually sounds like a “story problem” from which your glean out the cash flow.  The Cash Flow Answers Our Two Most Important Questions.  How Much Do I Get?  When Do I Get It?

Tricks to a Good Cash Flow  Keep Your Pluses and Minuses Straight  Mixing them up is a great way to get wrong answers to any engineering problem  An Easy to Remember Rule of Thumb  Money coming into my pocket is a positive event  Money going out of my pocket is a negative event

Another Trick to a Good Cash Flow  Pick the perspective of the investor and stick with it.  In the Water System Story their was Soak-It- To-You Inc. and the City of Carbondale  If I get who is who mixed up I will mess up pluses and minuses  There may be building projects where there are 10 and 12 parties involved (but only one of them is the investor you represent)  You can get all sorts of numbers in the cash flow that have nothing to do with your investors.

Count Your Money (Or I’ve seen this mistake before)  I Decide to see whether Soak-It-To-You made a good deal  Money invested in the system  $8,000,000 to buy  $18,000,000 and $6,000,000 to upgrade  Total in $32,000,000  Money Out  $4,000,000 per year for 10 years - $40,000,000  $21,000,000 when the city bought it back  Total out $61,000,000

What Did I Do Wrong?  Pedro Plush had 2 $1 bills and $23 pesos – Therefore he has 25 monies.  But I Can’t Do That Because Pesos and Dollars have different buying power  When I just added up all the money without regard to when I got it – what mistake did I make?  What Do I Need to Do About It?

So How Do I Adjust the Value of Money from Different Points In Time?  How Many of You Have a Job while Your in School  You do your job because  You like having no social life  You like being forced to put off homework till the last minute and then give up sleep to do it  There isn’t any recreational activity you’d rather be doing.  How do people get you to put-off or give up having time for yourself right now?

The Problem of Delayed Money  People would rather have their money now.  How could I get someone to put off having their money now?

If I Pay People for Waiting for Their Money  If I give someone $5,000 in 5 years  Part of the money will get counted as payment for waiting  Part of the money will be counted a giving me back my investment money  If I knew that ratio I would know how much $5,000 in 5 years is equal to today!  Then I could convert the future money to money now and then count it all up  (No Peso and Dollar screw up)

Big Question is How Do I Know What to Charge for Delayed Gratification?  I Go into McDonalds and offer to work for $50 an hour as a food service worker  I want evenings, holidays, and weekends off  I want my hours in 8 hour blocks  I want 32 hours a week  Do you think I’m going to get hired?

I Need to Figure Out What is Reasonable?  I look for a “Rate of Return” on my money  The Rate of Return is used to determine how much extra I have to be paid to wait for my money  A high rate of return means I get paid more generously than with a low rate of return  Rates of Return are measured in percentage of extra money that must be provided every year to get me to wait.

What Goes Into Such a “Rate of Return”  What normally happens to prices?  Lets say I could buy Dairy Queen Blizzards for $3 each  I lend you my money for 10 Blizzards $30  You pay me my $30 back in 5 years  But now Blizzards cost $3.50 each?  Why Am I Ticked?  What am I going to want to have done about this “inflation” problem?

One Thing to Take Care Of  You must give me enough extra money to cover my loss of buying power to inflation.  Inflation is measured in %  What is the current annual inflation rate?

Another Variation  I lend 100 students $30 of Blizzard Money (Ok your not sure I’d eat that many Blizzards – but it does sound like a rewarding challenge)  They all agree to pay me back $35 to cover inflation  Do you think all 100 students are going to come through and look me up in 5 years to pay me back?

The Element of Risk  The only sure money is the money in your hand right now!  I need to collect enough extra to reimburse me for the fact that some of my “investments” are going to go bad.  In practice risk premiums are calculated by comparisons to the market  Infrastructure projects with guarantees may be only less than 1%  Manufacturing and design may be around 6 to 9%  Mining may be around 9 to 12%  New start-up companies can be a lot higher

I’ve Still Not Been Paid for Waiting for My Money  Market rate for waiting has been the same since the dawn of capitalism  Its about 1 to 2%

The Last Factor  When two gas stations are side by side and one lowers its price just a little – what happens?  When banks want students to open new accounts with them and one bank offers a clock radio – what does the next bank do?  It is common for competitors to try to sweeten the mix to set themselves apart  This “motivation premium” is about 0.1%

OK Now I Know What People Consider  Inflation (say about 3.2%)  Risk (lets say we look at about a 7%)  Payment for Rating – called market rate or risk free rate – (about 1.5%)  Motivation Premium – (about 0.1%)  Ok now how do I get a Rate of Return out of this?

A First Impulse  Add it up  3.2% + 7% + 1.5% + 0.1% = 11.8%  Why it doesn’t work  Will my risk premium money have inflation?  Are people who skip out on paying me back likely to look me up to pay my 5% inflation premium?  Risk, inflation, and reward affect all money alike.

The Multiply Solution  When I multiply numbers together each factor is applied to all the money – including that from other factors.  But there are special tricks before we multiply  We convert from % to decimal form  Not really hard just divide by 100  Decimals or %.  We talk and write down answers in %  But we do all our math in decimals.

Lets Set this one Up!  (1.032)*(1.07)*(1.015)*(1.001) =  We recognized each of these things as  Inflation 3.2%.032  Risk 7%.07  Safe Rate (waiting premium) 1.5%.015  Motivation 0.1%.001  Which leaves us wondering what the 1s are all about.

An Example  I borrow $100 from you and promise to pay you $10 in interest when I pay you back next week  Next week I give you a $10 bill  Is anything wrong?  What happens when you multiply a number by 1?

Now Lets Finish Solving That Rate of Return Problem  (1.032)*(1.07)*(1.015)*(1.001)=  Of course I know what the 1 is for  That leaves me  Now because I’m going to talk about it I convert back to a percentage  100* = 12.19%

I Mentioned Class Assistant

An aside about Rate of Return  When we are trying to project the cash flow that we will get back from an investment sometimes we don’t know what the rate of inflation will be in 5 years  (If you do, Ben Bernanke has a job for you)  We write down the cash flows as if there were no inflation  (ok we do that a lot in engineering economic analysis)

Unscrewing the Rate of Return  Now I have a rate of return that tells how much I need for inflation and a cash flow with no inflation  I fix the problem by dropping out the inflation factor from by ROR  Thus we have two kinds of RORs  Real rate of return means both the cash flow and the ROR ignored inflation (even though its fake we call it real because it measures real buying power)  Nominal rate of return considers inflation in both the cash flow and the ROR  If inflation is included in one and not the other - you screwed up

Using Class Assistant

A Common Problem  Engineers go through design something  Then they estimate the costs and earnings  Put them in a cash flow  Since predicting inflation rates in 7 years was not their concern they calculate what costs and earnings are in todays terms  Then they need to apply an interest rate to see if they got enough money  They go to accounting to get the rate  Accountants track prices in a world that has inflation  They give an interest rate with inflation in  Engineer then uses an interest rate that considers inflation  He just mismatched interest rates

How to Make a Real Interest Rate from a Nominal  Say accountant says Rate of Return (ROR) is 17%  We ask about rate of inflation  He/She says 3.5%  We have a real cash flow so we need a real rate  (1.17)/(1.035) =  Take out the  Multiply by 100 to get % %

Using Class Assistant So This Does Not Happen to You My Accountant says 17% I ask him what rate Of inflation went With that interest Rate. He tells me 3.5% The spreadsheet Spits out a 13.05% Real interest rate Which I use on my Cash flow. Can also convert a real rate to a nominal

Now Its Your Turn to Estimate an Interest Rate Do Assignment #1