1. Background
At various universities, this course is referred to as Engineering Economy, Engineering Economic Analysis, Economic Decision Making, Economic Analysis, and Economic Decision Analysis, among others
The material to be covered is frequently cited by alumni as the topic they want to see given greater emphasis
The subject will be approached from a cash flow perspective, i.e., the concern will be with monies spent and received (saved)

2. Course Objectives Course objectives are for you to
be prepared for the economic justification portion of the FE exam
be able to prepare economic justifications for engineering proposals
be able to manage personal finances and make wise investment decisions
be able to evaluate economic justifications performed by others

3. Course Objectives Other course objectives are for you to
be comfortable using financial language
be aware of tradeoffs involving expenses and capital costs under tax and inflation conditions
be familiar with advanced techniques of modeling decision problems under risk and uncertainty conditions
have fun!

4. My Commitment to You I will endeavor to
start and end class on-time every time
be prepared and give a “best effort” in teaching the course material
treat you as professionals and cover material that will be of maximum benefit to you
determine your grade based on your performance, i.e., you are not competing with one another
return all graded work promptly
respond to your feedback

5. Your Commitment to Me You will endeavor to
attend every class and arrive on time, unless you are ill or have a personal “emergency”
read the handouts and text before coming to class; turn in all homework and take all tests
conduct yourself as a professional, maintain the highest integrity and code of conduct, and help other students learn the material
let me know if you have difficulty understanding the material and provide feedback at the end of each class on positive and negative aspects of the course

6. The textbook for the course is
Principles of Engineering Economic Analysis, J. A. White, K. E. Case, and D. B. Pratt, 5th edition, John Wiley & Sons, Inc., 2009.

7. Engineering Economic Analysis
Chapter 1
Engineering Economic Analysis

8. What Is Included in Chapter 1
The importance of the time value of money (TVOM)
Four discounted cash flow rules
Ten principles of engineering economic analysis
A 7-step approach for performing engineering economic analyses
When the TVOM can be ignored

9. Fundamental Concept
Money has a time value

10. Time Value of Money
Would you rather receive $1000 today or $1000 a year from today?
Would you rather receive $1000 today or $1050 a year from today?
Would you rather receive $1000 today or $1100 a year from today?
Would you rather receive $1000 today or $1500 a year from today?
Would you rather receive $1000 today or $2000 a year from today?
Would you rather receive $1000 today or $5000 a year from today?
Would you rather receive $1000 today or $10,000 a year from today?
Would you rather receive $1000 today or $100,000 a year from today?

11. Time Value of Money
Regardless of the value of inflation, money has a time value due to its “earning power”
Suppose you arrive in a city by airplane and need a car
you can buy a car
you can rent a car
Suppose you arrive in a city and need a place to stay
you can buy a house or condominium
you can rent a house, apartment, or hotel room
Suppose you arrive in a city and need money
you can rent money from a business or person

12. Four Discounted Cash Flow Rules
Money has a time value;
Money cannot be added or subtracted unless it occurs at the same point(s) in time;
To move money forward one time unit, multiply by one plus the discount or interest rate;
To move money backward one time unit, divide by one plus the discount or interest rate.

13. Principles of Engineering Economic Analysis
Money has a time value.
Make investments that are economically justified.
Choose the mutually exclusive investment alternative that maximizes economic worth.
Two investment alternatives are equivalent if they have the same economic worth.

14. “If you need a new machine and don’t buy it, you pay for it without ever getting it.”
Henry Ford

15. Principles of Engineering Economic Analysis
Marginal revenue must exceed marginal cost.
Continue to invest as long as each additional increment of investment yields a return that is greater than the investor’s TVOM.
Consider only differences in cash flows among investment alternatives.

16. Principles of Engineering Economic Analysis
Compare investment alternatives over a common period of time.
Risks and returns tend to be positively correlated.
Past costs are irrelevant in engineering economic analyses, unless they impact future costs.

17. Economic Justification Seven Questions to Answer
What investment alternatives are available?
What is the length of time over which the decision is to be made?
What TVOM will be used to move monies forward and/or backward in time?
What are the best estimates of the cash flows for each alternative?
Which investment alternative seems best, based on the economic criterion chosen?
How sensitive is the decision to changes or errors in the estimates used in the analysis?
Which investment is recommended?

18. SEAT Systematic Economic Analysis Technique Seven-Step Procedure
Identify the investment alternatives
Define the planning horizon
Specify the discount rate
Estimate the cash flows
Compare the alternatives
Perform supplementary analyses
Select the preferred alternative

19. Step 1: Identify the Feasible Alternatives
Most important step!
Beware the “Do Nothing” alternative
Consider a range of alternatives
Be objective!
Impact of “size gates”
“Design the whole, justify the whole, and implement the parts”

20. Example 1.5
A firm is considering three investment proposals (A,B, & C). A requires $1M investment, B requires $2.5M, and C requires $3M. The firm has $4.5M to invest. C is contingent on A; B and C are mutually exclusive. The “do nothing” alternative is not feasible. Form the set of mutually exclusive investment alternatives that exists.

21. Example 1.5 Forming Investment Alternatives from Investment Proposals

22. Example 1.5 Forming Investment Alternatives from Investment Proposals

23. Step 2: Define the Planning Horizon*
The width of the window
U.S. < 5 yrs; Japan > 15 yrs
Planning horizon vs. working life vs. depreciable life
Standard planning horizons
Impact of too short a planning horizon
Impact of too long a planning horizon
* See Chapter 4

24. Step 3: Specify the Discount Rate*
Hurdle rate, interest rate, return on investment (ROI), minimum attractive rate of return (MARR)
Money has a time value!
Opportunity cost for money
U.S. – double-digit rates
Japan – single-digit rates
* See Chapter 4

25. Step 4: Estimate the Cash Flows*
Examples of cash flows
Depreciation is not a cash flow
Annual cash flows
“Best estimates”
Tangibles and intangibles
Future estimates, not past estimates
Costs and revenues
Incremental cash flows
Don’t forget the competition!
*see Chapter 16

26. Step 5: Compare the Investment Alternatives*
Present worth method (PW) (* Ch. 5)
Capitalized worth method (CW) (* Ch. 5)
Discounted payback period method (DPBP)
(* Ch. 5)
Payback period method (PBP) (* Ch. 5)
Future worth method (FW) (* Ch. 6)
Annual worth method (AW) (* Ch. 7)
Internal rate of return method (IRR) (* Ch. 8)
External rate of return method (ERR) (* Ch. 8)
Modified internal rate of return (MIRR) (* Ch. 8)
Benefit/Cost ratio method (B/C) (* Ch. 14)

27. Step 6: Perform Supplementary Analyses*
GIGO
Don’t wade in rivers, on the average, two feet deep when wearing boots that are two feet tall!!
Breakeven analysis
Sensitivity analysis
Risk analysis
Going the extra mile!
Beware of “paralysis of analysis”
*see Chapter 13

28. Break-even, Sensitivity, and Risk Analyses
Break-even analysis
determining the value of one or more parameters that will make the PW=0
Sensitivity analysis
determining the impact of a range of values for one or more parameters on the measure of merit
Risk analysis
determining the probability the PW>0, given probability distributions for one or more parameters

29. Step 7: Select the Preferred Alternative*
Obtain the support of the users of the recommended system
Pre-sell the recommendation
Eliminate surprises
Do not over-sell the technical aspects of the recommended system
Technical aspects seldom convince management to make the required investment
The decision-makers’ perspectives are broad
Know their priorities and tailor the economic justification package accordingly
*see Chapter 15

30. Step 7: Select the Preferred Alternative
Relate the proposed investments to the well-being of the firm
Show how the investment relates to the firm’s strategic plan and stated corporate objectives
Your proposal will be only one of many submitted and many will not be funded
Failure to fund your proposal does not mean management is stupid
Management’s decision to fund your proposal does not mean they are brilliant

31. Step 7: Select the Preferred Alternative
Don’t confuse unfavorable results with destiny
Timing is everything!
Profit maximization is not always the “name of the game,” but “selling” is!
A firm’s ability to finance the proposal is as important as its economic merit
You get what you pay for
Don’t be penny-wise and dollar-foolish
Remember the “Golden Rule,” those with gold make the rules!
The less you bet the more you stand to lose in case you win!

32. Weighted Factor Comparison of Alternatives
Example 1.8 Three investment alternatives (A,B,C) are being considered by the Ajax Mfg. Co. The PWs are $25K, $20K, and $18K, respectively. There are differences in the quality (Q) of the tools being considered, the time (T) to fill a customer’s order, and the reputations (R) of the tool suppliers.

33. Weighted Factor Comparison Form
Company: Prepared by: Date:
Description of investment:

34. Weighted Factor Comparison Form Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009 Description of investment: order picking equipment for distribution center

35. Weighted Factor Comparison Form Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009 Description of investment: order picking equipment for distribution center

36. When the TVOM Need Not Be Considered
When no investment of capital is required
When all cash flows occur in a limited time period, e.g., less than a year
When annual cash flows are roughly proportional to cash flows the first year
When the same capital investment is required for all alternatives
When there are no essential differences in cash flows among the alternatives after the first year

37. Example 1.9
Six college students are making plans for spring break. They are considering traveling 1200 miles to Florida by bus, train, plane, rental cars, or rental van. Due to bus and train schedules, they limited their options to plane, two rental cars, or a rental van.
The final data used in their analysis of transportation options are as follows: round-trip airfare per person ($300); daily rental rate for each car, all charges except fuel ($50); rental car gas mileage (20 miles/gallon); drop charge for each car ($150); daily rental rate for a van, all charges except fuel ($80); rental van gas mileage (12 miles/gallon); drop charge for the van ($225); cost to travel to or from the airport at the spring break destination ($50 per cab, two cabs required); and average price of gasoline ($4.25/gallon). If they keep the rental vehicle, the charges will be for 7 days; if they drop the rental vehicle, the charges will be for 2 days.

38. Example 1.9 (Continued) Alternatives 1. fly to/from spring break
2. use two rental cars and incur drop charges
3. use two rental cars and do not incur drop charges
4. use a rental van and incur drop charges
5. use a rental van and do not incur drop charges.
Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $
2. Total cost = 2 rental cars ($50/day)(2 days) + 4 drops ($150/drop)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $
3. Total cost = 2 rental cars ($50/day)(7 days)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $
4. Total cost = 1 rental van ($80/day)(2 days) + 2 drops ($225/drop)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $
5. Total cost = 1 rental van ($80/day)(7 days)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $

39. Example 1.9 (Continued) Alternatives 1. fly to/from spring break
2. use two rental cars
a. incur drop charges
b. do not incur drop charges
3. use a rental van
Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $
2. Driving cost = 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon)
+ 2 rental cars ($50/day)(2 days) = $
a. Cost = 4 drops ($150/drop) = $600.00
b. Cost = 2 rental cars ($50/day)(5 days) = $500.00
Lowest cost = $
3. Driving cost = 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon)
+ 1 rental van ($80/day)(2 days) = $
a. Cost = 2 drops ($225/drop) = $450.00
b. Cost = 1 rental van ($80/day)(5 days) = $400.00
Lowest cost = $

40. Example 1.12
Hugh Kinney, a small business owner, must purchase a large number of light bulbs for his new office building. At Wal-Mart he found several options available, but narrowed his selection to either GE Soft White 100 incandescent or GE Soft White 100 helical fluorescent bulbs, costing 26¢ and $3.22, each, respectively. The light output per bulb is 1690 lumens and 1700 lumens, respectively; the energy used per bulb is 100 watts and 26 watts, respectively; and the rated life per bulb is 750 hours and 12,000 hours, respectively. Usage is estimated to be 2500 hours/year. Electrical energy costs $0.10 per kilowatt hour. Labor to install/replace a bulb is estimated to cost $2.00. Which bulb should he choose in order to minimize his annual cost?

41. Hugh’s Solution to Example 1.12
Energy cost/bulb:
Incandescent (2500 hr/yr)(100 w)($0.1/kWh)/1000 hr
= $25/yr
Fluorescent (2500 hr/yr)(26 w)($0.1/kWh)/1000 hr
= $6.25/yr
Acquisition, plus installation/replacement cost:
Incandescent (2500 hr/yr)($ $0.26)/750 hr
= $7.53/yr
Fluorescent (2500 hr/yr)($ $3.22)/12,000 hr
= $1.09/yr*
Annual cost:
Incandescent $ $7.53 = $32.53/yr
Fluorescent $ $1.09 = $7.34/yr
* violates 1st DCF rule, since bulb lasts longer than a year

42. Example 1.13
Stacey Kinney, an engineer and Hugh’s daughter, pointed out several errors in her father’s analysis. She explained that the energy cost consists of a fixed cost and a variable cost: $7.10 per meter; 8.803¢/kWh for < 2000 kWh in a month; and ¢/kWh for > 2000 kWh/mo. Since the energy load on the building > 2000 kWh/mo, she said the incremental cost would be 8.087¢/kWh, not 10¢/kWh.
Stacey also asked how the labor cost was determined. Given the answer, she asked if the employee will be paid overtime for installing/replacing bulbs. When she learned he would not, she reminded her father that there would not be an incremental cost to install or replace bulbs.

43. Stacey’s Solution to Example 1.13
Energy cost/bulb:
Incandescent (2500 hr/yr)(100 w)($ /kWh)/1000 hr
= $ /yr
Fluorescent (2500 hr/yr)(26 w)($ /kWh)/1000 hr
= $5.2566/yr
Acquisition, plus installation/replacement cost:
Incandescent (2500 hr/yr)($0.26)/750 hr
= $0.8667/yr
Fluorescent (2500 hr/yr)($3.22)/12,000 hr
= $6708/yr ($0.9883/yr based on 15% TVOM)
Annual cost:
Incandescent $ $ = $ /yr
Fluorescent $ $ = $5.9274/yr ($6.2449/yr based on 15% TVOM)

44. Pit Stop #1—Checking Your Pulse
True or False: If someone offers you the choice of receiving $1000 today versus receiving $1000 a year from today, you should take the money today if your time value of money is greater than zero.
True of False: A strength of the weighted factor comparison technique is its scientific foundation and its elimination of subjectivity from decision making.
True or False: If your time value of money is 10% annually, then you will be indifferent between receiving $1000 today and receiving $1100 one year from today.
True or False: Based on the principles of engineering economic analysis, you should bet on the horse with the lowest odds to win, because risk and returns tend to be positively correlated.
True or False: Every economic decision should be based on the time value of money.

45. Pit Stop #1—Checking Your Pulse
True or False: If someone offers you the choice of receiving $1000 today versus receiving $1000 a year from today, you should take the money today if your time value of money is greater than zero. TRUE
True of False: A strength of the weighted factor comparison technique is its scientific foundation and its elimination of subjectivity from decision making. FALSE
True or False: If your time value of money is 10% annually, then you will be indifferent between receiving $1000 today and receiving $1100 one year from today. TRUE
True or False: Based on the principles of engineering economic analysis, you should bet on the horse with the lowest odds to win, because risk and returns tend to be positively correlated. FALSE
True or False: Every economic decision should be based on the time value of money. FALSE