Fundamentals of engineering economics

Tai Lieu Chat Luong Summary of Discrete Compounding Formulas with Discrete Payments - - = - Flow Type S Compound amount N (F/e i, N ) G Present worth I L i E E : Q u = Factor Notation Excel Command Formula = FV(i,N P , ) = PV(i, N , F , -0) = P V ( i , N , A , 0) Cash Flow Diagram - i (PIE i, N Compound amount i, N ) - A L P A i r I f i; i D $ i r ( M E i N ) Y M E N T s E R I E S "r " I j Sinking fund I E T S E R I E s - AAA Present worth (P/A,i, N ) Capital recovery ( M e i, N ) (P/G,i, N) Conversion fact01 (AIG,i, Rr) Geometric gradient Present worth (PIA g, i, N ) ,, / = A [(I = P[ + illv - i ( + i)" (1 i I I + ilN - Linear gradient Present worth AA + i)" - iN - Summary of Formulas Effective Interest Rate per Payment Period Discrete compounding i = [ ( I + ~ / ( c K ) ] '- Continuous compounding i erlK - where i r C - - Recovery Period (Year effective interest rate per payment period nominal interest rate or APR = number of interest periods per payment period K = number of payment periods per year r / K = nominal interest rate per payment period = Market Interest Rate - i where i if ,f = = = i' + f + i'f market interest rate inflation-free interest rate general inflation rate Present Value of Perpetuities p r, - = market related risk index market rate of return Cost of Debt Capital Recovery with Return CR(i) = ( I = S ) ( A / P ,i, N ) + iS Book Value x 11 = I - where id cost of debt the amount of term loan c,, = the amount of bond financing c,, = total debt = c, t c,, k, = the before-tax interest rate on the term loan kh = the before-tax interest rate on the bond t,,, = the firm's marginal tax rate - D, 1'1 c, Straight-Line Depreciation - (I - S) D,? - N Declining Balance Depreciation D,, - aI(1 - a)"-' = - Weighted-Average Cost of Capital where a = declining balance rate and < a N Cost of Equity where i, rf = = cost of equity risk-free interest rate where k = cost of capital c,, = total equity capital V = Cd + C, Library of Congress Cataloging-in-Publication Data on File Vice President and Editorial Director, ECS: Marcia J Horton Acquisitions Editor: Dorothy Marrero Vice President and Director of Production and Manufacturing ESM: David W Riccardi Executive Managing Editor: Vince O'Brien Managing Editor: David A George Production Editor: Scotr Disanno Director of Creative Services: Paul Eelfanti Creative Director: Carole Anson Art Director and Cover Manager: Maureen Eide Managing Editor,AV Management and Production: Patricia Bltrns Art Editor: Xiaohorlg Zhu Manufacturing Manager: Trudy Pisciotti Manufacturing Buyer: Lisa McDowell Marketing Manager: Holly Stark O 2004 by Pearson Education, Inc Upper Saddle River New Jersey 07458 All rights reserved No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher The author and publisher of this book have used their best efforts in preparing this book These efforts include the development research and testing of the theories and programs to determine their effectiveness.The author and publisher make no warranty of any kind expressed or implied with regard to these programs or the documentation contained in this book.The author and publisher shall not be liable in any event for incidental or consequential damages in connection with, or arising out of the furnishing, performance or use of these programs Excel is a registered trademark of the Microsoft Coporation One Microsoft Way Redmond WA 98052-6399 ISBN 0-13-030791-2 Pearson Education Ltd., London Pearson Education Australia Pty Ltd Sydney Pearson Education Singapore, Pte Ltd Pearson Education North Asia Ltd Hong Kong Pearson Education Canada, Inc., Toronto Pearson Education de Mexico, S.A de C.V Pearson Education-Japan Tokyo Pearson Education Malaysia, Pte Ltd Pearson Education, Inc., Upper Saddle River, New Jersey Table of Contents nderstanding Money and Its Management 1.1 1.2 1.3 1.4 2.1 2.2 2.3 The Rational Decision-Making Process 1.1.1 How D o We Make Typical Personal Decisions? 1.1.2 How Do We Approach an Engineering Design Problem? 1.1.3 What Makes Economic Decisions Differ from Other Design Decisions? The Engineer's Role in Business 1.2.1 Making Capital-Expenditure Decisions 1.2.2 Large-Scale Engineering Economic Decisions 1.2.3 Impact of Engineering Projects on Financial Statements Types of Strategic Engineering Economic Decisions Fundamental Principles in Engineering Economics Summary Interest: The Cost of Money 2.1.1 The Time Value of Money 2.1.2 Elements of Transactions Involving Interest 2.1.3 Methods of Calculating Interest Economic Equivalence 2.2.1 Definition and Simple Calculations 2.2.2 Equivalence Calculations Require a Common Time Basis for Comparison lnterest Formulas for Single Cash Flows 2.3.1 Compound-Amount Factor 2.3.2 Present-Worth Factor 2.3.3 Solving for Time and Interest Rates viii TABLE OF CONTENTS 2.4 2.5 2.6 2.7 3.1 3.2 3.3 3.4 Uneven-Payment Series Equal-Payment Series 2.5.1 Compound-Amount Factor: Find F, Given A, i, and N 2.5.2 Sinking-Fund Factor: Find A, Given i, and N 2.5.3 Capital-Recovery Factor (Annuity Factor): Find A, Given P i , and N 2.5.4 Present-Worth Factor: Find P, Given A, i, and N 2.5.5 Present Value of Perpetuities Dealing with Gradient Series 2.6.1 Handling Linear Gradient Series 2.6.2 Handling Geometric Gradient Series Composite Cash Flows Summary Problems Market Interest Rates 3.1 I Nominal Interest Rates 3.1.2 Annual Effective Yields Calculating Effective Interest Rates Based on Payment Periods 3.2.1 Discrete Compounding 3.2.2 Continuous Compounding Equivalence Calculations with Effective Interest Rates 3.3.1 Compounding Period Equal to Payment Period 3.3.2 Compounding Occurs at a Different Rate than that at which Payments Are Made Debt Management 3.4.1 Borrowing with Credit Cards 3.4.2 Commercial Loans-Calculating Principal and lnterest Payments 3.4.3 Comparing Different Financing Options Summary Problems " a'i , " : & 'p 4.1 Measure of Inflation 4.1.1 Consumer Price Index 4.1.2 Producer Price Index TABLE OF CONTENTS Average Inflation Rate C f ) versus Specific General lnflation Rate Inflation Rate (f,) Actual versus Constant Dollars 4.2.1 Conversion from Constant to Actual Dollars 4.2.2 Conversion from Actual to Constant Dollars Equivalence Calculations under Inflation 4.3.1 Market and Inflation-Free Interest Rates 4.3.2 Constant-Dollar Analysis 4.3.3 Actual-Dollar Analysis 4.3.4 Mixed-Dollar Analysis 4.1.3 4.1.4 4.2 4.3 (7) Summary Problems valuating Business and Engineering Assets "., PM Sb e* 5.1 5.2 5.3 5.4 Loan versus Project Cash Flows Initial Project Screening Methods 5.2.1 Benefits and Flaws of Payback Screening 5.2.2 Discounted-Payback Period Present-Worth Analysis 5.3.1 Net-Present-Worth Criterion 5.3.2 Guidelines for Selecting a MARR 5.3.3 Meaning of Net Present Worth 5.3.4 Capitalized-Equivalent Method Methods to Compare Mutually Exclusive Alternatives 5.4.1 Doing Nothing Is a Decision Option 5.4.2 Service Projects versus Revenue Projects 5.4.3 Analysis Period Equals Project Lives 5.4.4 Analysis Period Differs from Project Lives Summary Problems x TABLE OF CONTENTS 6.1 6.2 6.3 Annual Equivalent Worth Criterion 6.1.1 Benefits of AE Analysis 6.1.2 Capital Costs versus Operating Costs Applying Annual-Worth Analysis 6.2.1 Unit-Profit or Unit-Cost Calculation 6.2.2 Make-or-Buy Decision Comparing Mutually Exclusive Projects 6.3.1 Analysis Period Equals Project Lives 6.3.2 Analysis Period Differs from Projects' Lives Summary Problems 7.1 7.2 7.3 7.4 Rate of Return 7.1.1 Return on Investment 7.1.2 Return on Invested Capital Methods for Finding Rate of Return 7.2.1 Simple versus Nonsimple Investments 7.2.2 Computational Methods Internal-Rate-of-Return Criterion 7.3.1 Relationship to the PW Analysis 7.3.2 Decision Rule for Simple Investments 7.3.3 Decision Rule for Nonsimple Investments Incremental Analysis for Comparing Mutually Exclusive Alternatives 7.4.1 Flaws in Project Ranking by IRR 7.4.2 Incremental-Investment Analysis 7.4.3 Handling Unequal Service Lives Summary Problems 7A.1 Net-Investment Test 7A.2 The Need for an External Interest Rate 7A.3 Calculation of Return on Invested Capital for Mixed Investments 258 260 261 TABLE OF CONTENTS evelopment of Project Cash Flows 8.1 8.2 8.3 8.4 8.5 9.1 9.2 9.3 xi 267 Accounting Depreciation 8.1.1 Depreciable Property 8.1.2 Cost Basis 8.1.3 Useful Life and Salvage Value 8.1.4 Depreciation Methods: Book and Tax Depreciation Book Depreciation Methods 8.2.1 Straight-Line Method 8.2.2 Declining-Balance Method 8.2.3 Units-of-Production Method Tax Depreciation Methods 8.3.1 MACRS Recovery Periods 8.3.2 MACRS Depreciation: Personal Property 8.3.3 MACRS Depreciation: Real Property How to Determine "Accounting Profit" 8.4.1 Treatment of Depreciation Expenses 8.4.2 Calculation of Net Income 8.4.3 Operating Cash Flow versus Net Incomc Corporate Taxes 8.5.1 Income Taxes on Operating Income 8.5.2 Gain Taxes on Asset Disposals Summary Problems Understanding Project Cost Elements 9.1.1 Classifying Costs for Manufacturing Environmcnts 9.1.2 Classifying Costs for Financial Statement$ 9.1.3 Classifying Costs for Predicting Cost Behavior Why D o We Need to Use Cash Flow in Economic Analysis? Income-Tax Rate to Be Used in Economic Analysis 308 308 310 312 314 315 xiv TABLE OF CONTENTS 13.3 Using Ratios to Make Business Decisions 13.3.1 Debt Management Analysis 13.3.2 Liquidity Analysis 13.3.3 Asset Management Analysis 13.3.4 Profitability Analysis 13.3.5 Market-Value Analysis 13.3.6 Limitations of Financial Ratios in Business Decisions Summary Problems Index Atlanta Gas & Light Company (AGLC) 229-230 Auto loan payments, calculating, 87-89 "Available earnings for common stockholders," use of term, 466 Average collection period, 476 Average inflation rate, 116-117,119,134 Balance sheet statement, 460467,481 accounting equation, 460 assets, 460462 current, 460462 fixed, 462,463-464 other, 462 common stock, 463 debt, 464 Dell Computer Corporation, 463-464 equity, 464 goodwill, 462 liabilities, 462464 net worth, 463 paid-in capital, 463 quadrants of, 460 reading, 4631164 retained earnings, 463 share value, 464 stockholder's equity, 462464 Base period 114 Benchmark interest rate, 232 Benefit-cost analysis, 435-453 benefit-cost ratio: definition of, 439442 incremental, 442445 benefits, 436,438 defined, 436,445 disbenefits, 436 general framework, 437 primary benefit 437-438 public project evaluation, 436439 secondary benefit, 437438 secondary effects, 437 social discount rate, 438439 projects with private counterparts, 439 projects without private counterparts, 438439 sponsor's costs, 438 sponsors, user of term 436 users, use of term, 436 valuation of benefitslcosts, 437 527 Benefit-cost ratio: definition of, 439-442 incremental, 442-445 Benefits 436 Beta, 332 Birminham Steel, Inc., 198-202 Bonds, 36,472 Book depreciation methods 273,274-280.297 declining-balance depreciation, 276-279 straight-line (SL) depreciation, 274-275 units-of-production depreciation, 279-280 units-of-production method, 279-280 Book value per share, 479 Borrowed-funds concept, 156-158 Bose Armar G., 2-3 Bose Corporation, Boston Metal Company (BMC), 361-365 Break-even analysis, 368-370,380 Business decisions, and need for financial information, 456-457 Capital 472 debt 472 equity, 472 working, 474 Capital costs, 403 operating costs vs 189-192 Capital expenditures 10,317 capitalization of, 286 depreciation expenses vs., 289 Capital gains 294,298 Capital losses 294.298 Capital recovery costs, 189-1 92 Capital-expenditure decisions, making, 10 Capitalization, 158 Capitalized assets, 270 Capitalized cost 158-159 Capitalized-equivalent method, present-worth analysis, 158-159 Capital-recovery factor 37-50.186 Capstone Turbine Corporation, 184-185 Car purchase: buying in cash vs taking a loan 98-100 buying vs leasing, 100-102 Cash flow, 289,296 composite 65-67 brute Force approach using PIF factors, 65 grouping approach using PIF and PIA factors, 65-67 development of, 267-305 diagrams, 25-26,67 equivalent 29-30 estimation, 145 incremental 317-31 loan vs project, 144-145 negative, 25 net, 29 net income vs., 314 from operation vs net income, 289-290 patterns, 67-68 positive, 25 single, interest formulas for 33-40 using in economic analysis, 314 Cash flow statement, 467-471.481 Dell Computer Corporation 470-471 with financing activities, 323-325 with only operating and investing activities, 319-322 reporting format, 468-471 financing activities, 470 investing activities, 469-470 operating activities 468-469 sourcesluses of cash, 467-468 Cashlcash equivalents, 462 Cash-flow approach, to replacement analysis, 399-402,422 Chad Cameroon Pipeline Project, 358 Challenger, 396,399-402,422 Chesapeake and Delaware (C&D) Canal, 434 Close of money 22 College education, investing in, 218 College savings plan example 46-47 Commercial loans 94-97 Common stock, 463,466467,373 Composite cash flows, 65-67 brute force approach using PIF factors, 65 grouping approach using PIF and PIA factors, 65-67 Compound interest, 27-28,67 Compound-amount factor 33-36 factor notation, 34-36 interest tables, 33-34 single-payment compound-amount factor, 34-35 Compounding: continuous, 85 discrete, 83-84 Compounding period: determining, 82-83 equal to payment period, 87 Compound-interest formula, 67 Computational methods: rate of return (ROR): direct-solution method, 225-226 rate of return calculation using Excel, 229 trial-and-error method 227-228 Constant dollars 119-120,134 conversion to actual dollars, 120 Constant-dollar analysis, 123-124 Consumer price index (CPI), 114-115,134 Continuous compounding, 83-84 Conventional investment, 223 Conventional payback period, with salvage value, 146-1 49 Conventional-payback method 145 Corporate taxes 291-296 depreciation recapture 293-295 effective (average) tax rate 292-293 gain taxes on asset disposals 293-296 gainsllosses on depreciable assets 295-296 income taxes on operating income, 291-293 marginal tax rate 291 Cost basis, 271-272,294 Cost of equity 336 Cost use of term 270 Cost-of-living adjustment calculation 62-63 Cost-of-living index, 115 Cost-reduction projects 16-17 Counting process, 33-34 Coupon, 36 CPI See Consumer price index (CPI) Credit cards: borrowing with, 91-94 calculating interests on, 92 paying off, 92-94 revolving credit, 91 Current assets, 460-462 accounts receivable, 462 cashlcash equivalents, 462 inventories 462 short-term investments, 462 Current dollars, 119-120 Current market value, 396-397,422 Current ratio 474-475 Days-sales-outstanding (accounts receivable turnover) ratio, 476 Debt 464,472 Index Debt capital, 472 Debt financing, 473 Debt management, 91-102 car purchase: buying in cash vs taking a loan, 98-100 buying vs leasing, 100-102 commercial loans, 94-97 credit cards: borrowing with, 91-94 calculating interests on, 92 paying off, 92-94 revolving credit, 91 financing options, comparison of, 98 Debt management ratios 472-474,481 debt ratio, 473 times-interest-earned ratio, 473-474 Debt ratio, 322.473 Decision making, accounting as basis for, 456457 Decision rules: for nonsimple investments, 235-237 for simple investments, 232-235 Decline in purchasing power, 134 Declining-balance depreciation, 276-279 declining balance with conversion to straight-line depreciation, 278-279 depreciation rate 276-277 switching policy, 277-278 Defender, 396,399-402,422 Deferred loan repayment example, 49-50 Deflation, 114,134 Deflation method actual-dollar analysis, 124-126, 134-135 Dell Computer Corporation, 3,458-459 balance sheet, reading, 463-464 balance sheet statement, 463464 book value per share, 479 cash flow statement, 470471 current ratio, 474-475 days-sales-outstanding (DSO) ratio, 476 debt ratio, 473 and financial ratios, 471480 income statement, 467 inventory-turnover ratio, 475-476 pricelearnings (PIE) ratio 479 profit margin on sales 377 quick (acid test) ratio 475 return on common equity (ROE), 478 return on total assets (ROA), 477 times-interest-earned ratio 473-474 total-assets-turnover ratio 476 Dell, Michael, 459 Depreciable assets, 271 effects of inflation on projects with, 325-328 gainsllosses on, 295-296 Depreciable property 271 Depreciation, 270,288,297,317 accounting 270-274,297 accounting profit, 289 determining, 285-290 assets 271 capitalized, 270 depreciable gainsllosses on 295-296 fixed 270 salvage value, 272-273 book depreciation methods 273.274-280.207 declining-balance depreciation, 276-279 straight-line (SL) depreciation, 274-275 units-of-production depreciation 279-280 cash flows 289 corporate taxes, 291-296 gain taxes on asset disposals, 293-296 income taxes on operating income, 291-293 depreciation expenses, treatment of, 286 net income, 289 calculation of, 286-288 operating cash flow vs., 288-290 project expenses, 286 project revenue, 286 tabular approach to finding, 287 within a year, 287-288 preliminary determinations, 271 tax depreciation methods, 273-274.280-285,297 MACRs depreciation: personal property, 28 1-284 MACRs depreciation: real property, 284-285 MACRS recovery periods, 280-281 types of, 273-274 Depreciation accounting, 270 Depreciation allowance under inflation, 325-328 Depreciation expenses capital expenditures vs., 289 Depreciation recapture, 293-295 Differences among alternatives 18 Differential cash flows 317-31 financing activities, 31 investing activities, 317-318 operating activities 317 Disbenefits 436 Disbursements, 25,29.270 Discount rate 30,36 Discounted-payback method, 145 Discounting factor, 36 Discrete compounding, 83-84 Discrete compounding formulas with discrete payments, 64 Diversification, 377-380,381 Dividends 467 Dollar measures of investment worth, 238 Double-declining balance method, 276-277 Earning power 23 Earning power of money, 122 Earnings per share, 466-467 Economic decisions: compared to other design decisions, large-scale engineering, I Economic equivalence, 29-33.67 calculations, 29-33 requiring a common time basis for comparison, 32 simple 30 defined, 29 example 31-32 future worth, 32 present worth 32 simple example, 30-32 Economic indifference, 30,31 Economic Recovery Act (1981), 280 Educational loan paying off (example) 48-49 Effective annual interest rates, See Annual effective yield Effective annual yield, 230 Effective (average) tax rate, 292-293,297-298 Effective interest 100 Effective interest rates, See also Annual effective calculating, 83-86 equivalence calculations with 87-91 compounding at different rate than payments, 89-9 compounding period equal to payment period, 87-89 example 85-56 Effective rate 100 Effective rate per payment period 84 End-of-period convention, 26 Engineering design problem: approach to, 6-9 design alternatives evaluating, 7-8 design goalslobjectives, setting, green engineering, necessity as the mother of invention, product costlprice, Engineering economic analysis, 27 Engineering economic decisions, 3-19, See also Strategic engineering economic decisions defined, engineering economics: fundamental principles in, 17-18 strategic decisions, types of, 13-17 engineer's role in business, 9-13 rational decision-making process, 3-9 Engineering economics: fundamental principles in, 17-18 strategic decisions, types of 13-17 Engineers, role in business, 9-13 Enron 454 Equal-payment series, 42-56 capital-recovery factor, 47-50 compound-amounted factor 42-46 present value of perpetuities, 55-56 present-worth factor, 50-55 sinking-fund factor, 46-47 Equal-payment-series capital-recovery factor, 48 Equal-payment-series compound-amount factor, 44 Equal-payment-series present-worth factor, 50 Equal-payment-series sinking-fund factor, 46 Equipment replacement, 16-1 Equity, 322,464,472 Equity capital, 472 Equivalence calculations, under inflation, 122-139 Equivalent cash flow, 29-30 Excel, 35-37,40,44,46,49,51-53,56.131-133,202, 225,234,245 break-even analysis with, 368-370 and brute force approach, 65 determining loan balancelprincipallinterest, 94-97 finding present worth for a linear gradient series using, 58-60.68 Goal Seek function 53-54.368,369-370 rate of return calculation using, 229 rate-of-return calculation using, 229-230 Solver function, 131-133 Index Expected return, 372 External interest rate, 235 need for, 260-261 General inflation rate, 118.120, 134 General Motors Corporation, 11-13 GENII-EV1 (EVI), 11-13 Geometric gradient series 61-64.68 Geometric-gradient-series present-worth factor, 62 Gillette MACH3 razor, 15 Goal Seek function, Excel, 53-54,368,369-370 Goodwill, 462 Gradient series, 56-64 decreasing, 56,61 Excel spreadsheet presentation of, 60 geometric, 61-64 compound growth, 612 geometric-gradient-series present-worth factor, 62 present-worth factor, 61-62 single-payment present-worth factor 61 increasing 56.61 linear, 56-60.68 as composite series 56-57 finding present worth using Excel, 58-60 present-uorth factor 57-58 strict, 56 Gradient-series present-worth factor, 58 Gradient-to-equal payment series conversion factor 58 Half-year convention 283.294 Hausmann, Steve, 394 Home Depot, 306-307 IKEA-USA, 394 Impact of engineering projects, 11-13 Income 285 Income statement, 464467,481 accounting income 465 cost of goods sold, 464 cost of revenue, 464 Dell Computer Corporation, 467 dividends, 467 earnings per share, 466-467 net income, 464466 net revenue, 464 net sales 464 operating expenses, 464 other income, 465 retained earnings, 466467 Income tax rate, used in economic analysis, 315-316 Income taxes, 286 on operating income, 291-293 Incremental analysis, 238 for cost-only projects, 243-245 Incremental analysis approach, 233 Incremental benefit-cost ratios 439-442 Incremental cash flows, 317-315 financing activities, 318 investing activities, 317-318 operating activities, 317 Incremental costs, 161 Incremental investment, 247 Incremental tax rate 298 Incremental-investment analysis 238-245 Infinite planning horizon, 309422 replacement analysis under, 410-422 Inflation, 22-23,113-139 actual dollars, 119-120 conversion from constant dollars to, 120-121 conversion to constant dollars from, 122 actual vs constant dollars, 119-122 actual-dollar analysis, 124-129 average inflation rate, 119 base period, 114 constant dollars, 119-120 conversion from actual dollars to 122 conversion to actual dollars, 120-121 constant-dollar analysis, 123-124 defined, 114, 134 deflation, 114,134 depreciation allowance under 325-328 earning power of money, 122-123 equivalence calculations under, 122-139 inflation-free interest rates, 123 market baskets 114-115 market interest rate 123 measures of, 114-1 19 average inflation rate, 116-117 consumer price index (CPI), 114-115 general inflation rate, 118,120 producer price index (PPI), 115-116 specific inflation rate, 118 mixed-dollar analvsis, 129-134 multiple inflation rates, handling, 329-330 purchasing power, 122-123 rates, applying, 329-330 yearly inflation rate, 119 lnflation premium, 331 Inflation-free interest rates, 123, 134 lntangible property, 271 Interest 22-28,67 annual percentage, 26 calculating 26-28 compound, 27-28 compound-amount factor, 33-36 compounding process, 33-34 defined, 22 elements of transactions involving, 24-26 future amount of money 24 interest period, 24-25 end-of-period convention, 26 interest rate, 24 interest transaction, example of, 24-25 number of interest periods, 24 plan for receiptsldisbursements, 24 present-worth factor, 36-37 principal, 24 simple, 27-28 solving for time and interest rates, 37-40 year, 25 Interest formulas 22.68 for single cash flows, 3 Interest period 24 Interest rate 22,67,170 defined, 24 market 24 Interest tables 33-34 Internal rate of return (IRR), 220,222-223,247 flows in project ranking by, 238 handling unequal service lives, 245-246 incremental-investment analysis, 238-245 mixed investment, 261,262-265 Internal-rate-of-return criterion, 232-237 Inventories, 462 Inventory-turnover ratio, 475476 Invested capital, return on, 223-224 Investing activities: cash flow statement, 469470 cash flow statement with, 319-322 cash flows from, 317-318 Index Investment pools 155-156 Investment project, useful life of, 222 Investment, return on 220-222 Investme~ltrisk, 18 Investment worth of projects, formula to evaluate 186 Large-scale engineering economic decisions, I1 Liabilities, 462-464 current, 463 other, 463 Line cost fees, 454-455 Linear gradient series 68 Liquidity position, 474 Liquidity ratios, 474475,481 current ratio, 474475 quick (acid test) ratio, 475 Loan cash flows, 144-145 Loan origination fee, 21 Long-term debt financing 472 Loss, 285 Lowest common multiple, of project lives 166,203 Make-or-buy decision, 195-1 97 Marginal analysis, 409 Marginal efficiency of capital, 220 Marginal revenue vs marginal cost, 18 Marginal tax rate, 291,297 Market baskets, 114-115 Market interest rate, 24.123, 134,145 Market price, 230 Market rate of return, 332 Market-value ratios, 478-479.481 book value per share, 479 pricelearnings ratio, 479 MARR (minimum acceptable rate of return) 261-262 MARR (minimum attractive rate of return), 169, 170,325,438 Maturity, bonds, 36 Merco, Inc., 233-234 MicroCHP (Capstone Turbine Corporation), 184 Microsoft Corporation, Microsoft Excel, See Excel Midmonth convention 284 Minimum payments: on credit card balances, paying, 78 Mixed investments: defined, 258 pure investments vs., 258-260 Mixed-dollar analysis 129-134 Modified Accelerated Cost Recovery System (MACRS), 280.294-295,298 depreciation: personal property 281 -284 real property, 284-285 property classifications 28 recovery periods, 280-281 Money management: debt management 91-102 effective interest rates equivalence calculations with, 87-91 money market rates, 80-83 annual effective yields, 80.81-82 annual percentage rate (APR) 79.80 compounding period, determining 81-83 nominal interest rates, 80 understanding, 79-11 Money market rates, 80-83 annual effective yields, 80,81-82 annual percentage rate (APR) 79.80 compounding period, determining 82-87 nominal interest rates, SO Money, time value of, 18 Multiple alternatives comparing 186 Multiple inflation rates: handling, 329-330 Multiple rates of return: external interest rate, need for, 260-261 net-investment test, 258-260 resolution of, 257-265 return on invested capital for mixed investments calculation of, 26 1-265 Mutually exclusive alternatives: incremental analysis, 237-246 present-worth analysis 237-246 sensitivity analysis, 361-368,380 Mutually exclusive, use of term, 169 National benefits, primary, 437438 Negative cash flows, 25.29 Negative rate of return, 222 Net BIC ratio, 440 Net cash flow, 25.289 Net equity flow, 336 Net income 285,296,464-466 calculation of, 286-288,317 operating cash flow vs., 288-290 project expenses 286 project revenue, 286 tabular approach to finding, 287 within a year, 287-288 Net investment defined, 258 Net present worth 155-158 borrowed-funds concept, 156-1 58 investment-pool concept, 155-156 Net revenue, 464 Net sales, 464 Net worth, 463 Net-investment test 258-260 New assets, purchase of, 286 New products, 15-16 Nickel-metal hydride (NiMH) battery pack, 11 Nominal interest, 102 Nominal interest rates, 80,123 relationship between effective interest rates and, 81 Noncash expense, 289 Nonconventional investment 223 Nonsimple investment 223,247 Office of Management and Budget (OMB), 439 Operating activities: cash flow statement, 468469 cash flow statement with, 319-322 cash flows from, 317 Operating costs, 398-399,403,422 defined 189 Operating expenses, 464 Opportunity cost, 331,401-402 Opportunity-cost approach, to replacement analysis, 401402,422 Other income, 465 Ownership costs defined, 189 Paid-in capital 463 Payback method, 145 Payback period, determination of, 145 Payback screening, 145 Percentage measures of investment worth, 238 Perfect negative cross correlation, 377 Perfect positive cross correlation, 377 Perpetual service life, 158 Perpetuities: defined 55 present value of, 55-56 Planning horizon (study period), 408 Positive cash flows, 25.29 Powerball lottery game, 20-21 Preferred stock, 463 Preferred stock, 466-467,473 Premium efficiency motors, and cutting electric costs (example), 198-202 Present worth, 32, 169 Present-worth analysis, 143-183,206 capitalized-equivalent method, 158-159 perpetual service life, 158 comparison of mutually exclusive alternatives, 160-169 analysis period, 162-164 doing nothing, 160-161 service vs revenue projects 161-162,169 conventional-payback method, 145 discounted-payback method, 145 discounted-payback period, 148-149 initial project screen methods, 145-149 loan vs project cash flows 144-145 methodsltechniques, 149-159 capitalized-equivalent method, 158-159 discounted cash flow techniques (DCFs), 149 MAAR selection, 153-155 net present worth, 155-158 net-present-worth criterion, 150-153 net present worth, 155-158 borrowed-funds concept, 156-158 investment-pool concept, 155-156 payback method 145 payback period, determination of, 145 payback screening, 145 benefitslflaws of, 147-148 Present-worth factor, 36-37 discounting process 36 single-payment present-worth factor, 36-37 Price index, 115 Pricelearnings ratio, 479 Primary benefit, 437-438 Principal, 24 Index Probabilities, 360-361 Producer price index (PPI), 115-116 Product expansion, 15-16 Project expenses, 286 Profit, 285 accounting, 285-290 unit, 192-194 Profit margin on sales, 477 Profitability ratios, 477478,481 profit margin on sales, 477 return on common equity (ROE) 478 return on total assets (ROA), 477 Project cash flows, 144-145 analysis, 307-357 beta, 332 borrowed funds, projects financed with 322-325 choice of MARR: known project financing, 336-337 unknown project financing, 337 cost of capital, 331-337 calculating, 334-336 defined, 334 marginal cost of capital, 335-336 weighted-average cost of capital, 334-335 cost of debt, 333-334 after-tax, 333 determining 334 cost of equity, 331-334 determining, 333 depreciation allowance under inflation 325-328 effects of inflation on, 325-330 multiple inflation rates, handling 329-330 statements, developing 318-325 tax-adjusted weighted-average cost of capital, 334 working capital 325 Project cost elements, understanding, 308-313 Project life, 162-164 analysis period different from project lives, 164-166 analysis period equal to, 162-164 shorter than analysis period, 166-167 Project lives, and analysis period, 198 Project revenue, 286 Project risk, 360 break-even analysis, 368-370,380 defined, 380 including risk in investment education, 371-376 investment strategies under uncertainty, 376-380 535 methods of describing, 361-37 origins of, 360-361 risk analysis, 361 scenario analysis, 370-371.380 sensitivity analysis, 36 1-365.380 for mutually exclusive alternatives, 365-368 Public investment decisions, 436 Public project evaluation, 436439 Purchasing power, 23,113.122-123 decline in, 134 Pure borrowing, 258 Pure investments, 246 defined, 258 mixed investments vs., 258-260 Quality improvement, 14-15 Quick (acid test) ratio 475 Rate of return (ROR): analysis, 219-255 benchmark interest rate, 232 computational methods, 225-231 direct-solution method, 225-226 rate of return calculation using Excel 229 trial-and-error method 227-228 defined 220,246 finding methods for 223-231 internal rate of return (IRR).220.222-223.247 flows in project ranking by 238 handling unequal service lives, 245-246 incremental-investment analysis 238-245 internal-rate-of-return criterion 232-237 decision rules for nonsimple investments 235-237 decision rules for simple investments 232-235 relationship to PW analysis 232 investment classification 224-225 marginal efficiency of capital, 220 mutually exclusive alternatives, incremental analysis for comparing, 237-246 negative rate of return, 222 nonsimple investment 221,247 return on invested capital, 222-223 return on investment, 220-222.229 simple investment, 223,247 yield, 220,222 yield to maturity, 229-231 Rational decision-making process, 3-9 personal decision making, 4-6 establishing goallobjective, evaluation of feasible alternatives 4-6 knowing other opportunities, review of, Ratios, See Financial ratios Real dollars, 119-120 Real interest rate, 123 Receipts, 25 Recovery, 318 Recovery allowance percentages, 281 Recovery periods, 280-281 Regional benefits, primary, 438 Relative measures of investment worth, 238 Relevant cash flow, 408 Repayment plans, 25 Replacement analysis, 395-433 basic concepts, 396-399 capital costs 403 cash-flow approach, 399-402,422 challenger, 396,399-402,422 current market value, 396-397,422 defender, 396,399-402,422 keeping, 399-401 replacing with the challenger 400401 econonlic service life, 402-407.422 for a forklift truck, 404-407 fundamentals, 396402 long required service period 407413 decision criterion, 408409 infinite planning horizon, 409-422 planning horizon (study period), 408 relevant cash flow, 408 technology, 408 operating costs, 398-399,403 opportunity-cost approach, 401402,422 relevant information for, 397 replacement problem, 396 sunk costs, 397-398,422 with tax considerations, 413422 technological change, role in asset improvement, 408,422 terminology, 396-399 Reporting format: cash flow statement 468471 financing activities, 470 investing activities, 469-470 operating activities, 468-469 Retained earnings, 463,466467 Return on common equity (ROE), 478 Return on invested capital, 222-223 for mixed investments, calculation of, 261-265 Return on invested capital (RIC), 261 Return on investment, 220-222,229 Return on total assets (ROA), 477 Revenue projects, 161-162,169 Revolving credit, 91 Risk, 360 defined, 372 and dispersion, 373 diversification, 377 and expected return, 377-380 including in investment evaluation, 371-376 probabilistic approach, 371-375 risk-adjusted discount rate approach, 375-376 mean, computing 374-375 trade-off between reward and, 376 and uncertainty 373 variance, computing, 374-375 Risk analysis, 361 Risk premium, 331 Risk-free interest rate, 331,332 Risk-free investments, 376 Risky assets, expected return on, 331 Rockford Corporation, 272 Rule of 72,40 Rule of 78th, 111 Salvage value, 164,272-273,317-318 Savings plans example 52-53 Scale, 238 Scenario analysis, 370-371,380 Screening capital investments, 145 Secondary benefit, 437-438 Secondary effects, 437 Securities and Exchange Commission (SEC), 456 Self-chilling beverage container, 6-9 Sensitivity analysis, 361-365.380 for mutually exclusive alternatives, 365-368 Service improvement, 14-15 Service projects 161 Share value, 464 Short-term debt financing, 472 Short-term investments, 462 SIEMEN Westinghouse 236 Simple interest, 27-28,67,190 Simple investments, 223,247 decision rules for 232-235 Simple vs compound interest, 27-28 Singapore Airlines, 187-188 Single cash flows, interest formulas for 3 Single payment, 67 Single project evaluating, 186 Single-payment compound-amount factor 34-35 Sinking-fund factor, 46-47 Social discount rate, 438-339 projects with private counterparts 439 projects without private counterparts, 138-439 Solver function: Excel, 131 Specific inflation rate, 118 Sponsor's costs 438 Sponsors use of term, 436 Standard deviation, 372 Statement of financial position 460 Stock price, factors affecting 459 Stockholders' equity, 462464 Straight-line (SL) depreciation 274-275 Strategic engineering economic decisions: cost reduction 16-17 equipment and process selection, 16 equipment replacement 16-17 new productsiproduct expansion, 15-16 service or quality improvement, 14-15 types of, 13-1 Sunk costs, 397-398.422 Survey of Current Business, 115 MACRs depreciation: real property, 284-285 MACRS recovery periods, 280-281 Time value of money 18-22-77 composite cash flows, 65-67 cost of money 22 defined, 22 economic equivalence, 29-33.67 eq ual-payment series, 42-56 gradient series, 56-64 interest 22-28 interest formulas for single cash flows, 33-40 uneven-payment series, 40-32 Times-interest-earned ratio 473-474 Top-10 movies adjusted for inflation, 112 Total-assets-turnover ratio, 476 Trane Ima9e Processing (TIP), 236 Trend analysis 480.481 True IRR (internal rate of return) 261 True rate of return 161 200% double-declining balance 276 Working-capital investment, 318 Working-capital terms, 469 WorldCom, 454-456 Yahoo, Yearly inflation rate, 119 Yield, 220,222 annual effective, 80,81-82 I 64dl t ! tBat=&m9.oIIdle disciplines I Incorporatea all critical decisiowa@hg- toalr informed financial decisions Provides Excel solutions for many examples STUDENT AND INSTRUCTOR RESOURCE# Study Guicie for Fundamentals of Engineering EconomicsMke w# tach text, more than 200 completely worked out solutions and guides ohow to take the Fundamentals of Engineer* aman with sample set test questions &reel for Engineering E c o n o m i u - O p t i d rpplcmbaim ~ W Wta imt HIEQg &IC e e e r i n g economic studies and various Excel applicatiom Csmprehensive book websk at a f f l w ~ n h a l l c o m / p a r l p a r ~d m fbm& tors, formatted Excel files, and links can be accessed qhb -Bfsrr ~mabca-cmhh ?L AWWPF T3W3 AUTHOR , r P € h a S Park is currently r R&mm d Industrid srPlt m s Engineering t h b m Universitp Ib meceived the M& a d Ph.D degrem h Wustrial engineering from Purdm University and the Georgia Institute of Technology, respectively Over his 25-year acade* cmeer, he has been actively involved in a variety of areas of research, teaching, and professional consulting His work has been recognized internationally in the fields of engineering economics, strategic and economic decisions within service sectors, financial engineering (real options valuation), risk analysis, and capital budgeting He also authored or coauthored leading textbooks on the related subjects, including Contemporary Engineering Economics (Prentice Hall), and Advanced Engineering Economics (John Wiley & Sons) He is the Edit* in-Chief of the journal The Engineering Economist and is a licensed Professional Engineer Upper Saddle Rim M?€WS