1. Economic Decision Making
Ulrich and Eppinger Chapter 15
Deiter & Schmidt Chapter 18
Adapted from Dr. Stamper

2. Product Development Process
Planning
Concept
Development
System-Level
Design
Detail
Design
Testing and
Refinement
Production
Ramp-Up
Concept Development Process
Mission
Statement
Development
Plan
Identify
Customer
Needs
Establish
Target
Specifications
Generate
Product
Concepts
Select
Product
Concept(s)
Test
Product
Concept(s)
Set Final
Specifications
Plan
Downstream
Development
Perform Economic Analysis
Benchmark Competitive Products
Build and Test Models and Prototypes

3. Overview Monday: (Dieter, Chap 18 and Ulrich, Chap 15 Appendix)
Time Value of Money, Cash Flow Diagrams, Net Present Value, Depreciation
Thursday
Economic Analysis Process for Product Development (Ulrich Chap 15)
Profitability
Monday
More analysis
Wednesday:
Lab exercises

4. Objectives Learn some of the language of the business community
Provide techniques to evaluate the financial attractiveness of various alternatives that are presented to engineers
Apply the economic evaluation techniques to personal and professional decisions

5. Time Value of Money Proposition:
The value of money changes over time: generally $1 in the future is worth less than $1 now
Evidence:
Organizations are willing to borrow money in the present and then return more than what they borrowed at some point in the future (renting money).

6. Example 1: Simple Interest Future Value
Assume:
Invest $100 now (P=$100)
At 8% annual interest rate (i=8%=0.08)
A single 1 year period (n=1)
Find: Future Value (F)
F = (1+i)P = (1+0.08)100= $108

7. Example 2: Simple Interest Present Value
Assume:
Desire a future payout of $100 (F=$100)
At 8% annual interest/discount rate (i=8%=0.08)
After a single 1 year period (n=1)
Find: Present value to give F=$100
Same equation: F = (1+i)P, but solve for P
P=F/(1+i) = $100/(1+0.08)= $92.59

8. Example 3: Compound Interest Future Value
Assume:
Invest $100 now (P=$100)
At 8% annual interest rate (i=8%=0.08)
For a 3 year period (n=3)
Find: Future Value (F)
Fafter 1 year = (1+i)P = (1+0.08)100= $108
Fafter 2 years = (1+i)(1+i)P = (1+0.08)(1+0.08)100= $116.64
Fafter 3 years = (1+i)(1+i)(1+i)P = $125.97

9. Example 4: Compound Interest Present Value
Assume:
Desire a future payout of $100 (F=$100)
At 8% annual interest rate (i=8%=0.08)
After a 3 year period (n=3)
Find: Present value to give F=$100
Same equation: F = (1+i)(1+i)(1+i)P, but solve for P
P=$100/[(1+0.08)(1+0.08)(1+0.08)]= $79.38

10. General Equations for Compound Interest
Future Value:
Present Value:
Where:
F is future value
P is present value
i is interest rate (or discount rate)
n is number of periods

11. How Do We Compare Alternatives? (Economic Decision Making)
We need some form of “equivalence”
Present Value and Future Value can provide that equivalence

12. Cash Flow Diagrams & Net Present Value
Note the cash flow diagram.
Incomes point into the line
Expenses point away from the line
Time starts in year 0 (start of year 1)
All other flows are at the end of the year
Page 867 Dieter and Schmidt

13. Net Present Value of the Costs of Machine A
Present Value of Year 0 Costs:
$25,000
Present Value of Year 1 Costs:
( )/(1+0.10)^1= $
Present Value of Year 2 Costs:
( )/(1+0.10)^2= $
Present Value of Year 3 Costs:
( )/(1+0.10)^3= $
Present Value of Year 4 Costs:
( )/(1+0.10)^4= $
Present Value of Year 5 Costs:
( )/(1+0.10)^5= -$931.38
Does it make sense that the PV of year 0 is the same as year 0?
Net Present Value of the Costs:
25,000
$ 28,823
Does it make sense that the PV of each year is decreasing with time?
Why is the PV of Year 5 negative?

14. Present Value of Year 3 Costs: (2000-500)/(1+0.10)^3= $1126.97
Using Excel for Year 3:
Present Value of Year 3 Costs:
( )/(1+0.10)^3= $
Why is the value red ?
Future Value
Interest
Payments Made Each Period
Number of periods

15. Using Excel to find the present Value for the 5 years
of $1500 costs each year:
Present Value of the 5 years:
( )/(1+0.10)^1= $
( )/(1+0.10)^2= $
( )/(1+0.10)^3= $
( )/(1+0.10)^4= $
( )/(1+0.10)^5= $
$ 5686
Interest
0 if Payments (Costs)
made at end of period
Number of periods
Additional Future Value
Payments (Costs) for Each Period

16. Alternatively we can use the NPV (Net Present Value) function in Excel to capture values of each year for this cash flow diagram.
Why do we have to account for year 0 separately?

17. Net Present Value of the Costs of Machine B
Present Value of Year 0 Costs:
$15,000
Present Value of Year 1 Costs:
(4000)/(1+0.10)^1= $
Present Value of Year 2 Costs:
(4000)/(1+0.10)^2= $
Present Value of Year 3 Costs:
( )/(1+0.10)^3= $
Present Value of Year 4 Costs:
(4000)/(1+0.10)^4= $
(4000)/(1+0.10)^5= $
Net Present Value of the Costs:
15,000
$ 32,793

18. Net Present Value Comparison
NPV Costmachine A = $28,823
NPV Costmachine B = $32,793
Costmachine A unadjusted = $29,500
Costmachine B unadjusted = $38,500

19. In-Class Exercise: 1
For Example 18.3 of Dieter and Schmidt we showed in how the Present Value (PV) and Net Present Value (NPV) functions in Excel could be used to calculate the Present Value of the costs of Machine A. Create an Excel spreadsheet that shows the annual costs and calculates the Present Value of the costs of Machine B in example Do two separate calculations, the first which uses the PV function, and the second which uses the NPV function. Raise your hand when you have finished so that you can check your answer with your instructor.

20. Economic Metrics to Evaluate Projects
Return on Investment (ROI)
Payback period

21. Other Economic Issues Profitability Depreciation and Taxes
Rate of return on investment (ROI)
Payback period
Depreciation and Taxes

22. Return on Investment (ROI)
Often given as a ratio of some desired economic outcome to the investment for that outcome.
Typical numerators:
Annual profit before taxes
Annual profit after taxes
Annual cash flow before taxes
Annual cash flow after taxes
Typical denominator: capital investment

23. ROI example: ROI = benefit/ cost = (gains-cost)/cost
Buying 100 shares of Arcelor Mittal stock at $18 per share would cost $1800.
If you later sold those shares for $2000, your gains minus cost would be $200.
The resulting ROI (ratio of benefit to investment) is $200/$1800 or 11.1%
Note that time value of money is not considered.
What is your ROI for attending Rose-Hulman?
How would you use that information?
The primary reason for calculating ROI for attending Rose is to compare it to other schools. You would look at starting salary as the gain (how many years of salary? Perhaps 5 since that is about the limit for the starting salary info to be useful) and total cost of 4 years of education as the cost. Unfortuantely the ROI for Rose looks much worse than Purdue. Is this the best tool for selecting a school. What is ROI good for?

24. Payback Period
Typical definition: Ratio of the investment to the annual benefit… giving an estimate of the time to recover the investment
If benefits are not uniform over time… it is the time at which the cumulative sum of the benefits equal the investment
Typically does not take into account the time-value of money

25. Payback Period Example
Suppose you buy a Mini-Donut maker for $8000 and set it up for your neighborhood’s biannual garage sale. After expenses for dough and grease, you make $500 per year.
What is the Payback Period?
Looks like 16 years before you have recouped the initial cost. Once again, we have ignored the time value of money.

26. What is the Payback Period and 10 year ROI for your Rose Education?
Payback: Assume $50,000 annual cost for Tuition, Room and Board, etc. and opportunity cost of $16,000 for the lost job at McDonalds.
Assume annual salary after graduation of $60,000. (Note that the delta due to Rose is $60,000-$16,000 or $44,000)
Evaluate ROI as a percentage.

27. Rose Payback Total cost over 4 years is $66,000*4=$264K
Total annual benefit is $44,000
It will take 6 years to pay back the cost of education at Rose.
How is this information helpful for decision making?

28. 10 Year Rose ROI Total cost is $264K
Total 10 year benefit is $44,000*6=$264K
ROI is $264/$264=1
You could view this as a 100% ROI

29. Homework Problem #7
Honda Civic
Hybrid vs. Conventional

30. Homework #5 Publishers Clearinghouse v. Megamillions
Sketch cash flow diagram for PC
Determine PV

31. Depreciation and Taxes
Since the capital used to produce goods, services, and energy declines in value over time, tax law currently allows the owners of capital equipment to reduce their taxes each year to reflect that declining value.

32. The categorization of expenditures has important tax implications
Types of Expenditures
Capital
Funds used to purchase facilities and equipment that are useful for more than 1 year
These purchases are “capitalized”
Expense
Funds used to purchase consumables (e.g. labor, material, utilities)
These purchases are “expensed”
The categorization of expenditures has important tax implications

33. Depreciation of Capital Assets
Accounting systems assume that capital equipment (not land) loses value over time
The loss of value of capital equipment is called depreciation
Depreciation is important in the economic analysis of engineering projects because depreciation can be used to reduce the taxes that are paid on corporate income

34. Taxes and Depreciation
The amount of tax a company pays is calculated by multiplying the corporate tax rate (approximately 35% for many companies) by the company’s taxable income
Where:
income = revenues – costs
taxable income = revenues – costs - depreciation

36. Example Cash Flow with Tax and Depreciation
From Dieter and Schmidt

37. Calculating Depreciation
Step 1: determine the period over which the capital asset should be depreciated.
Step 2: determine how the depreciating value should be distributed over the selected period

38. Determining the Period of Depreciation
See your business office for accounting rules
Examples:
Computers, trucks: 5 years
Office furniture, railroad track, Ag buildings: 7 years
Durable goods manufacturing equipment: 10 years
Sewage treatment plant: 15 years
What do you expect the time frame to be for a wind turbine?

39. Determining the Distribution
Straight line depreciation
Declining balance depreciation
Sum–of–years-digits depreciation

40. Straight-Line Depreciation
Initial Cost
Periods
Salvage Value

41. Declining Balance Depreciation
Period for which depreciation
Is being calculated
Initial Cost
Salvage Value
Total Number
of Periods
Depreciation in the jth year

42. Sum-of-Years-Digits Depreciation
Period for which depreciation
Is being calculated
Initial Cost
Total Number
of Periods
Salvage Value

43. Repaying a Loan
Generally you will make a down payment and annual payments.
The down payment occurs in year 0.
The amount of the loan is the cost of the purchase minus the down payment
The payment of the loan is easily found using Excel

44. Using the PMT Function to find Payments on a Loan
Principal
Monthly Interest rate
Annual rate/12
Number of Periods
30 years*12 months

45. Machine Comparison
You are concerned with the purchase of a heat-treating furnace for gas carburizing of steel parts. Furnace A will cost $325,000 and will last 10 years; furnace B will cost $400,000 and will also last 10 years. However, furnace B will provide closer control on case depth, which means that the heat treater can shoot for the low side of the specification range on case depth. This will mean that the production rate for furnace B will be 2740 lb/hr compared with 2300 lb/hr for furnace A. Total yearly production is required to be 15,400,000 lb. The cycle time for furnace A is 16.5 hr and that for furnace B is 13.8 hr. The hourly operating cost is $64.50 per hr. Assume that money is worth 10% and the tax rate is 50%. Also use straight line depreciation. How might you compare the two alternatives?

46. Let’s compare with NPV First organize the info
Production Rate
Yearly
Required
Operating
Depreciation
Production (lb)
hours
Cost ($/hr)
Oper Cost ($) $
Furnace A
2300
lb/hr
6696
64.5
431870
32500
Furnace B
2740
5620
362518
40000
B-A
-69351
7500
Interest Rate
0.1
First organize the info
Next, draw a Cash Flow Diagram
B saves $3,750 in taxes
B saves $69,351 in operating costs
B cost $75,000 more than A
Year 1 2 3 4 5 6 7 8 9 10
Initial
Cost
Furnace A
325,000
Furnace B
400,000
Net Difference
B-A
-75,000
73101 PV
$75,000
(66,456)
(60,414)
(54,922)
(49,929)
(45,390)
(41,264)
(37,513)
(34,102)
(31,002)
(28,184)
Sum
($374,176)
Check the NPV

47. Chapter 15: Product Development Economics
Product Design and Development
Fourth Edition
by Karl T. Ulrich and Steven D. Eppinger

48. Economic Analysis for Product Development (Ulrich and Eppinger)
Build a base-case financial model
Perform a sensitivity analysis
Use sensitivity analysis to understand project trade-offs
Consider the influence of qualitative factors on project success

50. Step 1: Build a Base-Case Model

51. Step 1: Build a Base-Case Model

52. Using Excel for Q4 of Year 1:
Present Value of Year 3 Costs:
(-2250)/(1+0.10/4)^3= -$2089
Future Value
Annual interest divided by number of periods per year
Payments Made Each Period
Number of periods

53. Homework Problem #2a

55. Step 2: Perform Sensitivity Analysis
(e.g. 20% decrease in development costs)

56. Step 2: Perform Sensitivity Analysis
(e.g. 25% increase in development time)

57. Step 2: Perform Sensitivity Analysis
Ulrich & Eppinger, “Product Design and Development”

58. Step 3: Use Sensitivity Analysis to Understand Project Trade-offs

59. Step 3: Use Sensitivity Analysis to Understand Project Trade-offs (estimate Trade-off Rules from sensitivity analyses)
Ulrich & Eppinger, “Product Design and Development”

60. Homework #2b

61. A Question:
What are some situations when you might not pursue an option that presents the best NPV?

62. Step 4: Consider the Influence of Qualitative Factors
Interactions between the Project and the Firm (e.g. strategic fit, risk/liability exposure)
Interactions between the Project and the Market (e.g. competitors, customers, suppliers)
Interactions between the Project and the Macro Environment (e.g. economic shifts, government regulations, social trends)
Ulrich & Eppinger, “Product Design and Development”

64. Modeling Uncertain Cash Flows
Dealing With Risk

65. Determining NPV with probabilities.
Probability that the Patent is allowed
NPV= Pa*PVa + Pb*PVb = 0.6($6.5 million) + 0.4($1.5 million) = $4.5 million

66. NPV with market testing is $2,650,000

67. HW Problem 2c

68. Economics Laboratory
Apply the tools of economic decision making to a large capital project and a personal project