Presentation on theme: "Economic Decision Making"— Presentation transcript:
1Economic Decision Making Ulrich and Eppinger Chapter 15Deiter & Schmidt Chapter 18Adapted from Dr. Stamper
2Product Development Process PlanningConceptDevelopmentSystem-LevelDesignDetailDesignTesting andRefinementProductionRamp-UpConcept Development ProcessMissionStatementDevelopmentPlanIdentifyCustomerNeedsEstablishTargetSpecificationsGenerateProductConceptsSelectProductConcept(s)TestProductConcept(s)Set FinalSpecificationsPlanDownstreamDevelopmentPerform Economic AnalysisBenchmark Competitive ProductsBuild and Test Models and Prototypes
3Overview Monday: (Dieter, Chap 18 and Ulrich, Chap 15 Appendix) Time Value of Money, Cash Flow Diagrams, Net Present Value, DepreciationThursdayEconomic Analysis Process for Product Development (Ulrich Chap 15)ProfitabilityMondayMore analysisWednesday:Lab exercises
4Objectives Learn some of the language of the business community Provide techniques to evaluate the financial attractiveness of various alternatives that are presented to engineersApply the economic evaluation techniques to personal and professional decisions
5Time Value of Money Proposition: The value of money changes over time: generally $1 in the future is worth less than $1 nowEvidence: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).
6Example 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
7Example 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=$100Same equation: F = (1+i)P, but solve for PP=F/(1+i) = $100/(1+0.08)= $92.59
8Example 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= $108Fafter 2 years = (1+i)(1+i)P = (1+0.08)(1+0.08)100= $116.64Fafter 3 years = (1+i)(1+i)(1+i)P = $125.97
9Example 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=$100Same equation: F = (1+i)(1+i)(1+i)P, but solve for PP=$100/[(1+0.08)(1+0.08)(1+0.08)]= $79.38
10General Equations for Compound Interest Future Value:Present Value:Where:F is future valueP is present valuei is interest rate (or discount rate)n is number of periods
11How Do We Compare Alternatives? (Economic Decision Making) We need some form of “equivalence”Present Value and Future Value can provide that equivalence
12Cash Flow Diagrams & Net Present Value Note the cash flow diagram.Incomes point into the lineExpenses point away from the lineTime starts in year 0 (start of year 1)All other flows are at the end of the yearPage 867 Dieter and Schmidt
13Net Present Value of the Costs of Machine A Present Value of Year 0 Costs:$25,000Present 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= -$931.38Does it make sense that the PV of year 0 is the same as year 0?Net Present Value of the Costs:25,000$ 28,823Does it make sense that the PV of each year is decreasing with time?Why is the PV of Year 5 negative?
14Present 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 ValueInterestPayments Made Each PeriodNumber of periods
15Using 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= $$ 5686Interest0 if Payments (Costs)made at end of periodNumber of periodsAdditional Future ValuePayments (Costs) for Each Period
16Alternatively 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?
17Net Present Value of the Costs of Machine B Present Value of Year 0 Costs:$15,000Present 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
18Net Present Value Comparison NPV Costmachine A = $28,823NPV Costmachine B = $32,793Costmachine A unadjusted = $29,500Costmachine B unadjusted = $38,500
19In-Class Exercise: 1For 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.
20Economic Metrics to Evaluate Projects Return on Investment (ROI)Payback period
21Other Economic Issues Profitability Depreciation and Taxes Rate of return on investment (ROI)Payback periodDepreciation and Taxes
22Return on Investment (ROI) Often given as a ratio of some desired economic outcome to the investment for that outcome.Typical numerators:Annual profit before taxesAnnual profit after taxesAnnual cash flow before taxesAnnual cash flow after taxesTypical denominator: capital investment
23ROI 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?
24Payback PeriodTypical definition: Ratio of the investment to the annual benefit… giving an estimate of the time to recover the investmentIf benefits are not uniform over time… it is the time at which the cumulative sum of the benefits equal the investmentTypically does not take into account the time-value of money
25Payback 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.
26What 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.
27Rose Payback Total cost over 4 years is $66,000*4=$264K Total annual benefit is $44,000It will take 6 years to pay back the cost of education at Rose.How is this information helpful for decision making?
2810 Year Rose ROI Total cost is $264K Total 10 year benefit is $44,000*6=$264KROI is $264/$264=1You could view this as a 100% ROI
29Homework Problem #7Honda CivicHybrid vs. Conventional
30Homework #5 Publishers Clearinghouse v. Megamillions Sketch cash flow diagram for PCDetermine PV
31Depreciation 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.
32The categorization of expenditures has important tax implications Types of ExpendituresCapitalFunds used to purchase facilities and equipment that are useful for more than 1 yearThese purchases are “capitalized”ExpenseFunds used to purchase consumables (e.g. labor, material, utilities)These purchases are “expensed”The categorization of expenditures has important tax implications
33Depreciation of Capital Assets Accounting systems assume that capital equipment (not land) loses value over timeThe loss of value of capital equipment is called depreciationDepreciation is important in the economic analysis of engineering projects because depreciation can be used to reduce the taxes that are paid on corporate income
34Taxes 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 incomeWhere:income = revenues – coststaxable income = revenues – costs - depreciation
36Example Cash Flow with Tax and Depreciation From Dieter and Schmidt
37Calculating 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
38Determining the Period of Depreciation See your business office for accounting rulesExamples:Computers, trucks: 5 yearsOffice furniture, railroad track, Ag buildings: 7 yearsDurable goods manufacturing equipment: 10 yearsSewage treatment plant: 15 yearsWhat do you expect the time frame to be for a wind turbine?
39Determining the Distribution Straight line depreciationDeclining balance depreciationSum–of–years-digits depreciation
40Straight-Line Depreciation Initial CostPeriodsSalvage Value
41Declining Balance Depreciation Period for which depreciationIs being calculatedInitial CostSalvage ValueTotal Numberof PeriodsDepreciation in the jth year
42Sum-of-Years-Digits Depreciation Period for which depreciationIs being calculatedInitial CostTotal Numberof PeriodsSalvage Value
43Repaying a LoanGenerally 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 paymentThe payment of the loan is easily found using Excel
44Using the PMT Function to find Payments on a Loan PrincipalMonthly Interest rateAnnual rate/12Number of Periods30 years*12 months
45Machine ComparisonYou 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 $64.50 per hr. Assume that money is worth 10% and the tax rate is 50%. Also use straight line depreciation. How might you compare the two alternatives?
46Let’s compare with NPV First organize the info Production RateYearlyRequiredOperatingDepreciationProduction (lb)hoursCost ($/hr)Oper Cost ($)$Furnace A2300lb/hr669664.543187032500Furnace B2740562036251840000B-A-693517500Interest Rate0.1First organize the infoNext, draw a Cash Flow DiagramB saves $3,750 in taxesB saves $69,351 in operating costsB cost $75,000 more than AYear12345678910InitialCostFurnace A325,000Furnace B400,000Net DifferenceB-A-75,00073101PV$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
47Chapter 15: Product Development Economics Product Design and DevelopmentFourth Editionby Karl T. Ulrich and Steven D. Eppinger
48Economic Analysis for Product Development (Ulrich and Eppinger) Build a base-case financial modelPerform a sensitivity analysisUse sensitivity analysis to understand project trade-offsConsider the influence of qualitative factors on project success
61A Question:What are some situations when you might not pursue an option that presents the best NPV?
62Step 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”