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**Economic Decision Making**

Ulrich and Eppinger Chapter 15 Deiter & Schmidt Chapter 18 Adapted from Dr. Stamper

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**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

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**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

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**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

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**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).

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**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

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**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

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**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

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**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

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**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

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**How Do We Compare Alternatives? (Economic Decision Making)**

We need some form of “equivalence” Present Value and Future Value can provide that equivalence

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**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

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**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?

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**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

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**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

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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?

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**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

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**Net Present Value Comparison**

NPV Costmachine A = $28,823 NPV Costmachine B = $32,793 Costmachine A unadjusted = $29,500 Costmachine B unadjusted = $38,500

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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.

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**Economic Metrics to Evaluate Projects**

Return on Investment (ROI) Payback period

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**Other Economic Issues Profitability Depreciation and Taxes**

Rate of return on investment (ROI) Payback period Depreciation and Taxes

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**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

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**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?

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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

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**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.

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**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.

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**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?

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**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

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Homework Problem #7 Honda Civic Hybrid vs. Conventional

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**Homework #5 Publishers Clearinghouse v. Megamillions**

Sketch cash flow diagram for PC Determine PV

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**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.

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**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

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**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

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**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

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**Example Cash Flow with Tax and Depreciation**

From Dieter and Schmidt

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**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

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**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?

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**Determining the Distribution**

Straight line depreciation Declining balance depreciation Sum–of–years-digits depreciation

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**Straight-Line Depreciation**

Initial Cost Periods Salvage Value

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**Declining Balance Depreciation**

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

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**Sum-of-Years-Digits Depreciation**

Period for which depreciation Is being calculated Initial Cost Total Number of Periods Salvage Value

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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

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**Using the PMT Function to find Payments on a Loan**

Principal Monthly Interest rate Annual rate/12 Number of Periods 30 years*12 months

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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?

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**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

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**Chapter 15: Product Development Economics**

Product Design and Development Fourth Edition by Karl T. Ulrich and Steven D. Eppinger

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**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

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**Step 1: Build a Base-Case Model**

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**Step 1: Build a Base-Case Model**

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**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

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Homework Problem #2a

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**Step 2: Perform Sensitivity Analysis**

(e.g. 20% decrease in development costs)

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**Step 2: Perform Sensitivity Analysis**

(e.g. 25% increase in development time)

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**Step 2: Perform Sensitivity Analysis**

Ulrich & Eppinger, “Product Design and Development”

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

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

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Homework #2b

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

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**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”

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**Modeling Uncertain Cash Flows**

Dealing With Risk

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**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

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**NPV with market testing is $2,650,000**

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HW Problem 2c

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

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2-1 Copyright © 2006 McGraw Hill Ryerson Limited prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition.

2-1 Copyright © 2006 McGraw Hill Ryerson Limited prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition.

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