Ch 10-1 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Cost Analysis and Estimating for Engineering and Management Chapter 10 Engineering Economy

Ch 10-2 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Overview l Methods to Determine Project Returns l Impact of Time Value of Money (Interest)  Simple and Compound Interest Calculations  Methods to Evaluate Projects l Various Rates of Return l Evaluation of Replacement Alternatives l Tax Effects on Decisions

Ch 10-3 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Money l All Projects Require Money l All Should Return Money (Payback) l When Large Sums of Money or Longer Times Are Involved – Interest Becomes Important l Decisions Are Based on Money

Ch 10-4 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Capital l Monetary Assets l Should Be Employed to Earn a Return l Invested  In Ordinary Financial Transactions  In Some Endeavor (Production/Service) l Need to Evaluate Investments

Ch 10-5 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Monitoring Return l Ways to Express Return  Total Dollars  Ratio with Sales  Return on Investment l Calculation of Return  Average Annual Rate of Return  Payback Period  Engineering-Economy Rate of Return

Ch 10-6 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Average Annual Rate of Return l Yearly After Tax Profit from Activity l Total Investment in the Activity l Alternately Eq 10.1 Eq 10.2

Ch 10-7 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Payback Period l How Many Years to Earn Back the Investment l Capital Liquidity Importance Eq 10.3

Ch 10-8 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Payback Caveats l Assumes Equal Annual Earnings l Does Not Account for  Interest  Depreciation / Obsolescence  Earnings After Payback

Ch 10-9 © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Interest l Choice of Investments  Traditional (Bank, Stock Market, etc.)  Capital into Endeavor (Equipment, etc.) l Time Value of Money l Interest Calculations  Simple  Compound

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Simple Interest l Interest I = Pni l Total Including Principal F = P + I = P(1+ni) l Payments Are at the End of the Periods

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Compound Interest l Interest Adds to Principal  Interest Earns Interest  In Subsequent Periods l Single Payment Compound Amount Factor (1+i) n l Used In All Variations

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Various Interest Calculations l Net Present Worth l Net Future Worth l Net Equivalent Annual Worth l Rate of Return l All Generally Yield Consistent Recommendations

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Set Up for Discussions l Example Situation  Investment $1025, for 3 Years l Factors Can Be Calculated or Found In Tables (10% and 20% in Appendices) Year Cost Revenue 0$1025$

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Net Present Worth l Convert All Amounts to Present Value Period n PW Factor at 10% Cash Flow Amount Year 1 to zero $450$409 Year 2 to zero Year 3 to zero Total $1061 Less proposed investment Net present worth $36

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Net Future Worth l Convert All Amounts to Future Value Period n Compound Amount Factor 10% Cash Flow Amount Year 1 to $450$545 Year 2 to Year $1413 Compounded to terminal year at 10% Net future worth $ 49

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Net Equivalent Annual Worth l Find Present Value of Receipts l Calculate Annual Equivalent l Calculate Net Annual Equivalent Worth

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Net Equivalent Annual Worth Example Amount Anticipated annual receipts$427 Less equal annual equivalent worth14 Equal annual receipts$  1.10 = $1128 Less payment  1.10 = $787 Less payment  1.10 = $413 Less payment413 0

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Rate of Return l Other Methods Assume an Interest Rate l Find the Interest Rate to Yield Same Return as Investment l Found By Trial-and-Error or Interpolation

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Example at 5%

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Example at 15%

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Interpolate

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Compare the Methods l Compare Present and Future Worths l Rate of Return Finds Actual Interest  Other Methods Assume an Interest MethodAmount Net present worth at 10%$36 Net future worth at 10%$49 Net annual equivalent worth at 10%$14 Rate of return12.3%

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Engineering Economy P, F, A, i, and n l Functional Notation F=P(P/F, i%, n) P/F means, Find P Given F l 6 Methods (Equations)  2 Single Payment  4 Uniform Payment Series

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Single Payment Methods Factor NameFunctional Notation EquationEquation Number Compound- amount factor (F/P, i%, n)(10.7) Present-worth factor (P/F, i%, n)(10.8)

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Single Payment Diagrams

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Uniform Payment Series Factor NameFunctional Notation EquationEquation Number Sinking-fund factor (A/F, i%, n)(10.9) Capital-recovery factor (A/P, i%, n)(10.10) Compound-amount factor (F/A, i%, n)(10.11) Present-worth factor (P/A, i%, n)(10.12)

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Uniform Series Diagrams

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Uniform Series Diagrams

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Assumptions l Cash Flow at Year End (Lump Sum) l Ignore Inflation l Special Handling of Taxes l Constant Interest Rate l Predetermined MARR l Save Non-Quantifiable Effects for End

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Interest l Cost of Using Capital l Internal Rate of Return (IRR) l Minimum Acceptable Rate of Return (MARR) l External Rate of Return (ERR) l Percentage Showing Yield on Different Uses of Capital

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management IRR l Based Solely on Project’s Cash Flow  Before Taxes l Find IRR for Present Worth of $0 l Required IRR < the Projected IRR  Approve Project l Compare Alternatives

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management MARR l Rate Set By Management l Sets Lower Limit on Acceptable Return l Rations Capital to Avoid Unproductive Investments

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Comparison of Alternatives l Feasible Alternatives l Mutually Exclusive l “Do Nothing” Is an Alternative l May Omit Costs/Revenues If the Same l Find Alternative with Highest Return or Lowest Cost l Equal/Unequal Lives Handled Differently

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Equal Life Example ( i =10%) Automatic Semiautomatic Investment cost$1,250,000$800,000 Annual Utilities570,000480,000 Labor, annual50,000700,000 Floor space80,00050,000 Maintenance140,00090,000 Equipment life5 years

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Cash Flows

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Comparison for Example Automatic Semiautomatic Annual capital recovery cost, P(A/P, 10%,5) $329,750$211,040 Annual cost1,002,5001,478,000 Comparative annual cost$1,332,250$1,689,040

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Unequal Life l Comparison Must Be for Equal Output  Extra Cost Involved with Extra Output l Different Useful Lives for Alternatives  Analysis Period Common Multiple of Useful Lives Example I 1 – 3 Years, I 2 – 4 Years  Common Multiple = 12 Years

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Unequal Life Example Investments I1I2 Initial cost $230,000$320,000 Annual operating cost25,0000 Salvage value040,000 Economic life, year34 Multiple of lives12 Repeated investments32 MARR before taxes10%

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management 12 Year Cash Flow

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Comparison l Present Worth for 12 Years PW ( I 1) = – $800,520 PW ( I 2) = – $629,116 l Select Investment 2, Lower Cost  Assuming Revenues Are Equal l Study Period May Be Excessive l Situation May Vary from Assumptions

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Restricted Life l Project Limited to 2 Years l Assume Salvage Value = $0 PW( I 1) = – $273,388 PW( I 2) = – $320,000 l Compare to Include Salvage Value (320, ,338)/(P/F,10%,2)=$56,400 Decision Depends on Salvage Cost of I 2

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Replacement l Existing Alternative In Operation l Economic Facts Are Different for Challenger l Equipment Life – Period of Lower Cost l Need Value for Existing Equipment  Don’t Use Book or Trade In Value  Need the Market Value

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Equivalent Annual Cost for Replacement Includes Resale Value ( F s ) Or Eq 10.13

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Example i = 20%, Life = 4 Years Year Defender (D)Challenger (C) Operating cost Salvage value Operating cost Salvage value 0 $120,000 $350,000 1$34,00070,000$ , ,00040,00010,000270, ,00025,00012,000240, ,00010,00015,000210, ,000170, ,000120,000

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Results l Existing (Defender) EAC(D) = – $86,618 l Challenger EAC(C) = – $105,208 l Challenger Has Higher Cost Don’t Replace

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Effects of Taxes l Taxable Income  Before Tax Cash Flow Less Depreciation and Other Charges l Rate of Return After Tax MARR  (Before Tax MARR)(1-t) Before Tax MARR = 20%, t = 38% After Tax MARR = About 12.4% l Timing of Cash Flow Has Impacts

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Considerations for After Tax Analysis l Costs, Savings, Revenues l Depreciation l Taxable Income l Cash Flow Effects l Engineering Economy Analysis l Decision Process  Consider Non-Economic Factors

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management After Tax Example Yr End Before Tax Dep. Deductible Charges 35% Tax Savings After Tax Cash Flow 0-$3 1-25$3.3-$28.3-$ $ $16.2-$ Defender Challenger

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Outcome EAC(D) = – $11.1 Million EAC(C) = – $12.5 Million l Different Depreciation Methods Used  Favor Challenger l Costs Represent Disbursements  Thus Positive Costs l Select Challenger

Ch © 2004 Pearson Education, Inc. Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Summary l Methods of Project Alternative Evaluation l How to Use and Apply Interest Calculations l How to Evaluate Replacements l What Is the Impact of Taxes for Economic Decisions