What is this course about? Time value of money Importance of interest, inflation, etc. Cash flow comparisons Project and Investment Analysis Making good economic decisions

Some interesting questions Buy or lease? Buy car or land for an investment? Buy a bond, stock, keep money in bed? Which investment to make?

Cash flow comparisons Needed for all kinds of decision making Example: Buying a car Alternatives: $18,000 now, or $600 per month for 3 years(= $21,600 total) Which is better?

Cash flow comparisons Needed for all kinds of decision making Example: Buying a car Alternatives: $18,000 now, or $600 per month for 3 years (= $21,600 total) Which is better? It depends! Issue: how much is money now worth compared to money in the future? Leads to idea of Time value of money!

Time value of money Would you rather have: $100 today, or $100 a year from now?

Time value of money Would you rather have: Basic assumption: $100 today, or $100 a year from now? Basic assumption: Given a fixed amount of money, and a choice of having it now or in the future, Most people would prefer to have it sooner rather than later

Time value of money Basic assumption: Reasons: Given a fixed amount of money, and a choice of having it now or in the future, most people would prefer to have it sooner Reasons: Security ? Interests ? Currency strength ? Uncertainty ?

Time value of money A consequence: Suppose you are willing to exchange a certain amount now for some other amount later Then the later amount has to be _______ ? A bird at hand is better than two birds in the bush. But how many birds in the bush is worth a bird at hand?

What this means for us In this course, we will learn methods to: Compare different cash flows over time Using the interest rate or discount rate: How much more a dollar today is worth, compared to a dollar in the future For example, if the interest rate is 5% per year: Then $1 today is worth as much as $1.05 next year

Interest rates Interest factor: The ratio between an amount one period in the future and an equivalent amount now. Example: If you are indifferent between $5 now and $6 one period in the future, the interest factor is 6/5 = 1.20 (per period) Interest rate = interest factor - 1 In above example, it’s 0.20 = 20%

Chapter 1 Engineering Economic Decisions Rational Decision-Making Process Economic Decisions Predicting Future Role of Engineers in Business Large-scale engineering projects Types of strategic engineering economic decisions

Rational Decision-Making Process Recognize a decision problem Define the goals or objectives Collect all the relevant information Identify a set of feasible decision alternatives Select the decision criterion to use Select the best alternative

Which Car to Lease? Recognize a decision problem Define the goals or objectives Collect all the relevant information Identify a set of feasible decision alternatives Select the decision criterion to use Select the best alternative Need a car Want mechanical security Gather technical as well as financial data Choose between Toyota and Honda Want minimum total cash outlay Select Honda

Engineering Economic Decisions Manufacturing Profit Planning Investment Marketing

Predicting the Future Required investment Forecasting product demand Estimating selling price Estimating manufacturing cost Estimating product life

Role of Engineers in Business Participate in a variety of decision-making processes, ranging from manufacturing, through marketing, to financing decisions Plan for the acquisition of equipment Design products from the concept to shipping

Role of Engineers in Business Create & Design Engineering Projects Evaluate Expected Profitability Timing of Cash Flows Degree of Financial Risk Evaluate Impact on Financial Statements Firm’s Market Value Stock Price Analyze Production Methods Engineering Safety Environmental Impacts Market Assessment

Accounting Vs. Engineering Economy Evaluating past performance Evaluating and predicting future events Accounting Engineering Economy Past Future Present

A Large-Scale Engineering Project Requires a large sum of investment Takes a long time to see the financial outcomes Difficult to predict the revenue and cost streams

A Large-Scale Engineering Project

Types of Strategic Engineering Economic Decisions Equipment and Process Selection Equipment Replacement New Product and Product Expansion Cost Reduction Service Improvement

Equipment & Process Selection How do you choose between Plastic Sheet Molding Compound (glass fiber reinforced polymer) and Steel sheet stock for the auto body panel? The choice of material will dictate the manufacturing process for the body panel as well as manufacturing costs.

Which Material to Choose?

Equipment Replacement Now is the time to replace the old machine? If not, when is the right time to replace the old equipment?

New Product and Product Expansion Shall we build or acquire a new facility to meet the increased demand? Is it worth spending money to market a new product?

Example - MACH 3 Project Gillette’s MACH3 Project R&D investment: $750 million Product promotion through advertising: $300 million Priced to sell at 35% higher than Sensor Excel (about $1.50 extra per shave). Question 1: Would consumers pay $1.50 extra for a shave with greater smoothness and less irritation? Question 2: What would happen if the blade consumption dropped more than 10% due to the longer blade life of the new razor?

Cost Reduction Should a company buy equipment to perform an operation now done manually? Should spend money now in order to save more money later?

Service/Quality Improvement Make-to-order Levi’s for women How many more jeans would Levi’s need to sell to justify the cost of additional robotic tailors?

Principle 1: A nearby dollar is worth more than a distant dollar Fundamental Principles in Engineering Economics Principle 1: A nearby dollar is worth more than a distant dollar Today 6-month later

Principle 2: All it counts is the differences among alternatives Fundamental Principles in Engineering Economics Principle 2: All it counts is the differences among alternatives Option Monthly Fuel Cost Monthly Maintenance Cash outlay at signing Monthly payment Salvage Value at end of year 3 Buy $960 $550 $6,500 $350 $9,000 Lease $2,400 Irrelevant items in decision making

Principle 3: Marginal revenue must exceed marginal cost Fundamental Principles in Engineering Economics Principle 3: Marginal revenue must exceed marginal cost Manufacturing cost Sales revenue Marginal revenue cost 1 unit

Fundamental Principles in Engineering Economics Principle 4: Additional risk is not taken without the expected additional return Investment Class Potential Risk Expected Return Savings account (cash) Low/None 1.5% Bond (debt) Moderate 4.8% Stock (equity) High 11.5%