GE403

Engineering Economy
First Semester 1443H

Principles of Engineering Economic Analysis, 5th edition

 Course Objectives
Course objectives are for you to

• be able to prepare economic justifications for engineering

proposals.

• be able to evaluate economic justifications performed by others.

• be able to manage personal finances and make wise investment
decisions.

Principles of Engineering Economic Analysis, 5th edition

 Course Objectives

Other course objectives are for you to

• be comfortable using financial language.

• be aware of tradeoffs involving expenses and capital costs

under tax and inflation conditions.

• be familiar with advanced techniques of modeling decision

problems under risk and uncertainty conditions.

Principles of Engineering Economic Analysis, 5th edition

 Textbook

Principles of Engineering Economic Analysis, J.

A. White, K. E. Case, and D. B. Pratt, 5th
edition, John Wiley & Sons, Inc., 2009.

Principles of Engineering Economic Analysis, 5th edition

 Course Topics

Principles of Engineering Economic Analysis, 5th edition

 Grade Distribution

Quizzes Tutorial 10%

1st Midterm Exam To be determined by the college 25%

2nd Midterm Exam To be determined by the college 25%

Final Exam To be determined by the college 40%

Principles of Engineering Economic Analysis, 5th edition

 Instructor Details

Name: Dr. Saif A. Alarifi

Department: Civil Engineering

Office: 2A46

Email: [email protected]

Principles of Engineering Economic Analysis, 5th edition

 Chapter 1

Engineering Economic Analysis

Principles of Engineering Economic Analysis, 5th edition

 Engineering economic analysis: using a combination of
quantitative and qualitative techniques to analyze
economic differences among engineering design
alternatives in selecting the preferred design

Principles of Engineering Economic Analysis, 5th edition

 What Is Included in Chapter 1

1. The importance of the time value of money (TVOM)

2. Four discounted cash flow rules

3. Ten principles of engineering economic analysis

4. A 7-step approach for performing engineering economic analyses

Principles of Engineering Economic Analysis, 5th edition

 Fundamental Concept

Money has a time value

Principles of Engineering Economic Analysis, 5th edition

 Time Value of Money
• Would you rather receive $1000 today or $1000 a year from today?
• Would you rather receive $1000 today or $1050 a year from today?
• Would you rather receive $1000 today or $1100 a year from today?
• Would you rather receive $1000 today or $1500 a year from today?
• Would you rather receive $1000 today or $2000 a year from today?
• Would you rather receive $1000 today or $5000 a year from today?
• Would you rather receive $1000 today or $10,000 a year from today?
• Would you rather receive $1000 today or $100,000 a year from today?

Principles of Engineering Economic Analysis, 5th edition

 Time Value of Money
 Regardless of the value of inflation, money has a time value due to its
“earning power”
 Suppose you arrive in a city by airplane and need a car
 you can buy a car
 you can rent a car
 Suppose you arrive in a city and need a place to stay
 you can buy a house or condominium
 you can rent a house, apartment, or hotel room
 Suppose you arrive in a city and need money
 you can borrow money from a business or person

Principles of Engineering Economic Analysis, 5th edition

 What Is Included in Chapter 1

1. The importance of the time value of money (TVOM)

2. Four discounted cash flow rules

3. Ten principles of engineering economic analysis

4. A 7-step approach for performing engineering economic analyses

Principles of Engineering Economic Analysis, 5th edition

 Four Discounted Cash Flow Rules

1. Money has a time value

2. Money cannot be added or subtracted unless it occurs at the same
point(s) in time

3. To move money forward one time unit, multiply by one plus the
discount or interest rate

4. To move money backward one time unit, divide by one plus the
discount or interest rate

Principles of Engineering Economic Analysis, 5th edition

 What Is Included in Chapter 1

1. The importance of the time value of money (TVOM)

2. Four discounted cash flow rules

3. Ten principles of engineering economic analysis

4. A 7-step approach for performing engineering economic analyses

Principles of Engineering Economic Analysis, 5th edition

 Principles of Engineering Economic Analysis

1. Money has a time value

2. Make investments that are economically justified

“If you need a new machine and

don’t buy it, you pay for it
without even getting it.”
Henry Ford

Principles of Engineering Economic Analysis, 5th edition

 Principles of Engineering Economic Analysis

3. Choose the mutually exclusive investment alternative that maximizes

economic worth

4. Two investment alternatives are equivalent if they have the same

economic worth

5. Marginal revenue must exceed marginal cost

6. Continue to invest as long as each additional increment of investment

yields a return that is greater than the investor’s TVOM

Principles of Engineering Economic Analysis, 5th edition

 “The object of management is not necessarily the highest
rate of return on capital, but … to assure profit with
each increment of volume that will at least equal the
economic cost of additional capital required.”
Donaldson Brown
Chief Financial Officer
General
Motor
1924

Principles of Engineering Economic Analysis, 5th edition

 Principles of Engineering Economic Analysis

7. Consider only differences in cash flows among investment

alternatives

8. Compare investment alternatives over a common period of time

9. Risks and returns tend to be positively correlated

10. Past costs are irrelevant in engineering economic analyses, unless

they impact future costs

Principles of Engineering Economic Analysis, 5th edition

 What Is Included in Chapter 1

1. The importance of the time value of money (TVOM)

2. Four discounted cash flow rules

3. Ten principles of engineering economic analysis

4. A 7-step approach for performing engineering economic analyses

Principles of Engineering Economic Analysis, 5th edition

 Economic Justification
Seven Questions to Answer
1. What investment alternatives are available?
2. What is the length of time over which the decision is to be made?
3. What TVOM will be used to move monies forward and/or backward
in time?
4. What are the best estimates of the cash flows for each alternative?
5. Which investment alternative seems best, based on the economic
criterion chosen?
6. How sensitive is the decision to changes or errors in the estimates
used in the analysis?
7. Which investment is recommended?

Principles of Engineering Economic Analysis, 5th edition

 Systematic Economic Analysis Technique (SEAT)
Seven-Step Procedure

1. Identify the investment alternatives

2. Define the planning horizon

3. Specify the discount rate

4. Estimate the cash flows

5. Compare the alternatives

6. Perform supplementary analyses

7. Select the preferred alternative

Principles of Engineering Economic Analysis, 5th edition

 Step1: Identify the Feasible Alternatives

 Most important step!

 Consider a range of alternatives

 Beware the “Do Nothing” alternative

 Be objective!

 Impact of “size gates”

 “Design the whole, justify the whole, and implement the parts”

Principles of Engineering Economic Analysis, 5th edition

 Example 1.5

A firm is considering three investment proposals (A,B, & C).

A requires $1M investment, B requires $2.5M, and C requires
$3M.

The firm has $4.5M to invest. C is contingent on A; B and C

are mutually exclusive. The “do nothing” alternative is not
feasible.

Form the set of mutually exclusive investment alternatives that

exists.

Principles of Engineering Economic Analysis, 5th edition

 Example 1.5 : Forming Investment
Alternatives from Investment Proposals

Pro po s als
ALT xA xB xC Co mme nts
1 0 0 0
2 0 0 1
3 0 1 0
4 0 1 1
5 1 0 0
6 1 0 1
7 1 1 0
8 1 1 1

Principles of Engineering Economic Analysis, 5th edition

 Example 1.5 : Forming Investment
Alternatives from Investment Proposals
Pro po s als
ALT x A x B x C Co mme nts
1 0 0 0 "Do nothing" not feasible
2 0 0 1 Violates contingency
3 0 1 0 Feasible
4 0 1 1 Mutually exclusive
5 1 0 0 Feasible
6 1 0 1 Feasible
7 1 1 0 Feasible
8 1 1 1 Violates multiple constraints
Fo ur alte rnative s : {B}, {A}, {A,C}, {A,B}

Principles of Engineering Economic Analysis, 5th edition

 Step 2: Define the Planning Horizon*

 The width of the window

 U.S. < 5 yrs; Japan > 15 yrs

 Planning horizon vs. working life vs. depreciable life

 Standard planning horizons

 Impact of too short a planning horizon

 Impact of too long a planning horizon

Principles of Engineering Economic Analysis, 5th edition * See Chapter 4

 Step 3: Specify the Discount Rate*

 Hurdle rate, interest rate, return on investment (ROI), minimum

attractive rate of return (MARR)

 Money has a time value!

 Opportunity cost for money

 U.S. – double-digit rates

 Japan – single-digit rates

Principles of Engineering Economic Analysis, 5th edition * See Chapter 4

 Step 4: Estimate the Cash Flows*
 Examples of cash flows

 Depreciation is not a cash flow

 Annual cash flows

 “Best estimates”

 Tangibles and intangibles

 Future estimates, not past estimates

 Costs and revenues

 Incremental cash flows

 Don’t forget the competition!

Principles of Engineering Economic Analysis, 5th edition * See Chapter 16

 Step 5: Compare the Investment Alternatives
 Present worth method (PW) (Chapter 5)
 Capitalized worth method (CW) (Chapter 5)
 Discounted payback period method (DPBP) (Chapter 5)
 Payback period method (PBP) (Chapter 5)
 Future worth method (FW) (Chapter 6)
 Annual worth method (AW) (Chapter 7)
 Internal rate of return method (IRR) (Chapter 8)
 External rate of return method (ERR) (Chapter 8)
 Modified internal rate of return (MIRR) (Chapter 8)
 Benefit/Cost ratio method (B/C) (Chapter 14)

 ,m

Principles of Engineering Economic Analysis, 5th edition

 Step 6: Perform Supplementary Analyses*
 GIGO
 Don’t wade in rivers, on the average, two feet deep when wearing
boots that are two feet tall!!
 Break-even analysis
 Sensitivity analysis
 Risk analysis
 Going the extra mile!
 Beware of “paralysis of analysis”

Principles of Engineering Economic Analysis, 5th edition * See Chapter 13

 Break-even, Sensitivity, and Risk Analyses
Break-even analysis: determining the value of one or more parameters that
will make the PW=0

Sensitivity analysis: determining the impact of a range of values for one or

more parameters on the measure of merit

Risk analysis: determining the probability the PW>0, given probability

distributions for one or more parameters

Principles of Engineering Economic Analysis, 5th edition

 Step 7: Select the Preferred Alternative*
 Obtain the support of the users of the recommended system
 Pre-sell the recommendation
 Eliminate surprises
 Do not over-sell the technical aspects of the recommended system
 Technical aspects seldom convince management to make the required
investment
 The decision-makers’ perspectives are broad
 Know their priorities and tailor the economic justification package
accordingly

Principles of Engineering Economic Analysis, 5th edition * See Chapter 15

 Step 7: Select the Preferred Alternative*
 Relate the proposed investments to the well-being of the firm
 Show how the investment relates to the firm’s strategic plan and
stated corporate objectives
 Your proposal will be only one of many submitted and many will not
be funded
 Failure to fund your proposal does not mean management is stupid
 Management’s decision to fund your proposal does not mean they are
brilliant
 Don’t confuse unfavorable results with destiny

Principles of Engineering Economic Analysis, 5th edition * See Chapter 15

 Step 7: Select the Preferred Alternative*
 Timing is everything!
 Profit maximization is not always the “name of the game,” but
“selling” is!
 A firm’s ability to finance the proposal is as important as its
economic merit
 Think big - you get what you pay for
 Don’t be penny-wise and dollar-foolish
 Remember the “Golden Rule,” those with gold make the rules!
 The less you bet the more you stand to lose in case you win!

Principles of Engineering Economic Analysis, 5th edition * See Chapter 15

 Example 1.8
Weighted Factor Comparison of Alternatives

Three investment alternatives (A, B, and C) are being considered by the

Ajax Mfg. Co. The PWs are $25K, $20K, and $18K, respectively. There
are differences in the quality (Q) of the tools being considered, the time (T)
to fill a customer’s order, and the reputations (R) of the tool suppliers.

Factors Weights Rankings

A B C
PW: present worth 30 10 8 7.2
Q: product quality 35 8 10 5
T: fill time 25 3 10 7
R: Supplier 10 8 5 10
reputation

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison Form
Company: Prepared by: Date:
Description of investment:

A B C
Factor Wt.
Rt. Sc. Rt. Sc. Rt. Sc.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Totals 100

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison Form
Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009
Description of investment: order picking equipment for distribution center

A B C
Factor Wt. Rt. Sc. Rt. Sc. Rt. Sc.
1. Present Worths 30 10 300 8 240 7.2 216
2. Product quality 35 8 280 10 350 5 175
3. Fill time, customer order 25 8 200 10 250 7 175
4. Supplier reputation 10 8 80 5 50 10 100
5.
6.
7.
8.
9.
10.
Totals 100 860 890 666

Principles of Engineering Economic Analysis, 5th edition

 Weighted Factor Comparison Form
Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009
Description of investment: order picking equipment for distribution center

A B C
Factor Wt. Rt. Sc. Rt. Sc. Rt. Sc.
1. Present Worths 40 10 400 8 320 7.2 288
2. Product quality 30 8 240 10 300 5 150
3. Fill time, customer order 20 8 160 10 200 7 140
4. Supplier reputation 10 8 80 5 50 10 100
5.
6.
7.
8.
9.
10.
Totals 100 880 870 678

Principles of Engineering Economic Analysis, 5th edition

 Pit Stop #1—Checking Your Pulse

 True or False: If someone offers you the choice of receiving $1000 today versus
receiving $1000 a year from today, you should take the money today if your time value
of money is greater than zero.

 True of False: A strength of the weighted factor comparison technique is its scientific
foundation and its elimination of subjectivity from decision making.

 True or False: If your time value of money is 10% annually, then you will be
indifferent between receiving $1000 today and receiving $1100 one year from today.

 True or False: Based on the principles of engineering economic analysis, you should
bet on the horse with the lowest odds to win, because risk and returns tend to be
positively correlated.

 True or False: Every economic decision should be based on the time value of money.
Principles of Engineering Economic Analysis, 5th edition
 Pit Stop #1—Checking Your Pulse

 True or False: If someone offers you the choice of receiving $1000 today versus receiving
$1000 a year from today, you should take the money today if your time value of money is
greater than zero. TRUE

 True of False: A strength of the weighted factor comparison technique is its scientific
foundation and its elimination of subjectivity from decision making. FALSE

 True or False: If your time value of money is 10% annually, then you will be indifferent
between receiving $1000 today and receiving $1100 one year from today. TRUE

 True or False: Based on the principles of engineering economic analysis, you should bet on
the horse with the lowest odds to win, because risk and returns tend to be positively
correlated. FALSE

 True or False: Every economic decision should be based on the time value of money.
FALSE
Principles of Engineering Economic Analysis, 5th edition