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    Econlesson4fe PDF

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    1. The document provides definitions and examples related to engineering economics concepts such as year-end convention, cash flow diagrams, present worth, compounding, comparison of alternatives using present worth and annual cost, alternatives compared to a standard using cost-benefit analysis and rate of return, break-even analysis, inflation, depreciation, tax considerations, and bonds. 2. Key concepts are illustrated through examples such as calculating present worth using discount factors, comparing investment alternatives, calculating book value and depreciation amounts, and determining maximum bond value. 3. Engineering economics tools such as cash flows, present worth, equivalence, rate of return, and tax considerations are discussed in the context of comparing project and investment alternatives.

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    Econlesson4fe PDF

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    LibyaFlower
    97 views7 pages
    1. The document provides definitions and examples related to engineering economics concepts such as year-end convention, cash flow diagrams, present worth, compounding, comparison of alternatives using present worth and annual cost, alternatives compared to a standard using cost-benefit analysis and rate of return, break-even analysis, inflation, depreciation, tax considerations, and bonds. 2. Key concepts are illustrated through examples such as calculating present worth using discount factors, comparing investment alternatives, calculating book value and depreciation amounts, and determining maximum bond value. 3. Engineering economics tools such as cash flows, present worth, equivalence, rate of return, and tax considerations are discussed in the context of comparing project and investment alternatives.

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    1. The document provides definitions and examples related to engineering economics concepts such as year-end convention, cash flow diagrams, present worth, compounding, comparison of alternatives using present worth and annual cost, alternatives compared to a standard using cost-benefit analysis and rate of return, break-even analysis, inflation, depreciation, tax considerations, and bonds. 2. Key concepts are illustrated through examples such as calculating present worth using discount factors, comparing investment alternatives, calculating book value and depreciation amounts, and determining maximum bond value. 3. Engineering economics tools such as cash flows, present worth, equivalence, rate of return, and tax considerations are discussed in the context of comparing project and investment alternatives.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    97 views7 pages

    Econlesson4fe PDF

    Uploaded by

    LibyaFlower
    1. The document provides definitions and examples related to engineering economics concepts such as year-end convention, cash flow diagrams, present worth, compounding, comparison of alternatives using present worth and annual cost, alternatives compared to a standard using cost-benefit analysis and rate of return, break-even analysis, inflation, depreciation, tax considerations, and bonds. 2. Key concepts are illustrated through examples such as calculating present worth using discount factors, comparing investment alternatives, calculating book value and depreciation amounts, and determining maximum bond value. 3. Engineering economics tools such as cash flows, present worth, equivalence, rate of return, and tax considerations are discussed in the context of comparing project and investment alternatives.

    Copyright:

    © All Rights Reserved
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    of 7

    ENGINEERING ECONOMICS REVIEW

    Fall 2006
    DEFINITIONS
    Year-end convention: Expenses occurring during the year are assumed to occur at the end of
    the year.
    CASH FLOW DIAGRAMS
    Some FE exam problems may use cash flow diagrams. They can also be useful to represent a
    word problem graphically. The flow of cash is shown as arrows on a time line scaled to the magnitude of
    the cash flow. Expenses are down arrows, and receipts are up arrows.
    Example: Cash flow diagram
    A mechanical device will cost $20,000 when purchased. Maintenance will cost $1000 per year.
    The device will generate revenues of $5000 per year for 5 years. The salvage value is $7000. Draw and
    simplify the cash flow diagram.
    =F5

    =A1-4

    =P0
    PRESENT WORTH
    The value (at the current time) of some value to be realized in the future.
    Example: Present worth
    How much is that $11,000 at the end of five years worth to you today, given a 10%
    effective annual interest rate?
    Using the formula in the factor conversion table:
    -n
    -5
    P = F(1 + i) = ($11,000 )(1 + 0.1) = $6831
    or using the factor table for 10%:
    P = F(P/F,i%,n) = ($11,000)(P/F,10%,5) = ($11,000)(0.6209) = $6831
    How much is that series of $4,000 at the end of the first four years worth to you today,
    given a 10% effective annual interest rate?
    Using the formula in the factor conversion table:
    n
    P = A[(1 + i) -1]/[i(1+1)n] = ($4,000 )(0.4641/0.14641) = $12,680
    or using the factor table for 10%:
    P = A(P/A,i%,n) = ($4,000)(P/A,10%,4) = ($4,000)(3.1699) = $12,680
    Thus, the Present Worth of the entire cash flow is as follows:
    PW = P0 +P/F + P/A = -$20,000 + $6,831 + $ 12,680 = - $489

    COMPOUNDING
    Using equivalence equations
    If there is a factor table for the interest rate in the NCEES FE Reference Handbook, use it; dont
    waste time using the equivalence equations. But sometimes the problem will have an interest rate
    for which there is no table. While it is possible to interpolate between the tablesfor example, if
    the interest rate is 5% you can use the average between the 4% table and the 6% tableerrors
    occur because the relations are not linear functions of interest rate.
    Nonannual compounding
    An interest rate that is compounded more than once in a year is converted from the
    compound nominal rate to an annual effective rate.
    ie ={1+r/m}m - 1
    ie = effective annual rate
    r = nominal rate per period
    m = number of compounding periods in a year
    After the interest rate is converted to an annual rate, the problem is solved as any annual interest
    rate problem using the factor conversion formulas or the factor tables. This is true if the cash
    flows in question are annual. If they are in terms of the compounding period, use the period rate,
    which is r/m.
    The interest rate must be in decimal (not percentage) form.
    Example: Nonannual compounding
    A savings and loan offers a 5.25% rate per year compounded daily over 365 days per year.
    What is the effective annual rate?

    Discount factors for continuous compounding


    The formulas for continuous compounding are the same formulas in the factor conversion table
    with the limit taken as the number of periods, n, goes to infinity. Solve continuous compounding
    problems with formulas in the NCEES FE Handbook.
    COMPARISON OF ALTERNATIVES
    Present worth
    When alternatives do the same job and have the same lifetimes, compare them by converting
    each to its cash value today. The superior alternative will have the highest present worth.
    Example: Present worth
    Investment A costs $10,000 today and pays back $11,500 2 years from now. Investment B costs
    $10,000 today and pays back $5500 each year for 2 years. If the interest rate of 6% is used for
    comparison, which investment is superior?

    P(A)= $10,000 + ($11,500)(P/F,6%,2)


    -2
    = $10,000 + ($11,500)(0.89)
    = $10,000 + $10, 235 = $235
    P(B) = $10,000 + ($5500)(P/A,6%,2)
    -2
    = $10,000 + ($5,500)(1.8334)
    = $10,000 + $10, 083 = $83
    $235 > $83, so Alternative A is superior.
    Capitalized costs
    Used for a project with infinite life that has repeating expenses every year.
    Compare alternatives by calculating the capitalized costs (i.e., the amount of money needed to
    pay the start-up cost and to yield enough interest to pay the annual cost without touching the
    principle.)
    NOTE: The factor conversion for a project with no end is the limit of the F/A factor as the
    number of periods, n, goes to infinity:
    Example: Capitalized cost
    What is the present worth of a public works project that will cost $25,000,000 now and will
    require $2,000,000 in maintenance annually? The effective interest rate is 12%.
    Present Worth = initial cost + annual cost (P/A,i%,), or capitalized cost
    = - $25M + ( - $2M)(1/0.12) = - $41.67M
    Annual cost
    Used for alternatives that do the same job but have different lives. Compare the cost per year of
    each alternative.
    The alternatives are assumed to be replaced at the end of their lives by identical
    alternatives.
    Example: Annual cost
    Brick will last 30 years, cost $1800, and require $5/yr maintenance. Wood will last 10 years, cost
    $450, and require $20/yr maintenance. Which is superior over 30 years? The interest rate is 8%.
    EUAC (brick) = ($1800)(A/P,8%,30) + $5
    = ($1800)(0.0888) + $5 = $165
    EUAC (wood) = ($450)(A/P,8%,10) + $20
    = ($450)(0.149) + $20 = $87.50
    (EUAC = Equivalent Uniform Annual Cost)
    $87.50 < $165, so Wood is superior.

    ALTERNATIVES COMPARED TO A STANDARD


    Cost (C) benefit (B) analysis
    B C > 0 or B/C >1
    Example: Cost-benefit analysis
    The initial cost of a proposed project is $40M, the capitalized perpetual annual cost is $12M, the
    capitalized benefit is $49M, and the residual value is $0. Should the project be undertaken?
    B = $49M, C = $40M + $12M + $0
    B C = $49M $52M = $3M < 0
    The project should not be undertaken.
    Rate-of-return problems
    The rate of return on an investment must exceed the minimum attractive rate of return
    (MARR). The rate of return is calculated by finding an interest rate that makes the present
    worth zero. Often this must be done by trial and error.
    PW (i%) = 0; if i% >= MARR, accept.
    Example: Rate of Return
    PW = -$100 +$3(P/A,i%,3) + $130(P/F, i%,3) = 0
    $33.33 = (P/A,i%,3) + $43.33(P/F, i%,3)
    i% = 8%
    (P/A,8%,3) + $43.33(P/F, 8%,3)=
    2.5771+43.33(0.7938) = $37. 24 > $33.33
    i% = 10%
    (P/A,10%,3) + $43.33(P/F, 10%,3)=
    2.4869+43.33(0.7513) = $32.50 < $33.33
    i-0.10/ 33.33 - 32.50 = .10-.08/32.50-37.24
    i% = 46.234/47.4 = 0.975
    BREAK-EVEN ANALYSIS
    Calculating when revenue is equal to cost, or when one alternative is equal to another if both
    depend on some variable.
    Example: Break-even analysis
    How many kilometers must be driven per year for leasing and buying to cost the same? Use 10%
    interest and year-end cost. Leasing: $0.15 per kilometer Buying: $5000 purchase cost, 3-year
    life, salvage $1200, $0.04 per kilometer for gas and oil, $500 per yr for insurance.

    EUAC (leasing) = $0.15x where x is kilometers driven


    EUAC (buying) = $0.04x + $500 + ($5 k)(A/P,10%,3) ($1.2 k)(A/F,10%,3) =
    $0.04x + $500 + ($5 k)(0.4021) ($1.2 k)(0.3021) = $0.04x +
    $2148
    Setting EUAC (leasing) = EUAC (buying) and solving for x
    $0.15x = $0.04x + $2148
    x = 19,527 km that must be driven to break even
    INFLATION
    Making a correction to the interest rate for inflation.
    d = i + f + (i f)
    To determine the value of P dollars n years from today, use the following: F = P(1+f)n
    If interest is being compounded during the inflationary period, F = P [(1+i)/(1+f)]n
    Example: Inflation
    1. An item presently costs $100. If the inflation rate is 6%, how much will it cost in 5 years?
    Solution F = $100 (1+.06)5 = $100 (1.3382) = $133.82.
    DEPRECIATION
    Straight line
    The depreciation per year is the cost minus the salvage value divided by the years of life.

    Accelerated Cost Recovery System (ACRS)


    The depreciation per year is the cost times the ACRS factor (see the table in the NCEES
    Handbook). Salvage value is not considered.
    Dj = (ACRS factor) C
    Example: Straight-line and ACRS
    An asset is purchased that costs $9000. It has a 10-year life and a salvage value of $200. Find the
    straight-line depreciation and ACRS depreciation for 3 years.

    Straight-line depreciation /year = ($9000 $200)/10 = $880/yr (each year)


    ACRS depreciation
    First year ($9000)(0.1) = $ 900
    Second year ($9000)(0.18) = $1620
    Third year ($9000)(0.144) = $1296

    Book value
    Assumed value of the asset after j years. The initial cost minus the sum of the
    th
    depreciations out to the j year

    BV = initial cost Dj
    Example: Book value
    What is the value of the asset in the previous example after 3 years using straight-line
    depreciation? Using ACRS depreciation?
    Straight line
    $9000 (3)($800) = $6360
    ACRS
    $9000 $900 $1620 $1296 = $5184
    TAX CONSIDERATIONS
    Expenses and depreciation are deductible, revenues are taxed. Example: Tax considerations A
    corporation pays 53% income tax on profits. It invests $10,000 in an asset that will provide
    $3000 in revenue per year for 8 years. The annual expenses are $700, the salvage value is $500, and 9%
    interest is used. What is the after-tax present worth? Disregard depreciation.
    P = $10,000 + ($3000)(P/A,9%,8)(1 0.53) ($700)(P/A,9%,8)(1 0.53) + ($500)(P/F,9%,8)
    = $10,000 + ($3000)(5.5348)(0.47) ($700)(5.5348)(0.47) + ($500)(0.5019) = $3766
    Tax credit
    A one-time benefit from a purchase that is subtracted from income taxes.
    Example: Tax credit
    An investment costs $5000 and is not depreciable, but there is a one-time 20% tax credit. In the same
    year, revenue is $45,000, and expenses (excluding the $5000 investment) are $25,000. The income tax
    rate is 53%, and the interest rate is 10%. What is the after-tax present worth for the year?
    Since 20% of $5000 is $1000, the corporation will get $1000 credit against its taxable income.
    P
    = $5k + (($45 k $25 k)(1 0.53) + ($1 k)(P/F,10%,1)
    = $5k + ($10.4 k)(0.9091) = $4455
    BONDS
    Bond value = present worth of payments over the life of the bond.
    Bond yield = equivalent interest rate of the bond compared to bond cost.
    Example: Bonds
    What is the maximum an investor should pay for a 25-year bond with a $20,000 face value and
    8% coupon rate (with interest paid semiannually)? The bond will be kept to maturity. The
    effective annual rate for comparison is 10%.
    bond = r%/periods = 8%/2 = 4% (effective rate per period)
    Coupon payment = ($20,000)(bond) = $800
    2
    The comparison interest rate is 0.10 = (1 + ) 1

    Solving for = (0.10 + 1) 1 = 0.0488


    There are 50 periods, so:P = ($800)(P/A,4.88%,50) + ($20,000)(P/F,4.88%,50)
    P = ($800)(18.600) + ($20.000)(0.09233) = $16,727
    The investor should pay no more than $16,727 for the bond.

    ENGINEERING ECONOMY REVIEW


    ADDITIONAL PROBLEMS
    (1) What is the uninflated present worth of $2000 in 2 years if the average inflation rate is 6% and i
    is 10%?
    2
    Answer: = $1471
    (2) It costs $75 per year to maintain a cemetery plot. If the interest rate is 6.0%, how much must be set
    aside to pay for maintenance on each plot without touching principle?
    Answer: = $1250
    (3) It costs $1,000 for hand tools and $1.50 labor per unit to manufacture a product. Another alternative
    is to manufacture the product by an automated process that costs $15,000, with a $0.50 per-unit cost.
    With an annual production rate of 5,000 units, how long will it take to reach the break-even point?
    Answer: = 2.8 years
    (4) A loan of $10,000 is made today at an interest rate of 15%, and the first payment of $3,000 is made 4
    years later. The amount that is still due on the loan after the first payment is most nearly:
    Answer: = $14,490
    (5) A machine is purchased for $1,000 and has a useful life of 12 years. At the end of 12 years, the
    salvage value is $130. By straight-line depreciation, what is the book value of the machine at the end of
    8 years?
    Answer: = $420
    (6) The maintenance cost for an investment is $2,000 per year for the first 10 years and $1,000 per year
    thereafter. The investment has infinite life. With a 10% interest rate, the present worth of the annual
    disbursement is most nearly:
    Answer: = $1480

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