GE 403
First Semester 1439/40
Chapter 1
Student Version
Principles of Engineering Economic Analysis, 5th edition
The textbook for the course is
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
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
Four Discounted Cash Flow Rules
1.
2.
Money has a time value;
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
Principles of Engineering
Economic Analysis
1. Money has a time value.
2. Make investments that are
economically justified.
3. Choose the mutually exclusive
investment alternative that maximizes
economic worth.
4. Two investment alternatives are
equivalent if they have the same
economic worth.
Principles of Engineering Economic Analysis, 5th edition
Principles of Engineering
Economic Analysis
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.
7. Consider only differences in cash
flows among investment alternatives.
Principles of Engineering Economic Analysis, 5th edition
Principles of Engineering
Economic Analysis
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
SEAT
Systematic Economic Analysis Technique
Seven-Step Procedure
Identify the investment alternatives
Define the planning horizon
Specify the discount rate
Estimate the cash flows
Compare the alternatives
Perform supplementary analyses
Select the preferred alternative
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 (C can’t
be selected without 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
ALT
1
2
3
4
5
6
7
8
xA
0
0
0
0
1
1
1
1
Proposals
xB
0
0
1
1
0
0
1
1
xC
0
1
0
1
0
1
0
1
Principles of Engineering Economic Analysis, 5th edition
Comments
Example 1.5 Forming Investment
Alternatives from Investment Proposals
Proposals
ALT x A x B x C
Comments
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
Four alternatives: {B}, {A}, {A,C}, {A,B}
Principles of Engineering Economic Analysis, 5th edition
Weighted Factor Comparison of Alternatives
Example 1.8
Three investment alternatives (A,B,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
PW: present worth
Q: product quality
T:
fill time
R: supplier reputation
Weights
30
35
25
10
Principles of Engineering Economic Analysis, 5th edition
Rankings
A
B
C
10
8
7.2
8
10
5
3
10
7
8
5
10
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
Factor
Wt.
1. Present Worths
30
2. Product quality
35
3. Fill time, customer order25
4. Supplier reputation
10
5.
6.
7.
8.
9.
10.
Totals
100
Rt.
10
8
8
8
B
Sc.
300
280
200
80
Rt.
8
10
10
5
860
Principles of Engineering Economic Analysis, 5th edition
C
Sc.
240
350
250
50
890
Rt.
7.2
5
7
10
Sc.
216
175
175
100
666
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
Factor
Wt.
1. Present Worths
40
2. Product quality
30
3. Fill time, customer order20
4. Supplier reputation
10
5.
6.
7.
8.
9.
10.
Totals
100
Rt.
10
8
8
8
B
Sc.
400
240
160
80
Rt.
8
10
10
5
880
Principles of Engineering Economic Analysis, 5th edition
C
Sc.
320
300
200
50
870
Rt.
7.2
5
7
10
Sc.
288
150
140
100
678
When the TVOM Need Not Be
Considered
1. When no investment of capital is required
2. When all cash flows occur in a limited time
period, e.g., less than a year
3. When annual cash flows are roughly
proportional to cash flows the first year
4. When the same capital investment is required for
all alternatives
5. When there are no essential differences in cash
flows among the alternatives after the first year
Principles of Engineering Economic Analysis, 5th edition
Example 1.9
Six college students are making plans for spring break. They are
considering traveling 1200 miles to Florida by bus, train, plane, rental
cars, or rental van. Due to bus and train schedules, they limited their
options to plane, two rental cars, or a rental van.
The final data used in their analysis of transportation options are as
follows: round-trip airfare per person ($300); daily rental rate for each
car, all charges except fuel ($50); rental car gas mileage (20
miles/gallon); drop charge for each car ($150); daily rental rate for a
van, all charges except fuel ($80); rental van gas mileage (12
miles/gallon); drop charge for the van ($225); cost to travel to or from
the airport at the spring break destination ($50 per cab, two cabs
required); and average price of gasoline ($4.25/gallon). If they keep the
rental vehicle, the charges will be for 7 days; if they drop the rental
vehicle, the charges will be for 2 days.
Principles of Engineering Economic Analysis, 5th edition
Example 1.9 (Continued)
Alternatives
1. fly to/from spring break
2. use two rental cars and incur drop charges
3. use two rental cars and do not incur drop charges
4. use a rental van and incur drop charges
5. use a rental van and do not incur drop charges.
Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $2200.00
2. Total cost = 2 rental cars ($50/day)(2 days) + 4 drops ($150/drop)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $1820.00
3. Total cost = 2 rental cars ($50/day)(7 days)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $1720.00
4. Total cost = 1 rental van ($80/day)(2 days) + 2 drops ($225/drop)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $1460.00
5. Total cost = 1 rental van ($80/day)(7 days)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $1410.00
Principles of Engineering Economic Analysis, 5th edition
Example 1.9 (Continued)
Alternatives
Principle #7
1.
fly to/from spring break
2.
use two rental cars
Consider only differences in cash flows
a. incur drop charges
among investment alternatives
b. do not incur drop charges
3.
use a rental van
a. incur drop charges
b. do not incur drop charges
Economic Analysis
1.
Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $2200.00
2.
Driving cost = 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon)
+ 2 rental cars ($50/day)(2 days) = $1220.00
a. Cost = 4 drops ($150/drop) = $600.00
b. Cost = 2 rental cars ($50/day)(5 days) = $500.00
Lowest cost = $1720.00
3.
Driving cost = 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon)
+ 1 rental van ($80/day)(2 days) = $1010.00
a. Cost = 2 drops ($225/drop) = $450.00
b. Cost = 1 rental van ($80/day)(5 days) = $400.00
Lowest cost = $1410.00
Principles of Engineering Economic Analysis, 5th edition
Example 1.12
Hugh Kinney, a small business owner, must purchase a
large number of light bulbs for his new office building. At
Wal-Mart he found several options available, but narrowed
his selection to either GE Soft White 100 incandescent or
GE Soft White 100 helical fluorescent bulbs, costing 26¢
and $3.22, each, respectively. The light output per bulb is
1690 lumens and 1700 lumens, respectively; the energy
used per bulb is 100 watts and 26 watts, respectively; and
the rated life per bulb is 750 hours and 12,000 hours,
respectively. Usage is estimated to be 2500 hours/year.
Electrical energy costs $0.10 per kilowatt hour. Labor to
install/replace a bulb is estimated to cost $2.00. Which bulb
should he choose in order to minimize his annual cost?
Principles of Engineering Economic Analysis, 5th edition
Hugh’s Solution to Example 1.12
Energy cost/bulb:
Incandescent (2500 hr/yr)(100 w)($0.1/kWh)/1000 hr
= $25/yr
Fluorescent
(2500 hr/yr)(26 w)($0.1/kWh)/1000 hr
= $6.25/yr
Acquisition, plus installation/replacement cost:
Incandescent (2500 hr/yr)($2.00 + $0.26)/750 hr
= $7.53/yr
Fluorescent
(2500 hr/yr)($2.00 + $3.22)/12,000 hr
= $1.09/yr*
Annual cost:
Incandescent $25.00 + $7.53 = $32.53/yr
Fluorescent
$6.25 + $1.09 = $7.34/yr
* violates 1st DCF rule, since bulb lasts longer than a year
Principles of Engineering Economic Analysis, 5th edition
Example 1.13
Stacey Kinney, an engineer and Hugh’s daughter, pointed
out several errors in her father’s analysis. She explained
that the energy cost consists of a fixed cost and a
variable cost: $7.10 per meter; 8.803¢/kWh for < 2000 kWh
in a month; and 8.8087¢/kWh for > 2000 kWh/mo. Since
the energy load on the building > 2000 kWh/mo, she said
the incremental cost would be 8.087¢/kWh, not 10¢/kWh.
Stacey also asked how the labor cost was determined.
Given the answer, she asked if the employee will be paid
overtime for installing/replacing bulbs. When she learned
he would not, she reminded her father that there would
not be an incremental cost to install or replace bulbs.
Principle #7
Consider only differences in cash flows
among investment alternatives
Principles of Engineering Economic Analysis, 5th edition
Stacey’s Solution to Example 1.13
Energy cost/bulb:
Incandescent (2500 hr/yr)(100 w)($0.080871/kWh)/1000 hr
= $20.2175/yr
Fluorescent
(2500 hr/yr)(26 w)($0.08087/kWh)/1000 hr
= $5.2566/yr
Acquisition, plus installation/replacement cost:
Incandescent (2500 hr/yr)($0.26)/750 hr
= $0.8667/yr
Fluorescent
(2500 hr/yr)($3.22)/12,000 hr
= $6708/yr ($0.9883/yr based on 15% TVOM)
Annual cost:
Incandescent $20.2175 + $0.8667 = $21.0842/yr
Fluorescent
$5.2566 + $0.6708 = $5.9274/yr
($6.2449/yr based on 15% TVOM)
Principles of Engineering Economic Analysis, 5th edition
Homework # 1
Principles of Engineering Economic Analysis, 5th edition