CO NTEN TS
PREFACE xvii
1 MAKING ECONOMIC DECISIONS 1
Making Economic Decisions 1
A Sea of Problems 3
Simple Problems 3
●
Intermediate Problems 3
●
Complex Problems 3
The Role of Engineering Economic Analysis 4
Examples of Engineering Economic Analysis 4
The Decision-Making Process 5
Rational Decision Making 5
Ethics 14
Ethical Dimension in Engineering Decision Making 14
Engineering Economy 17
Importance of Ethics in Engineering and
●
Engineering Decision Making for Current Costs 17
SUMMARY 21
PROBLEMS 22
2 ESTIMATING ENGINEERING COSTS AND BENEFITS
31
LightTUBe 31
Engineering Costs 33
Fixed, Variable, Marginal, and Average Costs 33 ● Sunk Costs 36 ● Opportunity Costs 37
● Recurring and Nonrecurring Costs 39 ● Incremental Costs 39 ● Cash Costs Versus Book Costs 40
● Life-Cycle Costs 41
Estimating Benefits 43
The Estimating Process 43
Types of Cost Estimates 43
●
Accuracy of Estimate 44
●
Difficulties in Estimation 45
Estimating Models 46
Per-Unit Model 47 ● Segmenting Model 49 ● Cost and Price Indexes 50 ● Power-Sizing Model 51
● Triangulation 53 ● Improvement and the Learning Curve 53
Cash Flow Diagrams 56
Categories of Cash Flows 57 ● Drawing a Cash Flow Diagram 57 ● Drawing Cash Flow Diagrams
with a Spreadsheet 59
x CONTENTS
SUMMARY 59
PROBLEMS 60
TRUST ME, YOU’LL USE THIS
3 INTEREST AND EQUIVALENCE
70
72
A Prescription for Success 72
Computing Cash Flows 74
Time Value of Money 76
Simple Interest 76 ● Compound Interest 77 ● Repaying a Debt 78
Equivalence 80
Difference in Repayment Plans 80 ● Equivalence Is Dependent on Interest Rate 82
Economically Equivalent Plans 83
●
Differences in
Single Payment Compound Interest Formulas 84
Nominal and Effective Interest 89
Continuous Compounding 94
Single Payment Interest Factors: Continuous Compounding 95
SUMMARY 97
PROBLEMS 99
4 EQUIVALENCE FOR REPEATED CASH FLOWS
104
Student Solar Power 104
Uniform Series Compound Interest Formulas 106
Cash Flows That Do Not Match Basic Patterns 114
Economic Equivalence Viewed as a Moment Diagram 118
Relationships Between Compound Interest Factors 121
Single Payment 121 ● Uniform Series 121
Arithmetic Gradient 122
Derivation of Arithmetic Gradient Factors 123 ● Reality and the Assumed Uniformity of
A, G, and g 128
Geometric Gradient 129
Spreadsheets for Economic Analysis 132
Spreadsheet Annuity Functions 133 ● Spreadsheet Block Functions for Cash Flow Tables 134
Compounding Period and Payment Period Differ 136
Uniform Payment Series: Continuous Compounding at Nominal Rate r per Period 138
SUMMARY 140
PROBLEMS 142
CONTENTS xi
5 PRESENT WORTH ANALYSIS
154
The Present Value of 30 Years of Benefits 154
Assumptions in Solving Economic Analysis Problems 156
End-of-Year Convention 156 ● Viewpoint of Economic Analysis Studies 157 ● Sunk
Costs 157 ● Borrowed Money Viewpoint 157 ● Effect of Inflation and Deflation 157
● Income Taxes 158
Economic Criteria 158
Time Period for Analysis 159
Useful Lives Equal the Analysis Period 159 ● Useful Lives Different from the Analysis
Period 163 ● Infinite Analysis Period: Capitalized Cost 166
Multiple Alternatives 169
Applications and Complications 172
Bond Pricing 175
SUMMARY 177
PROBLEMS 178
6 ANNUAL CASH FLOW ANALYSIS
191
Are More Efficient Appliances Cost Effective? 191
Annual Cash Flow Calculations 193
Resolving a Present Cost to an Annual Cost 193
●
Treatment of Salvage Value 194
Annual Cash Flow Analysis 197
Analysis Period 200
Analysis Period Equal to Alternative Lives 202 ● Analysis Period a Common Multiple of Alternative
Lives 202 ● Analysis Period for a Continuing Requirement 202 ● Infinite Analysis
Period 203 ● Some Other Analysis Period 205
Using Spreadsheets to Analyze Loans 206
Building an Amortization Schedule 206 ● How Much to Interest? How Much to Principal? 207
● Finding the Balance Due on a Loan 208 ● Pay Off Debt Sooner by Increasing Payments 208
SUMMARY 210
PROBLEMS 211
7 RATE OF RETURN ANALYSIS
220
Bar Codes Give a Number; RFID Codes Tell a Story and May Become the Spies
You Buy 220
Internal Rate of Return 222
Calculating Rate of Return 224
Plot of NPW Versus Interest Rate i 228
Interest Rates When There Are Fees or Discounts 231
xii CONTENTS
Loans and Investments Are Everywhere 234
Incremental Analysis 238
Present Worth Analysis 242
●
Analysis Period 245
Spreadsheets and Rate of Return Analysis 247
SUMMARY 248
PROBLEMS 249
APPENDIX 7A: DIFFICULTIES IN SOLVING FOR AN INTEREST RATE 258
What to Do If Cash Flow Diagram Has Two or More Sign Changes 259
Projects with Multiple Sign Changes 260
Modified Internal Rate of Return (MIRR) 264
SUMMARY 266
PROBLEMS 267
8 CHOOSING THE BEST ALTERNATIVE
270
Selecting the Best Pavement 270
Incremental Analysis 272
Graphical Solutions 272
Elements in Comparing Mutually Exclusive Alternatives 282
Doing a Set of Incremental Challenger–Defender Comparisons 283
Choosing an Analysis Method 285
SUMMARY 285
PROBLEMS 286
9 OTHER ANALYSIS TECHNIQUES
294
Clean and Green 294
Future Worth Analysis 296
Benefit–Cost Ratio Analysis 298
Variations on the Theme of Benefit–Cost Ratio 302
Payback Period 306
Sensitivity and Breakeven Analysis 310
Graphing with Spreadsheets for Sensitivity and
Breakeven Analysis 315
Doing What-If Analysis with Spreadsheets 318
SUMMARY
319
PROBLEMS
320
10 UNCERTAINTY IN FUTURE EVENTS
331
Video Game Development and Uncertainty 331
Estimates and Their Use in Economic Analysis 333
CONTENTS xiii
A Range of Estimates 333
Probability 336
Joint Probability Distributions 338
Expected Value 340
Economic Decision Trees 343
Risk 349
Risk Versus Return 352
Simulation 353
Real Options 356
SUMMARY 357
PROBLEMS 358
11 DEPRECIATION
367
Depreciation and Intangible Property 367
Income, Depreciation, and Cash Flow 369
Basic Aspects of Depreciation 370
Deterioration and Obsolescence 370 ● Depreciation and Expenses 371
Property 372 ● Depreciation Calculation Fundamentals 373
●
Types of
Time-Based Depreciation Methods 374
Straight-Line Depreciation 374 ● Sum-of-Years’-Digits Depreciation 376 ● Declining Balance
Depreciation 377
Modified Accelerated Cost Recovery System (MACRS) 379
Cost Basis and Placed-in-Service Date 380 ● Property Class and Recovery Period 380 ● Percentage
Tables 380 ● Where MACRS Percentage Rates (rt ) Come From 381 ● MACRS Method
Examples 385 ● Comparing MACRS and Classic Methods 386
Depreciation and Asset Disposal 387
Unit-of-Production Depreciation 391
Depletion 392
Cost Depletion 392
●
Percentage Depletion 392
Spreadsheets and Depreciation 394
Using VDB for MACRS 394
SUMMARY 396
PROBLEMS 397
12 INCOME TAXES FOR CORPORATIONS
405
On with the Wind 405
A Partner in the Business 407
Calculation of Taxable Income 407
Classification of Business Expenditures 407
●
Taxable Income of Business Firms 408
xiv CONTENTS
Income Tax Rates 409
Corporate Tax Rates 409 ● Combined Federal and State Income Taxes 411
Tax Rate for Economy Studies 412
●
Selecting an Income
Economic Analysis Taking Income Taxes into Account 412
Section 179 Deduction 416 ● Investment Tax Credit 416
The After-Tax Rate of Return 416
Estimating a Project’s After-Tax IRR 416 ● After-tax Minimum Attractive Rate of Return 417
Capital Gains and Losses for Nondepreciated Assets 417
After-Tax Cash Flows and Spreadsheets 417
SUMMARY
419
PROBLEMS
419
APPENDIX 12A: TAXES AND PERSONAL FINANCIAL DECISION MAKING 430
Income Taxes for Individuals 430
Calculating Taxable Income 430 ● Individual Tax Rates 431 ● Combined Federal and State
Income Taxes 433 ● Capital Gains/Losses for Individuals 433 ● Tax Credits vs. Tax
Deductions 433 ● Student Loan Interest Deduction 434
Student Loans 435
Retirement Accounts 437
PROBLEMS
439
13 REPLACEMENT ANALYSIS
442
Aging Bridges 442
The Replacement Problem 444
Replacement Analysis Decision Map 445
Minimum Cost Life of a New Asset — The Challenger 447
Defender’s Marginal Cost Data 449
Do We Have Marginal Cost Data for the Defender? 451
●
Are These Marginal Costs Increasing? 451
Replacement Analysis Technique 1: Defender Marginal Costs Can Be Computed
and Are Increasing 452
Replacement Repeatability Assumptions 453
Replacement Analysis Technique 2: Defender Marginal Costs Can Be Computed
and Are Not Increasing 454
Replacement Analysis Technique 3: When Defender Marginal Cost Data
Are Not Available 458
Complications in Replacement Analysis 459
Defining Defender and Challenger First Costs 459
Repeatability Assumptions Not Acceptable 461
A Closer Look at Future Challengers 462
CONTENTS xv
After-Tax Replacement Analysis 463
Marginal Costs on an After-Tax Basis 463
Replacement Analysis 466
●
Minimum Cost Life Problems 465
●
Spreadsheets and
SUMMARY 467
PROBLEMS 468
14 INFLATION AND PRICE CHANGE
478
The Athabasca Oil Sands 478
Meaning and Effect of Inflation 480
How Does Inflation Happen? 480 ● Definitions for Considering Inflation in Engineering
Economy 481
Analysis in Constant Dollars Versus Then-Current Dollars 488
Price Change with Indexes 491
What Is a Price Index? 491 ● Composite Versus Commodity Indexes 493
Indexes in Engineering Economic Analysis 495
Cash Flows That Inflate at Different Rates 496
●
How to Use Price
Different Inflation Rates per Period 497
Inflation Effect on After-Tax Calculations 498
Using Spreadsheets for Inflation Calculations 500
SUMMARY 502
PROBLEMS 503
15 SELECTION OF A MINIMUM ATTRACTIVE RATE OF RETURN
513
What’s the Rate of Return on a Dam? 513
Sources of Capital 515
Money Generated from the Firm’s Operation 515
Sources of Funds 516
●
External Sources of Money 515
●
Choice of
Cost of Funds 516
Cost of Borrowed Money 516
Money 517
●
Cost of Capital 516
●
Inflation and the Cost of Borrowed
Investment Opportunities 518
Opportunity Cost 520
Selecting a Minimum Attractive Rate of Return 524
Adjusting MARR to Account for Risk and Uncertainty 525
Representative Values of MARR Used in Industry 527
Capital Budgeting or Selecting the Best Projects 528
SUMMARY 530
PROBLEMS 531
xvi CONTENTS
16 ECONOMIC ANALYSIS IN THE PUBLIC SECTOR
537
From Waste to Power and Money 537
Investment Objective 539
Viewpoint for Analysis 540
Selecting an Interest Rate 542
No Time-Value-of-Money Concept 542 ● Cost of Capital Concept 542
Concept 543 ● Recommended Concept 544
●
Opportunity Cost
The Benefit–Cost Ratio 544
Incremental Benefit–Cost Analysis 547
Elements of the Incremental Benefit–Cost Ratio Method 547
Other Effects of Public Projects 552
Project Financing 552 ● Project Duration 553
Disbenefits 555 ● Project Politics 557
●
Quantifying and Valuing Benefits and
SUMMARY 558
PROBLEMS 559
17 ACCOUNTING AND ENGINEERING ECONOMY
567
A Tale of Three Engineers 567
The Role of Accounting 569
Accounting for Business Transactions 570
The Balance Sheet 570
Assets 571 ● Liabilities 571
●
Equity 572
●
Financial Ratios Derived from Balance Sheet Data 572
The Income Statement 573
Financial Ratios Derived from Income Statement Data 575
Statement, and Capital Transactions 575
●
Linking the Balance Sheet, Income
Traditional Cost Accounting 576
Direct and Indirect Costs 576 ● Indirect Cost Allocation 577
Accounting 578 ● Other Problems to Watch For 579
PROBLEMS
APPENDIX A
579
584
APPENDIX B 588
APPENDIX C 599
APPENDIX D 631
APPENDIX E 651
PHOTO CREDITS
REFERENCES
INDEX 661
657
659
●
Problems with Traditional Cost