Engineering Economics
Bo Hu
John Nieber
Topics Menu
Basics
Financial reporting
Journals, ledgers
Balance sheets
Income statements
Financial ratios
Costing of products & process equipment
Cost estimation
Financial analysis (Profitability)
Capital investment
Return on Investment (ROI)
Payback period
Venture Profit
Annualized Cost
Net present value
Investor’s rate of return (Discounted Cash Flow)
Cash flow diagram
Depreciation
Basics
Interest Fee charged for borrowing someone else’s money
Interest rate Percentage of money borrowed charged by lender.
Simple Interest Fixed interest of the principal ($ borrowed)
Compound Interest Percentage interest applied to principal +
previously accumulated interest.
Time Value of Money Money increases in value with time due
to interest.
Inflation National economies experience increased cost of
goods with time which is termed inflation.
Taxes Interest gained in an investment is taxed by the govt.
Cash Flows Difference between total cash receipts (inflow) and
total cash disbursements (outflow) in a period of
time (usually, one year).
Financial Statements, Records, and Reports
• Journal
– Debit and Credit Transactions
• Ledger
– Transactions for a particular account category
• Balance Sheet
– Assets and Liabilities
• Income statement (Profit/Loss)
– Record of profits and losses
• Cash flow statement
– Summary of cash flows in a given period.
Journal
JOURNAL
Page 43
Debit ($)
Credit ($)
2002
June 3
Heat Exchanger
Cash
Purchase of a HEX for ammonia plant
4 Cash
Ammonia product
Sales of product from ammonia plant ABC
6 Land
Cash
Purchase of land in Iowa from XYZ
15
11
80 450
11
12
125 000
20
11
265 000
BANK ACCOUNT, LEDGER 11
June 1
4
Balance forward
Sales
125 000
265 000
Source : SSL p. 473
Ledger
2002
80 450
Debit ($)
2002
42 500 000
43 125 000
June
Page 5
Credit ($)
3
6
Purchase
Purchase
43
43
80 450
265 000
Source : SSL p. 474
Balance Sheet
ASSETS
Current Assets
Cash and cash equivalents
Marketable securities
Accounts receivable
Inventories :
Finished products and work in progress
Materials and supplies
Deferred income tax assets
Total current assets
Investments
In nonconsolidated affiliates
Other
Total investments
Property
Land
Buildings
Plant machinery and equipment
Office equipment
Computer software
Less accumulated depreciation
Net property
Other Assets
Goodwill
Other intangible assets
Total other assets
107
45
2692
1420
312
54
4630
544
1476
2020
200
2190
7684
645
242
-6006
4955
952
1654
2606
Source : SSL p. 475
TOTAL ASSETS
14211
Balance Sheet (cont.)
LIABILITIES
Current liabilities
Short term debt (payable within one year)
Accounts payable
Income taxes payable
Deferred income tax liabilities
Dividends payable
Accrued current liabilities
Total current liabilities
Long -Term Debt
Other Noncurrent Liabilities
Pension and other post-retirement benefits
Reserve for discontinued operations
Other noncurrent obligations
Total other noncurrent liabilities
TOTAL LIABILITIES
STOCKHOLDERS' EQUITY
Common stock (authorized 2,000,000,000 shares
at $1.00 par value; 1,000,000,000 issued)
Capital in excess of par value of common stock
Retained earnings
Less treasury stock at cost, 300,000,000 shares
NET STOCKHOLDERS' EQUITY
TOTAL LIABILITIES + STOCKHOLDERS' EQUITY
150
2773
130
21
104
975
4153
3943
832
78
784
1754
9850
1000
4230
2559
-3428
4361
14211
Source : SSL p. 476
Income Statement
Net sales
Cost of goods sold
GROSS PROFIT
OPERATING EXPENSES
Research and development expenses
Selling, general, and administrative expenses
Insurance and finance company operations
Amortization and adjustments of goodwill
TOTAL OPERATING EXPENSES
INCOME FROM OPERATIONS
Interest expenses
GROSS INCOME
Provision for income taxes
NET INCOME
11,504
9,131
2373
446
439
34
64
983
1390
185
1205
402
803
Source : SSL p. 478
Cash Flow Statement
OPERATING ACTIVITIES
Net income available for common stockholders
Adjustments to reconcile net income to net cash:
Depreciation
Depletion
Amortization
Provision for deferred income tax
Net gain (loss) on sales of property
Changes in assets and liabilities involving cash:
Accounts and notes receivable
Inventories
Accounts payable
CASH PROVIDED BY OPERATING ACTIVITIES
INVESTING ACTIVITIES
Capital expenditures
Sales of property
Sales (purchases) of investments
CASH PROVIDED IN INVESTING ACTIVITIES
FINANCIAL ACTIVITIES
Payments on long-term debt
Purchases of treasury stock
Proceeds from sales of preferred stock
Dividends paid to stockholders
CASH PROVIDED (USED) IN FINANCING ACTIVITIES
INCREASE (DECREASE) IN CASH AND CASH EQUIV.
3151
675
383
486
125
-103
-441
-389
315
4202
-1227
231
2221
1225
-524
-15
620
-485
-404
5023
Source : SSL p. 479
Prepare for the class discussion
• Choose one of your favorite companies and
search their balance sheet, income statement,
and cash flow statement in the year 2009.
• During the class, we are going to analyze their
financial ratio and see whether these
companies are considered healthy.
Financial Ratios
• Financial Ratios (to measure the profitability of company)
• Current ratio : (current assets)/(current liabilities) =2
• Acid-Test (Quick) Ratio : (current assets minus
inventory)/(current liabilities) =1-2
• Equity Ratio : (stock holders’ equity)/(total assets) =0.5
• Return on Total Assets (ROA) : (income before
interest and taxes) / (total assets)
• Return on Equity (ROE) : (income before interest and
taxes)/(common stockholders’ equity)
• Operating Margin : (income from operations)/(net sales)
• Profit Margin (net income after taxes)/(net sales)
Cost estimate
Product Cost
Product cost breakdown (simple case)
Total cost = MC + LC + IC
MC = Material cost
LC = Labor cost
IC = Indirect cost (overhead)
MC = $ per kg of materials x mass utilized
LC = $ per hour rate x hours worked
IC = $freight + $overhead + $contractor expenses…etc
Capital Investment Installation Cost
Direct module expenses
Equipment purchase price
Installation materials cost
---------------------------------------------------- Total $A
Direct field labor
Material for construction
Equipment setting
---------------------------------------------------- Total $B
Indirect module expenses
Freight, Construction overhead,
Contractor engineering expenses
---------------------------------------------------- Total $C
BARE MODULE COST = $A+$B+$C
Capacity Cost Estimation
M
Q 

C E  C B 
 QB 
where C E  equipment cost with capacity Q
C B  known base cost for equipment with capacity QB
M  constant depending on equipment type
C1  INDEX 1 

 
C2  INDEX 2 
where C1  equipment cost in year 1
C2  equipment cost in year 2
INDEX 1  cost index in year 1
INDEX 2  cost index in year 2
from R. Smith (2005)
Capital costing
C F   f i C E ,i
i
where C F  fixed capital cost for the complete system
C E ,i  cost of equipment i
f i  installati on factor for equipment i
or
C F  f I  C E ,i
from R. Smith (2005)
i
where f I overall installati on factor for the complete system
Equipment cost
M
Q 
 f M f P fT
C E  C B 
 QB 
where C E  equipment cost with capacity Q
C B  known base cost for equipment with capacity QB
M  constant depending on equipment type
f M  correction factor for materials of construction
f P  correction factor for design pressure
fT  correction factor for design temperature
From R. Smith (2005)
Sources of Financial Data
Seider et al. (2004) Product and Process Design Principles.
Smith, Robin, (2005) Chemical Process : Design and Integration
The Chemical Engineering (CE) Plant Cost Index
The Marshall & Swift (MS) Equipment Cost Index
The Nelson-Farrar (NF) Refinery Construction Cost Index
The Engineering News-Record (ENR) Construction Cost Index
Financial Analysis
Return on Investment
Payback period
Venture Profit
Annualized Cost
Net present value
Investor’s rate of return
Cash Flows
Depreciation
Financial Analysis
• Return on investment (ROI)
Annual ( Net ) Earnings
(Total ) Capital Investment
(1  t )( S  C )

CTCI
Return on Investment 
where
t  sum of U.S. federal and state income tax rates
S  annual sales revenues
C  annual production cost
C TCI  total capital investment
Financial Analysis
• Payback Period
Total depreciabl e capital
Net earnings  annual depreciation
CTDC
CTDC


( 1  t )( S  C )  D cash flow
Payback Period (PBP) 
where
t  sum of U.S. federal and state income tax rates
S  annual sales revenues
C  annual production cost
CTDC  total depreciabl e capital
Financial Analysis
• Venture Profit (VP)
Venture Profit (VP)  Net earnings  iminCTCI
 ( 1  t )( S  C )  iminCTCI
where
t  sum of U.S. federal and state income tax rates
S  annual sales revenues
C  annual production cost
CTCI  total capital investment
imin  minimum acceptable return on investment
Financial Analysis
• Annualized Cost
Annualized Cost C A  C  iminCTCI
where
C  annual production cost
CTCI  total capital investment
imin  minimum acceptable return on investment
Financial Analysis
• Present Value of an Annuity (PV)
Present Worth P
Future value F of an annuity

of an annuity
(1  i) n
where
F  future value of an annuity
i  interest
n  number of interest periods
Financial Analysis
• Net Present Value (NPV)
n
Net Present Value (NPV)   | CF0 |   CF j ( P / F ,i%, j )
j 1
n
  | CF0 |   CFj
j 1
(special case CF j  A)
1
(1 i )j
  | CF0 |  A( P / A,i%, n )
where
F  future value of an annuity
i  interest
P  present value
n  number of interest periods
A  fixed sum of money paid
CF  cash flow
CF0  initial cash flow
(This method is also called the discounted cash flow method)
Financial Analysis
• Investor’s Rate of Return
Investor' s Rate of Return (IRR)  Discounted Cash Flow ROR
NPV { r }  0 for r
where
r  interest for zero NPV
Financial Analysis
• Cash Flow and Depreciation
Cash Flow – see Cash flow diagrams.
Depreciation – decrease in value of
something over time.
Payments
Time
Investment $
Equipment
Value
$
Depreciation
Time
References
• Seider,Seader, Lewin, (2004) Product and Process Design Principles, Wiley.
• Blank et al. (1989) Engineering Economy, 3rd Edition, McGraw-Hill.
• Smith, Robin (2005) Chemical Process : Design and Integration, Wiley.