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CONT E NTS
PREFACE
XXI
1 MAKING ECONOMIC DECISIONS 2
Alternative Fuel Vehicles 2
A Sea of Problems 4
Simple Problems 4
Intermediate Problems 4
Complex Problems 4
The Role of Engineering Economic Analysis 5
Examples of Engineering Economic Analysis 5
The Decision-Making Process 6
Rational Decision Making 6
Ethics 15
Ethical Dimension in Engineering Decision Making 15
Importance of Ethics in Engineering and Engineering Economy 18
Engineering Decision Making for Current Costs 19
SUMMARY 21
PROBLEMS 23
2 ENGINEERING COSTS AND COST ESTIMATING 34
North Slope Natural Gas Pipeline 34
Engineering Costs 36
Fixed, Variable, Marginal, and Average Costs 36
Sunk Costs 39
Opportunity Costs 40
Recurring and Nonrecurring Costs 41
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Incremental Costs 42
Cash Costs Versus Book Costs 43
Life-Cycle Costs 43
Cost Estimating 45
Types of Estimate 45
Difficulties in Estimation 47
Estimating Models 48
Per-Unit Model 48
Segmenting Model 50
Cost Indexes 51
Power-Sizing Model 52
Triangulation 54
Improvement and the Learning Curve 54
Estimating Benefits 58
Cash Flow Diagrams 58
Categories of Cash Flows 59
Drawing a Cash Flow Diagram 59
Drawing Cash Flow Diagrams with a Spreadsheet 60
SUMMARY 60
PROBLEMS 62
TRUST ME, YOU’LL USE THIS
70
3 INTEREST AND EQUIVALENCE 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 83
Nominal and Effective Interest 89
Continuous Compounding 93
Single Payment Interest Factors: Continuous
Compounding 93
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SUMMARY 96
PROBLEMS 97
4 EQUIVALENCE FOR REPEATED CASH FLOWS
102
Anne Scheiber’s Bonanza 102
Uniform Series Compound Interest Formulas 104
Expanded Factors as Calculator Functions 110
Cash Flows That Do Not Match Basic Patterns 110
Economic Equivalence Viewed as a Moment Diagram 114
Relationships Between Compound Interest Factors 116
Single Payment 117
Uniform Series 117
Arithmetic Gradient 118
Derivation of Arithmetic Gradient Factors 118
Reality and the Assumed Uniformity of A, G and g 123
Geometric Gradient 124
Compounding Period and Payment Period Differ 127
Uniform Payment Series: Continuous
Compounding at Nominal Rate r per Period 129
Spreadsheets for Economic Analysis 131
Spreadsheet Annuity Functions 131
Spreadsheet Block Functions for Cash Flow Tables
Using Spreadsheets for Basic Graphing 133
132
SUMMARY 135
PROBLEMS 137
5 PRESENT WORTH ANALYSIS 150
The Present Value of 30 Years of Benefits 150
Assumptions in Solving Economic Analysis Problems 152
End-of-Year Convention 152
Viewpoint of Economic Analysis Studies 152
Sunk Costs 153
Borrowed Money Viewpoint 153
Effect of Inflation and Deflation 153
Income Taxes 153
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Economic Criteria 154
Applying Present Worth Techniques 154
Useful Lives Equal the Analysis Period 155
Useful Lives Different from the Analysis Period 158
Infinite Analysis Period: Capitalized Cost 161
Multiple Alternatives 164
Bond Pricing 169
Spreadsheets and Present Worth 170
SUMMARY 172
PROBLEMS 173
6 ANNUAL CASH FLOW ANALYSIS 188
Are More Efficient Appliances Cost Effective 188
Annual Cash Flow Calculations 191
Resolving a Present Cost to an Annual Cost 191
Treatment of Salvage Value 191
Annual Cash Flow Analysis 195
Analysis Period 197
Analysis Period Equal to Alternative Lives 199
Analysis Period a Common Multiple of Alternative Lives 199
Analysis Period for a Continuing Requirement 199
Infinite Analysis Period 200
Some Other Analysis Period 201
Using Spreadsheets to Analyze Loans 203
Building an Amortization Schedule 203
How Much to Interest? How Much to Principal? 204
Finding the Balance Due on a Loan 204
Pay Off Debt Sooner by Increasing Payments 205
SUMMARY 206
PROBLEMS 207
7 RATE OF RETURN ANALYSIS 218
Bar Codes Give a Number; RFID Codes Tell a Story 218
Internal Rate of Return 221
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Calculating Rate of Return 222
Plot of NPW Versus Interest Rate 226
Interest Rates When There Are Fees or Discounts 229
Loans and Investments Are Everywhere 231
Incremental Analysis 235
Present Worth Analysis 238
Analysis Period 241
Spreadsheets and Rate of Return Analysis 242
SUMMARY 244
PROBLEMS 245
Appendix 7A: Difficulties in Solving for an Interest Rate 255
Why Multiple Solutions Can Occur 256
Projects with Multiple Sign Changes 257
Evaluating How Many Roots There Are 259
Modified Internal Rate of Return (MIRR) 263
SUMMARY 265
PROBLEMS 266
8 CHOOSING THE BEST ALTERNATIVE 270
The Size of a Pipeline 270
Incremental Analysis 272
Graphical Solutions 272
Elements in Comparing Mutually Exclusive Alternatives 281
Doing a Set of Incremental Challenger–Defender Comparisons 282
Choosing an Analysis Method 284
Spreadsheets and GOAL SEEK 284
SUMMARY 286
PROBLEMS 286
9 OTHER ANALYSIS TECHNIQUES
296
Clean and Green 296
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Future Worth Analysis 299
Benefit–Cost Ratio Analysis 301
Variations on the Theme of Benefit–Cost Ratio 305
Payback Period 309
Sensitivity and Breakeven Analysis 313
Graphing with Spreadsheets for Sensitivity and Breakeven
Analysis 318
Doing What-If Analysis with Spreadsheets 321
SUMMARY 322
PROBLEMS 323
10 UNCERTAINTY IN FUTURE EVENTS 334
Video Game Development and Uncertainty 334
Estimates and Their Use in Economic Analysis 336
A Range of Estimates 338
Probability 340
Joint Probability Distributions 343
Expected Value 345
Economic Decision Trees 347
Risk 353
Risk Versus Return 356
Simulation 357
Real Options 360
SUMMARY 361
PROBLEMS 362
11 DEPRECIATION
372
Depreciation and Competitiveness 372
Basic Aspects of Depreciation 374
Deterioration and Obsolescence 374
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Depreciation and Expenses 375
Types of Property 376
Depreciation Calculation Fundamentals 376
Historical Depreciation Methods 377
Straight-Line Depreciation 378
Sum-of-Years’-Digits Depreciation 379
Declining Balance Depreciation 381
Modified Accelerated Cost Recovery System (MACRS) 383
Cost Basis and Placed-in-Service Date 383
Property Class and Recovery Period 384
Percentage Tables 385
Where MACRS Percentage Rates (rt ) Come From 387
MACRS Method Examples 388
Comparing MACRS and Historical Methods 390
Depreciation and Asset Disposal 390
Unit-of-Production Depreciation 394
Depletion 395
Cost Depletion 395
Percentage Depletion 396
Spreadsheets and Depreciation 397
Using VDB for MACRS 397
SUMMARY 399
PROBLEMS 400
12 INCOME TAXES 408
On with the Wind 408
A Partner in the Business 411
Calculation of Taxable Income 411
Taxable Income of Individuals 411
Classification of Business Expenditures 412
Taxable Income of Business Firms 413
Income Tax Rates 414
Individual Tax Rates 414
Corporate Tax Rates 416
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Combined Federal and State Income Taxes 417
Selecting an Income Tax Rate for Economy Studies 418
Economic Analysis Taking Income Taxes into Account 418
Capital Gains and Losses for Nondepreciated Assets 422
Investment Tax Credit 422
Estimating the After-Tax Rate of Return 423
After-Tax Cash Flows and Spreadsheets 423
SUMMARY 425
PROBLEMS 425
13 REPLACEMENT ANALYSIS 440
The $7 Billion Upgrade 440
The Replacement Problem 442
Replacement Analysis Decision Map 443
Minimum Cost Life of a New Asset — The Challenger 444
Defender’s Marginal Cost Data 446
Do We Have Marginal Cost Data for the Defender? 448
Are These Marginal Costs Increasing? 448
Replacement Analysis Technique 1: Defender Marginal Costs
Can Be Computed and Are Increasing 449
Replacement Repeatability Assumptions 450
Replacement Analysis Technique 2: Defender Marginal Costs Can
Be Computed and Are Not Increasing 451
Replacement Analysis Technique 3: When Defender Marginal Cost
Data Are Not Available 455
Complications in Replacement Analysis 456
Defining Defender and Challenger First Costs 456
Repeatability Assumptions Not Acceptable 458
A Closer Look at Future Challengers 458
After-Tax Replacement Analysis 459
Marginal Costs on an After-Tax Basis 459
Minimum Cost Life Problems 461
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Spreadsheets and Replacement Analysis 463
SUMMARY 465
PROBLEMS 466
14 INFLATION AND PRICE CHANGE
476
The Athabasca Oil Sands 476
Meaning and Effect of Inflation 478
How Does Inflation Happen? 478
Definitions for Considering Inflation in Engineering Economy 479
Analysis in Constant Dollars Versus Then-Current Dollars 486
Price Change with Indexes 488
What Is a Price Index? 488
Composite Versus Commodity Indexes 490
How to Use Price Indexes in Engineering Economic Analysis 492
Cash Flows That Inflate at Different Rates 493
Different Inflation Rates per Period 494
Inflation Effect on After-Tax Calculations 496
Using Spreadsheets for Inflation Calculations 498
SUMMARY 500
PROBLEMS 501
15 SELECTION OF A MINIMUM ATTRACTIVE RATE OF RETURN
510
What’s the Rate of Return on a Dam? 510
Sources of Capital 512
Money Generated from the Firm’s Operation 512
External Sources of Money 512
Choice of Sources of Funds 512
Cost of Funds 513
Cost of Borrowed Money 513
Cost of Capital 513
Inflation and the Cost of Borrowed Money 514
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Investment Opportunities 515
Opportunity Cost 517
Selecting a Minimum Attractive Rate of Return 518
Adjusting MARR to Account for Risk and Uncertainty 519
Representative Values of MARR Used in Industry 521
Capital Budgeting or Selecting the Best Projects 522
Spreadsheets, Cumulative Investments, and the Opportunity Cost
of Capital 524
SUMMARY 527
PROBLEMS 528
16 ECONOMIC ANALYSIS IN THE PUBLIC SECTOR 536
From Waste to Power and Money 536
Investment Objective 539
Viewpoint for Analysis 540
Selecting an Interest Rate 542
No Time-Value-of-Money Concept 542
Cost of Capital Concept 542
Opportunity Cost Concept 543
Recommended Concept 543
The Benefit-Cost Ratio 544
Incremental Benefit-Cost Analysis 546
Elements of the Incremental Benefit-Cost
Ratio Method 547
Other Effects of Public Projects 551
Project Financing 551
Project Duration 552
Quantifying and Valuing Benefits and Disbenefits 554
Project Politics 555
SUMMARY 556
PROBLEMS 557
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17 ACCOUNTING AND ENGINEERING ECONOMY 564
The Two Faces of ABB 564
The Role of Accounting 566
Accounting for Business Transactions 566
The Balance Sheet 567
Assets 567
Liabilities 568
Equity 569
Financial Ratios Derived from Balance Sheet Data 569
The Income Statement 570
Financial Ratios Derived from Income Statement Data 572
Linking the Balance Sheet, Income Statement, and Capital
Transactions 572
Traditional Cost Accounting 573
Direct and Indirect Costs 573
Indirect Cost Allocation 574
Problems with Traditional Cost Accounting 575
Other Problems to Watch For 576
PROBLEMS 576
APPENDIX A: INTRODUCTION TO SPREADSHEETS
582
The Elements of a Spreadsheet 582
Defining Variables in a Data Block 583
Copy Command 583
APPENDIX B: TIME VALUE OF MONEY (TVM)
CALCULATORS
586
Advantages and Types of TVM Calculators 586
Notation for TVM Calculators 588
Examples with TVM Calculators and Tabulated Factors 588
PROBLEMS 593
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APPENDIX C: COMPOUND INTEREST TABLES
594
APPENDIX D: FUNDAMENTALS OF ENGINEERING (FE)
EXAM PRACTICE PROBLEMS 626
PROBLEMS 628
PHOTO CREDITS
645
REFERENCES 647
INDEX 649
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