Chapter 1 Engineering Economy

Assumes you have reviewed the McGraw Hill Lectures

I. Economic Equivalence
Definition: Combination of interest rate (rate of return) and time value of money to determine different amounts of money at different points in time that are economically equivalent

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Example of Equivalence
Different sums of money at different times may be equal in economic value at a given rate
$110
Year

Rate of return = 10% per year

$100 now

$100 now is economically equivalent to $110 one year from now, if the $100 is invested at a rate of 10% per year.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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Wording is important You would not say $100 is equal to $110. But You would say that $100 is equivalent to $110 in a year at 10%

Note, Interest and period are a part of the presentation!

Given the choice of the following two plans which would you choose? Using i = 10%
Year
1 2

Plan 1
$1400 1320

Plan 2
$400 400

3 4 5 Total

1240 1160 1080 $6200

400 400 5400 $7000

To make a choice the cash flows must be altered so a comparison may be made.
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Example Plan 1
Year Value 1 1400 2 1320 3 1240 4 1160 5 1080

- Cost Estimates

Value at Time 0 1400 (.9091) = 1273 1320 (.8264) = 1091 1240 (.7513) = 932 1160 (.6830) = 792 1080 (.6209) = 670 Total PW = 4758
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Example Plan 2 Cost Estimates

Year 1 2 3 4 5 Value 400 400 400 400 5400 Value at Time 0 400 (.9091) = 364 400 (.8264) = 331 400 (.7513) = 301 400 (.6830) = 273 5400 (.6209) = 3353 Total PW = 4622
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Now we can judge plan 1 & 2

At 10% for 5 years Plan One costs - 4758 at time zero Plan Two costs - 4622 at time zero

III MARR
Called the
Minimum Acceptable rate of return, or Minimum Attractive Rate of Return

MARR
MARR is a reasonable rate of return
(percent) established for evaluating and selecting alternatives An investment is justified economically if it is expected to return at least the MARR Also termed hurdle rate, benchmark rate and cutoff rate

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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MARR Characteristics
MARR is established by the financial managers of the firm MARR is fundamentally connected to the cost of capital Both types of capital financing are used to determine the weighted average cost of capital (WACC) and the MARR MARR usually considers the risk inherent to a project
2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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IV. Opportunity Cost

Definition: Largest rate of return of all projects not accepted (forgone) due to a lack of capital funds
If no MARR is set, the ROR of the first project not undertaken establishes the opportunity cost

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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Opportunity Cost
Opportunity cost - a benefit that is given up by engaging a resource in some other way.
We make a choice or decision.
Buying lunch instead of gas.

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Past (Sunk) Costs

Sunk cost - money spent due to a past decision. We cannot do anything about these costs.
Purchase price for unused tickets Purchase price paid for a car two years ago. Expansion plant bought and retrofitted in 1998 Engineering design costs on a new airplane

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 Some people have a difficulty with the idea of past decisions Get a guilty feeling Example from my experience at Rockwell

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Example: Assume MARR = 10%. Project A, not funded due to lack of funds, is projected to have RORA = 13%. Project B has RORB = 15% and is funded because it costs less than A Opportunity cost is 13%, i.e., the opportunity to make an additional 13% is forgone by not funding project A

Chapter Problems
Solve/work on questions 1-23, 1-27, 1-31, and 1-35 at the end of the chapter. Please remember these will be due at the time you take the quiz involving this chapter