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# Contemporary Engineering Economics

**by**Park, Chan S.

### 9780136118480

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## Summary

## Author Biography

**Dr. Chan S. Park**is a Ginn Distinguished Professor of Engineering in the Department of Industrial & Systems Engineering

at Auburn University.His teaching and research interests are in the area of engineering economic decisions and financial engineering. He received his PhD from Georgia Institute of Technology.

## Table of Contents

**PART 1 BASICS OF FINANCIAL DECISIONS 1**

**Chapter 1 Engineering Economic Decisions **

1.1 Role of Engineers in Business

1.1.1 Types of Business Organization

1.1.2 Engineering Economic Decisions

1.1.3 Personal Economic Decisions

1.2 What Makes the Engineering Economic Decision Difficult?

1.3 Economic Decisions Versus Design Decisions

1.4 Large-Scale Engineering Projects

1.4.1 How a Typical Project Idea Evolves

1.4.2 Impact of Engineering Projects on Financial Statements

1.4.3 A Look Back in 2009: Did Toyota Make the Right Decision?

1.5 Common Types of Strategic Engineering Economic Decisions

1.6 Fundamental Principles of Engineering Economics

Summary

Short Case Studies

**Chapter 2 Accounting and Financial Decision-Making **

2.1 Accounting: The Basis of Decision Making

2.2 Financial Status for Businesses

2.2.1 The Balance Sheet

2.2.2 The Income Statement

2.2.3 The Cash Flow Statement

2.3 Using Ratios to Make Business Decisions

2.3.1 Debt Management Analysis

2.3.2 Liquidity Analysis

2.3.3 Asset Management Analysis

2.3.4 Profitability Analysis

2.3.5 Market Value Analysis

2.3.6 Limitations of Financial Ratios in Business Decisions

Summary

Problems

Short Case Studies

**Chapter 3 Interest Rate and Economic Equivalence **

3.1 Interest: The Cost of Money

3.1.1 The Time Value of Money

3.1.2 Elements of Transactions Involving Interest

3.1.3 Methods of Calculating Interest

3.1.4 Simple Interest versus Compound Interest

3.2 Economic Equivalence

3.2.1 Definition and Simple Calculations

3.2.2 Equivalence Calculations: General Principles

3.3 Development of Formulas for Equivalence Calculations

3.3.1 The Five Types of Cash Flows

3.3.2 Single-Cash-Flow Formulas

3.3.3 Uneven Payment Series

3.3.4 Equal-Payment Series

3.3.5 Linear-Gradient Series

3.3.6 Geometric Gradient Series

3.4 Unconventional Equivalence Calculations

3.4.1 Composite Cash Flows

3.4.2 Determining an Interest Rate to Establish Economic Equivalence

3.4.3 Unconventional Regularity in Cash Flow Pattern

Summary

Problems

Short Case Studies

**Chapter 4 Understanding Money and Its Management **

4.1 Nominal and Effective Interest Rates

4.1.1 Nominal Interest Rates

4.1.2 Effective Annual Interest Rates

4.1.3 Effective Interest Rates per Payment Period

4.1.4 Continuous Compounding

4.2 Equivalence Calculations with Effective Interest Rates

4.2.1 When Payment Period is Equal to Compounding Period

4.2.2 Compounding Occurs at a Different Rate than That at Which Payments are Made

4.2.4 Compounding is Less Frequent than Payments

4.3 Equivalence Calculations with Continuous Payments

4.3.1 Single-Payment Transactions

4.3.2 Continuous-Funds Flow

4.4 Changing Interest Rates

4.4.1 Single Sums of Money

4.4.2 Series of Cash Flows

4.5 Debt Management

4.5.1 Commercial Loans

4.5.2 Loan versus Lease Financing

4.5.3 Home Mortgage

4.6 Investing in Financial Assets

4.6.1 Investment Basics

4.6.2 How to Determine Your Expected Return

4.6.3 Investing in Bonds

Summary

Problems

Short Case Studies

**PART 2 EVALUATION OF BUSINESS AND ENGINEERING ASSETS 207**

**Chapter 5 Present-Worth Analysis**

5.1 Describing Project Cash Flows

5.1.1 Loan versus Project Cash Flows

5.1.2 Independent versus Mutually Exclusive Investment Projects

5.2 Initial Project Screening Method

5.2.1 Payback Period: The Time It Takes to Pay Back

5.2.2 Benefits and Flaws of Payback Screening

5.2.3 Discounted Payback Period

5.2.4 Where Do We Go from Here?

5.3 Discounted Cash Flow Analysis

5.3.1 Net-Present-Worth Criterion

5.3.2 Meaning of Net Present Worth

5.3.3 Basis for Selecting the MARR

5.4 Variations of Present-Worth Analysis

5.4.1 Future-Worth Analysis

5.4.2 Capitalized Equivalent Method

5.5 Comparing Mutually Exclusive Alternatives

5.5.1 Meaning of Mutually Exclusive and “Do Nothing”

5.5.2 Analysis Period

5.5.3 Analysis Period Matches Project Lives

5.5.4 Analysis Period Differs from Project Lives

5.5.5 Analysis Period Is Not Specified

Summary

Problems

Short Case Studies

**Chapter 6 Annual Equivalent-Worth Analysis **

6.1 Annual Equivalent-Worth Criterion

6.1.1 Fundamental Decision Rule

6.1.2 Annual-Worth Calculation with Repeating Cash Flow Cycles

6.1.3 Comparing Mutually Exclusive Alternatives

6.2 Capital Costs Versus Operating Costs

6.3 Applying Annual-Worth Analysis

6.3.1 Benefits of AE Analysis

6.3.2 Unit Profit or Cost Calculation

6.3.3 Make-or-Buy Decision–Outsourcing Decisions

6.3.4 Pricing the Use of an Asset

6.4 Life-Cycle Cost Analysis

6.5 Design Economics

Summary

Problems

Short Case Studies

**Chapter 7 Rate-of-Return Analysis **

7.1 Rate of Return

7.1.1 Return on Investment

7.1.2 Return on Invested Capital

7.2 Methods for Finding the Rate of Return

7.2.1 Simple versus Nonsimple Investments

7.2.2 Predicting Multiple *i**’s

7.2.3 Computational Methods

7.3 Internal-Rate-of-Return Criterion

7.3.1 Relationship to PW Analysis

7.3.2 Net-Investment Test: Pure versus Mixed Investments

7.3.3 Decision Rule for Pure Investments

7.3.4 Decision Rule for Mixed Investments

7.4 Mutually Exclusive Alternatives

7.4.1 Flaws in Project Ranking by IRR

7.4.2 Incremental Investment Analysis

7.4.3 Handling Unequal Service Lives

Summary

Problems

Short Case Studies

**PART 3 ANALYSIS OF PROJECT CASH FLOWS **

**Chapter 8 Cost Concepts Relevant to Decision Making **

8.1 General Cost Terms

8.1.1 Manufacturing Costs

8.1.2 Nonmanufacturing Costs

8.2 Classifying Costs for Financial Statements

8.2.1 Period Costs

8.2.2 Product Costs

8.3 Cost Classification for Predicting Cost Behavior

8.3.1 Volume Index

8.3.2 Cost Behaviors

8.3.3 Cost-Volume-Profit Analysis

8.4 Future Costs for Business Decisions

8.4.1 Differential Cost and Revenue

8.4.2 Opportunity Cost

8.4.3 Sunk Costs

8.4.4 Marginal Cost

8.5 Estimating Profit from Production

8.5.1 Calculation of Operating Income

8.5.2 Sales Budget for a Manufacturing Business

8.5.3 Preparing the Production Budget

8.5.4 Preparing the Cost-of-Goods-Sold Budget

8.5.5 Preparing the Nonmanufacturing Cost Budget

8.5.6 Putting It All Together: The Budgeted Income Statement

8.5.7 Looking Ahead

Summary

Problems

Short Case Studies

**Chapter 9 Depreciation and Corporate Taxes **

9.1 Asset Depreciation

9.1.1 Economic Depreciation

9.1.2 Accounting Depreciation

9.2 Factors Inherent in Asset Depreciation

9.2.1 Depreciable Property

9.2.2 Cost Basis

9.2.3 Useful Life and Salvage Value

9.2.4 Depreciation Methods: Book and Tax Depreciation

9.3 Book Depreciation Methods

9.3.1 Straight-Line Method

9.3.2 Accelerated Methods

9.3.3 Units-of-Production Method

9.4 Tax Depreciation Methods

9.4.1 MACRS Depreciation

9.4.2 MACRS Depreciation Rules

9.5 Depletion

9.5.1 Cost Depletion

9.5.2 Percentage Depletion

9.6 Repairs or Improvements Made to Depreciable Assets

9.6.1 Revision of Book Depreciation

9.6.2 Revision of Tax Depreciation

9.7 Corporate Taxes

9.7.1 Income Taxes on Operating Income

9.8 Tax Treatment of Gains or Losses on Depreciable Assets

9.8.1 Disposal of a MACRS Property

9.8.2 Calculations of Gains and Losses on MACRS Property

9.9 Income Tax Rate to Be Used in Economic Analysis

9.9.1 Incremental Income Tax Rate

9.9.2 Consideration of State Income Taxes

9.10 The Need for Cash Flow in Engineering Economic Analysis

9.10.1 Net Income versus Net Cash Flow

9.10.2 Treatment of Noncash Expenses

Summary

Problems

Short Case Studies

**Chapter 10 Developing Project Cash Flows **

10.1 Cost—Benefit Estimation for Engineering Projects

10.1.1 Simple Projects

10.1.2 Complex Projects

10.2 Incremental Cash Flows

10.2.1 Elements of Cash Outflows

10.2.2 Elements of Cash Inflows

10.2.3 Classification of Cash Flow Elements

10.3 Developing Cash Flow Statements

10.3.1 When Projects Require Only Operating and Investing Activities

10.3.2 When Projects Require Working-Capital Investments

10.3.3 When Projects are Financed with Borrowed Funds

10.3.4 When Projects Result in Negative Taxable Income

10.3.5 When Projects Require Multiple Assets

10.4 Generalized Cash-Flow Approach

10.4.1 Setting up Net Cash-Flow Equations

10.4.2 Presenting Cash Flows in Compact Tabular Formats

10.4.3 Lease-or-Buy Decision

Summary

Problems

Short Case Studies

PART 4 HANDLING RISK AND UNCERTAINTY

**Chapter 11 Inflation and Its Impact on Project Cash Flows**

11.1 Meaning and Measure of Inflation

11.1.1 Measuring Inflation

11.1.2 Actual versus Constant Dollars

11.2 Equivalence Calculations under Inflation

11.2.1 Market and Inflation-Free Interest Rates

11.2.2 Constant-Dollar Analysis

11.2.3 Actual-Dollar Analysis

11.2.4 Mixed-Dollar Analysis

11.3 Effects of Inflation on Project Cash Flows

11.3.1 Multiple Inflation Rates

11.3.2 Effects of Borrowed Funds Under Inflation

11.4 Rate-of-Return Analysis Under Inflation

11.4.1 Effects of Inflation on Return on Investment

11.4.2 Effects of Inflation on Working Capital

Summary

Problems

Short Case Studies

**Chapter 12 Project Risk and Uncertainty **

12.1 Origins of Project Risk

12.2 Methods of Describing Project Risk

12.2.1 Sensitivity Analysis

12.2.2 Break-Even Analysis

12.2.3 Scenario Analysis

12.3 Probability Concepts for Investment Decisions

12.3.1 Assessment of Probabilities

12.3.2 Summary of Probabilistic Information

12.3.3 Joint and Conditional Probabilities

12.3.4 Covariance and Coefficient of Correlation

12.4 Probability Distribution of NPW

12.4.1 Procedure for Developing an NPW Distribution

12.4.2 Aggregating Risk over Time

12.4.3 Decision Rules for Comparing Mutually Exclusive Risky Alternatives

12.5 Risk Simulation

12.5.1 Computer Simulation

12.5.2 Model Building

12.5.3 Monte Carlo Sampling

12.5.4 Simulation Output Analysis

12.5.5 Risk Simulation with Oracle Crystal Ball

12.6 Decision Trees and Sequential Investment Decisions

12.6.1 Structuring a Decision-Tree Diagram

12.6.2 Worth of Obtaining Additional Information

12.6.3 Decision Making after Having Imperfect Information

Summary

Problems

Short Case Studies

**Chapter 13 Real-Options Analysis **

13.1 Risk Management: Financial Options

13.1.1 Features of Financial Options

13.1.2 Buy Call Options when You Expect the Price to Go Up

13.1.3 Buy Put Options when You Expect the Price to Go Down

13.2 Option Strategies

13.2.1 Buying Calls to Reduce Capital That Is at Risk

13.2.2 Protective Puts as a Hedge3

13.3 Option Pricing

13.3.1 Replicating-Portfolio Approach with a Call Option

13.3.2 Risk-Free Financing Approach

13.3.3 Risk-Neutral Probability Approach

13.3.4 Put-Option Valuation

13.3.5 Two-Period Binomial Lattice Option Valuation

13.3.6 Multiperiod Binomial Lattice Model

13.3.7 Black—Scholes Option Model

13.4 Real-Options Analysis

13.4.1 A Conceptual Framework for Real Options

in Engineering Economics

13.4.2 Types of Real-Option Models

13.5 Compound Options

13.6 Estimating Volatility at the Project Level

13.6.1 Mathematical Relationship between and

13.6.2 Estimating distribution

Summary

Problems

Short Case Studies

**PART 5 SPECIAL TOPICS IN ENGINEERING ECONOMICS **

**Chapter 14 Replacement Decisions **

14.1 Replacement Analysis Fundamentals

14.1.1 Basic Concepts and Terminology

14.1.2 Opportunity Cost Approach to Comparing Defender and Challenger

14.2 Economic Service Life *VT*

14.3 Replacement Analysis When the Required Service is Long

14.3.1 Required Assumptions and Decision Frameworks

14.3.2 Replacement Strategies under the Infinite Planning Horizon

14.3.3 Replacement Strategies under the Finite Planning Horizon

14.3.4 Consideration of Technological Change

14.4 Replacement Analysis With Tax Considerations

Summary

Problems

Short Case Studies

**Chapter 15 Capital-Budgeting Decisions **

15.1 Methods of Financing

15.1.1 Equity Financing

15.1.2 Debt Financing

15.1.3 Capital Structure

15.2 Cost of Capital

15.2.1 Cost of Equity

15.2.2 Cost of Debt

15.2.3 Calculating the Cost of Capital

15.3 Choice of Minimum Attractive Rate of Return

15.3.1 Choice of MARR when Project Financing Is Known

15.3.2 Choice of MARR when Project Financing is Unknown

15.3.3 Choice of MARR under Capital Rationing

15.4 Capital Budgeting

15.4.1 Evaluation of Multiple Investment Alternatives

15.4.2 Formulation of Mutually Exclusive Alternatives

15.4.3 Capital-Budgeting Decisions with Limited Budgets

Summary

Problems

Short Case Studies

**Chapter 16 Economic Analysis in the Service Sector **

16.1 What is the Service Sector?

16.1.1 Characteristics of the Service Sector

16.1.2 Diffculty of Pricing Service

16.2 Economic Analysis in Health-Care Service

16.2.1 Economic Evaluation Tools

16.2.2 Cost-Effectiveness Analysis

16.3 Economic Analysis in the Public Sector

16.3.1 What Is Benefit—Cost Analysis?

16.3.2 Framework of Benefit—Cost Analysis

16.3.3 Valuation of Benefits and Costs

16.3.4 Quantifying Benefits and Costs

16.3.5 Difficulties Inherent in Public Project Analysis

16.4 Benefit—Cost Ratios

16.4.1 Definition of Benefit—Cost Ratio

16.4.2 Relationship Among *B*/*C *Ratio, Profitability Index, and NPW

16.4.3 Comparing Mutually Exclusive Alternatives: Incremental Analysis

16.5 Analysis of Public Projects Based on Cost-Effectiveness

16.5.1 Cost-Effectiveness Studies in the Public Sector

16.5.2 A Cost-Effectiveness Case Study14