Engineering Economy
Applying Theory to Practice
Third Edition
Ted Eschenbach
Table of Contents
Part One: Basic Concepts and Tools
Chapter 1. Making Economic Decisions
1.1 What Is Engineering Economy?
1.2 Principles for Decision Making
Common Measure
Include All Consequences
Only Differences Matter
Make Separable Decisions Separately
Adopt a Systems Viewpoint
Use a Common Planning Horizon
Address Uncertainty
1.3 The Decision-Making Process
1. Define Problem
2. Choose Objective(s)
3. Identify Alternatives
4. Evaluate Consequences
5. Select
6. Implement
7. Audit
Summary of the Decision Process
1.4 The Environment for Decisions
Nonlinear Process
Iterative Modeling and Spreadsheets
One Decision in a Continuing Stream
Importance of Communication Skills
Analysis vs.
Action
Private and Public Politics
1.5 Ethics and Decision Making
Gaining Knowledge and Building Trust vs. Favors for Influence
Cost, Quality, and Functionality
The Environment We Live In
Safety and Cost
Emerging Issues and "Solutions"
Importance of Ethics in Engineering and Engineering Economy
1.6 The Role of Engineering Economy
Problem too Small to Merit Engineering Economy
Time Period too Short to Merit Engineering Economy
Engineering Economy Dominates Decision Making
Engineering Economy Is One Factor in Decision Making
1.6 Operational Economics
1.7 Summary
Chapter 2. The Time Value of Money
2.1 What Is Interest?
Interest Rates Vary
2.2 Simple vs. Compound Interest
Simple Interest
Compound
Interest
2.3 Cash Flow Diagrams
Categories of Cash Flow
Timing of Cash Flows
It Is Better Not to Simplify the Cash Flow Diagrams
Drawing Cash Flow Diagrams with a Spreadsheet
2.4 Equivalence for Four Loans
Equivalence Defined
Calculating the Interest for Each Year
Finding an Equivalent Present Worth
2.5 Limits on Equivalence
Equivalence Depends on the Interest Rate
Equivalence with Respect to Time Value of Money Only
2.6 Compounding Periods Shorter than a Year
Compounding Periods Are M per Year
Nominal vs. Effective Interest
Continuous Compounding
2.7 Summary
Chapter 3. Equivalence Ä a Factor Approach
3.1 Definitions and Assumptions
Assumptions
Definitions
Reality and the Assumed Uniformity of A and
G
3.2 Tables of Engineering Economy Factors
Factor Notation
Expanded Factors as Calculator Functions
Names of the Engineering Economy Factors
Format for the Interest Rate
Interpolation
Formulas vs. Factors
3.3 Single Payment Factors (Ps and Fs)
Formula Development
Tabulated Factors
(P/F) and (F/P) as a Function of i and N
3.4 Uniform Flows
Formula Development
Tabulated Factors
Calculating an Interest Rate
(A/P), (A/F), (P/A), and (F/A) vs. i and N
3.5 Combining Factors
Deferred Annuities
Annuities Due for Prepaid Expenses and Other Beginning-of-Year Cash Flows
Constructing Formulas from Cash Flow Diagrams
Deriving One Factor's Formula From Another's
3.6 Arithmetic Gradients
Definition
Using the
Arithmetic Gradient Factors
Arithmetic Gradient Formulas
3.7 Geometric Gradients
Geometric Gradients Change at a Constant Rate
The Basic Geometric Formula
The Four Geometric Rates
Inflation
Mathematical Model for PW
Present Worth Formula for a Single Geometric Gradient
Using Equivalent Discount Rates for Geometric Gradients
3.8 Summary
Chapter 4. Spreadsheets and Economic Analysis
4.1 Using Spreadsheets for Economic Analysis
Why Use Spreadsheets
Reality and the Flexibility of Spreadsheet Models
The Elements of a Spreadsheet
Relative and Absolute Addresses
4.2 Spreadsheet Modeling
Using a Data Block
Defining Variables in a Spreadsheet
Use Relative and Absolute Addresses in Your Formulas
Explaining and
Labeling Your Formulas
Formatting Your Spreadsheets
4.3 Financial Functions in Spreadsheets
Spreadsheet Annuity Functions
Spreadsheet Block Functions
4.4 Examples Show Spreadsheet Models Can Be More Realistic
4.5 Using Spreadsheets to Get a Project Funded
Sensitivity Analysis
Creating Graphs
Documenting Data Sources
4.6 Summary
Part Two: Analyzing a Project
Chapter 5. Present Worth
5.1 The Present Worth Measure
Is PW > 0?
Standard Assumptions
5.2 Examples of When to Use Present Worth
5.3 Rolling Back Irregular Cash Flows for PW Calculations
5.4 Salvage Values
5.5 Capitalized Cost and Perpetual Life
5.6 Staged Projects
5.7 Cost of Underutilized Capacity
5.8 Spreadsheets and Shorter Periods
5.9
Spreadsheets and More Exact Models
5.10 Summary
Chapter 6. Equivalent Annual Worth
6.1 The Equivalent Annual Worth Measure
6.2 Assumptions and Sign Conventions
6.3 Examples of Annual Evaluations
6.4 Finding the EAC of "Irregular" Cash Flows
EAC of a Single Interior Cash Flow
Deferred Annuities to Regular Annuities
6.5 EAC Formulas for Salvage Values and Working Capital
Capital Recovery with Salvage Values
Working Capital
6.6 Perpetual Life
Assumptions and Formulas
N vs. Infinity
Arithmetic Gradients and Perpetual Life
6.7 Repeated Renewals
Repetition for Every Subperiod
Capitalized Costs
Repeated Renewals with Neither an Initial nor a Final Cash Flow
6.8 Spreadsheets and Analyzing Loan Repayments
Finding
the Balance Due
Shortening the Time to Payoff by Increasing Payments
How Much Goes to Interest? How Much Goes to Principal?
6.9 Summary
Chapter 7. Rate of Return
7.1 The Internal Rate of Return
7.2 Assumptions
Loans
Investments
Multiple Sign Changes
Reinvestment Assumption
Applying the IRR Measure
7.3 Finding the IRR
Hints and Shortcuts for Finding the IRR
7.4 Loans and Leases
7.5 Spreadsheets and the IRR
RATE Investment Function
IRR Block Function
7.6 Multiple Sign Changes
Mineral Extraction
Environmental Restoration
Staged Construction or Expansion
Summary of Multiple Sign Change Consequences
7.7 Project Balances over Time
7.8 Modified Internal Rate of Return (MIRR)
7.9 Summary
Chapter
8. Benefit/cost Ratios and Other Measures
8.1 Measures of Economic Attractiveness
Conceptual Definitions
Frequency and Patterns of Use
8.2 Benefit/Cost Ratio
8.3 Present Worth Indexes
Mathematical Definition of PW Indexes
8.4 Future Worth
8.5 Payback Period
Difficulties with Payback Period
When Can Payback Be Used?
8.6 Discounted Payback
Why to Use or Not Use
Examples of Use
8.7 Breakeven Volume
8.8 Summary
Part Three: Comparing Alternatives and Projects
Introduction to mutually exclusive and constrained budget problems.
Chapter 9. Mutually Exclusive Alternatives
9.1 Applying Engineering Economy to Engineering Design
9.2 Key Assumption Is the Interest Rate or Minimum Attractive Rate of Return
Common
Assumptions
9.3 Comparing Alternatives with Lives of the Same Length
9.4 PWs and Explicitly Comparing Different-Length Lives
Approaches For Defining a Problem Horizon
Choosing the Best Horizon
Mutually Exclusive Alternatives without a Common Horizon
9.5 EAWs and EACs and Implicitly Comparing Different-Length Lives
9.6 Using EAC for Different-Length Lives Is a Robust Approach
Robustness Due to Discounting
Robustness Due to Estimated Lives
9.7 Benefit/Cost and IRR Comparisons of Mutually Exclusive Alternatives Require Incremental Analysis
9.8 Defender/Challenger Analysis
9.9 PW, EAW, and IRR Have the Same Interest Rate Assumption
9.10 Using Spreadsheet GOAL SEEK Tool to Calculate Incremental IRRs
9.11 Summary
Chapter 10. Replacement
Analysis
10.1 Why Is Equipment Replaced, Retired, or Augmented?
Reduced Performance
Altered Requirements
Obsolescence
Risk of Catastrophic Failure or Unplanned Replacement
Lease or Rental vs. Ownership
Summary of Reasons for Replacement
10.2 Old and New Are Mutually Exclusive
Different-Length Lives
Economic Life
10.3 Sunk Costs, Risks, and Short-Term Cost Savings
Sunk Costs
Risks of the New often Far Exceed Those of Extending the Old
Short-term Cost Savings Are Not Enough to Compare Repair vs. Replace
10.4 Optimal Challengers
Challenger's Optimal or Economic Life
Cost Curve for the Challenger's Economic Life
Spreadsheets for Challenger's Economic Life
10.5 Optimal Defenders
Typical Defender's Economic
Life
Incorrect Assumptions for Minimizing the Defender's EAC
When to Calculate the Defender=s Best EAC
Flowchart to Summarize the Decision Rules
10.6 Optimal Capacity Problems
10.7 Estimating Future Challengers
A Simple Rule of Thumb
MAPI
10.8 Replacement and Repair Models
Classifying Replacement Models
Block Replacement
10.9 Summary and Conclusions
Chapter 11. Constrained Project Selection
11.1 The Constrained Project Selection Problem
Mutually Exclusive Choices vs. Constrained Project Selection
Budgets and Project Selection
Problem Size
Budget Flexibility and Contingency Allowances
11.2 Ranking Projects
Investment Opportunity Schedule
Ranking by PW or EAW Does Not Work
Strengths and Weaknesses of
IRR
11.3 Determining the Minimum Attractive Rate of Return Using the Opportunity Cost of Capital
Minimum Attractive Rate of Return (MARR)
11.4 A Theoretically Optimal Approach for Determining the Capital Budget
11.5 Capital Limits in the Real World
Why Capital Are Imposed
Budget Limits and the Cost of Capital
11.6 Matching Assumptions to the Real World
Assumption of Indivisible Projects and Increments of Financing
Assumption of Project Independence
Assumption of Simultaneous Evaluation
Stability and Reinvestment Assumptions
11.7 Present Worth Indexes and Benefit/Cost Ratios
11.8 Using the SORT Spreadsheet Tool
Using Spreadsheet Investment and Block Functions
Using the SORT Tool
11.9 Summary
Appendix 11A Mathematical
Programming and Spreadsheets
Using Spreadsheets to Solve Linear Programs
Disadvantages of Mathematical Programming Models
Part Four: Enhancements for the Real World
Chapter 12. Depreciation
12.1 Introduction
Definitions
12.2 Basic Depreciation Methods
Straight-Line Method
Declining Balance Method
SOYD Method
Units-of-Production Method
12.3 Modified Accelerated Cost Recovery System (MACRS)
Based on Accelerated Cost Recovery System (ACRS)
MACRS
Alternate MACRS
12.4 Gains and Losses on Sales and Recaptured Depreciation
12.5 Optimal Depreciation Strategies
12.6 PW of a Depreciation Schedule
Straight-Line Method
Declining Balance Method
SOYD Method
MACRS
12.7 Depletion of Resources
Cost
Depletion
Percentage Depletion
12.8 Section 179 Deduction and Bonus Depreciation
Section 179
Recapture for Section 179 Assets
Bonus Depreciation
12.9 Spreadsheet Functions for Depreciation
Using VDB for MACRS
12.10 Summary
Chapter 13. Income Taxes
13.1 Principles of Income Taxes
Income, Property, Sales, and Value Added Taxes
Point of View
Principles of Calculation
13.2 Progressive Marginal Tax Rates
Effective Tax Rate for State, Local, and Federal Taxes
13.3 Finding Taxable Income When Depreciation Is Included
Categorizing Before-Tax Cash Flows
13.4 Calculating After-Tax Cash Flows and EACs Using Tables or Spreadsheets
Selecting an After-Tax Interest Rate
13.5 Calculating After-Tax Cash Flows and EACs using
Formulas
Straight-Line Depreciation
MACRS Depreciation
Sum-of-the-Years'-digits (SOYD) Depreciation
13.6 Investment Tax Credits (ITC) and Capital Gains
History of ITC
Computing and using an ITC
Capital Gains
13.7 Interest Deductions and an After-Tax IRR
Leverage
13.8 Summary
Appendix 13A: Personal Income Taxes
Chapter 14. Public Sector Engineering Economy
14.1 Defining Benefits, Disbenefits, and Costs
Agencies t)That Do Not Serve the Public Directly
Benefits to Whomsoever They Accrue
14.2 Why Are Public-Sector Problems Difficult?
Quantifying and Valuing Benefits
Long Problem Horizons
Probabilities of Rare Events
Multiple Objectives That May Conflict
Interest Groups with Differing Perspectives
Selecting
an Interest Rate
Summary
14.3 Correct Methods and Interest Rates
Evaluating a Single Project
Criteria for Mutually Exclusive Alternatives
Criteria for Constrained Project Selection
Deferred Maintenance
14.4 Whose Point of View?
What Is Internal? What Is External?
Federal Subsidies
Consumers' Surplus
14.5 Allocating Costs to Benefit Recipients
14.6 Valuing the Benefits of Public Projects
A Life's Present Value
Standards of Federal Agencies
Risk and Valuing Public Benefits
14.7 Cost Effectiveness
14.8 Summary
Chapter 15. Inflation
15.1 Defining and Measuring Inflation and Deflation
The Consumer Price Index (CPI)
Annual Inflation Rate
Producer Price Indexes
15.2 Consistent Assumptions for Interest
Rates and Cash Flow Estimates
Inflation Terminology
Matching Interest Rates to Inflation Assumptions
Differential Inflation
Estimating Differential Inflation
Accuracy of Inflation Estimates
15.3 Solving for PW or EAC When Inflation Is Included
15.4 Inflation Examples with Multiple Inflation Rates
15.5 Leases and Other Prepaid Expenses
15.6 Depreciation and Loan Payments
15.7 Inflation and Other Geometric Gradients
The Four Geometric Gradients
Formulas Based on the Equivalent Discount Rate
15.8 Summary
Part Five: Decision Making Tools
Chapter 16. Estimating Cash Flows
16.1 Introduction
Importance of Cost Estimating
The Impact of Early Project Decisions
16.2 Cash Flow Estimating and Life-Cycle Stages
Hidden
Costs
Costs during the Project Life Cycle
16.3 Cash Flow Estimating Standards
Stages of Cash Flow Estimating
Conceptual Design
Preliminary Systems Design
Final Systems Design
Cost Estimate Definitions and Accuracy
16.4 Design Criteria and Specifications
Design Criteria
Specifying Performance
16.5 Modeling the Base Case
16.6 Using Indexes for an Order-of-Magnitude Estimate
16.7 Using Capacity Functions for Order-of-Magnitude Estimates
16.8 Using Growth Curves
16.9 Using Learning Curves
16.10 Using Factor Estimates
16.11 Summary
Chapter 17. Sensitivity Analysis
17.1 What Is Sensitivity Analysis?
Sources of Uncertainty
Breakeven Charts
Why Do Sensitivity Analysis?
17.2 Uncertain Data and Its
Impact
Defining the Limits of Uncertain Data
Estimating Sensitivities
17.3 Techniques for Sensitivity Analysis
Scenarios
The Relative Sensitivity of the Economic Criteria to Different Variables
Tabulating Relative Sensitivity Analysis
Tornado Diagram
Spiderplot
More Advanced Techniques
17.4 Spiderplots
Defining Spiderplots
Interpreting a Spiderplot
17.5 Constructing a Spiderplot
By Hand
Using a Spreadsheet
Choosing a y-axis
17.6 Constructing Tornado Diagrams
Tornado Diagrams with Positive Values Only
Tornado Diagrams with Positive and Negative Values
Using the Tornado Diagram Template
17.7 Multiple Alternatives
Spiderplots
Scenarios
17.8 Sensitivity Analysis with Multiple Variables
17.9
Summary
Chapter 18. Uncertainty and Probability
18.1 Probabilities
18.2 Computing Expected Values
18.3 Choosing Alternatives Using Expected Values
18.4 Economic Decision Trees
Sequential Decisions
Cash Flows That Occur over Time
18.5 Risk
18.6 Risk/Return Tradeoffs
Buying Insurance
Balancing Risks and Returns
Efficient Frontier for Risk/Return Trade-offs
Approaches to Risk/Return Tradeoffs
18.7 Real Options
18.8 Probability Distributions for Economic Outcomes
Probability Distributions with Multiple Independent Variables
N and i Need Complete Distributions for Exact Answers
Continuous and Discrete Probability Distributions
Simulation
18.9 Summary
Chapter 19. Multiple Objectives
19.1 Multiple
Attributes
Definitions and Trade-offs
Attribute Categories
Selecting Multiple Objectives
Summary
19.2 The Process of Evaluating Multiple Objectives
Eliminating Dominated and Unsatisfactory Alternatives
Decision Rules for Choosing the Best Alternative
19.3 Identifying the Attributes
19.4 Evaluating the Alternatives
19.5 Graphical Techniques
Shaded Circles and Squares
Polar Graph
19.6 Numerical Scales for Evaluation
Numerical Variables
Choosing the Best and the Worst Case
Verbal Variables
Missing Values
19.7 Additive Models
Direct Assignment of Weights
Subjective Assignment of Importance Ratings
Tabular Additive Models
Graphical Additive Models
Closing Comment on Additive Models
19.8 Hierarchical
Attributes and Objectives
19.9 Summary
Appendixes
A. Accounting
A.1 Role of Accounting
A.2 General Accounting
Business Transactions
A.3 The Balance Sheet
Assets
Liabilities
Equity
Financial Ratios Derived from Balance Sheet Data
A.4 Income Statement
Definition
Financial Ratios Derived from Income Statement Data
Linking the Balance Sheet, Income Statement, and Capital Transactions
A.5 Traditional Cost Accounting
Direct and Indirect Costs
Indirect Cost Allocation
Problems with Traditional Cost Accounting
A.6 Activity Based Costs (ABC)
Definition
ABC Provides More Accurate Costs
Using ABC
Economic Justification Using ABC Data
Timely and Accurate Data
A.7 Summary
B. Time Value of Money
(TVM) and Calculators
B.1 Advantages and Types of TVM Calculators
B.2 Notation for TVM Calculators
B.3 Examples with TVM Calculators & Tabulated Factors
C. End-of-Period Compound Interest Tables
D. Fundamentals of Engineering (FE) Exam Practice Problems