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ECONOMICS:
DESCRIPTION
AND
ROLE
IN
DECISION
2006
525
2007
430
2008
619
2009
650
2010
625
What range of repair costs should be used to ensure that the analysis is sensitive
to changing warranty costs?
Going over the 5-year period, the average is RM570/repair. Hence the range is
-25% (RM430/repair) to +15 (RM650/repair). However, if the analysis uses the
more recent data; say the last 3 years which shows a more consistent outcome,
the average is RM631/repair giving a range of -1.7% (RM619/repair) to +3%
(RM650/repair).
The criteria used to select an alternative in engineering economy for a specific
set of estimates is called a measure of worth. The measure of worth used are:
Added
(EVA)
Capitalized Cost (CC) Cost Effectiveness
All of the measures of worth is affected by the time value of money i.e. money
makes more money over time.
Engineering economy is also used for the analysis of past cash flows in order to
determine if a specific criterion or measure of worth was attained.
Example:
You purchase 53 nos. shares for RM4,975 and expect to have 8% appreciation per
year. The share is now worth RM6,744 for a 10.67% return. You have therefore
attained your criterion of only 8% return.
PERFORMING AN ENGINEERING ECONOMY STUDY
Once all economic, non-economic, and risk factors have been evaluated, a final
decision of the best alternative is made. When only one viable alternative is
identified, the do-nothing (DN) alternative may be chosen provided the
measure of worth and other factors result in the alternative being a poor choice.
The do-nothing alternative maintains the status quo.
In economic analysis, financial units are generally used as the tangible basis for
evaluation. Thus, when there are several ways of accomplishing a stated
objective, the alternative with the lowest overall cost or highest overall net
income is selected.
PROFESSIONAL ETHICS AND ECONOMIC DECISIONS
Many of the fundamentals of engineering morals and ethics are interwined with
the roles of money and economic-based decisions in the making of professionally
ethical judgement. Morals relate to the underlying tenets that form the
character and conduct of a person in judging right and wrong. Ethical practices
can be evaluated by using a code of morals or code of ethics that forms the
standards to guide decisions and actions of individuals and organizations in a
profession.
There are several different levels and types of morals and ethics:
Cash inflows are the receipts, revenues, incomes and savings generated by
project and business activity. A plus sign indicates a cash inflows. Example,
Cash outflows are costs, disbursement, expenses and taxes caused by projects
and business. A negative or minus sign indicates a cash outflows. Example,
Operating costs: -$230,000 per year annual operating costs for software
services
First cost: -$800,000 next year to purchase replacement earthmoving
equipment
Cash flow estimates can be a single value known as point estimates or singlevalue estimates or it can be a range estimate, where range is given instead
of a single value.
Net cash flow (NCF) is the difference between cash inflows and cash outflows or
receipts (R) and disbursement (D).
Net Cash Flow (NCF) = Cash Inflows Cash Outflows
NCF
= R - D
The end-of-period convention means that all cash inflows/outflows are assumed
to take place at the end of the interest period in which they actually occur. When
several inflows and outflows occur within the same period, the net cash flow is
assumed to occur at the end of the period. End of the period means end of
interest period.
Example,
A company is incorporating a GPS data into its latest tracking device. This new
feature will increase the revenue by RM200,000 for each of the next 2 years and
RM300,000 for each of years 3 and 4. The planning horizon is 4 years. The
interest rate is 8% per annum. Determine the total interest and total revenue
after 4 years using a compound interest method.
Yea
r
Revenue
(A)
1
2
200,000
200,000
3.
300,000
Cum. Total
(E)
200,000
416,000
749,280
4.
300,000
416,000 =
33,280
0.08 x
749,280 =
59,942
109,222
359,942
1,109,222
Note that all receipts are deemed at the end of interest period. Total revenue is
RM1,000,000 and total interest RM109,222
Cash flow diagram represents cash flows drawn on the y-axis with a time scale on
the x-axis. The direction of the arrows on the diagram differentiate income (an
upward pointing arrow) and outgoing (downward pointing arrow).
Example,
A rental company spent RM2,500 on a new air compressor 7 years ago. The
annual rental income from the compressor has been RM750. The RM100 spent on
maintenance the first year has increased each year by RM25. The company plans
to sell the compressor at the end of next year for RM150. Construct the cash flow
diagram from the companys perspective and indicate where the present worth is
located.
ECONOMIC EQUIVALENCE
Economic equivalence is a combination of interest rate and time value of money
to determine the different amounts of money at different points in time that are
equal in economic value. Example, at 6% per year, RM100 at time 0 is RM94.34
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at time - 0 i.e. RM100/1.06 and RM106 in time 1 i.e. RM100(1.06). The interest
rate to be RM94.34 at time -1 and RM106 at time 1 must be 6%. These amount
are equivalent following the time value of money.
Comparison of alternative cash flow series requires the use of equivalence to
determine when the series are economically equal or if one is economically
preferable to another. The keys to the analysis are the interest rate and the
timing of the cash flows.
SIMPLE AND COMPOUND INTEREST
Simple interest is calculated using the principal only, ignoring any interest
accrued in the preceding interest periods.
Simple Interest (I) = Principal x Number of periods x Interest rate = Pni
For compound interest, the interest accrued for each interest period is calculated
on the principal plus the total amount of interest accumulated in all previous
periods.
Compound interest = (Principal + All accrued interest)(Interest rate)
Total due afte n years = Principal (1 + interest rate) n years = P(1 + i)n
MINIMUM ATTRACTIVE RATE OF RETURN (MARR)
For investment to be profitable, a fair rate of return (ROR) or return on
investment (ROI) must be realized.
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return
established for the evaluation and selection of alternatives. A project is not
economically viable unless it is expected to return at least the MARR. MARR is
also referred to as the hurdle rate, cutoff rate, benchmark rate and minimum
acceptable rate of return.
unfunded project. The expected rate of return on the unfunded project is called
the opportunity cost.
The opportunity cost is the rate of return of a forgone opportunity caused by the
inability to pursue a project. Numerically, it is the largest rate of return of all the
projects not accepted (forgone) due to the lack of capital funds or other
resources. When no specific MARR is established, the de facto MARR is the
opportunity cost, i.e. the ROR of the first project not undertaken due to
unavailability of capital funds.
Example,
Assume a project is targeted to have an MARR of 12%. A proposal A, for similar
project but not funded is expected to have a ROR of 13%. Another proposal B, is
funded and has a ROR of 14.5%. Since proposal A is not funded due to lack of
capital, its estimated ROR of 13% is the opportunity cost; that is, the opportunity
to make an additional 13% return is forgone.
INTRODUCTION TO SPREADSHEET USE
The functions on a computer spreadsheet can greatly reduced the amount of
hand work for equivalency computations involving compound interest and the
terms P, F, A, i and n. A total of seven Excel functions can perform most of the
fundamental enginering economy functions.
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