Contents
Preface page ix
part I The scope of engineering economics l
1 Engineering and investment decisions 3
1.1 Long-range planning in business 3
1.2 The investment decision 3
1.3 The scope of engineering economics 4
2 Compounding, discounting, and economic equivalence 6
2.1 Time value of money 6
2.2 Compounding 6
2.3 Discounting 10
2.4 Interest rate formulas 11
2.5 Economic equivalence 20
Problems 21
3 Cash flow analysis and inflation 25
3.1 Economic modeling 25
3.2 Estimating the life of an investment 25
3.3 The interest rate 26
3.4 The cash flow 26
3.5 Discounting costs or negative cash flows 29
3.6 Incremental cash flows 30
3.7 Inflation and its measurement 30
3.8 Inflation and its impact on cash flows 35
Problems 38
Case study 40
Part II Choosing between alternatives 41
4 Methods for evaluating investments 43
4.1 Net present value 43
4.2 Internal rate of return 45
4.3 Profitability index 47
4.4 Annual equivalent amount 48
4.5 Capital recovery cost with return 50
4.6 Capitalized equivalent 51
4.7 Payback period 52
Problems 54
Case study 59
5 Depreciation, taxes, and cost of capital 60
5.1 The concept of depreciation 60
5.2 Methods of depreciation 61
5.3 Comparison of depreciation methods 65
5.4 Corporate income taxes 67
5.5 Effect of different methods of depreciation on cash flow 68
5.6 The cost of capital 69
5.7 Calculating the marginal cost of capital 73
Problems 74
Case study 77
6 Comparing alternative investments 78
6.1 The need to compare alternatives 78
6.2 Constraints to investment 79
6.3 Types of alternatives 79
6.4 Classification of alternatives 79
6.5 Comparing alternatives 81
6.6 Comparing alternatives with different outlays 84
6.7 Comparing alternatives with different timing of cash flows 86
6.8 Comparing alternatives with different lives 87
Problems 89
Case study 95
7 Replacement analysis 97
7.1 Approaches to replacement analysis 97
7.2 The outsider viewpoint approach 97
7.3 Replacement based on uniform annual costs 99
7.4 Replacement based on unequal annual costs 100
7.5 Replacement based on cash flows 101
7.6 Repeated life analysis 103
7.7 Economic life for asset replacement 104
Problems 106
Case study 110
Part III Project selection 113
8 Risk analysis 115
8.1 The concept of risk 115
8.2 Measuring the risk of a project 115
8.3 Example of risk management 116
8.4 Project net present value 118
8.5 Risk-adjusted discount rate approach 119
8.6 NPV of projects based on risk 119
8.7 Another example of risk-adjusted discount rate 120
8.8 Decision tree analysis 121
Problems 124
Case study 128
9 Risk analysis models 130
9.1 Project NPV and risk when cash flows are dependent(perfectly correlated) 130
9.2 Example of NPV and risk of project with dependent cashflows 131
9.3 Project NPV and risk when cash flows are independent (not correlated) 132
9.4 Example of NPV and risk of project with independent cashflows 133
9.5 Determining the probability of NPV being positive 134
9.6 Expected NPV and project risk when cash flows are interdependent
(moderately correlated) 134
9.7 Example of conditional probability method for project NPV and risk
(interdependent cash flows) 136
9.8 Comparison of projects based on risk 137
Problems 138
Case study 142
10 Capital rationing methods 144
10.1 NPV approach to capital rationing 144
10.2 Profitability index approach 145
10.3 IRR approach to capital rationing 146
10.4 External capital rationing 148
10.5 Linear programming for capital budgeting 148
10.6 Example of linear programming in capital budgeting 149
Problems 152
Case study 158
11 Evaluation of public projects 161
11.1 The nature of public projects 161
11.2 Life-cycle costing of public projects 162
11.3 Life-cycle costing based on present worth 163
11.4 Benefit-cost analysis 164
11.5 The benefit-cost ratio 165
11.6 The discount rate 166
11.7 Benefit-cost analysis of a single project 166
11.8 Alternative BCR formulation 168
11.9 Benefit-cost analysis of mutually exclusive projects 169
11.10 Benefit-cost analysis of three mutually exclusive proposals 169
11.11 Approaches to benefit-cost analysis by U.S. government agencies 172
11.12 Examples of benefit-cost analysis of government projects 173
11.13 Capital budgeting for multiple projects 176
11.14 Selection of projects under capital rationing 176
Problems 179
Case study 181
Part IV Economic decision models 183
12 Cost analysis 185
12.1 The production function 185
12.2 The concept of cost 186
12.3 Cost functions 187
12.4 Short-run and long-run costs 188
12.5 Short-run cost function 188
12.6 The general (cubic) cost function 189
12.7 Quadratic cost functions 189
12.8 Linear cost functions 192
12.9 Production cost analysis 194
Problems 201
Case study 204
13 Cost analysis models 206
13.1 Minimum cost analysis 206
13.2 Determination of optimum size of project 207
13.3 Minimum cost among alternatives 208
13.4 Life-cycle cost analysis 211
13.5 Life-cycle analysis of products 211
13.6 Break-even cost analysis 212
13.7 Break-even cost of two proposals 214
13.8 Break-even of multiple alternatives 216
13.9 Make-or-buy decisions 216
13.10 Example of make-or-buy decision 220
Problems 221
Case study 226
14 Lease-or-buy decisions 227
14.1 Leasing of capital assets 227
14.2 Evaluation of the cost of a lease 227
14.3 Evaluation of the cost to buy 229
14.4 Lease-or-buy example 229
14.5 Break-even analysis: lease or buy 231
14.6 Factors affecting lease-or-buy decisions 232
14.7 The lessor's cost of lease 233
Problems 234
Case study 236
15 Profitability analysis 238
15.1 Maximizing the firm's objective 238
15.2 The concept of profit 238
15.3 Revenue functions 239
15.4 Total cost of sales 244
15.5 Profit maximization analysis 244
15.6 Break-even analysis with linear revenue and cost functions 247
15.7 Analysis of operations with linear functions 249
15.8 Profit analysis with nonlinear functions 252
15.9 Other combinations of cost and revenue functions 255
15.10 Revenue maximization 258
15.11 Profitability analysis in perspective 260
Problems 261
Case study 268
Part V Management of engineering economics studies 271
16 Data sources and cost estimates 273
16.1 Data sources 273
16.2 Engineering estimates 274
16.3 Elements of costs and revenue 274
16.4 Estimating cost functions 278
16.5 Linear cost function 278
16.6 Nonlinear cost functions 281
16.7 Multivariate cost function 284
16.8 Estimating project cost 287
16.8 Adjusting cost estimates for overseas projects 290
Problems 290
Case study 298
17 Forecasting revenues 300
17.1 The scope of forecasting in engineering economics 300
17.2 Forecasting procedure 300
17.3 Explanatory or causal forecasting models 301
17.4 Example of a causal forecasting model 303
17.5 Forecasting models with time lags 307
17.6 Time trend forecasting models 307
17.7 Example of trend forecasting models 311
17.8 Multiple regression with time trend 313
17.9 Econometric forecasting models 315
17.10 Judgemental or qualitative forecasts 315
17.11 The necessity for forecasting 316
Problems 317
Case study 325
18 Preparing an economic feasibility study 326
18.1 The need for economic feasibility studies 326
18.2 Framework of feasibility study 326
18.3 Defining the objective of the study 328
18.4 Selecting alternatives to be considered 330
18.5 Data and assumptions 330
18.6 Evaluation methods 331
18.7 Results and recommendation 332
Case studies 333
Part VI Appendices 337
A Interest rate factors and present worth factors 339
B Uniform gradient series formula and factors 365
C Corporate income taxes: the U.S. Tax Reform Act of 1986 367
D Depreciation rules: the U. S. Tax Reform Act of 1986 369
E Areas under normal probability curve 371
F Critical values of the t-distribution (two-tailed) 372
G Natural logarithms 373
H Common logarithms 374
Bibliography 376
Answers to selected problems 378
Index 382