8/9/2019 Engrecon Lecture Material
1/53
ME 416/516
Engineering Economics
ME 416/516
8/9/2019 Engrecon Lecture Material
2/53
ME 416/516
Topics
Motivation
Types of Costs
Two Typical Scenarios for Analysis
“Simple” Methods
The Time Value of Money
The Present Value Method
The Proect Timeta!le Accounting for Ta"es and #epreciation
Accounting for $nflation
8/9/2019 Engrecon Lecture Material
3/53
ME 416/516
Motivation
The o!ective is to introduce methods ofeconomic analysis for energy engineeringdecision ma%ing in a corporate& institutional or
governmental setting' (egal& environmental& pu!lic relations& energy
efficiency& safety and ethical considerationsare important& !ut the most importantconsideration for engineering designdecisions is economics)) “dollars and cents”'
8/9/2019 Engrecon Lecture Material
4/53
ME 416/516
More Motivation
$f factors can !e valued in *& they should !eincluded in the economic analysis'
The analysis methods here do not re+uire
ta!les' The use of computer spreadsheets ,li%e E-CE(. will !e emphasi/ed'
A spreadsheet is a computeri/ed accountant0sledger) ideal for economic analysis'
Spreadsheets give greater fle"i!ilitythan ta!le)!ased methods'
8/9/2019 Engrecon Lecture Material
5/53
ME 416/516
Types of Costs
There are usually two types of costs associatedwith an engineering proect& one-time costs&which include first costs and salvage costs& and
annual costs ,or !enefits. that occur everyyear or severalyears of the
proect'
8/9/2019 Engrecon Lecture Material
6/53
ME 416/516
1irst Costs
First CostsFirst Costs or Initial CostsInitial Costs are the costsnecessary to implement a proect& including2
3 Costs of new e+uipment
3 Costs of shipping and installation
3 Costs of renovations needed to installe+uipment
3 Cost of engineering3 Cost of permits& licenses& etc'
8/9/2019 Engrecon Lecture Material
7/53
ME 416/516
$tems that 4educe 1irst Cost
Some costs of starting proects may !e offset !yimmediate savings2
3 #educt gains from sale of replaced e+uipment
3 #educt investment tax credits' These aregovernment ta" incentives to purchase certaine+uipment& and reduce first costs !y reducingta"es'
8/9/2019 Engrecon Lecture Material
8/53
ME 416/516
Salvage Value
5e are attempting to estimate the total costof doing a proect' Cost is reduced if we can
sell the e+uipment at end of proect'Salvage valueSalvage value is the money that can !eo!tained at the end of the proect !y sellinge+uipment' Salvage value is a !enefit ratherthan a cost'
8/9/2019 Engrecon Lecture Material
9/53
ME 416/516
Annual Costs or 6enefits
Annual CostsAnnual Costs and BenefitsBenefits are costs and!enefits of the proect that accrue over two ormore years of the proect& including2
#irect operating costs such as la!or&supervision& anitorial& supplies& maintenance&material& electricity& fuel& etc'
$ndirect operating costs sometimes included&such as a portion of !uilding rent& a portion ofsecretarial e"penses& etc'
8/9/2019 Engrecon Lecture Material
10/53
ME 416/516
Annual Costs or 6enefits ,Cont0d.
Sometimes include ta" costs or !enefits' $f theproect increases profits& it also increases ta"es&which are an additional cost' There is a ta"
!enefit if proect reduces profits' #epreciation of e+uipment for ta" purposes is
also a ta" !enefit'
1inally& need to include savings or profits fromthe proect'
8/9/2019 Engrecon Lecture Material
11/53
ME 416/516
Two Analysis Scenarios
New Project ) selecting from two or morealternative solutions' The o!ective in thisscenario is to find the lowest cost solution
that accomplishes some o!ective'Example) 7our client& a school district is!uilding a new school' 7ou are designing theheating and cooling system' Should you
select2 ,8. a gas !oiler plus an air conditioner&,9. an electric air)to)air heat pump& or ,:. aground)source heat pump;
8/9/2019 Engrecon Lecture Material
12/53
ME 416/516
Second Analysis Scenario
Replacement Project ) a method foraccomplishing the goal is already in place& !uta new alternative solution can accomplish the
goal more cheaply' #o the future savings fromthe new method ustify spending money now tocover the first costs;
Example) Should 9 e"isting machines with an
operator each !e replaced with a single newmachine with the same output and a singleoperator;
8/9/2019 Engrecon Lecture Material
13/53
ME 416/516
“Simple” Methods
Simple Payback PeriodSimple Payback Period ,SPP.) The timere+uired for savings to offset first costs'
Simple Return on InvestmentSimple Return on Investment (ROI) The
simple percent return the proect pays over itslife'
These methods are “simple” !ecause they do notconsider the
time value of money time value of money '
Simple methods are
8/9/2019 Engrecon Lecture Material
14/53
ME 416/516
Simple Pay!ac% Period
SavingAnnual
CostFirstSPP=
For a replacement project:
For comparing two projects A and B,where the frst cost o A is greater than
B, but the annual costs o A are lowerthan B:
BCostAnnualACostAnnual
BCostFirstACostFirstSPP
−
−
=
8/9/2019 Engrecon Lecture Material
15/53
ME 416/516
Simple 4eturn on $nvestment
CostFirst
ifetimeCostFirstSavingsAnnual
!"#
−
=
$he simple rate o return oninvestment is:
ietime is the lie o the project%
8/9/2019 Engrecon Lecture Material
16/53
ME 416/516
Simple Methods E"ample
The Acme Threaded Products Corp' nowuses 9 machinists to operate its > screwmachines' Each screw machine costs
*89&???@yr for electricity& maintenance andwasted materials' Each machinist costs*:&???@yr' 1ind SPP for replacing > oldmachines with 9 new machines B *?&???
each that produce same output& cost*8>&???@yr each to operate& and can !e run!y only one machinist; The old machines can!e sold for *>??? each'
8/9/2019 Engrecon Lecture Material
17/53
ME 416/516
Solution
1irst cost is 9 D *?&??? ) > D *>???& or2
1irst cost *8?>&???'
Savings@yr is *:&??? ,la!or.& F > D *89&??? ) 9 D
*8>&??? ,operation.& or2
Savings@yr *&???@yr
SPP 1irst cost@,Savings@yr.
*8?>&???@,*&[email protected] SPP ! "#$% yr
8/9/2019 Engrecon Lecture Material
18/53
ME 416/516
1ollow)&??? and an annual savings of*&???@yr& the e"pected useful life of the
e+uipment is > years' Acme Threaded ProductsCorp' re+uires a minimum simple return oninvestment& 4
8/9/2019 Engrecon Lecture Material
19/53
ME 416/516
Solution
4&???@> yr.I@*8?>&???@yr
ROI ! '% ! '#%) ,per year.
8/9/2019 Engrecon Lecture Material
20/53
ME 416/516
Time Value of Money
“5ould you prefer *8?? now or a year fromnow;” Most would prefer “cash up front”!ecause *8 today is worth more than *8
some time in the future' 7ou could invest *8today and have more than *8 in a year'
A proect with a life of several years has cashflows at various times' To consider dollar
amounts at different times& we need to put allamounts on an equal basis taking the time
value of money into account.
8/9/2019 Engrecon Lecture Material
21/53
ME 416/516
Present and 1uture Value
Present *aluePresent *alue is the value now of an amount ofmoney 1 received n years in the future'
Future *alueFuture *alue is value n years in the future of an
amount of money P received now' $f we can earn interest rate i on investments& the
relationship !etween P and 1 is2
1 P,8 F i.n
or P 1@,8 F i.n
8/9/2019 Engrecon Lecture Material
22/53
ME 416/516
E"ample
Problem) $f a savings !ond with a yield ofG matures with a value of *8??? in J years&what does it cost now;
Solution) This is e+uivalent to as%ing what isthe present value P of 1 *8??? received n J years in the future at an interest rate of i G& so P 2
1@,8 F i.n *8???@,8 F?'?.J +,'#-"
A savings !ond with these terms would costthis amount today'
8/9/2019 Engrecon Lecture Material
23/53
ME 416/516
E"ample
Problem) $f you invest *?? today at KGinterest& how much time is re+uired for theinvestment to !e worth *89??;
Solution) Lere P *??& 1 *89??& i KG and n is the un%nown& so2
1 P,8 F i.n or 1@P ,8 F i.n
ln 1@P n ln,8 F $.or2 n Hln 1@PI@Hln,8 F i.I
n Hln 89??@??I@Hln,8 F ?'?K.I "' yr
8/9/2019 Engrecon Lecture Material
24/53
ME 416/516
The Present Value Method
Method determines the value in today’s dollars of a set of cash inflows and outflows at varioustimes from now into the future'
Set up a ta!le ,spreadsheet. of all costs andsavings associated with the proect& ma%ingcosts negative and income@savings positive'
Sum up all cash flows from each year to get thenet cas. flo/ ,NC1. for that year'
8/9/2019 Engrecon Lecture Material
25/53
ME 416/516
Present Value Method ,Cont0d.
Convert each NC1 from all years n to presentvalue !y multiplying NC1 D 8@,8 F i.n' This processis called discounting the NC1 to account for
present value' Most large companies have a“discount rate” or “rate of return” i that they use forall proects'
Add up discountedcash &ows or all'ears% $his is the
present value o the
investment%
8/9/2019 Engrecon Lecture Material
26/53
ME 416/516
Present Value Method ,Cont0d.
Replacement pro0ects2 $f present value isgreater than /ero& then the accumulated&discounted savings e"ceed costs& and the
investment should !e made'
Osing a spreadsheet& i can !e adusted so thatP is e"actly /ero' The value of i for which P ?
is the discounted rate of return' This meansthat the return on the proposed new investmentis the same as putting the money in the !an% atan interest rate of i'
8/9/2019 Engrecon Lecture Material
27/53
8/9/2019 Engrecon Lecture Material
28/53
ME 416/516
The Proect Timeta!le
8/9/2019 Engrecon Lecture Material
29/53
ME 416/516
Proect Timeta!le ,Cont0d.
All operating costs and savings plus any ta" anddepreciation effects that occur at any time in7ear 8 are assumed to ta%e place on the final
day of 7ear 8 & that is& one year after proectstart' Similarly& all costs or savings occurring inany year are considered to occur at the end ofthat year'
The salvage value is a positive cash flow ta%enat the end of the final proect year'
8/9/2019 Engrecon Lecture Material
30/53
ME 416/516
Present Value E"ample
2iven: CrimsonCorp lights its factory withfluorescent lights with a power !ill of *89&???@yrand a lamp replacement cost of *9??@year'
CrimsonCorp is considering high pressuresodium lights that could !e operated for a powercost of *???@yr and a replacement cost of*9??@yr' The cost of removing the old fi"tures
and installing new fi"tures is *:&???' The life ofthe new lamp fi"tures is estimated to !e at leastJ years'
8/9/2019 Engrecon Lecture Material
31/53
ME 416/516
Present Value E"ample
Find) ,a. 1or a 8?G minimum rate of return&should lights !e replaced; ,!. 5hat is theactual rate of return on this investment;
Solution) The 1irst Cost is *:&???' Theannual savings are the cost of operating oldlights less the cost of operating new lights' So&the annual savings are ,*89&??? F *9??. )
,*??? F *9??. *K??@yr' A spreadsheetsolution is used for this replacement pro!lem'
8/9/2019 Engrecon Lecture Material
32/53
ME 416/516
Solution Spreadsheet Part a
7ear 8st Cost Savings NC1 #iscount P? ):??? ):??? 8 ):???
8 K?? K?? ?'K?K8 J9':9 K?? K?? ?'J9> K::'K
: K?? K?? ?'8: 989'> K?? K?? ?'J: 'K K?? K?? ?'9?K K?'J K?? K?? ?'> >8J'K
K?? K?? ?'8:9 >K9':J K?? K?? ?'> >>J'K K?? K?? ?'>9>8 >?8':
8? K?? K?? ?':J :?8'9
Present Value $s2 9:KJJ
#iscount 4ate $s2 ?'8
8/9/2019 Engrecon Lecture Material
33/53
ME 416/516
Solution& Part b
The actual rate of return is the value of i thatcauses the present value to e"actly e+ual /ero'
This is easily determined once the E"cel
spreadsheet is set up !y using 2oal Seek'''
8/9/2019 Engrecon Lecture Material
34/53
ME 416/516
Ta"es
Ta"es& local& stateand federal& are afact of life
Ta"es are applied to profits& therefore2
3 an e"pense that decreases profit also decreases
ta"es owed !y the company'3 a cash inflow that increases profit also increases
ta"es owed'
8/9/2019 Engrecon Lecture Material
35/53
ME 416/516
Ta"es ,Cont0d.
To account for ta"es on the cash flow in aparticular year& add to the NC1 the +uantity2 )8D NC1 D ta" rate' The negative sign shows that
a “F” cash flow has a “)” ta" effect' The federal corporate ta" rate varies over time
,with politics and circumstances.' Consult youraccountant for details
The primary ta" effect descri!ed here affectsthe net cash flow any time there is any cashflow in a year)) positive or negative'
8/9/2019 Engrecon Lecture Material
36/53
ME 416/516
Ta"es ,Cont0d.
$n addition to the primary ta" effect& in someyears there can !e a ta" effect from investmentta3 credits or depreciation'
To encourage investment in some goods ,li%eenergy efficiency.& the government some)timeslegislates an investment ta" credit'
An investment ta" credit is a specified
percentage of the purchase price that can !esu!tracted directly from ta" !ill in the year of thepurchase ,7ear ? for our purposes.'
8/9/2019 Engrecon Lecture Material
37/53
ME 416/516
Ta" Credit vs. #eduction
A ta" credit is an amount su!tracted directlyfrom the ta"es owed' The ta"payer0s ta"es arereduced !y the entire amount of a credit'
A ta" deduction is an amount su!tracted fromincome' The company !enefits only !y the ta"rate times the deduction for a ta" deduction'
8/9/2019 Engrecon Lecture Material
38/53
ME 416/516
#epreciation
A company cannot deduct the cost of capitalpurchases from its income as a “cost of doing!usiness'” The $4S regards capital purchases as
investments rather than expenses' The company can “write off&” or depreciate
capital purchases over a num!er of years'
#epending on type of e+uipment& a company can
claim a depreciation deduction of a specifiedamount for a specified num!er of years& followinga “depreciation sc.edule'”
8/9/2019 Engrecon Lecture Material
39/53
ME 416/516
#epreciation ,Cont0d.
The ta" effect of a depreciation deduction can !ecalculated as2
,)8. D 1irst Cost D #eprec' 4ate D Ta" 4ate
Note that 1irst Cost is a negative +uantity& so thedepreciation effect is a positive cash flow'
The most commonly used gov0t approveddepreciation schedule is the Accelerated Cost4ecovery System ,AC4S.2
8/9/2019 Engrecon Lecture Material
40/53
ME 416/516
AC4S #epreciation Schedule
8/9/2019 Engrecon Lecture Material
41/53
ME 416/516
#epreciation ,Cont0d.
#epending on what the government decides isthe lifetime of a type of capital e+uipment& a :& & or 8?)year depreciation schedule is followed'
1ote4 the fact that an item has !een depreciated8??G for ta" purposes has no relation to itsactual value or salvage value'
8/9/2019 Engrecon Lecture Material
42/53
ME 416/516
Ta" and #epreciation E"ample
2iven) Previously& CrimsonCorp wasconsidering an investment with a first cost of*:&??? and annual savings of *K??@yr'
Assume that CrimsonCorp is entitled to a Ginvestment ta" credit on the first cost& that paysa :>G ta" on profits& and that the federal gov0tclassifies the lighting e+uipment in the “)year”
property class'
8/9/2019 Engrecon Lecture Material
43/53
ME 416/516
Ta" and #epreciation E"ample
Find) ,a. the present value of the investmentassuming a 8?G discount rate& and ,!. theactual rate of return for the investment'
Solution) Again& a computer spreadsheetsolution is recommended' The G investmentcredit is the only 7ear ? ta" effect& there is aprimary ta" effect for 7ears 8 ) 8?& and the )
year class depreciation schedule is followed in7ears 8 ) '''
8/9/2019 Engrecon Lecture Material
44/53
ME 416/516
Measures of $nflation
Prices tend to increase over time due to inflation in money0s value'
Although some goods inflate faster
than others ,li%e health care andeducation.& the average rate of inflation isreflected !y the Consumer Price Inde3 ,CP$.'
The ratio of the CP$ for one year to that ofanother is inversely proportional to the ratio ofthe !uying power of a dollar for the same twoyears'
8/9/2019 Engrecon Lecture Material
45/53
ME 416/516
$nflation@CP$ E"ample
2iven) The average CP$ ,!ased on 8KJ9)J> 8??. for 8K? was :J'J and the CP$ for 8KK8 was8:'9' Low much could a dollar !uy in 8KK8
compared to 8K?' Sol5n) The ratio of !uying power is inversely
proportional to the ratio of CP$2
CP$)8K?@CP$)8KK8 :J'J@8:'9 ?'9J
Therefore& the 8KK8 dollar is worth only 9J'G ofthe 8K? dollar for the average consumerpurchase'
8/9/2019 Engrecon Lecture Material
46/53
ME 416/516
$nflation
There is a simple relationship !etween thepurchasing power of a dollar now compared tothe value of a dollar n years in the future
assuming that the inflation rate is $2*now *future@,8 F $.n
Note that i is used for interest rate& $ for inflation
rate'
8/9/2019 Engrecon Lecture Material
47/53
ME 416/516
E"ample
2iven) $f it costs you *8&???@year to live now&how much will it cost in 8? years if the inflationrate is >'G;
Sol5n) *1uture *Now D ,8 F $.n
so *8&??? D ,8 F ?'?>.8? *9:&:??
8/9/2019 Engrecon Lecture Material
48/53
ME 416/516
E"ample
2iven) 1or medical care& the 8K? CP$ was :>'?and the 8KK8 CP$ was 8'
Find) the average inflation rate for medical care
over the 98 year period' Sol5n) *:> in 8K? *8 in 8KK9& so
*8 *:> D ,8 F $.98
ln,8@:>. 98 ln,8 F $.e"pH,8@98. ln,8@:>.I 8 F $
$ e"pH,8@98. ln,8@:>.I ) 8 ?'?J8 J'8G
8/9/2019 Engrecon Lecture Material
49/53
ME 416/516
$nflation
Note that a dollar in the future is worth less thana dollar now for two different reasons2
,8. 7ou could invest your dollar today and have
more than a dollar at the future time& so it ta%esmore than a dollar in the future to have thepresent value of a dollar today ,time value ofmoney.'
,9. 7our dollar in the future won0t !e a!le to !uy asmuch as it could today !ecause of inflation'
8/9/2019 Engrecon Lecture Material
50/53
ME 416/516
Accounting for $nflation
,8. $nflate all costs and savings using theavaila!le information& so that net cash flow!efore ta"es is accurate for the year in
+uestion' (ac%ing !etter information& use theaverage inflation rate'
,9. Calculate NC1AT the usual way'
,:. Calculate the present value discount factorthe same as !efore& using discount rate i'
P* 6iscount ! "7(" 8 in
8/9/2019 Engrecon Lecture Material
51/53
ME 416/516
Accounting for $nflation ,Cont0d.
,>. Calculate an inflation discount factor usinginflation rate $2
Inflation 6iscount ! "7(" 8 In
,. Calculate an overall discount factor2
Overall 6isc# ! Inflation 6isc# 9 P* 6isc#
,. The Present Value for a year is the NC1ATtimes the overall discount factor'
8/9/2019 Engrecon Lecture Material
52/53
ME 416/516
$nflation E"ample
2iven4 Acme A"les needs a heat treating ovenfor its account with #eutschmo!ile AQ' Anelectric oven and natural)gas fired oven are
considered' 1or !oth options assume a ta" rateof :>G& )year depreciation& a 8?)year life& no ta"credits& salvage value of 8?G of first cost&discount rate of 8?G& inflation rate of >G&
electricity inflation rate of G& and natural gasinflation rate of G& All costs of the two ovensare identical e"cept for the following2
8/9/2019 Engrecon Lecture Material
53/53
$nflation E"ample ,Cont0d.
Electric Oven) 1irst cost is *89&???& electricitycost is *:&???@yr& maintenance cost is*???@yr'
as Oven) 1irst cost is *8J&???& fuel cost is*8?&???@yr& maintenance cost is *K???@yr'
Find4 which option should Acme select;
Sol5n4 Ose spreadsheet solution method& asfollows2
Top Related