| CONTEMPORAR ENGINEERING ECONOMICS |TABLE 3.6 Summary of Discrete Compounding Formulas with Discrete Payments $ Compound r= 1 amount ee. + N (EP, i.N) 2 G Present ee L worth: p=rato” = Pv(i,N,0,F) iF E (P/F i, N) E Compound a S ee ae 7 = PV(i,N,A) U (FAA i, N) o123 A b AAA AA = PME(i,¥, 0,2) P Sinking [ : A fund SS Y (AFF, i, N) a+ M E N +i 7 Fererced weatil p= (or | _ (PUA, i, Ny a+ = PV(i,N,A) E 4 5 123 N-IN R i 1 Seay | a4 | = PMI (i,N, P) : (AP.i. N) a+i— G Linear R gradient x asi == = hone u : 26 40 E (PAG, i, N) é x Pata _ 7 ata 123 N-0N T Conversion factor 4 ~ G| a+ 0 - Ip (A4G, i, NY Q Geometric lien =a 147 ateg jg | af He ne 1 Present = N 4007 Ean ba (7) a= 0 ty 8 (PIA,, 8, 4,.N) Ie‘Summary of Project Analysis Methods Discounted payback period DPP Present Pw) Future worth Fw) Capitalized equivalent cE ‘equivalence AEG) Internal rate ‘of return Benefit-cost BE) Profitability index PIG) ‘A method for determining when in {4 project’s history it breaks even, ‘Management sets the benchmark PP* A variation of payback period when factors inthe time value of money. ‘Management sets the benchmark PP*. ‘A method which translates a project's cash flows into an ‘equivalent net present value A variation of the PW: a project's cash ‘lows are translated iato an equivalent ant future value A variation of the PW: a perpetual or very long-lived project that generates ‘constant stream of annual net cash flow A variation of the PW: a project's cash flows are translated into an annual equivalent sum ‘A relative percentage method which ‘measures the yield as a percentage of investment over the life of a project: ‘The IRR must exceed the minimum required rate of return (MARR). ‘A relative measure to evaluate public projects by finding the ratio ofthe ‘equivalent benefits over the equivalent costs Acrelative measure to evaluate projects in terms of net equivaleat ‘benefits generated per dollar invested Pwo > 0 FW > 0. CE) > 0 AE) > 0. act) > 1 PA) > 0 Seleet the one Select the one With the largest withthe least Pw cost in PW Select the one Select the one with the largest withthe least Bw cost in FW Select the one Select the one with the withthe last largest CE cost in CE Select the one Setect the one with the with the least largest AE AEC Incremental analysis: TETRR oa) > MARR, select the higher cost investment projet, A. Taeremental analysis: IBC()qs—a1 > 1, select the higher cost investment project, Al. Incremental analysis: IEPI(i)q3-a1 > 1, select the higher cost investment project, Al.EngineeringLab Right now, in your course, there are young men and women whose engineering achievements could revolutionize, improve, and sustain future generations. Don’t Let Them Get Away. Contemporary Engineering Economics, Sixth Edition, together with MyEngineeringLab, is a complete solution for providing an engaging in-class experience that will inspire your students to stay in engineering, while also giving them the practice and scaffolding they need to keep up and be successful in the course. Learn more at myengineeringlab.comThis page intentionally left blankCONTEMPORARY ENGINEERING ECONOMICS Sixth EditionThis page intentionally left blankSixth Edition CONTEMPORARY ENGINEERING ECONOMICS Chan S. Park Department of Industrial and Systems Engineering Auburn University PEARSONVice President and Eatorial Director, ECS: Marcia J Horton Executive Editor: Holly Stark Field Marketing Manager: Demetrius Hall Senior Product Marketing Manager: Bram un Kempen Marketing Assistant: Jon Bryant Senior Managing Editor: Scott Disanno Production Project Manager: Rose Kerman Program Manager: Erin Ault Senior Digital Producer: Felipe Gonzales Global HE Director of Vendor Sourcing and Procurement: Diane fynes Director of Operations: Nick Sklisis Operations Specialist: Maura Zaldivar-Garcia Cover Designer: Black Horse Designs Cover Image: Ryan Ener/Geny Images Manager, Rights and Permissions: Rachel Youderman Associate Project Manager, Rights and Permissions: Timothy Nicholls Full-Service Project Management: Kalpana Arumugam. Laserwords Pv. Lid. Composition: Laserwords Pvt Ld. 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Where those designations appecr inthis hook, and the publisher was aware ofa trademark lam, the designations have been printed in initial eaps or all caps. “The author and publishor of this book have used their hes efforts in preparing this hook. Those efforts include the development. research, and testing of theories and programs to determine their effective ness. The author and publisher make no warranty of any’ kind, expressed or implied, with regard 10 these programs or the documentation contained in this book. The author and publisher shall not be lable in any event for incidental or consequential damages with, of arising out of the furnishing, performance, lor use of these programs. Library of Congress Cataloging-in-Publication Data on File 10987654321 PEARSON ISBN-L0: 0-13-410559-1 ISBN-13: 978-0-13-410859-8For Sophie and AlexanderThis page intentionally left blankCONTENTS Preface PART I BASICS OF FINANCIAL DECISIONS + Chapter | Engineering Economic Decisions 2 LL Role of Engineers in Business L.L.1 Types of Business Organization 1.1.2 Engineering Economic Decisions 1.1.3. Personal Economie Decisions 1.14 Economic Decisions Versus Design Decisions 1.2 What Makes the Engineering Economic Decision Difficult? 1.3 Large-Scale Engineering Projects Are Tesla’s Plans for a Giant Battery Factory Realistic? 3.2. Impact of Engineering Projects on Financial Statements ‘Common Types of Strategic Engineering Economic Decisions 1.4.1 Equipment or Process Selection 1.4.2 Equipment Replacement 1.4.3 New Product or Product Expansion 144 Cost Reduction 1.4.5 Improvement in Service or Quality 1.5 Fundamental Principles of Engineering Economics Summary Short Case Studies Chapter 2 Accounting and Financial Decision Making 16 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 The Cash Flow Statement 2.3 Using Ratios to Make Business Decisions 2.3.1 Debt Management Analysis 2.3.2 Liquidity Analysis 3.3. Asset Management Analysis 2.3.4 Profitability Analysis xix 18 19 21 26 7 34 35 7 38,vill Contents 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 54 3B 32 33 34 Chapter 4 Understanding Money and Its Management 4a 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 Economic Equivalence 3.2.1 Definition and Simple Calculations 3.2.2 Equivalence Calculations: General Principles 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 Equal-Payment Series 3.3.4 Linear-Gradient Series 3.3.5 Geometric Gradient Series 3.3.6. Irregular (Mixed) Payment Series Unconventional Equivalence Calculations 3.4.1 Composite Cash Flows 3.4.2 Determining an Interest Rate to Establish Economic Equivalence 3.43. Unconventional Regularity in Cash Flow Pattern ‘Summary Problems Short Case Studies 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 132 e2eaSE 55 56 7 61 64 64 66 a a B 81 93 99 10s ut m1 17 119 120 121 130 133 134 134 137 13942 43 44 45 46 Equivalence Calculations with Effective Interest Rates ‘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 Equivalence Calculations with Continuous Compounding 4.3.1 Discrete-Payment Transactions with Continuous ‘Compounding 43.2 Continuous-Funds Flow with Continuous Compounding, Changing Interest Rates 4.4.1 Single Sums of Money 4.4.2. Series of Cash Flows Debt Management 4.5.1. Commercial Loans 4.5.2 Loan versus Lease Financing 4.5.3. Home Mortgage 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 203 Chapter 5 Present-Worth Analysis 204 Sa 5.2 Describing Project Cash Flows 5.1.1 Loan versus Project Cash Flows 5.1.2 Independent versus Mutually Exclusive Investment Projects 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? 141 Mi 142 146 150 150 152 157 1s7 159 160 160 168 172 179 179 179 132 190 191 200 206 206 209 210 210 213 213 214 Concenes ixContents 53 34 35 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 Variations of Present-Worth Analysis 5.4.1 Puture-Worth Analysis 5.4.2 Capitalized Equivalent Method Comparing Mutually Exclusive Alternatives 5.5.1 Meaning of Mutually Exclusive and “Do Nothing” 5.5.2 Service Projects versus Revenue Projects Application of Investment Criteria 5.54 Scale of Investment 5.5.5 Analysis Period 5.5.6 Analysis Period Matches Project Lives 5.5.7 Analysis Period Differs from Project Lives 5.5.8 Analysis Period is Not Specitied Summary Problems Short Case Studies Chapter 6 Annual Equivalent-Worth Analysis 264 61 62 63 64 65 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 Capital Costs Versus Operating Costs 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 Life-Cycle Cost Analysis, Design Economics Summary Problems Short Case Studies 215 25 219 222 223 223 26 231 zal 232 232 233 235 236 239 246 249 250 263 266 268 270 273 276 276 276 278 281 282 290 301 301 312Chapter 7 Rate-of-Return Analysis 316 1 12 13 14 Rate of Return 7.1.1 Return on Investment 7.1.2 Return on Invested Capital ‘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 Internal-Rate-of-Return Criterion 7.3.1 Relationship to PW Analysis Net-Investment Test: Pure versus Mixed Investments, 7.3.3 Decision Rule for Pure Investments 7.3.4 Decision Rule for Mixed Investments Modified Internal Rate of Return (MIRR) ‘Mutually Exclusive Alternatives 7.4.1 Flaws in Project Ranking by IRR 7.42. Incremental Investment Analysis 7.43 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 82 83 General Cost Terms 8.1.1 Manufacturing Costs 8.1.2 Nonmanufacturing Costs Classifying Costs for Financial Statements 8.2.1 Period Costs Product Costs Cost Classification for Predicting Cost Behavior 8.3.1 Volume Index 83.2. Cost Behaviors 83.3 Cost-Volume-Profit Analysis 318 318, 320 321 321 323 326 333 333 333 336 338 347 349 349 350 397 360 361 375 379 380 382, 383 384 385 385 385 388 389 389) 304 Contents xiai Contents 8.4 Future Costs for Business Decisions 84.1 Differential Cost and Revenue 84.2 Opportunity Cost 843 Sunk Costs 84.4 Marginal Cost 8.5 Estimating Profit from Operation 85.1 Calculation of Operating Income 8.5.2 Annual Sales Budget for a Manufacturing Business 8.5.3. Preparing the Annual 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 426 9.41 Asset Depreciation 9.1.1 Economie Depreci 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 93.1 Straight-Line Method 9.3.2 Declining Balance Method 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 399) 399) 403 405 405 4 4 4 412 414 als 417 419 419 420 423 428 429 430 430 430 431 433, 434 434 435 436 443 451 4s2 452 48s 455 455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 486 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 457 457 460 460 460 466 466 469 470 47 47 414 476 484 488 488 489 490 490 492 492 494 494 498 503 50S 509 513 S13 S14 S17 523 524 533 Contents xiiixiv Contents PART 4 HANDLING RISK AND UNCERTAINTY Chapter |! Inflation and Its Impact on Project Cash Flows wa 12 113 4 Meaning and Measure of Inflation 11.1.1 Measuring Inflation 11.1.2 Actual versus Constant Dollars 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 Effects of Inflation on Project Cash Flows 113.1 Multiple Inflation Rates 11.3.2 Effects of Borrowed Funds Under Inflation Rate-of-Return Analysis Under Inflation 11.4.1 Effects of Inflation on Return on Investment 11.42 Effects of Inflation on Working Capital ‘Summary Problems Short Case Studies Chapter 12 Project Risk and Uncertainty 578 14 122 123 24 Origins of Project Risk Methods of Describing Project Risk 12.2.1 Sensitivity (What-if) Analysis 12.2.2 Break-Even Analysis 12.2.3 Scenario Analysis 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 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 537 538 540 540 545 548 548, 548 549 583 583 337 559 562 562 566 568 570 575 580 580 581 586 590 592 592 397 600 60212S 126 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 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 662 BA 2 133 B4 BS ‘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 Option Strategies 13.2.1 Buying Calls to Reduce Capital That is at Risk 13.2.2 Protective Puts as a Hedge 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 Real-Options Analysis 13.4.1 How is Real Options Analysis Different? 13.4.2 A Conceptual Framework for Real Options in Engineering Economics ‘Simple Real-Option Models 13.5.1 Option to Defer Investment 13.5.2 Patent and License Valuation 13.5.3 Growth Option—Option to Expand 619 619 620 624 629 631 634 635 639 643 648 649 659 663 664 665 667 669 669 on 67s 675 678 679 681 682 683 686 688 688 689 694 694 697 698 Contents xvxvi Contents 13.6 13.5.4 Scale-Up Option 13.5.5 Compound Options Estimating Volatility at the Project Level 13.6.1 Mathematical Relationship between & and ory 13.6.2 Estimating V; Distribution ‘Summary Problems Short Case Studies PART 5 SPECIAL TOPICS IN ENGINEERING ECONOMICS = 725 Chapter 14 Replacement Decisions 726 14.1 14.2 14.3 144 Replacement Analysis Fundamentals 14.1.1 Basic Concepts and Terminology 14.1.2 Opportunity Cost Approach to Comparing Defender and Challenger Economic Service Life 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 Replacement Analysis with Tax Considerations Summary Problems Short Case Studies Chapter 15 Capital-Budgeting Decisions 780 15.1 15.2 ‘Methods of Financing 15.1.1 Equity Financing 15.1.2 Debt Financing 15.1.3 Capital Structure Cost of Capital 15.2.1 Cost of Equity 15.2.2 Cost of Debt 15.2.3 Calculating the Cost of Capital 700 703 709 709 710 716 NI mA mI 78 730 733 738 739 7al 746 750 750 764 165 715 782 782 784 786 791 796 797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 154° Capital Budgeting 15.4.1 Evaluation of Multiple Investment Altematives 15.4.2 Formulation of Mutually Exclusive Altematives 15.4.3 Capital-Budgeting Decisions with Limited Budgets ‘Summary Problems Short Case Studies Chapter 16 Economic Analysis in the Service Sector 828 16.1 What Is The Service Sector? 16.1.1 Characteristics of the Service Sector 16.1.2 Difficulty of Pricing Service 16.2 Economic Analysis in The Public Sector 16.2.1 What is Benefit-Cost Analysis? 16.2.2 Framework of Benefit-Cost Analysis 16.2.3 Valuation of Benefits and Costs 16.2.4 Quantifying Benefits and Costs 16.2.5 Difficulties Inherent in Public Project Analysis 16.3 Benefit-Cost Ratios 16.3.1 Definition of Benefit~Cost Ratio 16.3.2 Profitability Index (Net B/C Ratio) 16.3.2 Relationship Among B/C Ratio, Profitability Index, and NPW 16.3.3 Comparing Mutually Exclusive Alternatives: Incremental Analysis 16.4 Analysis of Public Projects Based on Cost-Fffectiveness 16.4.1 Cost-Effectiveness Studies in the Public Sector 16.4.2 A Cost-Effectiveness Case Study 16.5 Economic Analysis in Health-Care Service 165.1 Economic Evaluation Tools 16.5.2 Cost-Effectiveness Analysis in the Healthcare Sector 16.5.3 Cost-Utility Analysis ‘Summary Problems Short Case Studies 799 799 801 803 807 807 808, 809 817 818, 822 830 830 831 832 833 833 834 836 841 842 842 845 846 847 851 851 852 860 860 861 866 869 870 874 Contents ViiContents ‘Appendix A ‘Appendix B Appendix C Index Fundamentals of Engineering Review Questions Interest Factors for Discrete Compounding Values of the Standard Normal Distribution Function 881 901 931 935,PREFACE What is “Contemporary” About Engineering Economics? Decisions made during the engineering design phase of product development determine the majority of the costs associated with the manufacturing of that product (some say that this value may be as high as 85%). As design and manufacturing processes become more complex, engineers are making decisions that involve money more than ever before. Thus, the competent and successful engineer in the twenty-first century must have an improved understanding of the principles of science, engineering, and economics, coupled with relevant design experience. Increasingly, in the new world economy, successful businesses will rely on engineers with such expertise. Economic and design issues are inextricably linked in the producuservice life cycle. ‘Therefore, one of my strongest motivations for writing this text was to bring the realities of economics and engineering design into the classroom and to help students integrate these issues when contemplating many engineering decisions. Of course, my underlying. motivation for writing this book was not simply to address contemporary needs, but to address as well the ageless goal of all educators: to help students to learn. Thus, thoroughness, clarity, and accuracy of presentation of essential engineering economics were my aim at every stage in the development of the text New to the Sixth Edition ‘Much of the content has been streamlined to provide materials in depth and to reflect the challenges in contemporary engineering economies. Some of the highlighted changes are as follows: + All the chapter opening vignettes—a trademark of Contemporary Engineering Economics—have been updated or completely replaced with more current and, thought-provoking issues. Selection of vignettes reflects the important segment of global economy in terms of variety and scope of business as well. With more than 80% of the total GDP (Gross Domestic Product) in the United States provided by the service sector, engineers work on various economic decision problems in the service sector as well. For this reason, many engineering economic decision problems from the service sector are presented in this sixth edition. + Excel spreadsheet modeling techniques are incorporated into various economic decision problems to provide many “what-if” solutions to key decision problems. + About 20% of end-of-chapter problems are either new or revised. There are a total of 618 end-of-chapter problems and 65 short case-study questions. There are also 196 fully worked-out examples and 40 carefully selected and fully worked out Fundamentals of Engineering Exam Review Questions in Appendix A. xix1 = Blectrie vehicles Tesla ‘Consumer: ‘Auto Manufacturers Goods 2 + Communication chips Broadcom Technology ‘Semiconductor—Integrated Circuits 3 + Powerball—Lottery Cindy and Mark Services Lottery winning HL 4 + Financing home Personal Finance Financial anking/Howsing morigage 5 + Football stadium University of Services Sports enatel Colorado 6 + Industrial robots Delta Industrial “Manufacturing 7 ‘Investment in antique car Personal Personal Automobile 8 + iPhone manufacturing Apple: Consumer Electronic Equipment Goods 9 ‘Airline baggage handling Delia Airlines Services Airlines 10 ‘Aircraft manufacturing Eclipse Industrial Aerospace Goods u + Big Mac index Personal Services Restaurants 2 ‘= Aluminum auto body Alcoa. ‘Basic Materials Aluminum B Insurance Personal Services Travel 4 ‘+ Replacing absorption UCSF Medical Healtheare Hospitals chiller Center 1s + Capital budgeting Laredo Petroleum Energy il deiling 16 = Auto inspection program State of Public Government Pennsylvania * Some other specific changes in each chapter are summarized as follows: 1 + Revised Section 1.3 by providing one of contemporary issues—electric vehicle and battery ‘manufaeturing, 2 +Replaced all financial analyses (including financial ratios) based on the financial statements by Broadcom Corporation. + Provided two chapter examples and solutions to improve the understanding of financial analysis, 3. +Redesigned all Excel worksheets to take advantage ofits financial functions in solving various ‘economic equivalence problems.Preface Xxi 0 u n 3 “4 16 + Revised Section 4.3.2 to enhance the understanding of continuous-funds flow with continuous ‘compounding. + Revised Section 4.6.3 to reflect the current bond market. + Revised all Excel worksheets. + Streamlined the presentation + Revised Section 6.3.3 with a new make-buy example + Introduced a new example of HVAC retofitlife-cyele-costing analysis. + Created a new section (73.5) on mosified intemal rate of return + Streamlined the presentation. + Updated all data elated to cost of owning and operating a vehicle. + Updated tax information, + Upslated all Excel worksheets of generating depreciation schedules. + Revised all cash flow statement tables by using Excel + Updated all data elated vo consumer price index as wel as other cost data to reflet the current tend {in inflation as well as deflation in various economic sectors. + Revised all cash flow statements by using Excel. + Revised Excel worksheet related to sensi y analysis. + Revised ll financial options examples by providing many graphical illustrations to explain complex ‘conceptual financial as well as real option problems. + Extended Example 13.14 on how to estimate project vol ity. + Created a new graphical chart Figure 14.8) to facilitate the understanding of overall replacement. strategies under infinite planning horizon. + Created a new figure (Figure 15.1) to ilustrate the capital structure of a typical firm, + Extended Section 15.4.3 to include an example on how to find the optimal capital budget if projects ‘cannot be accepted in part (Example 15.12). + Streamlined the presentation, + Provide « new detailed yehicle inspection program on cost-benefit analysis + Added a new section (16.5.3) on cost-tiity analysis to improve the pedagogical aspect of healtheare decisions Overview of the Text Although it contains little advanced math and few truly difficult concepts, the introductory engineering economics course is often curiously challenging for the sophomores, juniors, and seniors. There are several likely explanations for this difficulty. + The course is the student’s first analytical consideration of money (a resource with which he or she may have had little direct control beyond paying for tuition, housing, food, and textbooks).oot Preface + The emphasis on theory may obscure the fact that the course aims, among other things, to develop a very practical set of analytical tools for measuring project worth. This is unfortunate since, at one time or another, virtually every engineer—not to mention every individual—is responsible for the wise allocation of limited financial resources. + ‘The mixture of industrial, civil, mechanical, electrical, and manufacturing engineering students, as well as other undergraduates who take the course, often fail to “see them- selves” using in the skills the course and text are intended to foster. This is perhaps less true for industrial engineering students for whom many texts take as their primary audience. But other disciplines are often motivationally shortchanged by a text’s lack of applications that appeal directly to their students Goal of the Text ‘This text aims not only to provide sound and comprehensive coverage of the concepts of engineering economic but also aims to address the difficulties of students as outlined previously, all of which have their basis in inattentiveness to the practical concerns of engineering economies. More specifically, this text has the following chief goals: + To build a thorough understanding of the theoretical and conceptual basis upon which the practice of financial project analysis is built. + To satisty the very practical needs of the engineer toward making informed financial decisions when acting as a team member or project manager for an engineering project. + To incorporate all critical decision-making tools—including the most contemporary, computer-oriented ones that engineers bring to the task of making informed financial decisions. + To appeal to the full range of engineering disciplines for which this course is often required: industrial, civil, mechanical, electrical, computer, aerospace, chemical, and manufacturing engineering, as well as engineering technology. Prerequisites ‘The text is intended for undergraduate engineering students at the sophomore level or above. The only mathematical background required is elementary calculus. For Chapters 12 and 13, a first course in probability or statistics is helpful but not necessary, since the treatment of basic topics there is essentially self-contained, Taking Advantage of the Internet ‘The integration of computer use is another important feature of Contemporary Engineering Economies. Students have greater uecess to and familiarity with the various spreadsheet twols and instructors have greater inclination either to treat these topics explicitly in the course or to encourage students to experiment independently A remaining concern is that the use of computers will undermine true understanding of course concepts. This text does not promote the use of trivial spreadsheet applications as a replacement for genuine understanding of and skill in applying traditional solution methods Rather, it focuses on the computer’ productivity-enhancing benefits for complexproject cash flow development and analysis. For spreadsheet coverage, the emphasis is on demonstrating a chapter concept that embodies some complexity that can be much more efficiently resolved on a computer than by traditional long-hand solutions. MyEngineeringLab™ ‘+ MyEngineeringLab is now available with Contemporary Engineering Economics, Sixth Edition and provides a powerful homework and test manager which lets instructors create, import, and manage online homework assignments, quizzes, and tests that are automatically graded. You can choose from a wide range of assignment options, including time limits, proctoring, and maximum number of attempts allowed. ‘The bottom line: MyEngineeringLab means less time grading and more time teaching. + Algorithmic-generated homework assignments, quizzes, and tests that directly correlate to the textbook. + Automatic grading that tracks students’ results. + Leaming Objectives mapped to ABET outcomes provide comprehensive reporting tools. If adopted, access to MyEngineeringL ab can be bundled with the book or pur- chased separately. Resources for Instructors and Students + MyEngineeringLab, myengineeringlab.com, which is also available as MyEngineeringL ab with Pearson eText 2.0, a complete online version of the book allows highlighting, note taking, and search capabilities. + Excel files of selected example problems from the text as well as end-of-chapter problems. + Instructor's Solutions Manual in both WORD and PDF versions + PowerPoint lecture notes. Acknowledgments ‘This book reflects the efforts of a great many individuals over a number of years. In particular, I would like to recognize the following individuals, whose reviews and comments on prior editions have contributed to this edition. Once again, I would like to thank each of them: Kamran Abedini, California Polytechnic—Pomona James Alloway, Syracuse University Mehar Arora, U. Wisconsin—Stout Joel Arthur, California State University—Chico Robert Baker, University of Arizona Robert Barrett, Cooper Union and Pratt Institute ‘Tom Barta, lowa State University Charles Bartholomew, Widener University Richard Bernhard, North Carolina State University Bopaya Bidanda, University of Pittsburgh Preface 20dood Preface James Buck, University of lowa Philip Cady, The Pennsylvania State University ‘Tom Carmichal, Souther College of Technology Jeya Chandra, The Pennsylvania State University Max C. Deibert, Montana State University Stuart E. Dreyfus, University of California-Berkeley Philip A. Farrington, University of Alabama at Huntsville W4. Foley, RP Jane Fraser, University of Southern Colorado Terry L Friesz, Penn State University Anil K. Goyal, RPI R. Michael Harnett, Kansa State University Bruce Hartsough, University of California—Davis Carl Hass, University of TexasAustin John Held, Kansas State University T. Allen Henry, University of Alabama RC. Hodgson, University of Notre Dame Scott Iverson, University of Washington Peter Jackson, Cornell University Philip Johnson, University of Minnesota Harold Josephs, Lawrence Tech Henry Kallsen, University of Alabama Alla Kammerdiner, Arizona State University W4. Kennedy, Clemson University Oh Keytack, University of Toledo Wayne Knabach, South Dakota State University Bahattin Koc, University of Buffalo Stephen Kreta, California Maritime Academy John Krogman, University af Wisconsin-Platteville Dennis Kroll, Bradley University Michael Kyte, University of Idaho Gene Lee, University of Central Florida William Lesso, University of Texas-Austin Martin Lipinski, Memphis State University Robert Lundquist, Ohio State University Richard Lyles, Michigan State University Gerald T, Mackulak, Arizona State University Abu S. Masud, The Wichita State University ‘Sue MeNeil, Carnegie-Mellon University James Milligan, University of Idaho Richard Minesinger, University of Massachusetts-Lowell, Gary Moynihan, The University of Alabama ‘Kumar Muthuraman, University of Texas James 8. Noble, University of Missouri—Columbia Michael L. Nobs, Washington University-St. Louis Kurt Norlin, Laure! Tech Integrated Publishing Solutions Peter O'Grady, University of Iowa Wayne Parker, Mississippi State UniversityElizabeth Pate-Cornell, Stanford University Cecil Peterson, GMI George Prueitt, U.S. Naval Postgraduate School IK. Rao, California State University-Long Beach ‘Susan Richards, GMI Bruce A. Reichert, Kansas State University Mark Roberts, Michigan Tech John Roth, Vanderbilt University Stan Settle, University of Southern California Paul L. Schillings, Montana State University Bill Shaner, Colorado State University Fred Sheets, California Polytechnic—Pomona Dean Shup, University of Cincinnati David Sly, Lowa State University Milton Smith, Texas Tech Stephen V. Smith, Drexel University David C. Slaughter, University of California-Davis Charles Stavridge, FAMU/FSU Junius Storry, South Dakota State University Frank E. Stratton, San Diego State University George Stukhart, Texas A&M University Donna Summers, University of Dayton Joe Tanchoco, Purdue University Deborah Thurston, University of Mlinois at Urbana-Champaign Lt Col. James Trehame, U.S. Army L. Jackson Turaville, Tennessee Technological University ‘Theo De Winter, Boston University Yoo Yang, Ca! Poly State University Special Acknowledgment Personally, I wish to thank Professor Stan Settle of University of Southern California for his inputs to the sixth edition with a detailed list of suggestions for improvement. My special thanks are due to Kyongsun Kim, who served as an accuracy checker for many solutions to the end-of-chapter problems. Her technical knowledge as well as pointed comments improved the solutions manual in many directions. 1 would also like to thank Erin Ault, Program Manager at Pearson, who assumed responsibility for the overall project and Rose Kernan, my production editor at RPK Editorial Services, Inc., who oversaw the entire book production. CHAN S. Park AUBURN, ALABAMA, Preface XXVThis page intentionally left blankCONTEMPORARY ENGINEERING ECONOMICS Sixth EditionThis page intentionally left blankPART ONE BASICS OF FINANCIAL DECISIONSCHAPTER Engineering Economic Decisions Are Electric Cars Finally the Next Big Thing? Tesla Motors was founded in 2003 by a group of engineers and venture capitalists. Tesla designs, develops, manufactures, and sells premium electric vehicles (EVs) and advanced electric vehicle powertrain ‘components by order only. Tesla’s business plan recognizes that innovative technology is often very expensive and that the very rich are usually the first people to adopt it. ‘Once prices come down, the technology source: Aleshave/Shulterstock ‘can move down into the market. That's why Tesh’s first car is a high-end sports car only made in limited numbers. In its 10 years since founding, Tesla has launched both a high-end limited edition “Tesla Roadster” and its “Model S" production car, and introduced “Model X,” a sport utility vehicle with seating for seven adults in 2015. Despite a public controversy about its limited driving range before recharging, the Model § had received the coveted Car of the Year Award and ‘earned the highest rating that Consumer Reports ever gave to a car, saying that “The mere fact the Tesla Model § exists at all is a testament to innovation and entrepreneurship, the very qualities that once made the American automobile industry the largest, richest, and most powerful in the world." While some of its most visible EV competitors went bankrupt or halted * Angus MacKenzie, “2013 Motor Trend Car of the Year: Tesla Model S," MotorTrend, January 2013,production, Tesla became a darling of many investors and Wall Street analysts. Tesla's goal is to be a mass manufacturer of electric cars. ihe story of how the Tesla founders got motivated to develop a series of luxury electric cars and eventually transformed their invention to a multibillion- dollar business is a typical one. Companies such as Google, Facebook, and Microsoft all produce computer-related products and have market values of sev- cral hundred billion dollars. These companies were all started by highly motivated young college students. One thing that is also common to all these successful businesses is that they have capable and imaginative engineers who constantly generate good ideas for capital investment, execute them well, and obtain good results. You might wonder what kind of role these engineers play in making such business decisions. In other words, what specific tasks are assigned to these engineers, and what tools and techniques are available to them for making such capital investment decisions? We answer these questions and explore related issues throughout this text. CHAPTER LEARNING OBJECTIVES After completing this chapter, you should understand the following concepts: = The role of engineers in business. = Types of business organization. ‘= The nature and types of engineering economic decisions. = What makes the engineering economic decisions difficult. = How a typical engineering project idea evolves in business . Fundamental principles of engineering economics. DBI Role of Engineers in Business Facebook, Google, and Microsoft produce computer products and have a market value of several hundred billion dollars each, as stated earlier. These companies were all started by young college students with technical backgrounds. When they went into the computer business, these students initially organized their companies as proprietorships. As the ‘businesses grew, they became partnerships and were eventually converted to corporations. This chapter begins by introducing the three primary forms of business organization and briefly discusses the role of engineers in business.4. CHAPTER | Engineering Economic Decisions 1.1.1 Types of Business Organization Asan engineer, you should understand the nature of the business organization with which ‘you are associated. This section will present some basic information about the type of ‘organization you should choose should you decide to go into business for yourself. The three legal forms of business, each having certain advantages and disadvantages, are proprictorships, partnerships, and corporations. Proprietorships A proprietorship is a business owned by one individual. This person is responsible for the firm’s policies, owns all its assets, and is personally liable for its debts. A proprietorship hhas two major advantages. First, it can be formed easily and inexpensively. No legal and organizational requirements are associated with setting up a proprietorship, and organiza tional costs are therefore virtually nil. Second, the earnings of a proprietorship are taxed at the owner’s personal tax rate, which may be lower than the rate at which corporate income is taxed. Apart from personal liability considerations, the major disadvantage of a proprietorship is that it cannot issue stocks and bonds, making it difficult to raise capital for any business expansion. Partnerships A partnership is similar to a proprietorship, except that it has more than one owner. Most partnerships are established by a written contract between the partners. The con- tract normally specities salaries, contributions to capital, and the distribution of profits and losses. A partnership has many advantages, among which are its low cost and ease of formation, Because more than one person makes contributions, a partnership typically has a larger amount of capital available for business use. Since the personal assets of all the partners stand behind the business, a partnership can borrow money more easily from a bank, Each partner pays only personal income tax on his or her share of a partnership's taxable income. On the negative side, under partnership law, each partner is liable for a business's debts. This means that the partners must risk all their personal assets—even those not invested in the business. And while each partner is responsible for his or her portion of the debts in the event of bankruptcy, if any partners cannot meet their pro rata claims, the remaining partners must take over the unresolved claims. Finally, a partnership has a limited life, insofar as it must be dissolved and reorganized if one of the partners quits. Corporations A corporation is a legal entity created under provincial or federal law. It is separate from its owners and managers. This separation gives the corporation four major advantages: 1. It can raise capital from a large number of investors by issuing stocks and bonds. 2. It permits easy transfer of ownership interest by trading shares of stock. 3. It allows limited liability—personal liability is limited to the amount of the indi- vidual’s investment in the business. 4, It is taxed differently than proprietorships and partnerships, and under certain conditions, the tax laws favor corporationsLI Role of Engineers in Business 5 ‘On the negative side, itis expensive to establish a corporation. Furthermore, a corpo- ration is subject to numerous governmental requirements and regulations, ‘Asa firm grows, it may need to change its legal form, because the form of a business affects the extent to which it has control of its own operations and its ability to acquire funds. The legal form of an organization also affects the risk borne by its owners in case of bankruptcy and the manner in which the firm is taxed. Apple Computer, for example, started out as 4 two-man garage operation. As the business grew, the owners felt con stricted by this form of organization: It was difficult to raise capital for business expansion; they felt that the risk of bankruptcy was too high to bear; and as their business income grew, their tax burden grew as well. Eventually, they found it necessary to convert the partnership into a corporation. With a market value of close to $700 billion in 2014, itis, the largest corporation in the United States. In the United States, the overwhelming majority of business firms are proprietorships, followed by corporations and partnerships. However, in terms of total business volume (dollars of sales), the quantity of business transacted by proprietorships and partnerships is several times less than that of corporations. Since most business is conducted by cor porations, this text will generally address economic decisions encountered in that form of ownership. 1.1.2 Engineering Economic Decisions What role do engineers play within a firm? What specific tasks are assigned to the engi- neering staff, and what tools and techniques are available to it to improve a firm’s profits? Engincers are called upon to participate in a variety of decisions, ranging from manufae- turing, through marketing, to financing decisions. We will restrict our focus, however, 10 various economic decisions related to engineering projects. We refer to these decisions as, engineering economic decisions. In manufacturing, engineering is involved in every detail of a produet’s production, from conceptual design to shipping. In fact, engineering decisions account for the major ity (some say 85%) of product costs. Engineers must consider the effective use of capital assets such as buildings and machinery. One of the engineer's primary tasks is to plan for the acquisition of equipment (capital expenditure) that will enable the firm to design and produce products economically. With the purchase of any fixed asset—equipment, for instance—we need to estimate the profits (more precisely, cash flows) that the asset will generate during its period of ser- vice. In other words, we have to make capital expenditure decisions based on predictions about the future. Suppose, for example, you are considering the purchase of a deburring machine to meet the anticipated demand for hubs and sleeves used in the production of gear couplings. You expect the machine fo last 10 years. This decision thus involves an implicit 10-year sales forecast for the gear couplings, which means that a long waiting period will be required before you will know whether the purchase was justified. ‘An inaccurate estimate of the need for assets can have serious consequences. If you invest too much in assets, you incur unnecessarily heavy expenses. Spending too little on fixed assets, however, is also harmful, for then the firm’s equipment may be too obsolete to produce products competitively, and without an adequate capacity, you may lose a portion ‘of your market share to rival firms. Regaining lost customers involves heavy marketing expenses and may even require price reductions or significant product improvements, both of which are costly.6 CHAPTER | Engineering Economic Decisions 1.1.3 Personal Economic Decisions In the same way that an engineer can play a role in the effective utilization of corporate financial assets, each of us is responsible for managing our personal financial affairs. After wwe have paid for nondiscretionary or essential needs, such as housing, food, clothing, and transportation, any remaining money is available for discretionary expenditures on items such as entertainment, travel, and investment. For money we choose to invest, we want to maximize the economic benefit at some acceptable risk. The investment choices are virtually unlimited and include savings accounts, guaranteed investment certificates, stocks, bonds, mutual funds, registered retirement savings plans, rental properties, land, business ownership, and more. How do you choose? The analysis of one’s personal investment opportunities uti- lizes the same techniques that are used for engineering economic decisions. Again, the challenge is predicting the performance of an investment into the future. Choosing wisely can be very rewarding, while choosing poorly can be disastrous. Some investors in the energy stock Enron who sold prior to the fraud investigation became millionaires. Others, who did not sell, lost everything. A wise investment strategy is a strategy that manages risk by diversifying investments. With such an approach, you have a number of different investments ranging from very low to very high risk and are in a variety of business sectors. Since you do not have all your money in one place, the risk of los- ing everything is significantly reduced. (We discuss some of these important issues in Chapters 12 and 13.) In this text, we will consider many types of invest ments—personal investments as well as business investments. The focus, however, will be on evaluating engineering pro- jects on the basis of their economic desirability and on dealing with investment situations. ‘that a typical firm or a public institution faces. 1.1.4 Economic Decisions Versus Design Decisions Economic decisions differ in a fundamental way from the types of decisions typically encountered in engineering design. In a design situation, the engineer utilizes known physical properties, the principles of chemistry and physics, engineering design correla- tions, and engineering judgment to arrive at a workable and optimal design. If the judg- ‘ment is sound, the calculations are done correctly, and we ignore technological advances, the design is time invariant. In other words, if the engineering design to meet a particular need is done today, next year, or in five years’ time, the final design would not change significantly, In considering economic decisions, the measurement of investment attractiveness, which is the subject of this text, is relatively straightforward. However, the information required in such evaluations always involves predicting or forecasting product sales, prod- uct selling prices, and various costs over some future time frame—five years, 10 years, 25 years, ete All such forecasts have two things in common. First, they are never completely accu- rate compared with the actual values realized at future times. Second, a prediction or forecast made today is likely to be different from one made at some point in the future. It is this ever-changing view of the future that can make it necessary to revisit and even change previous economic decisions. Thus, unlike engineering design, the conclusions reached through economic evaluation are not necessarily time invariant. Economic deci- sions have to be based on the best information available at the time of the decision and a thorough understanding of the uncertainties in the forecasted data.1.2 What Makes the Engineering Economie Decision Difficult? 7 [BY What Makes the Engineering Economic Decision Difficult? ‘The economic decisions that engineers make in business differ very little from the finan- cial decisions made by individuals, except for the scale of the concern, For example, everyone who experienced the Great Blackout of 2003 remembers where they were when it happened that summer day. The blackout, which cut power to much of the Northeastern and Midwestern United States, as well as parts of Canada, brought home the reality that the electrical grid in the United States was outdated.” Updating the grid will not be cheap— estimates range as high as $2 tillion—but the massive effort will also present huge oppor- tunities for U.S. manufacturers, with a market that could reach SI trillion. The race is on to capitalize on smart-grid technologies, which would include building new power plants, transmission lines, and focus on conservation. (See Figure 1.1.) Figure |.1 A helicopter lowers towers for high-voltage power lines into place. Many say the country needs to build more of these lines to move renewable power and hecome more efficient rank Andorka, “Powering Up: The Smart Grid's Nex Steps.” Industry Week, Api 2011.8 CHAPTER | Engineering Economic Decisions Obviously, this level of engineering decision by electric power companies is far more complex and more significant than a business decision about when to introduce a new product. Projects of this nature involve large sums of money over long periods of time, and it is difficult to estimate the magnitude of economic benefits in any precise manner. Even if we decide to rebuild the electric grid systems, should we build in incremental steps, or should we build to withstand a demand to occur 20 years from now? Even if we can justify the project on economic reasoning, how to finance the project is another issue. Any engineering economic decision pertaining to this type of a large-scale project will be extremely difficult to make. [FAY Large-Scale Engineering Projects In the development of any product, a company's engineers are called upon to translate an idea into reality. A firm's growth and development depend largely upon a constant flow of ideas for new produets, and for the firm to remain competitive, it has to make existing products better or produce them at a lower cost. We will present an example of how a large-scale engineering project evolves and what types of financial decisions have to be considered in the process of executing such a project.” 1.3.1 Are Tesla’s Plans for a Giant Battery Factory Realistic? Tesla Motors introduced the world’s first luxury electrical vehicles whose engines cut air pollution to zero and boosted operating efficiency to significant levels. Tesla, in short, ‘wanted to launch and dominate a new “green” era for automobiles and plans to build one of the world’s largest factories of any kind in the U.S. But it wouldn’t build its electric cars there—it would make the batteries to power them. The plant, slated for completion by 2017 at a cost of as much as $5 billion, would be able to turn out more lithium-ion batteries than all the battery factories in the world today. Tesla finally broke ground in June of 2014 on the site in Reno, Nevada, and expects to start producing batteries at the plant by 2017. It says the scale will help drive the cost of batteries down, in turn helping to make # mass-manufacturing within reach. How Economical is Tesla’s Plan? The biggest question remaining about the mass production of the electric vehicle con- cemed its battery production cost. Costs would need to come down for Tesla’s electric cars to be competitive around the world, where gasoline prices were stable or even declining. Economies of scale would help as production volumes increase, but further advances in engineering also would be essential. With the initial engineering specification, Tesla has designed the powerpacks and their associated circuitry, each of which contains up to 7.000 standard lithium-ion cells of the sort found in laptops. The firm is said to buy more of these sorts of cell than all the world’s computer-makers combined. “Elon Masks Tesla Picks Nevada to Host Battery Gigafacay.” Scientific American, September 5, 2014, “Thiarticle presens varius economic and financial ssc associated with locating the battery plant sn Nevada Some of the performance i rom Tesla Motors Corporation1.3 Large-Seale Engineering Projects 9 Equipment Installation Lunch and Ramp 20s Figure 1.2 Projected Timeline of Tesla’s Gigafactory. Source: “Assault on Batteries.” The Economist, Jane 14,2014, ‘Tesla argues that its battery packs, including their power-management and cooling systems, currently cost less than $300 a kilowatt-hour (kWh) of storage capacity: about half the costs of its rivals. ‘The gigafactory, which will eventually tun out batteries for 500,000 vehicles, should cut their costs by another 30%; two-thirds of that saving will come from scale alone with the rest due to improved manufacturing technology. When costs drop below $200 a kWh, battery-powered cars start to become competitive with conventional ones without govern- ment subsidies. The gigafactory could bring Tesla close to that. ‘What is the Business Risk? Although engineers at Tesla claim that they would be able to cut its current battery costs drastically, many financial analysts are skeptical as raw materials account for 70% of the price of a lithium battery. This would make the scope for savings limited, and even if the factory does tum out many cheap battery cells, that may not be enough. Technically, the key to increasing range and performance is to improve the efficiency, size, and price of the electronics that manage the power, along with overall vehicle weight. Tesla does not have the same advantages in these areas as it has with its batteries. ‘At a cost of $5 billion, which Tesla will share with Panasonic of Japan, its current battery supplier, and other partners, the gigafactory is a big gamble. Also, if electric-car demand stalls, the question is what we do with the huge output of cheap batteries. There is lot of cost that can be removed at larger scales of battery manufacturing, but it’s all about the capacity utilization. A battery plant that is not running will cost Tesla a fortune. Despite Tesla management's decision to build the giant battery factory, the financial analysts were still uncertain whether there would be enough demand. Furthermore, com- petitors, including U.S. automakers, just did not see how Tesla could achieve the econo- mies of scale needed to produce electric cars at a profit. The primary advantage of the design, however, is that the electric vehicle could cut auto pollution to a zero level. This isa feature that could be very appealing ata time when government air-quality standards are becoming more rigorous and consumer interest in the environment is getting strong.10 CHAPTER 1 Engineering Economic Decisions However, in the case of the Tesla products, if a significant reduction in production cost never materializes, demand might remain insufficient to justify the investment in the battery factory. 1.3.2 Impact of Engineering Projects on Financial Statements Engineers must understand the business environment in which a company’s major busi- ness decisions are made. It is important for an engineering project to generate profits, but it also must strengthen the firm’s overall financial position. How do we measure Tesla’s success in the giant battery factory project? Will enough electric car models be sold, for example, to keep the green-engineering business as Tesla’s major source of profits? While the giant battery project would provide revolutionary energy storage system for the company’s customers, the bottom line is its financial performance over the long run. Regardless of a business’ form, each company has to produce basic financial state- ‘ments at the end of each operating cycle (typically a year). These financial statements provide the basis for future investment analysis. In practice, we seldom make investment decisions solely on the basis of an estimate of a project's profitability, because we must also consider the overall impact of the investment on the financial strength and position of the company. ‘Suppose that you were the president of the Tesla Corporation. Suppose further that you even hold some shares in the company, making you one of the company’s many own- ers. What objectives would you set for the company? While all firms are in business in hopes of making a profit, what determines the market value of a company are not profits per se, but cash flow. It is, after all, available cash that determines the future investments and growth of the firm. Therefore, one of your objectives should be to increase the com- pany’s value to its owners (inclading yourself) as much as possible. To some extent, the market price of your company’s stock represents the value of your company. Many factors affect your company’s market value: present and expected future eam- ings, the timing and duration of those earnings, and the risks associated with them. Certainly, any successful investment decision will increase a company’s market value. Stock price can be a good indicator of your company’s financial health, and may also reflect the market's attitude about how well your company is managed for the benefit of its owners, Any successful investment decision on the giant battery factory's scale will tend to increase a firm’s stock prices in the marketplace and promote long-term success. Thus, in ‘making a large-scale engineering project decision, we must consider its possible effect on the firm’s market value. (In Chapter 2, we discuss the financial statements in detail and show how to use them in our investment decision making.) [EJ Common Types of Strategic Engineering Economic Decisions ‘The story of how the Tesla Corporation successfully introduced a new product and became the market leader in the advanced electric car market is typical: Someone had a good idea, executed it well, and obtained good results. Project ideas such as the giant14 Common Types of Strategic Engineering Economic Decisions 11 battery factory can originate from many different levels in an organization. Since some ideas will be good, while others will not, we need to establish procedures for screening projects. ‘Many large companies have a specialized project analysis division that actively searches for new ideas, projects, and ventures. Once project ideas are identified, they are typically classified as (1) equipment or process selection, (2) equipment replace- ment, (3) new product or product expansion, (4) cost reduction, or (5) improvement in service or quality. This classification scheme allows management to address key ques- tions: Can the existing plant, for example, be used to attain the new production levels? Does the firm have the knowledge and skill to undertake the new investment? Does the new proposal warrant the recruitment of new technical personnel? The answers to these questions help firms screen out proposals that are not feasible, given a company's. resources. The giant battery project represents a fairly complex engineering decision that required the approval of top executives and the board of directors. Virtually all big businesses face investment decisions of this magnitude at some time. In general, the larger the investment, the more detailed is the analysis required to support the expendi- ture. For example, expenditures aimed at increasing the output of existing products or at manufacturing a new product would invariably require a very detailed economic justification. Final decisions on new products, as well as marketing decisions, are generally made at a high level within the company. By contrast, a decision to repair damaged equipment can be made at a lower level. The five classifications of project ideas are as follows 1.4.1 Equipment or Process Selection This class of engineering decision problems involves selecting the best course of action ‘out of several that meet a project's requirements. For example, which of several proposed items of equipment shall we purchase for a given purpose? The choice often hinges on which item is expected to generate the largest savings (or the largest retum on the invest- ment). For example, the choice of material will dictate the manufacturing process for the body panels in the automobile. Many factors will affect the ultimate choice of the material, and engineers should consider all major cost elements, such as the cost of machinery and equipment, tooling, labor, and material. Other factors may include press and assembly, production and engineered scrap, the number of dies and tools, and the cycle times for various processes. 1.4.2 Equipment Replacement ‘This category of investment decisions involves considering the expenditure necessary to replace worn-out or obsolete equipment. For example, a company may purchase 10 large presses, expecting them to produce stamped metal parts for 10 years. After five years, however, it may become necessary to produce the parts in plastic, which would require ing the presses early and purchasing plastic molding machines. Similarly, a company may find that, for competitive reasons, larger and more accurate parts are required, making, the purchased machines become obsolete earlier than expected.12. CHAPTER I Engineering Economic Decisions ‘Suppose, for example, that a firm is using a lathe that was purchased 12 years ago to produce pump shafts. As the production engineer in charge of this product. you expect, demand to continue into the foreseeable future. However, the lathe has begun to show its age: Ithas broken frequently during the last two years and has finally stopped operating altogether. Now you have to decide whether to replace or repair it. If you expect a more efficient lathe to be available in the next one or two years, you might repair the old lathe instead of replacing it. The major issue is whether you should make the considerable investment in a new lathe now or later. As an added complication, if demand for your product begins to decline, you may have to conduct an economic analysis to determine whether dectining profits from the project offset the cost of a new lathe. 1.4.3 New Product or Product Expansion Investments in this category increase company revenues if output is increased. One common type of expansion decision includes decisions about expenditures aimed at increasing the output of existing production or distribution facilities. In these situations, we are basically asking, “Shall we build or otherwise acquire a new facility?” The expected future cash inflows in this investment category are the profits from the goods and services produced in the new facility. A second type of expenditure decision includes considering expenditures necessary to produce a new product or to expand into a new geographic area. ‘These projects normally require large sums of money over long periods 1.4.4 Cost Reduction A cost-reduction project is a project that attempts to lower a firm’s operating costs. Typically, we need to consider whether a company should buy equipment to perform an operation currently done manually or spend money now in order to save more money later. The expected future cash inflows on this investment are savings resulting from lower operating costs. 1.4.5. Improvement in Service or Quality Most of the examples in the previous sections were related to economic decisions in the ‘manufacturing sector. The decision techniques we develop in this book are also applicable to various economic decisions related to improving services or quality of product. We will provide several economic decision problems from the service sector throughout the text [I Fundamental Principles of Engineering Economics This book is focused on the principles and procedures engineers use to maike sound eco- nomic decisions. To the first-time student of engineering economics, anything related to ‘money matters may seem quite strange when compared to other engineering subjects, However, the decision logic involved in solving problems in this domain is quite similar to that employed in any other engineering subject. There are fundamental principles to follow in engineering economics that unite the concepts and techniques presented in this text, thereby allowing us to focus on the logic underlying the practice of engineering economics.1.5 Fundamental Principles of Engineering Economics + Principle 1: A dollar earned today is worth more than a dollar earned in the future. A fundamental concept in engineering economics is that money has a time value associated with it (Figure 1.3). Because we can eam interest on money received today, itis better to receive money earlier than later. This concept will be the basic foundation for all engineering project evaluation. Ifyou reecive $100 now, you can invest it and have ‘more money available six months from now S100 > Baring opportunity Sixmontts ater Figure 1.3 Time value of money. + Principle 2; All that counts are the differences among alternatives. An eco- nomic decision should be based on the differences among the altematives considered (Figure 1.4). All that is common is irrelevant to the decision. Certainly, any economic decision is no better than the alternatives being considered. Thus, an economic deci- sion should be based on the objective of making the best use of limited resources. Whenever a choice is made, something is given up. The opportunity cost of a choice is the value of the best alternative given up. Comparing Buy versus Lease Whatever you decide, you need to spend the same amount of money on fuel and maintenance Buy $960 $550 $6,500 $350 $9,000 Lease $960 $550 $2400 $550 ° * ‘rrelevant items in decision making Figure 1.4 Differential analysis. + Principle 3: Marginal revenue must exceed marginal cost. Effective decision making requires comparing the additional costs of alternatives with the additional benefits (Figure 1.5). Each decision alternative must be justified on its own economic merits before being compared with other alternatives. Any increased economic activ- ity must be justified on the basis of the fundamental economic principle that marginal