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Table of contents:
PART 1 UNDERSTANDING MONEY AND ITS
MANAGEMENT 1
Chapter 1 Engineering Economic Decisions 2
1.1 The Rational-Decision-Making Process 4
1.1.1 How Do We Make Typical Personal Decisions? 4
1.1.2 How Do We Approach an Engineering Design Problem? 7
1.1.3 What Makes Economic Decisions Different from Other Design
Decisions? 10
1.2 The Engineer’s Role in Business 10
1.2.1 Making Capital-Expenditure Decisions 10
1.2.2 Large-Scale Engineering Economic Decisions 11
1.2.3 Impact of Engineering Projects on Financial Statements 13
1.3 Types of Strategic Engineering Economic Decisions 14
1.4 Fundamental Principles in Engineering Economics 18
Summary 19
Chapter 2 Time Value of Money 20
2.1 Interest: The Cost of Money 22
2.1.1 The Time Value of Money 22
2.1.2 Elements of Transactions Involving Interest 24
2.1.3 Methods of Calculating Interest 26
2.2 Economic Equivalence 28
2.2.1 Definition and Simple Calculations 28
2.2.2 Equivalence Calculations Require a Common Time
Basis for Comparison 31
2.3 Interest Formulas for Single Cash Flows 33
2.3.1 Compound-Amount Factor 33
2.3.2 Present-Worth Factor 35
2.3.3 Solving for Time and Interest Rates 38
2.4 Uneven-Payment Series 40
2.5 Equal-Payment Series 42
2.5.1 Compound-Amount Factor: Find F, Given A, i, and N 43
2.5.2 Sinking-Fund Factor: Find A, Given F, i, and N 47
2.5.3 Capital-Recovery Factor (Annuity Factor): Find A, Given P, i and N 49
2.5.4 Present-Worth Factor: Find P, Given A, i, and N 52
2.5.5 Present Value of Perpetuities 57
2.6 Dealing with Gradient Series 57
2.6.1 Handling Linear Gradient Series 58
2.6.2 Handling Geometric Gradient Series 64
2.7 Composite Cash Flows 68
Summary 72
Problems 73
Chapter 3 Understanding Money Management 86
3.1 Market Interest Rates 87
3.1.1 Nominal Interest Rates 88
3.1.2 Annual Effective Yields 88
3.2 Calculating Effective Interest Rates Based on Payment Periods 91
3.2.1 Discrete Compounding 91
3.2.2 Continuous Compounding 92
3.3 Equivalence Calculations with Effective Interest Rates 94
3.3.1 Compounding Period Equal to Payment Period 94
3.3.2 Compounding Occurs at a Different Rate than That at Which Payments
Are Made 97
3.4 Debt Management 100
3.4.1 Borrowing with Credit Cards 100
3.4.2 Commercial Loans–Calculating Principal and Interest Payments 102
3.4.3 Comparing Different Financing Options 106
Summary 111
Problems 111
Chapter 4 Equivalence Calculations under Inflation 126
4.1 Measure of Inflation 127
4.1.1 Consumer Price Index 128
4.1.2 Producer Price Index 129
4.1.3 Average Inflation Rate (f) 130
4.1.4 General Inflation Rate (f) versus Specific Inflation (fj) 132
4.2 Actual versus Constant Dollars 134
4.2.1 Conversion from Constant to Actual Dollars 135
4.2.2 Conversion from Actual to Constant Dollars 136
4.3 Equivalence Calculations under Inflation 1404.3.1 Market and Inflation-Free Interest Rates 141
4.3.2 Constant-Dollar Analysis 141
4.3.3 Actual-Dollar Analysis 141
4.3.4 Mixed-Dollar Analysis 146
Summary 149
Problems 150
PART 2 EVALUATIING BUSIINESS AND ENGIINEERIING
ASSETS 159
Chapter 5 Present-Worth Analysis 160
5.1 Loan versus Project Cash Flows 162
5.2 Initial Project Screening Methods 163
5.2.1 Benefits and Flaws of Payback Screening 166
5.2.2 Discounted-Payback Period 167
5.3 Present-Worth Analysis 168
5.3.1 Net-Present-Worth Criterion 168
5.3.2 Guidelines for Selecting a MARR 172
5.3.3 Meaning of Net Present Worth 175
5.3.4 Net Future Worth and Project Balance Diagram 177
5.3.5 Capitalized-Equivalent Method 180
5.4 Methods to Compare Mutually Exclusive Alternatives 182
5.4.1 Doing Nothing Is a Decision Option 182
5.4.2 Service Projects versus Revenue Projects 183
5.4.3 Analysis Period Equals Project Lives 184
5.4.4 Analysis Period Differs from Project Lives 186
Summary 192
Problems 192
Chapter 6 Annual Equivalence Analysis 208
6.1 Annual Equivalent Worth Criterion 210
6.1.1 Benefits of AE Analysis 214
6.1.2 Capital (Ownership) Costs versus Operating Costs 214
6.2 Applying Annual-Worth Analysis 218
6.2.1 Unit-Profit or Unit-Cost Calculation 218
6.2.2 Make-or-Buy Decision 221
6.3 Comparing Mutually Exclusive Projects 224
6.3.1 Analysis Period Equals Project Lives 224
6.3.2 Analysis Period Differs from Project Lives 229
Summary 232
Problems 232
Chapter 7 Rate-of-Return Analysis 248
7.1 Rate of Return 250
7.1.1 Return on Investment 250
7.1.2 Return on Invested Capital 251
7.2 Methods for Finding Rate of Return 252
7.2.1 Simple versus Nonsimple Investments 252
7.2.2 Computational Methods 254
7.3 Internal-Rate-of-Return Criterion 260
7.3.1 Relationship to the PW Analysis 260
7.3.2 Decision Rule for Simple Investments 261
7.3.3 Decision Rule for Nonsimple Investments 265
7.4 Incremental Analysis for Comparing Mutually Exclusive Alternatives 267
7.4.1 Flaws in Project Ranking by IRR 267
7.4.2 Incremental-Investment Analysis 268
7.4.3 Handling Unequal Service Lives 274
Summary 276
Problems 277
Chapter 7A Resolution of Multiple Rates of Return 292
7A-1 Net-Investment Test 292
7A-2 The Need for an External Interest Rate 294
7A-3 Calculation of Return on Invested Capital for Mixed Investments 295
PART 3 DEVELOPMENT OF PROJECT CASH FLOWS 301
Chapter 8 Accounting for Depreciation and Income Taxes 302
8.1 Accounting Depreciation 304
8.1.1 Depreciable Property 304
8.1.2 Cost Basis 304
8.1.3 Useful Life and Salvage Value 305
8.1.4 Depreciation Methods: Book and Tax Depreciation 307
8.2 Book Depreciation Methods 307
8.2.1 Straight-Line Method 308
8.2.2 Declining-Balance Method 309
8.2.3 Units-of-Production Method 314
8.3 Tax Depreciation Methods 315
8.3.1 MACRS Recovery Periods 316
8.3.2 MACRS Depreciation: Personal Property 317
8.3.3 MACRS Depreciation: Real Property 321
8.4 How to Determine “Accounting Profit” 323
8.4.1 Treatment of Depreciation Expenses 323
8.4.2 Calculation of Net Income 323
8.4.3 Operating Cash Flow versus Net Income 326
8.5 Corporate Taxes 329
8.5.1 Income Taxes on Operating Income 329
8.5.2 Gain Taxes on Asset Disposals 331
Summary 334
Problems 336
Chapter 9 Project Cash-Flow Analysis 346
9.1 Understanding Project Cost Elements 348
9.1.1 Classifying Costs for Manufacturing Environments 348
9.1.2 Classifying Costs for Financial Statements 349
9.1.3 Classifying Costs for Predicting Cost Behavior 351
9.2 Why Do We Need to Use Cash Flows in Economic Analysis? 355
9.3 Income-Tax Rate to Be Used in Project Evaluation 356
9.4 Incremental Cash Flows from Undertaking a Project 358
9.4.1 Operating Activities 358
9.4.2 Investing Activities 358
9.4.3 Financing Activities 359
9.5 Developing Project Cash Flow Statements 359
9.5.1 When Projects Require Only Operating and Investing Activities 360
9.5.2 When Projects Are Financed with Borrowed Funds 364
9.6 Effects of Inflation on Project Cash Flows 366
9.6.1 Depreciation Allowance under Inflation 366
9.6.2 Handling Multiple Inflation Rates 370
9.7 Discount Rate to Be Used in After-Tax Economic Analysis: Cost of Capital 371
9.7.1 Cost of Equity 372
9.7.2 Cost of Debt 374
9.7.3 Calculating the Cost of Capital 375
9.7.4 Choice of a MARR in After-Tax Cash Flow Analysis 377
Summary 378
Problems 379
Chapter 10 Handling Project Uncertainty 398
10.1 Origins of Project Risk 400
10.2 Methods of Describing Project Risk 401
10.2.1 Sensitivity Analysis 401
10.2.2 Sensitivity Analysis for Mutually Exclusive Alternatives 405
10.2.3 Break-Even Analysis 408
10.2.4 Scenario Analysis 410
10.3 Including Risk in Investment Evaluation 412
10.3.1 Probabilistic Approach 413
10.3.2 Risk-Adjusted Discount Rate Approach 422
10.4 Investment Strategies under Uncertainty 423
10.4.1 Trade-Off between Risk and Reward 423
10.4.2 Broader Diversification Reduces Risk 424
10.4.3 Broader Diversification Increases Expected Return 424
Summary 427
Problems 428
PART 4 SPECIIAL TOPIICS IIN ENGIINEERIING
ECONOMIICS 443
Chapter 11 Replacement Decisions 444
11.1 Replacement-Analysis Fundamentals 446
11.1.1 Basic Concepts and Terminology 446
11.1.2 Approaches for Comparing Defender and Challenger 449
11.2 Economic Service Life 453
11.3 Replacement Analysis when the Required Service Period Is Long 458
11.3.1 Required Assumptions and Decision Frameworks 458
11.3.2 Handling Unequal Service Life Problems in Replacement Analysis 459
11.3.2 Replacement Strategies under the Infinite Planning Horizon 460
11.4 Replacement Analysis with Tax Considerations 466
Summary 473
Problems 474
Chapter 12 Benefit—Cost Analysis 488
12.1 Evaluation of Public Projects 490
12.1.1 Valuation of Benefits and Costs 491
12.1.2 Users’ Benefits 491
12.1.3 Sponsor’s Costs 492
12.1.4 Social Discount Rate 492
12.2 Benefit—Cost Analysis 494
12.2.1 Definition of Benefit—Cost Ratio 494
12.2.2 Incremental B/C-Ratio Analysis 496
12.3 Case Study–Highway Benefit—Cost Analysis by the State of Minnesota 500
12.3.1 Define the Base Case and the Proposed Alternatives 501
12.3.2 Highway User Benefits 501
12.3.3 Sponsors’ Costs 502
12.3.4 Illustrating Case Example 502
Summary 508
Problems 509
Chapter 13 Understanding Financial Statements 516
13.1 Accounting: The Basis of Decision Making 518
13.2 Financial Status for Businesses 519
13.2.1 The Balance Sheet 521
13.2.2 The Income Statement 525
13.2.3 The Cash-Flow Statement 528
13.3 Using Ratios to Make Business Decisions 532
13.3.1 Debt Management Analysis 533
13.3.2 Liquidity Analysis 534
13.3.3 Asset Management Analysis 535
13.3.4 Profitability Analysis 537
13.3.5 Market-Value Analysis 538
13.3.6 Limitations of Financial Ratios in Business Decisions 540
13.3.7 Where We Get the Most Up-to-Date Financial Information 540
Summary 540
Problems
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