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Engineering Economics Exam 2 Review

This review covers cash flow diagrams, net present worth, equivalent annual worth, perpetuity, bonds, internal rate of return, and incremental analysis. Includes important concepts, criteria, and strategies for comparing projects and prioritizing investments.

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Engineering Economics Exam 2 Review

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  1. Engineering Economics Exam 2 Review

  2. CASH FLOW DIAGRAM Yes -- you do need the Sticks!!

  3. Net Present Worth Review • NPW can compare mutually exclusive projects or prioritize investments (using Incremental Analysis) • Criteria: Choose highest NPW • NPW > 0 means that project beats the MARR • Project Life equality is an issue: • If projects are repeatable, use LCM: • Combine cycles into one, big CFD and analyze (Civil E method works, but is time consuming) • Analyze one cycle, then create & analyze simplified (repeated life) CFD • Study period is an alternative if specified: • Requires that salvage value function is known

  4. Equivalent Annual Worth Review • EAW can compare mutually exclusive projects or prioritize investments (using Incremental Analysis) • Criteria: Choose highest EAW (lowest EAC) • EAW > 0 means that project beats the MARR • Project Life equality is NOT an issue: • Compare on same payment frequency, though: • Move non-annual flows to present / future, then annualize (NOT average!) over project life • Can use Opportunity Cost formulation to simplify capital equipment: (P – S)(A/P,i,n) – S(i) • IMPORTANT: • Land does not change in value (pt in 3-D space)

  5. Perpetuity Review • Perpetuity (Capitalized Cost) is used to fund projects that will “last forever” • Relationship: can live off of the period’s interest, but can’t touch account principle: A = P(i) • Steps: • Separate non-recurring cash flows from the recurring flows, then calculate CCNR: • Find net present value of all non-recurring flows • For all the recurring flows, calculate CCR: • Find annual equivalent of one cycle of each recurring flow, then combine to find net annual • Use perpetuity relationship to find present value of the net annual equivalent • Total capitalized cost is: CCT = CCNR + CCR

  6. Bonds Review • Bonds are used to acquire start-up capital early on, but wait to pay back the bulk of the borrowing until the production cash flow is realized (interest-only loan) • Basically reusing two concepts: • Solving CFD and finding Effective Interest Rates • Use Bond Cash Flow Diagram to solve: • Translate Bond Terminology to CFD • Find ib and Dividend to flesh out the CFD • Solve CFD for unknown Price / Yield to Maturity • Annual Yield: ia = (1 + i)m – 1 • Yield to Maturity is i*, such that NPWBOND CFD = 0 • Watch for Sunk Costs Trick: • Only worry about remaining cash flows!

  7. Internal Rate of Return Review • IRR can compare mutually exclusive projects or prioritize investments - MUST USE Incremental Analysis • Criteria: Choose IRR that is greater than MARR • IRR > 0 means that project makes money, but not necessarily better than the safe investment rate • Concepts: • IRR is the interest rate (i*), such that NPW = 0 • Note: Can only have one sign change in net CFD, otherwise there are multiple IRRs! • Strategies: • If only one table factor in CFD equation, solve for it and use tables to find approximate IRR • If more than one table factor involved, use divide & conquer to find approximate IRR using tables • Use spreadsheet and P/F or P/A factors if large problem

  8. Incremental Analysis Review • Incremental Analysis can be used to prioritize investments (using NPW, EAW, or even NFW), but it MUST be used when comparing relative measures (IRR or Cost/Benefit Ratio) • Caution: Equal lifetime issues (NPW and IRR) • Steps: • Order projects by increasing first costs • Find first feasible project – becomes current best • Compare with Doing Nothing if that is an option • If a Revenue Project, IRR > MARR (worth > 0) • Pairwise Comparison on Incremental Cash Flow • If > 0 (IRR > MARR), then higher cost is better • If ≤ 0 (IRR ≤ MARR), then lower cost is better • Compare feasible options, & compare in–order!

  9. Incremental Analysis Review • Incremental Analysis comparison is like a single playoff tournament: • Seed the contenders on first costs, larger cost get byes • Only have to win incremental game to move on • Worthincr> $0 or if IRRincr > MARR  higher cost wins • Worthincr ≤ $0 or if IRRincr ≤ MARR  current best wins • Last one unbeaten is best choice • Start over with beaten contenders to find next best, etc. Do Nothing Low $ Contender Mid $ Contender High $ Contender

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