Midterm Exam Collective Flashcards
1
Q
Dimensions of Engineering Economic Analysis
A
- Financial Dimension
-Technical Dimension - Macro-economic dimension
-Ethical Dimension - Environmental Dimension
- Social Dimension
2
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Financial Dimension Considerations
A
-Direct Costs
-Indirect Costs
-Opportunity Costs
- Capital Costs
- Operating Costs
-End of Life Costs
3
Q
What to do with solutions that are not technically viable
A
They should not be considered during economic analysis. Vetting solutions for technical viability before preforming economic analysis prevents wasted effort to gather engineering economic data for infeasible solutions
4
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Technical Dimension
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Solutions likely differ in terms of technical performance- ideally captured in financial terms.
- reduced operating costs due to less maintenance
- reduced operating costs due to energy consumption
-increased sales from improved performance
5
Q
Macro-economic Dimension
A
- Availability if scarce skills or resources that may be required
- Expected shifts in demand for specific products
- The impact of new competitors that are expected to enter the market or that are artificially prevented from entering the market as a result of geopolitical factors
6
Q
Ethical Dimension
A
Globalization brings many ethical questions:
- protecting workers health and safety
-government oversight in different countries of operation
- safety vs affordability
- material toxicity
7
Q
A
8
Q
Whats the most important thing you want from a supervisor? According to recent graduates
A
Mentoring and the opportunity to learn and progress
9
Q
What is the most important thing you want from a supervisor? According to experienced employees
A
Integrity
10
Q
Environmental dimension
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- environment and ethincally intertwined questions such as protecting fragile habitats vs infrastructure protection
- carbon emissions
-solutions aversion to weather
-sustainability of material
-energy efficiency
-durability and longevity
11
Q
A
12
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Social dimension
A
-often intertwined ethically
- impact on alternatives on the quality of life of employees/community
- impact on alternative social issues
13
Q
Commonly used symbols:
t
A
=time usually in periods such as years or months
14
Q
Commonly used symbols
P
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= present value of money at time t designates as the present time
15
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Commonly used symbols:
F
A
= value of money at some future time, such as at t = n periods in the future
16
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Common used symbols:
A
A
Series of consecutive equal end if period amounts of money
17
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Commonly used symbols:
n
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Number of interest periods. In either months or years depending on how the interest rate is defined
18
Q
Commonly used symbols:
i
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Interest rate or rate of return per time period. Either in percent per year, or percent per month
19
Q
Cash flow diagrams
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A graphical representation with cash flow on the vertical axis and time on the horizontal axis
20
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Cash inflows
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Revenues(R), receipts, incomes, savings generated by projects and activities that flow in. (+)
21
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Net cash flow
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NCF = cash inflows - cash outflows
= R -D
22
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Cash outflows
A
Disbursements (D), costs, expenses, taxes caused by projects and activities that flow out. (-)
23
Q
How many perspectives can cash flows have?
A
They can have only one. From yours or someone elses
24
Q
End of period convention in cash flow
A
Commonly used in cash flow diagrams. It places all amounts at the end of the period in question
25
Point estimates
A single value estimate of a cash flow element
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Range estimate
A range estimate of a cash flow element.
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Applications of point vs range estimates
Though point estimates are commonly used, range estimates(with probabilities assigned) provide more insight into the risk and range of possible outcomes
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Factors that contribute to the time value of money
Inflation and purchasing power
Interest, interest rate and rate of return
- simple vs compound interest
Economic equivalence
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Inflation
Measures how much more expensive a good a set of goods or services has become over a certain period, usually a year.
* A measure in the change of purchasing power
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How does inflation change loans and investments
As inflation in increases, interest rates on loans increase. Rate of return of investments decrease
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Interest rates
A fee that is paid to use someone elses money.
Interest = amount owed now - principal
Interest rate (%) = interest accrued per time unit/ principal * 100
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Rate of return
A fee that is earned for letting someone else use your money
Return = amount owed now - principal
Rate of return (%)= interest accrued per time unit/ original amount *100
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Simple interest
Interest calculated on principal only
Interest = (principal)(number of periods)(interest rate)
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Compount interest
Interest is based on principal plus all accrued interest.
Interest earns interest and compounds over time.
Interest= (principal + all accrued interest)(interest rate)
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What should you assume interest to be
Always assume compounding interest
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Economic equivalence
Different sums of money at different times may be equal in economic value at a given time based on:
-interest rate/rate of return and or
-time value of money
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Equity Financing
Funds from retained earnings, new stock issues or owners infusion of money.
The funds are expected to yield a return
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Debt financing
Borrowed funds from outside sources- loans bonds, mortgages, venture capital pools
Interest is paid to the lender of these funds
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Pooled financing
Combination of equity and debt financing. Pooled financing results in an average cost of capital
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Weighted average cost of capital (WACC)
The weighted average cost of the different sources of capital being used to fund a project
WACC = (fraction of debt capital)(cost of debt capital) + (fraction of equity capital)(cost of equity capital)
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Minimum attractive rate of return
MARR is a reasonable rate of return (percent) established for evaluating and selecting alternatives.
An investment is justified if is meets the MARR. Also termed hurdle rate, benchmark rate and cut iff rate
Established by financial managers, takes into account risk. Higher risk higher MARR
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Types of cost
Fixed, variable, marginal and average costs
Sunk costs
Opportunity costs
Recurring and non recurring costs
Incremental costs
Cash costs versus book costs
Lifecycle costs
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Fixed costs
Dont change in line with the level of output or activity
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Variable costs
Change in line with the level of output or activity
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Marginal cost
Variable cost per unit of production
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Average cost
Total cost divided by number of units produced
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Sunk costs
Money already spent as a result of a decision that was made in the past. Should be disregarded in decision making
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Opportunity cost
Using resources for one project prevents us from using them for another or investing them
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Recurring and non recurring costs
Recurring costs are anticipated and occur at predictable intervals
Non recurring costs are adhoc expenses
51
Incremental costs
Represent the difference between two alternative options
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Cash costs vs book costs
Cash costs: money moves from your company yo another companys account
Book costs: money does not move from your companys account but costs are recorded in your accounting records
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Life cycle costs
The cost over the full life cycle of a product/project
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F/P
F = P(1+i)^n
(1+i)^n is the single payment compound amount factor.
Referred to as F/P factor
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P/F
P = F(1+i)^-n
(1+ i)^-n is called the single payment present worth factor.
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Uniform Series: A series and P
Cash flow occurs in consecutive periods starting one year after P. Cash flow is the same in each period.
Two forms: a given find p, p given find A
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A is given find P formula
P = A ( ((1+i)^n -1)/(i(1+i)^n))
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P is given find A
A = P( i(1+i)^n/(1+i)^n-1)
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Uniform series A and F
Cash flow ooccur in consecutive periods ending in the same period as F.
Cash flow amount is same in each period.
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F ig given find A formula
A = F( i/((1+i)^n -1)
Sinking fund factor
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A is given find F formula
Uniform series compound amount factor.
F= A((1+i)^n-1)/i)
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Series with an arithmetic gradient
Arithmetic gradients change by the same amount G each period.
When no base amount is present, convert the series to Pg to obtain the present worth. Ph is located two periods ahead of the first G
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G is given find P formula
Pg = (G) ((1+i)^n-i*n-1)/(i^2(1+i)^n)
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Arithmetic gradient with base amount present
When a base amount is present, break into two parts:
- the base amount forms uniform series and is converted to Pa
- This leaves a series with an arithmetic gradient which is converted to Pg
Pt = Pa + Pg
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Gradient uniform series (A/G) factor
Converts a series with an arithmetic gradient to a series with uniform values.
A/G = 1/i - n/(1+i)^n -1
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Geometic gradient
Series increasing at an increasing rate. Change at the same percentage g each period.
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Shifted series
Series that starts in a year later than 1. Combine methods to account for extra yrs
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Compounding Period
The time over which compounding is applied
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Payment period
Time period between cash flows.
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Commonly used symbols: interest rates
r = nominal interest rate per year (or per period t)
Aka annual percentage rate
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Commonly used symbols: interest rates
CP
Time period for each compounding
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Commonly used symbols: Onterest rates
m
Number of compounding periods per yr (or period t)
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Commonly ised symbols: interest rates
i
Effective interest rate per compounding period
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ia = effective interest rate per year
APY annual percentage yield
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Commonly used symbols: interest rates
PP= payment period. Ie time period between cash flows
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Effective interest rate formula
To convert nominal to effective rates:
i = (1+ r/m)^m-1
i = effective interest rate
r = nominal rate for some period
m = number times interest is compounded in period specified for i
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Continuous compounding
As compounding becomes more frequent CP becomes infinitely small.
Then m increases and interest is compounded continuously
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Effective continuous interest rate
i = e^r -1
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Varying interest rates
Vary over time. To find P, use the interest rates associated with the respective time period. When interest rates vary you can assume annual compounding
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Inflation symbols
CV
Constant value dollars. Money at today’s value.
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Inflation symbols
F
Inflated a.k.a. future dollars. Money at a future value based on the inflation rate.
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Inflation rate terms
f
Inflation rate
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Inflation compounding formula
f = (F/CV)^1/n -1
Or
F = CV(1+f)^n
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Actual percent increase
Actual % increase = ((1+f)^n-1)*100
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Inflation symbols
i_f
Market rate or inflation adjusted rate. Combination of i and f.
I_f = i+f + i*f
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Knowing when to use it and when to use i_f
The key to determine whether the future cash flows in the analysis have been defined in CV dollars or F dollars. If the value is an F dollars this amount includes the effects of inflation. That’s when we want to determine the present worth we use i_f. Otherwise, when using CV dollars you just want to use i
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The first way FW can be interpreted
The amount of future dollars required to maintain the same purchasing power as dollars today. No time value of money is included.
- use f in F/P factor: FW = PW(F/P,f,n)
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The second way FW can be interpreted
Amount required to maintain purchasing power of the present sum and earn at a market rate.
- use i_f in F/P factor: FW=Pw(F/P,i_f,n)
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The third way FW can be interpreted
Amount required in terms of CV dollars to maintain purchasing power for a future amount.
- use i_f in F/P factor then convert Fw to CV: FW= (F/P, i_f, n)/(1+f)^n
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Special case of a W. Recovery component to maintain purchasing power.
When calculating the capital recovery component of an AW calculation, the capital expenditure today must be recovered. Using future inflated dollars. One inflation is present. These dollars will have less buying power than the first cost that is spent today. This can be incorporated into an AW calculation by the following two steps.
1) convert the first cost to FW using only inflation f
2) spread this across the study. Using theA/F factor, and the market interest rate i_f
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Taxes
Governments primary source of revenue. From the perspective of Engineering economic analysis, where we are trying to choose between alternative course of action, it is important to understand how to appreciation works, as this can influence the taxes that are payable. This can contribute to making one alternative more attractive than another one after tax cash flows are considered.
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Taxes and or incentives
Mechanism to nudge behavior.
From the perspective of Engineering economic analysis, it’s important to be aware that incentives such as preferential tax rates, maybe used in an effort to make one alternative more financially attractive than another where preferential tax rates / incentives are driving the differing financial performance of alternatives. This will only become evident when after tax cash flows are considered.
96
Depreciation
Is an accounting method that allows a company to spread the cost of an asset overtime. Thus if an asset is purchased today, the cost of that asset can be spread over several years so that it reduces the taxable income of the organization over several years. Depreciation does not result in cash flowing from one entity to another, however, because it reduces the taxable income of an organization. It has an influence on the cash flow.
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Depreciation approaches
Several depreciation approaches exist, including:
- straight-line depreciation (simplest)
-Declining balance/double declining balance.
- CCA (capital cost allowance)
— the approach must be used to include a depreciation in tax returns that are filed with the Canadian revenue agency.
- modified accelerated cost recovery system (MACRS)
— the approach that must be used to include the depreciation in tax returns that are filed by the Us based organization
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What are the learning outcomes related to depreciation?
1) be aware that depreciation exists, be able to define the concept of depreciation, have a general understanding of its applicability, and explain its impact on cash flows.
2) apply straight line depreciation, and a basic ability to apply CCA depreciation
3) have a basic understanding of how to incorporate CCA depreciation to calculate an after tax cash flow
4) understand when the most responsible course of action is to consult attack specialist
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Depreciation terminology:
First cost P or unadjusted basis B
Total delivered and installed cost of asset
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Depreciation terminology:
Recovery period n
Depreciable life of asset and years. Book and tax depreciation may have different n values.
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Depreciation terminology:
Book value BV_t
Remaining underappreciated capital investment on the books in year t, where t = 1,2,…n
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Depreciation terminology
Depreciation D_t
Annual amount of assets value to be written off
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Depreciation terminology:
Market value MV
Amount realized if assets were sold on open market
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Depreciation terminology
Salvage value S
Estimated trade-in or MV at end of assets useful life n.
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Depreciation terminology
Depreciation rate d_t
Fraction of first cost removed each year t
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Straight line depreciation
With a straight line approach the book value BV_t and the asset decreases linearly with time t:
- the straight line runs from the B to S. B is equal to unadjusted basis the equivalent of the first cost that we have seen an engineering economic models up to this point.
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Depreciation rate in straight line depreciation
That depreciation rate d_t is constant at d=1/n.
D_t = (B-S)d_t
BV_t = B-tD_t
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Cost allowance. Tax depreciation for Canada.
Canadian income tax, law permits, corporations to depreciate most physical capital assets by the declining balance method at a rate specified in the tax legislation. Our focus is on incorporating CCA in the two engineering economic analysis to achieve a sufficiently accurate comparison of alternatives/evaluations of projects.
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CCA depreciation
CCA for yr 1: CCA = P(d/2)
CCA for all subsequent yrs: CCA_n = P(d) (1-d/2)(1-d)^n-2
Remaining book value in years n:
BV_n = P(1-d/2)(1-d)^n-1
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CCAs impact on cash flow
CCA is not a cash flow, it is a calculation that happens in an accounting system. However, it influences the cash flow indirectly. CCA reduces the taxable income a year. The company therefore pays less tax than it would have paid if CCA had not been present. The CCA itself does not include a cash flow diagram. To obtain an after tax cash flow that includes the effects of CCA, tax factors is used
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Capital Tax factor
Capital tax factor is used to include the effect of CCA on the after tax cash flow. With the CCA method depreciation of the assets continues indefinitely with the CCA amount becoming smaller and smaller as time passes. We can define a series in such a way that each term represents the tax credit, resulting from the application of the CCA worked back to the present moment.
PW = d/2 Pt/(1+i) + (1-d/2)DPt/(1+i)^2 +…
We can calculate the sum of the series to arrive at a capital tax factor
PW = P( 1- (td/i+d)(1+i/2/1+i) )
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Capital salvage factor
The capital salvage factor is used to include the effects of CCA on the after tax cash flow when an asset is sold. Following the same pattern of logic that we used when deriving the capital tax factor we can derive the capital salvage factor:
PW= S(1-(td/i+d))
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Formulating viable alternatives
Evaluation and selection of economic proposals require cash, full estimates over a stated period of time. Some proposals are viable from technological, economic, and or legal perspective. Others are not viable. Economic evaluation is one of the primary means used to select the best alternatives for implementation.
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The two types of economic proposals
Mutually exclusive alternatives and independent projects
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Mutually exclusive alternatives
Each viable proposal is called an alternative. Only one alternative can be selected. These alternatives compete against each other.
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Independent project
Each Bible proposal is called a project. More than one can be selected. These projects do not compete against each other however, a budget limitation may restrict selection.
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Two types of cash flow estimates
Revenue estimate and cost estimate
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Revenue estimate
Alternatives include estimates of costs, cash, outflows, and revenues, cash inflows
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Cost estimates
The alternative includes only costs revenues, and savings are assumed to be equal for all alternatives
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Parameters commonly estimated
P- 1st cost
n- expected life
i- effective interest rate or rate of return
s- salvage value of MV- market value
AOC- annual operating costs or M&O maintenance, and operating costs
Major upgrade or rework cost
121
Analyzing different life alternatives
Often alternative options that are being evaluated have different expected periods of service a.k.a. different lives. In order for I like to like comparison alternatives need to be compared over the same period of service. This can be achieved by taking one of two approaches when performing the analysis. Least common multiples of lives approach or specified study. Period approachnormally least common multiple is always
122
Least common multiple of lives approach
Assumptions:
Service provided is needed over the LCM or more years. Selected alternatives can be repeated over each lifecycle of LCM and exactly the same manner. Cash flow estimates are the same for each life cycle.
Procedure:
First cost is reinvested at beginning of each life cycle salvage value as accounted for at end of each cycle
Select the alternative with the numeric largest present worth value
123
Specified study period approach
Procedure:
What’s the study? Period and is specified all cash flows after year and are ignored. Savage value is the estimated market value MV at the end of the study..
Selection : select alternative with numerically largest present worth value
124
Analyzing using the future worth approach
Conceptually identical to those that use the present approach.
Again alternatives need to be compared to over an equal period of service and the LCM or specified study. Period. Approach can be used to compare alternatives with different lifespans.
125
Analyzing alternatives with very long period of service
Sometimes alternatives have very long expected period of service the present worth of an alternative for a very long infinite service. Period is called the capitalized cost if we set n = infinity we can adjust for the P/A factor to calculate the Cost instead
CC = A/i
126
Annual worth analysis
Will always result in the same alternative/project being selected as PW/FW LCM based analyses. But it simplifies the comparison of alternatives with different periods of service. The AW always remains constant, regardless over how many life cycles its calculated.
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Annual worth analysis assumptions
The following assumptions underpin AW analyses:
-the alternatives are required for at least the LCM
- any alternative with a life cycle < LCM will be repeated for successive periods
128
Annual worth analyses: synonyms
AW analyses are also called Equivalent annual worth and annual equivalent
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Related analyses to annual worth analyses
Equivalent annual cost
Equivalent uniform annual cost
Equivalent uniform annual benefit
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Annual worth analysis calculations
Two components.
Capital recovery (CR) = -P(A/P, i%,n) + S(A/F, i%, n)
Annual Amount (A)- consists of AOC and M&O as applicable
131
Annual worth analysis on very ling infinite life cycles.
A= Pi
132
Life Cycle Cost Analysis
LCC analysis includes all costs for entire life span
133
Return on investment (ROI)
Represents an alternative approach to comparing alternatives and can be used instead of other approaches. However conclusions may be different from other methods. It is not recorded as the primary basis for decision making
134
Rate of return
The rate paid on the unpaid balance of borrowed money.
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Internal rate of return (iror)
The interest rate (i*) that makes the PW/AW/FW of a cash flow series
136
Cases that yeild multiple i values
The cash flow in the previous example changed significantly more than once. This is non conventional cash flow
137
Finding i* for non conventional cash flows
If two i values are determined based onky on the cash flows then
Both i* <0 discard both values
Both i* > 0 Discard both values
One i* >0 one i*<0 use i* as ROR
138
Finding i* for non conventional cash flows
Modified ROR approach: additional inputs eatimated investment rate(applied positive cash flows and borrowing rates applied to all negative cash flows.
Return of invested capital approach
139
Using ROR
ROR assumes that any net positive cash flows are reinvested at i*.
The calculation of i* is more labour intensive than the calculation of PW/CC/AW/FW.
Can yeild multiple i* bvalues
In some cases IROR does jot lead to a useable i* and it is then necessary to resort to EROR
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Incremental cash flow
The difference in cash for every year in our evaluation period.
141
Incremental cash flow formula
Incremental cash flow = cash flow_larger initial investment - cashflow_smaller initial investment
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Incremental ROR analysis: More than two alternatives
1) order alternatives from smallest to largest initial investment
2) revenue alternatives: calc i* of actual CF and eliminate all with i* = MARR eliminate defender, challenger defender remains.
6) repeat steps 3- 5 until 1 alternative remains
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When all future cash flows are expressed in then current dollars the rate should be used to find the present worth is the
Inflated interest rate
145
When the market interest rate is less than the real interest rate, then:
A deflationary condition exists
146
Alternative A has a rate of return of 14% and alternative B has a rate of return of 17%. If the investment required in B is larger than that required for A the rate of return on the increment of investment between A and B is
Larger than 17%
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When comparing two mutually exclusive alternatives by the ROR method if the rate of return on the alternative with the higher first cost is less than that of the lower first cost alternative
The rate of return on the increment is less than the rate of return for the lower first cost alternative
