3360 unit 01.3 2014-i-01

ENGR 3360UUnit 1-5

General Introduction to Engineering Economic Analysis

Dr. J. Michael Bennett, P. Eng., PMP, UOIT,

Version 2014-X-01

Unit 1 – General Introduction to Engineering Economic Analysis

2014-I-01 Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco1-2

Change Record

2014-I-01 Initial Creation



1.4 Fundamental Business Structures

1. Sole proprietorship2. Partnership3. Limited partnership4. Corporation



4.1 Sole Proprietorship

Business owned by one personEasiest to start, least regulatedOwner keeps all of the profits BUT is responsible for all debtsOwner has unlimited liability which means that Loophole and Loophole can foreclose on your house, Mercedes, wifey’s diamonds, hubby’s Hummers, etc



Characteristics of Sole Proprietorships

Cheapest and fastest to set upAll business profits are taxed as personal incomeOwner has unlimited liability, extending to all of her assetsLife of the firm is limited to the life of the ownerTransfer of ownership requires the sale of the whole business to the new ownerEquity financing is limited to personal wealth of the owner



4.2 Partnership

Involves two or more owners. Here partners run the company togetherThey also share all profits and losses, under a pre-existing agreement



Characteristics of Partnerships

Inexpensive, easy to formGeneral partners have full liability for debtsPartnership is dissolved when a partner dies or withdrawsDifficult for partners to raise moneyManagement control resides only with the partners



4.3 Limited Partnership

Some of the partners are involved only as investorsThese are called limited partnersAre liable only up to the amount of their investmentThe daily running of the business is not their concern



Characteristics of Limited Partnerships

Limited partners have limited liabilityLPs can withdraw at any timeLPs have no control over the management of the business



4.1 Corporations

Corporations are owned by shareholdersSet up as an independent business entity with clearly specified rights and obligationsShareholders elect a Board of Directors which is responsible for picking managers to run the business in the best interests of the shareholdersThe corporation is a separate legal entity which is responsible for its debts



Corporations cont.

Humans and other legal entities (other corporations, trusts) can hold shares in the corporationIf no stockholders exist, can be a “non-stock corporation”Also a “membership corporations” Not-for-profit corps such as churches, charities etc.



Stocks

Can be closely held (private) or publicly traded“Traded” means traded on a stock exchange or an “over-the-counter” market



Characteristics of Corporations

Ownership of the corp is easily transferredThe corporation has unlimited life (oldest is a Japanese company, 800 years old)Shareholders’ liability is limited to amount of shares heldIs almost the only way to run large organizations (SC Johnson exception!)Is the easiest form to raise large amounts of capital quickly (e.g.. Google)



Corporate Finance (for all 4)

Capital Budgeting – what are the long-term strategies the company should undertake?Capital Structure – what is the best way to raise long-term financing to make new productsWorking Capital Management – how does the company manage its short-term cash flow in order to pay people, suppliers etc



Corporate Financing

Primary goal is to ensure that the return on capital exceeds the cost of capital without taking big risksGoal is to enhance corporate value



Rate of Return

Interest earned over a period of time is expressed as a percentage of the original amount, specifically;

Borrower’s perspective – interest rate paid

Lender’s perspective – interest rate earned

interest accrued per specific time periodRate of return (%) = original amount X100%



Economic Equivalence Different sums of money at different times may be equal in economic value

0 1

$100 now

$106 one

year from now

Interest rate = 6% per year

$100 now is said to be equivalent to $106 one year from now, if the $100 is invested at the interest rate of 6% per year.



Simple and Compound Interest

Simple Interest:Interest = (principal)(number of periods)(interest rate)

Compound Interest:Interest earns interest on interest Compounds over time Interest = (principal + all accrued interest) (interest rate)



Terminology and Symbols P = a present sum of money at a time designated as t = 0 { t represents time}

F = a future amount of money at some point in time later than t = 0 A = a series of equal, end-of-period cash flows n = the number of interest periods i = the interest rate or rate of return per time period, in percent



1.6. Introduction To Solution By Computer

Application of Microsoft’s Excel© spreadsheet program Excel financial functions

Present Value P: =PV(i%,n,A,F)Future Value F: =FV(i%,n,A,P)Equal, periodic value: =PMT(i%,n,P,F)No. of periods: =NPER((i%,A,P,F)Compound interest rate: =RATE(n,A,P,F)Compound interest rate: =IRR(first_cell:last_cell)Present value of a series: =NPV(i%,cell2:last_cell) + cell1



1.7 MARR (Minimum Attractive Rate of Return) Investors expect to earn a return on their investment (commitment of funds) over time We expect to see economic efficiencies greater than 100% A profitable investment should earn (return) funds in excess of the investment amounts Economic projects should earn a reasonable return, which is termed:

MARR – Minimum Attractive Rate of ReturnAlso termed the “hurdle” rate for an investment



The MARR

The MARR is established by the financial managers of the firm The MARR is expressed as a percent value Most, if not all, projects should earn at a rate equal to or greater than the established MARR MARR’s are set based upon:

The cost of all types of capital Allowance for risk



Types of Financing Equity Financing – the firm uses funds either from retained earnings, new stock issues, or owner’s infusion of money Debt Financing – the firm borrows funds from outside sources

The cost of debt financing = the interest rate charged on the debt (loan) amounts

The MARR is approximated from the weighted average cost of all sources of capital to the firm A firm’s ROR > MARR > cost of capital



1.8 Cash Flows: Their Estimation and Diagramming

Definition of termsCash Inflows - amount of funds flowing into the firmCash Outflows – amount of funds flowing out of the firm

Net Cash Flow equals Cash inflows – cash outflows

Assumption for analysis – end of periodFunds flow at the end of a given (interest) period



Cash Flow DiagramsA typical cash flow diagram might look like:

0 1 2 … … … n-1 n

1. Draw a time line

One time period

0 1 2 … … … n-1 n

2. Show the cash flows

Cash flows are shown as directed arrows (+ for up or – for down) ---

(+) inflow; (-) outflow

Always assume end-of-period

cash flows!


1.9 Course Assumptions

Fallacy of linearityShow me a linearity in nature!Pointy-Haired-Boss and St DilbertPHB e.g.

One woman creates a baby in 9 monthsNine women create one in 1 month!

Assumption of homo economicus



Guestimation

Engineers must do this all the timeHow many dogs are there in Canada?Interpolation si; extrapolation non!Rule-of-sixEstimation accuracyEstimation of SD




Rule of 72: Estimating Doubling Time

Common question:Estimate the number of time periods it takes for a cash flow to double in sizeGiven an interest rate i% per periodThe approximate time n for an investment at time t = 0 to double in value is given by:

n = 72/ie.g., $10,000 at 7% per year doubles to $20,000 in 10.3 years


Economists you should KnowAdam Smith (invisible-hand man)Karl Marx (boo-hiss)Alfred Marshall (2 blades of the scissors)John Maynard Keynes (when in doubt, SPEND)Milton Friedman (Chicago - yea)Paul Samuelson (ol’ guns and butter)Ben Bernanke (chair of the US Fed)Paul Krugman (contrarian)Mark Carney (former gov, Bank of Canada)Stephen Poloz (current gov)




Chapter Summary

Engineering Economy – application of economic factors and criteria to evaluate alternatives

Applies the time value of moneyApplication of economic equivalenceIntroduction of the MARR

Cash flow estimationModeling – cash flow diagramsDifficulties in estimationPerspectives – viewpoints taken

3360 unit 01.3 2014-i-01

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