University of Prince Edward Island Winter 2005 Department of Engineering. Stephen Champion Phone: Engineering Office

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1 Winter 2005 Department of Engineering ENGINEERING 362 ENGINEERING FINANCE Instructor: Stephen Champion Phone: Engineering Office Office Hours: W 5:00-6:00 Course Objective: The objective of this course is to expose students to the decision-making processes and basic concepts of economics and finance, specifically as they relate to engineering projects. We refer to these decisions as Engineering Economic Decisions. As a practicing engineer, you will be called upon to participate in a variety of financial related decision-making processes throughout the entire Project Life Cycle. Course Text: Engineering Economic Analysis, 9 th Edition, Donald G. Newman, Ted G. Eschenbach, Jerome P. Lavelle, 2004 (strongly recommended). Grade Determination: Class Participation 10% Pop Quizzes 20% Assignments 20% Exam 50% Class participation will be based on attendance and involvement in class discussion. Each class, assigned student (s) will be responsible to research a current news issue related to economics and finance, submit a one-page typed summary/analysis and present the article to the class. Articles can be selected from Journals, News Papers ect. Pop Quizzes will be given unannounced throughout the term and will be closed book. Quizzes will involve problem solving based on course material presented. Students are expected to review problems covered in class and be prepared each week. Two assignments will be assigned during the term. The assignments may be individual or in groups of up to three. Group work is encouraged and members of the group will receive the same grade. The assignments will involve financial analysis and related concepts of textbook material. Assignments should utilize spreadsheets and be submitted on the due date both in electronic and paper format. Page 1 of 2

2 Winter 2005 Department of Engineering The exam will be scheduled during exam week (TBA), and will involve both written explanations and problems. Students who wish to drop their quiz marks in favor of a 70% final will have to indicate their wish to do so prior to writing the final. Notice must be in written form and signed. Written notice is final and if no notice is given, the grading will be determined as outlined previously. Course Outline: Course will generally follow textbook as indicated. Where there are deviations from the text, students will be provided with supplementary material as required. Introduction Chapter 1 - Making Economic Decisions Chapter 2 - Engineering Costs and Estimating Chapter 3 - Interest and Equivalence Chapter 4 - More Interest Formulas Chapter 5 - Present Worth Analysis Chapter 6 - Annual Cash Flow Analysis Chapter 7 - Rate of Return Analysis Chapter 8 - Incremental Analysis Chapter 9 - Other Analysis Techniques Chapter 10 - Uncertainty in Future Events Chapter 11 - Depreciation (CCA v. MACRS) Chapter 12 - Income Tax (American) Handouts/Demo Chapter 13 - Replacement Analysis Chapter 14 - Inflation & Price Change Chapter 15 - Selection of Minimum Attractive Rate of Return Chapter 16 - Economic Analysis in the Public Sector (American) Chapter 17 - Rationing Capital Among Competing Projects Chapter 18 - Accounting and Engineering Economy Special Topics/Review Page 2 of 2

3 Introduction/Economics INTRODUCTION TO ECONOMICS OVERVIEW KEY QUESTIONS Choice & Change How do people choose what to consume and how to produce, and how are these Wages & Earnings What determines people s incomes, why do some receive larger rewards than others? Government, Environment & Economic Systems - What is the most effective role of government in protecting our environment while not adversely affecting private enterprise (free markets). Unemployment What is the cause of unemployment and why are some groups affected more than other s? Inflation Why do prices rise and why do some countries sometimes experience rapid price increases while others have stable prices? International Trade What determines the pattern and volume of trade between nations and what are the effects of tariffs and quotas on international trade? Wealth & Poverty What causes differences in wealth among nations, making people in some countries rich and those in other countries poor. Scarcity All economic questions arise from a single, inescapable fact: you can t always get what you want. Economists define scarcity to mean that Wants always exceed the Resources available to satisfy them. Wants are unlimited. Economic Activity is what people do to cope with scarcity, and Economics is the study of how people use their limited resources to try to satisfy unlimited wants. Choice Faced with scarcity people must make choices, balancing benefits against costs and making the best within the limits of possible alternatives optimizing or economizing. In making choices we inadvertently face costs. Opportunity Costs Emphasizes that making choices in the face of scarcity implies a cost or opportunity lost. The forgone alternative is the cost of the thing you choose to do. Dollar cost, time cost, external cost. Page 1

4 Introduction/Economics WHAT IS THE ECONOMY? The Economy is a mechanism that allocates scarce resources among competing uses, achieving three things, what, how, for whom. What goods and in what quantities? How ill the goods be produced, by hand or automated? For whom will the goods and services be produced for, the distribution depends on distribution of income. Two components: Decision Makers & Markets Decision Makers: Households, Firms, and Governments. Markets In ordinary speech, markets means a place where people buy and sell goods. In 1500, it was meat and vegetables, today, stocks and bonds, and meats and vegetables. The Global Economy Canada is just one small part 700 Billion (1992) v. global economy of 20 Trillion (1992). Trade Balance Exports Imports, NA under extreme pressure from Asia over the last decade. Open Economies, closed economies (i.e. China) Microeconomics deals with decisions of individual households and the way that individual markets work and the detailed way that regulation and taxes affect the allocation of labour and goods and services. Macroeconomics deals with the economy as a whole? Tries to understand the big picture rather than individual choices and decisions. Determination of overall level of economic activity of employment, aggregate income, average prices and inflation. Bank of Canada Banking has been around for centuries in the form of small localized bartering and later regional branch banking. It wasn t until the depression and specific concerns over economic stability and settling international account s that the benefits of a strong central bank were debated. It s about consistent policy. Monetary Policy - Ensuring that money can play its vital role in helping the economy run smoothly. Ultimate objective is to invoke policy to keep inflation low and stable and facilitate growth and job creation. Interest Rates The Bank of Canada sets the key policy rate which commercial banking institutions use to set their prime lending rate. These rates also indirectly affect mortgage rates and interest paid to consumers on bank accounts, GIC and other savings. Interest is the cornerstone of engineering Economic Analysis which we will cover in this course. Page 2

5 Introduction/Economics Reference: Economics, Canada in the Global Environment, 2 nd Edition, Michael Parkin, Robin Blade, ISBN X Page 3

6 Net Worth Review Net Worth: How much is enough? Globe & Mail, May 15, 1999 Even experts can t agree on what you need to sock away to ensure a comfortable retirement? Background/Summary Meet the Smith s; David 40 is a high school teacher earning $65,000 and his wife Judy also 40, a dental assistant earning $35,000. They have two children ages 6 and 10. They want to retire in 18 years with the same standard of living once they have their home paid for, yet they haven t saved a cent. David s fully inflation indexed teachers pension kicks in at 60% until Canada Pension at 60, which will reduce it by 20% (claw back). Globe asked 9 financial consultants across Canada what the Smith s needed each year if anything. Answers ranged from nothing to they can t get there from here (basically cash flow and age doesn t give them enough time). Checklist: (factors to consider) 1. Maintaining Lifestyle The Smith s after are currently spending $50,500 on themselves and children. At 65, the children are gone and they receive David s $32,000 teaching pension, $10,000 CPP and $10,000 OAS (C$1999), with index to inflation, so $41,000 for two instead of four. 2. How has estate been factored in? Die broke or leave a legacy? Some of the planners assumed that David and Judy wanted to leave their kids up to $100,000 in death benefits; one also assumed that they would live until 95 and want to live in their house until then. 3. Age at Death Experts assumptions ranged from years. Common sense, the longer you live, the more money you need. Assumption doubles the length they would live as retirees. 4. Rate of Return- BIG ONE. Expert s assumptions ranged from 7 9.5%. Based on one expert who used 7% ($17,350 yr) v.9.5% ($5,050). Time Value of Money. 5. Budgeting Smith s are 40 years old with no savings pretty poor savers. Some said shooting for net income equivalence of $50,500 in 18 years in impossible. 6. Inflation Experts assumed anywhere from 2%-3.1%. Make sure income increases will keep up. Some warn that government pay may not rise with real inflation. 7. Home Some planners do not take into account the value of your home, that s typically because retired people have to live somewhere. Relying on your home for cash is typically a last resort to many planners. 8. Bottom Line- ASSUMPTIONS always stand back and take a look at them. SENSITIVITY analysis to see what makes the most impact. Key Messages/Questions: 1. Is the financial industry using scare tactics to get people to invest, they typically get paid on percentages of portfolio holdings? 2. Is financial planning an art masquerading as a science? More over it is the LITTLE ASSUMPTIONS that planners make that ultimate lead to the conclusions they reach? 3. Some planners argue, expenses disappear with age (as long as health plans) mortgages/loans etc. vanish (what do you think of that?) Kids gone, pensions kick in and essentially you need less money, right? 4. Planners ALL OVER THE MAP in this exercise ranged from no extra savings needed to as much as $32,000 with an average of $10,000, what does that say? 5. Retirement planning is particularly complex and artistic, but engineering and finance littered with assumptions, have to be careful when they compound on each other. Page 1