ENGINEERING ECONOMIC ANALYSIS r T ~' ELEVENTH EDITION Donald G. Newnan San Jose State University Ted G. Eschenbach University of Alaska Anchorage Jerome P. Lavelle North Carolina State t University New York Oxford OXFORD UNIVERSITY PRESS
PREFACE XXI 1 MAKING ECONOMIC DECISIONS 2 Alternative Fuel Vehicles 2 A Sea of Problems 4 Simple Problems 4 Intermediate Problems 4 Complex Problems 4 The Role of Engineering Economic Analysis 5 Examples of Engineering Economic Analysis 5 The Decision-Making Process 6 Rational Decision Making 6 Ethics 15 Ethical Dimension in Engineering Decision Making 15 Importance of Ethics in Engineering and Engineering Economy 18 Engineering Decision Making for Current Costs 19 SUMMARY 21 PROBLEMS 23 2 ENGINEERING COSTS AND COST ESTIMATING 34 North Slope Natural Gas Pipeline 34 Engineering Costs 36 Fixed, Variable, Marginal, and Average Costs 36 Sunk Costs 39 Opportunity Costs 40 Recurring and Nonrecurring Costs 41
x CONTENTS Incremental Costs 42 Cash Costs Versus Book Costs 43 Life-Cycle Costs 43 Cost Estimating 45 Types of Estimate 45 Difficulties in Estimation 47 Estimating Models 48 Per-Unit Model 48 Segmenting Model 50 Cost Indexes 51 Power-Sizing Model 52 Triangulation 54 Improvement and the Learning Curve 54 Estimating Benefits 58 Cash Flow Diagrams 58 Categories of Cash Flows 59 Drawing a Cash Flow Diagram 59 Drawing Cash Flow Diagrams with a Spreadsheet 60 SUMMARY 60 PROBLEMS 62 TRUST ME, YOU'LL USE THIS 70 3 INTEREST AND EQUIVALENCE 72 A Prescription for Success 72 Computing Cash Flows 74 Time Value of Money 76 Simple Interest 76 Compound Interest 77 Repaying a Debt 78 Equivalence 80 Difference in Repayment Plans 80 Equivalence Is Dependent on Interest Rate 83 Nominal and Effective Interest 89 Continuous Compounding 93 Single Payment Interest Factors: Continuous Compounding 93
CONTENTS xi SUMMARY 96 PROBLEMS 97 4 EQUIVALENCE FOR REPEATED CASH FLOWS 102 Anne Scheiber's Bonanza 102 Uniform Series Compound Interest Formulas 104 Expanded Factors as Calculator Functions 110 Cash Flows That Do Not Match Basic Patterns 110 Economic Equivalence Viewed as a Moment Diagram 114 Relationships Between Compound Interest Factors 116 Single Payment 117 Uniform Series 117 Arithmetic Gradient 118 Derivation of Arithmetic Gradient Factors 118 Reality and the Assumed Uniformity of A, G and g 123 Geometric Gradient 124 Compounding Period and Payment Period Differ 127 Uniform Payment Series: Continuous Compounding at Nominal Rate r per Period 129 Spreadsheets for Economic Analysis 131 Spreadsheet Annuity Functions 131, Spreadsheet Block Functions for Cash Flow Tables 132 Using Spreadsheets for Basic Graphing 133 SUMMARY 135 PROBLEMS 137 5 PRESENT WORTH ANALYSIS 150 The Present Value of 30 Years of Benefits 150 Assumptions in Solving Economic Analysis Problems 152 End-of-Year Convention 152 Viewpoint of Economic Analysis Studies 152 Sunk Costs 153 Borrowed Money Viewpoint 153 Effect of Inflation and Deflation 153 Income Taxes 153
xii CONTENTS Economic Criteria 154 Applying Present Worth Techniques 154 Useful Lives Equal the Analysis Period 155 Useful Lives Different from the Analysis Period 158 Infinite Analysis Period: Capitalized Cost 161 Multiple Alternatives 164 Bond Pricing 169 Spreadsheets and Present Worth 170 SUMMARY 172 PROBLEMS 173 6 ANNUAL CASH FLOW ANALYSIS 188 Are More Efficient Appliances Cost Effective 188 Annual Cash Flow Calculations 191 Resolving a Present Cost to an Annual Cost 191 Treatment of Salvage Value 191 Annual Cash Flow Analysis 195 Analysis Period 197 Analysis Period Equal to Alternative Lives 199 Analysis Period a Common Multiple of Alternative Lives 199 Analysis Period for a Continuing Requirement 199 Infinite Analysis Period 200 Some Other Analysis Period 201 Using Spreadsheets to Analyze Loans 203 Building an Amortization Schedule 203 How Much to Interest? How Much to Principal? 204 Finding the Balance Due on a Loan 204 Pay Off Debt Sooner by Increasing Payments 205 SUMMARY 206 PROBLEMS 207 7 RATE OF RETURN ANALYSIS 218 Bar Codes Give a Number; RFID Codes Tell a Story 218 Internal Rate of Return 221
CONTENTS xiii Calculating Rate of Return 222 Plot of NPW Versus Interest Rate 226 Interest Rates When There Are Fees or Discounts 229 Loans and Investments Are Everywhere 231 Incremental Analysis 235 Present Worth Analysis 238 Analysis Period 241 Spreadsheets and Rate of Return Analysis 242 SUMMARY 244 PROBLEMS 245 Appendix 7A: Difficulties in Solving for an Interest Rate 255 Why Multiple Solutions Can Occur 256 Projects with Multiple Sign Changes 257 Evaluating How Many Roots There Are 259 Modified Internal Rate of Return (MIRR) 263 SUMMARY 265 PROBLEMS 266 8 CHOOSING THE BEST ALTERNATIVE 270 The Size of a Pipeline 270 Incremental Analysis 272 Graphical Solutions 272 Elements in Comparing Mutually Exclusive Alternatives 281 Doing a Set of Incremental Challenger-Defender Comparisons 282 Choosing an Analysis Method 284 Spreadsheets and GOAL SEEK 284 SUMMARY 286 PROBLEMS 286 9 OTHER ANALYSIS TECHNIQUES 296 Clean and Green 296
xiv CONTENTS Future Worth Analysis 299 Benefit-Cost Ratio Analysis 301 Variations on the Theme of Benefit-Cost Ratio 305 Payback Period 309 Sensitivity and Breakeven Analysis 313 Graphing with Spreadsheets for Sensitivity and Breakeven Analysis 318 Doing What-lf Analysis with Spreadsheets 321 SUMMARY 322 PROBLEMS 323 10 UNCERTAINTY IN FUTURE EVENTS 334 Video Game Development and Uncertainty 334 Estimates and Their Use in Economic Analysis 336 A Range of Estimates 338 Probability 340 Joint Probability Distributions 343 Expected Value 345 Economic Decision Trees 347 Risk 353 Risk Versus Return 356 Simulation 357 Real Options 360 SUMMARY 361 PROBLEMS 362 11 DEPRECIATION 372 Depreciation and Competitiveness 372 Basic Aspects of Depreciation 374 Deterioration and Obsolescence 374
CONTENTS XV Depreciation and Expenses 375 Types of Property 376 Depreciation Calculation Fundamentals 376 Historical Depreciation Methods 377 Straight-Line Depreciation 378 Sum-of- Years' -Digits Depreciation 379 Declining Balance Depreciation 381 Modified Accelerated Cost Recovery System (MACRS) 383 Cost Basis and Placed-in-Service Date 383 Property Class and Recovery Period 384 Percentage Tables 385 Where MACRS Percentage Rates {r, ) Come From 387 MACRS Method Examples 388 Comparing MACRS and Historical Methods 390 Depreciation and Asset Disposal 390 Unit-of-Production Depreciation 394 Depletion 395 Cost Depletion 395 Percentage Depletion 396 Spreadsheets and Depreciation 397 Using VDB for MACRS 397 SUMMARY 399 PROBLEMS 400 12 INCOME TAXES 408 On with the Wind 408 A Partner in the Business 411 Calculation of Taxable Income 411 Taxable Income of Individuals 411 Classification of Business Expenditures 412 Taxable Income of Business Firms 413 Income Tax Rates 414 Individual Tax Rates 414 Corporate Tax Rates 416
xvi CONTENTS Combined Federal and State Income Taxes 417 Selecting an Income Tax Rate for Economy Studies 418 Economic Analysis Taking Income Taxes into Account 418 Capital Gains and Losses for Nondepreciated Assets 422 Investment Tax Credit 422 Estimating the After-Tax Rate of Return 423 After-Tax Cash Flows and Spreadsheets 423 SUMMARY 425 PROBLEMS 425 13 REPLACEMENT ANALYSIS 440 The $7 Billion Upgrade 440 The Replacement Problem 442 Replacement Analysis Decision Map 443 Minimum Cost Life of a New Asset The Challenger 444 Defender's Marginal Cost Data 446 Do We Have Marginal Cost Data for the Defender? 448 Are These Marginal Costs Increasing? 448 Replacement Analysis Technique 1: Defender Marginal Costs Can Be Computed and Are Increasing 449 Replacement Repeatability Assumptions 450 Replacement Analysis Technique 2: Defender Marginal Costs Can Be Computed and Are Not Increasing 451 Replacement Analysis Technique 3: When Defender Marginal Cost Data Are Not Available 455 Complications in Replacement Analysis 456 Defining Defender and Challenger First Costs 456 Repeatability Assumptions Not Acceptable 458 A Closer Look at Future Challengers 458 After-Tax Replacement Analysis 459 Marginal Costs on an After-Tax Basis 459 Minimum Cost Life Problems 461
CONTENTS xvii Spreadsheets and Replacement Analysis 463 SUMMARY 465 PROBLEMS 466 14 INFLATION AND PRICE CHANGE 476 The Athabasca Oil Sands 476 Meaning and Effect of Inflation 478 How Does Inflation Happen? 478 Definitions for Considering Inflation in Engineering Economy 479 Analysis in Constant Dollars Versus Then-Current Dollars 486 Price Change with Indexes 488 What Is a Price Index? 488 Composite Versus Commodity Indexes 490 How to Use Price Indexes in Engineering Economic Analysis 492 Cash Flows That Inflate at Different Rates 493 Different Inflation Rates per Period 494 Inflation Effect on After-Tax Calculations 496 Using Spreadsheets for Inflation Calculations 498 SUMMARY 500 PROBLEMS 501 15 SELECTION OF A MINIMUM ATTRACTIVE RATE OF RETURN 510 What's the Rate of Return on a Dam? 510 Sources of Capital 512 Money Generated from the Firm's Operation 512 External Sources of Money 512 Choice of Sources of Funds 512 Cost of Funds 513 Cost of Borrowed Money 513 Cost of Capital 513 Inflation and the Cost of Borrowed Money 514
xviii CONTENTS Investment Opportunities 515 Opportunity Cost 517 Selecting a Minimum Attractive Rate of Return 518 Adjusting MARR to Account for Risk and Uncertainty 519 Representative Values of MARR Used in Industry 521 Capital Budgeting or Selecting the Best Projects 522 Spreadsheets, Cumulative Investments, and the Opportunity Cost of Capital 524 SUMMARY 527 PROBLEMS 528 16 ECONOMIC ANALYSIS IN THE PUBLIC SECTOR 536 From Waste to Power and Money 536 Investment Objective 539 Viewpoint for Analysis 540 Selecting an Interest Rate 542 No Time-Value-of-Money Concept 542 Cost of Capital Concept 542 Opportunity Cost Concept 543 Recommended Concept 543 The Benefit-Cost Ratio 544 Incremental Benefit-Cost Analysis 546 Elements of the Incremental Benefit-Cost Ratio Method 547 Other Effects of Public Projects 551 Project Financing 551 Project Duration 552 Quantifying and Valuing Benefits and Disbenefits 554 Project Politics 555 SUMMARY 556 PROBLEMS 557
CONTENTS xix 17 ACCOUNTING AND ENGINEERING ECONOMY 564 The Two Faces of ABB 564 The Role of Accounting 566 Accounting for Business Transactions 566 The Balance Sheet 567 Assets 567 Liabilities 568 Equity 569 Financial Ratios Derived from Balance Sheet Data 569 The Income Statement 570 Financial Ratios Derived from Income Statement Data 572 Linking the Balance Sheet, Income Statement, and Capital Transactions 572 Traditional Cost Accounting 573 Direct and Indirect Costs 573 Indirect Cost Allocation 574 Problems with Traditional Cost Accounting 575 Other Problems to Watch For 576 PROBLEMS 576 APPENDIX A: INTRODUCTION TO SPREADSHEETS 582 The Elements of a Spreadsheet 582 Defining Variables in a Data Block 583 Copy Command 583 APPENDIX B: TIME VALUE OF MONEY (TVM) CALCULATORS 586 Advantages and Types of TVM Calculators 586 Notation for TVM Calculators 588 Examples with TVM Calculators and Tabulated Factors 588 PROBLEMS 593
xx CONTENTS APPENDIX C: COMPOUND INTEREST TABLES 594 APPENDIX D: FUNDAMENTALS OF ENGINEERING (FE) EXAM PRACTICE PROBLEMS 626 PROBLEMS 628 PHOTO CREDITS 645 REFERENCES 647 INDEX 649