ENGINEERING ECONOMIC ANALYSIS

r T ~'ELEVENTH EDITION

Donald G. NewnanSan Jose State University

Ted G. EschenbachUniversity of Alaska Anchorage

Jerome P. LavelleNorth Carolina Statet 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 4Intermediate Problems 4Complex 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 15Importance 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 36Sunk Costs 39

Opportunity Costs 40Recurring and Nonrecurring Costs 41

x CONTENTS

Incremental Costs 42Cash Costs Versus Book Costs 43Life-Cycle Costs 43

Cost Estimating 45

Types of Estimate 45Difficulties in Estimation 47

Estimating Models 48

Per-Unit Model 48Segmenting Model 50Cost Indexes 51Power-Sizing Model 52Triangulation 54

Improvement and the Learning Curve 54

Estimating Benefits 58

Cash Flow Diagrams 58

Categories of Cash Flows 59Drawing a Cash Flow Diagram 59Drawing 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 76Compound Interest 77

Repaying a Debt 78

Equivalence 80

Difference in Repayment Plans 80

Equivalence Is Dependent on Interest Rate 83

Nominal and Effective Interest 89Continuous Compounding 93

Single Payment Interest Factors: ContinuousCompounding 93

CONTENTS x i

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 110Cash 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 118Reality and the Assumed Uniformity of A, G and g 123

Geometric Gradient 124

Compounding Period and Payment Period Differ 127

Uniform Payment Series: ContinuousCompounding 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 152Sunk Costs 153

Borrowed Money Viewpoint 153Effect of Inflation and Deflation 153Income Taxes 153

xii CONTENTS

Economic Criteria 154

Applying Present Worth Techniques 154

Useful Lives Equal the Analysis Period 155Useful Lives Different from the Analysis Period 158Infinite Analysis Period: Capitalized Cost 161Multiple Alternatives 164Bond Pricing 169

Spreadsheets and Present Worth 170

SUMMARY 172

PROBLEMS 173

6 A N N U A L CASH FLOW ANALYSIS 188

Are More Efficient Appliances Cost Effective 188

Annual Cash Flow Calculations 191

Resolving a Present Cost to an Annual Cost 191Treatment of Salvage Value 191

Annual Cash Flow Analysis 195

Analysis Period 197

Analysis Period Equal to Alternative Lives 199Analysis Period a Common Multiple of Alternative Lives 199Analysis Period for a Continuing Requirement 199

Infinite Analysis Period 200Some Other Analysis Period 201

Using Spreadsheets to Analyze Loans 203

Building an Amortization Schedule 203

How Much to Interest? How Much to Principal? 204Finding the Balance Due on a Loan 204Pay 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 x i i i

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 238Analysis 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 256Projects with Multiple Sign Changes 257Evaluating How Many Roots There Are 259Modified 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

1 0 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 375Types of Property 376Depreciation Calculation Fundamentals 376

Historical Depreciation Methods 377

Straight-Line Depreciation 378Sum-of- Years' -Digits Depreciation 379Declining 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 385Where MACRS Percentage Rates {r, ) Come From 387MACRS Method Examples 388Comparing MACRS and Historical Methods 390

Depreciation and Asset Disposal 390

Unit-of-Production Depreciation 394

Depletion 395

Cost Depletion 395Percentage 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 411Classification of Business Expenditures 412Taxable 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 417Selecting 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 425PROBLEMS 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 456Defining 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 459Minimum 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? 488Composite 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 512External Sources of Money 512Choice of Sources of Funds 512

Cost of Funds 513

Cost of Borrowed Money 513

Cost of Capital 513Inflation and the Cost of Borrowed Money 514

xv i i i 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 542Cost of Capital Concept 542Opportunity Cost Concept 543Recommended Concept 543

The Benefit-Cost Ratio 544

Incremental Benefit-Cost Analysis 546

Elements of the Incremental Benefit-CostRatio Method 547

Other Effects of Public Projects 551

Project Financing 551Project Duration 552Quantifying and Valuing Benefits and Disbenefits 554Project 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 568Equity 569

Financial Ratios Derived from Balance Sheet Data 569

The Income Statement 570

Financial Ratios Derived from Income Statement Data 572Linking the Balance Sheet, Income Statement, and CapitalTransactions 572

Traditional Cost Accounting 573

Direct and Indirect Costs 573Indirect Cost Allocation 574Problems 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