ENSC 201: The Business of Engineering

Instructor: John Jones jones@sfu.ca

Office Hours: 4:00-6:00 Wednesdays, TT 8909

Course Website: http://www2.ensc.sfu.ca/undergrad/courses/ENSC301/

Course Text: Engineering Economics in Canada Fraser, Jewkes, Bernhardt and Tajima Third Edition (earlier editions OK)

Course Structure

Two threads:

Engineering Economics (Mondays & Fridays)

and

Engineering Entrepreneurship (Wednesdays)

What to expect from this course:

1. Dull

Exhibit 1

What to expect from this course:

1. Dull

2. Easy

What to expect from this course:

1. Dull

2. Easy

3. Useful

What to expect from this course:

1. Dull 2. Easy 3. Useful

4. Win Valuable cash prizes!

Alternative Grading Schemes

Scheme 1: Entrepreneurial

Project: 40%

Assignments: 20%Mid-Term: 10%Final: 30%

Plus valuable cash prizes!

Scheme 2: Less Entrepreneurial

Essay: 10%Assignments: 35%Mid-Term: 15%Final: 40%

No valuable cash prizes.

Divisions of Economic Theory

Macroeconomics Microeconomics

Divisions of Economic Theory

Macroeconomics Microeconomics

Global or national scale

``What effect does the interestrate have on employment?’’

Hard to distinguish frompolitics

Not a science, since noexperiments

Divisions of Economic Theory

Macroeconomics Microeconomics

Global or national scale

``What effect does the interestrate have on employment?’’

Hard to distinguish frompolitics

Not a science, since noexperiments

Company or personal scale

``Given a particular interestrate, how profitable will myproject be?’’

Used as a guide to companypolicy or individual investmentdecisions.

The Idea

I would rather have a dollar now than a dollar atthis time next year.

So would you.

(If you wouldn’t, please see me after class. Bring yourdollar.)

Irrelevant Philosophical Question 1: What is a Bank?

One answer: a secure vault

Another answer: a source of investment funds

Utopia

Suppose the interest rate is 5%. Everyone in society has at least $1,000,000 in the bank.

So everyone gets $50,000/year in interest, andno-one works.

Where does the money come from?

A model economy:

Ten farmers live in a village. One farmer borrowsenough grain from his neighbours to live for a year without farming. During the year he studies engineering and designs a better plough. Now hecan grow twice as much grain. He repays the grain he has borrowed, with interest.

Improved Meansof Production

Capital

Ideas

Labour

Surplus

Warning of possible confusion:

Our preference for money now rather than moneylater has nothing to do with inflation. There willbe no inflation in this course until Unit 14.

Inflation is when a pizza costs $10 now and $11next year.

In the cases we are considering, the pizza costs$10 this year and $10 next year, but we still wantour pizza now.

End of Philosophical Digression

Consequences of The Idea

We cannot directly compare cash flows occurring atdifferent times.

To decide whether or not to begin a project, we mustbring all the cash flows to the same moment in time.

If you’d just as soon get $x at time t1 as $y at time t2,we say that the two cash flows are equivalent (for you).

Further Consequences of The Idea

Our preference for getting money now rather thanlater can be expressed as an interest rate, i.

To find the present cash flow, $P, equivalent to a cash flow of $F occurring N years in the future,

we can use a conversion factor:

P = F(P/F,i,N)

Is (P/F,i,N) greater or less than one?

Further Consequences of The Idea

Our preference for getting money now rather thanlater can be expressed as an interest rate, i.

To find the present cash flow, $P, equivalent to a cash flow of $F occurring N years in the future,

we can use a conversion factor:

P = F(P/F,i,N)

If N increases, does (P/F,i,N) increase or decrease?

Further Consequences of The Idea

Our preference for getting money now rather thanlater can be expressed as an interest rate, i.

To find the present cash flow, $P, equivalent to a cash flow of $F occurring N years in the future,

we can use a conversion factor:

P = F(P/F,i,N)

If i increases, does (P/F,i,N) increase or decrease?

Conversion Factors

Conversely, to find the future cash flow, $F, equivalent to a cash flow of $P occurring

now, we can use a different conversion factor:

F = P(F/P,i,N)

Is (F/P,i,N) greater or less than one?

Conversion Factors

Conversely, to find the future cash flow, $F, equivalent to a cash flow of $P occurring

now, we can use a different conversion factor:

F = P(F/P,i,N)

What is the relationship between (F/P,i,N)and (P/F,i,N)?

Sample Problem

You are the chief financial officer of a large corporation.You have just completed the evaluation of two competingproposals, A and B. Proposal A involves spending a large sum of money right now to generate a larger return in fiveyear’s time. Proposal B involves expenditures over the nextthree years, generating returns in years four and five.

Given that the cost of capital to the company is 12%, youfind both proposals equally attractive.

You are now told that the cost of capital to the company has increased to 15%. Which proposal is more attractive now?

You should be able to solve this in < 60 seconds.

Conversion Factors

There are formulas, found in the back of the textbook, forevaluating the conversion factors.

Warning! On no account should you rememberthese formulas!

Write out the solutions to problems leaving the conversionfactors unevaluated till the last stage. Then look them upin Appendix A.

Sometimes you will find it useful to enter the formulas onspreadsheets.

Some of the formulasfrom the back of thetextbook.

One page from Appendix A.

(There is also an Appendix B and an Appendix C, which we can ignore for the present.)

Cash Flow Diagrams

These are helpful in making sure we have taken all the important cash flowsinto account. They need not be exactly to scale, but it helps if they’re close.

Time

Pay out $1000 now

Receive $500 for the next 3 years

Present Value

This is an application of the notion of equivalence:

We compare a series of cash flows by bringing themall to the present and adding them up. The sum iscalled the present value of the series.

If the series represents cash flows coming to us, we want the present value to be positive and the biggerthe better.

Present Value

$1000

$500

For example, the present value of this series of cash flows is

PV = -1000 + 500(P/F,i,1) +500(P/F,i,2) + 500(P/F,i,3)

AnnuitiesA

The pattern of a regular series of annual payments comesup often enough that we give it a special name: an annuity.

By convention, an annuity starts one time period after the presentand continues for N years.

We can find its equivalent present value using another conversionfactor:

The Present

PV = A(P/A,i,N)

Present Value

$1000

$500

So a more concise expression for the present value of this series would be

PV = -1000 + 500(P/A,i,3)