ParkFMff.qxd 6/2/06 2:01 PM Page i Contemporary Engineering Economics ParkFMff.qxd 6/2/06 2:01 PM Page ii ParkFMff.qxd 6/2/06 2:01 PM Page iii Contemporary Engineering Economics Fourth Edition Chan S Park Depar tment of Industr ial and Systems Engineer ing Aubur n Univer sity Upper Saddle River, NJ 07458 ParkFMff.qxd 6/2/06 2:01 PM Page iv Library of Congress Cataloging-in-Publication Data on File Vice President and Editorial Director, ECS: Marcia J Horton Senior Editor: Holly Stark Editorial Assistant: Nicole Kunzmann Executive Managing Editor: Vince O’Brien Managing Editor: David A George Production Editor: Scott Disanno Director of Creative Services: Paul Belfanti Creative Director: Juan López Art Director: Heather Scott Interior and Cover Designer: Tamara Newnam Art Editor: Xiaohong Zhu Manufacturing Manager: Alexis Heydt-Long Manufacturing Buyer: Lisa McDowell Marketing Manager: Tim Galligan © 2007 by Pearson Education, Inc Pearson Prentice Hall Upper Saddle River, New Jersey 07458 All rights reserved No part of this book may be reproduced, in any form or by any means without permission in writing from the publisher The author and publisher of this book have used their best efforts in preparing this book These efforts include the development, research, and testing of the theories and programs to determine their effectiveness The author and publisher make no warranty of any kind, expressed or implied, with regard to these programs or the documentation contained in this book The author and publisher shall not be liable in any event for incidental or consequential damages in connection with, or arising out of, the furnishing, performance, or use of these programs Printed in the United States of America 10 ISBN 0-13-187628-7 Pearson Education Ltd., London Pearson Education Australia Pte Ltd., Sydney Pearson Education Singapore, Pte Ltd Pearson Education North Asia Ltd., Hong Kong Pearson Education Canada, Inc., Toronto Pearson Educación de Mexico, S.A de C.V Pearson Education–Japan, Tokyo Pearson Education Malaysia, Ptd Ltd Pearson Education, Inc., Upper Saddle River, New Jersey ParkFMff.qxd 6/2/06 2:01 PM Page v To my wife, Kim (Inkyung); and my children, Michael and Edward ParkFMff.qxd 6/2/06 2:01 PM Page vi ParkFMff.qxd 6/2/06 2:01 PM Page vii CONTENTS Preface xix PART B ASICS OF FINANCIAL DECISIONS Chapter Engineering Economic Decisions 1.1 Role of Engineers in Business 1.1.1 Types of Business Organization 1.1.2 Engineering Economic Decisions 1.1.3 Personal Economic Decisions 6 1.2 What Makes the Engineering Economic Decision Difficult? 1.3 Economic Decisions versus Design Decisions 1.4 Large-Scale Engineering Projects 1.4.1 How a Typical Project Idea Evolves 1.4.2 Impact of Engineering Projects on Financial Statements 1.4.3 A Look Back in 2005: Did Toyota Make the Right Decision? 9 12 13 1.5 Common Types of Strategic Engineering Economic Decisions 13 1.6 Fundamental Principles of Engineering Economics 15 Summary 17 Chapter Understanding Financial Statements 18 2.1 Accounting: The Basis of Decision Making 21 2.2 Financial Status for Businesses 2.2.1 The Balance Sheet 2.2.2 The Income Statement 2.2.3 The Cash Flow Statement 22 24 27 30 2.3 Using Ratios to Make Business Decisions 2.3.1 Debt Management Analysis 2.3.2 Liquidity Analysis 2.3.3 Asset Management Analysis 2.3.4 Profitability Analysis 2.3.5 Market Value Analysis 2.3.6 Limitations of Financial Ratios in Business Decisions 33 34 37 38 39 41 42 Summary 43 Problems 44 Short Case Studies 50 vii ParkFMff.qxd 6/2/06 2:01 PM Page viii viii CONTENTS Chapter Interest Rate and Economic Equivalence 52 3.1 Interest: The Cost of Money 3.1.1 The Time Value of Money 3.1.2 Elements of Transactions Involving Interest 3.1.3 Methods of Calculating Interest 3.1.4 Simple Interest versus Compound Interest 54 55 56 59 62 3.2 Economic Equivalence 3.2.1 Definition and Simple Calculations 3.2.2 Equivalence Calculations: General Principles 3.2.3 Looking Ahead 63 63 66 71 3.3 Development of Interest Formulas 3.3.1 The Five Types of Cash Flows 3.3.2 Single-Cash-Flow Formulas 3.3.3 Uneven Payment Series 3.3.4 Equal Payment Series 3.3.5 Linear Gradient Series 3.3.6 Geometric Gradient Series 71 72 73 80 84 96 102 3.4 Unconventional Equivalence Calculations 3.4.1 Composite Cash Flows 3.4.2 Determining an Interest Rate to Establish Economic Equivalence 107 107 114 Summary 119 Problems 119 Short Case Studies 129 Chapter Understanding Money and Its Management 134 4.1 Nominal and Effective Interest Rates 4.1.1 Nominal Interest Rates 4.1.2 Effective Annual Interest Rates 4.1.3 Effective Interest Rates per Payment Period 4.1.4 Continuous Compounding 136 136 137 140 141 4.2 Equivalence Calculations with Effective Interest Rates 4.2.1 When Payment Period Is Equal to Compounding Period 4.2.2 Compounding Occurs at a Different Rate than that at Which Payments Are Made 143 144 Equivalence Calculations with Continuous Payments 4.3.1 Single-Payment Transactions 4.3.2 Continuous-Funds Flow 152 152 152 4.3 145 ParkFMff.qxd 6/2/06 2:01 PM Page ix Contents ix 4.4 Changing Interest Rates 4.4.1 Single Sums of Money 4.4.2 Series of Cash Flows 156 156 158 4.5 Debt Management 4.5.1 Commercial Loans 4.5.2 Loan versus Lease Financing 4.5.3 Home Mortgage 159 159 167 171 4.6 Investing in Financial Assets 4.6.1 Investment Basics 4.6.2 How to Determine Your Expected Return 4.6.3 Investing in Bonds 175 175 176 179 Summary 187 Problems 188 Short Case Studies 199 PART EVALUATION OF BUSINESS AND ENGINEERING ASSETS Chapter 5.1 Present-Worth Analysis 203 204 Describing Project Cash Flows 5.1.1 Loan versus Project Cash Flows 5.1.2 Independent versus Mutually Exclusive Investment Projects 207 207 5.2 Initial Project Screening Method 5.2.1 Payback Period: The Time It Takes to Pay Back 5.2.2 Benefits and Flaws of Payback Screening 5.2.3 Discounted Payback Period 5.2.4 Where Do We Go from Here? 210 210 213 214 215 5.3 Discounted Cash Flow Analysis 5.3.1 Net-Present-Worth Criterion 5.3.2 Meaning of Net Present Worth 5.3.3 Basis for Selecting the MARR 215 216 220 222 5.4 Variations of Present-Worth Analysis 5.4.1 Future-Worth Analysis 5.4.2 Capitalized Equivalent Method 223 223 227 5.5 Comparing Mutually Exclusive Alternatives 5.5.1 Meaning of Mutually Exclusive and “Do Nothing” 5.5.2 Analysis Period 232 232 235 209 ParkFMff.qxd 6/2/06 2:01 PM Page x x CONTENTS 5.5.3 Analysis Period Equals Project Lives 5.5.4 Analysis Period Differs from Project Lives 5.5.5 Analysis Period Is Not Specified 236 238 246 Summary 249 Problems 249 Short Case Studies 265 Chapter Annual Equivalent-Worth Analysis 268 6.1 Annual Equivalent-Worth Criterion 6.1.1 Fundamental Decision Rule 6.1.2 Annual-Worth Calculation with Repeating Cash Flow Cycles 6.1.3 Comparing Mutually Exclusive Alternatives 270 270 273 275 6.2 Capital Costs versus Operating Costs 277 6.3 Applying Annual-Worth Analysis 6.3.1 Benefits of AE Analysis 6.3.2 Unit Profit or Cost Calculation 6.3.3 Make-or-Buy Decision 6.3.4 Pricing the Use of an Asset 280 281 281 283 286 6.4 Life-Cycle Cost Analysis 287 6.5 Design Economics 294 Summary 303 Problems 304 Short Case Studies 318 Chapter Rate-of-Return Analysis 322 7.1 Rate of Return 7.1.1 Return on Investment 7.1.2 Return on Invested Capital 324 324 326 7.2 Methods for Finding the Rate of Return 7.2.1 Simple versus Nonsimple Investments 7.2.2 Predicting Multiple i*’s 7.2.3 Computational Methods 327 327 329 331 7.3 Internal-Rate-of-Return Criterion 7.3.1 Relationship to PW Analysis 7.3.2 Net-Investment Test: Pure versus Mixed Investments 7.3.3 Decision Rule for Pure Investments 7.3.4 Decision Rule for Mixed Investments 338 338 339 341 344 ... engineering economic decisions í What makes the engineering economic decisions difficult í How a typical engineering project idea evolves in business í Fundamental principles of engineering economics. .. concepts of engineering economics but also to address the difficulties of students outlined above, all of which have their basis in inattentiveness to the practical concerns of engineering economics. .. Page xviii ParkFMff.qxd 6/2/06 2:01 PM Page xix PREFACE What is Contemporary About Engineering Economics? Decisions made during the engineering design phase of product development determine the