7-Engineering Economics 2014

MECHANICAL ENGINEERING
Engineering Economics
Based on
White, J.A (1990) Engineering Economics,
Chapter 15 in Eshbach's Handbook of
Engineering Fundamentals (4th Edition), John
Wiley & Sons
(available on-line through the UW Libraries)
Joyce Cooper
Design for Environment Lab
University of Washington
cooperjs@u.washington.edu
UWME DFE Lab:
http://faculty.washington.edu/cooperjs/
ME395: Introduction to Mechanical Design
Plan,
decompose,
& benchmark
Formulate &
analyze
Communicate
& justify
Engineering economics
In essence, design decisions are economic decisions.
Very few situations exist in which there are not alternative materials,
processes, and physical designs available to the engineer; and each
alternative has different costs associated with it.
The economicsSolid
of engineering
decisions
must be viewed from
Fuels Processing
Technologies
a broad perspective.
The life-cycle cost of a product is the total cost of design, production,
maintenance, subsequent replacements over the life of the product
and retirement of the product.
Design choices dictate a broad set of costs (e.g., screws vs. snap fits
impact assembly, maintenance, and recycling costs).
Typical economic decisions confronting engineers are new
product or process introduction, lease versus buy, make
versus buy, replacement of machinery and equipment,
process modification, and capacity expansion.
Solid Fuels Processing Technologies
In performing economic comparisons of engineering
alternatives, it is recommended that a cash flow approach be
taken.
Here, an end-of-period cash flow convention is used. Specifically,
when the period is equal to a year, any receipts or disbursements
occurring during a year will be shown as occurring at the end of the
year and the present is considered to be the end of year zero.
We use this convention in making cash flow diagrams.
Cash flow diagrams

Cash flow diagrams are used to depict the timing and
magnitudes of the cash flow amounts in the present & future.
Purchase costs; annual expenditures for maintenance, energy, and
labor charges; and salvage values occur in a cash flow series.
Cash flow diagrams
Begin at year 0Solid

(now) and
end at
the end of theTechnologies
project (year n-- represents project horizon)
Fuels
Processing
Cash flows each year can be a combination of receipts and payments
Receipts are represented by upward arrows above the time line
Payments are represented by downward arrows below the time line
Receipts (income)
time
Disbursements (payments or costs)

Cash Flow and Equivalence, EIT Review Manual,

Professional Publications Inc.
Types of cash flows

Single payment cash flow- can occur at the beginning of a time line
(t=0), at the end of the time line (t=n), or any time in between.
e.g., equipment costs
t=0
Uniform series cash flow- consists of a series of equal transactions

starting at t=1 and ending at t=n. A is typically used to represent
the magnitude of each flow.
A each
e.g., revenue (an up arrow) or
material costs (a down
arrow)
t=1
t=n
Uniform gradient cash flow- starts with a cash flow (denoted as G) at t=2
and increases by G each year through t=n, at which time the cash flow is
(n-1)G
(n-1)G
e.g., Increasing
maintenance costs with
aging equipment
3G
G
t=2
2G
t=n
Cash flow diagrams

For example, a mechanical device will cost $20,000 when purchased.
Maintenance will cost $1,000 per year. The device will generate revenues
of $5,000 each year for 5 years, after which the salvage value is expected
to be $7,000.
Salvage value
$7,000
Revenue
$5,000
$5,000
$5,000
Simplified version
$5,000 $5,000
time
1
$1,000
$20,000
2
$1,000
3
$1,000
$1,000 $1,000
Maintenance cost
Purchase cost
From FE Review Manual: Rapid Preparation for the Fundamentals of

Engineering Exam By Michael R. Lindeburg
The time value of money

In general,
Receiving $1 now is better than later.
Paying $1 later is better than now.
Also,

When allowing someone else to use your money (investing), you are paid
a profit
Allows for a return on investment (ROI) through interest
What you buy today is worth less a year from today
Because of depreciation

Simple Interest
If I borrow a present sum of money or a principal P at a simple
interest rate i, the annual cost of interest is I=Pi.
If I repay the loan in a lump sum at the end of n years, the amount owed
is:
where:
Amount owed = P + nI = P(1+ni)
For example,
P= principle or present worth

I= annual cost of interest
i= annual interest rate
n= number of years
If I borrow $1,000 for 6 years at a simple interest rate of 10%, at the end
of the 6 years I owe:
Amount owed =P(1+ni)=$1,000[1+6(0.1)]=$1,600

Compound Interest
In compound interest, the interest due at the end of a period is not
paid out but is instead added to the principal. Thus, during the next
period, interest is paid on the total sum.
First period: amount owed1=P(1+i)
Second period: amount owed2= P(1+i)+iP(1+i)= P(1+i)2
nth period: amount owedn= P(1+i)n
Simple vs. compound interest

For $1,000 loaned for 6 periods at 10% simple or compound interest
Simple Interest
(1) amount
ow ed at the
(2)=1,000 x 10%
beginning of the interest amount
period
period
f or period
Simple vs. Compound Interest
Am o un t O w e d
$2,000
Compound Interest
$1,500
Simple Interest
$1,000
(3)=(1)+(2)
amount
ow ed at the
end of the
period
$1,000
$100
$1,100
=1,000(1+.1)
$1,100
$100
$1,200
=1,000(1+.2)
$1,200
$100
$1,300
=1,000(1+.3)
$1,300
$100
$1,400
=1,000(1+.4)
$1,400
$100
$1,500
=1,000(1+.5)
$1,500
$100
$1,600
=1,000(1+.6)
Compound Interest
$500
$0
0
End of Interest Period
period
(4) amount
ow ed at the
beginning of
the period
(5)=(4)x10
% interest
amount f or
period
(6)=(4)+(5)
amount ow ed
at the end of
the period
$1,000
$100
$1,100
=1,000(1.1)
$1,100
$110
$1,210
=1,000(1.1)^2
$1,210
$121
$1,331
=1,000(1.1)^3
$1,331
$133
$1,464
=1,000(1.1)^4
$1,464
$146
$1,611
=1,000(1.1)^5
$1,611
$161
$1,772
=1,000(1.1)^6
In the reading, all

interest calculations
are based on
compound interest
rather than simple
interest.
Time value of money

The interest rate used in calculations is known
as the effective interest rate.
For compound
interest:
If compounding is once a year, the interest rate is
called an effective annual interest rate.
Effective quarterly, monthly, or daily interest rates are
also used.

Mnemonic convention
The amount owed in the nth period is called the future worth or future
value (F) with following mnemonic convention used:
F = P(1+i)n
denoted
as F = P(F|P
i%,n)
Solid Fuels
Processing
Technologies
where:
F = the future value or future worth
P= principle or present worth
i= annual interest rate
n= number of years
where (F|P i%, n) can be stated as

Find F, given P, using an interest rate of i% over n years.
The quantity (1 + i)n is referred to as the single sum, future worth

factor and is generally called a discounting factor
DISCOUNTING FACTORS (for future and other timed flows) are tabulated
in the appendix of the reading.
Why? because sometimes exams do not allow you to bring a calculator or use Excel.
Time value of money

I put $1,000 in a bank account that earns 4% per year. How much
will I have in 10 years?
The $1,000 is referred to as the present value of the investment. I am trying to
calculate the future value of the investment after 10 years.
n
F
=
P(F|P
i%,n)
=
P(1+i)
F = $1000(1+0.04)10 = $1,480
Well that is just not enough, I want MORE in 10 years. In fact, I

want $5,000.
Here $5,000 is the future value of my investment after 10 years. This time, I
am trying to calculate the present value to be invested today.
where:
P = F(P|F i%, n) = F(1+i)-n
(1+i)-n is the single sum, present worth
-10
P = $5000(1+0.04) = $3,378 factor
The mnemonic is Find P, given F, using
an interest rate of i% over n years
& these are also in the appendix
Discount factors for discrete compounding

Factor Name
Single payment compound
amount
Single payment present worth
Converts
P to F
Symbol
(F/P, i%, n)
Formula
F to P
(P/F, i%, n)
P = F (1 + i) n
Uniform series sinking fund
F to A
(A/F, i%, n)
A= F
i
(1 + i) n 1
Capital recovery
P to A
(A/P, i%, n)
A= P
i( 1 + i )n
( 1 + i )n 1
Uniform series compound

e.g., Value of IRA given periodic
amount contributions
A to F
(F/A, i%, n)
(1 + i) n 1
F=A
i
Uniform series present worth
A to P
(P/A, i%, n)
( 1 + i )n 1
P= A
i( 1 + i )n
Uniform gradient present worth
G to P
(P/G, i%, n)
Uniform gradient future worth
G to F
(F/G, i%, n)
( 1 + i )n 1
n
P = G 2
n
i( 1 + i )n
i (1+ i )
(1 + i) n 1 n
F = G

2
i
i
Uniform gradient uniform

series
G to A
(A/G, i%, n)
e.g., Periodic contribution to IRA that is

required to achieve a goal
e.g., Loan repayment
F = P(1 + i)n
n
A = G
n
i ( 1 + i ) 1
From Engineering Economic Analysis, EIT Reference Manual,

Professional Publications Inc.
Using discount factors: consider the national debt
From http://www.brillig.com/debt_clock/ at 6:17 this morning
And according to the US Treasury

From http://www.treasurydirect.gov/NP/debt/current
From http://www.treasurydirect.gov/NP/debt/current
Using discount factors
Concerning the national debt

The national debt is ~$17.9 trillion. What is the required
payment per year to completely pay off the debt in 20 years,
assuming an interest rate of 6%?

Using the capital recovery
discount factor (for loan repayment)
A = P(A|P,6%,20)
$17.9 trillion
0.06(1 + 0.06) 20
A = $17.9 trillion
(1 + 0.06) 20 1
time
1
A
2
A
20
A
= ($17.9 trillion)*0.0872
= $1.56 trillion per year (hmm)
Using discount factors with cash flow diagrams

That same mechanical device costs $20,000 when
purchased, the maintenance is $1,000 per year,
the revenues are $5,000 each year for 5 years,
and the salvage value is expected to be $7,000.
Present worth equivalent

For an interest rate of i%, the present worth equivalent of the cash flow series is:
Solid Fuels
P = -$20,000(P|F i%,0) + $4000(P|F
i%,1)Processing
+ $4000(P|F Technologies
i%,2) + $4000(P|F i%,3) + $4000(P|F i%,4)
+ $11,000(P|F i%,5)
OR
P = -$20,000(P|F i%,0) + $4000(P|A i%,5) + $7,000(P|F i%,5)
For an interest rate

of 6%
The present
worth equivalent
is more
commonly called
the net present
value (NPV).
Estimation
of e.g., the
present (or Design
future) worth allows comparison
of cash
diagrams
ME395:
Introduction
to Mechanical
Engineering
Examflow
By Michael
R. Lindeburg
Net present value

Net present value (NPV) formula in Excel does not calculate
the NPV and this has always driven me crazy.
Instead, despite the word net, the NPV function is really just a present value
of a cash flow function.
Net alwaysSolid
means
that something
has been
subtracted, so it is puzzling that
Fuels
Processing
Technologies
spreadsheets have done this (there are actually a number of crazy errors that have
been propagated over the years to maintain compatibility).
In any case, to calculate the real NPV in Excel, use
the NPV function, but leave out the initial cost.
Then, outside of the NPV function, subtract the
initial cost.
See
http://www.tvmcalcs.com/blog/comments/the_npv_function_do
esnt_calculate_net_present_value
Estimation
of NPV also
allows comparison of cash flow diagrams
ME395: Introduction
to Mechanical
Design
New slide
Discount factors and equivalence

Cash flows with the same NPV, or the same future worth, or the
same uniform series value are equivalent.
At a 5% interest
rate, THERE IS NO
DIFFERNENCE
between receiving
$100 now, or $105
in 1 year or
$110.25 in 2 years.
These single
payment cash
flows are
equivalent..
See that 2 discount factors have been used here
Discount factors and equivalence
New slide
If one cash flow has a higher NPV, or future worth, or uniform series
value as compared to another, the cash flows are not equivalent.
Option 1: the same mechanical device costing $20,000 when purchased, with
maintenance at $1,000 per year and revenues at $5,000 each year, and a salvage value
expected to be $7,000.
Option 2: this do nothing option uses an existing device with maintenance at $2,000
per year and revenues at $4,000 each year, and the salvage value is expected to be
negligible.
At a 6% interest rate, the 2
cash flows are not equivalent:
using the existing device is
much better.
Note that for the uniform series formulas,

time starts at t=1 and ends at t=n.
So the contribution here is JUST $4,000
or $2,000. because the are already a
uniform series from t=1 to t=5

Internal rate of return (IRR)
IRR is used in capital budgeting to
measure and compare the
profitability of investments.
The IRR is the interest
rate atProcessing
which
Solid Fuels
Technologies
the net present value (NPV) of a cash
flow is zero.
The term internal refers to the fact
that its calculation does not
incorporate external factors (e.g., the
interest rate or inflation).
4,000
4,000
4,000
4,000
11,000
+
+
+
+
= 20,000 +
(1 +
)
(1 +
)
(1 +
)
(1 +
)
(1 +
)
Note that in Excel, the IRR function works just fine by including years 0-5.
Using discount factors:

selection of an interest rate
The IRR is used in capital budgeting to measure and compare
the profitability of investments.
Another approach is to use a minimum attractive rate of return
(MARR) on investment capital, often set by the company at hand.
Solid
Fuels
Processing
Technologies
If a project proves
to be
profitable
after considering
the MARR, then it will be
recommended. Furthermore, if the money is not invested in the project under
consideration, then it will be assumed that the money can be invested
elsewhere and earn a return at least equal to the MARR.
The MARR is also referred to as a hurdle rate since it establishes the lower
bound or benchmark against which the acceptability of a project is measured.
If the hurdle is set too low, the company runs the risk of undertaking
investments it cannot afford.
If the hurdle is set too high, the firm runs the risk of rejecting projects that
would contribute significantly to its profitability.
Using discount factors with cash flow diagrams

Consider that same mechanical device costing $20,000 when purchased,
with maintenance at $1,000 per year and revenues at $5,000 each year
and a salvage value expected to be $7,000 over a 5 year time horizon.
For a minimum attractive rate of return (MARR) of 20% before taxes, the
present worth equivalent for the investment is a cost of $5,224 and the future
worth equivalent -$13,000.
present worth
present
equivalent (=cash
worth factor flow x present worth
end of
year=n
cash flow
(1+0.2) -5
factor)
0
-$20,000
1
-$20,000
1
$4,000
0.8333
$3,333
2
$4,000
0.6944
$2,778
3
$4,000
0.5787
$2,315
4
$4,000
0.4823
$1,929
5
$11,000
0.4019
$4,421
Sum = the present worth equivalent
-$5,224
Future worth = present worth equivalent x (1+0.2) 5 =
Simplified version
-$13,000

Put another way.
The future worth equivalent can be obtained using the single payment and
uniform series discount factors:
Factor Name
Single payment compound
amount
Single payment present worth
Converts
P to F
F to P
Symbol
(F/P, i%, n)
Formula
The device cost (P=$20,000) is

(P/F, i%, n)
converted to its future value (P to F):
P = F (1 + i)
(A/F, i%, n)
i
A= F
Solid Fuels
Processing Technologies
-$20,000(1+0.2)5 = -$49,766
(1 + i ) 1
F = P(1 + i)n
Uniform series sinking fund
F to A
Capital recovery
P to A
(A/P, i%, n)
Uniform series compound

amount
A to F
(F/A, i%, n)
(1 + i) n 1
F=A
i
Uniform series present worth
A to P
(P/A, i%, n)
P= A
Uniform gradient present worth
G to P
(P/G, i%, n)
Uniform gradient future worth
G to F
(F/G, i%, n)
( 1 + i )n 1
n
P = G 2
n
i
(
1
+
i
)
i
(
1
+
i )n
(1 + i) n 1 n
F = G

i2
i
Uniform gradient uniform

series
G to A
(A/G, i%, n)
A= P
i( 1 + i )n
( 1 + i )n 1
( 1 + i )n 1
i( 1 + i )n
n
A = G
n
i ( 1 + i ) 1
The annual flow (A=$4,000) is

converted to its future value (A to F):
$4,000[(1+0.2)5-1]/0.2 = $29,766
The salvage value ($7,000) is already
at the future value, so the result is:
-$49,766 + $29,766 + $7,000 =
-$13,000 (as before)
Still for the device costing $20,000 when purchased, with maintenance at $1000 per year and
revenues at $5,000 each year, and a salvage value expected to be $7,000 over a 5 year time
horizon and
assuming an MARR of 20%.
ME395: Introduction to Mechanical
Design
Comparing alternatives
To facilitate the comparison of engineering alternatives, the
following systematic approach is recommended:
STEP 1. Define the set of feasible alternatives to be compared.
Including considering the do nothing alternative

(e.g., to not make a capital investment)
STEP 2. Define theSolid

planning
to beTechnologies
used in the comparison.
Fuelshorizon
Processing
Experience suggests that a planning horizon of <5 years will support only small
incremental changes. Thus, depending on objectives, a planning horizon from 5 to
10 years is recommended.
It is important to distinguish between the length of the planning horizon, the
working life of equipment, and the depreciable life of equipment.
Working life = the period the equipment is capable of being used, e.g., 20 yrs
Depreciable life of the equipment = the allowable depreciation period
The planning horizon might have no relationship to the working and

depreciable lives; it is simply the time frame used to compare alternatives
and should realistically represent the time over which reasonably accurate
cash flow estimates can be provided.
STEP 3. Develop the cash flow profiles for each alternative.
Determine e.g., Ps, As, and salvage values
STEP 4. Specify the MARR (the hurdle rate).
The MARR sometimes depends on the type of investment

The MARR should be > the cost of securing capital
The MARR is rarely double digits
If the hurdle rate is set too high (e.g., at 20% in the mechanical device
example).the project looks worse than it might actually end up being
(there are few investments that yield double digit returns)
MARR = 20%
present worth
present
equivalent (=cash
end of
year=n
cash flow
(1+0.2) -5
factor)
0
-$20,000
1
-$20,000
1
$4,000
0.8333
$3,333
2
$4,000
0.6944
$2,778
3
$4,000
0.5787
$2,315
4
$4,000
0.4823
$1,929
5
$11,000
0.4019
$4,421
-$5,224
MARR = 6%
-$13,000
present worth
present
equivalent (=cash
end of
year=n
cash flow
(1+0.06) -5
factor)
0
-$20,000
1
-$20,000
1
$4,000
0.9434
$3,774
2
$4,000
0.8900
$3,560
3
$4,000
0.8396
$3,358
4
$4,000
0.7921
$3,168
5
$11,000
0.7473
$8,220
$2,080
$2,784
Hurdle is lower, project looks better
STEP 5. Compare the alternatives (provide a level playing field) using 3
methods:
The present worth (PW) or the annual worth (AW)
Estimate the present worth for all alternatives OR estimate the annual
worth for all
alternatives,
and compare
them.
Solid
Fuels Processing
Technologies
Internal rate of return (IRR) for the incremental investment
Compare the MARR with the IRR resulting from the incremental
investments among alternatives. Incremental investments are justified if
the incremental IRR is greater than the MARR; otherwise, they are not.
PW, AW, and IRR are equivalent methods. Thus, the same
recommendation results using present worth, annual worth, or internal
rate of return.
Comparing alternatives: compare the present worths

Assuming a MARR of 20% over a 5 year time horizon:
negligible.
Present worth method

Option 1
present
worth factor
end of
year=n
cash flow
(1+0.2) -5
0
-$20,000
1
1
$4,000
0.8333
2
$4,000
0.6944
3
$4,000
0.5787
4
$4,000
0.4823
5
$11,000
0.4019
Present worth method

Option 2
present worth
equivalent (=cash
flow x present worth
factor)
-$20,000
$3,333
$2,778
$2,315
$1,929
$4,421
-$5,224
present
worth factor
end of
year=n
cash flow
(1+0.2) -5
0
$0
1
1
$2,000
0.8333
2
$2,000
0.6944
3
$2,000
0.5787
4
$2,000
0.4823
5
$2,000
0.4019
present worth
equivalent (=cash
flow x present worth
factor)
$0
$1,667
$1,389
$1,157
$965
$804
$5,981
Present worth is higher, option 2 looks better
Comparing alternatives:
compare the incremental IRR to the MARR
Assuming a MARR of 20% over a 5 year time horizon:
negligible.
. IRR method, you are looking for the value of i for which the net present value of
For the
the incremental cash flow (cash flow for option 1 cash flow for option 2) is zero.
Compare the incremental IRR to the MARR.
IRR method
You can
Use the IRR function in excel, here it would
be =IRR(D2:D7)
Or solve for i for a zero present value of the
incremental cash flow as:
-$20,000+$2,000(A|P,i%,5)+$4,000(F|P,i%,5) = 0
IRR <MARR, meaning the investment in option 1 is not warranted
The impact of taxes and depreciation

In considering the impact of taxes on the economic performance of
alternatives, it is necessary to consider depreciation.
Depreciation charges are considered because
Under tax law, depreciation charges are an allowable corporate deduction in
determining theSolid
income
tax Processing
liability for a Technologies
firm.
Fuels
income taxes are cash flows and depreciation charges affect the size of
the income tax paid
Depreciation is an artificial expense that spreads the purchase price

of an asset or other property over time.
The inclusion of depreciation increases the after-tax present worth
(profitability) of an asset.
Depreciation methods
Prior to the early 1980s, a number of different depreciation
methods were used in the US to determine taxable income.
Commonly use methods were:
straight-line depreciation
assumes a constant depreciation value
Solid Fuels Processing
declining balance
where
D = depreciation charge for year
C = the purchase price and
Technologies
Sn = the expected salvage value
C Sn
D=
n
assumes a constant depreciation rate per year.
accelerated depreciation methods

double declining balance
the declining balance depends on accumulated depreciation
sum-of-the-years-digits
depreciation is determined by multiplying the depreciable cost by a schedule
of fractions
Depreciation methods
After 1981, the accelerated cost recovery system (ACRS) was
established.
The Modified Accelerated Cost Recovery System (MACRS,
pronounced as makers) is the current tax depreciation system
in the US: Solid Fuels Processing Technologies
Depreciation charges represent various combinations of declining
balance, double declining balance, and straight-line depreciation charge
Under MACRS depreciation, an asset is classified as either a 3-year, 5-year,
7-year, 10-year, 15-year, or 20-year asset or as real property. The
classification is based on the assets depreciation range (ADR), although
there are numerous exceptions.
The depreciation of stuff:

MACRS asset depreciation classes
The 3-year class (ADR midpoint of <=4 years) such as special tools and devices used in the
manufacture of rubber products, special handling devices such as returnable pallets, and
over-the-road tractors.
The 5-year class (ADR midpoint of 4-10 years) such as computers and peripherals,
automobiles, busses, general carpets, and electronic components.
The 7-year class (ADR midpoint of 10-16 years) such as office furniture, railroad cars and
Fuelsequipment
Processing
locomotives, and mostSolid
production
usedTechnologies
to manufacture wood products, sporting
goods, jewelry, musical instruments, films, and tapes, among others.
The 10-year class (ADR midpoint of 16-20 years) such as assets used to manufacture tobacco
and certain food products, as well as that used in petroleum refining.
The 15-year class (ADR midpoint of 20-25 years) such as telephone distribution equipment,
sewage treatment plants, and assets used to produce electricity for sale.
The 20-year class (ADR midpoint of 25+ years real property) such as sewer pipe, farm
buildings, railroad steam or electric generating equipment, and telephone distribution plants.
The real property class is divided into residential and nonresidential; residential property is
recovered over 27.5 years and nonresidential property is recovered over 31.5 years.
ADR = assets depreciation range

MACRS Depreciation
The MACRS deduction is calculated by applying appropriate
percentages to the cost basis for a specified recovery property class
and year;
The cost basis is usually the initial investment in the property.
Depending on the recovery property class, the percentage used will depend on the
month of the year in which the property was placed in service. For our purposes, it is
assumed that the property is placed in service at the beginning of the tax year and
disposed of at the end of the tax year.
The difference between the purchase price and the accumulated

depreciation at the end of year t is called the book value (Bt):
Bt = P-(D1 + D2 + + Dt) or
Bt = P[1-(d1 + d2 + + dt)]
where
P = cost basis for the property
Dt = dtP = depreciation charge for year t, t = 1,. . . , n
dt = depreciation percentage allowed for year t=1 to n for the specific recovery property class
as TABULATED for MACRS IN TABLE 15.5 of the reading, as compiled from THE TAX CODE
n = allowable write-off or depreciation period
MACRS percentages
dt = depreciation percentage allowed for year t=1 to n for the specific recovery property
class as TABULATED IN TABLE 15.5 of the reading, as compiled from THE TAX CODE
MACRS Depreciation
Suppose the earlier investment of $20,000 in the mechanical
device is for a 3-year recovery property.
The MACRS percentages are obtained from the table for a 4year period. The annual depreciation charges and book values
are:
MACRS percentages
Dt = dtP
For P=$20,000
D1 = $20,000(0.3333) =
D2 = $20,000(0.4444) =
D3 = $20,000(0.1482) =
D4 = $20,000(0.0741) =
$6,666
$8,888
$2,964
$1,482
B1 = $20,000 - $6,666 =
B2 = $13,334 - $8,888 =
B3 = $4,446 - $2,964 =
B4 = $1,482 - $1,482 =
$13,334
$4,446
$1,482
$0
So in 4-years the book value is zero. If your

cash flow diagram had a horizon of less than
4 years, you would have a salvage value.
Taxes
Types
Property taxes- based on the value of the property owned and do not
vary with profits,
Sales taxes- imposed on the sale of products, usually paid by the
purchaser
Excise taxes- imposed on the manufacture of certain products like
tobacco and alcohol, these are usually passed on to the consumer
Income taxes- imposed on corporate profits or personal income, gains
resulting from the sale of capital property are subject
Because state taxes are deductible from federal taxes, the

effective tax rate is:
effective tax rate=state rate +(1-state rate)(federal rate)
Tax Example
A corporation that pays 53% of its profits in income taxes. It invests
$10,000 in an asset that will produce $3,000 annual revenue for eight
years. If the annual expenses are $700, the salvage value at the end
of 8 years is $500, and an 9% interest is used, what is the after-tax
present worth disregarding
Solid Fuels depreciation?
Processing Technologies
P = -$10,000 + ($3000)(P|A,9%,8)(1-.053) ($700)(P|A,9%,8)(1-.053) + ($500)(P|F,9%,8)
= -$10,000 + ($3000)(5.5358)(1-.053) ($700)(5.5358)(1-.053) + ($500)(0.5019)
= -$3,766

Income taxes
What does depreciation do to income taxes?
It reduces the after tax cash flows:
ATCF
=
BTCF
(1-r
)-r
D
t
t
t
t
Solid Fuels Processing Technologiest
where
Dt = depreciation charge for year t

ATCFt = after-tax cash flow for year t
BTCFt = before-tax cash flow for year t
rt = income tax rate for year t
So depreciation itself is not a

cash flow but it has a role in the
final estimation of cash flows.
Inflation
Inflation is a measure of the buying power of
money.
When sharp increases occur in the amount of
currency in circulation, sudden decreases can
occur in the purchasing power of money due to
rising prices.
Generally, the inflation rate for a country is

determined using a market basket
approach:
Inflation is represented as the average rate of
increase in prices for a wide range of goods and
services. The Consumer Price Index (CPI) is one
commonly used measure of inflation in the US.
Inflation
Economic studies must be performed in terms of constantvalue dollars.
There are several methods to accomplish this when inflation is
present. One is to replace the effective annual interest rate i
with a value adjusted for inflation. The adjusted value is
called the combined discount rate:
icombined = i + j + ij
where j is the inflation rate per year and is used to compute the
present worth values.
We will use this and the CPI to estimate project costs, as follows next class.

Concepts
Cash flows
Discount factors
Depreciation, taxes, and inflation
Questions?

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MECHANICAL ENGINEERING

ME395: Introduction to Mechanical Design

Cash flow diagrams

Begin at year 0Solid

Disbursements (payments or costs)

Cash Flow and Equivalence, EIT Review Manual,

Types of cash flows

Uniform series cash flow- consists of a series of equal transactions

Cash flow diagrams

ME395: Introduction to Mechanical Design

From FE Review Manual: Rapid Preparation for the Fundamentals of

The time value of money

Solid Fuels Processing Technologies

ME395: Introduction to Mechanical Design

The time value of money

Amount owed = P + nI = P(1+ni)

P= principle or present worth

ME395: Introduction to Mechanical Design

The time value of money

Simple vs. compound interest

Simple vs. Compound Interest

End of Interest Period

In the reading, all

Time value of money

ME395: Introduction to Mechanical Design

The time value of money

where (F|P i%, n) can be stated as

The quantity (1 + i)n is referred to as the single sum, future worth

ME395: Introduction to Mechanical Design

Time value of money

Well that is just not enough, I want MORE in 10 years. In fact, I

ME395: Introduction to Mechanical Design

Discount factors for discrete compounding

Uniform series sinking fund

Uniform series compound

Uniform series present worth

Uniform gradient present worth

Uniform gradient future worth

Uniform gradient uniform

e.g., Periodic contribution to IRA that is

e.g., Loan repayment

ME395: Introduction to Mechanical Design

From Engineering Economic Analysis, EIT Reference Manual,

Using discount factors: consider the national debt

From http://www.brillig.com/debt_clock/ at 6:17 this morning

And according to the US Treasury

ME395: Introduction to Mechanical Design

Using discount factors

Concerning the national debt

Solid Fuels Processing Technologies

ME395: Introduction to Mechanical Design

Using discount factors with cash flow diagrams

Present worth equivalent

For an interest rate

Net present value

Discount factors and equivalence

Solid Fuels Processing Technologies

ME395: Introduction to Mechanical Design

See that 2 discount factors have been used here

Discount factors and equivalence

Note that for the uniform series formulas,

Using discount factors

ME395: Introduction to Mechanical Design

Using discount factors: