Engineering Economics Foundations

Fundament
als
Proposal
s
Cash
flow
Business
decision
making
Time
value or
money
Equivalence
Basis for
comaprision
Mutually
exclusive
alternatives

For-profit

Not-forprofit

Present
economy

Estimati
on risk

Multiple
attribute
decisions

Engineering Economics Foundations

Fundamentals - Proposals

Fundamentals

Proposals
Cash flow
Business
decision making
Time value or
money
Equivalence
Basis for
comparision
Mutually exclusive
alternatives

Proposals are evaluated

from business perspective
(discuss business value of
propesed solution)
Every proposal represents
a binary choice !

Engineering Economics Foundations

Fundamentals - Proposals
Economics drive every potential project
A Request for Proposal (RFP) may be
answered by several suppliers/contractors
(bidders)
For a proposal writer, the key is to diagnose
problem and propose the treatment
In diagnosing a problem, existing issues must
be addressed with specifity
A proposed treatment should include ways in
which the customer can evaluate progress

Engineering Economics Foundations

Fundamentals - Proposals
Key elements of proposal include:
Background of the project
Features and benefits
Technical elements
Related research
Management elements
Cost considerations
Risk and rewards
A description of developing organization

Test your understanding #1

Move each of the proposal elements
to the correct question

What is the estimated

schedule ?
Does the bidder know
of similar systems in
existence elsewhere ?
How will the product
make the buyers
organization more
productive ?
What are the proposed
modeling techniques ?
What is the
background of bidder ?

Management
elements
Background

PROPOSAL
ELEMENTS
Background
Features and
benefits
Description of the
bidder

Features and
benefits

Technical
elements
Related
research

Risk and rewards

Related research
Management
elements
Technical elements

Test your understanding #1

Move each of the proposal elements
to the correct question

What is the process to

be followed ?
Does the client
understand why the
proposal is to replace
current software ?
How are unpredictable
revisions to the
clients requirements
handled ?
What is the
experience with
similar projects ?

Management
elements

Background

PROPOSAL
ELEMENTS
Background
Features and
benefits
Description of the
bidder
Risk and rewards

Risk and
rewards
Description of
the bidder

Related research
Management
elements
Technical elements

Engineering Economics Foundations

Fundamentals Cash flow

Fundamentals

Proposals
Cash flow
Business
decision making
Time value or
money
Equivalence
Basis for comparision
Mutually exclusive
alternatives

Cash flow
instances
Cash flow streams

Engineering Economics FoundationsCash Flow Bussineses make money

Business and
money
Money
comes
from

Custome
rs

Gross
revenues

Owner
s

Equity

Money
goes to

Banks/
Bonds

Goods/
Service
s
Creating/
Purchasin
g

Researc
h
Cost of
selling

Taxes
/Admin/
etc.

Return
to
owners

Test your understanding #2

Move each of terms to the correct
definition

A company s net
worth, the difference
between companys
assets and liabilities

A form of investment
that behaves like an
interest-only loan
Payments received by
business from selling
goods and services

Equity

TERMS
Gross revenue
Indirect
material
Equity

Bond

Indirect labour
Manufacturing
overhead

Gross revenue

Bond

Test your understanding #2

Move each of terms to the correct
definition

The total of indirect

costs in a
manufacturing
operation
Personnel costs not
charged to production
Cost of raw material
and purchased
components not
charged to production

Manufacturing
overhead

Indirect labour

TERMS
Gross revenue
Indirect
material
Equity
Indirect labour

Indirect
material

Manufacturing
overhead
Bond

Engineering Economics Foundations

Fundamentals Cash flow
Cash flow in a business (during period
of time) = All of the business income
All of the cash paid out
(except to owners)

Alternative investments that are

available to businesses usually have
different cash flows

Engineering Economics Foundations

Fundamentals Cash flow
An investment can be represented by
a diagram, as the cash flow shown
below
Cash flow (1000
EUR)

-15 -8
-5 1 2

5
3

15
46

8
Time
(month)

Test your understanding #3

EXAMPLES
mainitain the development
salary
negotiated discounts
against material costs
increases
substitution: if buyer
manages to find another
product that performs the
same function or is able to
collaborate with a supplier
to produce a funcionally
equivalent specifiaction
that is more economical to
produce
inventory reduction
process improvement

ANSWERS

TERMS

Operating and
maintance

Cost
avoidance

Cost
avoidance

Operating
and
maintance
Initial
investment
Income

Test your understanding #3

EXAMPLES
software
customization
salvage value

training
equipment

ANSWERS

TERMS

Income

Cost
avoidance

Initial
investment

Operating
and
maintance
Initial
investment
Income

Test your understanding #4

DEFINITIONS
For software , a
small percentage
overall expenses, but
probably not zero
Selling
Typically included
benefits such as
vacation, insurance,
bonuses, stock
options etc.
Taxes

ANSWERS
Costs of goods
sold-materials

Operating
expenses

Costs of sold
labor

TERMS
Costs of sold
labor
Operating
expenses
Investmentrelated
expenses
Return on equity

Operating
expenses

Costs of goods
sold-materials

Test your understanding #4

DEFINITIONS
Interest on loans
Cash dividends on
stock

Depreciation

ANSWERS
Investmentrelated
expenses
Return on
equity

Investmentrelated
expenses

TERMS
Costs of sold
labor
Operating
expenses
Investmentrelated
expenses
Return on equity

General and
administrative

Operating
expenses

Costs of goods
sold-materials

Test your understanding #5

You are project manager assigned to a
project early in the project lifecycle.
One of the things that must be done is
to do a justification to the project.
Since very little information is known
about the project, the estimates are
considered to be rough estimates.

Test your understanding #5

The following table is the project
managers estimate of the cash flow
that will take place over next five
years. What is the net cash flow at the
end of fiveCash
years
? flow
flow in Cash
Year

EUR
1
2
3
4
5

out in EUR
500.000,0
0,00
0
300.000,00 90.000,00
100.000,0
400.000,00
0
175.000,0
100.000,00
0
50.000,00 35.000,00

ANSWERS
A 50.000,00
B 50.000,00
C 100.000,00
D 150.000,00

Engineering Economics Foundations

Fundamentals Business decision making

Fundamentals

Proposals
Cash flow
Business
decision making
Time value of
money
Equivalence
Basis for
comparision
Mutually exclusive
alternatives

State the problem

Identify
alternatives
Evaluate the
alternatives
Make a decision
Implement
decision

Engineering Economics Foundations

Fundamentals Business decision making

Understan
d the real
problem

Define
the
selection
Identify
criteria
all
reasonabl
e
technicall
y
feasible
solutions

Evaluate
each
proposal
against
the
selection
criteria

Select the
preferred
proposal

Monitor
the
perfoman
ce of the
selected
proposal

Engineering Economics Foundations

Fundamentals Time value of money

Fundamentals

Proposals
Cash flow
Business
decision making
Time value of
money
Equivalence
Basis for
comparision
Mutually
exclusive
alternatives

Interest is the
time value of
money
It is the
relationship
between the
value of a EUR
today and the
value of a EUR
at some time in

Engineering Economics Foundations

Fundamentals Time value of money

Fundamentals

Proposals
Cash flow
Business
decision making
Time value of
money
Equivalence
Basis for
comparision
Mutually
exclusive
alternatives

It is the rate that

someone or some
business will pay
to use someones
else money
The equivalent of
these amounts can
be computed using
various formulas

Engineering Economics Foundations Fundamentals

Common variables in interest formulas

P = value or amount of money at a

time designated as the present or time
0
P is also referred to as present worth
(PW), present value (PV)
F = value or amount of money at some
future time
F also called future worth (FW) and
future value (FV)

Engineering Economics Foundations Fundamentals

Common variables in interest formulas

i = interest rate or rate of return per time

period; percent per year, percent by
month
n = number of interest periods; years,
months, days
A = series of consecutive, equal, end-ofperiod amounts of money. A is also called
the annual worth (AW) and equivalent
uniform annual worth; EURs per month,
EURs per day

Engineering Economics Foundations Fundamentals

Common variables in interest formulas

NPV = net present value, the sum of

all present values
t = time, stated in periods; years,
months days

Engineering Economics Foundations

Fundamentals Time value of money - Formulas

Future value (F) of present

amount (P) - year end total
(Compound interest)

Engineering Economics Foundations

Fundamentals Time value of money - Formulas

Future value (F) of present

amount (P) - over n years end
total (Compound interest)

Engineering Economics Foundations

Fundamentals Time value of money - Formulas

Present amount (P) required to

equal some future amount (F) at
some assumed interest rate (i)

Test your understanding #6

If a software development had:
Gross revenue of 14.025.000,00 EUR last year
Various costs of labour, material, operating expenses etc.
of 9.050.00,00 EUR
Income taxes of 2.040.300,00 EUR
What was their actual profit and profit margin ?
a) 2.497.700,00 EUR ; 33.50% margin
b) 1.669.800,00 EUR; 13.36% margin
c) 2.934.700,00 EUR; 20.92% margin
d) 2.040.300,00 EUR; 34.91% margin

Test your understanding #6

Formulas:
Gross revenue (costs+taxes) = Actual
profit
Actual profit/ Gross revenue = Profit margin
Actual profit = 14.025.000,00 EUR-(9.050.00,00
EUR+2.040.300,00 EUR) = 2.934.700,00 EUR
Profit margin =2.934.700,00 EUR/ 14.025.000,00
EUR
Profit margin = 20.92%

Test your understanding #7

If 15.000,00 EUR is invested at 6%
compunded annually, what is the future
value of the investment after 10 years ?
a) 15.000,00 EUR x 10 x 0.06
b) 15.000,00 EUR x
c) 15.000,00 EUR + 10 x (0.06 x 15.000,00
EUR)
d) (0.06 = 15.000,00 EUR)

Engineering Economics Foundations

Fundamentals Time value of money - Formulas

Net Present Value (NPV) = The difference

between the present value of cash
inflows and the present value of cash
outflows.
NPV is used in capital budgeting to
analyze the profitability of a projected
investment or project.

Engineering Economics Foundations

Fundamentals Time value of money - Formulas
The
following is the formula for calculating NPV:

Ct = net cash inflow during the period t

Co = total initial investment costs
r = required rate of return
t = number of time periods

Test your understanding #8

The software company is deciding
whether or not develop the new
product. It will have to invest in
developers training 100.000,00 EUR,
expects 30.000,00 EUR/year in sales
and will reserve 5.000,00 EUR/year
for expenses. The required rate of
return is 10%.
What is the Net Present Value (NPV) ?

Test your understanding #8

End
of
Year
0
1
2
2
3
4
5
5
6
6

Cash flow EUR

0,00
(30.000-5.000)/(1+0,10)
(30.000-5.000)/(1+0,10)

(30.000-5.000)/(1+0,10)

(30.000-5.000)/(1+0,10)

(30.000-5.000)/(1+0,10)

(30.000-5.000)/(1+0,10)

Present
value EUR

-100.000,00
22.727,00

20.661,00
20.661,00
18.783,00

ANSWERS

17.075,00

A)

24.404,00 EUR

15.523,00
15.523,00

B)
B)

10.888,00
10.888,00 EUR
EUR

14.112,00
14.112,00

C)
C)

5.231,00 EUR
5.231,00 EUR

D)
D)

8.881,00 EUR
8.881,00 EUR

Net Present Value (NPV) is the sum of the Present

Values. Since the NPV is greater than zero, it would be
better to invest in the project than to do nothing.

Test your understanding #9

If a software company would like to
receive 1.331.000,00 EUR in three
years and assumes an interest rate of
10 percent, how much that company
need to invest now ?
A) 751.314,00 EUR
B) 887.334,00 EUR
C) 1.000.000,00 EUR
D) 1.210.000,00 EUR

Test your understanding #9

Present ammount required

equal some future amount
some assumed interest rate:
P=
P = 1.000.000,00 EUR

to
at

Engineering Economics Foundations

Fundamentals Equivalence

Fundamentals

Proposals
Cash flow
Business
decision making
Time value of
money
Equivalence
Basis for
comparision
Mutually
exclusive
alternatives

Economic
equivalence is
established
when we are
indifferent
between a
future payments
and a present
sum of money

Test your understanding #10

Select a correct answer for scenario:
Microsoft is offering a product for
8.825,00 EUR if you will pay full
price now or 1.000,00 EUR/year for
next 12 years. If interest is 7%
which is better deal ?
A) Full price now
B) 1.000,00 EUR/year

Test your understanding #10

Assuming a reasonable interest

rate, investing now 8.825,00 EUR
will grow, with compound interest,
to an amount greater then
12.000,00 EUR.
= 8.825,00x2.252

Test your understanding #11

STU Software has decided to buy a
new server farm and has begun to
shop locally. As a startup , they have
a little cash for investment. They
found a server farm for 35.000,00
EUR, including taxes, delivery,
installation, etc. One dealer offers a
5-year loan at 0% interest, with a
5.000,00 EUR down payment.

Test your understanding #11

What would the STU Software monthly
payments be if they took the offer ?
A)
B)
C)
D)

500,00
583,34
666,67
625,00

EUR
EUR
EUR
EUR

Engineering Economics Foundations

Fundamentals Bases for Comparison

Fundamentals

Proposals
Cash flow
Business
decision making
Time value of
money
Equivalence
Basis for
comparision
Mutually
exclusive
alternatives

To compare the
alternatives that
provide the same
service over
extended periods
of time where
interest is involved
we must reduced
them to an
equivalent basis

Engineering Economics Foundations

Fundamentals Bases for
Comparison ROI and IRR

Return on Investment (ROI) and

Internal Rate of Return (IRR) can
be used to compare investments,
both want to get more value out of
a financial venture that was put in

Engineering Economics
Foundations Fundamentals
Bases for Comparison ROI
Return on Investment (ROI):
Expressed as an interest rate
Gives quick assessment of investment
perfomance and can be computed manually
Is useful when comparing two investments
over the same period
Does not allow comparison of investments
over different time periods

Engineering Economics
Foundations Fundamentals
Bases for Comparison IRR
Internal Rate of Return(IRR):
Mathematically more complicated than ROI
Annualized compund rate that can be earned
on invested money, also known as the yield
Takes into account the investment growth, but
unlike ROI, also accounts for the timing of the
cash flows
Calculating IRR uses spreadsheets and on-line
automated calculators

Engineering Economics
Foundations Fundamentals
Bases for Comparison ROI
In general you can calculate ROI
once you know:
The starting investment value The ending investment value The general formula is:

Engineering Economics
Foundations Fundamentals
Bases for Comparison IRR
In general you can calculate IRR
once you know:
The cash flows of the investment
(, )
The time elapsed in years after
the first cash flow (, ) where
The IRR is the value that solves
equatioin:

Engineering Economics Foundations

Fundamentals Bases for
Comparison IRR and NPV
Both Net Present Value (NPV) and
IRR are used to evaluate the
desirability
of
investment
of
projects
NPV can be thought of as the
flipside of IRR
NPV is the discounted value of a
stream of cash flows, generated
from an investment

Engineering Economics Foundations

Fundamentals Bases for
Comparison IRR and NPV
IRR computes the break-even rate of return
showing the discount rate, bellow which an
investment results in a postive
Recall that IRR is the basis for comparison that
represents the value of a cash flow stream in
terms of a compound interest rate over the
planning horizont
Present Worth (PW) is the basis for comparison
that translates a cash flow stream into an
equivalent single cash flow instance at the
beginning of the planning horizon

Test your understanding #12

Using a simple short term (less than one
year) ROI calculation : 1.000,00 EUR is
invested ; the investment earns 1.250,00
EUR. What is the ROI ?
A)
B)
C)
D)

18%
20%
25%
30%

Test your understanding #12

The starting investment value

= 1.000,00 EUR
The ending investment value
= 1.250,00 EUR
Formula:
= 25 %

Engineering Economics Foundations

Fundamentals Mutually Exclusive Alternatives

Fundamentals

Proposals
Cash flow
Business
decision making
Time value of
money
Equivalence
Basis for
comparision
Mutually
exclusive
alternatives

Mutually
exclusive
proposals are
two or more
proposals that
dont fit together
Either you do
one, the other or
neither

Engineering Economics
Foundations Fundamentals
Mutually Exclusive Alternatives
When presented with a choice, you can
either choose to carry out a specific
proposal or you can choose not to. But
the real choices confronting an
organization typically are not so simple
Any given set of proposals may be
turned into a set of mutually exclusive
alternatives. The choice can then be
made from among these alternatives

Engineering Economics
Foundations Fundamentals
Proposals Mutually Exclusive