Economic Decision Making

# Economic Decision Making

## Economic Decision Making

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1. Economic Decision Making Ulrich and Eppinger Chapter 15 Deiter & Schmidt Chapter 18 http://highered.mcgraw-hill.com/sites/dl/free/0072837039/595507/Chapter18Corr06_09.pdf Adapted from Dr. Stamper

2. Product Development Process Concept Development System-Level Design Detail Design Testing and Refinement Production Ramp-Up Planning Concept Development Process Mission Statement Development Plan Identify Customer Needs Establish Target Specifications Generate Product Concepts Select Product Concept(s) Test Product Concept(s) Set Final Specifications Plan Downstream Development Perform Economic Analysis Benchmark Competitive Products Build and Test Models and Prototypes

3. Overview • Monday: (Dieter, Chap 18 and Ulrich, Chap 15 Appendix) • Time Value of Money, Cash Flow Diagrams, Net Present Value, Depreciation • Thursday • Economic Analysis Process for Product Development (Ulrich Chap 15) • Profitability • Monday • More analysis • Wednesday: • Lab exercises

4. Objectives • Learn some of the language of the business community • Provide techniques to evaluate the financial attractiveness of various alternatives that are presented to engineers • Apply the economic evaluation techniques to personal and professional decisions

5. Time Value of Money Proposition: • The value of money changes over time: generally \$1 in the future is worth less than \$1 now Evidence: • Organizations are willing to borrow money in the present and then return more than what they borrowed at some point in the future (renting money).

6. Example 1: Simple Interest Future Value • Assume: • Invest \$100 now (P=\$100) • At 8% annual interest rate (i=8%=0.08) • A single 1 year period (n=1) • Find: Future Value (F) • F = (1+i)P = (1+0.08)100= \$108

7. Example 2: Simple Interest Present Value • Assume: • Desire a future payout of \$100 (F=\$100) • At 8% annual interest/discount rate (i=8%=0.08) • After a single 1 year period (n=1) • Find: Present value to give F=\$100 • Same equation: F = (1+i)P, but solve for P • P=F/(1+i) = \$100/(1+0.08)= \$92.59

8. Example 3: Compound Interest Future Value • Assume: • Invest \$100 now (P=\$100) • At 8% annual interest rate (i=8%=0.08) • For a 3 year period (n=3) • Find: Future Value (F) • Fafter 1 year = (1+i)P = (1+0.08)100= \$108 • Fafter 2 years = (1+i)(1+i)P = (1+0.08)(1+0.08)100= \$116.64 • Fafter 3 years = (1+i)(1+i)(1+i)P = \$125.97

9. Example 4: Compound Interest Present Value • Assume: • Desire a future payout of \$100 (F=\$100) • At 8% annual interest rate (i=8%=0.08) • After a 3 year period (n=3) • Find: Present value to give F=\$100 • Same equation: F = (1+i)(1+i)(1+i)P, but solve for P • P=\$100/[(1+0.08)(1+0.08)(1+0.08)]= \$79.38

10. General Equations for Compound Interest • Future Value: • Present Value: • Where: • F is future value • P is present value • i is interest rate (or discount rate) • n is number of periods

11. How Do We Compare Alternatives?(Economic Decision Making) • We need some form of “equivalence” • Present Value and Future Value can provide that equivalence

12. Cash Flow Diagrams & Net Present Value • Note the cash flow diagram. • Incomes point into the line • Expenses point away from the line • Time starts in year 0 (start of year 1) • All other flows are at the end of the year Page 867 Dieter and Schmidt http://highered.mcgraw-hill.com/sites/dl/free/0072837039/595507/Chapter18Corr06_09.pdf

13. Net Present Value of the Costs of Machine A Does it make sense that the PV of year 0 is the same as year 0? Present Value of Year 0 Costs: • \$25,000 Present Value of Year 1 Costs: • (2000-500)/(1+0.10)^1= \$1363.63 Present Value of Year 2 Costs: • (2000-500)/(1+0.10)^2= \$1239.67 Present Value of Year 3 Costs: • (2000-500)/(1+0.10)^3= \$1126.97 Present Value of Year 4 Costs: • (2000-500)/(1+0.10)^4= \$1024.52 Present Value of Year 5 Costs: • (2000-500-3000)/(1+0.10)^5= -\$931.38 Net Present Value of the Costs: 25,000 +1363.63 +1239.67 +1126.97 +1024.52 -931.38 \$ 28,823 Does it make sense that the PV of each year is decreasing with time? Why is the PV of Year 5 negative?

14. Using Excel for Year 3: Present Value of Year 3 Costs: (2000-500)/(1+0.10)^3= \$1126.97 Why is the value red ? Future Value Interest Payments Made Each Period Number of periods

15. Using Excel to find the present Value for the 5 years of \$1500 costs each year: Present Value of the 5 years: (2000-500)/(1+0.10)^1= \$1363.63 (2000-500)/(1+0.10)^2= \$1239.67 (2000-500)/(1+0.10)^3= \$1126.97 (2000-500)/(1+0.10)^4= \$1024.52 (2000-500)/(1+0.10)^5= \$ 931.38 \$ 5686 Interest 0 if Payments (Costs) made at end of period Number of periods Additional Future Value Payments (Costs) for Each Period

16. Alternatively we can use the NPV (Net Present Value) function in Excel to capture values of each year for this cash flow diagram. Why do we have to account for year 0 separately?

17. Net Present Value of the Costs of Machine B Present Value of Year 0 Costs: • \$15,000 Present Value of Year 1 Costs: • (4000)/(1+0.10)^1= \$3636.36 Present Value of Year 2 Costs: • (4000)/(1+0.10)^2= \$3305.79 Present Value of Year 3 Costs: • (4000+3500)/(1+0.10)^3= \$5634.86 Present Value of Year 4 Costs: • (4000)/(1+0.10)^4= \$2732.05 Present Value of Year 3 Costs: • (4000)/(1+0.10)^5= \$2483.69 Net Present Value of the Costs: 15,000 +3636.36 +3305.79 +5634.86 +2732.05 +2483.69 \$ 32,793

18. Net Present Value Comparison • NPV CostmachineA = \$28,823 • NPV CostmachineB = \$32,793 • CostmachineA unadjusted = \$29,500 • CostmachineBunadjusted = \$38,500

19. In-Class Exercise: 1 For Example 18.3 of Dieter and Schmidt we showed in how the Present Value (PV) and Net Present Value (NPV) functions in Excel could be used to calculate the Present Value of the costs of Machine A. Create an Excel spreadsheet that shows the annual costs and calculates the Present Value of the costs of Machine B in example 18.3. Do two separate calculations, the first which uses the PV function, and the second which uses the NPV function. Raise your hand when you have finished so that you can check your answer with your instructor.

20. Economic Metrics to Evaluate Projects • Return on Investment (ROI) • Payback period

21. Return on Investment (ROI) • Often given as a ratio of some desired economic outcome to the investment for that outcome. • Typical numerators: • Annual profit before taxes • Annual profit after taxes • Annual cash flow before taxes • Annual cash flow after taxes • Typical denominator: capital investment

22. ROI example: • ROI = benefit/ cost = (gains-cost)/cost • Buying 100 shares of Arcelor Mittal stock at \$18 per share would cost \$1800. • If you later sold those shares for \$2000, your gains minus cost would be \$200. • The resulting ROI (ratio of benefit to investment) is \$200/\$1800 or 11.1% • Note that time value of money is not considered. • What is your ROI for attending Rose-Hulman? • How would you use that information?

23. Payback Period • Typical definition: Ratio of the investment to the annual benefit… giving an estimate of the time to recover the investment • If benefits are not uniform over time… it is the time at which the cumulative sum of the benefits equal the investment • Typically does not take into account the time-value of money

24. Payback Period Example • Suppose you buy a Mini-Donut maker for \$8000 and set it up for your neighborhood’s biannual garage sale. After expenses for dough and grease, you make \$500 per year. • What is the Payback Period? • Looks like 16 years before you have recouped the initial cost. Once again, we have ignored the time value of money.

25. What is the Payback Period and 10 year ROI for your Rose Education? • Payback: Assume \$50,000 annual cost for Tuition, Room and Board, etc. and opportunity cost of \$16,000 for the lost job at McDonalds. • Assume annual salary after graduation of \$60,000. (Note that the delta due to Rose is \$60,000-\$16,000 or \$44,000) • Evaluate ROI as a percentage.

26. Rose Payback • Total cost over 4 years is \$66,000*4=\$264K • Total annual benefit is \$44,000 • It will take 6 years to pay back the cost of education at Rose. • How is this information helpful for decision making?

27. 10 Year Rose ROI • Total cost is \$264K • Total 10 year benefit is \$44,000*6=\$264K • ROI is \$264/\$264=1 • You could view this as a 100% ROI

28. Homework Problem #7 • Honda Civic • Hybrid vs. Conventional

29. Homework #5 • Publishers Clearinghouse v. Megamillions • Sketch cash flow diagram for PC • Determine PV

30. Depreciation and Taxes • Since the capital used to produce goods, services, and energy declines in value over time, tax law currently allows the owners of capital equipment to reduce their taxes each year to reflect that declining value.

31. Types of Expenditures • Capital • Funds used to purchase facilities and equipment that are useful for more than 1 year • These purchases are “capitalized” • Expense • Funds used to purchase consumables (e.g. labor, material, utilities) • These purchases are “expensed” The categorization of expenditures has important tax implications

32. Depreciation of Capital Assets • Accounting systems assume that capital equipment (not land) loses value over time • The loss of value of capital equipment is called depreciation • Depreciation is important in the economic analysis of engineering projects because depreciation can be used to reduce the taxes that are paid on corporate income

33. Taxes and Depreciation • The amount of tax a company pays is calculated by multiplying the corporate tax rate (approximately 35% for many companies) by the company’s taxable income • Where: • income = revenues – costs • taxable income = revenues – costs - depreciation

34. Example Cash Flow with Tax and Depreciation From Dieter and Schmidt

35. Calculating Depreciation • Step 1: determine the period over which the capital asset should be depreciated. • Step 2: determine how the depreciating value should be distributed over the selected period

36. Determining the Period of Depreciation • See your business office for accounting rules • Examples: • Computers, trucks: 5 years • Office furniture, railroad track, Ag buildings: 7 years • Durable goods manufacturing equipment: 10 years • Sewage treatment plant: 15 years What do you expect the time frame to be for a wind turbine?

37. Determining the Distribution • Straight line depreciation • Declining balance depreciation • Sum–of–years-digits depreciation

38. Straight-Line Depreciation Initial Cost Periods Salvage Value

39. Declining Balance Depreciation Period for which depreciation Is being calculated Initial Cost Salvage Value Total Number of Periods Depreciation in the jth year

40. Sum-of-Years-Digits Depreciation Period for which depreciation Is being calculated Initial Cost Total Number of Periods Salvage Value

41. Repaying a Loan • Generally you will make a down payment and annual payments. • The down payment occurs in year 0. • The amount of the loan is the cost of the purchase minus the down payment • The payment of the loan is easily found using Excel

42. Using the PMT Function to find Payments on a Loan Principal Monthly Interest rate Annual rate/12 Number of Periods 30 years*12 months

43. Machine Comparison You are concerned with the purchase of a heat-treating furnace for gas carburizing of steel parts. Furnace A will cost \$325,000 and will last 10 years; furnace B will cost \$400,000 and will also last 10 years. However, furnace B will provide closer control on case depth, which means that the heat treater can shoot for the low side of the specification range on case depth. This will mean that the production rate for furnace B will be 2740 lb/hr compared with 2300 lb/hr for furnace A. Total yearly production is required to be 15,400,000 lb. The cycle time for furnace A is 16.5 hr and that for furnace B is 13.8 hr. The hourly operating cost is \$64.50 per hr. Assume that money is worth 10% and the tax rate is 50%. Also use straight line depreciation. How might you compare the two alternatives?

44. Let’s compare with NPV First organize the info Next, draw a Cash Flow Diagram B saves \$3,750 in taxes B saves \$69,351 in operating costs B cost \$75,000 more than A Check the NPV

45. Chapter 15: Product Development Economics Product Design and Development Fourth Edition by Karl T. Ulrich and Steven D. Eppinger

46. Economic Analysis for Product Development(Ulrich and Eppinger) • Build a base-case financial model • Perform a sensitivity analysis • Use sensitivity analysis to understand project trade-offs • Consider the influence of qualitative factors on project success

47. Step 1: Build a Base-Case Model

48. Step 1: Build a Base-Case Model