Engineering Economics & Management/UNIT II

UNIT II
Introduction to Elementary Economic analysis Interest formulas and their applications- comparison Present worth method- Future worth method- Annual equivalent method- Rate of return method. ELEMENTARY ECONOMIC ANALYSIS In a business situation there are many possibilities of ma in! an economic decision ma in! which becomes a part of its operations. In order to mana!e such economic decisions we can ma e use of simple economic analysis. Factors affecting economic decisions "he followin! are some of the ma#or factors to be considered in economic decision ma in! Price of the raw materials "ransportation cost of the raw materials Availability of the raw materials $uality of the raw materials

Methods of Simple economic analysis "he followin! are the ways in analy%in! the economic decisions &. (. *. +. -. 'aterial selection for a product )esi!n selection for a product )esi!n selection for a process industry ,uildin! material selection for construction activities Process plannin!. Process modification

Material selection for a product "he cost of a product can be reduced with the selection of raw materials. Amon! various elements of cost/ raw materials cost is most si!nificant. "he process of raw materials selection nd their substitution plays an important role. Design selection for a product "he desi!n modification of a product will result in reduced raw material requirements/ increased machinability of the materials and reduced labour. )esi!n is an important factor which decides the cost factor. Design selection for a process industry "he desi!n select with specific to the process will have sequential steps to be followed to avoid wasta!es and duplication of tas with the required cycle time of the product. Building material selection for construction activities

Engineering Economics & Management/UNIT II "his is one such criterion to be ta en into consideration when a pro#ect is bein! carried out.

Process planning/ Process modification &. 'ost economical process is selected dependin! upon0 current production commitments/ delivery date/ and quality to be produced/ quality statements. &. 1election of materials0 ri!ht quality/ shape and si%e of raw material. (. 1election of #i!s/ fi2tures and special attachments. *. 1election of cuttin! tools. +. 1election of inspection !au!es. -. 'a e the process layout indicatin! sequence of operation. 3. )ocumentation of process i.e. for operation/ route sheet etc. INTEREST FORMULAS AND THEIR APPLICATIONS Interest-Meaning Interest is the rental value of money. 4hen an amount is deposited/ a desired rate of interest will be provided every year for reali%in! the value of money. "he followin! are some of the variables that has been used in calculatin! the interest rate. P5represents the principal amount A5equal amount deposited every year i interest rate n5number of years f5future amount received at the end of the year "o find out the Future worth amount the followin! formula is used which is denoted as F= P (1 !" #n "o find out the Pr!n$!%a& amount the followin! formula is used P= F' (1 !" #n Methods of calculating the payments "he followin! are the methods used in calculatin! the interest payment 6i7 1in!le payment compound method 6ii7 1in!le payment present worth method 6iii7Equal payment series compound amount 6iv7 1in!le payment series compound amount 6v7 1in!le payment series present worth method 6vi7 Equal payment series sin in! fund method 6vii7 8apital recovery method

CAPITAL (UD)ETIN) (OR" CAPITAL E*PENDITURE

Engineering Economics & Management/UNIT II 8apital e2penditure refers to the e2penditure on research and development/ advertisin! and trainin! of e2ecutives. In the lon! run/ it depends on the functional period of the pro#ect/ !enerally the items included in capital bud!etin! are e2penditure on new capital equipment/ e2penditure on e2pansion or diversification of assets/ addition to the stoc or capital/ e2penditure on replacement of depreciated capital/ e2penditure on advertisement/ e2penditure on research and development and innovation. Factors affecting investment decision )e!ree of certainty Emotional and intan!ible factors 9e!al factors Availability of funds Future earnin! 8ost consideration Methods of calculating capital expenditures

"he followin! are the various methods of calculatin! the investment decisions.
1 P!"-B!#$ P%&I'D M%()'D/!**+!, %-+I.!,%*( M%()'D It represents the period in which the total investment in a pro#ect is reserved by way of return from the pro#ect. a. when annual cash flows are even0 Pay-bac period: ori!inal investment annual cash flows b. when annual cash flows are uneven0 6i78alculate annual cash inflows-earnin!s after ta2 before depreciation. 6ii7Find the cumulative values of the annual cash inflows. 6iii79ocate from the cumulative values the pay-bac period. !dvantages/ It does not ta e into account the cash inflows earned after the pay-bac period. )oes not consider time value of money. )ifficult to determine the minimum acceptable pay-bac period. Full life of the asset is not considered under the pay-bac period. 0 !.%&!1% &!(% 'F &%(+&* M%()'D 2!&&3/&!(% 'F &%(+&* M%()'D Avera!e profits after ta2 and after depreciation are calculated and then it is divided by the total ori!inal investment 6or7 avera!e investment of the pro#ect.

Engineering Economics & Management/UNIT II

ARR: avera!e profits after depreciation and ta2es ;ri!inal investment <&==6or7avera!e investment Avera!e investment may be calculated by the followin! formula/ Avera!e investment:value of investment in be!innin! >value of investment at end of the pro#ect life is ?=@ we ta e A of ori!inal investment as avera!e investment. !dvantages/ It is very simple to understand and easy to calculate. It uses the entire earnin! of a pro#ect. "his method is based upon the well nown concepts of profit. Disadvantages/ It i!nores time value of money 6interest factor7. It does not ta e considerations real cash flows of the pro#ect. "his method cannot be applied to a situation where investment in pro#ect is to be made in part. DIS#'+*(%D #!S) F,'4 M%()'DS/ M'D%&* M%()'DS "he discounted cash flow methods ta e into account the profitability by way of cash inflows and the time value of money. a. Bet present value method b. Internal rate of return method. c. Profitability inde2 method. 5 *%( P&%S%*( .!,+% M%()'D/ P&%S%*( 4'&() M%()'D )etermine the cut-off the rate that should be selected as minimum required rate of return. Bormally for this purpose/ the cost of capital is considered to be minimum required rate of return. "his rate is called discountin! rate. "he difference between the total present value of the future cash inflows C the cost of investment is net present value 6or7 e2cess present value. BPD 6or7 EPD : total present value of the investment
future

cash inflows-cost of ori!inal

Engineering Economics & Management/UNIT II "lr : A& > A( > A* >E. > An 6&>r7n

6&>r7 6&>r7( 6&>r7*

6 I*(%&*!, &!(% 'F &%(+&* 2I&&3/ F+(+&% 4'&() M%()'D/ IRR is the rate at which the sum of discounted cash inflow equals the sum of discounted cash flows. Present value of cash inflows 8ash out flows 7 P&'FI(!BI,I(" I*D%8/ Profitability inde2 is the ratio of total present value of the future cash inflows to ori!inal investment. Profitability inde2 : total present value of future cash inflows 8ost of ori!inal investment !dvantages/ "hey reco!ni%e the time value of money. "hey consider the cash inflows of the pro#ects then the net profits. "hey consider the cash inflows over the entire life of the pro#ect. "hey ta e into consideration the ob#ective of ma2imum profitability. :&

Disadvantages/ 'ore difficult to understand and operate. It is not easy to determine an appropriate discount rate. Bot !ive !ood results while comparin! pro#ects with unequal investments of funds.