Engineering Economics

Bo Hu
John Nieber
Topics Menu
Basics
Financial reporting
Journals, ledgers
Balance sheets
Income statements
Financial ratios
Costing of products & process equipment
Cost estimation
Financial analysis (Profitability)
Capital investment
Return on Investment (ROI)
Payback period
Venture Profit
Annualized Cost
Net present value
Investors rate of return (Discounted Cash Flow)
Cash flow diagram
Depreciation
 Basics

Interest Fee charged for borrowing someone elses money

Interest rate Percentage of money borrowed charged by lender.
Simple Interest Fixed interest of the principal ($ borrowed)
Compound Interest Percentage interest applied to principal +
previously accumulated interest.
Time Value of Money Money increases in value with time due
to interest.
Inflation National economies experience increased cost of
goods with time which is termed inflation.
Taxes Interest gained in an investment is taxed by the govt.
Cash Flows Difference between total cash receipts (inflow) and
total cash disbursements (outflow) in a period of
time (usually, one year).
 Financial Statements, Records, and Reports

Journal
Debit and Credit Transactions
Ledger
Transactions for a particular account category
Balance Sheet
Assets and Liabilities
Income statement (Profit/Loss)
Record of profits and losses
Cash flow statement
Summary of cash flows in a given period.
 Journal
JOURNAL Page 43
2002 Debit ($) Credit ($)

June 3 Heat Exchanger 15 80 450

Cash 11 80 450
Purchase of a HEX for ammonia plant
4 Cash 11 125 000
Ammonia product 12 125 000
Sales of product from ammonia plant ABC
6 Land 20 265 000
Cash 11 265 000
Purchase of land in Iowa from XYZ
Source : SSL p. 473
Ledger

BANK ACCOUNT, LEDGER 11 Page 5

2002 Debit ($) 2002 Credit ($)

June 1 Balance forward 42 500 000 June

4 Sales 43 125 000 3 Purchase 43 80 450
6 Purchase 43 265 000

Source : SSL p. 474

 Balance Sheet
ASSETS
Current Assets
Cash and cash equivalents 107
Marketable securities 45
Accounts receivable 2692
Inventories :
Finished products and work in progress 1420
Materials and supplies 312
Deferred income tax assets 54
Total current assets 4630
Investments
In nonconsolidated affiliates 544
Other 1476
Total investments 2020
Property
Land 200
Buildings 2190
Plant machinery and equipment 7684
Office equipment 645
Computer software 242
Less accumulated depreciation -6006
Net property 4955
Other Assets
Goodwill 952
Other intangible assets 1654
Total other assets 2606
Source : SSL p. 475
TOTAL ASSETS 14211
 Balance Sheet (cont.)
LIABILITIES
Current liabilities
Short term debt (payable within one year) 150
Accounts payable 2773
Income taxes payable 130
Deferred income tax liabilities 21
Dividends payable 104
Accrued current liabilities 975
Total current liabilities 4153
Long -Term Debt 3943
Other Noncurrent Liabilities
Pension and other post-retirement benefits 832
Reserve for discontinued operations 78
Other noncurrent obligations 784
Total other noncurrent liabilities 1754
TOTAL LIABILITIES 9850

STOCKHOLDERS' EQUITY
Common stock (authorized 2,000,000,000 shares 1000
at $1.00 par value; 1,000,000,000 issued)
Capital in excess of par value of common stock 4230
Retained earnings 2559
Less treasury stock at cost, 300,000,000 shares -3428
NET STOCKHOLDERS' EQUITY 4361

Source : SSL p. 476

TOTAL LIABILITIES + STOCKHOLDERS' EQUITY 14211
 Income Statement

Net sales 11,504

Cost of goods sold 9,131
GROSS PROFIT 2373
OPERATING EXPENSES
Research and development expenses 446
Selling, general, and administrative expenses 439
Insurance and finance company operations 34
Amortization and adjustments of goodwill 64
TOTAL OPERATING EXPENSES 983
INCOME FROM OPERATIONS 1390
Interest expenses 185
GROSS INCOME 1205
Provision for income taxes 402
NET INCOME 803
Source : SSL p. 478
 Cash Flow Statement
OPERATING ACTIVITIES
Net income available for common stockholders 3151
Adjustments to reconcile net income to net cash:
Depreciation 675
Depletion 383
Amortization 486
Provision for deferred income tax 125
Net gain (loss) on sales of property -103
Changes in assets and liabilities involving cash:
Accounts and notes receivable -441
Inventories -389
Accounts payable 315
CASH PROVIDED BY OPERATING ACTIVITIES 4202
INVESTING ACTIVITIES
Capital expenditures -1227
Sales of property 231
Sales (purchases) of investments 2221
CASH PROVIDED IN INVESTING ACTIVITIES 1225
FINANCIAL ACTIVITIES
Payments on long-term debt -524
Purchases of treasury stock -15
Proceeds from sales of preferred stock 620
Dividends paid to stockholders -485
CASH PROVIDED (USED) IN FINANCING ACTIVITIES -404 Source : SSL p. 479
INCREASE (DECREASE) IN CASH AND CASH EQUIV. 5023
 Prepare for the class discussion
Choose one of your favorite companies and
search their balance sheet, income statement,
and cash flow statement in the year 2009.
During the class, we are going to analyze their
financial ratio and see whether these
companies are considered healthy.
 Financial Ratios
Financial Ratios (to measure the profitability of company)
Current ratio : (current assets)/(current liabilities) =2
Acid-Test (Quick) Ratio : (current assets minus
inventory)/(current liabilities) =1-2
Equity Ratio : (stock holders equity)/(total assets) =0.5
Return on Total Assets (ROA) : (income before
interest and taxes) / (total assets)
Return on Equity (ROE) : (income before interest and
taxes)/(common stockholders equity)
Operating Margin : (income from operations)/(net sales)
Profit Margin (net income after taxes)/(net sales)
Cost estimate
 Product Cost

Product cost breakdown (simple case)

Total cost = MC + LC + IC
MC = Material cost
LC = Labor cost
IC = Indirect cost (overhead)

MC = $ per kg of materials x mass utilized

LC = $ per hour rate x hours worked
IC = $freight + $overhead + $contractor expensesetc
Capital Investment Installation Cost
Direct module expenses
Equipment purchase price
Installation materials cost
---------------------------------------------------- Total $A
Direct field labor
Material for construction
Equipment setting
---------------------------------------------------- Total $B
Indirect module expenses
Freight, Construction overhead,
Contractor engineering expenses
---------------------------------------------------- Total $C

BARE MODULE COST = $A+$B+$C

Capacity Cost Estimation
M
Q
C E C B
QB
where C E equipment cost with capacity Q
C B known base cost for equipment with capacity QB
M constant depending on equipment type
C1 INDEX 1

C2 INDEX 2
where C1 equipment cost in year 1
C2 equipment cost in year 2
INDEX 1 cost index in year 1 from R. Smith (2005)
INDEX 2 cost index in year 2
 Capital costing

C F f i C E ,i
i

where C F fixed capital cost for the complete system

C E ,i cost of equipment i
f i installati on factor for equipment i

or
C F f I C E ,i
from R. Smith (2005)

where f I overall installati on factor for the complete system

Equipment cost
M
Q
C E C B f M f P fT
QB

where C E equipment cost with capacity Q

C B known base cost for equipment with capacity QB
M constant depending on equipment type
f M correction factor for materials of construction
f P correction factor for design pressure
fT correction factor for design temperature
From R. Smith (2005)
 Sources of Financial Data
Seider et al. (2004) Product and Process Design Principles.
Smith, Robin, (2005) Chemical Process : Design and Integration
The Chemical Engineering (CE) Plant Cost Index
The Marshall & Swift (MS) Equipment Cost Index
The Nelson-Farrar (NF) Refinery Construction Cost Index
The Engineering News-Record (ENR) Construction Cost Index
Financial Analysis

Return on Investment
Payback period
Venture Profit
Annualized Cost
Net present value
Investors rate of return
Cash Flows
Depreciation
 Financial Analysis
Return on investment (ROI)
Annual ( Net ) Earnings
Return on Investment
(Total ) Capital Investment
(1 t )( S C )

CTCI
where
t sum of U.S. federal and state income tax rates
S annual sales revenues
C annual production cost
C TCI total capital investment
 Financial Analysis
Payback Period

Total depreciabl e capital

Payback Period (PBP)
Net earnings annual depreciation
CTDC CTDC

( 1 t )( S C ) D cash flow
where
t sum of U.S. federal and state income tax rates
S annual sales revenues
C annual production cost
CTDC total depreciabl e capital
 Financial Analysis
Venture Profit (VP)
Venture Profit (VP) Net earnings iminCTCI
( 1 t )( S C ) iminCTCI
where
t sum of U.S. federal and state income tax rates
S annual sales revenues
C annual production cost
CTCI total capital investment
imin minimum acceptable return on investment
 Financial Analysis
Annualized Cost

Annualized Cost C A C iminCTCI

where
C annual production cost
CTCI total capital investment
imin minimum acceptable return on investment
 Financial Analysis
Present Value of an Annuity (PV)

Present Worth P Future value F of an annuity

of an annuity (1 i) n

where
F future value of an annuity
i interest
n number of interest periods
 Financial Analysis
Net Present Value (NPV)
n
Net Present Value (NPV) | CF0 | CFj ( P / F ,i%, j )
j 1
n
1
| CF0 | CFj
j 1 (1 i )j
(special case CF j A) | CF0 | A( P / A,i%, n )

where
F future value of an annuity P present value
i interest n number of interest periods
A fixed sum of money paid
CF cash flow CF0 initial cash flow
(This method is also called the discounted cash flow method)
 Financial Analysis
Investors Rate of Return

Investor' s Rate of Return (IRR) Discounted Cash Flow ROR

NPV { r } 0 for r
where
r interest for zero NPV
 Financial Analysis
Cash Flow and Depreciation
Cash Flow see Cash flow diagrams.
Depreciation decrease in value of
something over time.
Payments

Depreciation
Equipment
Value
Time $

Investment $
Time
 References
Seider,Seader, Lewin, (2004) Product and Process Design Principles, Wiley.
Blank et al. (1989) Engineering Economy, 3rd Edition, McGraw-Hill.
Smith, Robin (2005) Chemical Process : Design and Integration, Wiley.