Engineering economy : applying theory to practice

635 Pages·2003·6.28 MB·English

by  Eschenbach, Ted G

ENGINEERING ECONOMY
APPLYING THEORY TO PRACTICE
Second Edition
Ted G. Eschenbach
University of Alaska Anchorage
New York ■ Oxford
OXFORD UNIVERSITYPRESS
2003
Oxford University Press
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Copyright ©2003 by Oxford University Press, Inc.
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All rights reserved. No part of this publication may be reproduced,
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Library of Congress Cataloging-in-Publication Data
Eschenbach, Ted.
Engineering economy : applying theory to practice / Ted G. Eschenbach.—2nd ed.
p. cm.
Includes bibliographical references and index.
ISBN 0-19-516152-1
1. Engineering economy. I. Title.
TA177.4.E833 2003
658.15—dc21
20022193014
10 9 8 7 6 5 4 3 2 1
Printed in the United States of America
on acid-free paper
This book is dedicated to the women and men of NASA
and to the families of
Michael P. Anderson
David M. Brown
Kalpana Chawla
Laurel B. Clark
Rick D. Husband
William C. McCool
Ilan Ramon
Preface
This text introduces the basic theory and application of engineering economy. It is suitable
for a first course in engineering economy, for self-study by practicing engineers, and for
reference during the practice of engineering. This text includes enough material so that in-
structors have some choices for a first course at the undergraduate level. At the graduate
level, instructors might add supplementary material, such as the cases that are available
through this text’s publisher. Examples from all major engineering disciplines are included,
with both private- and public-sector applications.
HIGHLIGHTS OF SECOND EDITION CHANGES
Users of the first edition (and three additional sets of reviewers specifically chosen for this
revision) have suggested the following improvements:
1. Aunified treatment of arithmetic and geometric gradients.
2. Covering mutually exclusive comparisons before constrained project selection.
3. A complete treatment of incremental analysis for benefit/cost ratios and internal
rate of return analysis of mutually exclusive alternatives.
4. Acomplete rewrite of the inflation chapter.
5. The addition of short-term economic analyses to Chapter 1.
6. Amuch simpler presentation for analyzing the defender in replacement problems.
7. Anew appendix on accounting, which introduces the income statement and balance
sheet but focuses on cost data used for economic analysis.
8. The addition of more—and of more difficult—problems within most problem sets.
9. Numerous improvements in wording, in the numerical results of examples and
problems, and in the exhibits used to illustrate concepts.
xxiii
xxiv Preface
SUPPORT PACKAGE FORTHE SECOND EDITION
This second edition is part of a mutually supportive set of engineering economy texts from
Oxford University Press. In particular, this means there is a particularly strong supplements
package.
1. Companion website featuring student resources
(www.oup.com/us/engineeringeconomy)
• INTERACTIVE MULTIPLE-CHOICE PROBLEMS: A set of web-based problems that tests
and reinforces knowledge of key concepts. Authored by William Smyer.
• EXCEL SPREADSHEET PROGRAM: Twenty-nine generators create quasi-random prob-
lem sets and solutions. Authored by Thomas Lacksonen.
• QUICKSTUDYGUIDE: This 270-page book is available as a .pdf file and contains a 36-
page summary of engineering economy, followed by 383 problems, each with a de-
tailed solution. Authored by Donald Newnan and Ed Wheeler.
2. Instructor Supplements—available to adopters
• ACD-ROM containing
PowerPoint slides with accompanying Excel spreadsheets
• A SOLUTIONS MANUAL including answers to end-of-chapter problems and mini-
cases.
• An EXAM FILE, edited by Meenakshi Sundaram, has 420 problems covering all of
the chapters of this text.
KEY FEATURES OFTHETEXT
The first edition was based on studying what other texts have done well, surveying nearly
250 teachers of engineering economy, and responding to the comments by four sets of
reviewers. Users and three additional sets of reviewers have helped to improve key features
from the first edition. The following points are still the text’s foundation:
1. Conceptually linking theory and practice.
2. Breadth and depth of coverage matched to introductory courses.
3. Emphasis on mutually exclusive alternatives while maintaining the discussion of
constrained project selection.
4. Pedagogical support for the students.
5. Modern computational tools.
1. Conceptually LinkingTheory and Practice. Often,therealismofengineering
economy texts stops with the numbers plugged into examples and problems. This text
presents the theory, and then it examines common practical violations of theoretical
assumptions.
For example, most texts define payback period and demonstrate its inferiority to time-
value-of-money measures. This text also explains why payback continues to be used and
why its use does not lead to bankruptcy. Similarly, this text, like most, explains the
assumptions of repeated lives or salvage values that are needed for valid present worth
Preface xxv
comparisons. This text adds a thorough discussion of the impact of failing to satisfy the
assumption of identical cost repetition while using equivalent annual techniques.
I believe that understanding how and why basic principles are applied is more impor-
tant and interesting than fine theoretical nuances. In practice and in this text, ranking on the
internal rate of return is used for constrained project selection, and present worth and
equivalent annual cost are used for the selection of mutually exclusive alternatives. This
text now includes complete coverage of incremental internal rate of return and benefit/cost
ratios for mutually exclusive alternatives.
Because students learn best when theory is clearly linked to real-world applications,
the examples and homework problems are specifically chosen to illustrate practical reali-
ties and to include situations in which students can apply engineering economy concepts in
their own lives.
2. Coverage Matched to Introductory Engineering Economy Courses.
Engineering economy relies on concepts and tools that are developed in accounting, fi-
nance, management science, probability, and statistics. Many topics have far more depth
than can be included in an introductory course, and many engineering economy courses
have no specific prerequisites. To best choose what to include here, I analyzed a list of
needs established by a survey of nearly 250 faculty members in engineering economy.
For example, depreciation methods, income taxes, the distinction between assets and
income, and use of cost accounting data are covered, but more advanced accounting topics
are not. Similarly, the weighted cost of capital is discussed, but finance models for risk and
stock prices are not. Basic models for multiple criteria are included, while utility theory is
not. The application of expected value and decision trees is included from probability and
learning-curve models for cost estimation from statistics; however, general forecasting
models are omitted.
The survey led to a text that has more material than most instructors will cover in one
semester. Thus, instructors have choices in the topics they will cover. To support this flex-
ibility, topics that were found to be “elective” are presented as independently as possible.
For example, the text includes cost estimating, inflation, sensitivity analysis, multiple
criteria evaluation, and economic decision trees, but each presentation is completely inde-
pendent. Appendixes of more advanced material are also included with several chapters.
3. Emphasis on Mutually Exclusive Alternatives while Maintaining Coverage
of Constrained Project Selection. Engineering students will first apply the tools of
engineering economy in engineering design. These problems require choices between
mutually exclusive alternatives. More design examples have been included in Chapters 1
through 8, and mutually exclusive alternatives are now discussed in Chapter 9. The special
case of replacement analysis is now discussed in Chapter 10.
The discussion of mutually exclusive alternatives still focuses on the use of present
worth and equivalent annual measures. However, incremental internal rates of return and
benefit/cost ratios are now covered completely, even though they are not the technique of
choice.
This text now delays coverage of constrained project selection until Chapter 11. Many
authors relegate capital budgeting to the back of engineering economy texts, where the
xxvi Preface
presentation focuses on theoretical models and advanced techniques that are rarely used.
However, the capital budgeting problem is often solved in the real world by ranking on the
internal rate of return. Discussing this constrained project selection problem in Chapter 11
provides a solid, intuitive foundation for selecting the interest rate for the time value of
money. This is applied in the comparison of mutually exclusive alternatives.
4. Pedagogical Support. Students learn more when the presentation’s structure and
the expectations are clear. Chapter objectives, key words and concepts, and lists of major
points are used to facilitate student understanding.
Realistic examples can engage student interest, and problems drawn from student life
can motivate high performance. These examples include factor-based solutions, the tra-
ditional basis of engineering economy, and newer spreadsheet-based solutions, which
use computer power for more realistic models and more complete analysis. To support
continuity of understanding and development of realistic problems, some examples and
homework problems are carried through a sequence of chapters.
Exhibits are used liberally. Advances in computer power have made it possible—and
sometimes desirable—to combine tables and graphics to form more powerful exhibits.
Asingle numbering scheme for the exhibits is used to make it easier to find a referenced
exhibit, whether table or figure.
5. Modern Computational Tools. Spreadsheets enhance the student’s analytical ca-
pabilities, allow the inclusion of more realistic problems, and better prepare students to use
engineering economy after graduation. For these reasons, spreadsheets are used in the
examples, and they can be applied to the homework problems. Computer support is rec-
ommended for problems with a CD icon. The power of spreadsheets allows students to
learn more and to address problems in realistic detail. Real-world engineering economy al-
most universally relies on spreadsheets as an analytical tool.
Thistextisdesignedtosupportuseofspreadsheetsasinstructorsprefer:(1)Spread-
sheetscanbeanintegralpartofthecourse,includinginstructionontheirconstructionand
use.(2)Spreadsheetscanberequiredorencouragedforhomeworkwithoutrequiringtheir
useinclass.(3)Studentscanusespreadsheetsontheirowntodohomework.Thespreadsheet
instructionsectionsareplacedattheendsofchapters,sotheymaybeskippedifdesired.
While spreadsheets are very useful, I have long been a proponent of understanding a
problem and using hand calculations rather than relying on computers to solve it. That is
why some examples and problems are designed to show that calculators are the easiest tool
and the best choice. This text offers a variety of hand-calculation and computer problems
that reflect what is expected of the practicing engineering economist. It also incorporates
spreadsheets throughout the text for complex problems, especially those related to infla-
tion, sensitivity, and taxes.
ORGANIZATION OFTHETEXT
The overall flow of the material is shown in Exhibit P.1. The first three parts are included in
most courses, but the last chapters in each part (Chapters 4, 8, 10, and 11) can be skipped
without a loss of continuity. Of the chapters that can be skipped without a loss of continuity,
Preface xxvii
EXHIBITP.1 Organization of the Text (Dotted material can be skipped)
Part One
Basic Concepts and Tools
1 Making Economic
Decisions
2 The Time Value of Money
3 Equivalence—A Factor
Approach
4 Spreadsheets and Part Two
Analyzing a Project
Economic Analysis
5 Present Worth
6 Equivalent Annual Worth
7 Rate of Return
8 Benefit(cid:1)Cost Ratios and Part Three
Comparing Alternatives
Other Measures
and Projects
9 Mutually Exclusive Choices
10 Replacement Analysis
11 Constrained Project
Selection
Part Four Part Five Appendix A:
Enhancements for the Real Decision-Making Tools Accounting
World 16 Estimating Cash Flows
12 Depreciation 17 Sensitivity Analysis
13 Income Taxes 18 Uncertainty and
14 Public-Sector Engineering Probabilities
Economy 19 Multiple Objectives
15 Inflation
Chapter 19 on multiple objectives is the most suitable for self-study. Chapters 10 on
replacement analysis, 13 on income taxes, and 17 on sensitivity analysis are the most diffi-
cult for self-study.
Some chapters or sections are more important for specific groups of engineers, such as
Chapter 14 on public-sector applications for civil engineers, Chapter 10 on replacement
analysis for industrial engineers, and Section 16.7 on capacity functions for chemical
engineers.
Part One presents concepts that form the fundamental basis for engineering economic
calculations. Part Two reinforces this material for increasingly complex cash flows. Part
Three compares alternatives—those that are mutually exclusive and those that are con-
strained by a limited budget. Part Four includes the effect of income taxes on the private
sector, special concerns of the public sector, and inflation. Part Five explains tools that are
needed to deal with the complexities of the real world.
THE INSTRUCTOR’S MANUAL
The instructor’s manual includes solutions to end-of-chapter problems and minicases.
xxviii Preface
The end-of-text tables are also available in pamphlet form in quantity from the pub-
lisher for those instructors who do closed-book testing.
ACKNOWLEDGMENTS
I have had an enormous amount of help in completing this text. The authors of the numer-
ous other texts that I have used provided fine examples and shaped my understanding of the
subject. Similarly, students at the University of Alaska Anchorage, the University of
Missouri–Rolla, and Merrimack College have endured classroom testing of drafts and
patiently pointed out where further work was needed.
Nearly 250 faculty responded to a six-page survey about their current texts, courses,
and desired material for an introductory text. Their responses directed me to the best and
worst aspects of existing texts and provided great insight into their courses. Their responses
specifically guided me in the addition and deletion of topics in my outline.
Other faculty members have provided material, reviewed the manuscript, or tested it
in class. They have provided many helpful comments and criticisms. I would like to thank
the following individuals in particular for their help with the first edition:
James A. Alloway, Jr., Syracuse University
Richard W. Lyles, Michigan State University
Daniel L. Babcock, University of Missouri–Rolla
Anthony K. Mason, California Polytechnic State University at San Luis Obispo
Susan Burgess (deceased), University of Missouri–Rolla
Paul R. McCright, University of South Florida
John R. Canada, North Carolina State University
Nancy L. Mills, University of Southern Colorado
Barry Clemson, Old Dominion University
Murl Wayne Parker, Mississippi State University
William J. Foley, Rensselaer Polytechnic Institute
Louis Plebani, Lehigh University
Timothy J. Gallagher, Colorado State University
Jang W. Ra, University of Alaska Anchorage
Carol S. Gattis, University of Arkansas, Fayetteville
James Rice,University of Illinois, Chicago(I apologize for losing this entry between
the first-edition manuscript and the book.)
Joseph E. Gust, Jr., Northern Arizona University
Herbert P. Schroeder, University of Alaska Anchorage
Kim Hazarvartian, Merrimack College
Jack W. Schwalbe, Florida Institute of Technology
Donald P. Hendricks, Iowa State University
Paul L. Shillings, Montana State University
Ken Henkel, California State University, Chico
Sanford Thayer, Colorado State University
Leonard Hom, California State University, Sacramento
David Veshosky, Lafayette College
W. J. Kennedy, Clemson University
Preface xxix
Ed Wheeler, University of Tennessee, Martin
Robert G. Lundquist, Ohio State University
Bob White, Western Michigan University
Henry Wiebe, University of Missouri–Rolla
Ed Wheeler of the University of Tennessee, Martin, not only reviewed drafts of the
manuscript, he also contributed sets of problems for every chapter. Because engineering
economy and finance are closely related subjects, Tim Gallagher, professor of finance at
Colorado State University, reviewed the manuscript. Jarad Golkar, then of Texas A&M
University, independently solved the end-of-chapter problems for over half of the text. His
“review” of the solutions manual has helped ensure a clean first edition.
For the second edition, the following individuals have provided comments based on
their use of the first edition, or they have reviewed the manuscript and provided specific
suggestions for improvement.
The acquisition of Irwin by McGraw-Hill and the release of my text so that it could be
published by Oxford University Press has led to some delays. It may have also led to the
omission of some reviewer’s names. I apologize to any reviewer whose name has been
inadvertently omitted, and I ask that you notify me so I can correct the omission.
David G. Alciatore, Colorado State University
Bill Moor, Arizona State University
Richard Bernhard, North Carolina State University
Maureen Sevigny, Oregon Institute of Technology
Ed Dodson, University of California at Santa Barbara
William Girouard, California State Polytechnic University at Pomona
Unknown,University of Arizona
S. M. Gupta, Northeastern University
Dennis Kroll, Bradley University
Jerome Lavelle, North Carolina State University
Gene H. Lee, University of Central Florida
Robert G. Lundquist, Ohio State University
Paul R. Munger, University of Missouri–Rolla
Steven R. Maberry, University of New Mexico
Donald G. Newnan
David C. Slaughter, University of California at Davis
Richard Monroe, Old Dominion University
William Peterson, Old Dominion University
Karen Schmahl, Miami University
Alice Smith, Auburn University
John Whittaker, University of Alberta
Rochelle Young, University of Colorado at Boulder
I would like to highlight the contribution of three reviewers to this edition. Dick
Bernhard provided the most complete set of comments that I have ever seen. Karen
Schmahl relied on her experience as a practicing engineering economist and as an instruc-
tor for detailed suggestions on the entire text. Jerome Lavelle provided very detailed
comments on selected chapters. Jerome also contributed the new accounting appendix,
which significantly strengthens the text.