Please note – concepts presented in these slides are considered common Please note – concepts presented in these slides are considered common knowledge to those schooled in Engineering Economics, however, these concepts knowledge to those schooled in Engineering Economics, however, these concepts were not developed by Dr. Paul.were not developed by Dr. Paul.
The Big Picture PatternThe Big Picture Pattern
All the Problems are Done the Same All the Problems are Done the Same WayWay
Two Most Important QuestionsTwo Most Important Questions How Much Do I Get?How Much Do I Get? When Do I Get It?When Do I Get It?
How Much Do I Get?How Much Do I Get?
More is better (at least when it comes to More is better (at least when it comes to money)!money)!
How Do I Determine How Much Money How Do I Determine How Much Money There Is?There Is?
A Good ProjectA Good Project For a Good Project You Get More Out of It For a Good Project You Get More Out of It
than You Put Into It.than You Put Into It.
When Do I Get It?When Do I Get It?
You’d like to take a really nice spring You’d like to take a really nice spring break vacationbreak vacation Then I offer you $3,000 to work through spring Then I offer you $3,000 to work through spring
breakbreak You get paid at the end of Spring BreakYou get paid at the end of Spring Break
Someone Else Offers you $3,000 to work Someone Else Offers you $3,000 to work through spring breakthrough spring break You get paid in 5 yearsYou get paid in 5 years
Which offer motivates you more?Which offer motivates you more?
The When RealityThe When Reality
The Motivational Clout of Money is The Motivational Clout of Money is Influenced by when you get it.Influenced by when you get it. Money now has more pull than money a Money now has more pull than money a
long time in the future.long time in the future. You might even be saying if I get it now I You might even be saying if I get it now I
could invest it and grow more money for the could invest it and grow more money for the future.future.
An Issue of EquivalenceAn Issue of Equivalence Padro Plush has 2 one dollar bills and 23 Padro Plush has 2 one dollar bills and 23
PesosPesos That must mean he has 25 monies!That must mean he has 25 monies!
Freddy Flush has 20 one dollar bills and 5 Freddy Flush has 20 one dollar bills and 5 PesosPesos He has 25 monies too!He has 25 monies too!
They must both have the same amount of They must both have the same amount of money because they both have 25 money because they both have 25 monies!monies! (You are buying this aren’t you?)(You are buying this aren’t you?)
How Do I Fix an Equivalence How Do I Fix an Equivalence Problem?Problem?
Since Pesos and Dollars do not have the Since Pesos and Dollars do not have the same monetary power what do I have to same monetary power what do I have to do before I can count the money?do before I can count the money?
Meet the Cash FlowMeet the Cash Flow
Carbondale Sells its Water System to Soak-it-to-You Carbondale Sells its Water System to Soak-it-to-You Inc for $8,000,000Inc for $8,000,000
Due to the diligence and well managed maintenance Due to the diligence and well managed maintenance programs of government bodies they spend programs of government bodies they spend $18,000,000 on fixing up the system the first year and $18,000,000 on fixing up the system the first year and then $6,000,000 the second.then $6,000,000 the second.
After that Soak-It-To-You makes $4,000,000 per year After that Soak-It-To-You makes $4,000,000 per year for 10 more yearsfor 10 more years
Then Sammy Socialist is elected Mayor on a promise Then Sammy Socialist is elected Mayor on a promise to condemn and buy back the water system so that to condemn and buy back the water system so that residents are not “screwed over” by high for profit residents are not “screwed over” by high for profit system costs.system costs. They pay Soak-It-To-You $21,000,000 for the systemThey pay Soak-It-To-You $21,000,000 for the system
A Cash Flow is a List A Cash Flow is a List Showing When Money Showing When Money Moves and How MuchMoves and How Much Time 0 Time 0 -$8,000,000-$8,000,000 Time 1 Time 1 -$18,000,000-$18,000,000 Time 2 Time 2 -$6,000,000-$6,000,000 Time 3 $4,000,000Time 3 $4,000,000 Time 4 $4,000,000Time 4 $4,000,000 Time 5 $4,000,000Time 5 $4,000,000 Time 6 $4,000,000Time 6 $4,000,000 Time 7 $4,000,000Time 7 $4,000,000 Time 8 $4,000,000Time 8 $4,000,000 Time 9 $4,000,000Time 9 $4,000,000 Time 10 $4,000,000Time 10 $4,000,000 Time 11 $4,000,000Time 11 $4,000,000 Time 12 $4,000,000Time 12 $4,000,000 Time 13 $21,000,000 Time 13 $21,000,000
0 1 2
3 …………………………………………………….1213
$8,000,000
$18,000,000
$6,000,000
$4,000,000 per year
$21,000,000
A Cash Flow Can Also BeRepresented With a Graphic
Making A Cash FlowMaking A Cash Flow
Making a Cash Flow is One of the First Making a Cash Flow is One of the First Things one does in an Engineering Things one does in an Engineering Economics ProblemEconomics Problem Problem usually sounds like a “story problem” Problem usually sounds like a “story problem”
from which your glean out the cash flow.from which your glean out the cash flow. The Cash Flow Answers Our Two Most The Cash Flow Answers Our Two Most
Important Questions.Important Questions. How Much Do I Get?How Much Do I Get? When Do I Get It?When Do I Get It?
Tricks to a Good Cash Tricks to a Good Cash FlowFlow
Keep Your Pluses and Minuses StraightKeep Your Pluses and Minuses Straight Mixing them up is a great way to get wrong Mixing them up is a great way to get wrong
answers to any engineering problemanswers to any engineering problem
An Easy to Remember Rule of ThumbAn Easy to Remember Rule of Thumb Money coming into my pocket is a positive Money coming into my pocket is a positive
eventevent Money going out of my pocket is a negative Money going out of my pocket is a negative
eventevent
Another Trick to a Good Another Trick to a Good Cash FlowCash Flow
Pick the perspective of the investor and stick Pick the perspective of the investor and stick with it.with it.
In the Water System Story their was Soak-It-To-In the Water System Story their was Soak-It-To-You Inc. and the City of CarbondaleYou Inc. and the City of Carbondale If I get who is who mixed up I will mess up pluses and If I get who is who mixed up I will mess up pluses and
minusesminuses There may be building projects where there are There may be building projects where there are
10 and 12 parties involved (but only one of them 10 and 12 parties involved (but only one of them is the investor you represent)is the investor you represent) You can get all sorts of numbers in the cash flow that You can get all sorts of numbers in the cash flow that
have nothing to do with your investors.have nothing to do with your investors.
Count Your MoneyCount Your Money(Or I’ve seen this mistake before)(Or I’ve seen this mistake before)
I Decide to see whether Soak-It-To-You I Decide to see whether Soak-It-To-You made a good dealmade a good deal Money invested in the systemMoney invested in the system
$8,000,000 to buy$8,000,000 to buy $18,000,000 and $6,000,000 to upgrade$18,000,000 and $6,000,000 to upgrade Total in $32,000,000Total in $32,000,000
Money OutMoney Out $4,000,000 per year for 10 years - $40,000,000$4,000,000 per year for 10 years - $40,000,000 $21,000,000 when the city bought it back$21,000,000 when the city bought it back Total out $61,000,000Total out $61,000,000
What Did I Do Wrong?What Did I Do Wrong?
Pedro Plush had 2 $1 bills and $23 Pedro Plush had 2 $1 bills and $23 pesos – Therefore he has 25 monies.pesos – Therefore he has 25 monies. But I Can’t Do That Because Pesos and But I Can’t Do That Because Pesos and
Dollars have different buying powerDollars have different buying power
When I just added up all the money When I just added up all the money without regard to when I got it – what without regard to when I got it – what mistake did I make?mistake did I make?
What Do I Need to Do About It?What Do I Need to Do About It?
So How Do I Adjust the So How Do I Adjust the Value of Money from Value of Money from Different Points In Time?Different Points In Time?
How Many of You Have a Job while Your How Many of You Have a Job while Your in Schoolin School You do your job becauseYou do your job because
You like having no social lifeYou like having no social life You like being forced to put off homework till the You like being forced to put off homework till the
last minute and then give up sleep to do itlast minute and then give up sleep to do it There isn’t any recreational activity you’d rather be There isn’t any recreational activity you’d rather be
doing.doing. How do people get you to put-off or give up How do people get you to put-off or give up
having time for yourself right now?having time for yourself right now?
The Problem of Delayed The Problem of Delayed MoneyMoney
People would rather have their money People would rather have their money now.now. How could I get someone to put off having How could I get someone to put off having
their money now?their money now?
If I Pay People for Waiting If I Pay People for Waiting for Their Moneyfor Their Money
If I give someone $5,000 in 5 yearsIf I give someone $5,000 in 5 years Part of the money will get counted as payment for Part of the money will get counted as payment for
waitingwaiting Part of the money will be counted a giving me back Part of the money will be counted a giving me back
my investment moneymy investment money
If I knew that ratio I would know how much If I knew that ratio I would know how much $5,000 in 5 years is equal to today!$5,000 in 5 years is equal to today! Then I could convert the future money to money Then I could convert the future money to money
now and then count it all upnow and then count it all up (No Peso and Dollar screw up)(No Peso and Dollar screw up)
Big Question is How Do I Big Question is How Do I Know What to Charge for Know What to Charge for Delayed Gratification?Delayed Gratification?
I Go into McDonalds and offer to work for I Go into McDonalds and offer to work for $50 an hour as a food service worker$50 an hour as a food service worker I want evenings, holidays, and weekends offI want evenings, holidays, and weekends off I want my hours in 8 hour blocksI want my hours in 8 hour blocks I want 32 hours a weekI want 32 hours a week
Do you think I’m going to get hired?Do you think I’m going to get hired?
I Need to Figure Out What is I Need to Figure Out What is Reasonable?Reasonable?
I look for a “Rate of Return” on my moneyI look for a “Rate of Return” on my money The Rate of Return is used to determine The Rate of Return is used to determine
how much extra I have to be paid to wait how much extra I have to be paid to wait for my moneyfor my money A high rate of return means I get paid more A high rate of return means I get paid more
generously than with a low rate of returngenerously than with a low rate of return Rates of Return are measured in Rates of Return are measured in
percentage of extra money that must be percentage of extra money that must be provided every year to get me to wait.provided every year to get me to wait.
What Goes Into Such a What Goes Into Such a “Rate of Return”“Rate of Return”
What normally happens to prices?What normally happens to prices? Lets say I could buy Dairy Queen Blizzards for Lets say I could buy Dairy Queen Blizzards for
$3 each$3 each I lend you my money for 10 Blizzards $30I lend you my money for 10 Blizzards $30 You pay me my $30 back in 5 yearsYou pay me my $30 back in 5 years But now Blizzards cost $3.50 each?But now Blizzards cost $3.50 each? Why Am I Ticked?Why Am I Ticked? What am I going to want to have done about What am I going to want to have done about
this “inflation” problem?this “inflation” problem?
One Thing to Take Care One Thing to Take Care OfOf
You must give me enough extra money You must give me enough extra money to cover my loss of buying power to to cover my loss of buying power to inflation.inflation.
Inflation is measured in %Inflation is measured in % What is the current annual inflation rate?What is the current annual inflation rate?
Another VariationAnother Variation
I lend 100 students $30 of Blizzard I lend 100 students $30 of Blizzard Money Money (Ok your not sure I’d eat that many Blizzards – but it (Ok your not sure I’d eat that many Blizzards – but it does sound like a rewarding challenge)does sound like a rewarding challenge)
They all agree to pay me back $35 to They all agree to pay me back $35 to cover inflationcover inflation
Do you think all 100 students are going to Do you think all 100 students are going to come through and look me up in 5 years come through and look me up in 5 years to pay me back?to pay me back?
The Element of RiskThe Element of Risk
The only sure money is the money in your hand The only sure money is the money in your hand right now!right now!
I need to collect enough extra to reimburse me I need to collect enough extra to reimburse me for the fact that some of my “investments” are for the fact that some of my “investments” are going to go bad.going to go bad.
In practice risk premiums are calculated by In practice risk premiums are calculated by comparisons to the marketcomparisons to the market Infrastructure projects with guarantees may be only Infrastructure projects with guarantees may be only
less than 1%less than 1% Manufacturing and design may be around 6 to 9%Manufacturing and design may be around 6 to 9% Mining may be around 9 to 12%Mining may be around 9 to 12% New start-up companies can be a lot higherNew start-up companies can be a lot higher
I’ve Still Not Been Paid for I’ve Still Not Been Paid for Waiting for My MoneyWaiting for My Money
Market rate for waiting has been the Market rate for waiting has been the same since the dawn of capitalismsame since the dawn of capitalism Its about 1 to 2%Its about 1 to 2%
The Last FactorThe Last Factor
When two gas stations are side by side When two gas stations are side by side and one lowers its price just a little – what and one lowers its price just a little – what happens?happens?
When banks want students to open new When banks want students to open new accounts with them and one bank offers a accounts with them and one bank offers a clock radio – what does the next bank do?clock radio – what does the next bank do?
It is common for competitors to try to It is common for competitors to try to sweeten the mix to set themselves apartsweeten the mix to set themselves apart This “motivation premium” is about 0.1%This “motivation premium” is about 0.1%
OK Now I Know What People OK Now I Know What People ConsiderConsider
Inflation (say about 3.2%)Inflation (say about 3.2%) Risk (lets say we look at about a 7%)Risk (lets say we look at about a 7%) Payment for Rating – called market rate Payment for Rating – called market rate
or risk free rate – (about 1.5%)or risk free rate – (about 1.5%) Motivation Premium – (about 0.1%)Motivation Premium – (about 0.1%) Ok now how do I get a Rate of Return out Ok now how do I get a Rate of Return out
of this?of this?
A First ImpulseA First Impulse
Add it upAdd it up 3.2% + 7% + 1.5% + 0.1% = 11.8%3.2% + 7% + 1.5% + 0.1% = 11.8%
Why it doesn’t workWhy it doesn’t work Will my risk premium money have inflation?Will my risk premium money have inflation? Are people who skip out on paying me back Are people who skip out on paying me back
likely to look me up to pay my 5% inflation likely to look me up to pay my 5% inflation premium?premium?
Risk, inflation, and reward affect all Risk, inflation, and reward affect all money alike.money alike.
The Multiply SolutionThe Multiply Solution
When I multiply numbers together each factor When I multiply numbers together each factor is applied to all the money – including that from is applied to all the money – including that from other factors.other factors.
But there are special tricks before we multiplyBut there are special tricks before we multiply We convert from % to decimal formWe convert from % to decimal form Not really hard just divide by 100Not really hard just divide by 100
Decimals or %.Decimals or %. We talk and write down answers in %We talk and write down answers in % But we do all our math in decimals.But we do all our math in decimals.
Lets Set this one Up!Lets Set this one Up!
(1.032)*(1.07)*(1.015)*(1.001) =(1.032)*(1.07)*(1.015)*(1.001) = We recognized each of these things asWe recognized each of these things as
Which leaves us wondering what the 1s Which leaves us wondering what the 1s are all about.are all about.
An ExampleAn Example
I borrow $100 from you and promise to I borrow $100 from you and promise to pay you $10 in interest when I pay you pay you $10 in interest when I pay you back next weekback next week
Next week I give you a $10 billNext week I give you a $10 bill Is anything wrong?Is anything wrong? What happens when you multiply a What happens when you multiply a
number by 1?number by 1?
Now Lets Finish Solving Now Lets Finish Solving That Rate of Return That Rate of Return ProblemProblem
(1.032)*(1.07)*(1.015)*(1.001)= 1.1219(1.032)*(1.07)*(1.015)*(1.001)= 1.1219 Of course I know what the 1 is forOf course I know what the 1 is for That leaves me 0.1219That leaves me 0.1219 Now because I’m going to talk about it I Now because I’m going to talk about it I
convert back to a percentageconvert back to a percentage 100* 0.1219 = 12.19%100* 0.1219 = 12.19%
I Mentioned Class I Mentioned Class AssistantAssistant
An aside about Rate of An aside about Rate of ReturnReturn
When we are trying to project the cash flow When we are trying to project the cash flow that we will get back from an investment that we will get back from an investment sometimes we don’t know what the rate of sometimes we don’t know what the rate of inflation will be in 5 yearsinflation will be in 5 years (If you do, Ben Bernanke has a job for you)(If you do, Ben Bernanke has a job for you)
We write down the cash flows as if there We write down the cash flows as if there were no inflationwere no inflation (ok we do that a lot in engineering economic (ok we do that a lot in engineering economic
analysis)analysis)
Unscrewing the Rate of ReturnUnscrewing the Rate of Return Now I have a rate of return that tells how much I Now I have a rate of return that tells how much I
need for inflation and a cash flow with no inflationneed for inflation and a cash flow with no inflation I fix the problem by dropping out the inflation I fix the problem by dropping out the inflation
factor from by RORfactor from by ROR Thus we have two kinds of RORsThus we have two kinds of RORs
Real rate of return means both the cash flow and the Real rate of return means both the cash flow and the ROR ignored inflation (even though its fake we call it ROR ignored inflation (even though its fake we call it real because it measures real buying power)real because it measures real buying power)
Nominal rate of return considers inflation in both the Nominal rate of return considers inflation in both the cash flow and the RORcash flow and the ROR
If inflation is included in one and not the other - If inflation is included in one and not the other - you screwed upyou screwed up
Using Class AssistantUsing Class Assistant
A Common ProblemA Common Problem
Engineers go through design somethingEngineers go through design something Then they estimate the costs and earningsThen they estimate the costs and earnings
Put them in a cash flowPut them in a cash flow Since predicting inflation rates in 7 years was not their concern Since predicting inflation rates in 7 years was not their concern
they calculate what costs and earnings are in todays termsthey calculate what costs and earnings are in todays terms Then they need to apply an interest rate to see if they Then they need to apply an interest rate to see if they
got enough moneygot enough money They go to accounting to get the rateThey go to accounting to get the rate Accountants track prices in a world that has inflationAccountants track prices in a world that has inflation They give an interest rate with inflation inThey give an interest rate with inflation in Engineer then uses an interest rate that considers inflationEngineer then uses an interest rate that considers inflation
He just mismatched interest ratesHe just mismatched interest rates
How to Make a Real Interest How to Make a Real Interest Rate from a NominalRate from a Nominal
Say accountant says Rate of Return (ROR) is Say accountant says Rate of Return (ROR) is 17%17%
We ask about rate of inflationWe ask about rate of inflation He/She says 3.5%He/She says 3.5%
We have a real cash flow so we need a real We have a real cash flow so we need a real raterate
(1.17)/(1.035) =1.130435(1.17)/(1.035) =1.130435 Take out the 1 0.130435Take out the 1 0.130435 Multiply by 100 to get % 13.0435%Multiply by 100 to get % 13.0435%
Using Class Assistant So Using Class Assistant So This Does Not Happen to This Does Not Happen to YouYou
My Accountant says17%
I ask him what rateOf inflation went With that interestRate.
He tells me 3.5%
The spreadsheetSpits out a 13.05%Real interest rateWhich I use on myCash flow.
Can also convert a real rate to a nominal
Now Its Your Turn to Now Its Your Turn to Estimate an Interest Estimate an Interest RateRateDo Assignment #1Do Assignment #1
