Engineering Economics

Bo HuJohn Nieber

BasicsFinancial reporting

Journals, ledgersBalance sheetsIncome statementsFinancial ratios

Costing of products & process equipmentCost estimation

Financial analysis (Profitability)Capital investment

Return on Investment (ROI)Payback periodVenture ProfitAnnualized CostNet present valueInvestor’s rate of return (Discounted Cash Flow)

Cash flow diagramDepreciation

Topics Menu

Interest Fee charged for borrowing someone else’s moneyInterest 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).

Basics

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.

Ledger

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

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. 473

Source : SSL p. 474

Journal

Balance Sheet

ASSETSCurrent Assets

Cash and cash equivalents 107Marketable securities 45Accounts receivable 2692Inventories : Finished products and work in progress 1420 Materials and supplies 312Deferred income tax assets 54

Total current assets 4630Investments

In nonconsolidated affiliates 544Other 1476

Total investments 2020Property

Land 200Buildings 2190Plant machinery and equipment 7684Office equipment 645Computer software 242Less accumulated depreciation -6006

Net property 4955Other Assets

Goodwill 952Other intangible assets 1654

Total other assets 2606

TOTAL ASSETS 14211Source : SSL p. 475

Balance Sheet (cont.)

LIABILITIESCurrent liabilities

Short term debt (payable within one year) 150Accounts payable 2773Income taxes payable 130Deferred income tax liabilities 21Dividends payable 104Accrued current liabilities 975

Total current liabilities 4153Long -Term Debt 3943Other Noncurrent Liabilities

Pension and other post-retirement benefits 832Reserve for discontinued operations 78Other 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 4230Retained earnings 2559Less treasury stock at cost, 300,000,000 shares -3428

NET STOCKHOLDERS' EQUITY 4361

TOTAL LIABILITIES + STOCKHOLDERS' EQUITY 14211Source : SSL p. 476

Income Statement

Net sales 11,504 Cost of goods sold 9,131GROSS PROFIT 2373OPERATING EXPENSES Research and development expenses 446 Selling, general, and administrative expenses 439 Insurance and finance company operations 34 Amortization and adjustments of goodwill 64TOTAL OPERATING EXPENSES 983INCOME FROM OPERATIONS 1390 Interest expenses 185GROSS INCOME 1205 Provision for income taxes 402NET INCOME 803

Source : SSL p. 478

Cash Flow StatementOPERATING 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 315CASH PROVIDED BY OPERATING ACTIVITIES 4202INVESTING ACTIVITIES Capital expenditures -1227 Sales of property 231 Sales (purchases) of investments 2221CASH PROVIDED IN INVESTING ACTIVITIES 1225FINANCIAL ACTIVITIES Payments on long-term debt -524 Purchases of treasury stock -15 Proceeds from sales of preferred stock 620 Dividends paid to stockholders -485CASH PROVIDED (USED) IN FINANCING ACTIVITIES -404INCREASE (DECREASE) IN CASH AND CASH EQUIV. 5023

Source : SSL p. 479

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 breakdown (simple case)Total cost = MC + LC + IC

MC = Material costLC = Labor costIC = Indirect cost (overhead)

MC = $ per kg of materials x mass utilized

LC = $ per hour rate x hours worked

IC = $freight + $overhead + $contractor expenses…etc

Product Cost

Direct module expensesEquipment purchase priceInstallation materials cost---------------------------------------------------- Total $A

Direct field laborMaterial for constructionEquipment setting---------------------------------------------------- Total $B

Indirect module expensesFreight, Construction overhead,Contractor engineering expenses---------------------------------------------------- Total $C

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

Capital Investment Installation Cost

2 year in index cost NDEXI

1 year in index cost NDEXI

2 year in cost equipmentC

1 year in cost equipmentC where

INDEX

INDEX

C

C

type equipment on depending constantM

Qcapacity withequipment for cost base knownC

Qcapacity withcost equipmentC where

Q

QCC

2

1

2

1

2

1

2

1

BB

E

M

BBE

Capacity Cost Estimation

from R. Smith (2005)

Capital costing

systemcomplete the for factor oninstallati overall f where

CfC

or

i equipment for factor oninstallatif

i equipment of cost C

systemcomplete the for cost capital fixedC where

CfC

I

ii,EIF

i

i,E

F

ii,EiF

from R. Smith (2005)

Equipment cost

etemperatur design for factor correctionf

pressure design for factor correctionf

onconstructi of materials for factor correctionf

type equipment on depending constantM

Qcapacity withequipment for cost base knownC

Qcapacity withcost equipmentC where

fffQ

QCC

T

P

M

BB

E

TPM

M

BBE

From R. Smith (2005)

Sources of Financial DataSeider 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 periodVenture ProfitAnnualized CostNet present valueInvestor’s rate of returnCash FlowsDepreciation

Financial Analysis• Return on investment (ROI)

investment capital totalC

cost production annualC

revenues sales annualS

rates tax income state and federal U.S.of sumt

))(1(

)(

)( Investmenton Return

TCI

where

C

CSt

InvestmentCapitalTotal

EarningsNetAnnual

TCI

Financial Analysis• Payback Period

capital edepreciabl totalC

cost production annualC

revenues salesannualS

rates tax income stateand federal U.S. of sumt

where

flow cash

C

D)CS)(t1(

C

ondepreciati annual earnings Net

capital edepreciabl Total (PBP) Period Payback

TDC

TDCTDC

Financial Analysis• Venture Profit (VP)

investment on return acceptable minimum i

investment capital totalC

cost production annualC

revenues salesannualS

rates tax income stateand federal U.S. of sumt

where

Ci)CS)(t1(

Ci earnings Net (VP) Profit Venture

min

TCI

TCImin

TCImin

Financial Analysis• Annualized Cost

investment on return acceptable minimum i

investment capital totalC

cost production annualC

where

CiC C Cost Annualized

min

TCI

TCIminA

Financial Analysis• Present Value of an Annuity (PV)

periods interest of number n

interesti

annuity an of value future F

where

i)(1

annuity an of F value Future

annuity an of

P Worth Presentn

Financial Analysis• Net Present Value (NPV)

method) flow cash discounted the called also is method (This

flow cash initial 0CF flow cash CF

paidmoney of sumfixedA

periods interest of number n interesti

value present P annuity an of value future F

where

A)jCF case (special )n%,i,A/P(A |CF|

)i1(

1CF |CF|

)j%,i,F/P(CF|CF| (NPV) Value Present Net

0

n

1jjj0

n

1jj0

Financial Analysis

• Investor’s Rate of Return

NPV zero for interestr

where

r for 0}r{NPV

ROR Flow Cash Discounted (IRR) Return of Rate sInvestor'

Financial Analysis• Cash Flow and Depreciation

Cash Flow – see Cash flow diagrams.Depreciation – decrease in value of

something over time.

Investment $

Payments

EquipmentValue$

Depreciation

Time

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.