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Global engineering economics: financial decision making for engineers / Xiall M. Fraser ... [et al.]. ā€” 4th ed.

Includes index.

Previous editions published under title: Engineering economics in Canada.

ISBN 978-0-13-207161-1

1. Engineering economy. I. Fraser, Xiall M. (Xiall Morris), 1952ā€”

TA1 77.4.F725 2008 65 8.15 C2008-903776-6

Copvright Ā© 2009, 2006, 2000, 1997 Pearson Education Canada, a division of Pearson Canada Inc., Toronto, Ontario.

Pearson Prentice Hall. All rights reserved. This publication is protected by copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval svstem, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission, write to the Permissions Department.

ISBN-13: 978-0-13-207161-1 ISBX-10: 0-13-207161-4

Vice-President, Editorial Director: Gary Bennett Acquisitions Editor: Cathleen Sullivan .Marketing Manager: Michelle Bish Developmental Editor: .Maurice Esses Production Editor: Imee Salumbides Copy Editor: Laurel Sparrow Proofreader: Susan Bindernagel Production Coordinator: Sarah Lukaweski Compositor: Integra

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For permission to reproduce copyrighted material, the publisher gratefully acknowledges the copyright holders listed in the Mini-Cases and tables, which are considered an extension of this copyright page.

Printed and bound in the United States of-America.

CHAPTER 1 CHAPTER 2 CHAPTER 3

Appendix 3A Appendix 3B CHAPTER 4

Appendix 4A CHAPTER 5

Appendix 5A CHAPTER 6 CHAPTER 7 CHAPTER 8

Appendix 8A CHAPTER 9

Appendix 9A CHAPTER 10 CHAPTER 11 CHAPTER 12 CHAPTER 13

Appendix 13A

Engineering Decision Making 1 Time Value of Money 18 Cash Flow Analysis 44

Continuous Compounding and Continuous Cash Flows 79

Derivation ot Discrete Compound Interest Factors 83

Comparison Methods Part 1 86

The MARR and the Cost of Capital 123

Comparison Methods Part 2 126

Tests for Multiple IRRs 161

Depreciation and Financial Accounting 171

Replacement Decisions 220

Taxes 266

Deriving the Tax Benefit Factor 304 Inflation 306

Computing a Price Index 339

Public Sector Decision Making 343

Dealing with Uncertainty: Sensitivity Analysis 386

Dealing with Risk: Probability Analysis 420

Qualitative Considerations and Multiple Criteria 472

Calculating the Consistency Ratio for AHP 500

APPENDIX A Compound Interest Factors for Discrete Compounding, Discrete Cash Flows 505

APPENDIX B Compound Interest Factors for Continuous Compounding, Discrete Cash

Flows 529

APPENDIX C Compound Interest Factors for Continuous Compounding, Continuous Compounding

Periods 547

APPENDIX D Answers to Selected Problems 565

Glossary Index

570 577

Contents

Preface xiii

CHAPTER 1 Engineering Decision Making 1

Engineering Economics in Action, Part 1A: Naomi Arrives 2

1.1 Engineering Decision Making 2

1.2 What Is Engineering Economics? 3

1.3 Making Decisions 4

Engineering Economics in Action, Part 1B: Naomi Settles In 5

1.4 Dealing With Abstractions 6

1.5 The Moral Question: Three True Stories 8

NET VALUE 1.1: PROFESSIONAL ENGINEERING ASSOCIATIONS AND

1.6 Uncertainty. Sensitivity Analysis, and Currencies 11

1.7 How This Book Is Organized 12

Engineering Economics in Actions, Part 1C: A Taste of What Is to Come 13

Problems 14

Mini-Case 1.1: Imperial Oil v. Quebec 16

CHAPTER 2 Time Value of Money 18_

Engineering Economics in Action, Part 2A: A Steal For Steel 19

2.1 Introduction 19

2.2 Interest and Interest Rates 19 NET VALUE 2.1: INTEREST RATES 20

2.3 Compound and Simple Interest 22

2.4 Effective and Nominal Interest Rates 24

2.5 Continuous Compounding 27

2.6 Cash Flow Diagrams 28

2.7 Equivalence 31

2.7.1 Mathematical Equivalence 31

2.7.2 Decisional Equivalence 31

2.7.3 Market Equivalence 32 Review Problems 33

Summary 37

Engineering Economics in Action, Part 2B: You Just Have to Know When 37

Problems 38

Mini-Case 2.1: Student Credit Cards 43

ETHICAL DECISIONS 10

CHAPTER 3 Cash Flow Analysis 44_

Engineering Economics in Action, Part 3A: Apples and Oranges 45

3.1 Introduction 45

3.2 Timing of Cash Flows and Modelling 46

3.3 Compound Interest Factors for Discrete Compounding 46

3.4 Compound Interest Factors for Single Disbursements or Receipts 47

3.5 Compound Interest Factors for Annuities 49

3.6 Conversion Factor for Arithmetic Gradient Series 56

3.7 Conversion Factor for Geometric Gradient Series 59 NET VALUE 3.1: ESTIMATING GROWTH RATES 60

3.8 Non-Standard Annuities and Gradients 63

3.9 Present Worth Computations When Nā€”>A 65 Review Problems 66

Summary 69

Engineering Economics in Action, Part 3B: No Free Lunch 70

Problems 70

Mini-Case 3.1: The Gorgon LNG Project in Western Australia 77

Appendix 3A Continuous Compounding and Continuous Cash Flows 79 Appendix 3B Derivation of Discrete Compound Interest Factors 83

CHAPTER4 Comparison Methods Part 1 86_

Engineering Economics in Action, Part 4A: What's Best? 87

4.1 Introduction 87

4.2 Relations Among Projects 89

4.3 Minimum Acceptable Rate of Return (MARR) 91

4.4 Present Worth (PW) and Annual Worth (AW) Comparisons 92

4.4.1 Present Worth Comparisons for Independent Projects 92

4.4.2 Present Worth Comparisons for Mutually Exclusive Projects 95

4.4.3 Annual \Yorth Comparisons 95 NET VALUE 4.1: CAR PAYMENT CALCULATORS 96

4.4.4 Comparison of Alternatives Wth Unequal Lives 98

4.5 Payback Period 102 Review Problems 105 Summary 109

Engineering Economics in Action, Part 4B: Doing It Right 109

Problems 110

Mini-Case 4.1: Rockwell International 122

Appendix 4A The MARR and the Cost of Capital 123

CHAPTER 5 Comparison Methods Part 2 126_

Engineering Economics in Action, Part 5A: What's Best? Revisited 127

5.1 Introduction 127

5.2 The Internal Rate of Return 127

5.3 Internal Rate of Return Comparisons 130

5.3.1 IRR for Independent Projects 130

5.3.2 IRR for .Mutually Exclusive Projects 132

5.3.3 Multiple IRRs 137

NET VALUE 5.1: CAPITAL BUDGETING AND FINANCIAL MANAGEMENT RESOURCES 139

5.3.4 External Rate of Return Methods 140

5.3.5 When to Use the ERR 142

5.4 Rate of Return and Present/Annual Worth Methods Compared 143

5.4.1 Equivalence of Rate of Return and Present/Annual Worth Methods 143

5.4.2 Why Choose One Method Over the Other? 147 Review Problems 149

Summary 152

Engineering Economics in Action, Part 5B: The Invisible Hand 153

Problems 154

Mini-Case 5.1: The Galore Creek Project 160 Appendix 5A Tests for Multiple IRRs 161

CHAPTER6 Depreciation and Financial Accounting 171_

Engineering Economics in Action, Part 6A: The Pit Bull 172

6.1 Introduction 172

6.2 Depreciation and Depreciation Accounting 173

6.2.1 Reasons for Depreciation 1--.3

6.2.3 Straight-Line Depreciation 7 74

6.2.4 Declining-Balance Depreciation 176

6.3 Elements of Financial Accounting 179

6.3.1 Measuring the Performance of a Firm 180

6.3.2 The Balance Sheet 180

6.3.3 The Income Statement 185

6.3.4 Estimated Values in Financial Statements 187

6.3.5 Financial Ratio Analysis 187'

6.3.6 Financial Ratios 188 NET VALUE 6.1: SECURITIES REGULATORS 188 Review Problems 195

Summary 199 Problems 200

Engineering Economics in Action, Part 6B: Usually the Truth 200

Mini-Case 6.1: Business Expense or Capital Expenditure? 213 Extended Case: Part 1 Welcome to the Real World 215

CHAPTER 7 Replacement Decisions 220_

Engineering Economics in Action, Part 7A: You Need the Facts 221

7.1 Introduction 221

7.2 A Replacement Example 222

7.3 Reasons for Replacement or Retirement 225

7.4 Capital Costs and Other Costs 226

7.5 Defender and Challenger Are Identical 227

NET VALUE 7.1: ESTIMATING SALVAGE VALUES AND SCRAP VALUES 227

7.6 Challenger Is Different From Defender: Challenger Repeats Indefinitely 231

7.6.1 Converting From Subcontracted to In-House Production 233

7.6.2 The Irrelevance of Sunk Costs 234

7.6.3 WTien Capital or Operating Costs Are Non-Monotonic 235

7.7 Challenger Is Different From Defender; Challenger Does Not Repeat 238

Review Problems 240 Summary 244

Engineering Economics in Action, Part 7B: Decision Time 245

Problems 246

Mini-Case 7.1: Paying for Replacement 264

CHAPTER 8 Taxes 266_

Engineering Economics in Action, Part 8A: It's in the Details 267

8.1 Introduction 267

8.2 Personal Income Taxes and Corporate Income Taxes Compared 268 NET VALUE 8.1: GOVERNMENT TAX WEBSITES 268

8.3 Corporate Tax Rates 269

8.4 Before-and After-Tax MARR 270

8.5 The Effect of Taxation on Cash Flows 271

8.5.1 The Effect of Taxes on First Cost 272

8.5.2 The Effect of Taxes on Savings 273

8.5.3 The Effect of Taxes on Salvage or Scrap Value 274

8.6 Present Worth and Annual Worth Tax Calculations 275

8.7 IRR Tax Calculations 277

8.7.1 Accurate IRR Tax Calculations 277

8.7.2 Approximate After-Tax Rate-of-Return Calculations 2T7

8.8 Specific Tax Rules in Various Countries 279

8.8.1 Australia Tax Calculations 279

8.8.2 UK Tax Calculations 281

8.8.3 US Tax Calculations 284

8.8.4 Canadian Tax Calculations 288

Review Problems 290 Summary 294

Engineering Economics in Action, Part 8B: The Work Report 294

Problems 295

Mini-Case 8.1: Flat Taxes 303

Appendix 8A Deriving the Tax Benefit Factor 304

CHAPTER 9 Inflation 306_

Engineering Economics in Action, Part 9A: The Inflated Expert 307

9.1 Introduction 307

9.2 Measuring the Inflation Rate 308

NET VALUE 9.1: GOVERNMENT COLLECTION OF STATISTICS 308

9.3 Economic Evaluation With Inflation 310

9.3.1 Converting Between Real and Actual Dollars 310

9.4 The Effect of Correctly Anticipated Inflation 313

9.4.1 The Effect of Inflation on the MARR 313

9.4.2 The Effect of Inflation on the IRR 315

9.5 Project Evaluation Methods With Inflation 317 Review Problems 323

Summary 326 Problems 327

Engineering Economics in Action. Part 9B: Exploiting Volatility 327

Mini-Case 9.1: Economic Comparison of High Pressure and Conventional Pipelines: Associated Engineering 338 Appendix 9A Computing a Price Index 339

Chapter 10 Public Sector Decision Making 343_

Engineering Economics in Action, Part 1 DA: New Challenges Down Under 344

10.1 Introduction 344

10.2 Market Failure 346

10 .2.1 .Market Failure Defined 34". 10 .2.2 Remedies for Market Failure 348

10.3 Decision Making in the Public Sector 350

10.3.1 The Point of Mew Used for Project Evaluation 351 NET VALUE 10.1: INTERNATIONAL BENEFIT-COST ANALYSIS GUIDES 352

10 .3.2 Identifying and Me asuring the Costs of Public Projects 353 10.3.3 Identifying and Mea suring the Benefits of Public Projects 3 53 10 .3.4 Benefit-Cost Ratios 35".

10 .3.5 The ALARR in the Public Sector 362 Review Problems 364

Summary 369

Engineering Economics in Action, Part 1 OB: Look at It Broadly 369

Problems 370

Mini-Case 10.1: Emissions Trading 384

CHAPTER 11 Dealing With Uncertainty: Sensitivity Analysis 386_

Engineering Economics in Action, Part 11 A: Filling a Vacuum 387

11.1 Introduction 387

11.2 Sensitivity Graphs 388

11.3 Break-Even Analysis 391

11 .3.1 Break-Even Analysis for a Single Project 392 11 .3.2 Break-Even Analysis for Multiple Projects 394

11.4 Scenario Analysis 398

Review Problems 400

Summary 403 Problems 404

Engineering Economics in Action, Part 11B: Where the Risks Lie 404

Mini-Case 11.1: China Steel Australia Limited 414 Extended Case: Part 2 Back to the Real World 417

CHAPTER 12 Dealing With Risk: Probability Analysis 420_

Engineering Economics in Action, Part 12A: Trees From Another Planet 421

12.1 Introduction 421

12.2 Basic Concepts of Probability 422

12.3 Random Variables and Probability Distributions 423

12.4 Structuring Decisions With Decision Trees 430

12.5 Decision Criteria 433

12.5.1 Expected Value 433

12.5.2 Dominance 435

12.6 Monte Carlo Simulation 440

12.6.1 Dealing With Complexity 440

12.6.2 Probability Distribution Estimation 440

12.6.3 The Monte Carlo Simulation Approach 441 NET VALUE 12.1: MONTE CARLO SIMULATION ANALYSIS SOFTWARE 442

12.7 Application Issues 447 Review Problems 448 Summary 457

Engineering Economics in Action, Part 12B: Chances Are Good 457

Problems 458

Mini-Case 12.1: Predicting Water Demand in High-Rise Buildings in Hong Kong 470

CHAPTER 13 Qualitative Considerations and Multiple Criteria 472_

Engineering Economics in Action, Part 13A: Don't Box Them In 473

13.1 Introduction 473

13.2 Efticiency 475

13.3 Decision Matrixes 477

13.4 The Analytic Hierarchy Process 481 NET VALUE 13.1: AHP SOFTWARE 481

13.5 The Consistency Ratio for AHP 486

Review Problems 486 Summary 489

Engineering Economics in Action, Part 13B: Moving On 490

Problems 490

Mini-Case 13.1: Northwind Stoneware 498

Appendix 13A Calculating the Consistency Ratio for AHP 500

Appendix A Compound Interest Factors for Discrete Compounding, Discrete Cash Flows 505

Appendix B Compound Interest Factors for Continuous Compounding, Discrete Cash Flows 529

Appendix C Compound Interest Factors for Continuous Compounding, Continuous Compounding

Periods 547

Appendix D Answers to Selected Problems 565 Glossary 570 Index 577

Courses on engineering economics are found in engineering curricula throughout the world. The courses generally deal with deciding among alternative engineering projects with respect to expected costs and benefits. For example, in Canada, the Canadian Engineering Accreditation Board requires that all accredited professional engineering programs provide studies in engineering economics. Many engineers have found that a course in engineering economics can be as useful in their practice as any of their more technical courses.

There are several stages to making a good decision. One stage is being able to determine whether a solution to a problem is technically feasible. This is one of the roles of the engineer, who has specialized training to make such technical judgments. Another stage is deciding which of several technically feasible alternatives is best. Deciding among alternatives often does not require the technical competence needed to determine which alternatives are feasible, but it is equally important in making the final choice. Some engineers have found that choosing among alternatives can be more difficult than deciding what alternatives exist.

The role of engineers in society is changing. In the past, engineers tended to have a fairly narrow focus, concentrating on the technical aspects of a problem and on strictly computational aspects of engineering economics. As a result, many engineering economics texts focused on the mathematics of the subject. Today, engineers are more likely to be the decision makers, and they need to be able to take into account strategic and policy issues.

Society has changed in other ways in recent years. In particular, the world has become more interlinked. An engineer may be trained in one part of the world and end up practising somewhere completely different. The mathematics of engineering economics, like all of an engineer's technical skills, is the same everywhere.

This book is designed for teaching a course on engineering economics to match engineering practice today. It recognizes the role of the engineer as a decision maker who has to make and defend sensible decisions. Such decisions must not only take into account a correct assessment of costs and benefits; they must also reflect an understanding of the environment in which the decisions are made.

This book is a direct descendant of a book entitled Engineering Economics in Canada, and in some senses is the fourth edition of that book. But given the increasing globalization of many engineering activities, the title and the contents have been updated. This is appropriate because the contents are applicable to engineers everywhere. For Canadian users of the previous editions, this text retains all of the valued features that made it your text of choice. For new users, it is a proven text that can support a course taught anywhere in the world.

This book also relates to students' everyday lives. In addition to examples and problems with an engineering focus, there are a number that involve decisions that many students might face, such as renting an apartment, getting a job, or buying a car.

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