Transcript Economic Decision Making Ulrich and Eppinger Chapter 15 Deiter & Schmidt Chapter 18 http://highered.mcgraw-hill.com/sites/dl/free/0072837039/595507/Chapter18Corr06_09.pdf Adapted from Dr.

Economic Decision Making
Ulrich and Eppinger Chapter 15
Deiter & Schmidt Chapter 18
http://highered.mcgraw-hill.com/sites/dl/free/0072837039/595507/Chapter18Corr06_09.pdf
Adapted from Dr. Stamper
Product Development Process
Concept
System-Level Detail
Development Design
Design
Planning
Testing and
Refinement
Production
Ramp-Up
Concept Development Process
Mission
Statement
Identify
Customer
Needs
Establish
Target
Specifications
Generate
Product
Concepts
Select
Product
Concept(s)
Test
Product
Concept(s)
Perform Economic Analysis
Benchmark Competitive Products
Build and Test Models and Prototypes
Set
Final
Specifications
Plan
Downstream
Development
Development
Plan
Overview
• Monday: (Dieter, Chap 18 and Ulrich, Chap 15 Appendix)
• Time Value of Money, Cash Flow Diagrams, Net Present Value,
Depreciation
• Thursday
• Economic Analysis Process for Product Development (Ulrich
Chap 15)
• Profitability
• Monday
• More analysis
• Wednesday:
• Lab exercises
Objectives
• Learn some of the language of the business
community
• Provide techniques to evaluate the financial
attractiveness of various alternatives that are
presented to engineers
• Apply the economic evaluation techniques to
personal and professional decisions
Time Value of Money
Proposition:
• The value of money changes over time: generally
$1 in the future is worth less than $1 now
Evidence:
• Organizations are willing to borrow money in the
present and then return more than what they
borrowed at some point in the future (renting
money).
Example 1: Simple Interest Future Value
• Assume:
– Invest $100 now (P=$100)
– At 8% annual interest rate (i=8%=0.08)
– A single 1 year period (n=1)
• Find: Future Value (F)
– F = (1+i)P = (1+0.08)100= $108
Example 2: Simple Interest Present Value
• Assume:
– Desire a future payout of $100 (F=$100)
– At 8% annual interest/discount rate (i=8%=0.08)
– After a single 1 year period (n=1)
• Find: Present value to give F=$100
– Same equation: F = (1+i)P, but solve for P
– P=F/(1+i) = $100/(1+0.08)= $92.59
Example 3: Compound Interest Future Value
• Assume:
– Invest $100 now (P=$100)
– At 8% annual interest rate (i=8%=0.08)
– For a 3 year period (n=3)
• Find: Future Value (F)
– Fafter 1 year = (1+i)P = (1+0.08)100= $108
– Fafter 2 years = (1+i)(1+i)P = (1+0.08)(1+0.08)100= $116.64
– Fafter 3 years = (1+i)(1+i)(1+i)P = $125.97
Example 4: Compound Interest Present Value
• Assume:
– Desire a future payout of $100 (F=$100)
– At 8% annual interest rate (i=8%=0.08)
– After a 3 year period (n=3)
• Find: Present value to give F=$100
– Same equation: F = (1+i)(1+i)(1+i)P, but solve for P
– P=$100/[(1+0.08)(1+0.08)(1+0.08)]= $79.38
General Equations for Compound Interest
• Future Value:
• Present Value:
•
Where:
– F is future value
– P is present value
– i is interest rate (or discount rate)
– n is number of periods
How Do We Compare Alternatives?
(Economic Decision Making)
• We need some form of “equivalence”
• Present Value and Future Value can provide
that equivalence
Cash Flow Diagrams & Net Present Value
Note the cash flow diagram.
• Incomes point into the line
• Expenses point away from the
line
• Time starts in year 0 (start of
year 1)
• All other flows are at the end of
the year
Page 867 Dieter and Schmidt
http://highered.mcgraw-hill.com/sites/dl/free/0072837039/595507/Chapter18Corr06_09.pdf
Net Present Value of the Costs of Machine A
Present Value of Year 0 Costs:
– $25,000
Does it make sense that
the PV of year 0 is the
same as year 0?
Present Value of Year 1 Costs:
– (2000-500)/(1+0.10)^1= $1363.63
Present Value of Year 2 Costs:
– (2000-500)/(1+0.10)^2= $1239.67
Present Value of Year 3 Costs:
– (2000-500)/(1+0.10)^3= $1126.97
Present Value of Year 4 Costs:
– (2000-500)/(1+0.10)^4= $1024.52
Net Present Value of the Costs:
Does it make sense that
the PV of each year is
decreasing with time?
Present Value of Year 5 Costs:
– (2000-500-3000)/(1+0.10)^5= -$931.38
Why is the PV of Year 5
negative?
25,000
+1363.63
+1239.67
+1126.97
+1024.52
-931.38
$ 28,823
Using Excel for Year 3:
Present Value of Year 3 Costs:
(2000-500)/(1+0.10)^3= $1126.97
Why is the value red ?
Future Value
Interest
Number of periods
Payments Made Each Period
Using Excel to find the present
Value for the 5 years
of $1500 costs each year:
Present Value of the 5 years:
(2000-500)/(1+0.10)^1= $1363.63
(2000-500)/(1+0.10)^2= $1239.67
(2000-500)/(1+0.10)^3= $1126.97
(2000-500)/(1+0.10)^4= $1024.52
(2000-500)/(1+0.10)^5= $ 931.38
$ 5686
Interest
Number of periods
0 if Payments (Costs)
made at end of period
Additional Future Value
Payments (Costs) for Each Period
Alternatively we can use the NPV (Net Present Value) function in Excel to
capture values of each year for this cash flow diagram.
Why do we have to
account for year 0
separately?
Net Present Value of the Costs of Machine B
Present Value of Year 0 Costs:
• $15,000
Present Value of Year 1 Costs:
• (4000)/(1+0.10)^1= $3636.36
Present Value of Year 2 Costs:
• (4000)/(1+0.10)^2= $3305.79
Present Value of Year 3 Costs:
• (4000+3500)/(1+0.10)^3= $5634.86
Present Value of Year 4 Costs:
• (4000)/(1+0.10)^4= $2732.05
Present Value of Year 3 Costs:
• (4000)/(1+0.10)^5= $2483.69
Net Present Value of the Costs:
15,000
+3636.36
+3305.79
+5634.86
+2732.05
+2483.69
$ 32,793
Net Present Value Comparison
•
•
•
•
NPV Costmachine A = $28,823
NPV Costmachine B = $32,793
Costmachine A unadjusted = $29,500
Costmachine B unadjusted = $38,500
In-Class Exercise: 1
For Example 18.3 of Dieter and Schmidt we showed in how the
Present Value (PV) and Net Present Value (NPV) functions in
Excel could be used to calculate the Present Value of the costs
of Machine A. Create an Excel spreadsheet that shows the
annual costs and calculates the Present Value of the costs of
Machine B in example 18.3.
Do two separate calculations, the first which uses the PV
function, and the second which uses the NPV function.
Raise your hand when you have finished so that you can check
your answer with your instructor.
Economic Metrics
to Evaluate Projects
• Return on Investment (ROI)
• Payback period
Return on Investment (ROI)
• Often given as a ratio of some desired
economic outcome to the investment for that
outcome.
• Typical numerators:
– Annual profit before taxes
– Annual profit after taxes
– Annual cash flow before taxes
– Annual cash flow after taxes
• Typical denominator: capital investment
ROI example:
• ROI = benefit/ cost = (gains-cost)/cost
• Buying 100 shares of Arcelor Mittal stock at $18
per share would cost $1800.
• If you later sold those shares for $2000, your
gains minus cost would be $200.
• The resulting ROI (ratio of benefit to investment)
is $200/$1800 or 11.1%
• Note that time value of money is not considered.
• What is your ROI for attending Rose-Hulman?
• How would you use that information?
Payback Period
• Typical definition: Ratio of the investment to
the annual benefit… giving an estimate of the
time to recover the investment
• If benefits are not uniform over time… it is
the time at which the cumulative sum of the
benefits equal the investment
• Typically does not take into account the timevalue of money
Payback Period Example
• Suppose you buy a Mini-Donut maker for
$8000 and set it up for your neighborhood’s
biannual garage sale. After expenses for
dough and grease, you make $500 per year.
• What is the Payback Period?
• Looks like 16 years before you have recouped
the initial cost. Once again, we have ignored
the time value of money.
What is the Payback Period and 10
year ROI for your Rose Education?
• Payback: Assume $50,000 annual cost for
Tuition, Room and Board, etc. and opportunity
cost of $16,000 for the lost job at McDonalds.
• Assume annual salary after graduation of
$60,000. (Note that the delta due to Rose is
$60,000-$16,000 or $44,000)
• Evaluate ROI as a percentage.
Rose Payback
• Total cost over 4 years is $66,000*4=$264K
• Total annual benefit is $44,000
• It will take 6 years to pay back the cost of
education at Rose.
• How is this information helpful for decision
making?
10 Year Rose ROI
•
•
•
•
Total cost is $264K
Total 10 year benefit is $44,000*6=$264K
ROI is $264/$264=1
You could view this as a 100% ROI
Homework Problem #7
• Honda Civic
– Hybrid vs. Conventional
Homework #5
• Publishers Clearinghouse v. Megamillions
• Sketch cash flow diagram for PC
• Determine PV
Depreciation and Taxes
• Since the capital used to produce goods,
services, and energy declines in value over
time, tax law currently allows the owners of
capital equipment to reduce their taxes each
year to reflect that declining value.
Types of Expenditures
• Capital
– Funds used to purchase facilities and equipment
that are useful for more than 1 year
– These purchases are “capitalized”
• Expense
– Funds used to purchase consumables (e.g. labor,
material, utilities)
– These purchases are “expensed”
The categorization of expenditures has important
tax implications
Depreciation of Capital Assets
• Accounting systems assume that capital
equipment (not land) loses value over time
• The loss of value of capital equipment is called
depreciation
• Depreciation is important in the economic
analysis of engineering projects because
depreciation can be used to reduce the taxes
that are paid on corporate income
Taxes and Depreciation
• The amount of tax a company pays is calculated
by multiplying the corporate tax rate
(approximately 35% for many companies) by the
company’s taxable income
• Where:
– income = revenues – costs
– taxable income = revenues – costs - depreciation
Example Cash Flow
with Tax and Depreciation
From Dieter and Schmidt
Calculating Depreciation
• Step 1: determine the period over which the
capital asset should be depreciated.
• Step 2: determine how the depreciating value
should be distributed over the selected period
Determining the Period of
Depreciation
• See your business office for accounting rules
• Examples:
– Computers, trucks: 5 years
– Office furniture, railroad track, Ag buildings: 7 years
– Durable goods manufacturing equipment: 10 years
– Sewage treatment plant: 15 years
What do you expect the time frame to
be for a wind turbine?
Determining the Distribution
• Straight line depreciation
• Declining balance depreciation
• Sum–of–years-digits depreciation
Straight-Line Depreciation
Initial Cost
Salvage Value
Periods
Declining Balance Depreciation
Initial Cost
Period for which depreciation
Is being calculated
Salvage Value
Total Number
of Periods
Depreciation in the jth year
Sum-of-Years-Digits Depreciation
Initial Cost
Salvage Value
Total Number
of Periods
Period for which depreciation
Is being calculated
Repaying a Loan
• Generally you will make a down payment and
annual payments.
• The down payment occurs in year 0.
• The amount of the loan is the cost of the
purchase minus the down payment
• The payment of the loan is easily found using
Excel
Using the PMT Function to find
Payments on a Loan
Monthly Interest rate
Annual rate/12
Principal
Number of Periods
30 years*12 months
Machine Comparison
You are concerned with the purchase of a heat-treating furnace for gas
carburizing of steel parts.
Furnace A will cost $325,000 and will last 10 years; furnace B will cost
$400,000 and will also last 10 years.
However, furnace B will provide closer control on case depth, which
means that the heat treater can shoot for the low side of the
specification range on case depth.
This will mean that the production rate for furnace B will be 2740 lb/hr
compared with 2300 lb/hr for furnace A.
Total yearly production is required to be 15,400,000 lb. The cycle time
for furnace A is 16.5 hr and that for furnace B is 13.8 hr. The hourly
operating cost is $64.50 per hr.
Assume that money is worth 10% and the tax rate is 50%. Also use
straight line depreciation.
How might you compare the two alternatives?
Let’s compare with NPV
Production Rate
2300lb/hr
2740lb/hr
Furnace A
Furnace B
First organize the info
Interest Rate
Yearly
Required Operating
Yearly
Depreciation
Production (lb)
hours
Cost ($/hr) Oper Cost ($)
$
15400000
6696
64.5
431870
32500
5620
362518
40000
B-A
-69351
7500
0.1
Next, draw a Cash
Flow Diagram
B saves $3,750 in taxes
B saves $69,351 in operating costs
B cost $75,000
more than A
Year
0
1
2
3
4
5
6
7
8
9
10
73101
73101
73101
Initial
Cost
Furnace A
325,000
Furnace B
400,000
Check the NPV
Net Difference
B-A
-75,000
73101
73101
PV
$75,000 (66,456) (60,414) (54,922) (49,929)
(45,390)
Sum
($374,176)
73101
73101
73101
73101
73101
(41,264) (37,513) (34,102) (31,002) (28,184)
Chapter 15: Product
Development Economics
Product Design and Development
Fourth Edition
by Karl T. Ulrich and Steven D. Eppinger
Economic Analysis
for Product Development
(Ulrich and Eppinger)
1. Build a base-case financial model
2. Perform a sensitivity analysis
3. Use sensitivity analysis to understand project
trade-offs
4. Consider the influence of qualitative factors
on project success
Step 1: Build a Base-Case Model
Step 1: Build a Base-Case Model
Using Excel for Q4 of Year 1:
Present Value of Year 3 Costs:
(-2250)/(1+0.10/4)^3= -$2089
Annual interest divided
by number of periods
per year
Future Value
Payments Made Each Period
Number of periods
Homework Problem #2a
2.
a. Use Excel to find the NPV for a drug eluting Cardiac Stent project:
• Years 1-4 development: $70M/year
• Years 4-8 FDA testing, IP costs, manufacturing ramp up: $ 110
• M/year
• Year 10 until expiration of patent
– Volume: 600,000 units / year
– Revenue: $2500 / unit
– Costs: $1200 / unit
• Patent issues at start of year 8 and is enforceable for 17 years
• Cost of money is 5%
Step 2: Perform Sensitivity Analysis
(e.g. 20% decrease in development costs)
Step 2: Perform Sensitivity Analysis
(e.g. 25% increase in development time)
Step 2: Perform Sensitivity Analysis
Ulrich & Eppinger, “Product Design and Development”
Step 3: Use Sensitivity Analysis to
Understand Project Trade-offs
Step 3: Use Sensitivity Analysis to
Understand Project Trade-offs
(estimate Trade-off Rules from sensitivity analyses)
Ulrich & Eppinger, “Product Design and Development”
Homework #2b
.
a. Use Excel to find the NPV for a drug eluting Cardiac Stent project:
• Years 1-4 development: $70M/year
• Years 4-8 FDA testing, IP costs, manufacturing ramp up: $ 110
• M/year
• Year 10 until expiration of patent
– Volume: 600,000 units / year
– Revenue: $2500 / unit
– Costs: $1200 / unit
• Patent issues at start of year 8 and is enforceable for 17 years
• Cost of money is 5%
b. Find the NPV if the FDA testing takes twice as long as planned (still at $110M/year)
A Question:
What are some situations when you might not
pursue an option that presents the best NPV?
Step 4: Consider the Influence of
Qualitative Factors
• Interactions between the Project and the
Firm (e.g. strategic fit, risk/liability exposure)
• Interactions between the Project and the
Market (e.g. competitors, customers,
suppliers)
• Interactions between the Project and the
Macro Environment (e.g. economic shifts,
government regulations, social trends)
Ulrich & Eppinger, “Product Design and Development”
Modeling Uncertain Cash Flows
Dealing With Risk
Determining NPV with probabilities.
Probability that the Patent is allowed
NPV= Pa*PVa + Pb*PVb = 0.6($6.5 million) + 0.4($1.5 million) = $4.5 million
NPV with market testing is $2,650,000
HW Problem 2c
2.
a. Use Excel to find the NPV for a drug eluting Cardiac Stent project:
• Years 1-4 development: $70M/year
• Years 4-8 FDA testing, IP costs, manufacturing ramp up: $ 110
• M/year
• Year 10 until expiration of patent
– Volume: 600,000 units / year
– Revenue: $2500 / unit
– Costs: $1200 / unit
• Patent issues at start of year 8 and is enforceable for 17 years
• Cost of money is 5%
b. Find the NPV if the FDA testing takes twice as long as planned (still at $110M/year)
c. For the original case, determine the NPV if there is a 5% probability that there is no FDA approval, a 10%
probability of 1.5B intellectual property settlement in year 14, and a 85% probability of business as predicted.
Economics Laboratory
Apply the tools of economic decision
making to a large capital project and
a personal project