Among the many theoretical frameworks that have developed in order to provide the best financial management practices, engineering economy "analysts and engineers with the tools to determine which course of action results in the lowest cost, greatest profit, or other aspects, often using comparative cost studies." Very often, engineering economy is used to evaluate projects relating to their costs and their future-value, so, in this sense, it can also be considered a decision-taking tool.
As one of the papers on the subject describes engineering economy, a proper definition of engineering economy should start from the two words forming the term. As such, economy is generally defined as "thrifty and efficient use of resources." In this sense, engineering economy answers the question "is it in the best interest of the enterprise to invest its limited resources in a proposed technical endeavor, or would the same investment produce a higher return elsewhere?." As such, engineering economy operates which such terms as time-value of money, inflation, depreciation, decision making among alternatives, evaluating replacement alternatives and optimization, terms which will be referred to later on in the paper. However, perhaps the best definition of the term refers to engineering economy as "the formulation, estimation, and evaluation of economic outcomes when alternatives to accomplish a defined purpose are available."
Following the last definition, we can now assume that engineering economy deals with making the best selection among a set of alternatives by evaluating the different outcomes that each of the alternative implies.
When we are faced with an engineering project, in general, there are two main things to consider. One of them is how much the project costs, the second one is how much benefit the project will bring. The problem with the project benefit is that, most often, these are future benefits, while the costs are in the present. How can we compare future benefits with present costs? The answer is rather simple: by calculating the future benefits in terms of present benefits. Hence, it is now the proper time to introduce the concept of the time value of money, perhaps the most important concept in engineering economy.
Time Value of Money
The time value of money is basically underlined by two general principles: future value and present value. The first concept is based on the idea that a dollar available in the present is more valuable than one that will be received some time in the future. The reason for this is simple: a dollar in the present can be invested and can produce an amount of money greater than a dollar. Hence, we have to be able to evaluate how much the present dollar will bring in the future, if it is invested at a certain given rate.
The calculation we use are fairly simple. Suppose PV is the present value and FV, the future value. K is the rate of annual interest.
Hence, FV = PV + k* PV = PV * (1+k)
That is to say the future value of the dollar is equal to the present value plus the gain from the investment, which is given by multiplying the present value with the rate of return on the investment, in this case, the interest rate.
If we continue this for several years, we will obtain the generalized formula for the future value of money, according to which FVn = PV (1+k) n
The present value of money is somewhat of a reverse concept. Assume we have the ability to invest some money in a project, possible investment that would bring us $130 after a five-year period. We need to calculate the present-value of this future revenue and compare it to the actual cost of the project. If the cost of the project is greater, then it is not economically efficient to act upon it. This process of finding the present value of a future cash flow is called discounting.
The formula we use in this case is obviously the reverse formula we have described above. Hence,
PV = FV/(1+k) n
As I have pointed out, the concepts of present and future values of money are the basics for engineering economy. Now we can move on to more applied concepts, involving project selection, among them, that of capital budget and capital budgeting.
One of the basic principles of economics is that the resources are limited, while the needs are not. Any company faces at a certain point the question: "which of these projects is it best for the company to be done?" This question comes in a context of limited constraints (a limited budget). Capital budgeting refers exactly to this, that is to analyzing all existing projects and determining which one of them should be included in the "to be done" list of projects. This may be considered perhaps the most important process within a company, because it determines how well the respective company will operate in the future. Choosing either projects that cost too much or those that do not bring the expected return can prove fatal.
Let us consider the list of proposed projects that a company needs to choose from. Some of these are mutually exclusive projects. These types of projects represent alternative possibilities of investment. In this sense, if one of the projects is accepted, all the others that form this group are to be excluded. An example of such projects could be acquiring two things that have the same basic function. Additionally, we can talk about interdependent projects, that is project that depend on one another: acquiring one of them would mean acquiring all from this group.
After this short classification of projects, we should refer to the selection phase and how it relates to engineering economy. According to Halpern, there are six steps involved in the process of project selection.
1. Determining the cost of the project.
2. Estimating the future cash flows of the project (of course, this has everything to do with what I have already talked about in the lines here above)
3. Evaluate the project's risk (this refers to the fact that a project is usually done in an environment of risk, with estimated cash flows and future revenues. Hence, we need to evaluate how probable these outcomes actually are).
4. Estimate the cost of capital.
5. Discounting the future cash flows, in order to obtain their present value.
6. Compare the present value of future cash flows to the necessary costs. If the present value is greater than the cost of the project, then the project is to be accepted.
There are four different methods to classify projects and make a selection among them. These are:
The payback period method
The net present value method
The regular internal rate of return method
The modified internal rate of return method.
The payback period is defined as the number of years in which a company can recuperate its initial investment, from the annual cash flows. The simplest method to calculate this is to add up the values of the annual cash flows until the original investment is equaled. This helps in the selection process in the following way: if we have two projects, for example, we will be selecting the project that has the lowest payback period. Some companies use the discounted payback period, which means that the cash flows are actualized and used in the calculation.
The Net present value is perhaps the most important and most used method of engineering economy for the project selection. One of the main techniques involves here refers to the discounted cash flows technique, to which I will briefly refer here.
The concept is rather simple: the project that is being analyzed will produce future cash flows. Each of these cash flows are discounted, so that we evaluate their present value. Each of these discounted cash flows are then summed up and the total value is compared to the initial cost of the project. If the cost is greater, the project is not to be done, otherwise, a positive NPV will mean that the highest NPV from two projects will gain.
The Internal Rate of Return methodology is defined as the discount rate at which the Net present value is equal to 0. This discount rate is very important in evaluating an investment, because it can tell the evaluator whether or not the project will be profitable. Generally, the discount rate that is used is the cost of capital used for the project, because this is the "hurdle rate," that is, the rate at which the company breaks even.
Indeed, the cost of capital represents the cost of credit, bonds, shares, etc. that the company uses for financing. As such, if the cost of capital is higher than the return rate for a certain project, the company will lose money, because it will have a cost to pay (the cost of capital), a cost which in turn is not covered by the investment strategy of the company.