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Session 1339

Economic Criteria John H. Ristroph University of Southwestern Louisiana

Abstract The standard method for developing economic criteria such as present worth entails extrapolating banking formulae into the more complex industrial environment, but discerning students recognize that the two en- vironments are different and question the validity of this approach. This paper first develops a very funda- mental, easily understood economic decision criterion for the banking environment in a manner that recog- nizes an assumption central to economic analyses: reinvestment. This basic criterion is extended to show that present worth, equivalent annual worth, and future worth produce the same decisions, so they may be used as surrogate criteria. The next step is to explicitly consider the more complex nature of industrial in- vestments and capital accumulation. The development of industrial criteria parallels that of the banking environment, but it addresses additional issues, such as how to determine the appropriate discount rate. A final section provides a summary and conclusions. Introduction This paper addresses a fundamental problem in teaching engineering economics. It is common practice to derive formulas within the context of a single savings account or loan with a stated rate of interest. Then these formulas are ported to a totally different environment, that of industry wherein reinvestment occurs in a multitude of projects with different rates of return. This can lead good students to ask potentially embarrassing questions such as: 1. Why use formulas derived under one set of conditions in a totally different environment? 2. Why is the minimum attractive rate of return (MARR) used as the discount rate? Answering these questions merely requires a few pages of reading.

Oakford and Theusen [1] provided the first empirical validation of the effectiveness of present worth (PW) analyses in the 1960's when they: 1. observed that economic analyses should seek to maximize the wealth of a entire firm at some future point in time; 2. modeled the investment process via a computer simulation and numerically determined an op- timal discount rate policy; and 3. explained their logic using the concept of a unit investment of one dollar for one year. This paper extends their work by developing a closed-form mathematical model for the future total worth (FTW) of an entire firm, its wealth at the end of the planning horizon, as a function of project selection.

The model is suitable for presentation in an undergraduate class. Its level of mathematical complexity is well within students' grasp, and it: 1. avoids developing equations in one environment and then using them in a totally different one; 2. explains why PW works (e.g., why it produces the same decisions as FTW); 3. shows how to determine the appropriate discount rate. The objective is not to question current methods of analysis, but to present why they work.

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Ristroph, J. H. (1999, June), Economic Criteria Paper presented at 1999 Annual Conference, Charlotte, North Carolina. 10.18260/1-2--7606