Cash Flow - Fundamentals of Engineering Economics

Summary

In this video, Justin Dick Mayer from Engineering Training Exam discusses the concept of cash flow in engineering economics. The video covers the workflow for solving cash flow problems, including identifying transactions, creating cash flow diagrams, and analyzing both expenses and credits over the lifespan of a project. Using a small business loan example, the video illustrates how to handle costs, returns on investment, and common mistakes in cash flow analysis. By the end, viewers will understand how to visually represent financial transactions and make informed engineering economic decisions.

Takeaways

• 😀 Cash flow in engineering economics refers to the series of expenses and credits that occur during the life of a project.
• 😀 The general workflow for solving cash flow problems includes identifying each transaction, summarizing them in a cash flow diagram, and analyzing them in terms of type, magnitude, and timing.
• 😀 A cash flow diagram visually represents the cash flow transactions over time, with vertical lines showing the type and magnitude of each transaction.
• 😀 The 'end of the year convention' assumes that all transactions happen at the end of the period in which they occur.
• 😀 Cash flow diagrams should be drawn from the point of view of the individual or entity involved, which affects how expenses and credits are represented.
• 😀 In the example, a business owner takes a loan for $25,000 to buy equipment and receives a 6% return annually on this amount over 8 years.
• 😀 Expenses (such as the initial cost of $25,000) are represented as negative transactions in cash flow diagrams, while returns are positive transactions.
• 😀 Each year after the equipment purchase, the business owner receives $1,500 as a return on investment, which is depicted as positive vertical arrows in the diagram.
• 😀 Common mistakes in cash flow problems include confusing the direction of expenses and credits and incorrectly adjusting the return on investment by deducting it from the original purchase amount.
• 😀 It's crucial to understand that the return on investment (6%) is based on the original purchase price, not a decreasing amount over time, which helps prevent errors in calculating subsequent returns.
• 😀 The goal of this process is to help prepare for engineering economics problems on exams by illustrating how to correctly visualize and analyze cash flow over a project's lifespan.

Q & A

What is the main topic discussed in the video?

The main topic discussed in the video is cash flow, specifically in the context of engineering economics and how to analyze it for engineering projects.

How are cash flow transactions categorized in the context of engineering economics?

Cash flow transactions are categorized as either expenses (outflows of money) or credits/revenues (inflows of money). These transactions occur throughout the lifetime of an engineering project.

What is the significance of a cash flow diagram?

A cash flow diagram helps visualize the magnitude, type, and timing of individual transactions throughout the project's lifespan, providing a clear basis for economic analysis.

What is the 'end of the year' convention in cash flow diagrams?

The 'end of the year' convention assumes that all transactions (either expenses or credits) occur at the end of the period in which they happen, rather than at the beginning or during the year.

How does the point of view affect the representation of cash flow in a diagram?

The point of view matters because a cash flow from the perspective of the borrower (such as a loan) looks different from the perspective of the lender (the bank giving the loan).

What is the first step in solving cash flow problems?

The first step is to identify the nature of each transaction, including when it occurs in the project timeline, whether it is an expense or credit, and its magnitude.

How is the transaction data summarized in cash flow analysis?

The data is summarized in a table with columns for the year, the type of transaction (expense or credit), and the corresponding amounts. This helps organize and clearly present the cash flow over time.

What mistake do people often make in cash flow problems regarding expenses and credits?

People often make the mistake of incorrectly viewing expenses and credits, either failing to recognize the point of view or miscalculating the returns based on an incorrect interpretation of the original purchase price.

In the example of the business owner purchasing equipment, what was the initial cost and expected return?

The initial cost of the equipment was $25,000, and the expected return on investment was 6% annually on the original purchase price, resulting in $1,500 per year over the next 8 years.

What is a common error when calculating return on investment (ROI) in cash flow analysis?

A common error is subtracting the ROI from the original cost of the equipment at each period, which reduces the ROI over time. However, the problem specifies that the ROI is constant, based on the original purchase price.