Understanding Money and Its Management: A Guide for Engineers Part 01

This article provides an overview of the fundamental concepts related to money and its management that are crucial for engineers to understand. It covers the essential aspects of financial decision making, including the time value of money and interest rates, and how they are affected by inflation.

The Rational Decision-Making Process

Engineering projects, like any other important decision, require a structured and logical approach. This section explores how two engineering students, Monica and Sonya, approached their financial and design problems, highlighting the essential elements of the rational decision-making process:

1. Recognize the Decision Problem: Identifying the challenge, the need, or the opportunity that requires a decision. Monica faced the decision of buying a car, while Sonya wanted to design a self-chilling soda can.
2. Define the Goals or Objectives: Clearly stating the desired outcome or the expected result of the decision. Monica's goal was to find a new car with a warranty and flexibility, while Sonya wanted a safe, practical, and innovative solution to the self-chilling soda can problem.
3. Collect All the Relevant Information: Gathering as much data and details as possible to understand the problem fully. Monica researched lease programs, visited dealerships, and compared models, while Sonya conducted a survey to assess consumer demand and investigated the cost of materials.
4. Identify a Set of Feasible Decision Alternatives: Listing all viable options or solutions to the problem. Monica considered buying or leasing a car, while Sonya explored various chilling methods for her soda container.
5. Select the Decision Criterion: Deciding on the metric or standard that will be used to evaluate the alternatives. Monica considered the total cost of each option, while Sonya focused on cost-effectiveness and marketability.
6. Select the Best Alternative: Choosing the option that best meets the established criteria, considering both objective and subjective factors. Monica opted for leasing a Honda Civic, while Sonya selected the chemical ice pack as the most viable chilling method for her soda can.

Interest: The Cost of Money

Money has a time value, meaning a dollar received today is worth more than a dollar received in the future. This concept is fundamental to engineering economic analysis, as it highlights the importance of accounting for interest and its effect on cash flows over time.

The article discusses the key elements of transactions involving interest:

1. Principal (P): The initial amount invested or borrowed.
2. Interest Rate (i): The cost or price of money, expressed as a percentage per period of time.
3. Interest Period (n): The time interval for calculating interest.
4. Number of Interest Periods (N): The total duration of the transaction.
5. Receipts or Disbursements (A): The plan for cash flows over time, often involving equal payments.
6. Future Amount (F): The total amount accumulated after considering the effect of interest over multiple periods.

The article contrasts simple interest and compound interest:

• Simple Interest: Interest earned on only the principal amount, not on any accumulated interest.
• Compound Interest: Interest earned on the total amount, including the principal and accumulated interest from previous periods.

Market Interest Rates

The market interest rate is the cost of money as quoted by financial institutions in the marketplace. It reflects the overall economic conditions, considering both earning power and purchasing power.

The article explains:

1. Nominal Interest Rate (APR): The stated annual interest rate, regardless of the compounding frequency.
2. Annual Effective Yield (or Effective Annual Interest Rate): The actual interest rate earned or paid in a year, considering the effect of compounding.

The article further elaborates on how to calculate effective interest rates for different compounding periods (discrete and continuous compounding) and provides examples of how to determine the effective interest rate per payment period.

Measure of Inflation

Inflation refers to a decline in the purchasing power of money over time, meaning that the same dollar amount buys less of a good or service. Understanding and measuring inflation is crucial for economic analysis, as it affects the value of cash flows over time.

The article explains the importance of the Consumer Price Index (CPI) as a measure of inflation:

• The CPI measures the change in the prices of a basket of goods and services typically purchased by urban consumers, reflecting the decline in purchasing power over time.
• It is important to distinguish between the general inflation rate (based on the CPI for all items in the market basket) and the specific inflation rate for individual items.