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Daily Dose 013 | Engineering Economics
How do you find the Rate of Return on an engineering investment?
Where is your first thought when asked to find the rate of return on an engineering investment?
Or better yet, where is your overall mindset when you think about ENGINEERING ECONOMICS?
For most engineers, they’d rather stick to the physical realm of our industry – and I don’t blame them.
But in order to be the most well rounded asset to those we provide services to, we must be dangerous in all aspects of engineering research and design – and that includes ENGINEERING ECONOMICS.
In this lesson, we will dive in a practice problem in the subject of ENGINEERING ECONOMICS, specifically, working on determining the RATE OF RETURN on an engineering investment made by a company.
Key Definition
What is RATE OF RETURN?
The RATE OF RETURN is a profit on an investment over a period of time, expressed as a proportion of the original investment.
The time period can be anything, but is typically a year, in which case is referred to as the annual return.
It takes in to account any change in value of the investment as well cash flows which the investor receives from the investment, such as interest payments or dividends.
As engineers, we may see it measured in dollars or as a percentage of the original amount invested.
A loss instead of a profit is described as a negative return.
The Process
How can you find the Rate of Return on an engineering investment?
Knowing the potential rate of return on an engineering investment allows us to move forward (or not) with confidence knowing that we we will benefit positively from our decision.
Just like when you invest time into studying for the FE Exam – you expect to score well when you take it.
It’s the same in the world of engineering economics, if we invest money, we want to expect a positive return.
The Rate of Return (RoR) is a number that quantifies this expectation. It tells us the percentage profit (or loss) you can expect from an investment over a period of time – allowing us to make the best call in the interest of those we are representing.
At first, this problem type may appear complicated, but it’s not – we will break it down into a simple, streamlined, repeatable process.
- Step 1: Identify Initial Investment
- Step 2: Estimate Future Cash Flows
- Step 3: Determine the Time Horizon
- Step 4: Use the Rate of Return Formula
- RoR = (Total Expected Returns – Initial Investment)/Initial Investment × 100%
- Total Expected Returns = Sum of all estimated future cash flows
- Initial Investment = Initial money put into the project
- Step 4: Interpret the Result:
- If RoR > 0: You’re gaining a profit! The bigger the number, the more profitable it is
- If RoR = 0: You’re breaking even. Not a profit, but not a loss either
- If RoR < 0: The project might lead to a loss
- Step 5: Comparative Analysis (Bonus Step)
This is the starting point. Note down how much money is initially put into the project/investment. It could be the cost of materials, machinery, labor, etc.
Unlike a one-time investment, cash flows occur periodically. They could be profits or losses. Estimate these amounts for each period (usually a year).
How long will the project/investment last? Is it a 5-year plan? 10 years? Knowing the time frame helps in calculating the average returns over the years.
With the data defined, use the formula:
Where:
Make your call, if:
If you have multiple projects or investment options, calculate the RoR for each. The one with the highest RoR is generally the most profitable. But remember, higher returns often will come with higher risks.
Understanding how to find the Rate of Return on an engineering investment might appear intricate initially, but they operate on a set of well-defined principles. Think of each problem as a puzzle, waiting for you to piece it together.
This is the general blueprint that will help you tackle a range of problems involving the Rate of Return.
And with all of that being stated, check out the video and see how we can go about solving this type of problem in the most efficient manner.
As always, we are here to help, Prepineer
