Economics is the Study of Money.
Economics is the study of how money behaves over time. You may come across situations where you need to analyze cash flow over a period of time, see how much an item will depreciate, or analyze multiple options to see which choice would be the most economically feasible. In this economics study guide you will learn how to analyze the problem and find the best solution out of the choices you are given.
Once you are finished going through this study guide. I have some review questions here
Time Value of Money
When looking at cash flow one needs to think in two terms. One is the current worth of the cash, and the second is the future value of the cash
If you place $1,000 in a bank drawing 5% interest you would have $1050 in one year. Now if you spent that money to buy equipment that cost $1,000, but made you $700 and had a resale of $400 at the end of the year. Which would be the obvious choice? You would choose the equipment purchase because it made the most cash at the end.
For the PE Exam you will most likely find at least 1 question for economics. These questions can be easily broken down to looking at two or more options, one a current amount, a second future amount, and a third cash transactions in the middle. You will ultimately have to evaluate the options with present cash value or future cash value.
A is the annual amount. This is an amount that is paid each time interest is earned
C is the initial cost which can be the present cost of the item.
F is the future worth of the item
G is the gradient amount. This is like the annual payment, but on each payment the amount is increased by the amount being paid. For instance, $50, $100, $150,
i is the interest rate. This can be given as a yearly rate (think compound interest, like your credit cards) or an annual rate
n is the number of compounding periods
P is the present worth of the item
r is the nominal rate, or rate per anum
There are essentially 9 different types of equations you may be using. The next section briefly will explain each of them and show you the equation you need to use with each problem. Do not worry about having to know all these equations. The following equations are shown for reference, or if you want you can use them on the exam, but there is a free compound interest cheat sheet you can print out and bring with you.
Single Payment Compound Amount
Single payment compound amount is when you put one large sum of money in. Then over a period of time you accrue interest. This is basically like your bank.
Single Payment Present Worth
Single payment present worth is when you take the future value you expect and see how much you need to invest at a certain percent interest to come up with that money.
Uniform Series Sinking Fund
Uniform series sinking fund is not as bad as it sounds. Basically you know the future amount and you want to know how much you need to pay each increment to hit that amount. Think of a mortgage, you pay x amount each month until you have paid off the house.
Capital recovery is where you give someone a sum of money and over time they pay it back. Kind of like giving someone a loan and they pay in increments until it is paid off
Uniform Series Compound Amount
Uniform series compound amount is where you find out how much you need to pay over time to end up with a set amount at the end. Think of this as a 401k. You make payments through your life and hope to have a ton of cash there at the end.
Uniform Series Present Worth
Uniform series present worth is where you find out how much you need to pay at the present to get a certain amount back over time.
Next come the gradient series. These are where an increasing amount is paid
Uniform Gradient Present Worth
Uniform Gradient Future Worth
Uniform Gradient Uniform Series
The value of everything does not always go up. Some things will lose value like a car, equipment or mobile home. When this happens the item is considered to depreciate in value. Generally the item will be set to depreciate over a set amount of years until the worth is 0.
Originally depreciation could be found by using the Straight Line Depreciation Method
But in 1982 the US government sent out a mandate that uses either the Accelerated Cost Recovery System (ACRS) or Modified Accelerated Cost Recovery System (MACRS)
Modified Accelerated Cost Recovery System (MACRS)
The MACRS or ACRS uses two values when determining an items cost. One is the amount of years until the item is worth nothing. The second value is how long you have owned the item.
||Recovery Period (Years)
Comparison of Alternatives
Now that you are familiar with how the value of an item or money can increase or decrease with time, it is time to look at ways of comparing the choices. In this economics study guide we will look at five different ways to make the comparison. These analyses are: present worth, annual cost, rate of return, cost benefit, and break even
Present Worth Analysis
Present worth analysis is when you take all the values that are given and you bring them to present terms. The equations you will likely be using are the Single Payment Present Worth and the Uniform Series Present Worth equations
Annual Cost Analysis
The annual cost analysis is looking at the cost of items that have a different length of life. This analysis assumes that each item will be replaced by an identical one. This will allow you to evaluate the options over a set period of time.
Rate of Return Analysis
In the rate of return analysis a company picks a minimum attractive rate of return (MARR). Then the rate of return for the item is calculated. If the item returns more than the MARR, then the item is a viable option.
A cost-benefit analysis is when you take all the cost and convert them to the present worth.. Then take all the benefits and convert them into present worth. Then divide the benefits by the cost. If the value is greater than one then the project would be acceptable.
Break Even Analysis
Last is the break even analysis. This is where you wish to find out how long until an item has been paid off.