What is Engineering Economy?

• Economic decision making for engineering systems is called engineering economy.

​

• This definition may seem restricted to engineering projects and systems only, engineering economy however is also the study of industrial economics and the economic and financial factors which influence industry.

​

1

ECON 401: Engineering Economics

What is Engineering Economy?

• Engineering economy is a collection of techniques that simplify comparisons of alternatives on an economic basis.

​

• Engineering economy is not a method or process for determining what the alternatives are.

2

ECON 401: Engineering Economics

What is Engineering Economy?

• Engineering economics begins only after the alternatives have been identified.

​

• If the best alternative is actually one that the engineer has not even recognized as an alternative, then all the engineering economic analysis tools will not result in its selection.

​

3

ECON 401: Engineering Economics

What is Engineering Economy?

Engineers are the people who are familiar with all the technicalities of machinery and production therefore they are the best judges of:

1. the useful lives of an asset, and
2. they also have the technical knowledge to calculate the number of units a proposed plant would produce when operational.

​

4

ECON 401: Engineering Economics

What is Engineering Economy?

• In today’s competitive world of business it has become essential that engineers should practice financial project analysis for engineering projects and make rational decisions.

5

ECON 401: Engineering Economics

What is Engineering Economy?

• Engineering economy also includes the study of accounting practices for manufacturing concerns.

​

• Unique features of accounting for manufacturing concerns are process costing, batch costing, cost allocation, etc.

6

ECON 401: Engineering Economics

What is Engineering Economy?

• Engineering economy deals with justification and selection of projects.
• Many engineers work on projects which address a specified activity or a problem.
• Any decision regarding the project must be justified.

​

7

ECON 401: Engineering Economics

What is Engineering Economy?

• In business environments, many if not all, decisions are justified using monetary criteria such as “profit”.
• Such decisions are made at the managerial level and many engineers become managers in manufacturing environment.

​

8

ECON 401: Engineering Economics

What is Engineering Economy?

• Therefore, all engineers, regardless of their employment, should know methods and tools used in evaluation of projects.

​

• The purpose of engineering economy is to expose all engineering students to the methods which are widely used for evaluation of projects.

9

ECON 401: Engineering Economics

What is Engineering Economy?

• Even though, engineering economy deals mostly with selection of projects in business environment, the tools and methods can be and are used by individuals and non-profit organizations such as government, hospitals, and charitable entities, etc.

​

10

ECON 401: Engineering Economics

�SOME EXAMPLES�

Let us present few examples in different environments where engineering economy can facilitate the decision making process.

​

• Business Environment:

A small manufacturing company needs to buy a forklift truck for material handling. Two different brands, say A and B, are being considered. Which truck should be bought? The decision will probably be based on minimization of cost.

​

11

ECON 401: Engineering Economics

�SOME EXAMPLES�

• Individuals:

A new college graduate needs a new car. Should this new car be bought or leased? Methods from engineering economy can be used for determining the best choice.

​

12

ECON 401: Engineering Economics

�SOME EXAMPLES�

The following figure shows how engineering is composed of physical and economic components:

​

​

13

ECON 401: Engineering Economics

ENGINEERING

Economic Environment

Physical Environment

Produce products and services based on physical laws (e.g. Newton’s Law)

Assessing the worth of these products/services in economic terms

Production / Construction

Total Environment

�SOME EXAMPLES�

Physical Environment:

Engineers produce products and services depending on physical laws. Physical efficiency takes the form:

System output(s)

Physical (efficiency) = ------------------------ System input(s)

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14

ECON 401: Engineering Economics

�SOME EXAMPLES�

• Economic Environment:

Much less of a quantitative nature is known about economic environments -- this is due to economics being involved with the actions of people, and the structure of organizations.

​

System worth

Economic (efficiency) = ------------------------ System cost

​

​

15

ECON 401: Engineering Economics

�SOME EXAMPLES�

• Satisfaction of the physical and economic environments is linked through production and construction processes.

​

• Engineers need to control systems to achieve a balance in both the physical and economic environments, and within the bounds of limited resources.

​

16

ECON 401: Engineering Economics

Rational Decision-Making Process

1. Recognize a decision problem
2. Define the goals or objectives
3. Collect all the relevant information
4. Identify a set of feasible decision alternatives
5. Select the decision criterion to use
6. Select the best alternative

17

ECON 401: Engineering Economics

Rational Decision Making Process

18

ECON 401: Engineering Economics

Which Car to Lease?�Saturn vs. Honda

1. Recognize a decision problem

​

• Define the goals or objectives

​

• Collect all the relevant information
• Identify a set of feasible decision alternatives
• Select the decision criterion to use
• Select the best alternative

​

​

• Need a car

​

• Want mechanical security

​

• Gather technical as well as financial data
• Choose between Saturn and Honda
• Want minimum total cash outlay
• Select Honda

19

ECON 401: Engineering Economics

Financial Data Required to Make an Economic Decision

20

ECON 401: Engineering Economics

Engineering Economic Decisions

21

Planning

Investment

Marketing

Profit

Manufacturing

ECON 401: Engineering Economics

Predicting the Future

• Estimating a Required investment
• Forecasting a product demand
• Estimating a selling price
• Estimating a manufacturing cost
• Estimating a product life

22

ECON 401: Engineering Economics

Role of Engineers in Business

23

ECON 401: Engineering Economics

Types of Business Organizations

24

ECON 401: Engineering Economics

Proprietorships

Advantages

Disadvantages

• Formed easily and inexpensively
• Earnings are taxed at owner’s personal income tax, which will be lower than corporate income tax

​

• Personal liability
• Difficult to raise capital (cannot issue stocks bonds) for business expansion

25

ECON 401: Engineering Economics

Partnerships

Advantages

Disadvantages

• Low cost (one person’s contribution is lesser)
• Ease of formation as the personal assets of all the partners stand behind the business

​

• Each partner is liable for a business’s debts
• Partnership has a limited life, as when one partner quits, partnership is to be reorganized

26

ECON 401: Engineering Economics

Corporations

Advantages

Disadvantages

• Can raise capital from large number of investors
• Easy transfer of ownership interest by trading shares of stock
• Personal liability is limited (to the individual investment)

​

​

• Expensive
• Subject to numerous government rules and regulations

27

ECON 401: Engineering Economics

Role of Engineers in Business

28

Create & Design

​

• Engineering Projects

Evaluate

​

• Expected

Profitability

• Timing of

Cash Flows

• Degree of

Financial Risk

Analyze

​

• Production Methods
• Engineering Safety
• Environmental Impacts
• Market Assessment

​

Evaluate

​

• Impact on

Financial Statements

• Firm’s Market Value
• Stock Price

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

PRINCIPLE 1:

A nearby penny is worth a distant dollar

• A fundamental concept in engineering economics is that money has a time value associated with it.
• It is better to receive money earlier

than later.

​

29

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

• If you receive $100 now, you can invest it and have more money available six months from now.

​

• This concept will be the basic foundation for all engineering project evaluation.

​

​

​

​

30

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

Time Value of Money

31

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

PRINCIPLE 2:

All that counts are the differences among

alternatives.

• An economic decision should be based on the differences among the alternatives considered.
• All that is common is irrelevant to the decision.

​

32

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

Irrelevant items in decision making

Differential Analysis

33

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

PRINCIPLE 3:

Marginal Revenue must exceed Marginal Cost.

• Each decision alternative must be justified on its own economic merits before being compared with other alternatives.
• Marginal revenue means the additional revenue made possible by increasing the activity by one unit.

​

34

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

• Marginal cost means that productive resources like natural resources, human resources, capital goods available to make goods and services are limited. Therefore, people can not have all the goods and services they want.

​

• As a result, they must choose some things and give up others.

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35

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

Cost of Goods Sold

$2 per unit

Gross Revenue

$4 per unit

Marginal Cost

Marginal Revenue

Marginal Analysis

36

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

PRINCIPLE 4:

Additional Risk is not taken without the

Expected Additional Return.

• Investors demand a minimum return that must be greater than the anticipated rate of inflation or any perceived risk.

​

​

37

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

• Expected returns from bonds and stocks are normally higher than the expected return from a savings account.

38

ECON 401: Engineering Economics

FUNDAMENTAL PRINCIPLES OF ENGINEERING ECONOMICS

Risk and Return Trade Off

39

ECON 401: Engineering Economics

Types of Strategic Engineering Economic Decisions

1. Equipment and process selection
2. Equipment replacement
3. New product and product expansion
4. Cost reduction, and
5. Service or quality improvement

40

ECON 401: Engineering Economics

Types of Strategic Engineering Economic Decisions

41

ECON 401: Engineering Economics

Types of Strategic Engineering Economic Decisions

42

ECON 401: Engineering Economics

Two Factors in Engineering Economic Decisions

43

The factors of time and uncertainty are the defining aspects of any engineering economic decision.

ECON 401: Engineering Economics

The Time Value of Money

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Chapter Outline

• Time value associated with money
• Determining future value at given interest rate
• Present value based on current value of funds to be received
• Determining Yield on an Investment.
• Compounding or discounting occurring on a less than annual basis

Relationship to �The Capital Outlay Decision

• The time value of money is used to determine whether future benefits are sufficiently large to justify current outlays
• Mathematical tools of the time value of money are used in making capital allocation decisions

Future Value – Single Amount

• Measuring value of an amount that is allowed to grow at a given interest over a period of time
• Assuming that the worth of $1,000 needs to be calculated after 4 years at a 10% interest per year, we have:

1^st year……$1,000 X 1.10 = $1,100 2^nd year…...$1,100 X 1.10 = $1,210 3^rd year……$1,210 X 1.10 = $1,331 4^th year……$1,331 X 1.10 = $1,464

Future Value – Single Amount (Cont’d)

A generalized formula for Future Value:

​

Where

FV = Future value

PV = Present value

i = Interest rate

n = Number of periods;

​

In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1(FV_IF)

Table 9–1

Future Value – Single Amount (Cont’d)

• In determining future value, the following can be used:

​

​

Where = the interest factor

​

• If $10,000 were invested for 10 years at 8%, the future value would be:

Present Value – Single Amount

• A sum payable in the future is worth less today than the stated amount
• The formula for the present value is derived from the original formula for future value:

​

​

• The present value can be determined by solving for a mathematical solution to the formula above, thus restating the formula as:

​

• Assuming

Present Value of $1(PV_IF)

Table 9–2

Relationship of Present �and Future Value

Future Value – Annuity

• Annuity:
• A series of consecutive payments or receipts of equal amount
• Future Value of an Annuity:
• Calculated by compounding each individual payment into the future and then adding up all of these payments

Future Value – Annuity (cont’d)

• A generalized formula for Future Value of Annuity:

FV_A = A × FV_IFA

Where:

FV_A = Future value of the Annuity

FV_IFA = Annuity Factor = {[(1+i)ⁿ – 1] ÷ i}

A = Annuity value

i = Interest rate

n = Number of periods;

• Assuming, A = $1,000, n = 4, and i = 10%

Compounding Process for Annuity

Future Value �of an Annuity of $1(FV_IFA)

Table 9–3

Present Value – Annuity

• Calculated by discounting each individual payment back to the present and then adding up all of these payments
• A generalized formula for Present Value of Annuity:

PV_A = A × PV_IFA

Where:

PV_A = Present value of the Annuity

PV_IFA = Annuity Factor = {1 – [1 ÷ (1+i)ⁿ] ÷ i}

A = Annuity value

i = Interest rate

n = Number of periods

Present Value �of an Annuity of $1(PV_IFA)

Assuming that A = $1,000, n = 4, i = 10%, we have:

Table 9–4

Time Value Relationships

• Comparisons include:
• The relationship between present value and future value
• Inverse relationship exists between the present value and future value of a single amount
• The relationship between the Present Value of a single amount and the Present Value of an Annuity
• The Present Value of an Annuity is the sum of the present values of single amounts payable at the end of each period
• The relationship between the Future Value and Future Value of Annuity
• The Future Value of an Annuity is the sum of the future values of single amounts receivable at the end of each period

​

Determining the Annuity Value

• A re-look at the variables involved in time value of money:
1. FV/PV : Future/Present value of money
2. N : no. of years
3. I : Interest or YIELD
4. A : Annuity Value / payment per period in an annuity

​

• Given the first three variables, and determining the fourth variable “A” (unknown ).

​

Annuity Equaling a Future Value

• Assuming that at a 10% interest rate, after 4 years, an amount of $4,641 needs to accumulated:

​

​

​

​

• For n = 4, and i = 10%, is 4.641. Thus, A equals $1,000 as below :

Annuity Equaling a Present Value

• Determining what size of an annuity can be equated to a given amount:

​

​

​

• Assuming n = 4, i = 6%:

Relationship of Present� Value to Annuity

Annual interest is based on the beginning balance for each year as shown in the following table that shows flow of funds:

Table 9–5

Loan Amortization

• A mortgage loan to be repaid over 20 years at 8% interest:

Loan Amortization Table

• In such a case the part of the payments to the mortgage company will go toward the payment of interest, with the remainder applied to debt reduction, as indicated in the following table:

Table 9–6

Six Formulas

Determining the Yield on Investment

• Determining the unknown variable “ i “, given the following variables :
1. FV/PV : Future/Present value of money
2. N : no. of years
3. A : Annuity Value / payment per period in an annuity

​

Yield – Present Value �of a Single Amount

• To calculate the yield on an investment producing $1,464 after 4 years having a present value of $1,000:

​

​

​

​

​

​

​

​

​

​

• We see that for n = 4 and = 0.683, the interest rate or yield is 10%

​

Yield – Present Value �of a Single Amount (Cont’d)

• Interpolation may also be used to find a more precise answer

​

​

​

• Difference between the value at the lowest interest rate and the designated value

​

​

​

• The exact value can be determined as:

​

​

Yield – Present Value of an Annuity

• To calculate the yield on an investment of $10,000, producing $1,490 per annum for 10 years:

​

​

​

​

​

• Hence:

Yield – Present Value of an Annuity (Cont’d)

• Flip back to the table containing the Present Value-Annuity factors on Slide 9-16
• Read across the columns for n = 10 periods, one can see that the yield is 8 percent
• Interpolation applied to a single amount can also be applied here for a more precise answer

​

​

Special Considerations �in Time Value Analysis

• Compounding frequency
• Certain contractual agreements may require semiannual, quarterly, or monthly compounding periods
• In such cases,

N = No. of years × No. of compounding periods during the year

I = Quoted annual interest / No. of compounding periods during the year

Special Considerations �in Time Value Analysis

• Patterns of Payment
• Problems may evolve around a number of different payment or receipt patterns
• Not every situation involves a single amount or an annuity
• A contract may call for the payment of a different amount each year over the stated period or period of annuity

​

​

Compounding frequency : Cases

• Case 1: Determine the future value of a $1,000 investment after 5 years at 8% annual interest compounded semiannually
• Where, n = 5 × 2 = 10; i = 8% / 2 = 4% (using Table 9–1 FV_IF = 1.480)

​

​

​

​

• Case 2: Determine the present value of 20 quarterly payments of $2,000 each to be received over the next 5 years, where i = 8% per annum
• Where, n = 20; i = 2%

Patterns of Payment : Cases

• Assume a contract involving payments of different amounts each year for a three-year period
• To determine the present value, each payment is discounted to the present and then totaled

(Assuming 8% discount rate)

Deferred Annuity

• Situations involving a combination of single amounts and an annuity.
• When annuity is paid sometime in the future

​

Deferred Annuity : Case

• Assuming a contract involving payments of different amounts each year for a three year period :
• An annuity of $1,000 is paid at the end of each year from the fourth through the eighth year
• To determine the present value of the cash flows at 8% discount rate

• To determine the annuity

Deferred Annuity : Case (Cont’d)

​

​

​

​

​

​

​

• To discount the $3,993 back to the present, which falls at the beginning of the fourth period, in effect, the equivalent of the end of the third period, it is discounted back three periods, at 8% interest rate

Deferred Annuity : Case (Cont’d)

Alternate Method to Compute Deferred Annuity

1. Determine the present value factor of an annuity for the total time period, where n = 8, i = 8%, the PV_IFA = 5.747

​

• Determine the present value factor of an annuity for the total time period (8) minus the deferred annuity period (5). Here, 8 – 5 = 3; n = 3; i = 8%. Thus the value is 2.577

​

• Subtracting the value in step 2 from the value of step 1, and multiplying by A;

​

​

​

​

​

​

Alternate Method to Compute Deferred Annuity (Cont’d)

4. $3,170 is the same answer for the present value of the annuity as that reached by the first method

​

• The present value of the five-year annuity is added up to the present value of the inflows over the first three years to arrive at:

​

​

Money Management Strategy: Financial Statements and Budgeting

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

3-83

Chapter 3�Learning Objectives

1. Recognize relationships among financial documents and money management activities
2. Design a system for maintaining personal financial records
3. Develop a personal balance sheet and cash flow statement
4. Create and implement a budget
5. Relate money management and savings activities to achieve financial goals

3-84

Successful Money Management

Objective 1: Recognize relationships among financial documents and money management activities

​

• Daily spending and saving decisions are the heart of financial planning

​

• Decisions must be coordinated with needs, goals, and personal situations

3-85

Successful Money Management

• Money management is the day-to-day financial activities needed to manage personal economic resources, while working toward long-term financial security

3-86

Successful Money Management (continued)

OPPORTUNITY COST AND MONEY-MANAGEMENT

• Spending money on current living expenses reduces the amount you can save and invest
• Saving and investing for the future reduces the amount you can spend now
• Buying on credit ties up future income
• Using savings for purchases results in lost interest and depletes savings
• Comparison shopping can save money but takes valuable time

3-87

COMPONENTS OF MONEY MANAGEMENT

3-88

A System for Personal Financial Records

Objective 2: Design a system for maintaining personal financial records

​

Benefits of an Organized System of Financial Records

• Handling daily business affairs, including payment of bills on time
• Planning and measuring financial progress
• Completing required tax reports
• Making effective investment decisions
• Determining available resources for current and future buying

​

​

3-89

A System for Personal Financial Records (continued)

ITEMS IN YOUR HOME FILE

• Personal and employment records
• Money management records
• Tax records
• Financial services records
• Consumer purchase, auto and credit records
• Housing records
• Insurance records
• Investment records
• Estate planning and retirement records

3-90

A System for Personal Financial Records (continued)

ITEMS IN THE SAFE DEPOSIT BOX

• Records that would be hard to replace
• Birth, marriage and death certificates, copy of will
• Citizenship and military papers
• Adoption and custody papers
• Serial numbers and photos of valuables
• CDs and credit and banking account numbers
• Mortgage papers and titles
• List of insurance policy numbers
• Stock and bond certificates
• Coins and other collectibles

3-91

A System for Personal Financial Records (continued)

RECORDS ON YOUR PERSONAL COMPUTER

• Current and past budgets
• Summary of checks written and other banking transactions
• Past income tax returns prepared with tax preparation software
• Account summaries and performance�results of investments
• Computerized versions of wills, �estate plans, and other documents

​

3-92

A System for Personal Financial Records (continued)

HOW LONG SHOULD RECORDS BE KEPT?

• Birth certificates, wills, and Social Security information should be kept indefinitely
• Keep records on personal property and investments as long as you own them
• Keep documents related to the purchase and sale of real estate indefinitely
• Copies of tax returns and supporting data should be kept six years

​

3-93

Personal Financial Statements

Objective 3: Develop a personal balance sheet and cash flow statement

​

Purpose of Personal Financial Statements

​

• Report your current financial position in relation to the value of the items you own and the amounts you owe

​

• Measure your progress toward your financial goals

​

• Maintain information on your financial activities

​

• Provide data you can use when preparing tax forms or applying for credit

3-94

Personal Financial Statements (continued)

BALANCE SHEET: WHERE ARE YOU NOW?

Also called the Net Worth Statement or Statement of Financial Planning

​

Preparation of Balance Sheet requires using the following Steps

​

STEP 1: LISTING ITEMS OF VALUE

​

• Assets - what you own

​

• Liquid assets
• Real estate
• Personal possessions
• Investment assets

3-95

Personal Financial Statements (continued)

STEP 2: DETERMINING THE AMOUNTS OWED

• Liabilities - what you owe
• Current liabilities (< 1 year)
• Long term liabilities

​

STEP 3: COMPUTING NET WORTH

• Assets – Liabilities = Net Worth
• Assets = Net Worth + Liabilities
• Insolvency is the inability to pay debts when they are due

​

​

​

​

3-96

Personal Financial Statements (continued)

Net Worth is an indication of the financial position at any given date

​

​

​

Ways to increase Net Worth

​

• Increasing your savings
• Reducing spending
• Increasing the value of investments and other possessions
• Reducing the amounts you owe

​

​

3-97

Personal Financial Statements (continued)

​

THE CASH FLOW STATEMENT

​

• Cash Flow is the actual inflow, outflow for a given time period

​

​

​

​

• The Cash Flow statement is also called personal income and expenditure statement

​

3-98

Personal Financial Statements (continued)

THE CASH FLOW STATEMENT

The process of preparing cash flows statement follows these steps

​

​

STEP 1: RECORD INCOME

• Wages, salaries, and commissions
• Self-employment business income
• Savings and investment income
• Gifts, grants, scholarships and educational loans
• Government payments, such as Social Security, public assistance, and unemployment benefits
• Amounts received from pension and retirement programs
• Alimony and child support payments

​

3-99

Personal Financial Statements (continued)

​

STEP 2: RECORD CASH OUTFLOWS

• Fixed Expenses

​

• Variable expenses

​

STEP 3: DETERMINE NET CASH FLOWS

• The difference between income and outflows can either be positive or negative

​

• Cash flow statement provides the foundation for preparing and implementing a spending, saving, and investment plan

​

3-100

Budgeting for Skilled Money Management

Objective 4: Create and implement a budget

​

• A budget is a spending plan

​

• The main purposes of a budget are to help you
• Live within your income
• Spend your money wisely
• Reach your financial goals
• Prepare for financial emergencies
• Develop wise financial management habits

3-101

Budgeting for Skilled Money Management (continued)

STARTING THE BUDGETING PROCESS

​

​

​

Insert Exhibit 3-5

3-102

Budgeting for Skilled Money Management (continued)

CHARACTERISTICS OF SUCCESSFUL BUDGETING

​

• Well-planned
• Realistic
• Flexible
• Clearly communicated

​

3-103

Selecting a Budgeting System

Which one works for you?

• Mental budget – it is all in your head
• Physical budget-use envelopes for your expenses such as food, rent, etc.
• Written budget – use spreadsheets
• Computerized budget – use software such as Quicken (http://www.quicken.com/)
• Online budget- (http://www.mint.com/)
• Budget App-using your phone to track expenses.

3-104

Money Management and Achieving Financial Goals

Objective 5: Relate money management and savings activities to achieve financial goals

​

Reasons for saving include…

​

• Setting aside money for irregular and unexpected expenses
• Paying for the replacement of expensive items, such as cars or a down payment on a house
• Buying special items like recreational equipment or to pay for a vacation
• Providing for long-term expenses such as retirement or the education of children
• Earning income from the interest on savings for use in paying living expenses

3-105

Money Management and Achieving Financial Goals (continued)

SELECTING A SAVINGS TECHNIQUE

​

• Payroll deductions into savings accounts

​

• Automatic payments from checking into savings accounts or mutual funds

​

• Saving regularly in 401(k) plans

​

• Also save coins, make periodic deposits

​

• Write a check each payday as a % of income and deposit into savings

3-106