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Basics of Financial
Decisions
ONE
CHAPTER
Engineering Economic
Decisions
Google Cofounder Sergey Brin Comes to Class at
Berkeley
1
Sergey Brin, cofounder of Google, showed up for
class as a guest speaker at Berkeley on October 3, 2005.
Casual and relaxed, Brin talked about how Google came to be,
answered students’ questions, and showed that someone worth
$11 billion (give or take a billion) still can be comfortable in an old
pair of blue jeans. Indistinguishable in dress, age, and demeanor
from many of the students in the class, Brin covered a lot of
ground in his remarks, but ultimately it was his unspoken message
that was most powerful: To those with focus and passion, all things
are possible. In his remarks to the class, Brin stressed simplicity.
Simple ideas sometimes can change the world, he said. Likewise,
Google started out with the simplest of ideas, with a global audience
in mind. In the mid-1990s, Brin and Larry Page were Stanford students
pursuing doctorates in computer science. Brin recalled that at that
time there were some five major Internet search engines, the impor-
tance of searching was being de-emphasized, and the owners of these
major search sites were focusing on creating portals with increased
content offerings.“We believed we could build a better search.We
had a simple idea—that not all pages are created equal. Some are
more important,” related Brin. Eventually, they developed a unique
approach to solving one of computing’s biggest challenges: retrieving
relevant information from a massive set of data.
According to Google lore,
1
by January of 1996 Larry and Sergey had
begun collaboration on a search engine called BackRub, named for its
unique ability to analyze the “back links” pointing to a given website.
1
UC Berkeley News
, Oct. 4, 2005, UC Regents and Google Corporate Information: http://www.
google.com/corporate/history.html.
2
How Google Works
Query
1.
The Web server sends the
query to the index
servers—it tells which
pages contain the words
that match the query.
2.
The query travels to the
Doc servers (which
retrieve the stored
documents) and snippets
are generated to describe
each search result.
Google user
Google Web servers
3.
The search results are
returned to the user in a
fraction of a second.
Doc servers
Index servers
Larry, who had always enjoyed tinkering with machinery and had gained some
“notoriety” for building a working printer out of Lego
®
bricks, took on the
task of creating a new kind of server environment that used low-end PCs in-
stead of big expensive machines. Afflicted by the perennial shortage of cash
common to graduate students everywhere, the pair took to haunting the de-
partment’s loading docks in hopes of tracking down newly arrived computers
that they could borrow for their network. A year later, their unique approach
to link analysis was earning BackRub a growing reputation among those who
had seen it. Buzz about the new search technology began to build as word
spread around campus. Eventually, in 1998 they decided to create a company
named “Google” by raising $25 million from venture capital firms Kleiner
Perkins Caufield & Byers and Sequoia Capital. Since taking their Internet
search engine public in August 2004, the dynamic duo behind Google has seen
their combined fortune soar to $22 billion. At a recent $400, Google trades at
90 times trailing earnings, after starting out at $85. The success has vaulted
both Larry and Sergey into
Forbes
magazine’s list of the 400 wealthiest Ameri-
cans. The net worth of the pair is estimated at $11 billion each.
3
4
CHAPTER 1 Engineering Economic Decisions
A Little Google History
• 1995
•Developed in dorm room of Larry Page and Sergey Brin, graduate students at
Stanford University
• Nicknamed BackRub
• 1998
• Raised $25 million to set up Google, Inc.
• Ran 100,000 queries a day out of a garage in Menlo Park
• 2005
•Over 4,000 employees worldwide
•Over 8 billion pages indexed
The story of how the Google founders got motivated to invent a search engine and even-
tually transformed their invention to a multibillion-dollar business is a typical one.
Companies such as Dell, Microsoft, and Yahoo all produce computer-related products
and have market values of several billion dollars. These companies were all started by
highly motivated young college students just like Brin. One thing that is also common to
all these successful businesses is that they have capable and imaginative engineers who
constantly generate good ideas for capital investment, execute them well, and obtain good
results. You might wonder about what kind of role these engineers play in making such
business decisions. In other words, what specific tasks are assigned to these engineers, and
what tools and techniques are available to them for making such capital investment deci-
sions? We answer these questions and explore related issues throughout this book.
CHAPTER LEARNING OBJECTIVES
After completing this chapter, you should understand the following concepts:
The role of engineers in business.
Types of business organization.
The nature and types of engineering economic decisions.
What makes the engineering economic decisions difficult.
How a typical engineering project idea evolves in business.
Fundamental principles of engineering economics.
1.1
Role of Engineers in Business
Y
ahoo, Apple Computer, Microsoft Corporation, and Sun Microsystems produce
computer products and have a market value of several billion dollars each. These
companies were all started by young college students with technical backgrounds.
When they went into the computer business, these students initially organized
their companies as proprietorships. As the businesses grew, they became partnerships and
were eventually converted to corporations. This chapter begins by introducing the three pri-
mary forms of business organization and briefly discusses the role of engineers in business.
Section 1.1 Role of Engineers in Business
5
1.1.1
Types of Business Organization
As an engineer, you should understand the nature of the business organization with which
you are associated. This section will present some basic information about the type of or-
ganization you should choose should you decide to go into business for yourself.
The three legal forms of business, each having certain advantages and disadvantages,
are proprietorships, partnerships, and corporations.
Proprietorships
A
proprietorship
is a business owned by one individual. This person is responsible for
the firm’s policies, owns all its assets, and is personally liable for its debts. A proprietorship
has two major advantages. First, it can be formed easily and inexpensively. No legal and
organizational requirements are associated with setting up a proprietorship, and organiza-
tional costs are therefore virtually nil. Second, the earnings of a proprietorship are taxed
at the owner’s personal tax rate, which may be lower than the rate at which corporate in-
come is taxed. Apart from personal liability considerations, the major disadvantage of a
proprietorship is that it cannot issue stocks and bonds, making it difficult to raise capital for
any business expansion.
Partnerships
A
partnership
is similar to a proprietorship, except that it has more than one owner.
Most partnerships are established by a written contract between the partners. The con-
tract normally specifies salaries, contributions to capital, and the distribution of profits
and losses. A partnership has many advantages, among which are its low cost and ease of
formation. Because more than one person makes contributions, a partnership typically
has a larger amount of capital available for business use. Since the personal assets of all
the partners stand behind the business, a partnership can borrow money more easily from
a bank. Each partner pays only personal income tax on his or her share of a partnership’s
taxable income.
On the negative side, under partnership law each partner is liable for a business’s
debts. This means that the partners must risk all their personal assets—even those not in-
vested in the business. And while each partner is responsible for his or her portion of the
debts in the event of bankruptcy, if any partners cannot meet their pro rata claims, the re-
maining partners must take over the unresolved claims. Finally, a partnership has a limited
life, insofar as it must be dissolved and reorganized if one of the partners quits.
Corporations
A
corporation
is a legal entity created under provincial or federal law. It is separate from
its owners and managers. This separation gives the corporation four major advantages:
(1) It can raise capital from a large number of investors by issuing stocks and bonds;
(2) it permits easy transfer of ownership interest by trading shares of stock; (3) it allows
limited liability—personal liability is limited to the amount of the individual’s investment
in the business; and (4) it is taxed differently than proprietorships and partnerships, and
under certain conditions, the tax laws favor corporations. On the negative side, it is ex-
pensive to establish a corporation. Furthermore, a corporation is subject to numerous
governmental requirements and regulations.
As a firm grows, it may need to change its legal form because the form of a business
affects the extent to which it has control of its own operations and its ability to acquire
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