i

ii

TIME IS MONEY:

ENGINEERING ECONOMY

ES 311

ERNESTO T. GONZALES
 iii

TIME IS MONEY: ENGINEERING ECONOMY

by

Ernesto T. Gonzales
and
Jose Rizal Memorial State University

All rights reserved. This book or any portion thereof

may not be reproduced or used in any manner whatsoever
without the express written permission of the author
except for the use of brief quotations in a book review.

Page and cover design: Ernesto T. Gonzales

Editor:
ISBN:

Published by:
JOSE RIZAL MEMORIAL STATE UNIVERSITY
Gov. Guading Adaza St. Sta Cruz, Dapitan City, 7101
Tel. No. (065) 908-8294
[email protected]
 iv

Course Introduction

Engineering Economy is a course for all programs in engineering. The focus of this
course is to provide understanding on engineering economic principles and methods and to
apply it in engineering field. It is designed to teach students to formulate cash-flow, perform
analysis on engineering economic problems and evaluate between alternative of engineering
investment/projects to make decision. This course also will offer variety of activities that will
address the multiple intelligences and diversity of students and worksheets will be provided.
This course will use a flexible learning package which include course introduction,
course syllabus, learning guide, learning contract, summative assessments are included that
will provide insights to the students as to what the course is all about, the course
requirements, and what are the activities and assessments to be accomplished.
This learning package is distinct from other books because it has the following major
parts:
Course Introduction –It presents the vital information about the course.
Course Syllabus-This provides vital information on the course outcomes, learning
outcomes, activities, assessments, grading system and the course requirements.
Learning Guide- This provides significant information as to the students’ schedules
of submitting the output and the course requirements, feedback modality,
communication mechanism, and the contact information of the instructor/professor
and other authorities of the University/Campus.
Learning Contract- It is a document which contains the commitment of the learners
in accomplishing the activities which includes also the Data Privacy Act, plagiarism
rules, safety reminders, and parents’ support.
Summative Assessments- These are forms which include the summative
assessment plan, summative assessment instructions, and assessment rubrics.
Flexible Learning Module - This is the meat of the package that contains the front
contents, module content (learning outcomes, pretest, content, learning activities, and
assessments), and the back contents.
Moreover, a flexible learning module is also included. It is a material which presents
introductory concepts essential in effectively understanding engineering economy. A variety
of problems along with different methods of solving them were presented here to provide
options as which method is more preferable to the students.
With this learning package, the author hopes that the learner will be more efficient in
analyzing and solving calculus-related problems.
 v

Contents

Page

Copyright iii

Course Introduction iv

Course Syllabus vi

Learning Guide ix

Learning Agreement xiii

Summative Assessment xiv

Flexible Learning Module 1

References

Glossary

Rubrics

Answer Key

User’s Evaluation Form

About the Author

 vi

Course Syllabus
vii
viii
ix
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Learning Guide
The key to successfully finish this material lies in your perseverance to sincerely and
honestly perform the learning activities and accomplish the assessments. This flexible learning
package is developed with the aim to aid your learning for this course. Aside from meeting the
content and performance standards of this course in performing all the learning activities and
assessments, you will be able to learn the skills and values which are needed in achieving the
future skills and the graduate attributes to become globally competitive individuals.
Classroom Rules and Conduct
The following are the house rules which will help you to be on track and successfully
finish this course:
1. Schedule and manage your time to read and understand every component of this
learning package.
2. Study on how you can manage to perform all the learning activities in consideration
with your resources and accessibility to technology. Do not ask questions that are
already answered in the guide.
3. If you did not understand the readings and the other tasks, read again. If there are
still clarifications and questions, feel free to reach me through the contact information
indicated in this guide.
4. Do not procrastinate. As much as possible, follow the time table.
5. Read and understand the assessment and technology tools as indicated in the
directions in every assessment or activity.
6. Before the end of the midterms, you will be tasked to send back the material trough
the pigeon boxes in your department. For online learners, you will submit your output
and other tasks in the google classroom. While waiting for my feedback of your
accomplished module, you may continue on accomplishing the tasks in the
succeeding units that are scheduled for the finals.
7. Most importantly, you are the learner; thus, you do all the tasks in your own. You
may ask assistance and guidance from your parents, siblings or friends, but all the
activities shall be performed by you alone.
8. Course requirements must be submitted as to schedule.
9. Plagiarism is strictly prohibited. Be aware that plagiarism in this course would include
not only using another’s words, but another’s specific intellectual posts in social
media. Assignments must be done independently and without reference to another
student’s work. Any outside sources used in completing an assignment, including
internet references must be fully cited on any homework assignment or exercise.
10. All students should feel free to talk to the instructor face-to-face or through media
during office hours.
11. Academic accommodations are available for students with special needs. Students
with special needs should schedule an appointment with the instructor early in the
semester to discuss any accommodations for this course.
 xi

Week Unit Title Activities

August 24-28, 2020 Orientation Reading of Learning Package
Introduction to Engineering Discussing introduction to
September 1-2, 2020
Economics engineering economy
Cost Concepts and Design
September 3-18, 2020 Problem solving
Economics
September 21-October 2,
Problem solving
2020 Principles of Money-Time
Relationships
October 5 – October 19 Problem solving
October 20-21, 2020
October 26-30, 2020
November 3-6, 2020
November 9-13, 2020
November 16-20, 2020
November 23-27, 2020
December 1-4, 2020
December 7-11, 2020
December 14-18, 2020
December 21, 2020

Evaluation
To pass the course, you must observe the following:
1. Read the course module and answer the pretest, quizzes, self-assessment
activities.
2. Write your thoughts and suggestions in the comment boxes.
3. Perform all the learning activities.
4. Accomplish the assessments.
5. Submit the course requirements.
6. Perform the Midterm and Final Assessments

Technology Tools
In order to perform all the learning activities and accomplish the assessments, you
will need these software applications: word processing and presentation software. These are
applications that are available in your desktop or laptop that will not require internet
connection. All materials and activities that will involve reporting, interpretation, and problem
solving will be created using Microsoft word or any application alike, be saved in the CD or
flash drive. These materials will be submitted through the pigeon boxes. For online learners,
materials will be uploaded in google classroom.
 xii

Feedback Modality and Communication Mechanisms

Feedback system will be facilitated through text messaging. If you need to call, send
me a message first and wait for me to respond. Do not give my CP number to anybody. I will
not entertain messages or calls from numbers that are not registered. You may send your
clarifications and questions through the google classroom.

Grading Plan

The term grade is computed using the formula:

40% - Performance
30% - Major Requirements
30% - Formative Assessment
Midterm Grade = 100% of the Midterm Grade (if applicable)
Final Grade = 50% of the Midterm Grade + 50% of the Final
Term Grade (if applicable)

Contact Information

Person/Office Email address CP number

Instructor [email protected] 09304055563
IMDO [email protected] 09399168104
FLS
CAS
DSAS
Library
DRMMO
 xiii

JOSE RIZAL MEMORIAL STATE UNIVERSITY

LEARNING AGREEMENT

By signing this learning agreement, I commit to the following terms and conditions of Jose
Rizal Memorial State University in the implementation of Flexible Learning System.
Specifically, I commit to observe the following:
1. That I must observe all guidelines of the state pertaining to the prevention of COVID,
specifically to stay home, to observe physical distancing and the use of face masks
when interacting with others.
2. That I shall prioritize my health and safety while I comply with all the necessary
learning activities and assessments needed in my enrolled courses.
3. That I will exhaust all means of complying the requirements at home or in a less risky
place and location that will not allow me to be exposed to other people.
4. That I have already read and understood all instructions pertaining to my enrolled
courses.
5. That I commit to do all the learning activities diligently, following deadlines and the
learning guide enabling me to deliver the course requirements.
6. That I commit to answer all forms of assessment in the learning package honestly.
7. That I shall initiate in giving feedback to my instructor at least once every two weeks.
8. That I shall not reproduce or publish any part of the learning package content without
the written consent of the University and the author/s.
9. That I shall not commit any form of plagiarism in all course requirements.
Conformed:

Name and signature of student Date signed

Name and signature of parent/guardian Date signed

Contact Number of Parent/Guardian

** Please email the signed copy of this learning agreement to your instructor as soon as you
have received the learning package.
 xiv

Jose Rizal Memorial State Form No.

F16: Summative Assessment Plan
Background: This form aims to document the summative assessment strategies that a teacher deems
appropriate to the course being taught and its corresponding course outcomes. Summative assessments
are methods used to evaluate student learning, skill acquisition, and academic achievement at the
conclusion of a defined instructional period – typically at the end of a course or a semester. Summative
assessments are requirements across all courses in JRMSU. Please refer to the JRMSU Handbook on
Flexible Learning for the guidelines in designing summative assessments.

Course Title: Engineering Economy SY/ Sem: 2020-2021/ 1st Semester

Course Code: ES 311

No. Course Title of Description Scoring/ Weight (%)

Outcomes Assessment Grading in
Standard Final Grade
1 Solve Written exam Solve future Accuracy 30% 15%
problems value, present
involving value, annuities Completeness
interest and 25%
the time value
Explanation
of money 25%

Neatness and
Organization
20%

2 Evaluate Written Exam Present cases or Accuracy 30% 15%

project options for them
alternatives to evaluate and Completeness
by applying select 25%
engineering
Explanation
economic 25%
principles and
methods and Neatness and
select the Organization
most 20%
economically
efficient one
1
 2

PREFACE

The emergence of the pandemic gave birth to the new normal, and the birth
of the new normal bring forth new modalities of learning. Two of which are the
online and modular modalities. This is somehow new to both educators and
learners. Even though we utilize technology alongside our usual academic pursuit,
we haven’t fully used it as our entire medium of delivering and receiving instruction.
Thus, to help guide the students in taking courses under these new situations, this
module is created.

In this module, key concepts on engineering economic principles are

presented while at the same time striking a balance between theory and
application. Learning activities and assessments are also incorporated after every
discussion to evaluate the knowledge and skill you acquired in every unit.

With this module, the author hoped that the learners will gain basic
knowledge engineering economic principles and apply such learning in real-life
scenarios.
 3

ACKNOWLEDGEMENT

The author wishes to express his earnest gratitude to all who made
substantial contributions to this work. This module would not have been made
possible without the assistance and cooperation of the following:

Dr. Daylinda Luz-Reluya Laput, the University President, for her never-
ending support and consideration in doing this module a success;

Dr. Alice Mae A. Arbon, Vice President for Academic Affairs, and Dean of
the Graduate School for the reassurance and kind-heartedness;

The Flexible Learning System committee, for the series of trainings to equip
us with ideas on the development of this learning material.

The College of Engineering colleagues, the assistance and careful

monitoring on the development of the outcome on this endeavor.

To his friends, colleagues;

To his parents, brothers, sister and relatives for the warmth, and love;

Finally, to Almighty God, who is the reason of his entire existence.

The Author
 4

TABLE OF CONTENTS

Page

COVER PAGE i
COPYRIGHT PAGE ii
VMGO iii
PREFACE iv
ACKNOWLEDGEMENT v

Module: Ever X has its Y

Unit 1 Introduction to Engineering Economics 5 -8
Unit 2 Cost Concepts and Design Economics 9 – 23
Unit 3 Principles of Money-Time Relationships 24 - 39
Unit 4
Unit 5
Unit 6

References
Rubric
Glossary
Answer Key
 5

UNIT 1

Introduction to Engineering Economics

Learning Outcomes:

At the end of this unit, you will be able to:

• Understand the importance of engineering economics

Pre – Test:

Multiple Choice.

1. A civil engineer named ________ in the later part of the 19th century made use of
engineering economic analysis in building railroads in the U. S.
a. Eugene Grant b. Gustave Eiffel
c. Arthur Wellington d. Maurice Albertson

2. In 1930, Eugene Grant published his book, ____________, which emphasized on

techniques that depended on financial and actuarial mathematics.
a. The Value of Time and Money
b. Principles of Engineering Economy
c. Engineering Economics: A Tool for Wise Decision-Making
d. The Fundamentals of Engineering Economics

3. Which of the following is not a step of the engineering economic analysis

procedure?
a. Problem recognition, definition, and evaluation
b. Selection of a criterion (or criteria)
c. Development of the cash flows for each alternative
d. None of the above

4. Which of the following is not a step of the engineering economic analysis

procedure?
a. Consult banks for advice
b. Use a common unit of measure
c. Make uncertainty explicit
d. Revisit your decisions

5. What is the last step of the engineering economic analysis procedure?

a. Analysis and comparison of the alternative
b. Revisit your decisions
c. Performance monitoring and post evaluation results
d. Development of the feasible alternatives
 6

Content:

ENGINEERING ECONOMY/ECONOMICS DEFINED

• As defined by Arreola

Engineering economy is that branch of economics which involve the

application of definite laws of economics, theories of investment and business
practices to engineering problems involving cost.

It is also defined to be the study of economic theories and their application

to engineering problems with concept of obtaining the maximum benefit at the
least cost as a basis for decision.

It also involves the study of cost features and other financial data and their
application in the field of engineering as a basis for decision.

• As defined by Kasner

Engineering economics is equated with practicality and economic

feasibility. It is also the search for the recognition of alternatives which are then
compared and evaluated in order to come up with the most practical design and
creation.

• As defined by Sullivan, et al.

Engineering economy is the systematic evaluation of the economic merits

of proposed solutions to engineering problems.

IMPORTANT USES OF ENGINEERING ECONOMY

1. Seeking new objectives for the application of engineering – An important use

of engineering economy is to seek new objectives for engineering application.
Engineers are constantly seeking new and wider application of their technical
knowledge for the benefit of mankind and in line with this, engineering
economy provides basic principles and laws.
2. Discovery of factors limiting the success of a venture or enterprise – upon
knowing the objectives, next is to determine ways and means to attain such
objectives. With Engineering Economy, the so-called limiting factors which
may hinder the success of a project are being discovered.
3. Comparison of alternatives as a basis for decision – The principles of
engineering economy helps to point out the analysis of choosing the best
alternatives on a quantitative basis.
4. Analysis of possible investment of capital – Engineering economy enables
engineers to consider all aspects of investment from both the technical and
financial viewpoints. It provides several patterns of analysis to determine rate
of return, annual costs and pay out periods, which all serves as bases for
decision.
5. Determination of bases for decision – Engineers‟ main concern is on future
actions, that is on what to do and not on what has been accomplished.
 7

Decisions on future actions are more valid and accurate if the principles of
engineering economy are correctly applied.

Origins of engineering economy. A civil engineer named Arthur Wellington in

the later part of the 19th century made use of engineering economic analysis in building
railroads in the U. S. In 1930, Eugene Grant published his book, Principles of
Engineering Economy, which emphasized on techniques that depended on financial
and actuarial mathematics.

What are the principles of engineering economy?

Principle 1. Develop the alternatives. The choice is among alternatives.

Principle 2. Focus on the differences. Only the difference in expected outcomes
is considered. Principle 3. Use a consistent viewpoint. Prospective outcomes of
the alternatives, economic, etc.
should be considered.
Principle 4. Use a common unit of measure. Using a common unit of
measurement of the possible outcomes in comparing alternatives.
Principle 5. Consider all relevant criteria. Consider both monetary and other unit
of measure in measurement of outcomes.
Principle 6. Make uncertainty explicit. Uncertainty is inherent in projecting future
outcomes and should considered in their analysis and comparison.
Principle 7. Revisit your decisions. Projected results and decisions should be
compared with actual results to improve the decision process.

The Engineering Economic Analysis Procedure

Steps:
1. Problem recognition, definition, and evaluation.
2. Development of the feasible alternatives.
3. Development of the cash flows for each alternative.
4. Selection of a criterion (or criteria).
5. Analysis and comparison of the alternative.
6. Performance monitoring and post evaluation results.

Learning Activity 1:

Activity 1.
Direction. Write an essay that answers the following questions.

1. In your own words, what is engineering economy?

2. Is studying engineering economics important? Cite situational examples that will
support your claim.
 8

Congratulations! You are now ready for the next unit.

Write your insights and thoughts about the activities below.
 9

UNIT 2

Cost Concepts and Design Economics

Learning Outcomes:

At the end of this unit, you will be able to:

• Analyze short-term alternatives when the time value of money is not
a factor using breakeven analysis

Pre – Test:

Matching Type.

1. Cost that involves payment of cash a Sunk cost

2. Cost that has occurred in the past and has no b. Operation &
relevance to estimates of future costs and maintenance
revenues related to an alternative course of cost
action
3. First cost or cost incurred during the c. Demand
acquisition phase
4. Cost which includes many of the recurring d. Life cycle
annual expense items associated with the cost
operation phase of the life cycle
5. The quantity of a certain commodity that is e. Disposal
bought at a certain price at a given place cost
and time
6. Cost that are unaffected by changes in f. Fixed cost
activity level over a feasible range of
operations for the capacity or capability
available
7. Does not involve cash transaction; non-cash g. Necessities
8. Summation of cost estimates from inception h. Cash cost
to disposal for both equipment and projects
9. Includes non-recurring costs of shutting i. Book cost
down the operation and the retirement and
disposal of assets at the end of the life cycle
10. Products or services that are required to j. Investment
support human life and activities, that will be cost
purchased in somewhat the same quantity
even though the price varies considerably
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Content:

TERMINOLOGIES
Fixed cost – those that are unaffected by changes in activity level over a feasible range
of operations for the capacity or capability available. (Insurance and taxes on facilities,
general management and administrative salaries, license fees and interest costs of
borrowed capital).

Variable cost – are those associated with an operation that vary in relation to changes in
quantity of output or other measures of activity level. For the example, the cost of materials
and labor used in a product or service are variable costs – because they vary with the
number of output units even though the costs per unit stay the same.

Incremental cost (incremental revenue) – refers to the additional cost or revenue that will
result for increasing the output of a system by one of more units. This is often quite difficult
to determine in practice. Thus, if to produce 100 units will cost P200, and the total cost for
producing 110 units is P215, then the increment cost for additional 10 units is P15 or 1.50
per unit.

Recurring costs – costs that are repetitive and occur where an organization produces
similar goods or services on a continuing basis. Variable costs are also recurring costs,
because they repeat with each unit of output. Fixed cost that is paid on a repeatable basis
is a recurring cost (ex. office space rental).

Non-recurring costs – are those that are not repetitive even though the total expenditures
maybe cumulative over a relatively short period of time. Usually it involves the developing
or establishing a capability or capacity to operate.

Direct cost – those that can be reasonably measured and allocated to a specific output
or work (labor and materials).

Indirect cost – costs that are difficult to attribute or allocate to a specific output. They are
costs allocated through a selected formula (such as proportional to direct labor hours or
direct materials) to the outputs or work activities (ex. Cost of common tools, general
supplies equipment maintenance).

Overhead cost – used to mean all expenditures that are not direct cost (administrative,
insurance, taxes, electricity, general repairs)

Standard cost – representation cost per unit of output that are established in advance of
actual production or service delivery. They are developed from anticipated direct labor
hours, materials and overhead categories. Standard costs play an important role in cost
control and other management functions like estimating future manufacturing costs.

Cash cost – cost that involves payment of cash.

 11

Book cost – does not involve cash transaction; non-cash. The most common example of
book cost is the depreciation. It is included in an analysis for it affects income taxes, which
are cash flows.
Opportunity cost – is incurred because of the use of limited resources such that the
opportunity to use those resources to monetary advantage in alternative use is foregone.
It is the cost of the best rejected opportunity and is often hidden or implied.

Example of opportunity cost:

Consider a student who could earn P 5,000/ month or P60,000 for working during
a year but chooses instead to go to school for a year and spend P35,000 to do so. The
opportunity cost of going to school for that year is P95,000 (the 60,000 for the income
gone and the P35,000 for the school expenses).

Sunk cost – is one that has occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course of action. It represents money
which has been invested and which cannot be recovered due to certain reasons. A sunk
cost is common to all alternatives and is not part of the future cash flows and can be
disregarded in an engineering economic analysis.

Life cycle cost – refers to the summation of cost estimates from inception to disposal for
both equipment and projects as determined by an analytical study and estimate of total
costs experienced during their life. The objective of LCC analysis is to choose the most
cost-effective approach from a series of alternatives so the least long-term cost of
ownership is achieved.

LCC analysis helps engineers justify equipment and process selection based on
total costs rather than the initial purchase price. Usually the cost of operation,
maintenance, and disposal costs exceed all other costs many times over. Life cycle costs
are the total costs estimated to be incurred in the design, development, production,
operation, maintenance, support, and final disposition of a major system over its
anticipated useful life span (DOE, 1995). The best balance among cost elements is
achieved when the total LCC is minimized (Landers, 1996).

Fig 2.1 The life cycle cost

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1 = Needs assessment; definition of requirements

2 = Conceptual (preliminary) design; advanced development; prototype testing
3 = Detailed design; production or construction planning; facility and resource
acquisition
4 = Production or construction
5 = Operation or customer use; maintenance and support
6 = Retirement and disposal

Life cycle begins with the identification of the economic need or want and ends
with retirement and disposal activities. Life cycle is divided into two general time periods,
the acquisition phase and the operation phase. And each phase is further subdivided into
interrelated but different activity periods.

The figure shows the relative cost profiles for the life cycle. The greatest potential
for achieving life-cycle cost savings is early in the acquisition phase. Savings on the life-
cycle costs of a product is dependent on many factors. And here, effective engineering
design and economic analysis during this phase are critical in maximizing potential
savings. One aspect of cost-effective engineering design is the minimizing of the impact
of design changes during the steps in the life cycle.

The cumulative committed life cycle cost curve increases rapidly during the
acquisition phase. In general, approximately 80% of life cycle costs are “locked in” at the
end of this phase by the decisions made during the requirements analysis and preliminary
and detailed design. In contrast, as reflected by the cumulative life-cycle cost curve, only
about 20% of actual costs occur during the acquisition phase, with about 80% being
incurred during the operation phase.

One purpose of the life-cycle concept is to make explicit the interrelated effects of
costs over the total life span for a product. The objective of the design process is to
minimize the life cycle cost – while meeting other performance requirements.

Investment cost – first cost or cost incurred during the acquisition phase. It is the capital
required for most of the activities in the acquisition phase.

Capital investment – series of expenditures over an extended period on a large

construction project.

Working capital – refers to the funds required for current assets (equipment, facilities)
that are needed for the start-up and support of operational activities.

Operation and maintenance cost – includes many of the recurring annual expense items
associated with the operation phase of the life cycle. The direct and indirect costs of
operation in five primary resource areas, 1) people 2) machines 3) materials 4) energy 5)
information – are major parts of the costs in this category.
 13

Disposal cost – includes those non-recurring costs of shutting down the operation and
the retirement and disposal of assets at the end of the life cycle. Ex. Costs associated with
personnel, materials.

SOME ECONOMIC RELATIONSHIPS

Consumer and Producer Goods and Services

• Consumer goods and services are those products or services that are directly
used by people to satisfy their wants. (Food, clothing, homes, cars, appliances,
medical services, etc)

• Producer goods and services are used to produce consumer goods and services
or other producer goods. (Machine tools, factory buildings, buses, etc.).

Producer goods and services are intermediate step or serve as a mean to satisfy human
wants. The amount of producer goods needed is determined indirectly by the amount of
consumer goods or services that are demanded by people.

Necessities and Luxuries

• Necessities are those products or services that are required to support human life
and activities, that will be purchased in somewhat the same quantity even though
the price varies considerably.

• Luxuries are those products or services that are desired by human and will be
purchased if money available after the required necessities have been obtained.

Demand

Demand is the quantity of a certain commodity that is bought at a certain price at a given
place and time. Demand refers to how much (quantity) of a product or service is desired
by buyers. The quantity demanded is the amount of a certain product people are willing to
buy at a certain price.

Law of Demand – The demand for a commodity varies inversely as the price of the
commodity, though not proportionately.

It states that if all other factors remain equal, the higher the price, the less people
will demand a good. In other words, the higher the price, the lower the quantity demanded.
The amount buyers purchase at a higher price is less because, as the price of goes up,
so does the opportunity cost of buying that good: people will naturally avoid buying a
product that is beyond their capacity to buy. The chart below shows that the curve is a
downward slope:
 14

Fig 3.2 General Price-Demand Relationship

As the selling price per unit (p) is increased, there will be less demand (D) for the
product, and as the selling price is decreased, the demand will increase. Expressing as a
linear function:

Equation 1. p = a – bD ;

Where, a = the intercept on the price axis

b = the slope, the amount by which demand increases for each unit
decrease in p

D = (a – p) / b ; (b ≠ 0) Equation 2

Supply
Supply is the quantity of a certain commodity that is offered for sale at certain price
at a given place and time. It represents how much the market can offer.

Law of Supply - the supply of the commodity varies directly as the price of the commodity,
though not proportionately.

Fig 3.2 General Price-Supply Relationship

 15

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of time.
Time is important to supply because suppliers must, but cannot always, react quickly to a
change in demand or price. So, it is important to try and determine whether a price change
that is caused by demand will be temporary or permanent.

Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show
how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20.
Because the record company's previous analysis showed that consumers will not demand
CDs at a price higher than $20, only ten CDs were released because the opportunity cost
is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20
people, the price will subsequently rise because, according to the demand relationship,
as demand increases, so does the price. Consequently, the rise in price should prompt
more CDs to be supplied as the supply relationship shows that the higher the price, the
higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not
be pushed up because the supply more than accommodates demand. In fact after the 20
consumers have been satisfied with their CD purchases, the price of the leftover CDs may
drop as CD producers attempt to sell the remaining ten CDs. The lower price will then
make the CD more available to people who had previously decided that the opportunity
cost of buying the CD at $20 was too high.

The Law of Supply and Demand

The law of supply and demand may be stated as follows:

“Under conditions of perfect competition, the price at which a given product will be
supplied and purchased is the price that will result in the supply and the demand being
equal.”
 16

Fig 3.3 Price-Supply-Demand Relationship

When supply and demand are equal (i.e. when the supply function and demand
function intersect) the economy is said to be at equilibrium. At this point, the allocation of
goods is at its most efficient because the amount of goods being supplied is exactly the
same as the amount of goods being demanded. Thus, everyone (individuals, firms, or
countries) is satisfied with the current economic condition. At the given price, suppliers are
selling all the goods that they have produced and consumers are getting all the goods that
they are demanding.

Competition, Monopoly, and Oligopoly

Perfect competition occurs in a situation where a commodity or services is supplied

by a number of vendors and there is nothing to prevent additional vendors entering the
market. There is no restriction against other vendors from entering the market. Buyers are
free to buy from any vendor, and the vendors likewise are free to sell to anyone.

An opposite of perfect competition is Perfect monopoly which exist when a unique

product or service is available from only a single vendor and that vendor can prevent the
entry of all others into the market. Examples of monopolies are the services offered by
Meralco electric pants throughout the country, the telephone companies and other public
utilities, in which the sole right are being granted by the government.

Oligopoly exists when there are so few suppliers of a product or service that action
by one will almost inevitable result in similar action by the others. Examples of oligopoly
in the Philippines are the oil companies and manufacturers of soft drinks who hold
franchises to produce drinks of foreign origin. Any change in price of anyone of them is
usually accompanied by a similar change by the other competitors.

Utility

The focus of economics is to understand the problem of scarcity: the problem of

fulfilling the unlimited wants of humankind with limited and/or scarce resources. Underlying
 17

the laws of demand and supply is the concept of utility, which represents the advantage
or fulfillment a person receives from consuming a good or service. Utility, then, explains
how individuals and economies aim to gain optimal satisfaction in dealing with scarcity.

Utility - is an abstract concept rather than a concrete, observable quantity. The units to
which we assign an “amount” of utility, therefore, are arbitrary, representing a relative
value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains
from consuming a given amount of goods or services in an economy. The amount of a
person's total utility corresponds to the person's level of consumption. Usually, the more
the person consumes, the larger his or her total utility will be. Marginal utility is the
additional satisfaction, or amount of utility, gained from each extra unit of consumption.

Although total utility usually increases as more of a good is consumed, marginal

utility usually decreases with each additional increase in the consumption of a good. This
decrease demonstrates the law of diminishing marginal utility. Because there is a
certain threshold of satisfaction, the consumer will no longer receive the same pleasure
from consumption once that threshold is crossed.

In other words, total utility will increase at a slower pace as an individual increases
the quantity consumed.

The Law of Diminishing Return

“When the use of one of the factors of production is limited, either in increasing
cost or absolute quantity, a point will be reached beyond which an increase in the variable
factors will result in a less than proportionate increase in output”

“When one of the factors of production is fixed in quantity or is difficult to increase,

increasing the other factors of production will increase in a less than proportionate
increase in output.

This law was originally applied in agriculture, correlating the input o men, fertilizers
and other variable factors to the input in crops or harvest. Example: Increasing gradually
the quantity of fertilizer for a fixed area of land will result in an increase in output up to a
certain extent, beyond which the output will decrease or even become nil.

Total Revenue

The Total revenue, TR, that will result from a business venture during a given
period is the product of the selling price per unit, p, and the number of units sold, D.

TR = price x demand = p * D Equation 3

If the relationship between price and demand as given by equation 1 is used,

TR = (a – bD)D = aD - bD2 Equation 4

 18

COST, VOLUME AND BREAKEVEN POINT RELATIONSHIPS

Break even analysis is a useful tool to study the relationship between fixed costs, variable
costs, and returns. A break-even point defines when an investment will generate a
positive return can be determined graphically or with simple mathematics.

Quick Facts...

• A break-even point defines when an investment will generate a positive

return.
• Fixed costs are not directly related to the level of production.
• Variable costs change in direct relation to volume of output.
• Total fixed costs do not change as the level of production increases.

Break-even analysis computes the volume of production at a given price necessary

to cover all costs. Break-even price analysis computes the price necessary at a given level
of production to cover all costs.

At any demand, D, the total cost is

CT = CF + CV equation 5
Where:
CT = Total cost
CF = Fixed cost
CV = Variable cost

For linear relationship:

CV = cv (D) equation 6

where:
cv = is the variable cost per unit
D = is the total product produced or volume demanded

There are 2 scenarios in solving the breakeven points:

1st Scenario:

When total revenue (equation 5) and total cost as given by equations 5 and 6 are
combined, the typical results as a function of demand is shown in Figure 5.
 19

Fig 3.4 Combined cost and revenue functions, and break-even points as functions of
volume and their effect on typical profit

At break even point D’1, total revenue is equal to total cost, and an increase in
demand will result in a profit for the operation. Then at optimal demand, D*, profit is
maximized. At breakeven point D’2, total revenue and total cost are again equal, but
additional volume will result in an operating loss instead of a profit.

At any volume, D,
Profit = total revenue – total costs
= (aD – bD2) – (CF+ cvD)
= - bD2 + (a – cv) D - CF equation 7

Two conditions must be met in order for a profit to occur:

1. (a – cv) > 0; that is, the price per unit that will result in no demand has to be greater
than the variable cost per unit
2. Total revenue (TR) must exceed total cost (CT) for the period involved.

If these 2 conditions were met, the optimal value of D that maximizes profit is

D* = (a – cv) / 2b equation 8

For break-even point:

Total revenue = total cost

aD – bD2 = CF + cvD
-bD2 + (a – cv) D – CF = 0 Equation 9

Equation 10 is a quadratic equation with one unknown (D), solving for breakeven
points D’1 and D’2……
 20

−( a−cv ) ± √( a−cv )2 −4(−b)(−cf )

'
D= Equation 10
2(−b)

Sample problem:
A company produces an electronic timing switch that is used in consumer and
commercial products made by several other manufacturing firms. The fixed cost (CF) is
$73,000 per month, and the variable cost (cv) is $83 per unit. The selling price per unit is
p = $180 – 0.02(D), based on Equation 1. For this situation (a) determine the optimal
volume for this product and confirm that a profit occurs (instead of a loss) at this demand;
and (b) find the volumes at which breakeven occurs; that is, what is the domain of
profitable demand?
Solution:
a. D* = (a – cv)/ 2b = (180 – 83) / 2(0.02) = 2,425 units per month (from Equation 1)

Is (a – cv) > 0?
($180 – 83) = $97, which is greater than 0.

And is (total revenue – total cost) > 0 for D* = 2,425 units per month?
[$180(2,425) – 0.02(2,425)2] – [$73,000 + 83(2,425] = $44,612

b. Total revenue = total cost (break-even point)

(From Equation 10)
2
−( a − cv ) ± √( a − cv ) − 4( − b)( − cf )
'
D=
2( − b)
2
−(-97) ± √( 97) − 4(-0.02)(-73,000)
'
D=
2(-0.02)
D’1 = (-97 + 59.74)/(-0.04) = 932 units per month
D’1 = (-97 - 59.74)/(-0.04) = 3,918 per month

Thus, the domain of profitable demand is 932 to 3,918 units per month.
 21

Fig 3.4 Typical Breakeven Chart with price (p) a constant

2nd Scenario:

When the price per unit (p) for a product or service can be represented more simply
as being independent of demand and is greater than variable cost per unit (c v), a single
breakeven point results. Assuming that the demand is immediately met, TR = p.D and
using equations 5 and 6, the typical situation is shown in Figure 3.4.

Total fixed costs do not change as the level of production increases.

The total cost line is the sum of the total fixed costs and total variable costs.

The total income (Profit) line is the gross value of the output.

The key point (break-even point) is the intersection of the total cost line and the
total income line (Point P). A vertical line down from this point shows the level of production
necessary to cover all costs. Production greater than this level generates positive revenue;
losses are incurred at lower levels of production.

Breakeven Point

Break even = Total revenue = Total cost

= pD = CF + CV
= pD = CF + cvD’

D’ = CF / (p – cv) Equation 11

Break Even = Fixed Cost / (Unit Price - Variable Unit Cost)

 22

Sample problem:

An engineering consulting firm measures its output in a standard service hour unit,
which is a function of the personnel grade levels in the professional staff. The variable
cost (cv) is $62 per standard service hour. The charge-out rate [i.e., selling price (p)] is
1.38.cv = $85.56 per hour. The maximum output of the firm is 160,000 hours per year, and
its fixed cost (CF) is $2,024,000 per year. For this firm, (a) what is the breakeven point in
standard service hours and in percentage of total capacity and (b) what is the percentage
reduction in the breakeven point (sensitivity) if fixed costs are reduced 10 percent; if
variable cost per hour is reduced 10 percent; if both costs are reduced 10 percent; and if
the selling price per unit is increased by 10 percent?

Solution:

a. Total revenue = total cost pD’ = CF + cvD’

D’ = CF / (p – cv)
D’ = $2,024,000 / ($85.56 - $62) = 85,908 hours per year
D’ = 85,908 / 160,000 = 0.537 or 53.7% capacity

b. 10% reduction in CF:

D’ = 0.9 ($2,024,000_ = 77,318 hours per year

($85.56 - $62)
D’ = 85,908 – 77,318 / 85,908 = 0.10 or 10% reduction in D’

and 10% reduction in cv:

D’ = __($2,024,000) = 68,011 hours per year

[$85.56 – 0.9 ($62)]
D’ = 85,908 – 68,011 / 85,908 = 0.208 or 20.8% reduction in D’

and 10% reduction in both CF and cv:

D’ = ___0.9 ($2,024,000) = 61,210 hours per year
[$85.56 – 0.9 ($62)]
D’ = 85,908 – 61,210 / 85,908 = 0.287 or 28.7% reduction in D’

and 10% increase in p:

D’ = _($2,024,000) ___ = 63,021 hours per year
[1.1($85.56) – $62]
D’ = 85,908 – 63,021 / 85,908 = 0.266 or 26.6% reduction in D’

Therefore, the breakeven point is more sensitive to a reduction in variable cost per
hour than to the same percentage reduction in fixed cost, but reduced costs in both areas
should be sought. And also, breakeven point in this example is highly sensitive to the
selling price per unit, p.
 23

The breakeven point in an operating situation can be determined in 1) units of

output 2) percentage utilization of capacity 3) sales volume (demand).

Learning Activity:

Activity 1.
Solve the following problems. Show your work on a clean paper.

1. A company produces a gear that is commonly used by several lawnmower

manufacturing companies. The base cost of operation is $750,000 per year. The cost of
manufacturing is $1.35 per gear. If these gears are sold at $7.35 each, how many must
be sold each year to breakeven?

2. A company manufacturing wooden chairs has fixed expenses of $34,950 per month.
The labor cost per chair is $15. The material cost is $65 per chair. The other variable cost
to produce a chair is $20. If each chair is sold at $250 each, how many chairs must the
company sold per month in order to break even?

3. A cell phone company has a fixed cost of $1,000,000 per month and a variable cost of
$20 per month per subscriber. The company charges $29.95 per month to its cell phone
customers.
(a) What is the breakeven point for this company?
(b) The company currently has 95,000 subscribers and proposes to raise its monthly
fees to $39.95 to cover add-on features such as text messaging, song downloads, game
playing, and video watching. What is the new breakeven point if the variable cost
increases to $25 per customer per month?
(c) If 20,000 subscribers will drop their service because of the monthly fee increase in
Part (b), will the company still be profitable?

Congratulations! You are now ready for the next unit.

Write your insights and thoughts about the activities below.
 24

UNIT 3

Principles of Money-Time Relationships

Learning Outcomes:

At the end of this unit, you will be able to:

• Make cash flow diagrams
• Solve problems about money-time relationships

Pre – Test:

Multiple Choice.

1. Suppose that P1,000 is borrowed at a simple interest rate of 18% per annum. At
the end of one year, the interest would be ______.
a. P1,800 b. P180
c. P2,160 d. P21,600

2. It is the difference between total cash coming (inflows or cash receipts) and total
cash going out (outflows or cash disbursements) for a given period of time.
a. Cash flow b. Cash flow diagram
c. Time value of money d. Present value

3. ______ is a bunch of structured payments or equal payments made regularly, like

every month or every week.
a. Annuity b. Present value
c. Future value d. Monthly/Weekly due

4. It means that the interest is compounded at the end of each finite length period.
a. Discrete compounding b. Perpetuity
c. Nominal Interest d. Effective Interest

5. In a cash flow diagram, the horizontal line represents _________.

a. Positive cash flow
b. Negative cash flow
c. Deposits
d. time scale

Content:

TERMINOLOGIES

Capital – refers to wealth in the form of money or property that can be used to produce
more wealth.

The Concept of Time Value of Money – “Money makes money”. This is true because if
we invest money today, by tomorrow we will have accumulated more money that what we
had originally invested. And also, if you borrow money today you will have to pay in the
 25

future an amount that is larger than what you have originally owed. This change in the
amount of money over a given time period is called time value of money”.

Equity capital – is owned by individuals who have invested their money or property in a
business project or venture in the hope of receiving a profit and sometimes in exchange
for a share of ownership in the company. Equity financing allows a business to obtain
funds without incurring debt or having to repay a specific amount of money at a particular
time.

Debt Capital – also called borrowed capital, is represented by funds borrowed by a

business that must be repaid over a period of time, usually with interest. Debt financing
can be either short-term, with full repayment due in less than one year, or long-term, with
repayment due over a period greater than one year.

Return on Capital - measures of how effectively a company uses the money (borrowed
or owned) invested in its operations.

Interest - The term "interest" is used to indicate the rent paid for the use of money. It is
also used to represent the percentage earned by an investment in a productive operation.
From the lender's point of view, the interest is the income produced by the money which
he has lent. From the borrower's point of view, interest is the amount of money paid for
the use of borrowed capital. The percentage of money charge as interest is called as
interest rate.

Simple Interest

The interest is said to be simple interest if the interest to be paid is directly proportional to
the length of time the amount or principal is borrowed. The principal is the amount of
money borrowed or invested.

Total interest (I) is computed by the formula:

I = (P) (n) (i)

where: P = principal amount lent or borrowed
n = number of interest period (ex. years)
i = interest rate per interest period

The total amount, F to be repaid at the end of N interest period is

F = P + I of F = P[1 + (n x i)]
 26

Sample Problems.
1. Suppose that P1,000 is borrowed at a simple interest rate of 18% per annum. At the
end of one year, the interest would be:
I = (P) (n) (i)
I = 1,000 (1) (0.18) = P 180

2. Michelle invested $5000.00 in mutual fund with the interest rate of 4.8%. How much
interest would she earn after 2 years?
P = $5000.00 ; i= 4.8% ; n= 2 I = (P) (n) (i)
I = ($5000.00)(4.8%)(2) = $480.00

Hence, Michelle would earn $480 after 2 years.

3. Jeff has one savings account with the interest rate of 3.3%, and one money market
account with the interest rate of 5.1% in a bank. If he deposits $1,200.00 to the savings
account, and
$1,800.00 to the money market account, how much money will he have after 6 years?

Savings account: Money market account:

P = $1,200.00 i = 3.3% P = $1,800.00 i = 5.1%
n= 6 n=6

I = ($1,200.00) (3.3%) (6)]

= ($1,800.00)[1+(5.1%)(6)]
I = 237.60 = ($1,800.00)(1.306)
= $2,350.80
F=P+I Total amount:
F = $1,200.00 + 237.60 F =$1437.60 + $2350.80
$1,437.60 = $3,788.40
Hence, Jeff will have $3,788.40 after 6 years.

Compound Interest

• Whenever the interest charge for any interest period is based on the remaining
principal amount plus any accumulated interest chargers up to the beginning of
that period, the interest is said to be compound.
• Compound interest calculations apply to investments where the amount of
interest is calculated on the present balance of the account.

Sample Problem.

For instance, if you invested $100 in a bank with an interest rate of 10% compounded
annually (once per year), then in the first year of your investment you would earn $10. If
this were simple interest, you would continue to earn $10 per year for the period of your
investment. However, since the interest is compounded, you earn interest on your interest.
The amount of compound interest for the first interest period is the same as for simple
 27

interest. However, for further interest periods, the amount of compound interest increases
to an amount greater than simple interest.

Simple Interest Compound Interest

Year 1 $100 * 10% = $10 $100 * 10% = $10
Year 2 $100 * 10% = $10 $110 * 10% = $11
Year 3 $100 * 10% = $10 $121 * 10% = $12.10
Total Interest $30 $33.10

From the illustration above, you can see that under simple interest payments, a
yearly sum of $10 is gained through interest. For each year of the loan period, $10 is
earned. However, under compound interest payments, the yearly interest is added to the
principle for the next period. This has the effect of increasing interest earned each year
for the duration of the period (note: in example above, $33.10 earned from compound
interest versus $30 earned from simple interest).

NOTATION AND CASH FLOW DIAGRAMS

Notations used in formulas for compound interest formulas

i = interest rate per interest period

N = number of compounding periods
P = present sum of money; the equivalent worth of one or more cash
flows at a reference point in time called the present
F = future sum of money; the equivalent worth of one or more cash
flows at a reference point in time called the future
A = end-of-period cash flows in a uniform series continuing for a
specified number of periods; starting at the end of the first period
and continuing through the last period
Cash Flow Diagram

• Cash flow is the difference between total cash coming (inflows or cash receipts)
and total cash going out (outflows or cash disbursements) for a given period of
time. Cash flow provides a means for planning the most effective use of your
cash.
• A cash flow diagram is a picture of a financial problem that shows all cash inflows
and outflows plotted along a horizontal time line. It is used to visualize cash flow:
individual cash flows are presented as vertical arrows along a horizontal time
scale.
 28

The cash flow diagram employs several conventions:

1. The horizontal line is a time scale, with progression of time moving from left to
right divided into equal periods such as days, months, or years.
2. The arrows signify cash flows and are placed at the end of the period. Funds that
you pay out such as savings deposits or lease payments are negative cash flows
that are represented by downward arrows Funds that you receive such as
proceeds from a mortgage or withdrawals from a saving account are positive cash
flows represented by upward arrows.
3. The cash flow diagram is dependent on the point of view (e.g. lender versus
borrower viewpoint).
Example: You are 40 years old and have accumulated $50,000 in your savings account.
You can add $100 at the end of each month to your account which pays an annual interest
rate of 6% compounded monthly. Will you be able to retire in 20 years?

The time line is divided into 240 monthly periods (20 years times 12 payments per
year) since the payments are made monthly and the interest is also compounded monthly.
The $50,000 that you have now (present value) is a negative cash outflow since you will
treat it as though you were just now depositing it into the account. It is represented with
a downward pointing arrow with its base at the beginning of the first period. The 240
monthly $100 deposits are also negative outflows represented with downward pointing
arrows placed at the end of each period. Finally, you will withdraw some unknown amount
(the future value) after 20 years. Represent this positive inflow with an upward pointing
arrow with its base at the very end of the last period.
This diagram was drawn from your point of view. From the bank's point of view,
the present value and the series of deposits are positive cash inflows, and the final
withdrawal of the future value will be a negative outflow.
 29

INTEREST FORMULAS FOR DISCRETE CASH FLOWS

Single Cash Flows / Payments

Figure shows a cash flow diagram involving a present single sum, P and a future
single sum F, separated by N periods with interest at i% per period. The dashed arrow
indicates the quantity to be determined.

Finding F When Given P

F = P(1 + i)N

The quantity (1+i)N is commonly called the single payment compound amount
factor. The functional symbol of (1+i)N is (F/P, i%, N). Therefore the equation can be
expressed as

F = P (F/P, i%, N)

where the factor in parentheses is read “find F given P at i% interest per period for N
interest periods.”

Problem. Find the compound amount of US$ 1 000 in 4 years at 8% interest compounded
annually.

F = P(1 + i)N
F = 1 000 × (1 + 0.08)4 = 1 000 × 1.3605 = US$ 1,360.5
 30

Finding P When Given F

P = F (1 / 1 + i)N = F(1+i%) -N

The quantity (1+i)-N is called the single payment present worth factor. The functional
symbol for this factor is (P/F, i%, N). Hence

P = F (P/F, i%, N)

Problem. How much should be invested now (at present time) at 8% compound interest
per year, in order to receive US$ 1360.5 within 4 years; or what is the present equivalent
worth of US$ 1 360.5 to be received four years in the future?

P = 1,360.5 x (1/1+.08)-4 = 1,360.5 × (1/1.3605) = 1 360.5 × 0.73503 = US$ 1,000

Uniform Series

Uniform series mean uniform amount of money, A, occurring at the end of each period for
n periods with interest at i% per period. A uniform series is often called annuity.

Annuity - is a bunch of structured payments or equal payments made regularly, like every
month or every week.

Other assumptions:

1. P (present worth) occurs at one interest period before the first A.

2. F (future worth) occurs at the same time as the last and n interest periods after
P.
3. A (annual worth) occurs at the end of periods 1 through N, inclusive.

Figure shows a general cash flow diagram relating uniform series (ordinary
annuity) to the present equivalent and future equivalent values.
 31

Finding F When Given A

(1 + 𝑖)𝑁 − 1
𝐹 = 𝐴[ ]
𝑖

The quantity {[(1 + i)N – 1] / i} is called the uniform series compound amount factor.
The functional symbol for this factor is (F/A, i%, N). Hence,
F = A (F/A, i%, N)

Problem. Example: If you deposit $10,000 in a bank every year for 18 years at interest
rate 8%. Then this amount becomes

F = 10,000 x {[(1 + 0.08)18 – 1] / 0.08]} = $374; 502

Finding P When Given A

(1 + 𝑖)𝑁 − 1
𝑃 = 𝐴[ ]
𝑖(1 + 𝑖)𝑁

The equation in bracket is called the uniform series present worth factor. And the functional
symbol for this factor is (P/A, i%, N). Therefore:

P = A (P/A, i%, N)

Problem. If a certain machine undergoes a major overhaul now, its output can be
increased by 20% - which translates into additional cash flow of $20,000 at the end of
each year for five years. If i = 15% per year, how much can we afford to invest to overhaul
this machine?

P = 20,000 x {[(1 + 0.15)5 – 1] / 0.15 (1 + 0.15)5 = $20,000 (3.3522) = $67,044

Problem. You are running a bank. A customer agrees to pay you $100,000 each year with
annual interest rate of 10% for 5 years. How much money will you lend to him?

P = 100,000 x (P/A, i%, N) = $379,080

Finding A When Given F

𝑖
𝐴 = 𝐹[ ]
(1 + 𝑖)𝑁 − 1
This is the relation for finding the amount, A, of a uniform series of cash flows
occurring at the end of N interest periods that would be equivalent to its future equivalent
value occurring at the end of the last period. The quantity in bracket is called the sinking
fund factor and the functional symbol for this factor is (A/F, i%, N). Hence, A = F (A/F, i%,
N)
 32

Problem. How much do you need to invest every year in a bank with an interest rate of
8% in order to yield $1 million in 30 year?

A = 1,000,000 x (A/F, 8%; 30) = $8,827

Problem. An enterprising student is planning to have personal savings totaling $1,000,000

when she retires at age 65. She is now 20 years old. If the annual interest rate will average
7% over the next 45 years on her savings account, what equal end-of-year amount must
she save to accomplish her goal.

A = $1,000,000 (A/F, 7%, 45) = $1,000,000 (0.0035) = $3,500

Finding A When Given P

𝑖(1 + 𝑖)𝑁
𝐴 = 𝑃[ ]
(1 + 𝑖)𝑁 − 1

The quantity in bracket is called the capital recovery factor and the functional
symbol for this factor is (A/P, i%, N). Therefore,

A = P (A/P, i%, N)

Problem. You want to buy an apartment at the price of 4 million Hong Kong dollars. You
will do this with a mortgage from a bank at the annual interest rate 8% for 30 years. What
is your annual payment?

A = 4,000,000 (A/P, 8%, 30) = $355,200

($29,600 per month).

Table 1. Discrete Compounding Interest Factors and Symbols

To Given: Factor by which to Factor Name Factor

Find: multiply “Given”
Functional
Symbol

For Single Cash

Flow
F P (1 + i)N Single payment (F/P, i%, N)
compound amount
P F 1 / (1 + i)N Single payment (P/F, i%, N)
present worth
 33

For Uniform series (annuities)

F A [(1 + i)N – 1] / i Uniform series (F/A, i%, N)
compound amount
P A [(1 + i)N – 1] / i(1 + i)N Uniform series (P/A, i%, N)
present worth
A F i / [(1 + i)N – 1] Sinking Fund (A/F, i%, N)
A P i(1 + i)N / [(1 + i)N –1] Capital recovery (A/P, i%, N)

INTEREST FORMULAS FOR DISCRETE COMPOUNDING AND DISCRETE CASH

FLOWS
Discrete Compounding – it means that the interest is compounded at the end of each
finite length period, such as month or a year. The formulas also assume discrete (lump-
sum) cash flows spaced at the end of equal time intervals of a cash flow diagram.

Deferred Annuities (Uniform Series)

Ordinary Annuity – is one where the equal payments are made at the end of each
payment period starting from the first period.

Deferred Annuity – is one where the payment of the first amount is deferred a certain
number of periods after the first.

If the annuity is deferred J periods (J<N), the entire framed ordinary annuity has
been forward from “time present”, or “time 0”, by J periods. Since the annuity deferred for
J periods, the first payment is made at the end of period (J + 1), assuming that all periods
involved are equal in length.

The present equivalent at the end of period J of an annuity with cash flow of amount
A is A (P/A, i%, N-J). The present equivalent of the single amount A (P/A, i%, N-J) as of
time 0 will then be

A (P/A, i%, N-J) (P/F, i%, J)

 34

Problem. Suppose that a father, on the day his son is born wishes to determine what lump
amount would have to be paid into an account bearing interest of 12% per year to provide
withdrawals of $2,000 on each of the son’s 18th, 19th, 20th, and 21st birthdays.

Solution: N = 21 ; J = 17
P17 = A (P/A, 12%, 4) = $2,000 (3.0373) = $6,074.60
P0 = F17(P/F, 12%, 17) = $6,074.60 (0.1456) = $884.46

NOMINAL AND EFFECTIVE INTEREST RATES

Nominal Interest Rate - Nominal means "in name only". This is sometimes called the
quoted rate or basic annual interest. It is the stated rate of interest applied to your
investment.

Periodic Rate - The amount of interest you are charged each period, like every month.

Effective interest rate - the actual annual interest rate that accrues, after taking into
consideration the effects of compounding (when compounding occurs more than once per
year). The rate that you actually get charged on an annual basis. Remember you are
paying interest on interest.

To illustrate: Consider a principal amount of $1,000 to be invested for three years at a

nominal rate of 12% compounded semi-annually. The interest earned during the first six
months would be:
$1,000 x (0.12/2) = $60

The interest earned during the second six months would be

$1,060 x (0.12/2) = 63.60

Then total interest earned during the year is

$60.00 + $63.20 = $123.60

The effective annual interest rate for the entire year is ($123.60 / $1,000) X 100 = 12.36%
 35

The relationship between effective annual interest, i, and nominal interest r, is

i = (1 + r/M)M – 1

where M is the number of compounding periods per year and r is expressed in decimal.

Problem. A credit card company charges an interest rate of 1.375 per month on the unpaid
balance of all accounts. The annual interest rate they claim is 12 x 1.375% = 16.5%. What
is the effective rate of interest per year being charged by the company?

i = (1 + 0.165/12)12 – 1
= 0.1781 or 17.81% per year

Interest Problems with Compounding More Often Than Once Per Year

Single Amounts

If a nominal interest rate is quoted and the number of compounding periods per year and
number of years are known, any problem involving future amounts, annual, or present
equivalent values can be calculated by straightforward use of equations F = P(1 + i) N and
i = (1 + r/M)M – 1 respectively.

Problem. Suppose that a $100 lump-sum amount is invested for 10 years at a nominal
rate of 6% compounded quarterly. How much is it worth at the end of the tenth year?

Solution: There are 4 compounding periods per year, or a total of 4 x 10 = 40 periods. The
interest rate per interest period is 6%/4 = 1.5%.

F = P (F/P, 1.5%, 40) = $100.00 (1.015)40 = $100.00 (1.814) = $181.40

Other solution: Using i = (1 + r/M)M – 1 i = (1 + 6/10)10 – 1 = 6.14%
F = P (F/P, 6.14%, 10) = $100.00 (1.0614)10 = $181.40

Problem. At a certain interest rate compounded semi-annually, P2,000 will amount to

6,500 in 10 years. What is the amount at the end of 15 years?

Solution: Solve first for the interest

For 10 years: F = P (1+i)N N = 10 (2) = 20 periods
6,500 = 2,000 (1+i)20
3.25 = (1+i)20
3.251/20 = 1+i
1.06 = 1+i i = 1.06 – 1
i = 0.06 or 6%
For 15 years: F = 2,000 (1.06)30
F = 11,486.98
 36

Uniform Series

Problem. Suppose that one has a bank loan for $10,000, which is to be repaid in equal
end-of-month installments for five years with a nominal interest rate of 12% compounded
monthly. What is the amount of each payment?

Solution: Number of installments = 5 x 12 = 60, interest rate per month is 12%/12 = 1%.

A = P(A/P, 1%, 60) = 10,000 (0.0222) = $222

Problem. A father wishes to provide P4,000 for his son on his 21 st birthday. How much
should he deposit every 6 months in a savings bank which pay 3% compounded semi-
annually, if the first deposit is made when the son is 3 1/2 years old?

N = 17.5 years (2) = 35 periods i = 3/2 = 1.5%

A = F(A/F, 1.5%, 35) = 4,000 [0.015 / (1+0.015)35 -1]

= 4,000 (0.015/0.684)
= 4,000 (0.022)
= P87.73

Interest Problems with Cash Flows Less Often Than Compounding Periods

Problem. Suppose that there exists a series of 10 end-of-year receipts of $1,000 each,
and it is desired to compute their equivalent worth as one of the tenth year is the nominal
interest rate is 12% compounded quarterly.

Solution. Interest = 12/4 = 3% per quarter, but the uniform series cash flows do not occur
at the end of each quarter.

1st Procedure: Compute an equivalent cash flow for the time interval that corresponds to
the stated compounding frequency.

A = F(A/F,3%,4)
= $1,000 (0.2390)
= $239 at the end of each quarter is equivalent to $1,000 at the end of each year.
Therefore, the future equivalent at the end of 10th quarter is: N = 10(4) = 40 periods
F = A(F/A,3%,40)
= $239 (75.4012) = $18,021

2nd Procedure:

Get the effective interest rate:

i = (1+r/M)M -1 = (1+12/4)4 – 1 = 0.1255 or 12.55%
F = A (F/A, 12.55%,10) = $1,000 (F/A, 12.55, 10) = $18,022
 37

Learning Activity 1:
Direction. Draw the cash flow diagram for each given situation.
1. Before evaluating the economic merits of a proposed investment, the XYZ Corporation
insists that its engineers develop a cash-flow diagram of the proposal. An investment of
$10,000 can be made that will produce uniform annual revenue of $5,310 for five years
and then have a market (recovery) value of $2,000 at the end of year (EOY) five. Annual
expenses will be $3,000 at the end of each year for operating and maintaining the project.
Draw a cash-flow diagram for the five-year life of the project. Use the corporation’s
viewpoint.
2. Consider a truck that is going to be purchased for $55,000. It will cost $9,500 each year
to operate including fuel and maintenance. It will need to have its engine rebuilt in 6 years
for a cost of $22,000 and it will be sold at year 9 for $6,000. Use the owner’s viewpoint.

Learning Activity 2:

Solve the following problems. Draw cash flow diagrams if necessary. Write your detailed
solution (showing formulas in your equation after short notations such as A = F(A/F,3%,4))
on a clean paper.

1. Find the simple interest earned on $850 invested at 5.1% in 54 months.

2. Find the principal, if the principal plus interest at the end of one and one-half years is
$3360 for a simple interest of 8% per annum.
3. If $10,000 is invested for 20 years at 6 percent, how much is the amount accumulated
when the interest is compounded semi-annually?
4. If $500 is invested now, %700 two years from now, and $900 four years from now, all
at 4%, what will be the total amount in 10 years?
5. What effective annual interest rate corresponds to nominal rate of 8% compounded
monthly?
6. You deposit $10,000 in a savings account five years ago. The account has earned
5.25% interest compounded continuously since then. How much is the account today?
7. If $500 is invested at the end of each year for 6 years at an effective annual interest
rate of 7 percent, what is the total dollar amount available upon the deposit of the sixth
payment?
8. A piece of property is purchased for $10000 and yields $1000 yearly profit. If the
property is sold after 5 years, what is the minimum price to breakeven with interest at
6%?
9. A man buys a house and lot for $100,000 down payment and deferred semi-annual
payments of $8,000 for 5 years, starting 3 years from now. What is the cash price of the
house and lot if the rate of interest is 12% compounded semi-annually?
 38

10. What lump sum of money must be deposited into a bank account at the present time
so that $500 per month can be withdrawn for five years, with the first withdrawal scheduled
for six years from today? The interest rate is 3/4% per month. (Hint: Monthly withdrawals
begin at the end of the month 72.)

Assessment
Direction. Solve the following problems. Draw cash flow diagrams if necessary. Write
your detailed solution (showing formulas in your equation instead of short notations such
as A = F(A/F,3%,4)) on a clean paper.
1. You deposit $300 in a savings account that pays 4% simple annual interest. Find your
account balance after 9 months.
2. Approximately how many years will it take to double an investment at 5.87% interest
rate compounded quarterly?
3. What single amount of money paid at the end of three years will fairly discharge two
debts, one $3000 due in 2 years and another of $2500 due in 5 years, if the interest rate
is 3% compounded annually?
4. What nominal rate compounded monthly is equivalent to 12% compounded quarterly?
5. A small pump maybe purchased now for $400 or by making a down payment of $35
and additional payments of $45 at the end of each month of the next ten months. What
is the nominal annual interest rate?
6. How much money should be deposited each year for 12 years if you wish to withdraw
$309 each year for five years, beginning at the end of the 14th year? Let i = 8% per year.

7. It is estimated that you will pay about $80,000 into the Social Security system (FICA)
over your 40-year work span. For simplicity, assume this is an annuity of $2,000 per year,
starting with your 26th birthday and continuing through your 65th birthday.

a. What is the future equivalent worth of your Social Security savings when you retire at
age 65 if the government’s interest rate is 6% per year?

b. What annual withdrawal can you make if you expect to live 20 years in retirement? Let
i = 6% per year.

8. The Turners have 10 years to save a lump-sum amount for their child’s college
education. Today a four-year college education costs $75,000, and this is expected to
increase by10%per year into the foreseeable future.

a. If the Turners can earn 6% per year on a conservative investment in a highly rated tax-
free municipal bond, how much money must they save each year for the next 10 years to
afford to send their child to college?

b. If a certain college will “freeze” the cost of education in 10 years for a lump-sum of
current value $150,000, is this a good deal?
 39

Congratulations! You are now ready for the next unit.

Write your insights and thoughts about the activities below.
 40

UNIT 4

Depreciation

Learning Outcomes:

At the end of this unit, you will be able to:

• Apply different methods of depreciation in problem-solving

Pre – Test:

Multiple Choice.

1. It is the expected period of time that a property will be used in a trade or business
or to produce income.
a. depreciable life b. life period
c. life span d. property life

2. It is the simplest and most widely used depreciation method.

a. Declining Balance Method
b. Sinking-Fund Method
c. Single-Line Method
d. Sum-of-Years-Digits Method

3. Which of the following is not a requirement of a depreciation method?

a. It should be simple
b. It should recover the sunken cost
c. Ensure that book value will be reasonably close to the market value at any time
d. The method must be acceptable by the BIR

4. It is the amount the property would sell if disposed off as a junk.

a. Salvage value
b. Market value
c. Useful life value
d. Scrap value

5. This depreciation method is sometimes called the constant percentage method or

the Matheson formula.
a. Declining balance method
b. Sinking fund method
c. Single line method
d. Units-of-production method
 41

Content:

TERMINOLOGIES

Depreciation – is defined as the decrease in the value of a property, such as machinery,

equipment, building or other structure, due to the passage of time. This is due to many
reasons, from deterioration and obsolescence to impending retirement. Depreciation cost
depends upon the physical and economic life of the equipment and its first cost.

Physical life of an equipment is the length of time during which it is capable of performing
the function for which it was designed and manufactured.

Economic life of an equipment is the length of time during which it will operate at a
satisfactory unit.

Basis (or cost basis) is the cost of acquiring an asset (purchase price) including normal
costs of making the asset serviceable. Also referred to as unadjusted cost.

Adjusted (cost) basis refers to changes to the original cost basis of a property caused
by various types of improvements or casualty losses.

VALUE is the present worth (PW) of all the future profits that are to be received though
ownership of a particular property.

Market Value (MV) is what will be paid by a willing buyer to a willing seller for a
property where each has equal advantage and is under no compulsion to buy or
sell.

Salvage or residual value (SV) is the price that can be obtained from the sale of
the property after it has been used. It is the best estimate of an asset’s net market
value at the end of its useful life. If used in depreciation calculations, it is referred
to as estimated salvage (ES), representing an asset’s terminal value.

Useful life sometimes referred to as depreciable life, is the expected period of

time that a property will be used in a trade or business or to produce income. It is
not how long the property will last but how long the owner expects to productively
use it.

Book Value (BV) is the worth of a property as shown on the accounting records
of a company. Ordinarily, it means the original cost of the property less all amounts
that have been charged as depreciation expense.

Scrap Value is the amount the property would sell if disposed off as a junk.

Depreciable property – property for which depreciation is allowed under federal, state or
municipal income tax laws and regulations.
 42

A property is depreciable if it meets all of the following basic requirements:

1. It must be used in business or held to produce income.

2. It must have a determinable useful life, and the life must be longer than
one year.
3. It must be something that wears out, decays, gets used up, becomes
obsolete or loses value from natural causes.
4. It is not inventory, stock in trade, or investment property.

Examples of depreciable assets are cars, computers, office furniture, machines, buildings,
and significant additions or improvements (as opposed to repairs) to these kinds of
property.

Requirements of a Depreciation Method:

1. It should be simple
2. It should recover capital
3. Ensure that the book value will be reasonably close to the market value at any
time
4. The method must be acceptable by the BIR

DEPRECIATION METHODS:

1. Straight-Line (SL) Method

• It is the simplest and most widely used depreciation method.
• It assumes that the loss in value is directly proportional to the age of the
property.
• In the straight-line method, the depreciation base is evenly allocated over the
lifetime of the asset, resulting in equal annual depreciation
• It does not need annuity tables.
• It does not take into account the interest or profit earned on the accumulated
depreciation fund. Likewise, O and M cost are disregarded.

N = depreciable life of an asset in years

B = cost basis
dk= annual depreciation reduction in year k (1 ≤ k ≤ N)
BVk= book value at the end of year k
SVN = estimated salvage value at the end of year N
d*k = cumulative depreciation through year k

dk = (B – SVN) / N
 43

d*k = kdk for 1 ≤ k ≤ N

BVk = B – d*k

Sample problem 1. A new electrical saw for cutting small pieces of lumber in a furniture
manufacturing plant has a cost basis of $4,000 and a 10-year depreciable life. The
estimated SV of the saw is zero at the end of 10 years. Determine the annual depreciation
amounts using the straight- line method. Tabulate the annual depreciation amounts and
the book value of the saw at the end of each year.

Sample computation:
dk = (B – SVN) / N = (4,000 – 0) / 10 = $400
d*5 = kdk = 5 [(4,000 – 0) / 10] = 2,000 or 5 (400) = 2,000
BV5 = B – d*5 = 4,000 - 2,000 = $2,000

The depreciation and book value amounts for each year are shown below.

EOY, k dk BVk
0 - $4,000
1 $400 $4,000 – 400 = 3,600
2 400 3,200
3 400 2,800
4 400 2,400
5 400 2,000
6 400 1,600
7 400 1,200
8 400 800
9 400 400
10 400 0

2. Declining Balance (DB) Method

• Sometimes called the constant percentage method or the Matheson formula.
• It is assumed that the annual cost of depreciation is a fixed percentage of the
BV at the beginning of the year.
• The ratio of the depreciation is a fixed percentage of the BV at the beginning
of the year is constant throughout the life of the asset and is designated by R
(0 ≤ R ≤ 1). There are cases where R > 1 such as in 200% declining balance
where R = 2 and 150% declining balance where R = 1.5. In these cases, R =
2/N when a 200% declining balance is being used and R = 1.5/N if the 150%
DB method is specified.
• The annual depreciation charges, different each year, decrease from year to
year, greatest during the 1st year and least in the last year of life of the
property.
• With this method, a property can never depreciate to zero value.

d1 = B (R)
dk = B (1 – R) k-1 (R)
 44

d*k = B [1 – (1-R)k]
BVk = B(1 – R)k
BVN = B(1 – R)N

Rework with sample problem 1 with the declining balance method when R = 2/N (200%
declining balance)

Sample computation: with the declining balance method when R = 2/N (200% declining
balance)

R = 2/N = 2 / 10 = 0.20
d6 = 4,000 (1 – 0.20)5 (0.20) = $262.14
d*6 = 4,000 [1 – (1-0.20)6] = $2,951.42
BV6 = 4,000 (1 – 0.20) 6 = 1,048.58

The depreciation and book value amounts for each year are shown below.

EOY, k dk BVk
0 - 4,000
1 4,000(0.2) = 800.00 4,000 – 800 = 3,200.00
2 3,200(0.2) = 640.00 3,200 – 640 = 2,560.00
3 512.00 2,048.00
4 409.60 1,638.40
5 327.68 1,310.72
6 262.14 1,048.58
7 209.72 838.86
8 167.77 671.09
9 134.22 536.87
10 107.37 429.50

3. Sum-of-the-Years-Digits (SYD or SOYD) Method

• It provides very rapid depreciation during the early years of life of the property,
and therefore enables faster recovery of capital.
• The basic assumption for this method is that the value of the property
decreases at a decreasing rate.
• To compute:
a) List the digits corresponding to the number for each permissible year
of life in reverse order
b) Determine the sum of these digits
c) For any year, the depreciation factor is the number from the reversed-
order listing for that year divided by sum of the digits.
d) The depreciation deduction for any year is the product of the SYD
depreciation factor that year and the difference between the cost basis
(B) and the SVN.
 45

In general, the annual cost of depreciation for any year k, when N equals the depreciable
life of an asset, is:

dk = (B – SVN) x [2 (N – k + 1) / N (N + 1)]

The book value at the end of the year k is

BVk = B – [2 (B – SVN) / N] k + [(B – SVN) / N (N + 1)] k (k + 1)

And the cumulative depreciation through the kth year is simply

d*k = B - BVk

Using SYD method, rework with sample problem no. 1.

No. of the year SYD

Year in Reverse Order Depreciation
Factor
1 10 10/55
2 9 9/55
3 8 8/55
4 7 7/55
5 6 6/55
6 5 5/55
7 4 4/55
8 3 3/55
9 2 2/55
10 1 1/55
Sum of the 55
digits

Sample computation using SYD Factor:

d4 = 0.1273 (4,000) = 509.09

Sample computation using formulas:

d4 = 4,000 [2(10 – 4 + 1) / 10 (11)] = $ 509.09

BV4 = 4,000 – [2(4,000) / 10] x 4 + [4,000 / 10 (11)] x 4x 5 = 1,527.27

d*4 = 4,000 – 1,527.27 = $2,472.73

 46

The depreciation and book value amounts for each year are shown below.

EOY, k dk BVk
0 - $4,000.00
1 $727.27 3,272.73
2 654.55 2,618.18
3 581.82 2,036.36
4 509.09 1,527.27
5 436.36 1,090.91
6 363.64 727.27
7 290.91 436.36
8 218.18 218.18
9 145.45 72.73
10 72.73 0

4. Sinking Fund Method

• This method depreciates an asset as if the firm were to make a series of equal
deposits whose value at the end of the asset’s useful life just equaled the cost
of replacing the asset.
• It is assumed that a sinking fund is established in which funds will accumulate
for replacement purposes and will bear interest.
• The total depreciation which has occurred up to any given time is assumed to
equal the amount in the sinking fund at that time.

If A’ = sinking fund deposit

C = purchase price of replacement asset – net salvage value of current asset
N = useful life of current asset
i = annual interest rate then
A’ = C (A/F, i%, N)

The amount in the sinking fund at the end of year k (k = 1,2….N) is the accumulated
depreciation through k, thus:

d*k = A’ (F/A, i%, k)

= C (A/F, i%, N) (F/A, i%,k)

The depreciation in year k, which includes interest earned at that time, is given as:

dk = d*k – d*k-1
= C (A/F, i%, N) [(F/A, i%,k) - (F/A, i%,k-1)]

The book value, BV, as usual is defined as BVk = B – d*k

Sample problem 2. A contractor imported a bulldozer for his job, paying P250,000 to the
manufacturer. Freight and insurance charges amounted to P18,000; customs, broker’s
 47

fee, P8,500; taxes, permits and other expenses, P25,000. If the contractor estimates the
life of the bulldozer to be 10 years with a salvage value of P20,000, tabulate the annual
depreciation amounts and the book value of the bulldozer at the end of each year using
sinking fund formula at 8%.

B = 250,000 + 18,000 + 8,500 + 25,000 = 301,500

SV = 20,000

A’ = C (A/F, i%, N)
= 301,500 – 20,000 (A/F, 8%, 10)
= 281,500 (0.0690)
= 19,423.50

d*2 = A’ (F/A, 8%, 2) = 19,423.50 (2.0800) = 40,400.88

d*6 = A’ (F/A, 8%, 6) = 19,423.50 (7.3359) = 142,488.85

BV6 = B – d*6 = 301,500 - 142,488.85 = 159,011.15
d6 = C (A/F, i%, 10) [(F/A, i%,6) - (F/A, i%,6-1)]
= 19, 423.50 (7.3359 – 5.8666)
= 19, 423.50 (1.4693)
= 28,538.95

or simply: d6 = d*6 – d*5 = 142,488.85 - 113,949.90 = 28,538.95

The depreciation and book value amounts for each year are shown below.
EOY, k dk d*k BVk
0 - - 301,500.00
1 19,423.50 19,423.50 282,076.50
2 20,977.38 40,400.88 261,099.12
3 22,655.57 63,056.45 238,443.55
4 24,467.78 87,524.23 213,975.77
5 26,425.67 113,949.90 187,550.09
6 28,583.95 142,488.85 159,011.15
7 30,823.15 173,312.00 128,188.00
8 33,288.00 206,600.00 94,900.00
9 35,952.89 242,552.89 58,947.11
10 38,827.59 281,380.48 20,119.52

5. Units-of-Production Method

This method results in the cost basis (minus final SV) being allocated equally over
the estimated number of units produced during the useful life of the asset.

Depreciation per unit of production = (B – SVN)/ Estimated lifetime production in units

 48

Sample problem 3. A piece of equipment used in a business has a basis of $50,000 and
is expected to have a $10,000 salvage value when replaced after 30,000 hours of use.
Find depreciation rate per hour of use, and find its book after 10,000 hours operation.

Solution:
Depreciation per unit of production = ($50,000 – 10,000) / 30,000 = $1.33 per hour
After 10,000 hours, BV = $50,000 - $1.33/hr (10,000 hr) = $36,700

Learning Activity:

Direction: Solve the following problems. Write your detailed solution on a clean paper.

1. Compute the depreciated value after six years of a $10,000 machine having a useful
life of 10 years and a salvage value of 10% of its first cost at that time, using straight-line
depreciation? Tabulate the annual depreciation amounts and the book value of the camera
at the end of each year.

2. A manufacturing company buys a machine for $50,000. It estimates the machine’s

useful life to be 20 years and that it can be sold for $5,000. Using straight-line depreciation,
what is the annual depreciation charge?

3. A piece of machinery costs $20,000 and has an estimated life of 8 years and a scrap
value of $2,000. What uniform annual amount must be set aside for eight years for
replacement if the interest rate is 4%?

4. A company brought an equipment costing $100,000 with a guaranteed life of 10 years

and a salvage value of $5,000. Solve its book value after 3 years. Use sinking fund method
of computing its depreciation. Money is worth 4% per annum. Tabulate the annual
depreciation amounts and the book value of the equipment at the end of each year.

4. A piece machinery costs $50,000 and a guaranteed resale value of $5,000 at the end
of 10 years. Using SOYD method, what is its book value at the end of 5 years? Tabulate
the annual depreciation amounts and the book value of the equipment at the end of each
year.

5. A given item has a spelling price of $1,000. Its value depreciates at a rate of 12% per
annum. What will be its selling price after 6 years? Tabulate the annual depreciation
amounts and the book value of the equipment at the end of each year.

6. M/s Cube textiles purchased a machinery for P200,000 on 1st January. It has an
estimated useful life of 10 years and an estimated residual value of P20,000. The firm
sells the asset at the residual value at the end of the 10 th year. The machine has an
expected production of 15,000 units during its useful life. Find depreciation rate per unit of
production, and find its book value after 12,000 units have been produced.

7. A certain machine costs $5,000 and has an expected resale value of $1,000 at the end
of its 5-year useful life. Compute the depreciation charge on the 4th year using sum-of-the-
years-digit method.
 49

8. An equipment costs Php 1,500,000. At the end of its economic life of five years, its
salvage value is Php 500,000. Using Sum of the Years Digit Method of Depreciation, what
will be its book value for the third year?

Assessment:

Direction: Solve the following problems. Write your detailed solution on a clean paper.

1. The cost of a certain machinery is $30,000. Its useful life is 6 years, and its resale value
is $5,000. Estimate the book value of the machine after 2 years, using constant
percentage depreciation method. Tabulate the annual depreciation amounts and the book
value of the equipment at the end of each year.

2. An asset purchased for $50,000 has a depreciable life of 5 years, and it has a terminal
book (salvage) value of $5,000 at the end of its depreciable life. With the straight-line
method of depreciation, what is the asset’s book value at the end of year 3?

3. A company purchased an equipment costing $60,000. The equipment has guaranteed

useful life of 16 years with salvage value of $6,000. Using sinking fund method, what is
the book value of the equipment after 12 years? Money is worth 12% per annum. Tabulate
the annual depreciation amounts and the book value of the equipment at the end of each
year.

4. An underwater camera costs $1000. It has an expected life of 12 years, at the end of
which the estimated value is $730. Using straight-line depreciation, what is the book value
of the camera at the end of 8 years? Tabulate the annual depreciation amounts and the
book value of the camera at the end of each year.

5. A company is trying to consider buying an equipment with an initial cost of $80,000. The
salvage value is expected to be $20,000 after 20 years. A fund is set up to replace it at
the end of 20 years. What is the uniform annual deposit that should be made to the fund?
Money is worth 10% per annum.

6. A company purchased a new equipment for $50,000. It is expected to last 14 years and
has an estimated salvage value of $8,000. Solve the depreciation charge on the
equipment and its book value for the 3rd year of its life using SOYD method of computing
depreciation. Tabulate the annual depreciation amounts and the book value of the
equipment at the end of each year.

7. Cisco Systems is purchasing a new bar code scanning device for its service center in
San Francisco. The table that follows lists the relevant cost items for this purchase. The
operating expenses for the new system are $10,000 per year, and the useful life of the
system is expected to be five years. The SV for depreciation purposes is equal to 25% of
the hardware cost.
Cost Item Cost
Hardware $160,000
Training $15,000
Installation $15,000
 50

a. What is the BV of the device at the end of year three if the SL depreciation method is
used?

b. Suppose that after depreciating the device for two years with the SL method, the firm
decides to switch to the double declining balance depreciation method for the remainder
of the device’s life (the remaining three years). What is the device’s BV at the end of four
years?

8. A special-purpose machine is to be depreciated as a linear function of use (units-of-

production method). It costs $35,000 and is expected to produce 150,000 units and then
be sold for $5,000. Up to the end of the third year, it had produced 60,000 units, and during
the fourth year it produced 18,000 units. What is the depreciation deduction for the fourth
year and the BV at the end of the fourth year?

Congratulations! You are now ready for the next unit.

Write your insights and thoughts about the activities below.
 51

UNIT 5

Applications of Money-Time Relationships

Learning Outcomes:

At the end of this unit, you will be able to:

• Evaluate viability of proposed prospects

Pre – Test:

Multiple Choice.

1. It is a method of evaluating a viability of a proposed project that is based on the

concept of equivalent worth of all cash flows relative to some base or beginning
point in time.
a. Present Worth Method b. Future Worth Method
c. Point of Origin Method d. Internal Rate of Return Method

2. It is based on the equivalent worth of all cash inflows and outflows at the end of
the planning horizon (study period) at an interest rate generally the MARR.
a. Present Worth Method b. Future Worth Method
c. External Rate of Return Method d. Internal Rate of Return Method

3. Internal Rate of Return Method is also called as ______.

a. Interest method
b. cash flow method
c. probability index
d. employer’s method

4. A project is acceptable when i'% of the ERR method is to the firm’s MARR.
a. less than
b. greater than
c. less than or equal
d. greater than or equal

5. As criterion for Annual Worth Method, a project is acceptable if the annual worth
is _______.
a. less than
b. greater than
c. less than or equal
d. greater than or equal
 52

Content:

METHODS FOR EVALUATING THE VIABILITY OF A PROPOSED PROJECT

1. THE PRESENT WORTH METHOD

• It is based on the concept of equivalent worth of all cash flows relative to

some base or beginning point in time called the present.

• It is a measure of how much money an individual or a firm could afford to

pay for the investment in excess of its cost.

• The criterion for this method in order that a project be economically feasible
is that the present worth of the net cash flows be equal to or greater than
zero (PW ≥ 0) .

• To find the PW as a function of i% of a series of cash receipts and/or

expenses, use the following relationship:

PW (i%) = F0 (1+i)0 + F1 (1+i)-1 + F2 (1+i) -2 + ………+ Fk (1+i) –k + FN (1+i) –N

= ∑𝑁
𝑘=0 𝐹𝑘 (1 + 𝑖)
−𝑘

Where, I = effective interest rate, or MARR, per compounding period

k = index for each compounding period (0 ≤ k ≥ N)
Fk = future cash flow at the end of period k
N = number of compounding periods in the planning horizon

Sample problem1: An investment of $10,000 can be made that will produce a uniform
annual of $5,500 for five years and then have a market (salvage) value of $2,000. Annual
expenses will be $3,150 each year. The company is willing to accept any project that will
earn 10% per year or more, on all invested capital. Show whether this is a desirable
investment by using the PW method.
 53

Solution:
PW Cash Cash
Outflows Inflows
Annual revenue: $5,550 (P/A, 10%, 5)

P = $5,500 [(1.1)5 – 1]/ 0.1(1.1)5 = $5,500 (3.7908) $20,849

Market (salvage) value: $2,000 (P/F,10%,5)
P = $2,000 (1.1)-5 = $2,000 (0.6209) $1,242
Investment -$10,000
Annual Expenses: $3,150 (P/A, 10%, 5)
P = $3,150 [(1.1)5 – 1]/ 0.1(1.1)5 = $3,150 (3.7908) -$11,941
Total -$21,941 $22,091

Because total PW (10%) = $22,091 - $21,941 = $150, which is > 0, the project is
shown to be marginally acceptable.

Sample problem 2: An existing machine in a factory has an annual maintenance cost of

P40,000. A new and more efficient machine will require an investment of P90,000 and is
estimated to have a salvage value of P30,000 at the end of 8 years. Its annual expenses
for maintenance and upkeep, etc total is P22,000. If the company expects to earn 12% on
its investment, will it be worthwhile to purchase the new machine?

Solution:

PW for existing machine:

P40,000 (P/A, 12%,8) = P40,000 (4.9676)
= 198,704

PW for new machine:

P90,000 + P22,000 (P/A,12%,8) – P30,000 (P/F,12%,8) = P90,000 + P22,000 (4.9676)
– P30,000 (0.4038)
= P90,000 + 109,287 – 12,114
= P187,173

PW of new machine is less than the PW of the existing machine. Thus, it will be
worthwhile to invest in the new machine.

Sample problem3: A piece of new equipment has been proposed by engineers to increase
the productivity of a certain manual welding operation. The investment cost is $25,000,
and the equipment will have a market value of $5,000 at the end of a study period of five
years. Increased productivity attributable to the equipment will amount to $8,000 per year
 54

after extra operating costs have been subtracted from the revenue generated by the
additional production. If the firm’s MARR is 20% per year, is this proposal a sound one?
Use the PW method.

Solution:

PW = PW of cash inflows – PW of cash outflows

PW (20%) = $8,000 (P/A, 20%, 5) + $5,000 (P/F, 20%, 5) - $25,000

= $8,000 (2.9906) + $5,000 (0.4019) - $25,000
= $23,924.8 + $2009.5 – $25,000
= $934.30

Because PW (20%) > 0, this equipment is economically justified.

1.1 Bond Value

• A bond provides an excellent example of commercial value being the PW of the

future net cash flows that are expected to be received through ownership of an
interest-bearing certificate. Thus, the value of a bond, at any time, is the PW of
future cash receipts.
• A bond is a debt instrument requiring the issuer (also called the debtor or
borrower) to repay to the lender/investor the amount borrowed plus interest
(coupons) over a specified period of time.
• Owner of the bonds is paid two types of payments by the borrower.
1. the first consists of the series of periodic interest payments he or she will
receive until the bond is retired.
2. when the bond is retired or sold, the bondholder will receive a single payment.
• The PW of the bond is the sum of present worths of these two types of payments
at the bond’s yield rate (i%):

VN = C (P/F, i%, N) + rZ (P/A, i%, N)

 55

Where: Z = face, or par value

C = redemption or disposal price (usually equal to Z)
A = periodic interest payments to be received
r = bond rate (nominal interest) per interest period
N = number of periods before redemption
i% = bond yield rate per period
VN = value (price) of the bond N interest periods prior to redemption – this
is a PW measure of merit.

A bond is said to be redeemable at par if C = Z.

A bond is said to be redeemable at premium if C > F.
A bond is said to be redeemable at a discount if C < F.

Sample Problem 4: A bond with a face value of $5,000 pays interests of 8% per year. This
bond will be redeemed at par value at the end of its 20-year life, and the first interest
payment is due one year from now. How much should be paid now for this bond in order
to receive a yield of 10% per year on the investment?

N = 20 years
r = 8% per year
Z = C = $5,000
i% = 10% per year

VN = $5,000 (P/F, 10%, 20) + $5,000 (0.08) (P/A, 10%, 20)

= $5,000 (0.1486) + $400 (8.5136)
= $743 + $3,405.44
= $4,148.44

Sample Problem 5: A certain U.S. Treasury bond that matures in eight years has a face
value of $10,000. This means that the bondholder will receives $10,000 cash when the
bond’s maturity date is reached. The bond stipulates a fixed nominal interest rate of 8%
per year, but interest payments are made to the bondholder every three months; therefore,
each payment amounts to 2% of the face value.

A prospective buyer of this bond would like to earn 10% nominal interest (compounded
quarterly) per year on his or her investment. How much should this buyer be willing to pay
for the bond?

r = 2% per quarter
i% = 10%/4 = 2.5% per quarter
N = 8 (4) = 32 quarters
C = Z = $10,000
 56

VN = $10,000 (0.02) (P/A, 2.5%, 32) + $10,000 (P/F, 2.5%, 32)

= $200 (21.8492) + $10,000 (0.4537)
= $4,369.83 + $4,537.71
= $8,907.54

2. THE FUTURE WORTH METHOD

• It is based on the equivalent worth of all cash inflows and outflows at the end of
the planning horizon (study period) at an interest rate generally the MARR.
• All cash inflows and outflows are compounded forward to a reference point in time
called the future.
• Criterion: A project is feasible if FW ≥ 0
• To determine the future worth of a project, the following relationship is used:

FW (i%) = F0 (1+i)N + F1 (1+i)N-1 + ……... + FN (1+i)0

= ∑𝑁
𝑘=0 𝐹𝑘 (1 + 𝑖)
𝑁−𝑘

Sample problem 1: (Same problem in PW). An investment of $10,000 can be made that
will produce a uniform annual of $5,500 for five years and then have a market (salvage)
value of $2,000. Annual expenses will be $3,150 each year. The company is willing to
accept any project that will earn 10% per year or more, on all invested capital. Show
whether this is a desirable investment by using the FW method.

Solution:
FW (10%) = -10,000 (F/P,10%,5) + 2,350 (F/A, 10%,5) + 2,000
= -10,000 (1.6105) + 2,350 (6.1051) + 2,000
= -16,105 + 14,347 + 2,000
= 242

Since FW (10%) > 0, it is a good project.

Sample problem2: (Same problem in PW) A piece of new equipment has been proposed
by engineers to increase the productivity of a certain manual welding operation. The
investment cost is $25,000, and the equipment will have a market value of $5,000 at the
end of a study period of five years. Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use the FW method.

FW (20%) = -$25,000 (F/P,20%,5) + $8,000 (F/A, 20%,5) + $5,000

= - $25,000 (2.4883) + $8,000 (7.4416) + $5,000
= -$62,207.5 + $59,532.8 + $5,000
= $2,325.3

Since FW (20%) > 0, it is a good project.

 57

3. THE ANNUAL WORTH METHOD

• The AW of a project is an equal annual series of dollar amounts, for a stated

study period, that is equivalent to the cash inflows and outflows at an interest
rate that is generally the MARR.
• The AW is the annual equivalent revenues (or savings), R, minus annual
equivalent expenses, E, less its annual equivalent capital recovery cost, CR.
• Criterion: A project is acceptable if AW ≥ 0
• AW is calculated as follows:

AW (i%) = R – E – CR(i%)

• The Capital Recovery (CR) amount for a project is the equivalent uniform
annual cost of the capital invested. It is an annual amount that covers the
following items:
1. Loss in value of the asset
2. Interest on invested capital (i.e., at the MARR)
CR is computed with i = MARR using the following:

CR (i%) = I (A/P, i%, N) – S (A/F, i%, N)

Where, I = initial investment for the project

S = salvage (residual) value at the end of the study
period
N = project study period

As an example, consider a machine or other asset that will cost $10,000, lasts five
years, and have a salvage (market) value of $2,000. The MARR is 10% per year. The CR
amount is:
CR (10%) = $10,000 (A/P, 10%,5) - $2,000 (A/F, 10%, 5)
= $10,000 (0.2638) - $2,000 (0.1638)
= $2,638 - $328
= $2,310

Sample problem1: (Same problem in PW and FW) A piece of new equipment has been
proposed by engineers to increase the productivity of a certain manual welding operation.
The investment cost is $25,000, and the equipment will have a market value of $5,000 at
the end of a study period of five years. Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use the AW method.
 58

Solution:

AW (20%) = R – E – CR ; R – E = $8,000
= $8,000 – [$25,000 (A/P,20%,5) - $5,000 (A/F,20%,5)]
= $8,000 – [$25,000 (0.3344) - $5,000 (0.1344)]
= $8,000 – ($8360 – $672)
= $8,000 – $7,688
= $312

AW (20%) is positive, the equipment more than pays for itself over a period of five years
while earning a 20% return per year on the unrecovered investment.

4. THE INTERNAL RATE OF RETURN (IRR) METHOD

• It is the most widely used rate of return method for performing engineering
economic analysis.
• Also known as investor’s method, discounted cash flow method, and
probability index.
• This involves solving for the interest rate, termed internal rate of return (IRR),
that equates the equivalent worth of an alternative’s cash inflows (receipts or
savings) to the equivalent worth of cash outflows (expenditures, including
investments costs).
• IRR can be defined also as the interest rate that reduces the present worth
amount of a series of receipts and disbursements to zero.
• Criterion: A project is acceptable if i' ≥ MARR
• By using a PW formulation, IRR is the i% at which

∑𝑁 𝑁
𝑘=0 𝑅𝑘 (P/F,i’%,k) = ∑𝑘=0 𝐸𝑘 (P/F,i’%,k)

where: Rk = net revenues for the kth year

Ek = net expenditures including any investments costs for the kth year
N = project life (or study period)
 59

• In computing the IRR for an alternative is to determine the i'% at which the
net PW is zero.

PW = ∑𝑁 𝑁
𝑘=0 𝑅𝑘 (P/F,i’%,k) - ∑𝑘=0 𝐸𝑘 (P/F,i’%,k) = 0

• Using PW = 0, FW = 0 or AW = 0 normally involves trial and error calculations

until the i’% is converged upon or can be interpolated.

Sample problem1: (Same problem in PW and FW) An investment of $10,000 can be made
that will produce a uniform annual of $5,500 for five years and then have a market
(salvage) value of $2,000. Annual expenses will be $3,150 each year. The company is
willing to accept any project that will earn 10% per year or more, on all invested capital.
Determine whether it is acceptable by using the IRR method.

Solution: Notice that the sum of positive cash flows (13,750) exceeds the sum of negative
cash flows ($10,000), so a positive value of i’% can be determined.

PW = 0 = -10,000 + (5,500 – 3150) (P/A, i'%,5) + 2,000 (P/F, i’%,5)

We can solve i'% by linear interpolation. Let’s plug-in 2 values of i'% that will yield a
positive PW and negative PW.

At i’% = 5%: PW = - 10,000 + 2,350 (4.3295) + 2,000 (0.7835) = 1,741

At i’% = 15%: PW = - 10,000 + 2,350 (3.3522) + 2,000 (0.4972) = -1,128

1,741 ≤ PW = 0 ≤ -1,128 so 5% ≤ i’% ≤ 15%

Interpolating,

[15% - 5%] / [$1,741 – (-$1,128)] = [i’% -5%] / [$1,741 - $0]

Solving for i’, i’ = 11.07%

Since i’ > MARR (10%), the project is feasible.

Sample problem2: A piece of new equipment has been proposed by engineers to increase
the productivity of a certain manual welding operation. The investment cost is $25,000,
and the equipment will have a market value of $5,000 at the end of a study period of five
years. Increased productivity attributable to the equipment will amount to $8,000 per year
after extra operating costs have been subtracted from the revenue generated by the
additional production. Evaluate the IRR of the proposed equipment. Is the investment a
good one? Recall that the MARR is 20% per year.

PW = 0 = $8,000 (P/A, i’%,5) + $5,000 (P/F, i’%,5) – $25,000

At i’% = 25%
 60

PW = $8,000 (P/A, 25%,5) + $5,000 (P/F, 25%,5) – $25,000

= $8,000 (2.6893) + $5,000 (0.3277) – $25,000
= $21,514.4 + $1,638.5 - $25,000
= -1,847.1

At i’% = 20%
PW = $8,000 (P/A, 20%,5) + $5,000 (P/F, 20%,5) – $25,000
= $8,000 (2.9906) + $5,000 (0.4019) – $25,000
= $23,924.8 + $2,009.5 - $25,000
= 934.3

[25% -20%]/[934.3 – (-1,847.1)] = [i’% -20%]/[$934.3 - $0]

Solving for i’, i’ = 21.7%

Since i’ > MARR (20%), the project is feasible.

Sample problem3: A project is estimated to cost P100,000, lasts 8 years and have a
P10,000 salvage value. The annual gross income is expected to average P24,000 and
annual expenses, excluding depreciation will total P6,000. If capital is earning 10% before
income taxes, determine is this a desirable investment using the IRR Method.

PW = 0 = 24,000 (P/A, i’%,8) + 10,000 (P/F, i’%,8) – 100,000

At i’% = 10%
PW = 18,000 (P/A, 10%,8) + 10,000 (P/F, 10%,8) – 100,000
= 18,000 (5.3349) + 10,000 (0.4665) – 100,000
= 96,028.2 + 4,665 – 100,000

= 693.2

At i% = 12% = 18,000 (P/A, 12%,8) + 10,000 (P/F, 12%,8) – 100,000

= 18,000 (4.9676) + 10,000 (0.4039) – 100,000
= 89,416.8 + 4,039 – 100,000
= -6,544.2

x 693.2
= ; x = 0.19
2 639.2– (- 6,544.2)

10% + 0.19 = 10.19%

The project is feasible.

 61

5. THE EXTERNAL RATE OF RETURN (ERR) METHOD

• It directly takes into account the interest rate (ε) external to a project at which
net cash flows generated (or required) by the project over its life can be
reinvested (or borrowed).
• If the ERR, which is usually the firm’s MARR, happens to equal the project’s
IRR, then the ERR method produces results identical to those of the IRR
method.
• Three steps used in calculating procedure:
1. All net cash outflows are discounted to time 0 (the present) at ε% per
compounding period.
2. All net cash inflows are compounded to period N at ε%.
3. The external rate of return, which is the interest rate that establishes
between the two quantities, is determined.

∑𝑁 𝑁
𝑘=0 𝐸𝑘 (P/F, ε%,k) (F/P, i’%, N) = ∑𝑘=0 𝑅𝑘 (F/P, ε%,N-k)

where Rk = excess of receipts over expenses in period k

Ek = excess of expenditures over receipts in period k
N = project life or number of periods for the study
ε = external investment rate per period

• A project is acceptable when i’% of the ERR method is greater than or equal
to the firm’s MARR.
• Advantage over IRR: it can be solved directly.

Sample Problem 1. A piece of new equipment has been proposed by engineers to

increase the productivity of a certain manual welding operation. The investment cost is
$25,000, and the equipment will have a market value of $5,000 at the end of a study period
of five years. Increased productivity attributable to the equipment will amount to $8,000
per year after extra operating costs have been subtracted from the revenue generated by
the additional production. Suppose that ε = MARR = 20% per year. What is the
alternative’s external rate of return, and is the alternative acceptable?

Solution:

$25,000 (F/P, i’%, 5) = $8,000 (F/A, 20%, 5) + $5,000

$25,000 (F/P, i’%, 5) = $8,000 (7.4416) + $5,000
$25,000 (F/P, i’%, 5) = $64,532.80
(F/P, i’%, 5) = $64,532.80 / $25,000 (F/P, i’%, 5) = 2.5813
(1 + i’%)5 = 2.5813
i’% = 2.5813 1/5 – 1
i’% = 20.88%

because i’ > MARR, the alternative is barely justified.

 62

Sample Problem 2. When ε = 15% and MARR = 20% per year, determine whether the
project whose total cash flow diagram appears below is acceptable. Notice in this example
that the use of an ε% different from the MARR is illustrated. This might occur if, for some
reason, part or all of the funds related to a project are “handled” outside the firm’s normal
capital structure.

Solution:

E0 = $10,000 (k =0) E1 = $5,000 (k=1)

Rk = $5,000 for k = 2,3,…,6

[$10,000 + $5,000 (P/F, 15%,1)] (F/P, i’%, 6) = $5,000 (F/A,15%,5) [$10,000 + $5,000
(0.8696)] (1+i’%)6 = $5,000 (6.7424)
[$10,000 + $4,348] (1+i’%)6 = $33,712
$14,348 (1+i’%)6 = $33,712 (1+i’%)6 = $33,712 / $14,348 (1+i’%)6 = 2.35
(1+i’%) = 2.351/6 (1+i’%) = 1.15
i’% = 1.15 – 1
i’% = 0.15 = 15%

The i’% is less than MARR = 20%; therefore, this project would be unacceptable
acceptable according to the ERR method.

6. THE PAYBACK (PAY-OUT) PERIOD

• Often called the simple payout period, mainly indicates a project’s liquidity
rather than its profitability.
• The payback method calculates the number of years required for cash inflows
to just equal cash outflows.
• The simplest payback period is the smallest value of θ (θ ≤ N) for which this
relationship is satisfied under our normal end-of-year cash flow convention.
• For a project where all capital investment occurs at time 0:

∑𝜃𝑘=0(𝑅𝑘 - Ek) – I ≥ 0

• The simplest payback period ignores the time value of money and all cash
flows that occur after θ.
 63

Sample Problem:

A piece of new equipment has been proposed by engineers to increase the productivity of
a certain manual welding operation. The investment cost is $25,000, and the equipment
will have a market value of $5,000 at the end of a study period of five years. Increased
productivity attributable to the equipment will amount to $8,000 per year after extra
operating costs have been subtracted from the revenue generated by the additional
production. If the firm’s MARR is 20% per year, calculate the simple payback period.

Calculation of the simple payback period (θ)

Year Net Cash Flow Cumulative PW at I

k
= 0%/yr trough
Year k
0 -$25,000 -$25,000
1 8,000 -17,000
2 8,000 -9,000
3 8,000 -1,000
4 8,000 +7,000
5 13,000 +20,000

θ = 4 years because the cumulative balance turns positive at EOY 4.

• The discounted payback period, θ’ (θ’ ≤ N), is calculated so that the time value
of money is considered:

∑𝜃𝑘=0(𝑅𝑘 - Ek) (P/F, i%,k) – I ≥ 0

where i = is the MARR

I = is the capital investment
θ’ = smallest payback period

Calculation of the discounted payback period (θ’)

Year k Present worth of Cumulative PW at

cash flow at MARR = 20%/yr
i=20%/yr through Year k
0 -$25,000 -$25,000
1 6,667 -18,333
2 5,556 -12,777
 64

3 4,630 -8,147
4 3,858 -4,289
5 5,223 +934

θ’ = 5 years because the cumulative discounted balance turns positive at EOY 5

THE BENEFIT-COST RATIO METHOD

• Benefit-cost analysis is a systematic method of assessing the desirability of

government projects or policies when it is important to take a long view of future
effects and a broad view of possible side effects.
• Involves the calculation of a ratio of benefits to costs.
• The B/C ratio is actually a ratio of discounted benefits to discounted costs.
• For over 60 years, the B/C ratio method has been the accepted procedure for
making go/no-go decisions on independent projects and for comparing alternative
projects in the public sector.
• The B/C ratio is defined as the ratio of the equivalent worth measure applied can
be present worth, annual worth, or future worth.
• It is also known as Savings-Investment Ratio (SIR) by some governmental
agencies.
• A project is desirable or acceptable when the B/C ratio is greater than or equal to
1.0.

Conventional B/C ratio with PW

B/C = PW (benefits of the proposed project) = PW (B)

PW (total costs of the proposed project) I + PW (O &M)

Where: PW = present worth

B = benefits of the proposed project
I = initial investment in the proposed projects
O&M = operating and maintenance costs of the proposed project

Modified B/C ratio with PW

B/C = PW (B) – PW (O&M)

I
Conventional B/C ratio with AW

B/C = AW (benefits of the proposed project) = AW (B)

AW (total costs of the proposed project) CR + AW (O &M)

Where: AW = annual worth

B = benefits of the proposed project
 65

CR = capital recovery amount (i.e., the equivalent annual cost of

the initial investment, I, including an allowance for salvage value, if
any.)
O&M = operating and maintenance costs of the proposed project

Modified B/C ratio with AW

B/C = AW (B) – AW (O&M)

CR

Conventional B/C ratio with PW, Salvage value (S) included

B/C = PW (benefits of the proposed project) = PW (B)

PW (total costs of the proposed project) I – PW (S) + PW (O &M)

Modified B/C ratio with PW, Salvage value (S) included

B/C = PW (B) – PW (O&M)

I – PW (S)

Sample Problem 1. The city of Bugtussle is considering extending the runways of its
Municipal Airport so that commercial jets can use the facility. The land necessary for the
runway extension is currently farmland, which can be purchased for $350,000.
Construction costs for the runway extension are projected to be $600,000, and the
additional annual maintenance costs for the extension are estimated to be $22,500. If the
runways are extended, a small terminal will be constructed at a cost of $250,000. The
annual operating and maintenance costs for the terminal are estimated at $75,000. Finally,
the projected increase in flights will require the addition of 2 air traffic controllers, at an
annual costs of $100,000. Annual benefits of the runway extension have been estimated
as follows:

$325,000 rental receipts from airlines leasing space at the facility

$ 65,000 airport tax charged to passengers
$ 50,000 convenience benefit for residents of Bugtussle
$ 50,000 additional tourism dollars of Bugtussle

Apply the B/C ratio method with a study period of 20 years and a nominal interest rate of
10% per year to determine whether the runways at Bugtussle Municipal Airport should be
extended.

Solution:

Conventional B/C:
B/C = PW (B) / [I + PW (O&M)]
 66

B/C = $490,000 (P/A,10%,20) / [$1,200,000 + $197,500 (P/A, 10%, 20)

B/C = $490,000 (8.5136) / [$1,200,000 + $197,500 (8.5136)
B/C = $4,171,664 / ($1,200,000 + $1,681,436)
B/C = $4,171,664/ $2,881,436
B/C = 1.45

Modified B/C:
B/C = [PW (B) – PW (O&M)] / I
B/C = $490,000 (P/A,10%,20) - $197,500 (P/A, 10%, 20) / $1,200,000
B/C = $4,171,664 - $1,681,436 / $1,200,000
B/C = 2.08

Conventional B/C:
B/C = AW (B) / [CR + AW (O&M)] ; CR (i%) = I (A/P, i%, N) – S (A/F, i%, N)
B/C = $490,000 / [$1,200,000 (A/P, 10%, 20) + $197,000]
B/C = $490,000 / [$1,200,000 (0.1175) + $197,000]
B/C = $490,000 / $141,000 + $197,000 B/C = $490,000 / $338,000
B/C = 1.45

Modified B/C:
B/C = [AW (B) - AW (O&M)] / CR ; CR (i%) = I (A/P, i%, N) – S (A/F, i%, N)
B/C = $490,000 - $197,000 / [$1,200,000 (A/P, 10%, 20)
B/C = $293,000 / $141,000
B/C = 2.08

Learning Activity:

Direction: Read and answer the following problems. Write your detailed solution on a clean
paper. Draw the cash flow diagram if necessary.

1. A new municipal refuse-collection truck can be purchased for $84,000. Its expected
useful life is six years, at which time its market value will be zero. Annual receipts less
expenses will be approximately $18,000 per year over the six-year study period. Use the
PW method and a MARR of 18% to determine whether this is a good investment.

2. Should a homeowner’s incremental investment of $10,000 be traded off for energy

savings of $130 per month? Let’s assume a MARR of 0.5% per month and a 20-year
useful life of the solar-powered system. Use the PW method.

3. What is the maximum price you will pay for a bond with a face value of $1,000 and a
coupon rate of 14%, paid annually, if you want a yield to maturity of 10%? Assume that
the bond will mature in 10 years and the first payment will be received in one year.

4. Determine the FW of the following engineering project when the MARR is 15% per year.
Is the project acceptable?
 67

Proposal A
Investment cost $10,000
Expected life 5 years
Market (salvage) value −$1,000
Annual receipts $8,000
Annual expenses $4,000

Note: A negative market value means that there is a net cost to dispose of an asset.

5. A corporate jet costs $1,350,000 and will incur $200,000 per year in fixed costs
(maintenance, licenses, insurance, and hangar rental) and $277 per hour in variable costs
(fuel, pilot expense, etc.). The jet will be operated for 1,200 hours per year for five years
and then sold for $650,000. The MARR is 15% per year. Determine the capital recovery
cost of the jet.

6. A company is considering constructing a plant to manufacture a proposed new product.

The land costs $300,000, the building costs $600,000, the equipment costs $250,000, and
$100,000 additional working capital is required. It is expected that the product will result
in sales of $750,000 per year for 10 years, at which time the land can be sold for $400,000,
the building for $350,000, and the equipment for $50,000. All of the working capital would
be recovered at the EOY 10. The annual expenses for labor, materials, and all other items
are estimated to total $475,000. If the company requires a MARR of 15% per year on
projects of comparable risk, determine if it should invest in the new product line. Use the
AW method.

7. AMT, Inc., is considering the purchase of a digital camera for the maintenance of design
specifications by feeding digital pictures directly into an engineering workstation where
computer-aided design files can be superimposed over the digital pictures. Differences
between the two images can be noted, and corrections, as appropriate, can then be made
by design engineers. The capital investment requirement is $345,000 and the estimated
market value of the system after a six-year study period is $115,000. Annual revenues
attributable to the new camera system will be $120,000, whereas additional annual
expenses will be $22,000. You have been asked by management to determine the IRR of
this project and to make a recommendation. The corporation’s MARR is 20% per year.

8. A computer call center is going to replace all of its incandescent lamps with more energy
efficient fluorescent lighting fixtures. The total energy savings are estimated to be $1,875
per year, and the cost of purchasing and installing the fluorescent fixtures is $4,900. The
study period is five years, and terminal market values for the fixtures are negligible.

a. What is the IRR of this investment?

b. What is the simple payback period of the investment? Tabulate the net cash flow and
the cumulative PW.

9. The International Parcel Service has installed a new radio frequency identification
system to help reduce the number of packages that are incorrectly delivered. The capital
investment in the system is $65,000, and the projected annual savings are shown below.
The system’s market value at the EOY five is negligible, and the MARR is 18% per year.
 68

End of Year Savings

1 $25,000
2 30,000
3 30,000
4 40,000
5 46,000

a. What is the FW of this investment?

b. What is the IRR of the system?
c. What is the discounted payback period for this investment?

Assessment:

Direction: Read and answer the following problems. Write your detailed solution on a clean
paper. Draw the cash flow diagram if necessary.

1. Josh Ritchey has just been hired as a cost engineer by a large airlines company. Josh’s
first idea is to stop giving complimentary cocktails, wine, and beer to the international flying
public. He calculates this will save 5,000,000 drinks per year, and each drink costs $0.50,
for a total of $2.5 million per year. Instead of complimentary drinks, Josh estimates that
the airlines company can sell 2,000,000 drinks at $5.00 per drink. The net savings would
amount to $12.5 million per year! Josh’s boss really likes the idea and agrees to give Josh
a lumpsum bonus now equaling 0.1% of the present equivalent worth of three years of net
savings. If the company’s MARR is 20% per year, what is Josh’s bonus?

2. A $5,000 bond is offered for sale. It has a stated interest rate of 7% paid annually. At
the end of 8 years, the $5,000 debt will be repaid along with the last interest payment. If
you want 8% interest rate of return in this investment, how much would you be willing to
pay for the bond.

3. A man is considering to buy a 20-year corporate bond. The bond has a face value of
$1,000 and pays 6% interest per year in two semi-annual payments and in addition he will
receive $1,000 at the end of 20 years, along with the last interest payment. If the investor
believes he should receive 8% annual interest, compounded semi-annually, what will be
the amount he is willing to pay for the bond?

4. Your company is considering the introduction of a new product line. The initial
investment required for this project is $500,000, and annual maintenance costs are
anticipated to be $35,000. Annual operating costs will be directly proportional to the level
of production at $7.50 per unit, and each unit of product can be sold for $50. If the MARR
is 15% and the project has a life of 5 years, what is the minimum annual production level
for which the project is economically viable?

5. A retrofitted space-heating system is being considered for a small office building. The
system can be purchased and installed for $110,000, and it will save an estimated 300,000
kilowatt-hours (kWh) of electric power each year over a six-year period. A kilowatt-hour of
electricity costs $0.10, and the company uses a MARR of 15% per year in its economic
 69

evaluations of refurbished systems. The market value of the system will be $8,000 at the
end of six years, and additional annual operating and maintenance expenses are
negligible. Use the PW method to determine whether this system should be installed.

6. A large automobile manufacturer is considering the installation of a high-tech material

handling system for $200,000. This system will save $100,000 per year in manual labor,
and it will incur $64,000 in annual operating and maintenance expenditures. The
salvage value at the end of the system’s 10-year life is negligible. If the company’s hurdle
rate (MARR) is 10% per year, should the system be recommended for implementation?

7. A bond with a face value of $5,000 pays interest of 8% per year. This bond will be
redeemed at par value at the end of its 20-year life, and the first interest payment is due
one year from now. If this bond is purchased now for $4,600, what annual yield would the
buyer receive?

8. An integrated, combined cycle power plant produces 285MW of electricity by gasifying

coal. The capital investment for the plant is $570 million, spread evenly over two years.
The operating life of the plant is expected to be 20 years. Additionally, the plant will operate
at full capacity 75% of the time (downtime is 25% of any given year).

a. If this plant will make a profit of three cents per kilowatt-hour of electricity sold to the
power grid, what is the simple payback period of the plant? Is it a low-risk venture?
Tabulate the net cash flow and the cumulative PW.
b. What is the IRR for the plant? Is it profitable?

9. Automobile leases are built around three factors: negotiated sales price, residual value,
and interest rate. The residual value is what the dealership expects the car’s value will be
when the vehicle is returned at the end of the lease period. The monthly cost of the lease
is the capital recovery amount determined by using these three factors. Determine the
monthly lease payment for a car that has an agreed-upon sales price of $34,995, an APR
of 9% compounded monthly, and an estimated residual value of $20,000 at the end of a
36-month lease. An up-front payment of $3,000 is due when the lease agreement
(contract) is signed.

10. Evaluate a combined cycle power plant on the basis of the PW method when the
MARR is 12% per year. Pertinent cost data are as follows:

Power Plant
(thousands of $)
Investment cost $13,000
Useful life 15 years
Market value (EOY 15) $3,000
Annual operating expenses $1,000
Overhaul cost—end of 5th year $200
Overhaul cost—end of 10th year $550
 70

11. Vidhi is investing in some rental property in Collegeville and is investigating her income
from the investment. She knows the rental revenue will increase each year, but so will the
maintenance expenses. She has been able to generate the data that follows regarding
this investment opportunity. Assume that all cash flows occur at the end of each year and
that the purchase and sale of this property are not relevant to the study. If Vidhi’s MARR
= 6% per year, what is the FW of Vidhi’s projected net income?

12. A Solar Sea Power Plant (SSPP) is being considered in a North American location
known for its high temperature ocean surface and its much lower ocean temperature 100
meters below the surface. Power can be produced based on this temperature differential.
With high costs of fossil fuels, this particular SSPP may be economically attractive to
investors. For an initial investment of $100 million, annual net revenues are estimated to
be $15 million in years 1–5 and $20 million in years 6–20. Assume no residual market
value for the SSPP.

a. What is the simple payback period for the SSPP?

b. What is the discounted payback period when the MARR is 6% per year?
c. Would you recommend investing in this project?

Congratulations! You are now ready for the next unit.

Write your insights and thoughts about the activities below.
 71

UNIT 6

Comparing Alternatives

Learning Outcomes:

At the end of this unit, you will be able to:

• Determine which to choose among mutually exclusive alternatives
and how much capital to invest because of different levels of
investment produce varying economic outcomes

Pre – Test:

Multiple Choice.

1. Alternatives are called ______ when the selection of one feasible method or
alternative excludes the consideration of any other alternative.
a. exclusive b. mutually exclusive
c. inclusive d. mutually inclusive
2. _______ are those with all negative cash flows except for a possible positive cash
flow element from disposal of assets at the end of the projects‟ useful life.
a. Investment alternatives b. Cost alternatives
c. Repeatability assumption d. Co-terminated assumption

3. In comparing alternatives, the one with ________ equivalent worth at a particular

interest is preferred.
a. most negative
b. least negative
c. both a and b
d. none of the above

4. Alternative D is preferred to C if it has _____ PW of costs.

a. greater
b. lesser
c. greater or equal
d. lesser or equal

5. _______ are those with initial (or front-end) capital investments that produce cash
flows from increased revenue, savings through reduced costs, or both.
a. Investment alternatives
b. Cost alternatives
c. Repeatability assumption
d. Co-terminated assumption

Content:

BASIC CONCEPTS FOR COMPARING ALTERNATIVES

• Alternatives are called mutually exclusive when the selection of one feasible
method or alternative excludes the consideration of any other alternative.
 72

• An engineering economy study must be performed to determine which one to

choose among mutually exclusive alternatives and how much capital to invest
because of different levels of investment produce varying economic outcomes.
• If the extra benefits obtained by investing additional capital are better than those
that could be obtained from investment of the same capital elsewhere in the
company at the MARR, the investment should be made. If this is not the case,
we obviously would not invest more than the minimum amount of capital required,
including the possibility of nothing at all. Stated simply, our rule will keep as much
as possible invested at a rate of return equal to or greater than the MARR.

Rule 1. When revenues and other economic benefits are present and vary
among the alternatives, choose the alternative that maximizes overall
profitability. That is select the alternative that has the greatest positive
equivalent worth at i = MARR and satisfies all project requirements.
Rule 2. When revenues and other economic benefits are not present or are
constant among the alternatives, consider only the costs and select the
alternative that minimizes total cost. That is select the alternative that
has the least negative equivalent worth at i = MARR and satisfies all
project requirements.

Case 1. Useful lives are the same for all alternatives and equal to the study period.

• The most straightforward technique for comparing mutually exclusive alternatives

when all useful lives are equal to the study period is to determine the equivalent
worth of each alternative based on total investment at i = MARR. Then for
investment alternatives, the one with the greatest positive equivalent worth is
selected. And in the case of cost alternatives, the one with the least negative
equivalent worth is selected.

1st example involves an investment project situation:

Alternatives A and B are two mutually exclusive investment alternatives with estimated net
cash flows as shown. Useful life of each alternative is 4 years. The MARR = 10% per year.
Investment alternatives are those with initial (or front-end) capital investments that
produce cash flows from increased revenue, savings through reduced costs, or both.

Alternative
A B
Capital investment -$60,000 -$73,000
Annual revenues less expenses 22,000 26,225

The PW values are:

PW (10%)A = -$60,000 + $22,000 (P/A,10%,4) = $9,738 PW (10%)B = -$73,000 + $26,000
(P/A, 10%, 4) = $10,131
 73

Since the PWA is > 0 at i=MARR, it is the base alternative and would be selected unless
the additional capital associated with Alternative B is justified. In this case, Alternative B
is preferred because it has a greater PW value.

The extra benefits obtained by investing the additional $13,000 of capital in B, have a
present worth of:
$10,131 - $9,738 = $393
That is, PW (10%)diff = -$13,000 + $4,225 (P/A, 10%, 4) = $393
And the additional capital invested in B is justified.

2nd example involves a cost project situation:

Alternatives C and D are two mutually exclusive cost alternatives with estimated net cash
flows as shown over a three-year life. MARR at 10% per year. Cost alternatives are those
with all negative cash flows except for a possible positive cash flow element from disposal
of assets at the end of the projects‟ useful life. It occurs when the organization must take
some action and the decision involves the most economical way of doing it (e.g. the
addition of environmental control capability to meet new regulatory requirements).

Alternative
End of Year
C D
0 -$380,000 -$415,000
1 -$38,100 -$27,400
2 -$39,100 -$27,400
3 -$40,100 -$27,400
3a 0 $26,000
a
Market Value

At MARR = 10% per year

PW (10%) C = - $477,077 PW (10%) D = - 463,607
 74

Alternative D is preferred to C because it has the lesser PW of costs. Hence the lower
annual expenses obtained by investing the additional $35,000 of capital in Alternative D
has a present worth of - 463,607 – (- $477,077) = $13,470. Therefore, the additional capital
invested in Alternative D is justified.

Case 2. Useful lives are different among alternatives and at least one does not
match the study period.

• When the useful lives of mutually exclusive alternatives are different, the
repeatability assumption and co-terminated assumption maybe used.

The repeatability assumption involves two main conditions:

1. The study period over which the alternatives are being compared is either
indefinitely long or equal to a common multiple of the lives of the alternatives.
2. The economic consequences that are estimated to happen in an alternative‟s
initial useful life span will also happen in all succeeding life spans
(replacements)

The co-terminated assumption uses a finite (limited) and identical study period for all
alternatives. This planning horizon, combined with appropriate adjustments to the
estimated cash flows, puts the alternatives on a common and comparable basis.

Guidelines:
1. Useful life < Study period
a. Cost alternatives: contracting for the service or leasing the needed
equipment for the remaining years maybe appropriate or repeat part of
the useful life of the original alternative, and then use an estimated market
value to truncate it at the end of the study period.
b. Investment alternatives: Assumption used here is that all cash flows will
be reinvested in other opportunities available to the firm at the MARR to
the end of the study period.
2. Useful life > Study period: The most common technique is to truncate the
alternative at the end of the study period using an estimated market value,
that the disposable assets will be sold at the end of the study period at that
value.

Sample Problem. The following data have been estimated for two mutually exclusive
investment alternatives, A and B, associated with a small engineering project for which
revenues as well as expenses are involved. They have useful lives of four and six years,
respectively. If the MARR = 10% per year, show which alternative is more desirable by
using equivalent worth methods. Use the repeatability assumption.

A B
Capital investment -3,500 -5,000
Annual revenue 1,900 2,500
Annual expenses -645 -1,020
 75

Useful life (years) 4 6

Market value at end of useful life 0 0

Solution:
LCM = 12 years
Alt. A.
PW (10%) = -3,500 – 3,500 [(P/F, 10%, 4) + (P/F, 10%, 8)] + (1,900 – 645) (P/A, 10%, 12)
= $1,028

Alt. B.
PW (10%) = -5,000 – 5,000 (P/F, 10%, 6) + (2,500 – 1,020) (P/A, 10%, 12)
= $2,262

Based on the PW method we would select Alternative B because it has the larger value.

Suppose that the above problem is modified such that an analysis period of 6 years is
used (co- terminated assumption) instead of 12 years.

Solution: Use the FW to analyze the situation.

Alt. A.
FW (10%) = [-3,500 (F/P, 10%, 4) + (1,900 – 645) (F/A, 10%, 4)] (F/P, 10%, 2)
= $847

Alt. B.
FW (10%) = -5,000 (F/P, 10%, 6) + (2,500 – 1,020) (F/A, 10%, 6)
= $2,561

Based on the FW of each alternative at the end of the six-year stuffy period, we would
select Alt. B because it has the larger value.

Imputed Market Value Technique

• Obtaining a current estimate from the marketplace for a piece of equipment or

another type of asset is the preferred procedure in engineering practice when a
market value at time T < useful life is required.
• The imputed market value technique is sometimes called the implied market
value.
• It is calculated based on the sum of two parts as follows:

MVT = [PW at the end of year T of remaining capital recovery amounts] + [PW at the end
of year T of original market value at the end of useful life}

Sample Problem. A piece of production equipment is to be replaced immediately because

it no longer meets quality requirements for the end product. The two best alternatives are
a used piece of equipment (E1) and a new automated model (E2). Select the preferred
 76

alternative with a 5 year study period using the imputed market value technique. The
MARR is 15% per year. Select the best alternative using n= 5 years.

Alternative
E1 E2
Capital investment -$14,000 -$65,000
Annual expenses -14,000 -9,000
Useful life (years) 5 20
Market value at end of useful
8,000 13,000
life

Solution:

For Alt. 1

PW = -14,000 – 14,000 (P/A, 15%, 5) + 8,000 (P/F, 15%, 5)

= -14,000 – 14,000 (3.3522) + 8,000 (0.4972)
= -14,000 – 46,930.8 + 3,977.60
= -56,953.2

For Alt. 2

MV5 = [ 65,000 (A/P, 15%, 20) – 13,000 (A/F, 15%, 20)] (P/A, 15%, 15)
+ 13,000 (P/F, 15%, 15)
= [ 65,000 (0.1598) – 13,000 (0.0098)] (5.8474)
+ 13,000 (0.1229)
= (10,387 – 127.4) (5.8474) + 1,597.70
= 59,991.98 + 1,597.70
= 61,589.69

PW = -65,000 – 9,000 (P/A, 15%, 5) + 61.589.69 (P/F, 15%, 5)

= -65,000 – 9,000 (3.3522) + 61.589.69 (0.4972)
= -65,000 – 30,169.80 + 30,622.39
= -64,547.41

Alternative 1 is preferred because it has the least negative equivalent worth at i = 15%

Learning Activity:

Direction: Read and answer the following problems. Write your detailed solution on a clean
paper.

1. The Consolidated Oil Company must install antipollution equipment in a new refinery
to meet federal clean-air standards. Four design alternatives are being considered, which
will have capital investment and annual operating expenses as shown below. Assuming a
useful life of 8 years for each design, no market value, a desired MARR of 10% per year,
 77

determine which design should be selected on the basis of the PW method. Confirm your
selection by using the FW and AW methods. Which rule applies? Why?

2. Three mutually exclusive design alternatives are being considered. The estimated cash
flows for each alternative are given next. The MARR is 20% per year. At the conclusion of
the useful life, the investment will be sold.
A B C
Investment cost $28,000 $55,000 $40,000
Annual expenses $15,000 $13,000 $22,000
Annual revenues $23,000 $28,000 $32,000
Market value $6,000 $8,000 $10,000
Useful life 10 years 10 years 10 years
IRR 26.4% 24.7% 22.4%

3. Consider the three mutually exclusive projects that follow. The firm’s MARR is 10% per
year.
EOY Project 1 Project 2 Project 3
0 −$10,000 −$8,500 −$11,000
1–3 $5,125 $4,450 $5,400

a. Calculate each project’s PW.

b. Determine the IRR of each project.
c. Which project would you recommend?
d. Why might one project have the highest PW while a different project has the largest
IRR?

4. Consider the following EOY cash flows for two mutually exclusive alternatives (one must
be chosen):
X Y
Capital investment $6,000 $14,000
Annual expenses $2,500 $2,400
Useful life 12 years 18 years
Market value at $0 $2,800
end of useful life
The MARR is 5% per year.

a. Determine which alternative should be selected if the repeatability assumption applies.

b. Determine which alternative should be selected if the analysis period is 18 years, the
repeatability assumption does not apply, and a battery system can be leased for $8,000
per year after the useful life of either battery is over.
 78

Assessment:

Direction: Read and answer the following problems. Write your detailed solution on a clean
paper.

1. A stem cell research project requires expensive specialized laboratory equipment. For
this purpose, three pieces of equipment and their associated cash flows (listed below) are
under consideration. One piece of equipment must be selected, and the laboratory’s
MARR is 15% per year. Use the PW method to rank-order the economic attractiveness of
the three projects.

EOY A B C
0 −$136,500 −$84,000 −$126,000
1−4 −$12,500 −$28,500 −$15,500
5 −$10,000 −$28,500 −$15,500

2. Three mutually exclusive design alternatives are being considered. The estimated sales
and cost data for each alternative are given on the next page. The MARR is 20% per year.
Annual revenues are based on the number of units sold and the selling price. Annual
expenses are based on fixed and variable costs. Determine which selection is preferable
based on AW. State your assumptions.

A B C
Investment cost $30,000 $ 60,000 $50,000
Estimated units 15,000 20,000 18,000
to be sold/year
Unit selling price, $3.50 $4.40 $4.10
$/unit
Variable costs, $1.00 $1.40 $1.15
$/unit
Annual expenses $15,000 $30,000 $26,000
(fixed)
Market value 0 $20,000 $15,000
Useful life 10 years 10 years 10 years

3. You have been asked to evaluate the economic implications of various methods for
cooling condenser effluents from a 200-MW steam electric plant. In this regard, cooling
ponds and once through cooling systems have been eliminated from consideration
because of their adverse ecological effects. It has been decided to use cooling towers to
dissipate waste heat to the atmosphere. There are two basic types of cooling towers: wet
and dry. Furthermore, heat may be removed from condenser water by (1) forcing
(mechanically) air through the tower or (2) allowing heat transfer to occur by making use
of natural draft. Consequently, there are four basic cooling tower designs that could be
considered. Assuming that the cost of capital to the utility company is 12% per year, your
job is to recommend the best alternative (i.e., the least expensive during the service life)
in view of the data in the table below. Further, assume that each alternative is capable of
satisfactorily removing waste heat from the condensers of a 200-MW power plant. What
noneconomic factors can you identify that might also play a role in the decision-making
process?
 79

Alternative Types of Cooling Towers for a 200-Megawatt Fossil-Fired Power Plant

Operating at Full Capacity a

a
100 hp = 74.6 kW; cost of power to plant is 2.2 cents per kWh or kilowatt-hour; induced-draft fans and pumps operate
around the clock for 365 days/year (continuously). Assume that electric motors for pumps and fans are 90% efficient.

Congratulations! You are now ready for the next unit.

Write your insights and thoughts about the activities below.
 80

References

Sullivan, Wicks, & Koelling (2015) Engineering Economy 16th ed.

Cuaresma and Cabanayan (2012) Compiled Lecture in Engineering Economy
 81

Rubrics
4 3 2 1 0
Accuracy 90-100% of Almost all Most (75- More than No evidence
the steps (85-89%) of 84%) of the 75% of the of attempting
and solutions the steps steps and steps and to solve/
have no and solutions solutions solutions answer the
mathematical have no have no have problem/que
errors. mathematical mathematical mathematical stion.
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 82

Glossary
Capital – refers to wealth in the form of money or property that can be used to produce
more wealth.

Capital investment – series of expenditures over an extended period on a large

construction project.

Interest - The term "interest" is used to indicate the rent paid for the use of money.
Investment cost – first cost or cost incurred during the acquisition phase. It is the capital
required for most of the activities in the acquisition phase.

Concept of Time Value of Money – “Money makes money”. This is true because if we
invest money today, by tomorrow we will have accumulated more money that what we
had originally invested. And also, if you borrow money today you will have to pay in the
future an amount that is larger than what you have originally owed. This change in the
amount of money over a given time period is called time value of money”.

Debt Capital – also called borrowed capital, is represented by funds borrowed by a

business that must be repaid over a period of time, usually with interest. Debt financing
can be either short-term, with full repayment due in less than one year, or long-term, with
repayment due over a period greater than one year.

Disposal cost – includes those non-recurring costs of shutting down the operation and
the retirement and disposal of assets at the end of the life cycle. Ex. Costs associated with
personnel, materials.

Equity capital – is owned by individuals who have invested their money or property in a
business project or venture in the hope of receiving a profit and sometimes in exchange
for a share of ownership in the company. Equity financing allows a business to obtain
funds without incurring debt or having to repay a specific amount of money at a particular
time.

Operation and maintenance cost – includes many of the recurring annual expense items
associated with the operation phase of the life cycle. The direct and indirect costs of
operation in five primary resource areas, 1) people 2) machines 3) materials 4) energy 5)
information – are major parts of the costs in this category.

Return on Capital - measures of how effectively a company uses the money (borrowed
or owned) invested in its operations.

Working capital – refers to the funds required for current assets (equipment, facilities)
that are needed for the start-up and support of operational activities.
 83

Answer Key
UNIT 1
PRE-TEST
1. c
2. b
3. d
4. a
5. c
UNIT 2
PRE-TEST
1. h
2. a
3. j
4. b
5. c
6. f
7. i
8. d
9. e
10. g
LEARNING ACTIVITY
1. D’ = CF / (p – cv)
D’ = $750,000 / ($7.35 – 1.35)
D’ = 125,000 gears

2. D’ = CF / (p – cv); cv = $15 + $65 + $20 = $100

D’ = 34,950 / ($250 – $100)
D’ = 233 chairs
3. a) Breakeven point = $1,000,000/ ($29.95-$20.00) = 100,503 customers per
month
b) New breakeven point = $1,000,000/($39.95-$25.00) = 66,890 per month
c) For 75,000 subscribers per month, profit equals:
75,000*($39.95-$25.00)- $1,000,000 = $121,250 per month
This improves on the monthly loss experienced in part (a).
UNIT 3
PRE-TEST
1. b
2. a
 84

3. a
4. a
5. d
LEARNING ACTIVITY 1
1.

2.

LEARNING ACTIVITY 2
1. I = Pin
I = 850 (0.051) (54/12) = $195
2. F = P(1 + in)
3360 = P [1 + 0.08(1.5)]
P = $3000
3. F = P(1 + i)n
i = 0.06/2 ; n = 20 x 2
F = 10000(1 + 0.06/2) 20 x 2 = $32,620
4. F = P(1 + i)n
Ftotal = F1 + F2 + F3
= 900 (1.04)6 + 700 (1.04)8 + 500(1.04)10
= $2836.907
 85

5. ER = (1 + r/M)M – 1
ER = (1 + 0.08/12)12 – 1 = 8.3%
6. For continuous compounding,
F = Pert
F = 10000e0.0525(5) = 13,001.76
(1+𝑖)𝑛 −1
7. 𝐹 = 𝐴[ ]
𝑖

(1 + 0.07)6 − 1
𝐹 = 1500 [ ] = $3576.64
0.07
(1+𝑖)𝑛 −1
8. F1 = P(1+i)n and 𝐹2 = 𝐴 [ ]
𝑖

F = F1 – F2
(1+0.06)5 −1
F = 10000(1+0.06)5 - 1000 [ ] = $7745.2
0.06

9. i = 0.12/2 = 0.06
8000 (1+𝑖)10 −1
𝑃1 = ( ); P = P1(1+i)-5
𝑖 (1+𝑖)10

8000 (1+0.06)10 −1
P= ( )(1+0.06)-5 = $44000
0.06 (1+0.06)10

Cash Price = 100,000 + 44,000 = $144,000

10. This is a deferred annuity, the time periods are months, and i = 3/4 % per month:
P71 = $500 (P/A, 3/4%, 60) = $500 (48.1733) = $24,086.65
P0 = $24,086.65 (P/F, 3/4% ,71) = 24,086.65 (0.58836) = $14,171.62

UNIT 4
PRE-TEST
1. a
2. c
3. b
4. d
5. a
LEARNING ACTIVITY
1. SVN = 0.1(10,000) = $1,000
dk = (B – SVN) / N = [10,000 – 1,000] / 10 = $900
d*6 = kdk = 6 (900) = $5,400
BV6 = B – d*6 = 10,000 – 5,400 = $4,600
 86

EOY, k dk BVk
0 - $10,000
1 $900 $9,100
2 $900 $8,200
3 $900 $7,300
4 $900 $6,400
5 $900 $5,500
6 $900 $4,600
7 $900 $3,700
8 $900 $2,800
9 $900 $1,900
10 $900 $1,000

2. dk = (B – SVN) / N = (50,000 – 5,000) / 20 = $2,250.00

3. C = purchase price of replacement asset – net salvage value of current asset

C = 20,000 – 2,000 = $18,000
A’ = C (A/F, i%, N)
A’ = 18,000 (A/F, 0.04%, 8)
A’ = $1,953.50

4. A’ = C (A/F, i%, N)
A’ = (100,000 – 5,000) (A/F, 4%, 10)
A’ = $7,912.640

d*3 = A’ (F/A, 4%, 3) = $24,700.097

BV3 = B – d*3 = 100,000 – 24,700.097 = $75,299.903

The depreciation and book value amounts for each year are shown below.
EOY, k dk d*k BVk
0 - - 100,000.00
1 7,912.640 7,912.640 92,087.360
2 8,229.146 16,141.786 83,858.214
3 8,558.311 24,700.097 75,299.903
4 8,900.644 33,600.741 66,399.259
5 9,257.670 42,857.411 57,142.589
6 9,626.936 52,484.347 47,515.653
7 10,012.014 62,496.361 37,503.639
8 10,412.494 72,908.855 27,091.145
9 10,828.994 83,737.849 16,262.151
10 11,262.151 95,000.000 5,000.00

4.
 87

No. of the year SYD

Year in Reverse Order Depreciation
Factor
1 10 10/55
2 9 9/55
3 8 8/55
4 7 7/55
5 6 6/55
6 5 5/55
7 4 4/55
8 3 3/55
9 2 2/55
10 1 1/55
Sum of the 55
digits

d5 = (6/55) (50,000 – 5,000) = $4,909.091

or

d5 = (50,000 – 5,000) [2(10 – 5 + 1) / (10 x 11)] = $4,909.091

BV5 = 50,000 – [2(50,000 – 5,000)/10] x 5 + [(50,000 – 5,000)/(10x11)] x5x6 = $17,272.727

The depreciation and book value amounts for each year are shown below.

EOY, k dk d*k BVk

0 - $50,000.000
1 $8,181.818 8,181.818 41,818.182
2 7,363.636 15,545.454 34,454.546
3 6,545.455 22,090.909 27,909.091
4 5,727.273 27,818.182 22,181.818
5 4,909.091 32,727.273 17,272.727
6 4,090.909 36,818.182 13,181.818
7 3,272.727 40,090.909 9,909.091
8 2,454.545 42,545.454 7,454.546
9 1,636.364 44,181.818 5,818.182
10 818.182 45,000.000 5,000.000

5. R = 0.12
dk = B (1 – R) k-1 (R)
d6 = 1,000 (1 – 0.12)5 (0.12) = $63.328
d*k = B [1 – (1-R)k]
d*6 = 1,000 [1 – (1 – 0.12)6] = $535.596
BVk = B(1 – R)k
BV6 = 1,000 (1 – 0.12)6 = $464.404
 88

The depreciation and book value amounts for each year are shown below.

EOY, k dk BVk
0 - 1,000
1 120 880
2 105.6 774.4
3 92.928 681.472
4 81.77664 599.69536
5 71.96344 527.73192
6 63.328 464.404

6. Depreciation per unit of production = (P200,000 – P20,000) / 15,000 units

= P12 per unit
After 12,000 units, BV = P200,000 – P12 / unit (12,000 units) = P56,000

7. D4 = (5,000 – 1,000) [2(5 – 4 + 1) / (5 x 6)] = $533.33

8. Sum of years = 1 + 2 + 3 + 4 + 5 = 15

Total depreciation = (1,500,000 - 500,000) (5 + 4 + 3) /15

Total depreciation = (1,500,000 - 500,000) (12) / 15
Total depreciation = Php 800,000

Book Value = 1,500,000 - 800,000

Book Value = Php 700,000

UNIT 5
PRE-TEST
1. a
2. b
3. c
4. d
5. d
LEARNING ACTIVITY
1. PW(18%) = −$84,000 + $18,000 (P/A, 18%, 6) = −$21,043.
Since PW < 0, this is not an acceptable investment.

2. PW = −$10,000 + $130(P/A, 0.5%, per month, 240 months)

= −$10,000 + $130(139.5808)
= $8,145.50

The positive-valued PW signals a favorable investment. Additionally, 13 tons/year × 20

years = 260 tons of carbon dioxide will be avoided.
 89

3. Desired yield per year = 10%

VN = $1,000 (P/F, 10%, 10) + 0.14 ($1,000) (P/A,10%,10)

= $1,000 (0.3855) + $140 (6.1446) = $1,245.74

4. FW(15%) = −$10,000 (F/P,15%,5) + ($8,000 − $4000)(F/A,15%,5) − $1,000

= −$10,000 (2.0114) + $4000(6.7424) − $1,000
= $5,855.60

Positive FW means the project is acceptable.

5. CR = $1,350,000 (A/P, 15%, 5) − $650,000 (A/F, 15%, 5) = $306,310

6.Capital Investment = −$300,000 − $600,000 − $250,000 − $100,000 = −$1,250,000

Revenue = $750,000 per year
Market Value = $400,000 + $350,000 + $50,000 = $800,000
Expenses = −$475,000 per year

AW(15%) = $750,000 − $475,000 – [$1,250,000(A/P, 15%, 10) + ($800,000 + $100,000)

(A/F, 15%, 10)]
= $275,000 −$1,250,000(0.1993) + $900,000(0.0493)
= $70,245 > 0
Therefore, they should invest in the new product line (Note: All of the $100,000 working
capital would be recovered at the end of year 10, that’s why we add it to the market value).

7. We can easily see that the sum of positive cash flows ($835,000) exceeds the sum of
negative cashflows ($455,000). Thus, it is likely that a positive valued IRR can be
determined. By writing an equation for the PW of the project’stotal net cash flow and
setting it equal to zero, we can compute the IRR:

PW = 0 = − $345,000 + ($120,000 − $22,000)(P/A, i '%, 6) + $115,000(P/F, i '%, 6)

i '% = ?

To use linear interpolation, we first need to try a few values for i '.A good starting point is
to use the MARR.

At i ’= 20%: PW = −$345,000 + $98,000(3.3255) + $115,000(0.3349) = +$19,413

Since the PW is positive at 20%, we know that i ' > 20%.

At i ' = 25%: PW = −$345,000 + $98,000(2.9514) + $115,000(0.2621) = −$25,621

Now that we have both a positive and a negative PW, the answer is bracketed (20% ≤ i′
% ≤ 25%).

Interpolating,
 90

line BA / line BC = line dA / line de

(25% − 20%) / [$19,413 − (−$25,621)] = (i ' % − 20%) / ($19,413 − $0)

i ' ≈ 22.16%

Because the IRR of the project (22.16%) is greater than the MARR, the project is
acceptable.

8. (a) 0 = −$4,900 + $1,875(P/A, i′, 5); i′ = 26.4%

(b) θ = $4,900 / $1,875 = 3 years (to the integer year)

Year k Net Cash Flow Cumulative PW at I

= 0%/yr trough Year k

0 -$4,900 -$4,900
1 1,875 -3025
2 1,875 -1330
3 1,875 +545
4 1,875 +2420
5 1,875 +4295
From the table, θ= 3 years is correct.

9. (a) FW(18%) = $84,028 ≥ 0, so the profitability is acceptable.

(b) IRR = 38.4% ≥ 18%, so the investment is a profitable one.
(c) 𝜃′ = 4 years, so the liquidity is marginal at best.

Calculation of the discounted payback period (θ’)

Year k Present worth of Cumulative PW at

cash flow at MARR = 18%/yr
i=18%/yr through Year k
0 -$65,000 -$65,000
1 21,186.441 -43,813.559
2 21,545.533 -22,268.026
3 18,258.926 -4,009.100
4 20,631.555 +16,622.455
 91

5 20,107.024 +36,729.479

UNIT 6
PRE-TEST
1. b
2. b
3. b
4. b
5. a
LEARNING ACTIVITY
1. Present Worth Method, MARR = 12% per year
PWD1 (12%) = −$600,000 − $780,000(P/A,12%,10) = −$5,007,156
PWD2 (12%) = −$760,000 − $728,000(P/A,12%,10) = −$4,873,346
PWD3 (12%) = −$1,240,000 − $630,000(P/A,12%,10) = −$4,799,626
PWD4 (12%) = −$1,600,000 − $574,000(P/A,12%,10) = −$4,843,215
Select Design D3 to minimize the present worth of costs.

Future Worth Method, MARR = 12% per year

FWD1 (12%) = −$600,000(F/P, 12%,10) − $780,000(F/A,12%,10) = −$15,551,446
FWD2 (12%) = −$760,000 (F/P,12%,10) − $728,000(F/A,12%,10) = −$15,135,862
FWD3 (12%) = −$1,240,000 (F/P,12%,10) − $630,000(F/A,12%,10) = −$14,906,873
FWD4 (12%) = −$1,600,000 (F/P,12%,10) – $574,000(F/A,12%,10) = −$15,042,234
Select Design D3 to minimize the future worth of costs.

Annual Worth Method, MARR = 12% per year

AWD1 (12%) = −$600,000 (A/P,12%,10) – $780,000 = −$886,200
AWD2 (12%) = −$760,000 (A/P,12%,10) – $728,000 = −$862,520
AWD3 (12%) = −$1,240,000 (A/P,12%,10) – $630,000 = −$849,480
AWD4 (12%) = −$1,600,000 (A/P,12%,10) – $574,000 = −$857,200
Select Design D3 to minimize the annual worth of costs.

2. PWA(20%) = −$28,000 + ($23,000 − $15,000)(P/A,20%,10) + $6,000(P/F,20%,10)

= $6,509
PWB(20%) = −$55,000 + ($28,000 − $13,000)(P/A,20%,10) + $8,000(P/F,20%,10)
= $9,180
PWC(20%) = −$40,000 + ($32,000 − $22,000)(P/A,20%,10) + $10,000(P/F,20%,10)
= $3,540
Select Alternative B to maximize present worth.

Note: If you were to pick the alternative with the highest total IRR, you would have
incorrectly selected Alternative A.

3. (a) PW1(10%) = $2,745; PW2(10%) = $,2566; PW3(10%) = $2,429

 92

(b) IRR1 = 25%; IRR2 = 26.5%; IRR3 = 22.2%

(c) Select Project 1 to maximize profitability.
(d) This is because the IRR method assumes reinvestment of cash flows at the IRR
whereas the PW method assumes reinvestment at the MARR.

4. (a) Use AW to deal with different useful lives

AWx(5%) = −$6,000(A/P,5%,12) − $2,500 = −$3,176.80
AWy(5%) = −$14,000(A/P,5%,18) + $2,800(A/F,5%,18) − $2,400 = −$3,497.60

Select Alternative X (could also calculate PW over 36 years and compare)

(b) PWx(5%) = −$6,000 − $2,500(P/A,5%,12) − $8,000(P/A,5%,6)(P/F,5%,12)

= −$50,767.45
PWy(5%) = −$3,497.60(P/A,5%,18) = −$40,885.54

Select Alternative Y (could also calculate AW over 18 years and compare)

93