1

ENGINEERING ECONOMICS
CHAPTER: FOUR
INFLATION AND DEPRECIATION

*****

Mettu University (2014/2022) Abraham. A

Civil Engineering Department
 4.1 Inflation
2

 Inflation is defined as a general increase in the price of goods and

services across the economy, or, in other words, a general decrease in
the value of money.
 As inflation occurs, individuals can purchase fewer goods and services
with the same amount of money
 Inflation is an increase in the amount of money necessary to obtain
the same amount of goods or services before the inflated price was
present.
 Purchasing power, or buying power, measures the value of a
currency in terms of the quantity and quality of goods or services that
one unit of money will purchase.
 Inflation decreases the purchasing ability of money in that less goods
or services can be purchased for the same one unit of money
 Causes of Inflation
3

 A) Demand-pull inflation: it occurs when demand

for goods and services within the economy exceeds
the economy’s capacity to produce goods and
services.
 B) Cost-push inflation: occurs when the price of
input goods and services increases.

 What is the Inflation’s Impact on National and

individuals Economy?
 Different Interest Rates
4

 Real or Inflation-free interest rates(i) –the actual rate

without the application of inflation rate.
 Inflation rates (f)- measure of the rate of change in the
value of money.
 Inflation-adjusted interest rates(if)- combination of the
real interest rate and the inflation rate, sometimes called
inflated interest rate.

Inflation affects buying power, the amount of goods and

services that can be purchased by a given unit of currency.

Make no mistake: Inflation is a formidable force in our economy

 4.1 Inflation
5

 “ if ” is the inflation-adjusted or market interest

rate and is defined as

 Then:
To determine PW

To determine FW
 4.1 Inflation
6

 For example: For a real interest rate of 10% per year and an
inflation rate of 4% per year, a market interest rate of 14.4%
 if= 0.10 + 0.04 + 0.10(0.04) = 0.144
 Example 1: Abbott Mining Systems wants to determine whether it
should upgrade a piece of equipment used in deep mining
operations in one of its international operations now or later. If the
company selects plan A, the upgrade will be purchased now for
$200,000. However, if the company selects plan B, the purchase
will be deferred for 3 years when the cost is expected to rise to
$300,000. Abbott is ambitious; it expects a real interest of 12%
per year. The inflation rate in the country has averaged 3% per
year. From only an economic perspective, determine whether the
company should purchase now or later (a) when inflation is not
considered and (b) when inflation is considered.
 4.1 Inflation
7

 Solution:
(a) Inflation not considered: The real rate, or MARR, is i = 12% per
year. The cost of plan B is $300,000 three years hence. Calculate the
FW(B) value for plan A three years from now and select the lower cost.
FW(A) = - 200,000(F/P, 12%,3) = $-280,986
FW(B) = $-300,000
Select plan A (purchase now).
b) Inflation considered; the real rate (12%), and inflation of 3% must
be accounted for. First, compute the inflation-adjusted MARR by
Equation.
if= 0.12 + 0.03 + 0.12(0.03) = 0.1536
Use if to compute the FW value for plan A in future dollars.
 FW(A) = -200,000(F/P/15.36%,3) = $-307,040

 FW(B), = $-300,000

 Purchase later (plan B)

 4.1 Inflation
8

 Generally: to calculate the inflation rate or worth

of ; *** PW, FW, AW,….. *****The previous
formulas in the chapter two and three are possible
by only considering the inflation rates because the
previous are considered only real interest (i).
 Therefore; if=i + f + if
 Where i= Real interest
 f= inflation interest
 4.2 DEPRECIATION
9

 Depreciation is a book method (noncash) to represent the reduction

in value of a tangible asset.
 The method used to depreciate an asset is a way to account for the
decreasing value of the asset to the owner and to represent the
diminishing value (amount) of the capital funds invested in it.
 The annual depreciation amount is not an actual cash flow, nor does it
necessarily reflect the actual usage pattern of the asset during
ownership.
 Though the term amortization is sometimes used interchangeably with
the term depreciation, they are different.
 Depreciation is applied to tangible assets,
 while amortization is used to reflect the decreasing value of
intangibles, such as loans, mortgages, patents, trademarks, and
goodwill.
 4.2 DEPRECIATION
10

 Any equipment which is purchased today will not work for ever.
This may be due to wear and tear of the equipment or
obsolescence of technology.
 Hence, it is to be replaced at the proper time for continuance of
any business. The replacement of the equipment at the end of its
life involves money. This must be internally generated from the
earnings of the equipment.
 The recovery of money from the earnings of an equipment for its
replacement purpose is called depreciation fund since we make
an assumption that the value of the equipment decreases with the
passage of time.
 4.2 DEPRECIATION
11

 Depreciation means decrease in the value of any physical asset

or fixed assets due to their use in business, passage of time or
obsolescence.
 Depreciation is a measure of the wearing out, consumption or
other loss of value of a depreciable asset arising from use,
effluxion of time or obsolescence through technology and
market changes.
 Depreciation is allocated so as to charge a fair proportion of
the depreciable amount in each accounting period during the
expected useful life of the asset.
 Depreciation includes amortization of assets whose useful life is
predetermined.
 Depreciable Asset
12

 Depreciable assets are assets which

i. are expected to be used during more than one
accounting period;
ii. have a limited useful life;
iii. are held by an enterprise for use in the production or
supply of goods and services, for rental to others, or for
administrative purposes and not for the purpose of sale
in the ordinary course of business.
 What is depletion?
13

 The term ‘Depletion’ refers to the physical

deterioration by the exhaustion of natural resources,
like, quarries, mines, oil-wells, etc. Due to mining or
extraction, the stock of minerals/oil, etc. is
depleted/reduced. In case of such assets, usually
depreciation is charged on the basis of quantity
produced.
 What is amortization?
14

 Amortization refers to the economic deterioration or

to reflect the decreasing value of intangible assets
like, loans, mortgages, patents, trademarks, goodwill,
patents, trademark, copyright etc. It is the practice to
write off the intangible assets over a reasonable
period.
 When a part of an intangible asset is written off, it is
called amortization.
 What is obsolescence?
15

 The term ‘Obsolescence’ refers to the economic

deterioration of assets, due to change in technology,
invention of improved equipment, market decline due
to change in taste and fashion, etc., or inadequacy of
existing plant to meet the increased business.
 Depreciation is affected by obsolescence as it
decreases the value of asset.
 Causes of Depreciation
16

Wear and tear. Fixed assets are purchased for use in

business. Due to constant use of fixed assets in business for
generating income, the value of such assets is decreased. It is called
‘wear’ and ‘tear’. It is main cause of depreciation.
Passage of time. Every asset has a certain economic useful life. With
the passage of time effective life of the assets goes on decreasing.
Certain assets like a lease, have a certain legal life. With the
passage of time, value of such assets goes down, even may not be
actually used in the business.
Depletion. Depletion is reduction of natural resources. In case of
wasting assets, depletion is also a cause of fall in the value of assets
like, mines, oils wells, quarries, etc.
 Causes of Depreciation
17

Obsolescence. Due to invention of new technology, Some asset

are obsolete compare to new and up-to-date asset
Accidents. Accidents may also cause a permanent fall in the
useful life as well as in the value of assets.
Permanent fall in price. A permanent fall in the market value of
investments is recorded as depreciation. Other assets are
depreciated on the basis of its useful life.
 Significance of Depreciation
18

 Economic depreciation measures the expected

decline in the real market value of the asset each
period
 Depreciation lowers taxes using
 Taxes=(income-deduction)(tax rate)
 Objectives of Providing Depreciation
19

 To ascertain the true and fair profits

 To show the asset at its proper value
 To make arrangement of funds for replacement of
fixed asset
 Ascertaining accurate cost of production
 To comply with legal provisions
 To avail tax benefits
 FACTORS AFFECTING THE DEPRECIATION
20

 Cost of Asset
 Useful Life of the Asset
 Scrap Value
 Depreciable value of asset
 historical cost
 Depreciation Amounts
21

 Tax law states that: Any productive asset with a finite life
must be depreciated for tax purposes.
 Depreciation amounts represents a prorated amount per
year that can be treated as an expense(deduction) but is
not a real cash flow.
 It represents a form of tax savings to a profitable firm
 Important Terms in depreciation
22

 Book Value(BV)-remaining capital investment at the

end of the year after applying the depreciation. It is
the value of an asset at a certain time less the
accumulated depreciation. It become the salvage value
directly after its useful life.
 Market Value(MV)-amount of an asset in an open
market
 Salvage Value(S)- estimated trade-in value at the end
of the asset’s life
 First Cost(F)-initial purchase price and all the incurred
cost in placing the asset
 Important Terms in depreciation
23

 Recovery Period(n)-depreciable life of the asset

 Depreciation rate(d)- fraction of the first cost
remove each year
 Personal Property- all property except real
property
 Real Property- real estate, improvements, buildings
and other structures
 4.2 Depreciation
24

 There are two different purposes for using the depreciation

methods

 Book depreciation Used by a corporation or business for

internal financial accounting to track the value of an asset or
property over its life.

 Tax depreciation Used by a corporation or business to

determine taxes due based on current tax laws of the
government entity (country, state, province, etc.). Even though
depreciation itself is not a cash flow, it can result in actual
cash flow changes because the amount of tax depreciation
is a deductible item when calculating annual income taxes
for the corporation or business.
 Methods of Depreciation
25

1. Straight line method of depreciation

2. Declining balance method of depreciation
3. Sum of the years-digits method of depreciation
4. Sinking-fund method of depreciation
5. Service output method of depreciation
 4.2.1. Straight line method of depreciation
26

 The straight-line method is typically used to calculate an

average decline in value over a period of time.
 In this method of depreciation, a fixed sum is charged as the
depreciation amount throughout the lifetime of an asset such
that the accumulated sum at the end of the life of the asset is
exactly equal to the purchase value of the asset.
 Here, we make an important assumption that inflation is absent.
 Straight-line depreciation is a very common, and the simplest,
method of calculating depreciation expense. In straight-line
depreciation, the expense amount is the same every year over
the useful life of the asset.
 4.2.1. Straight line method of depreciation
27

 Straight line depreciation derives its name from the fact that the
book value decreases linearly with time.
 The depreciation rate is the same (1/n) each year of the recovery
period n.
 Straight line depreciation is considered the standard against which
any depreciation model is compared.
 For book depreciation purposes, it offers an excellent representation
of book value for any asset that is used regularly over an estimated
number of years.
 4.2.1. Straight line method of depreciation
28

The formulae for depreciation and book value are as follows:

(𝑷;𝑭)
Dt =
𝒏
Bt = Bt–1 – Dt =
= Bt–1 – [(P – F)/n]
= P – t x [(P – F)/n]

P = first cost of the asset,

F = salvage value of the asset,
n = life of the asset,
Bt = book value of the asset at the end of the period t,
Dt = depreciation amount for the period t.
 4.2.1. Straight line method of depreciation
29

 Example 2: A company has purchased an equipment whose first

cost is $100,000 with an estimated life of eight years. The
estimated salvage value of the equipment at the end of its lifetime
is $20,000. Determine the depreciation charge and book value at
the end of various years using the straight line method of
depreciation.
 P = $ 100,000 F = $ 20,000 n = 8 years
 Dt = (P – F)/n = (100,000 – 20,000)/8 = $10,000
 In this method of depreciation, the value of Dt is the same for all the
years. The calculations pertaining to Bt for different values of t are
summarized in Table below
 4.2.1. Straight line method of depreciation
30

End of year Depreciation Book value (Bt)

(t) (Dt) (Bt = Bt–1 – Dt )

0 - 100,000
1 10000 90,000
2 10000 80,000
3 10000 70,000
4 10000 60,000
5 10000 50,000
6 10000 40,000
7 10000 30,000
8 10000 20,000
If we are interested in computing Dt and Bt for a specific period (t), the
formulae can be used.
In this approach, it should be noted that the depreciation is the same for all
the periods.
 4.2.1. Straight line method of depreciation
31

 Example 3: Consider Example 2 and compute the depreciation and the

book value for period 5.
 P = $ 100,000 F = $ 20,000 n = 8 years
 D5 = (P – F)/n = (100,000 – 20,000)/8
= $ 10,000 (This is independent of the time period.)
 Bt = P – t (P – F)/n
B5 = 1,00,000 – 5 (1,00,000 – 20,000)/8
 = Rs. 50,000
 4.2.2. Declining balance method of depreciation
32

 Declining balance is also known as the fixed percentage or

uniform percentage method.
 In this method of depreciation, a constant percentage of the book
value of the previous period of the asset will be charged as the
depreciation amount for the current period.
 This approach is a more realistic approach, since the depreciation
charge decreases with the life of the asset which matches with the
earning potential of the asset.
 The book value at the end of the life of the asset may not be
exactly equal to the salvage value of the asset. This is a major
limitation of this approach.
 4.2.2. Declining balance method of depreciation
33

 The formulae for depreciation and book value are

as follows:

P = first cost of the asset, F = salvage value of the asset,

n = life of the asset, K = a fixed percentage, and
Bt = book value of the asset at the end of the period t,
Dt = depreciation amount at the end of the period t.
 4.2.2. Declining balance method of depreciation
34

 The actual formulae for the depreciation rate for each year t,
and Book value in year t is determined in terms of P are as
follows:

 While availing income-tax exception for the depreciation

amount paid in each year, the rate K is limited to at the most
2/n. If this rate is used, then the corresponding approach is
called the double declining balance method of depreciation.
 4.2.2. Declining balance method of depreciation
35

 Example 4: Consider Example2 and demonstrate the

calculations of the declining balance method of depreciation
by assuming 0.2 for K.
P = $ 100,000 F = $ 20,000 n = 8 years K = 0.2
The calculations pertaining to Dt and Bt for different values of
t are summarized in Table below using the following formulae:
 4.2.2. Declining balance method of depreciation
36

 Dt and Bt according to Declining Balance Method of Depreciation

End of years Book value
(n) Depreciation (Dt) (Bt)
0 100,000
1 20,000 80,000
2 16,000 64,000
3 12,800 51,200
4 10,240 40,960
5 8,192 32,768
6 6,554 26,214
7 5,243 20,972
8 4,194 16,777
 4.2.2. Declining balance method of depreciation
37

 Example 5: Consider Example 2, and calculate the depreciation

and the book value for period 5 using the declining balance
method of depreciation by assuming 0.2 for K.
 Solution

P = $ 100,000 F = $ 20,000 n = 8 years K = 0.2

 4.2.3 Sum-of-the-Years-Digits Method of Depreciation
38

 In this method of depreciation also, it is assumed that the book value of

the asset decreases at a decreasing rate. If the asset has a life of eight
years, first the sum of the years is computed as
Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8
𝑛(𝑛:1)
= 36 =
2
 The rate of depreciation charge for the first year is assumed as the
highest and then it decreases.
 The rates of depreciation for the years 1–8, respectively are as follows:
8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.
 For any year, the depreciation is calculated by multiplying the
corresponding rate of depreciation with (P – F).
 4.2.3 Sum-of-the-Years-Digits Method of Depreciation
39

 Dt = Rate x (P – F)

 The formulae for Dt and Bt for a specific year t are as follows:

 4.2.3 Sum-of-the-Years-Digits Method of Depreciation
40

 Example 6: Consider Example 2 and demonstrate the calculations of

the sum-of-the-years-digits method of depreciation.
 Solution
P = $ 100,000 F = $ 20,000 n = 8 years
𝑛(𝑛:1) 8∗9
Sum = = = 36
2 2
 The rates for years 1- 8, are respectively 8/36, 7/36, 6/36, 5/36, 4/36, 3/36,
2/36 and 1/36.
 The calculations of Dt and Bt for different values of t are
summarized in Table using the following formula:
 4.2.3 Sum-of-the-Years-Digits Method of Depreciation
41

End of Book value

years (n) Depreciation (Dt) (Bt)
0 100,000.00
1 17,777.77 82,222.23
2 15,555.55 66,666.68
3 13,333.33 53,333.35
4 11,111.11 42,222.24
5 8,888.88 33,333.36
6 6,666.66 26,666.70
7 4,444.44 22,222.26
8 2,222.22 20,000.04
If we are interested in calculating Dt and Bt for a specific t, then the usage
of the formulae would be better.
 4.2.3 Sum-of-the-Years-Digits Method of Depreciation
42

 Example 7: Consider Example 2 and find the depreciation and

book value for the 5th year using the sum-of-the-years-digits
method of depreciation.
 Solution
P = $ 100,000 F = $ 20,000 n = 8 years
 4.2.4 Sinking Fund Method of Depreciation
43

 In this method of depreciation, the book value

decreases at increasing rates with respect to the life
of the asset.
 Let:
P = first cost of the asset,
F = salvage value of the asset,
n = life of the asset,
i = rate of return compounded annually,
A = the annual equivalent amount,
Bt = the book value of the asset at the end of the period t, and
Dt = the depreciation amount at the end of the period t.
 4.2.4 Sinking Fund Method of Depreciation
44

 The loss in value of the asset (P – F) is made available an the form of

cumulative depreciation amount at the end of the life of the asset by
setting up an equal depreciation amount (A) at the end of each period
during the lifetime of the asset.
A = (P – F)x[A/F, i, n]
 The fixed sum depreciated at the end of every time period earns an
interest at the rate of i% compounded annually, and hence the actual
depreciation amount will be in the increasing manner with respect to
the time period. A generalized formula for Dt is
Dt = (P – F)x(A/F, i, n)x(F/P, i, t – 1)
 The formula to calculate the book value at the end of period t is
Bt = P – (P – F) (A/F, i, n) (F/A, i, t)
 4.2.4 Sinking Fund Method of Depreciation
45

 The above two formulae are very useful if we have to calculate

Dt and Bt for any specific period. If we calculate Dt and Bt for all
the periods, then the tabular approach would be better.
 Example 8: Consider Example2 and give the calculations

regarding the sinking fund method of depreciation with an

interest rate of 12%, compounded annually.
 Solution

P = $ 100,000 F = $ 20,000 n = 8 years i = 12%

A = (P – F)x[A/F, 12%, 8]
= (100,000 – 20,000) 0.0813
= $ 6,504
 4.2.4 Sinking Fund Method of Depreciation
46

 In this method of depreciation, a fixed amount of $ 6,504 will be

depreciated at the end of every year from the earning of the asset.
The depreciated amount will earn interest for the remaining period of
life of the asset at an interest rate of 12%, compounded annually. For
example, the calculations of net depreciation for some periods are as
follows:
Depreciation at the end of year 1 (D1) = $ 6,504.
Depreciation at the end of year 2 (D2) = 6,504 + 6,504x0.12= $7,284.48
Depreciation at the end of the year 3 (D3)
= 6,504 + (6,504 + 7,284.48)x0.12 = $ 8,158.62
Depreciation at the end of year 4 (D4)
= 6,504 + (6,504 + 7,284.48 + 8,158.62)x0.12 = $ 9,137.65
 4.2.4 Sinking Fund Method of Depreciation
47

 These calculations along with book values are summarized in

Table below
End of Fixed Net Depreciation Book value
years (n) Depreciation (Dt) (Bt)
0 6,504 100,000.00
1 6,504 $6,504.00 $93,496.00
2 6,504 $7,284.48 $86,211.52
3 6,504 $8,158.62 $78,052.90
4 6,504 $9,137.65 $68,915.25
5 6,504 $10,234.17 $58,681.08
6 6,504 $11,462.27 $47,218.81
7 6,504 $12,837.74 $34,381.07
8 6,504 $14,378.27 $20,002.80
Bt = Bt–1 – Dt
 4.2.4 Sinking Fund Method of Depreciation
48

 Example 9: Consider Example 2 and compute D5 and B7 using the

sinking fund method of depreciation with an interest rate of 12%,
compounded annually.
 Solution
P = $ 100,000 F = $ 20,000 n = 8 years i = 12%
Dt = (P – F) (A/F, i, n) (F/P, i, t – 1)
D5 = (P – F) (A/F, 12%, 8) (F/P, 12%, 4)
= (1,00,000 – 20,000)x0.0813x1.574 = $10,237.30
 This is almost the same as the corresponding value given in the table.
The minor difference is due to truncation error.
Bt = P – (P – F) (A/F, i, n) (F/A, i, t)
B7 = P – (P – F) (A/F, 12%, 8) (F/A, 12%, 7)
= 1,00,000 – (1,00,000 – 20,000)x0.0813x10.089= 34,381.10
 4.2.5 Service Output Method of Depreciation
49

 In some situations, it may not be realistic to compute depreciation

based on time period. In such cases, the depreciation is computed
based on service rendered by an asset. Let
P = first cost of the asset
F = salvage value of the asset
X = maximum capacity of service of the asset during its lifetime
x = quantity of service rendered in a period.
Then, the depreciation is defined per unit of service rendered:
Depreciation/unit of service = (P – F)/X
𝑃−𝐹
Depreciation for x units of service in a period = 𝑋
x
 4.2.5 Service Output Method of Depreciation
50

 Example 10: The first coat of a road laying machine is $

8,000,000. Its salvage value after five years is $ 50,000. The
length of road that can be laid by the machine during its lifetime is
75,000 km. In its third year of operation, the length of road laid is
2,000 km. Find the depreciation of the equipment for that year.
 Solution

P = $ 80,00,000 F = $ 50,000 X = 75,000 km x = 2,000 km

𝑃−𝐹
Depreciation for x units of service in a period = 𝑋
x
80,00,000−50,000
Depreciation for year 3 = 75,000
(2,000)= $ 212,000
 Exercises
51

1) Define the following:

(a) Depreciation
(b) Book value

2. Distinguish between declining balance method of depreciation and

double declining balance method of depreciation.

3. The Alpha Drug Company has just purchased a capsulation machine for
Rs. 2,000,000. The plant engineer estimates that the machine has a useful
life of five years and a salvage value of Rs. 25,000 at the end of its
useful life. Compute the depreciation schedule for the machine by each of
the following depreciation methods:
(a) Straight line method of depreciation
(b) Sum-of-the-years digits method of depreciation
(c) Double declining balance method of depreciation
 Exercises
52

4. A company has recently purchased an overhead travelling crane for Rs.

2,500,000. Its expected life is seven years and the salvage value at the
end of the life of the overhead travelling crane is Rs. 100,000. Using the
straight line method of depreciation, find the depreciation and the book
value at the end of third and fourth year after the crane is purchased.

5. An automobile company has purchased a wheel alignment device for

Rs. 1,000,000. The device can be used for 15 years. The salvage value at
the end of the life of the device is 10% of the purchase value. Find the
following using the double declining balance method of depreciation:
(a) Depreciation at the end of the seventh year
(b) Depreciation at the end of the twelfth year
(c) Book value at the end of the eighth year
 Exercises
53

6) A company has purchased a bus for its officers for Rs. 10,00,000. The
expected life of the bus is eight years. The salvage value of the bus at the
end of its life is Rs. 1,50,000. Find the following using the sinking fund
method of depreciation:
(a) Depreciation at the end of the third and fifth year
(b) Book value at the end of the second year and sixth year

7) Consider Problem 4 and find the following using the sum-of-the-years

digits method of depreciation:
(a) Depreciation at the end of the fourth year
(b) Depreciation at the end of the seventh year
(c) Book value at the end of the fifth year
(d) Book value at the end of the eighth year
 Exercises
54

8) A company has purchased a Xerox machine for Rs. 2,00,000. The

salvage value of the machine at the end of its useful life would be
insignificant. The maximum number of copies that can be taken during
its lifetime is 1,00,00,000. During the fourth year of its operation, the
number of copies taken is 9,00,000. Find the depreciation for the
fourth year of operation of the Xerox machine using the service output
method of depreciation.
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