INTRODUCTION

WHY DO ENGINEERS NEED TO LEARN ABOUT ECONOMICS?

Ages ago, the most significant barriers to engineers were technological. The things
that engineers wanted to do, they simply did not yet know how to do, or hadn't yet
developed the tools to do. There are certainly many more challenges like this which face
present-day engineers. However, we have reached the point in engineering where it is no
longer possible, in most cases, simply to design and build things for the sake simply of
designing and building them. Natural resources (from which we must build things) are
becoming scarcer and more expensive. We are much more aware of negative side-effects
of engineering innovations (such as air pollution from automobiles) than ever before.

For these reasons, engineers are tasked more and more to place their project ideas
within the larger framework of the environment within a specific planet, country, or
region. Engineers must ask themselves if a particular project will offer some net benefit
to the people who will be affected by the project, after considering its inherent benefits,
plus any negative side-effects (externalities), plus the cost of consuming natural
resources, both in the price that must be paid for them and the realization that once they
are used for that project, they will no longer be available for any other project(s).

Simply put, engineers must decide if the benefits of a project exceed its costs, and
must make this comparison in a unified framework. The framework within which to
make this comparison is the field of engineering economics, which strives to answer
exactly these questions, and perhaps more.

―Engineering is the profession in which a knowledge of the mathematical and

natural sciences gained by study, experience, and practice is applied with judgment to
develop ways to utilize, economically, the materials and forces of nature for the benefit of
mankind‖

- Accreditation Board for Engineering and Technology (ABET)

It should be clear from this discussion that consideration of economic factors is as

important as regard for the physical laws and science that determine what can be
accomplished with engineering.

8
 The following figure shows how engineering is composed of physical and
economic components:

Figure 1 : Physical and Economic Components of an Engineering System

1. Physical Environment: Engineers produce products and services depending on

physical laws (e.g. Ohm's law; Newton's law).

Physical efficiency takes the form:

2. Economic Environment: Much less of a quantitative nature is known about

economic environments -- this is due to economics being involved with the actions
of people, and the structure of organizations.

Satisfaction of the physical and economic environments is linked through

production and construction processes. Engineers need to manipulate systems to
achieve a balance in attributes in both the physical and economic environments,
and within the bounds of limited resources. Following are some examples where
engineering economy plays a crucial role:

9
 1. Choosing the best design for a high-efficiency gas furnace
2. Selecting the most suitable robot for a welding operation on an automotive
assembly line
3. Making a recommendation about whether jet airplanes for an overnight
delivery service should be purchased or leased
4. Considering the choice between reusable and disposable bottles for high-
demand beverages

With items 1 and 2 in particular, note that coursework in engineering should

provide sufficient means to determine a good design for a furnace, or a suitable
robot for an assembly line, but it is the economic evaluation that allows the further
definition of a best design or the most suitable robot.

In item 1 of the list above, what is meant by ―high-efficiency"? There are two
kinds of efficiency that engineers must be concerned with. The first is physical
efficiency, which takes the form:

For the furnace, the system outputs might be measured in units of heat energy, and
the inputs in units of electrical energy, and if these units are consistent, then physical
efficiency is measured as a ratio between zero and one. Certain laws of physics (e.g.,
conservation of energy) dictate that the output from a system can never exceed the input
to a system, if these are measured in consistent units. All a particular system can do is
change from one form of energy (e.g. electrical) to another (e.g., heat). There are losses
incurred along the way, due to electrical resistance, friction, etc., which always yield
efficiencies less than one. In an automobile, for example, 10-15% of the energy supplied
by the fuel might be consumed simply overcoming the internal friction of the engine. A
perfectly efficient system would be the theoretically impossible Perpetual Motion
Machine!

The other form of efficiency of interest to engineers is economic efficiency, which

takes the form:

10
 You might have heard economic efficiency referred to as "benefit-cost ratio". Both
terms of this ratio are assumed to be of monetary units, such as dollars. In contrast to
physical efficiency, economic efficiency can exceed unity, and in fact should, if a project
is to be deemed economically feasible. The most difficult part of determining economic
efficiency is accounting for all the factors which might be considered benefits or costs of
a particular project, and converting these benefits or costs into a monetary equivalent.
Consider for example a transportation construction project which promises to reduce
everyone's travel time to work. How do we place a value on that travel time savings? This
is one of the fundamental questions of engineering economics.

In the final evaluation of most ventures, economic efficiency takes precedence

over physical efficiency because projects cannot be approved, regardless of their physical
efficiency, if there is no conceived demand for them amongst the public, if they are
economically infeasible, or if they do not constitute the "wisest" use of those resources
which they require.

ECONOMICS

- A social science that studies how individuals, governments, firms and nations
make choices on allocating scarce resources to satisfy their unlimited wants.
Economics can generally be broken down into: macroeconomics, which
concentrates on the behavior of the aggregate economy; and microeconomics,
which focuses on individual consumers.

- Economics is often referred to as "the dismal science."

FUNDAMENTAL ECONOMIC CONCEPTS

Economics deals with the behavior of people, and as such, economic concepts are
usually qualitative in nature, and not universal in application.

VALUE

 Designates the worth that a person attaches to an object or service.

 Is a measure or appraisal of utility in some medium of exchange.
 Is not the same as cost or price.

11
CONSUMER AND PRODUCER GOODS

1. Consumer goods: Consumer goods are the goods and services that directly satisfy
human wants. For example, TV, shoes, houses.
2. Producer goods: Producer goods are the goods and services that satisfy human
wants indirectly as a part of the production or construction process. For example,
factory equipment, industrial chemicals and materials.

UTILITY

 Utility is the power of a good or service to satisfy human needs.

UTILITY OF GOODS

1. Consumer goods: Basic human needs of food, clothing and shelter. In

commercial advertisements, emphasis is given to senses not reasoning. The utility
in this case is considered objectively and/or subjectively.
2. Producer goods: The utility stems for their means to get to an end. The utility in
this case is considered objectively.

DEMAND
An economic principle that describes a consumer's desire and willingness to pay a
price for a specific good or service. Holding all other factors constant, the price of a good
or service increases as its demand increases and vice versa.

Think of demand as your willingness to go out and buy a certain product. For
example, market demand is the total of what everybody in the market wants.

Businesses often spend a considerable amount of money in order to determine the

amount of demand that the public has for its products and services. Incorrect estimations
will either result in money left on the table if it's underestimated or losses if it's
overestimated.

12
LAW OF DEMAND

The law of demand states that other factors being constant (cetris peribus), price
and quantity demand of any good and service are inversely related to each other. When
the price of a product increases, the demand for the same product will fall.
It explains consumer choice behavior when the price changes. In the market,
assuming other factors affecting demand being constant, when the price of a good rises, it
leads to a fall in the demand of that good. This is the natural consumer choice behavior.
This happens because a consumer hesitates to spend more for the good with the fear of
going out of cash.

The above diagram shows the demand curve which is downward sloping. Clearly
when the price of the commodity increases from price p3 to p2, then its quantity demand
comes down from Q3 to Q2 and then to Q3 and vice versa.

ELASTICITY

The degree to which a demand or supply curve reacts to a change in price is the
curve's elasticity. Elasticity varies among products because some products may be more
essential to the consumer. Products that are necessities are more insensitive to price
changes because consumers would continue buying these products despite price
increases. Conversely, a price increase of a good or service that is considered less of a
necessity will deter more consumers because the opportunity cost of buying the product
will become too high.

A good or service is considered to be highly elastic if a slight change in price leads

to a sharp change in the quantity demanded or supplied. Usually these kinds of products
13
are readily available in the market and a person may not necessarily need them in his or
her daily life. On the other hand, an inelastic good or service is one in which changes in
price witness only modest changes in the quantity demanded or supplied, if any at all.
These goods tend to be things that are more of a necessity to the consumer in his or her
daily life.

To determine the elasticity of the supply or demand curves, we can use this simple
equation:
Elasticity = (% change in quantity / %
change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If

it is less than one, the curve is said to be inelastic.

As we mentioned previously, the demand curve is a negative slope, and if there is

a large decrease in the quantity demanded with a small increase in price, the demand
curve looks flatter, or more horizontal. This flatter curve means that the good or service
in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as

quantity changes little with a large movement in price.

14
 Elasticity of supply works similarly. If a change in price results in a big change in
the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity
in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the
quantity supplied, the supply curve is steeper and its elasticity would be less than one.

SUPPLY

Supply refers to the amount of a product that producers and firms are willing to
sell at a given price all other factors being held constant. Usually, supply is plotted as
a supply curve showing the relationship of price to the amount of product businesses are
willing to sell.

LAW OF SUPPLY

Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price paid
by buyers for a good rises, then suppliers increase the supply of that good in the market.
Law of supply depicts the producer behavior at the time of changes in the prices of
15
goods and services. When the price of a good rises, the supplier increases the supply in
order to earn a profit because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive
relation between the price and the quantity supplied). When the price of the good was at
P3, suppliers were supplying Q3 quantity. As the price starts rising, the quantity supplied
also starts rising.

LAW OF SUPPLY AND DEMAND

A theory explaining the interaction between the supply of a resource and the
demand for that resource. The law of supply and demand defines the effect that the
availability of a particular product and the desire (or demand) for that product has on
price. Generally, if there is a low supply and a high demand, the price will be high. In
contrast, the greater the supply and the lower the demand, the lower the price will be.

The law of supply and demand is not an actual law but it is well confirmed and
understood realization that if you have a lot of one item, the price for that item should go
down. At the same time you need to understand the interaction; even if you have a high
supply, if the demand is also high, the price could also be high. In the world of stock
investing, the law of supply and demand can contribute to explaining a stock’s price at
any given time. It is the base to any economic understanding.

16
 The Law of Supply The Law of Demand
states that at higher prices, producers states that people will buy more of a product
are willing to offer more products for at a lower price than at a higher price, if
sale than at lower prices nothing changes

states that the supply increases as prices states that at a lower price, more people can
increase and decreases as prices afford to buy more goods and more of an item
decrease more frequently, than they can at a higher
price
states that those already in business will
try to increase productions as a way of states that at lower prices, people tend to buy
some goods as a substitute for others more
increasing profits
expensive

17
 PRESENT ECONOMY

1 SOURCE: Engineering Economy, 3rd edition, Matias Arreola

Present Economy involves the analysis of problems for manufacturing a product
or rendering a service based on present or immediate costs.

Present economy studies occur in the following situation:

1. SELECTION OF MATERIALS

- In manufacturing a product, it usually happens that two or more materials are

available and such materials will be equally satisfactory.

Example:
A machine part to be machined may be either from an alloy of aluminum or steel.
There is an order for 8, 000 if steel is used, the steel per unit weighs 110 grams; for
aluminum, 30g. When steel is used, 50 units can be produced per hour; for aluminum,
80 units per hour with the aid of a tool costing P640.00 which will be useless after the
8, 000 units are finished. The cost of the machine and operator is P10.80 per hour. If
all other costs are identical, determine which material will be more economical.

Solution:
Steel Aluminum
Material Cost 110 (3.8) = P0.418 30 (8.7) =P 0.261
1, 000 1, 000
Labor & machine 10.8 = 0.216 10.80 = P 0.135
50 80
Tool - --- 640 = P0.080
8,000
Cost per piece P0.634 P0.476
Cost of 8, 000 units P 5, 072 P 3.808

Aluminum is cheaper!...... ans.

18
2. SELECTION OF METHOD
- In digging ditches or irrigation canals, manual labor or a ditch digging machine
may be used and both methods will give satisfactory results.

Example:
The ore of a gold mine in the Mt. Province contains on the average 0.5 of gold /
ton. One method of processing costs P1650 per ton and recovers 93% of the gold,
while another method costs only P1500 per ton and recovers 81% of the gold. If gold
can be sold at 8500 per gram, which method is better and by how much?
Solution:

First method:
Income = 0.93 (0.5) (8,500) = 3952.50
- Cost = 0.81 (0.5) (8,500) = 1650.00
Net receipt = 2302.50
Second method:
Income = 0.81 (0.5) (8,500) = 3442.50
- Cost = 1,500.00
Net receipt = 1942.50
The first method of processing is better by 360.00!

3. SELECTION OF DESIGN

- In the design of a machine to produce a certain product, the engineer responsible

for the work will usually make as many designs as possible and from which, by a
process of elimination, he will particular care being given to the one which will do the
work with the utmost economy.

Example:
A company manufactures 1, 000, 000 units of a product yearly. A new design of
the product will reduce materials cost by 12% but will increase processing cost by
2%. If materials cost is P1.20 per unit, how much can the company afford to pay for
the preparation of the new design and making changes in equipment?
Solution:
The maximum amount the company should spend should not exceed the savings
they will make on the new design.

19
 Decrease in materials cost = 1, 000, 000 (0.12) (1.20) = 144, 000
- Increase in processing cost = 1, 000, 000 (0.02) (0.40) = 8, 000
Net savings on new design P136,000

4. SITE SELECTION
- In the choice of factory site many factors are to be considered, among which are
the cost of the land, the construction cost at the different possible sides, the availability of
skilled labor, and many other factors.

Example:
A certain masonry dam requires 200, 000.00 of gravel for its construction the
contractor found two possible sources for the gravel with the following data:
Source A Source B
Average distance, gravel pit to dam site 3km 1.2km
Gravel cost/cu.m. at pit ---- 10.00
Purchase price of pit P800,000 ------
Road construction necessary P450,000 NONE
Overburden to be removed at 4.20/cu.m ---- 900,000cu.m.
Hauling cost per cu.m. per km P4.00 P4.00
Which of the two sites wiil give lesser cost?
Solution:
Cost of 200, 000 cu.m. of gravel, source A
Purchase price of gravel pit 800, 000
Road construction 450, 000
Hauling = 200,000(3)(4.00) 2,400,000
Total cost P3, 650,000
Cost of 200,000 cu.m., source B:
Cost of gravel of pit = 200,000(10.00) 2,000,000

20
 Removal of overburden = 90,000(4.20) 378,000
Hauling = 200,000(1.2)(4.00) 960,000
Total cost 3, 338,000
SOURCE B is cheaper by 312,000...

5. COMPARISON OF PROFFICIENCY OF WORKERS

- In industrial operations where the efficiency of workers is a factor affecting

costs, it is usually observed that workers have varying efficiencies.
Example:
Two workers, A&B, produce the same product on identical machine A receives
P25.00/hr and he produces 100units /hr. the machine rate or cost of operation of the
machines usd by them is P100.00/hr (a) determine the cost per piece for worker A (b)
determine the hourly wage of worker B in order that his cost will equal that of A.
Solution:
(a) Cost per piece for worker A = (25.00+ 100.00)/100 = 1.25
(b) let w= wage of worker B/hr so that his cost per piece is equal to that of A. then,
(w + 100.00)/120 = 1.25
W= 50.00
Note that a 20% increase (20units) in production per hr entitles workers B to an increase
in hourly wage equivalent to [(50.00 – 25.00)/25.00 (100)] = 100%

6. ECONOMY OF TOOL & EQUIPMENT MAINTENCE

- In many activities, tools have to be sharpened from time to time and equipment
have to be kept in optimum operating condition all the time.

Example:
A machine used for cutting materials in a factory has the following outputs per hr.
at various speeds and requires periodic tool regrinding at the intervals cited.

21
 SPEED OUTPUT/HR TOOL REGRINDING
A 200 pcs Every 8hrs
B 250 pcs Every 7hrs
C 280 pcs Every 5hrs

A set of tools costs P1800 and can be ground the 20 times. Each regrinding costs
18.00 and the needed to regrind and per hour, including the time the tool is changed. The
tool grinder who also sets the tools to the machine is paid 25.00/ hr. The hourly rate
chargeable against the machine is 54.00, regardless of machine speed. Which speed is the
most economical?

Solution:

Speed A: 200pcs / hr B: 250pcs / hr C: 280pcs/hr

In 8hr: 8(200) = 1600pcs. 7hrs(250)=1750
5hrs(280)=1400
Cost of production:
Tool cost = 1800/20 = 90.00 90.00 90.00
Regrinding cost = 18.00 18.00 18.00
Wage of machine operation (8+1)(28.00) = 252.00 224.00 168.00
Wage of tool grinder 1(25.00) = 25.00 25.00 270.00
Machine cost = 8(54) = 432.00 378.00 25.00
817.00 735.00 571.00
Cost/ piece = total/ prod. = 0.5106 0.420 0.4079

The foregoing comparative analysis that speed C is the most economical...

7. ECONOMY IN THE UTILIZATION OF PERSONNEL

- In many industrial operations it is observed that a certain number of workers

cooperating on a specific phase of the work will lead to the highest productivity.

Example:
A man decided to paint his house himself after office hours. He can paint 25
sq.m./hr or the average. It takes him 15 minutes to prepare his materials and 20 minutes

22
to keep the materials after painting. If there are 900 sq. m. to paint his house if he devotes
2 ½ hours each day?

Solution:
No. of hrs required: 900 = 25 hrs
25
Net time daily devoted to actual painting = 2.5 – 15 + 20 = 192 hrs
60
No. of days = 36 = 18.8 say 19 days
1.92

2 SOURCE: Engineering Economy, 15th Edition, William G. Sullivan

RULE 1: When revenues and other economic benefits are present and vary among
alternatives, choose the alternatives that maximizes overall profitability based on the
number of defect- free units of a product or service produced.

RULE 2: When revenues and other economic benefits are not present or are constant
among all alternatives, consider only the costs and select the alternative that minimizes
total cost per defect- free unit of a product or service output.

TOTAL COST IN MATERIAL SELECTION

- In many cases, economic selection among materials cannot be based solely on the
costs of materials.

Example:
A good example of this situation is illustrated by a part for which annual demand
is 100,000 units. The part is produced on a high-speed turret lathe, using 1112 screw-
machine steel costing $0.30 per pound. A study was conducted to determine whether it
23
might be cheaper to use brass screw stock, costing $1.40 per pound. Because the weight
of steel required per piece was 0.0353 pounds and that of brass was 0.0384 pounds, the
material cost per piece was $0.0106 for steel and $0.0538 for brass. However, when the
manufacturing engineering department was consulted, it was found that, although 57.1
defect-free parts per hour were being produced by using steel, the output would be 102.9
defect-free parts per hour if brass were used. Which material should be used for this part?

Solution:
The machine attendant was paid $15.00 per hour, and the variable (i.e., traceable)
overhead costs for the turret lathe were to be $10.00 per hour. Thus, the total cost
comparison for the two materials was as follows:
1112 Steel Brass
Material $0.30 x 0.0353 = $ 0.0106 $1.40 x 0.0384 = $0.0538
Labor $15.00 / 57.1 = 0.2627 $15.00 / 102.9 = 0.1458
Variable overhead $10.00 / 57.1 = 0.1751 $10.00 / 102.9 = 0.0972
Total cost per piece $0.4484 $0.2968
Saving per piece by use of brass = $0.4484 - $0.2968 = $0.1516

Because 100,000 parts are made each year, revenues are constant across the
alternatives. Rule 2 would select brass, and its use will produce a savings of $151.60 per
thousand (a total of $15, a 160 for the year). It is also clear that other than the cost of
material were important in the study.

MAKING VERSUS PURCHASING (OUTSOURCING) STUDIES

- In the short run, say, one year or less, a company may consider producing an item
in-house even though the item can be purchased from a supplier at a price lower
than the company’s standard production costs. This could occur if (1) direct,
indirect, and overhead costs are incurred regardless of whether the item is
purchased from an outside supplier and (2) the incremental cost of producing an
item in the short run is less than the supplier’s price. Therefore, the relevant short-
run costs of make versus purchase decisions are the incremental costs incurred and
the opportunity costs of the resources involved.
24
Example:
A manufacturing plant consists of three departments: A, B and C. Department A
occupies 100 sq.m. in one corner of the plant. Product X is one of several products being
produced in Department A. the daily production of Product X is 576 pieces. The cost
accounting records show the following average daily production costs for Product X:

Direct labor (1 operator working 4hrs $120.00

per day at $22.50 / hr,
including fringe benefits,
plus a part-time foreman
at $30 per day)
Direct material 86.40
Overhead (at $0.82 per sq.m. of floor 82.00
area)
Total cost per day = $288.40

The department foreman has recently learned about an outside company that sells
Product X at $0.35 per piece. Accordingly, the foreman figured a cost per day of
$0.35(576) = $201.60, resulting in a daily savings of $288.40 - $201.60 = $86.80.
Therefore, a proposal was submitted to the plant manager for shutting down the
production line of Product X and buying it from the outside company.

Solution:
If the manufacture of Product X is discontinued, the firm will save at most $90.00
in direct labor, $86.40 in direct materials, and $3.00 in variable overhead costs, which
totals $179.40 per day. This estimate of actual cost savings per day is less than the
potential savings indicated by the cost accounting records ($288.40 per day), and it would
not exceed the $201.60 to be paid to the outside company if Product X is purchased. For
this reason, the plant manager used Rule 2 and rejected the proposal of the foreman and
continued the manufacture of Product X.

25
TRADE- OFFS IN ENERGY EFFICIENCY STUDIES

It explains how the annual expenses of operating an electrical device is calculated

and traded off against capital investment cost.

Example:
Two pumps capable of delivering 100hp to an agricultural application are being
evaluated in a present economy study. The selected pump will only be utilized for one
year, and it will have no market value at the end of the year. Pertinent data are
summarized as follows:
ABC Pump XYZ Pump
Purchase price $2,900 $6,200
Annual maintenance $170 $510
Efficiency 80% 90%

If electric power costs $0.10 per kWh and the pump will be operated 4,000 hrs. per
year, which pump should be chosen? Recall that 1hp = 0.746 kW.

Solution:
The annual expense of electric power for the ABC pump is
(100hp / 0.80)(0.746 kW / hp)(4,000 hrs / yr) = $37,300.
For the XYZ Pump, the annual cost of owning and operating the ABC pump is
$40,370, while the total cost of owning and operating the XYZ pump for one year is
$39,886. Consequently, the more energy- efficient XYZ pump should be selected to
minimize total annual cost. Notice the difference in annual energy expense ($4,144) that
results from a 90% efficient pump relative to an 80% efficient pump. This cost reduction
more than balances the extra $3,300 in capital investment and $340 in annual
maintenance required for the XYZ pump.

26
 3 SOURCE: Engineering Economy, 3rd Edition, Hipolito Sta. Maria

SELECTIONS IN PRESENT ECONOMY

There are many cases in engineering economy studies where interest is not a
factor, these studies are frequently called present economy problems. Such studies
usually involve the selection between alternative designs, materials, or methods.

Example:
An electrical contractor has a job which should be completed in 100 days. At
present, he has 80 men n the job and it is estimated that they will finish the work in 130
days. If of the 80 men, 50 are paid P190 a day. 25 at P220 a day and 5 at P300 a day and
if for each day beyond the original 100 days, the contractor has to pay P2.00 liquidated
damages:
(a) How many more men should the contractor add so he can complete the work on time?
(b) If the additional men of 5 are paid P220 a day and the rest at P190 a day, would the
contractor save money by employing more men and not paying the fine?

Solution:
(a) Let x = number of men to be added to complete the job on time

Equating man – days, we have

(x + 80) (100) = (80) (130)

x = 24 men

27
(b) 80 men on the job:
Wages: (50) (P190) (130) = P 1, 235, 000
(25) (220) (130) = 715, 000
(5) (P300) (130) = 195, 000

Damages: (P 2, 0000) (130) = 60, 000

Total expense P 2, 205, 000
104 men on the job:
Wages: (50 + 19) (P190) (100) = P 1, 311, 000
(25 + 5) (220) (100) = 660, 000
(5) (P300) (100) = 150, 000
Total expense = P2, 121, 000
Saving by employing more men
= P 2, 205, 000 - P2, 121, 000
= P 84, 000 ans.

28
 INTEREST

1 SOURCE: Engineering Economy, 15th edition, William G. Sullivan

SIMPLE INTEREST
When the total earned or changed is linearly proportion to the initial amount of the
loan (principal), the interest rate, and the number of interest periods for which the
principal is committed, the interest and interest rate is said to be simple. Simple interest is
not used frequently in modern commercial practice.

I = (P) (N) (i)

Where, P = principal amount lent or borrowed;
N = number of interest periods (e.g., years)
i = interest rate per interest period.

Example:
The total amount repaid at the end of N interest periods is P + I. Thus, if $1,000
were loaned for 3 years at a simple interest rate of 10% per year, the interest earned
would be
I = $1,000 x 3 x 0.10 = $300.

COMPOUND INTEREST
Whenever the interest charge for any interest period (a year, for example) is based
on the remaining principal amount plus any accumulated interest charges up to the
beginning of that period, the interest is said to be compound.

29
Period (1) (2) = 1 x 10% (3) = 1 + 2
Amount Owned at Interest Amount Amount Owned
Beginning of
For Period At End of Period
Period
1 $1,000 $100 $1,100
2 $1,100 $110 $1210
3 $1,200 $121 $1,331

2 SOURCE: Engineering Economy, Hipolito Sta. Maria, 3rd Edition

INTEREST is the amount of money paid for the use of borrowed capital or the
income produced by money which has been loaned.

SIMPLE INTEREST:
Simple interest is calculated using the principal only, ignoring any interest that had
been accrued in preceding periods. In practice, simple interest is paid on short-term loans
in which the time of the loan is measured in days.

I = Pin
F = P=I = P + Pin
F = P(1 + in)

Where: I = interest
P = principal or present worth
n = # of interest periods
i = rate of interest per interest period
F = accumulated amount or future worth
(a) Ordinary simple interest is computed on the basis of 12 months of 30 days each or
360 days a year.

30
 1 interest period = 360 days
Exact simple interest is based on the exact # of days in a year. 365 days for an
ordinary year and 366 days for a leap year.
1 interest period = 365 or 366 days

Example:

1. Determine the ordinary simple interest on ₱700 for 8 months and 15 days if the
rate of interest is 15%?

Solution:
# of days = (8)(30) + 15 = 255 days
I = Pin = ₱700 (255/360) X 0.15 = ₱74.38,ans.

2. Determine the exact simple interest on ₱500 for the period from January 10 to
October 28, 1996 at 16% interest.

Solution:
Jan. 10-31 = 21 (excluding Jan. 10) Aug. = 31
Feb. = 29 (1996, leap year braders) Sep. = 30
Mar. = 31 Oct. = 28 (include Oct. 28)
Apr. = 30 292 days
May = 31 Exact simple interest = ₱500(292/366)X
Jun. = 30 0.16 = ₱63.83,ans.
Jul. = 31

31
 3 SOURCE: Engineering Economy, 7th Edition, Leland Blank & Anthony
Tarquin

INTEREST
The terms interest, interest period, and interest rate are useful in calculating
equivalent sums of money for one interest period in the past and one period in the future.
However, for more than one interest period, the terms simple interest and compound
interest become important.

SIMPLE INTEREST

Simple interest is calculated using the principal only, ignoring any interest
accrued in preceding interest periods. The total simple interest over several periods is
computed as

Where I is the amount of interest earned or paid and the interest rate i is expressed
in decimal form.

Example:

Green Tree Financing lent an engineering company $100,000 to retrofit an

environmentally unfriendly building. The loan is for 3 years at 10% per year simple
interest. How much money will the firm repay at the end of 3 years?

32
Solution:
The interest for 3 years is

Total interest for 3 years from Equation is

The amount due after 3 years is

The interest accrued in the first year and in the second year does not earn interest.
The interest due each year is $10,000 calculated only on the $100,000 loan principal.

COMPOUND INTEREST
In most financial and economic analyses, we use compound interest calculations.
For compound interest, the interest accrued for each interest period is calculated
on the principal plus the total amount of interest accumulated in all previous periods.
Thus, compound interest means interest means interest on top of interest.
Compound interest reflects the effect of the time value of money on the interest
also. Now the interest for one period is calculated as

In mathematical terms, the interest It for time period t may be calculated using the
relation.

33
Example:
Assume an engineering company borrows $100,000 at 10% per year compound
interest and will pay the principal and all the interest after 3 years. Compute the annual
interest and total amount due after 3 years. Compare with the previous example that
involved simple interest.

Solution:

To include compounding of interest, the annual interest and total owed each year
are calculated by

Interest, year 1: 100, 000 (0.10) = $10, 000

Total due, year 1: 100, 000 + 10, 000 = $110, 000
Interest, year 2: 110, 000 (0.10) = $11, 000
Total due, year 2: 110, 000 + 11, 000 = $121, 000
Interest, year 3: 121, 000 (0.10) = $12, 100
Total due, year 3: 121, 000 + 12, 100 = $133, 000

The repayment plan requires no payment until year 3 when all interest and the
principal, a total of $133, 100, are due. (a) Simple and (b) compound interest and total
amounts owed. The differences due to compounding are clear. An extra $133,000 –
130,000 = $3100 in interest is due for the compound interest loan.

Note that while simple interest due each year is constant, the compounded interest
due grows geometrically. Due to this geometric growth of compound interest, the
difference between simple and compound interest accumulation increases rapidly as the
time frame increases. For example, if the loan is for 10 years, not 3, the extra paid for
compounding interest may be calculated to be $59, 374.

34
 ANNUITIES

1 SOURCE: Engineering Economy, 3rd edition, Matias Arreola

An annuity consists of a series of equal payments made at equal intervals of time.

Annuities occur in the following instances:

1. Payment of a debt by a series of equal payments at equal intervals of time. This
occurs when goods are bought on the installment plan, the payments which are
usually of the equal amounts paid periodically, usually monthly.

2. Accumulation of a certain amount by setting equal amounts periodically. This

occurs when a person saves equal amounts and deposits these periodically in a
bank; when equal amounts are set aside at equal intervals of time to take care
depreciation of equipment and to provide for their replacement at a definite future
time. Periodic deposits in a sinking fund, equal in amount, are also annuities.

3. Substitution of a series of equal amounts periodically in lieu of a lump sum at

retirement of an individual.

TYPES OF ANNUITIES
Annuities in engineering economy are usually classified into four categories.
These are: (1) ordinary annuity, (2) deferred annuity, (3) annuity due, and (4) perpetuity.
An ordinary annuity is one where the equal payments are made at the end of each
payment period starting from the first period.
A deferred annuity is one where the payment of the first amount is deferred a
certain number of periods after the first.

35
 An annuity due is one where the payments are made at the start of each period,
beginning from the first period.
A perpetuity is an annuity where the payment periods extend forever or in which
the periodic payments continue indefinitely.

ORDINARY ANNUITY
The four essential elements of an ordinary annuity are:
1. The amounts of all payments are equal.
2. The payments are made at equal intervals of time.
3. The first payment is made at the end of the first period and all payments thereafter
are made at the end of the corresponding period.
4. Compound interest is paid on all amounts in the annuity.

Formulas when each payment is ₱A

Let A = amount of each payment of an ordinary annuity
P = present value of the n ₱A payments
F = future worth or accumulated amount of the n ₱A payments.
Then

( ) [ ]

( ) [ ]

Example:
A one – bagger concrete mixer can be purchased with a down payment of ₱8, 000
and equal installments of ₱600 each paid at the end of every month for the next 12
months. If money is worth 12% compounded monthly, determine the equivalent cash
price of the mixer.

36
Solution:
The equivalent cash price of the mixer is the present value of all the payment.
Thus,

₱ ₱ ( )

DEFERRED ANNUITY
If each payment is ₱A, then the present value of the deferred annuity is

( )( )

The accumulated amount F is the same as that for an ordinary annuity.

Example:
A1 = ₱3, 000 is the maintenance cost for each of the first 5 years, and A2 = ₱5, 000
is the annual maintenance cost for each of the last 5 years.
P = the present worth (at time 0) of the various expenditures
= A1 (P/A, 9%, 5) + A2 (P/A, 9%, 5) (P/F, 9%, 5) + ₱8, 000 (P/F, 9%, 4) + 10, 000
(P/F, 9%, 9)
=

= 11, 668.95 + 12, 640.03 + 5, 667.40 + 4, 604.28

= ₱34, 580.66
A = equivalent uniform annual cost
= P ((A/P, i%, n) = ₱34,580.66 (A/P, 9%, 10)
= 5, 388.35 ans.
37
ANNUITY DUE
̅

̅
The future amount, ( , is derived by considering last payment omitted.
Thus,
̅
( )

If each payment is ₱A, then the present value and future amount are, respectively,
̅
̅ ( ) [ ( )]

̅
̅ ( ) [ ( ) ]

Example:
A farmer bought a tractor costing ₱25, 000 payable in 10 semi – annual payments,
each installment payable at the beginning of each period. If the rate of interest is 26%
compounded semi – annually, determine the amount of each installment.

Solution:

̅ [ ( )] * +

38
PERPETUITY
For a perpetuity where the periodic payments are each equal to ₱A, the present
value is

Obviously the future amount is infinite.

Example:
It costs ₱50, 000 at the end of each year to maintain a section of Kennon road in
Baguio City. If money is worth 10%, how much would it pay to spend immediately to
reduce the annual cost to ₱10, 000?

Solution:
The amount that could be spent immediately is the present value of the perpetual
savings of ₱40, 000 each year.

2 SOURCE: Engineering Economy, 15th Edition, William G. Sullivan

Such a uniform series is often called annuity. It should be noted that the
formulas and tables to be presented are derived such that A occurs at the end of each
period, and thus,

39
 1. P (present equivalent value) occurs one interest period before the first A
(uniform amount).
2. F (future equivalent value) occurs at the same time as the last A, and N
periods after P, and
3. A (annual equivalent value) occurs at the end of periods 1 through N,
inclusive.

ORDINARY ANNUITY
All annuity (uniform series) discussed to this point involve the first cash flow
being made at the end of the first period, and they are called ordinary annuities.

DEFERRED ANNUITY
If the cash flow does not begin until some later date, the annuity is known as a
deferred annuity.
The present value at the end of period J of an annuity with cash flows of amount
A is, from A (P/A, i%, N – J). The present equivalent of the single amount A (P/A, i%, N
– J) as of time zero will then be

( ⁄ )( ⁄ )

Example:
To illustrate the preceding discussion, suppose that a father, on the day his son
is born, wishes to determine what lump amount would have to 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.

40
Solution:
The problem is represented in the following cash – flow diagram. One should
first recognize that an ordinary annuity of four withdrawals of $2,000 each is involved
and that the present equivalent of his annuity occurs at the 17th birthday when a (P/A, I%,
N – J) factor is utilized. In this problem, N = 21 and J = 17. It is often helpful to use a
subscript with P to F to denote the respective point in time. Hence,

( )

Money at a given point in time, such as the end of period 17, is the same
regardless of whether it is called a present equivalent or a future equivalent. Hence,

( )

which is the amount that the father would have to deposit on the day his son is born.

3 SOURCE: http://easycalculation.com/finance/learn-annuity.php

WHAT IS ANNUITY?
- It is the method of converting an amount (usually pension sum) into an income for
the rest of our life period. Annuity is one of the retirement strategies.

Factors affecting Annuities

1. Investment amount
2. Gender, age, health
3. Choice of benefit options

41
ANNUITY RATE
The amount of income an annuity provides each year in return for the amount
invested from your pension sum is defined as the annuity rate.

Example:
If the amount invested is $50000 and amount of income provided by annuity is
$5000.

Solution:
Annuity rate=10% that is 10% of $50000= $5000

TYPES OF ANNUITIES
The two basic annuities are
1. Immediate Annuity
2. Deferred Annuity
Each of these annuities is again classified as fixed and variable.

IMMEDIATE ANNUITY
Immediate annuity returns payment immediately after an initial investment is
made. The income starts within one year after the initial investment is made. The
following factors are to be noted while choosing immediate annuity
1. The minimum amount must be $10000
2. The monthly interest rates remain same during the investment period if it is
fixed immediate annuity and interest rates may vary according to annuity progress in case
of variable immediate annuity.

42
Where,
P = Sum to invest
n = Time period (in years)
i = Annual rate of return

DEFERRED ANNUITY
Deferred annuity accumulates money until the investment period and the
accumulated sum is withdrawn during the retirement period. Deferred annuity is suitable
to those who need a steady income after their retirement period. This annuity earning is
tax deferred which means that the tax need not to be paid on all gains during the
investment period. There are three basic types of deferred annuity.
1. Fixed deferred annuity, where the annuity rate remains the same
2. Equity indexed annuity, where the annuity rate may increase based on the rise in
the stock market
3. Variable deferred annuity, where the annuity rate depends on the progress of the
annuity. This is risky because there is a chance of losing principal investment when the
market does not perform as expected.
If investment is made at the beginning,

If investment is through period of payments,

Where,
A = Amount,
i = Expected rate of return,
n = Time period.

43
ANNUITY DUE
Annuity due refers to annuities whose payments are made at the beginning of the
period.

Need of Annuities
1. The payment of tax is deferred.
2. Annuity provides large amount which is more helpful for retiring persons.
3. The annuity income and payments are guaranteed.

Disadvantages of Annuities
1. When you are starting annuity for the first type, you need to provide
commission to insurance brokers (from 10%).
2. Surrender charges need to be paid when you are withdrawing annuity (from
7%).

44
 CASH-FLOW DIAGRAMS

1 SOURCE: Engineering Economy, 3rd Edition, Hipolito Sta. Maria

A cash-flow diagram is simply graphical representation of cash flows drawn on a

time scale. Cash-flow diagram for economic analysis problems is analogous to that of
free body diagram for mechanic problems.

Receipt (positive flow or cash inflow)

Disbursement (negative flow or cash outflow)

Example:

A loan of ₱100 at simple interest of 10% will become ₱150 after 5 yrs.

P150

0 1 2 3 4 5

P100

In calculations of compound interest, the interest for an interest period is

calculated on the principal plus total amount of interest accumulated in previous periods.
It meant ―interest on top of interest’.

45
 Compound Interest (Borrower’s Viewpoint)

Interest
Principal at
Interest Earned Amount at
Beginning of
Period During End of Period
Period
Period
1 P Pi P+Pi=P(1+ni)
2 P(1+i) P(1+i)i P(1+i)+P(1+i)i=
P(1+i)2
3 P(1+i)2 P(1+i)2i P(1+i)2+
P(1+i)2i=
P(1+i)3
… … … …
n P(1+i)n-1 P(1+i)n-1i P(1+i)n

F= P(1+i)n

The quantity (1+i) n is commonly called the ―single payment compound amount
factor‖ and is designated by the functional symbol/P, i%, n. Thus,

F = (F/P, I%, n)

The symbol F/P, i%, n is read as ―F given at P at i% n interest periods.

2 SOURCE: http://www.frickcpa.com/tvom/tvom_cashflowdiagram.asp

46
Illustrating Interest Payments

However, in most cases including the interest payments in the drawing does more
harm than good; they end up confusing a diagram whose primary purpose is to provide a
simplified representation of a complex problem:

If you think the drawing above is messy, imagine how you would draw a diagram
to depict daily compounding. Or worse, continuous compounding.

So the rule of thumb regarding the inclusion of interest payments in a cash flow
diagram is this: in general interest payments are presumed and not shown. Only when
illustration of the interest payments serves a specific purpose should they be included in
the diagram.

47
Enhancing the Cash Flow Diagram

Now that we know how to draw cash flows, we can embellish our diagram to
make it more useful.

In general we want to add labels to our diagram but only to the point that they are
helpful. Keep in mind that the purpose of the diagram is to illustrate a complex financial
transaction as concisely as possible. Adding too much information only confuses the
issue.

Here are some ideas for labels to include in a cash flow diagram:

 Include the dollar amount for each inflow or outflow where possible; for
annuities with large periodic payments, you may want to indicate the
payment amount only once.
 Identify an unknown value with a question mark and its name (e.g., "? PV"
for an unknown present value). On this site unknown values are shown in
red.
 Use an arrow line from one cash flow to another cash flow to show an
accumulation, discounting, or amortization.
 Include the interest rate on the accumulation or discount line and show the
compounding frequency.
 Label the time increment (e.g., years, months, etc.).
 Add concise text labels to explain things not evident in the diagram.


Example 1:

What is the present value of $10 to be paid in 3 years at 5% compounded monthly?

In order to be clear it always helps to add the appropriate units to the time line
(e.g., years). You should also label the interest rate i with the compounding frequency.
48
Example 2:

From the borrower's perspective, what is the interest rate charged on a loan of
$100 that requires four annual payments of $27 using annual compounding.

This example is an amortization of a loan and you need to find the interest rate i.
specifying $0 as the future value is optional.

Example 3:

How many years will it take for $10 to grow to $20 at 8% compounded monthly?

Here n is the unknown so you value time units in reference to their relative
relationship with n.

49
 3 SOURCE: www.isr.umd.edu/~austin/ence202.d/economics.

CASH FLOW DIAGRAMS

Cash flow diagrams are a means of visualizing (and simplifying) the flow of
receipts and disbursements (for the acquisition and operation of items in an enterprise).

The diagram convention is as follows:

Horizontal Axis: The horizontal axis is marked off in equal increments, one per period,
up to the duration of the project.

Revenues: Revenues (or receipts) are represented by upward pointing arrows.

Disbursements: Disbursements (or payments) are represented by downward pointing

arrows.

All disbursements and receipts (i.e. cash flows) are assumed to take place at the
end of the year in which they occur. This is known as the "end-of-year" convention.

Arrow lengths are approximately proportional to the magnitude of the cash flow.

Expenses incurred before time = 0 are sunk costs, and are not relevant to the
problem.

Since there are two parties to every transaction, it is important to not those cash
flow directions in cash flow diagrams depend upon the point of view taken.

Example:

Typical Cash Flow Diagrams

50
 This figure shows cash flow diagrams for a transaction spanning five years. The
transaction begins with a $1000.00 loan. For years two, three and four, the borrower pays
the lender $120.00 interest. At year five, the borrower pays the lender $120.00 interest
plus the $1000.00 principal.

1. Cash Flow over Time: Upward arrow means positive flow, downward arrow
means negative flow. There are two cash flows to each problem (borrower and
lender flows).

2. Net Cash Flow: The arithmetic sum of receipts (+) and disbursements (-) that
occur at the same point in time.

EQUIVALENCE

1 SOURCE: Engineering Economy, 15th Edition, William G. Sullivan

51
 We should consider the comparison of alternative options, or proposals, by
reducing them to an equivalent basis that is dependent on (1) the interest rate, (2) the
amounts of money involved, and (3) the timing of the monetary receipts or expenses.

Three Plans for Repayment of $17, 000 in four Months with Interest at 1% per Month
(1) (2) (3) = 1% x (4) = (2) + (5) (6) = (3) +
Amount (2) (3) (5)
Owned at Interest Total Money Principal Total
Beginning of Accrued Owned at Payment End-of-
Month Month for Month End of Month
Month Payment
(Cash Flow)
Plan 1: Pay interest due at the end of each month and principal at end of month
1 $17, 000 $170 $17,170 $0 $170
2 17, 000 170 17,170 0 170
3 17, 000 170 17,170 0 170
4 17, 000 170 17,170 17, 000 17, 170
68, 000 $- $680
mo (total
interest)
Plan 2: Pay off the debt in four equal end-of-month installments (principal and interest)
1 $17, 000 $170 $17, 170 $4, 187.10 $4, 357.10
2 12, 812.90 128.13 12, 941.03 4228.97 4, 357.10
3 8, 583.93 85.84 8, 669.77 4, 271.26 4, 357.10
4 4, 312.67 43.13 4, 355.80 4, 313.97 4, 357.10
42, 709.5 $- $427.10 Difference = $1.30 due to round off
mo (total
interest)

52
Plan 3: Pay principal and interest in one payment at the end of fourth month.
1 $17, 000 $170 $17, 170 $0 $0
2 17, 170 171.70 17, 341.70 0 0
3 17, 341.70 173.142 17, 515.12 0 0
4 17, 515.12 175.15 17, 690.27 17, 000 17, 6690.27
69, 026.8 $- $690.27
mo (total
interest)

2 SOURCE: Engineering Economy, 3rd edition, Hipolito Sta.Maria

An equation of value is obtained by setting the sum of the values on a certain

comparison or focal date of one set of obligations equal to the sum of the values on the
same date of another set of obligations.

Example:

A man bought a lot worth P1, 000, 000 if paid in cash. On the statement basis, he
paid a down payment of P200, 000; P300, 000 at the end of one year; P400, 000 at the
end of three years and a final payment at the end of five years. What was the final
payment if interest was 20%?

53
Solution:
Let Q = the final payment
Using today as the focal date, the equation of value is
P800, 000 = ₱300, 000 (P/F, 20%) + P400, 000 (P/F, 20%, 3) + Q (P/F, 20%, 5)
P800, 000 = ₱300, 000 (1.20)-1 +n P400, 000 (1.20)-3 + Q(1.20)-5
P800, 000 = ₱300, 000 (0.8333) + p400, 000 (0.5787) + Q(0.4019)
Q = ₱792, 560

3 SOURCE: www.isr.umd.edu/~austin/ence202.d/economics.

In engineering economy two things are said to be equivalent when they have the
same effect. Unlike most individual involved with personal finance, industrial decision
makers using engineering economics are not so much concerned with the timing of a
project's cash flows as with the profitability of that project. This means that mechanisms
are needed to compare projects involving receipts and disbursements occurring at
different times, with the goal of identifying an alternative having the largest eventual
profitability [Lindeberg82].

EQUIVALENCE CALCULATIONS INVOLVING A SINGLE FACTOR

The interest equations are affected by three factors: (a) amounts, (b) times of
occurrence of amounts, and (c) rate of interest.

1. Single-Payment Compound-Amount Factor

54
Example 1:

Let P = $1000, i = ??, n = 4 years, and F = $1200. The interest rate is

F = $1200.00 = $1000.00 [1 + i ]^4

Rearranging terms in this equation gives i = 1.2^0.25 - 1 = 0.046635.

Example 2:

Let P = $1000, i = 10%, n = ?? years, and F = $1200.

F = $1200.00 = $1000.00 [1 + 0.10 ]^n

Rearranging terms in this equation gives n = 1.91 years.

2. Single-Payment Present-Worth Factor

Example:

Let F = $1000, i = 12%, n = 4 years, and P = ?

Solution:

3. Equal-Payment-Series Compound-Amount Factor

[ ]

The derivation of this formula can be found on page 46 of the economics text.

55
Example:

Let A = $100.00, i = 10%, and F = $1000.00. How many years n are needed?

Solution:

* +

Rearranging the terms in this equation gives n = 7.27 years.

4. Equal-Payment-Series Sinking-Fund Factor

[ ]

Example:

Paying towards a future amount. Let F = $1000.00, i = 12%, and n = 4 years. What
is A?

5. Equal-Payment-Series Capital-Recovery Factor

56
Example:

Paying back a loan. Let P = $1000, i = 12%, n = 4 years, and A = ?

Solution:

6. Equal-Payment-Series Present-Worth Factor

* +

Example:

Let A = 100, i = 10%, and n = 8 years.

Solution:

7. Uniform Gradient-Series Factor

As explained above, the gradient (G) is a value in the cash flow that starts
with 0 at the end of year 1, G at the end of year 2, 2G at the end of year 3, and so
on to (n-1)G at the end of year n.

This can be described as

57
 [ ]

Example:

Let G = 100, i = 12%, n = 4 years, and A =?

Solution:

[ ]

EQUIVALENCE CALCULATIONS INVOLVING CASH FLOW

Two cash flows need to be presented along the same time period using a similar
format to facilitate comparison.

When interest is earned, monetary amounts can be directly added only if they
occur at the same point in time.

EQUIVALENCE BETWEEN CASH FLOWS

Equivalent cash flows are those that have the same value.

Example:

Two equivalent cash flows.

Cash flow 1 Cash flow 2

P = $ 1000.00 P = $ 0.00
i = 12% i = 12%
n = 4 years n = 4 years
F = $0.00 F = $1000(1+0.12)4 = $ 1, 573. 50

58
 The equivalence can be established at any point in time. Arbitrarily setting n = 8
years, for example, gives:

For cash flow 1: F = $1000.0 [1 + 0.12]8 = $2475.96

For cash flow 2: F = $1573.5 [1 + 0.12]4 = $2475.96

Note: Two or more distinct cash flows are equivalent if they are equivalent to the same
cash flow.

EQUIVALENCE FOR DIFFERENT INTEREST RATES

Example:

Given the following cash flow:

Interest rate applicable

Year end Amount from previous year (t – 1)
to current year end (t)
1 $ 0.00 12% compounded quarterly
2 $ 200.00 12% compounded quarterly
3 $ 0.00 7% compounded annually
4 $ 100.00 10% compounded annually
5 $ 100.00 10% compounded annually

The above cash flow can be converted to its present value as follows:

Assuming the following cash flow:

Time (year end) Receipts Disbursement

1 $ 0.00 -$ 1000.00
2 $ 0.00 -$ 500.00
3 $ 482.00 $ 0.00
4 $ 482.00 $ 0.00
5 $ 482.00 -$ 250.00
6 $ 482.00 0
7 $ 482.00 0

59
 In this case, equivalence states that the actual interest rate earned on an investment
is the one that sets the equivalent receipts to the equivalent disbursements.

For the above table, the following equality can be set:

$1000 + $500.00 (P/F,i,1) + $250(P/F,i,5) =

$482(P/A,i,3)(P/F,I,1) + $482.00 (P/A,i,2)(P/F,i,5)

By trial and error i = 10% will make the above equation valid. The equivalence
can be made at any point of reference in time, it does not need to be the origin (time =
zero) to produce the same answer.

If the receipts and disbursement of cash flow are equivalent for some interest rate,
the cash flows of any equivalent portion of the investment are equal at that interest rate to
the negative (-) of the equivalent amount of t= he cash flows that constitute the remaining
portion on the investment.

For example, break-up the above cash flow between year 4 and 5. Perform the
equivalence at the 4th year produces the following:

-1000(F/P,10,4)-500(F/P10,3)+482(F/A,10,3) = -(250(P/F,10,1)+482(P/A,10,2)(P/F,10,1))

-1000(1.464)-500(1.331) + 482(3.310) = -$(-250(0.9091)+482(1.7355)(0.9091))

-$534 = -$534

EQUIVALENCE CALCULATIONS WITH MORE FREQUENT COMPOUNDS

1. Compounding and Payment Periods Coincide

Assume for example that

Interest = 10% compounded semiannually => 5% per semiannual period

Payments are done semiannually for three years => 3(2) = 6 periods

The calculations from here on are the same as before.

60
 2. Compounding More Frequent than Payments

Calculations based on the compounding period:

Example:

Payments = 100 at year end for three years; Interest = 6% per year
compounded quarterly.

i = 6/4 = 1.25%
F = $100 (F/P, 1.25, 8) + $100 (F/P, 1.25, 4) + $100
= $318.8

Effective interest rate for l = 1 year,

* + [ ]

Solution:

F = $100 (F/A,6.14,3) = $318.80

3. Compounding Less Frequent than Payments

Usually no interest is paid for funds deposited during an interest period. In this
case, funds earn interest after completing the next interest period.

61
 BONDS AND AMORTIZATION

1 Source: Engineering Economy, 3rd Edition, Matias Arreola

BONDS
A bond is a certificate of indebtedness of a corporation usually for a period not less than
10 years, and guaranteed by a mortgage on certain assets of the corporation or its
subsidiaries.
Bonds are issued when there is need for more capital such as for of the plant or the
services rendered by the corporation. Bonds represent indebtedness, and in return for the
money borrowed the corporation agrees to pay interest at a stipulated rate and at specified
periods in addition to the date. Because of the guarantee existing behind the bond, it
represents a more stable investment than either a common or preferred stock. However,
the bondholder has no voice in managing the affairs of the corporation, and is not given
any share in the profits of the corporation.
The par value of a bond is the amount stated on the bond. The bond rate is the rate
of interest quoted on the bond.

Classification of Bonds
Bonds are classified into several ways. Bonds may be classified according to the method
of payment of interest, as to the security behind the bond, and in many other ways.
According to the method of paying interest, bonds are classified into:
1. Registered bonds. In all registered bonds, the owner’s name is recorded in the
books of the corporation, and interest is paid periodically to the owners without
their asking for it.
2. Coupon bonds. These are bonds to which are attached coupons indicating the
interest is to be paid. The owner can collect the interest due by surrendering the
same to the officers of the corporation or cashing it at specified banks.

62
According to the security behind the bonds, the classified is as follows:
1. Mortgage bonds. These are bonds whose security is a mortgage on certain
specified assets of the corporation. If the corporation fails to pay the bond value on
the date of maturity, title to the property is transferred to the bondholders, who
may take possession and sell the same to reimburse the amounts they have
invested.
2. Collateral trust bonds. In such types of bonds, the corporation pledges securities
which it owns, such as the stocks or bonds of one of its subsidiaries. In case of
default in the payment of the bond value at maturity the bondholders have to
depend on the assets of the subsidiary for redemption of their investment. Usually
however the issuing corporation includes a guaranty involving its properties to
enhance the value of the bond to prospective investors.
3. Equipment obligations bonds. These bonds refer primarily to bonds whose
guaranty is a lien on railroad equipment, such as freight and passenger cars,
locomotives, and other railroad equipment.
4. Debenture bonds. These are bonds without any security behind them except a
promise to pay by the issuing corporation. These bonds may only be issued by
large and well – known firms, whose record of achievement is known to the
public.
5. Joint bonds. Sometimes two or more corporations issue bonds which are
guaranteed jointly and severally by them. Such bonds are called joint bonds. Each
of the issuing corporations is liable for the entire bond issue in case of default.

Bonds Amortization and Retirement

Bonds represent debt, and therefore some provision must be made for its repayment at
some future time. The amount necessary to redeem or retire bonds may be done in three
ways.
1. The corporation may issue another set of bonds equal to the amount of bonds due
for redemption. This method in effect is borrowing from Pedro to pay Jose, and
will cause the corporation to be perpetually in debt.\

2. The corporation may set up a sinking fund into which payments are made
periodically and usually of equal amounts. The amounts deposited, together with
the interests they earn become at maturity date equal to the amount of the bonds to
be par value of their bonds to be retired. The bondholders are then paid the par
63
 value of their bonds. The corporation, however, must, in addition to the amount set
aside for bond retirement, pay periodically the interest on the bonds. To determine
the amount of the periodic payment, let

A = amount of the periodic payment part of which will pay for bind retirement, the
balance for periodic interest.
F = the amount of the bond issue, which will be repaid at maturity date
n = the nimber of periods until the bonds are retired.
i = rate of interest on the bonds per period.
In this case, the total periodic payment will be
A = Fi + F(A/F, i%, n) = F(A/P, i%, n)
Since I + (A/F, i%, n) = (A/P, i%, n)

3. Usually the interest on the bonds is more than the interest on the sinking fund set
up by the company. In such a case, it is more economical to retire the bonds
annually in order that the corporation may take advantage of the higher bond rate.
The corporation may therefore float or issue callable or serial bonds. These bonds
permit repayment of the principal on certain bonds before maturity. The callable
bonds to be retired on a definite date are usually determined by lot, while those for
serial bonds are indicated on the bond issue, and bonds are retired according to a
certain schedule where the serial number of the bonds to be retired at specific
dates is stated.

Value of a bond
The value of the bond is defined to be the present worth of all the amounts the bond
holder will receive through his possession of the bond. The bondholder will receive two
types of payments, which are:
1. A single payment which the owner will receive at the date of maturity of the bond,
which is usually equal to the par value of the bond, and
2. The periodic payments for interest on the bond until it is redeemed by the issuing
corporation.

64
 ( ⁄ ) ( ⁄ )

Or

Where,
Vn = value of the bond n periods before redemption
F = par value of the bond
C = amount paid to the bondholder at maturity of the bond, which is usually
equal to F
n = number of periods prior for redemption
r = rate of interest on the bond per period
i = actual rate of interest on the amount invested in the bond, usually called
yield.

Example:
A corporation floats ₱1,000,000 worth of bonds of ₱1,000 denomination. The bond rate
is 9% and the bonds are to be retired in 10 years, the annual payments being as nearly
equal as possible. Prepare an amortization schedule.

Solution:
F = ₱1,000,000; n = 10; i = 9%

65
 Year Principal Interest at Number of Amount of Total
9% a year bonds principal payment
retired retired

1 ₱1,000,000 ₱90,000 66 ₱66,000 ₱156,000

2 934,000 84,060 72 72,000 156,000
3 862,000 77,580 78 78,000 155,060
4 784,000 70,560 85 85,000 155,560
5 699,000 62,910 93 93,000 155,910
6 606,000 54,540 101 101,000 155,540
7 505,000 45,450 110 110,000 155,450
8 395,000 35,550 120 120,000 155,550
9 275,000 24,750 131 131,000 155,750
10 144,000 12,960 144 144,000 156,960
Totals 6,204,000 558,360 1,000 1,000,000 1,558,360

2 Source: Engineering Economy, 7th Edition, Leland Blank & Anthony Tarquin

RATE OF RETURN OF A BOND INVESTMENT

Bond is a long term note issued by a corporation or a government entity (the
borrower) to finance major projects. The borrower receives money now in return for a
promise to pay the face value V of the bond on the stated maturity due. Bonds are usually
issued in face value amounts of $1000, $5000, or $ 10,000. Bond dividend, also called
bond interest, is paid periodically between the time the money is borrowed and the time
the face value is repaid. The bond dividend is paid c times per year. Expected payment
periods are usually semiannually or quarterly. The amount of interest is determined using
the stated dividend or interest rate, called bond coupon rate b.
66
 CLASSIFICATION AND CHARACTERISTICS OF BONDS

Classification Issued by Characteristics Examples

Bills (≤ 1year)
Backed by faith and
Treasury securities Federal government credit of the federal Notes (2 – 10year)
government
Bonds (10 – 30years)
General obligation
Federal tax – exempt
Revenue
Municipal Local governments Issued against taxes
Zero coupon
received
Pu t
Backed by specified First mortgage
assets or mortgage
Mortgage Corporation Second mortgage
Foreclosure, if not
repaid Equipment trust

Not backed by
collateral, but by
reputation of Convertible
corporation
Debenture Corporation Subordinated
Bond rate may ―float‖
Junk or high yield
Higher interest rates
and higher risk

Example:
General electric just released $10 million worth of $10,000 ten – year bonds. Each bond
pays dividends semiannually at a rate of 6% per year, (a) determine the amount a
67
purchaser will receive each 6 months and after 10 years. (b) suppose a bond is purchased
at a time when it is discounted by 2% to $9800. What are the dividend amiunts and the
final payment amount at the maturity date?

Solution:
(a)

The face value of $10,000 is repaid after 10 years.

(b) Purchasing the bond at discount from the face value does not change the dividend or
final repayment amounts. Therefore, $300 per 6 months and 10 years remain the
amounts.

3 Source: www.valpo.edu/student/asme/FE%20Slides/EngEconSlides.pdf

BONDS
Bond value is the present worth of payments over the life of the bond. Bond yield is the
equivalent interest rate of the bond compared to the bond cost.

Example:
What is the maximum amount an investor should pay for a 25 – year bond with a $20,
000 face value and 8% coupon rate (interest only paid semiannually)? The bond will be
kept to maturity. The investor’s effective annual interest rate for economic decisions is
10%.

68
Solution:
For this problem take the compounding period to be six months. Then, there 50
compounding periods. Since 8% is a nominal rate, the effective bond rate per period is
calculated.
The bond payment received semiannually is

10 % is the investor’s effective rate per year, to calculate the effective analysis rate per
period, we have,

The maximum amount that the investor should be willing to pay is the present worth of
the investment.
⁄ ⁄

Then, the present worth is

69
 DEPRECIATION

1 SOURCE: Enginering Economy, 3rd edition, Hipolito Sta. Maria

Depreciation is the decreasing of the value of physical property as time goes by.

Value, in a commercial sense, is the present worth of all future profits that are to
be received through ownership of a particular property.

The market value of a property is the amount which a willing buyer will pay to a
willing seller for the property where each has equal advantage and is under no
compulsion to buy or sell.
The use of value of property is what the property is worth to the owner as an
operating unit.

Fair value is the value which is usually determined by a disinterested third party
in order to establish a price that is fair to both buyer and seller.

Book value is the worth of property as shown on accounting records of an

enterprise.

Salvage value is the price that can be obtained from the sale of the property after
it has been used.

Scrap value is also known as junk value or proceeding to junkshop.

Purposes of Depreciation:

1. To provide for the recovery of capital which has been invested in physical property.

2. To enable the cost of depreciation to be charged to the cost of producing products or

services that results from the use of property.

70
Types of Depreciation:

1. Normal Depreciation

(a) physical
(b) Functional
2. Depreciation due to changes in price levels
3. Depletion

Physical depreciation is due to the lessening of the physical ability of a property to

produce results. Its common causes are wear and deterioration. Functional depreciation is
due to the lessening in the demand for the function which the property was designed to
render. Its common causes are inadequacy, changes in styles, population centers shift,
saturation of markets or more efficient machines are produced.
Depreciation is due to change in price levels is almost impossible to predict and
therefore is not considered in economic studies.
Depletion refers to the decrease in the value of a property due to the gradual
extraction of its contents.

Physical and Economic Life

Physical life of a property is the length of time during which it is capable of

performing the function for which it was designed and manufactured.
Economic life is the length of time during which the property may be operated at a
profit.

Requirements of a Depreciation Method:

1. It should be simple.
2. It should recover capital.
3. The book value will be reasonably close to the market value at any time.
4. The method should be accepted by the Bureau of Internal Revenue.
71
Depreciation Methods:

L = useful life of property in years d = annual cost of depreciation

Co = original cost Cn = book value at the end of n years
CL = the value at the end of the life, the scrap value Dn= depreciation up to age n years

THE STRAIGHT LINE METHOD

This method assumes that the loss in value is directly proportional to the age of
property.

d = [Co -CL]/L Dn = n[Co -CL]/L Cn = Co - Dn

Example:

An electronic balance costs ₱90,000 and has an estimated salvage value of

₱90,000 at the end of its 10yrs life. What would be the book value after 3yrs, using the
straight line method in solving depreciation?

Solution:

Co = ₱90,000 CL = ₱8,000 L = 10
n=3

d = [Co -CL]/L = [₱90,000-₱8,000]/10= ₱8,200

D3 = (n)(d)=(3)( ₱8,200) = ₱24,600

C3 = Co – D3
C3 = Co - D3 = ₱90,000-₱24,000 = ₱65, 400

72
THE SINKING FUND METHOD

This methods assumes that a sinking fund is established in which funds will
accumulate for replacement. The total depreciation that has taken place up to any given
time is assumed to be equal to the accumulated amount in the sinking fund at that time.

d = (Co – CL)/ F/A, i%, L Dn = d(F/A, i%, n) Cn = CO – Dn

Example:
A broadcasting corporation purchased an equipment for P53, 000 and paid P1,500
for freight and delivery charges to the job site. The equipment has a normal life of 10
years with a trade-in value of P5,000 against the purchased of a new equipment at the end
of the life.
(a) Determine the annual depreciation cost by the straight line method.
(b) Determine the annual depreciation cost by sinking fund method. Assume interest at 6-
½% compounded annually.

Solution:
CO = P53,000 + P1,500 = P54,500
CL = P5,000
(a) d = (CO – CL)/ L = (P54,500 – P5, 000)/10 = P4, 950
(b) d = (54,000 – 5,000)/F/A, 6.5%, 10 = P49, 500/ 13.3846 = P3,668

DECLINING BALANCE METHOD

In this 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
salvage value at the beginning of the year. The ratio of the depreciation in any ear to the
book value at the beginning of that year is constant throughout the life of the property and
is designated by k, the rate of depreciation:
dn = depreciation during the nth year

73
 Book value at Depreciation
Book value at the
Year the beginning of during the
end year
year year
1 CO d1 = kCO C1 = CO – d1 = CO(1 – k)
2 CO(1 – k) d2 = kC1 C2 = C1 – d2 = CO(1 – k)2
3 CO(1 – k)2 d3 = kC2 C3 = C2 – d3 = CO(1 – k)3
… … … …
N CO(1 – k)n – 1 dn = kCn-1 Cn = Cn-1 – dn = CO(1 – k)n
… … … …
L CO(1 – k)L-1 dL = kCL-1 CL = CL-1 – dL = CO(1 –
k)L

dn = CO(1 – k)n – 1k Cn = CO(1 – k)n = CO [CL/CO]n/L

k = 1 - n (Cn/CO) = 1 – L (Cn/CO)

This method does not apply, if the salvage value is zero, because k will be equal to
one and d1 will be equal to CO.

Example:

A certain type of machine loses 10% of its value each year. The machine costs P2,
000.00 originally. Make out a schedule showing the yearly depreciation, the total
depreciation and the book value at the end of each year for 5 years.

Solution:

Book value Depreciation Total Book value

Year at the beginning during the depreciation at at the end
of year year 10% the end of year
of year
1 ₱2000.00 ₱200.00 ₱200.00 ₱1800.00
2 1800.00 180.00 380.00 1620.00
3 1620.00 1620.00 542.00 1458.00
4 1458.00 1458.00 687.80 1312.20
5 1312.00 1312.00 819.00 1180.98

74
DOUBLE DECLINING BALANCE (DDB) METHOD

This method is very similar to the declining balance method except that the rate of
depreciation k is replaced by 2/L.

dn = CO(1 – 2/L)n – 1(2/L) Cn = CO(1 – 2/L)n CL = CO(1 – 2/L)L

When the DDB method is used, the salvage value should not be subtracted from
the first cost when calculating the depreciation charge.

Example:

Determine the rate of depreciation, total depreciation up to the end of the book
value at the end of 8 years for an asset that costs P15, 000 new and has an estimated scrap
value of P 2, 000 at the end of 10 years by (a) the declining balance method and (b) the
double declining balance method

Solution:

CO = ₱15,000 CL = ₱2,000 L = 10 n=8

(a) DBM

k = 1 – 10 2000/ 15, 000 = 0.1825 or 18.25%

(b) DDBM

C8 = 15,000(1 – 0.1825)8 = P2,992

D8 = 15,000 – 2,517 = ₱12, 438.00

2 SOURCE: Engineering Economy, 15th Edition, William G. Sullivan

Depreciation is the decrease in value of physical properties with the passage of

time and use. More specifically, depreciation is an accounting concept that establishes an
annual deduction against before-tax income such that the effect of time and use on an
asset’s value can be reflected in a firm’s financial statement.
75
DEPRECIATION METHODS AND RELATED TIME PERIODS

The depreciation methods permitted under the revenue code have changed with
time. In general, the following summary indicates the primary methods used for property
placed in service during three distinct time periods.

Adjusted (Cost) Basis – The original cost basis of the asset, adjusted by allowable
increase or decrease, is used to compute depreciation deductions. For example, the cost of
any improvement to a capital asset with a useful life greater than one year increase the
original cost basis, and a casualty or theft loss decrease it. If the basis is altered, the
depreciation deduction may need to be adjusted.

Basis or Cost Basis – the initial cost of acquiring an asset (purchase price plus any sales
tax, including transportation expenses another normal costs of making the asset
serviceable for its intended use: this amount is also called the unadjusted cost basis.

Book Value – the worth of a depreciable property as shown in the accounting records of
the company. It is the original cost basis of the property, including any adjustments, less
all allowable depreciation deductions. It thus represents the amount of capital that
remains invested in the property and must be recovered in the future through the
accounting process. The BV of a property may not be an accurate measure of its market
value.

Market Value – the amount that will be paid by a willing buyer to a willing seller for a
property, where cash has equal advantage and in under no compulsion to buy or sell. This
approximates the present value of what will be received through ownership of the
property, including the time value of money (or profit).

Recovery Period – the number of years over which the basis of a property is o\recovered
through the accounting process. For the classical methods of depreciation, this period is
normally the useful life.

Recovery Rate – a percentage (in decimal) for each year recovery period that utilized to
compute an annual depreciation deduction.

THE STRAIGHT-LINE METHOD

The SL depreciation is the simplest method. It assumes that a constant amount is

depreciated each year over the depreciable (useful) life of the asset. If we define

N = depreciable life of years in asset

76
B = cost basis, including allowable SVn = salvage value at the end of n years
adjustments dk = cumulative depreciation through
dk = annual depreciation deduction in year k
year k
BVk = book value at the end of year k

Example:

A laser surgical tool has a basis of ₱200,000 and a five-year depreciable life. The
estimated SV of the laser is ₱20,000 at the end of five years. Determine the annual
depreciation amounts and the book value of the laser at the end of each year.

Solution:

d3 = [₱200,000-₱20,000]/5 = ₱36,000 0 --- 200,000

1 ₱36,000 ₱164,000
d3 = 3[₱200,000-₱20,000]/5 = ₱108,000 2 ₱36,000 ₱128,000
3 ₱36,000 ₱92,000
BV3 = ₱200,000-₱108,000 = ₱92,000 4 ₱36,000 ₱56,000
5 ₱36,000 ₱20,000

^Yearly depreciation^

THE DECLINING BALANCE METHOD

In this method, sometimes called the constant-percentage or the Matheson

Formula, it is assumed that the annual cost of depreciation is a fixed percentage of the
book value at the beginning of the year. The ratio of the depreciation in any one year to
the book value at the beginning of the year is constant throughout the life of the asset, and
is designated by R(0<R<1). In this method, R = 2/n when a 200% DB is being used (i.e.,
twice the SL rate of 1/n), and n equals the depreciable (useful) life of an asset. If the
150% DB method is specified, then R = 1.5/n. the following relationships hold true for
the DB method:

77
d1 = B(R) d*k = B[1-(1-R)k]
dk = B(1-R)k-1(R) BVk = B(1-R)k
Example:

A new electric 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 salvage
value of the item is zero at the end of ten years. Use the DB method to calculate the
annual depreciation amounts when

(a) R = 2/n (200% DB method)

(b) R = 1.5/n (150% DB method)

Tabulate the annual depreciation amount and BV for each year.

Solution:

(a) (b)
R = 2/10 = 0.2 R = 1.5/10 = 0.15
d6 = ₱4,000(1 - 0.2)5(0.2) = ₱62.14 d6 = ₱4,000(1 - 0.15)5(0.15) =
d*6 = ₱4,000[1 – (1 - 0.2)6] = ₱266.22
₱2,951.42 d*6 = ₱4,000[1 – (1 - 0.15)6] =
BV6 = ₱4,000(1 – 0.2)6 = ₱1,048.58 ₱2,491.40
BV6 = ₱4,000(1 – 0.15)6 = ₱1,508.60

The depreciation and BV amounts for each year, where R = 2/n = 0.2, are shown
in the following table:

200% DB Method Only

EOY,k dk BVk
0 --- ₱4,000
1 ₱800 3,200
2 640 2,560
3 512 2,048
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
78
 10 107.37 429.50
DECLINING BALANCE WITH SWITCHOVER TO STRAIGHT LINE

Because the DB method never reaches a BV zero, it is permissible to switch from

this method to the SL method so that an asset’s BVn will be zero (or some other
determined amount, such as SVn).
Table below illustrates a switchover from double DB depreciation to SL
depreciation for example above. The switchover occurs in the year in which a larger
depreciation amount is obtained from the SL method. From the table below, it is apparent
that d6 = ₱262.14 . The BV at the end of year six is ₱1,048.58. Additionally, observe that
BV10 is ₱4,000 - ₱3,570.5 = ₱429.5 without switchover to the SL method in the table.
With switchover, BV10 equals zero. It is clear that this asset’s dk, d*k, and BVk in years 7
through 10 are established from the SL method, which permits the full cost basis to be
depreciated over the 10-year recovery period.

The 200% DB Method with Switchover to the SL Method

Depreciation Method
(1) (2) (3) (4)
Beginning- 200% SL Depreciation
Year, k of-year DB Methodc Amount
BVa Methodb Selectedd
1 ₱4,000 ₱800 >₱400 ₱800.00
2 3,200 640 >355.56 640.00
3 2,560 512 >320.00 512.00
4 2,048 409.60 >292.57 409.60
5 1,638 327.68 >273.07 327.68
6 1,310.72 262.14 =262.14 262.14(switch)
7 1,048.58 209.72 <262.14 262.14
8 768.44 167.77 <262.14 262.14
9 524.30 134.22 <262.14 262.14
10 262.16 107.37 <262.14 262.14
₱3,750.50 ₱4,000.00

This methods result in the cost basis (minus final SV) being allocated equally over
the estimated number of units produced during the useful life of the asset. The
depreciation rate is calculated as

]⁄

79
Example:

A piece of equipment used in a business has a basis of ₱50,000 and is expected to

have a ₱10,000 SV when replaced after 30,000 hours of use. Find its depreciation rate per
hour of use, and find its BV after 10,000 hours of operation.

Solution:

Depreciation per unit production = [₱50,000 - ₱10,000] / 30,000hrs = ₱1.33 per hour

After 10,000 hours, BV = ₱50,000 - ₱1.33/hr[10,000hrs], or BV = ₱36,700

MACRS Class Lives and Recovery Periodsa

Recovery Period
Description of Class
Asset Class GDSb ADS
Assets Life
00.11 Furnitures 10 7 10
00.12 Computers 6 5 5
00.22 Automobiles 3 5 5
00.23 Buses 9 5 9
00.241 General Purpose 4 5 5
Trucks
00.242 Heavy Trucks 6 5 6
00.26 Tractors 4 3 4
01.1 Agriculture 10 7 10
10.0 Mining 10 7 10
133.2 Petroleum and Gas 14 7 14
13.3 Refining 16 10 16
15.0 Construction 6 5 6
22.3 Carpets 9 5 9
24.4 Wood Products 10 7 10
28.0 Chemicals 9.5 5 9.5
30.1 Rubber 14 7 14
32.2 Cement 20 5 20
34.0 Metal 12 7 12
36.0 Electronics 6 15 6
37.11 Motor 12 7 12
37.2 Aerospace 10 5 10
48.12 Telephone 18 7 18
49.13 Electric Utility 28 7 28
80
COMPARISON OF DEPRECIATION METHODS

Example:

The Ateneo Bus Company has decided to purchase a new bus for ₱85,000 with a
trade-in of their old bus. The old bus has a BV of ₱10,000 at the time of the trade-in. the
new bus will be kept for 10 years before sold. Its estimated SV at that time is expected to
be ₱5,000.

First, we must calculate the cost basis. The basis is the original purchase price of
the bus plus the BV of the old bus that was traded in [Equation (7-11)]. Thus, the basis is
₱85,000 + ₱10,000, or ₱95,000. We need to look at table 7-2 and find buses, which are
asset class 00.23. Hence, we find that buses have a nine-year class(useful) life, over
which we depreciate the bus with historical methods discussed in Section 7.3, and a five-
year GDS recovery period.

Solution:
SL METHOD

For this method, we use the class life of 9 years, even though the bus will be kept
for ten years. By using equations (7-2) and (7-4), we obtain the following information:

dk = [₱95,000 – ₱5,000] / 9 years = ₱10,000, for k = 1to 9

SL Method
EOY
dk BVk
k
0 --- ₱95,000
1 ₱10,000 85,000
2 10,000 75,000
3 10,000 65,000
4 10,000 55,000
5 10,000 45,000
6 10,000 35,000
7 10,000 25,000
8 10,000 15,000
9 10,000 5,000

81
 Notice that no depreciation was taken after year nine because the class life was
only nine years. Also, the final BV was estimated SV, and the BV will remain at ₱5,000
until the bus is sold.

Solution:
DB Method

To demonstrate .this method, we will use the 200% DB equations. With equations
(7-6) and (7-8), we calculate the following:

R = 2/9 = 0.2222; d1 = ₱95,000(0.2222) = ₱21,111;

d5 = ₱95,000(1 – 0.2222) BV5 = ₱95,000(1 – 0.2222)5 = ₱27,040

200% DB Method
EOY k dk BVk
0 --- ₱95,000
1 ₱21,111 73,889
2 16,420 57,469
3 12,771 44,698
4 9,932 34,765
5 7,726 27,040
6 6,009 21,031
7 4,674 16,357
8 3,635 12,722
9 2,827 9,859

Solution:
DB with Switchover to SL Depreciation

To illustrate the mechanics of table 7-1 for this example, we first specify that the
bus will depreciated by the 200% DB Method (R = 2/n). Because DB methods never
reach a zero BV, suppose that we further specify that a switchover to SL depreciation will
be made to ensure a BV of ₱5,000 at the end of the vehicle’s nine-year class life.

82
 Depreciati
Beginning-
200% on
of SL Method
DB Amount
EOY k -year BV (BVg=5000)
Method Selected
1 ₱95,000 ₱21,111 ₱10,000 ₱21,111
2 73,889 16,420 8,611 16,420
3 57,469 12,771 7,496 12,771
4 44,698 9,933 6,616 9,933
5 34,765 7,726 5,953 7,726
6 27,040 6,009 5,510 6,009
7 21,031 4,674 5,344 5,344a
8 15,687 3,635 5,344 5,344
9 10,344 2,827 5,344 5,344

3 SOURCE: Engineering Economy, 7th Edition, Leland Blank & Anthony

Tarquin

Depreciation is a book method (noncash) to represent the reproduction 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.
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 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 deductible item when calculating annual income taxes for
the corporation or business.

83
 In most industrialized countries, the annual tax depreciation is tax – deductible;
that is, it is subtracted from income when calculating the amount of taxes due each year.
However, the tax depreciation amount must be calculated using a government – approved
method.
First cost P or unadjusted basis B is the delivered and installed cost of the asset
including purchase price, delivery and installation fees, and other depreciable direct costs
incurred to prepare the asset for use. The term unadjusted basis, or simply basis, is used
when the asset is new, with the term adjusted basis used after some depreciation has been
charged. When the first cost has no added, depreciable costs, the basis is the first cost,
that is, P = B.
Book value BVt represents the remaining, undepreciated capital investment on the books
after the total amount of depreciation charges to date has been subtracted from the basis.
The book value is determined at the end of each year t (t = 1, 2, . . . , n), which is
consistent with the end – of – year convention.
Recovery period n is the depreciable life of the asset in years. Often there are different
from the asset’s estimated productive life.
Market value MV, a term also used in replacement analysis, is the estimated amount
realizable if the asset were sold on the open market. Because of the structure of
depreciation laws, the book value may be sustainability different. For example, a
commercial building tends to increase in market value, but the book value will decrease
as depreciation charges are taken. However, a computer workstation may have a market
value much lower than its book value due to rapidly changing technology.
Salvage value S is the estimated trade – in or market value at the end of the asset’s useful
life. The salvage value, expressed as an estimated dollar amount or as a percentage of the
first cost, may be positive, zero, or negative due to dismantling and carry – away costs.
Depreciation rate or recovery rate d1 is the fraction of the first cost removed by
depreciation each year t. this rate may be the same each year, which is called the straight
line rate d, or different for each year recovery period.
Personal property, one of the two types of property for which depreciation is allowed is
the income – producing, tangile possessions of a corporation used to conduct business.
Included is most manufacturing and service industry property – vehicles, manufacturing
equipment, materials handling devices, computers and networking equipment,
communications equipment, office furniture, refining process equipment, construction
assets, and much more.

84
Real property includes real estate and all improvements – office buildings,
manufacturing structures, test facilities, warehouses, apartments, and other structures.
Land itself is considered real property, but it is not depreciable.
Half year convention assumes that assets are placed in service or disposed of in
midyear, regardless of when these events actually occur during the year. This convention
is utilized in this text and in most U.S. – approved tax depreciation methods. There are
also midquarter and midmonth conventions.

STRAIGHT LINE (SL) DEPRECIATION

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.

D = (B – S) dt
= (B – S) / n
Where t = year (t = 1, 2, …, n)
Dt = annual depreciation charge
B = first cost or unadjusted basis
S = estimated salvage value
n = recovery period
dt = depreciation rate = 1/n

Since the asset is depreciated by the same amount each year, the book value after t
years of service, denoted by BVt, will be equal to the first cost B minus the annual
depreciation times t.
BVt = B - tDt
Earlier we defined dt as a depreciation rate for a specific year t. however, the SL
model has the same rate for all years, that is,
d = dt = 1/n

85
 The format for the spreadsheet function to display the annual depreciation Dt in a
single – cell operation is
= SLN (B, S, n)
Example:
If an asset has a first cost of $ 50, 000 with a $ 10, 000 estimated salvage value
after 5 years, (a) calculate the annual depreciation and (b) calculate and plot the book
value of the asset after each year, using straight line depreciation.

Solution:
(a) The depreciation each year for 5 years can be found by:

Enter the function = SLN (50000, 10000, 5) in any cell to display the of $8000.
(b) The book value after each year t is computed. For years 1 and 5,

DECLINING BALANCE (DB) AND DOUBLE DECLINING BALANCE (DDB)

DEPRECIATION

The declining balance method is commonly applied as the book depreciation

method. Like the SL method, DB method itself cannot be used to determine the annual
tax – deductible depreciation in the United States. This method is used routinely in most
other countries for tax and book depreciation purposes.
Declining balance is also known as the fixed percentage or uniform percentage
method. DB depreciation accelerates the write – off of asset value because the annual
depreciation is determine by multiplying the book value at the beginning of a year by a
fixed (uniform) percentage d, expressed in decimal form. If d = 0.1, then 10% of the book

86
value is removed each year. Therefore, the depreciation amount depreciation amount
decreases each year.
The maximum annual depreciation rate for the DB method is twice the straight
line rate, that is,

In this case the method is called double declining balance (DDB). If n = 10 years,
the DDB rate is 2/10 = 0.2; so 20% of the book value is removed annually. Another
commonly used percentage for the DB method is 50% of the SL rate, where d = 1.5 / n.
The depreciation for year t is the fixed rate d times the book value at the end of the
previous year.

The actual depreciation rate for each year t, relative to the basis B, is

If BVt-1 is not known, the depreciation in year t can be calculated using B and d.

Book value in year t is determined in one ways: by using the rate d and basis B or
by subtracting the current depreciation charge from the previous book value. The
equations are

The spreadsheet functions DDB and DB are used to display depreciation amounts
for specific years. The functions is repeated in consecutive spreadsheet cells because the
depreciation amount Dt changes with t. For the double declining balance method, the
format is

87
 The DDB function automatically checks to determine when the book value equals
the estimated S value. No further depreciation is charged when this occurs.
If the depreciation rate is known, always use the DDB function to ensure correct
results.
Example:
Underwater electroacoustic transducers were purchased for use in SONAR
applications. The equipment will be DDB depreciated over an expected life of 12 years.
There is a first cost of $ 25, 000 and an estimating salvage of $2500. (a) Calculate the
depreciation for years 1 and 4. (b) Calculate the implied salvage value after 12 years.

Solution:
(a) The DDB fixed depreciation rate is d = 2/n = 2/12 = 0.1667 per year,
Year 1:

Year 4:

The DDB functions for D1 and D4 are, respectively, = DDB (25000, 25000, 12, 1)
and = DDB (25000, 2500, 12, 4).
(b) From Equation, the implied salvage value after 12 years is

Since the estimated S = $ 2500 is less than $ 2803, the asset is not fully
depreciated when its 12 – year expected life is reached.

DEPLETION METHODS
Depletion is a book method (noncash) to represent the decreasing value of a
natural resource as it is recovered, removed, or felled. The two methods of depletion for
88
book or tax purposes are used to write off the first cost, or value of the estimated
quantity, of resources in mines, wells, quarries, geothermal deposits, forests, and the like.
Cost depletion sometimes referred to as factor depletion, cost depletion is based
on the level of activity or usage, not time, as in depreciation. Cost depletion may be
applied to most types of natural resources and must be applied to timber production. The
cost depletion factor for year t, denoted by CDt, is the ratio of the first cost of the
resource to the estimated number of units recoverable.

Percentage depletion. This is a special consideration given for natural resources.

A constant, stated percentage of the resource’s gross income may be depleted each year
provided it does not exceed 50% of the company’s taxable income. The depletion amount
for year t is calculated as

Example:

A gold mine was purchased for $ 1 million. It has an anticipated gross income of
$5.0 million per year for years 1 to 5 and $3.0 million per year after year 5. Assume that
depletion charges do not exceed 50% of taxable income. Compute annual depletion
amounts for the mine. How long will it take to recover the initial investment at i = 0%
Solution:
The rate for gold is PD = 0.15. Depletion amounts are
Year 1 to 5: 0.15 (5.0 million) = $750, 000
Year thereafter 0.15 (3.0 million) = $450, 000

89
 A total of $3.75 million is written of in 5 years, and the remaining $6.25 million is
written off at $450, 000 per year. The total number of years is

In 19 years, the initial investment could be fully depleted.

BASIC METHODS
FOR MAKING
ECONOMY STUDIES

1 SOURCE: Engineering Economy, 3rd Edition, Hipolito Sta. Maria

The Rate of Return (ROR) Method

The rate of return on the capital invested is given by the formula,

Rate of return = net annual profit / capital invested

Rate of return is a measure of the effectiveness of an investment of capital. It is a

financial efficiency. When this method is used, it is necessary to decide whether the
computed rate of return is sufficient to justify the investment. The advantage of this
method is that it is easily understood by management and investors. The applications of
the rate of return is controlled by the following conditions. A single investment of the
capital at the beginning of the first year of the project life and identical revenue and cost
data for each year. The capital invested is the total amount of capital investment required
to finance the project, whether equity or borrowed.

The Annual Worth (AW) Method

In this method, interest on the original investment (sometimes called minimum

required profit) is included as a cost. If the excess of annual cash inflows over annual

90
cash outflows is not less than zero the proposed investment is justified – is valid. This
method the same limitations as the rate of return pattern a single initial investment of
capital and uniform revenue and cost throughout the life of the investment.

The Future Worth (FW) Method

The future worth method for economy studies is exactly comparable to the present
worth method except that all cash inflows and outflows are compounded forwarded to a
reference point in time called the future. If the future worth of the net cash flows is equal
to, or greater than, zero, the project is justifiable economically.

The Payback (Payout) Period Method

The payback period is commonly defined as the length of time required to recover
the first cost of an investment from the net cash flow produced by that investment for an
interest rate of zero.

Payout period = (investment – salvage value)/ net annual cash flow)

Example:
An investment of P270, 000 can be made in a project that will produce a uniform
annual revenue of P185, 400 for 5 years and then have a salvage value of 10% of the
investment. Out-of-pocket costs for operation and maintenance will be P81,000 per year.
Taxes and insurance will be 4% of the first cost per year. The company expects capital to
earn not less than 25% before income taxes. Is this a desirable investment? What is the
payback period of the investment?

Solution:

By the rate of return method:

Annual Revenue: = 185, 400.00
Annual Cost:
Depreciation= (270,000 – 27,000)/F/A,25%, 5) = 29, 609.00
Operation and Maintenance = 81, 000.00
Taxes and Insurance= 270,000 (0.04) = 10, 800.00
Total Annual Cost = 121, 409.00
Net Annual Profit = ₱63, 991.00
91
 Rate of return= (63,991/ 270,000)(100) = 23.70%

Since the rate of return is less than 25%, the investment is not justified.

By the annual worth method

Annual Revenue: = 185, 400.00
Annual costs:
Depreciation= (270,000 – 27,000)/F/A, 25%, 5 = 29, 609.00
Operation and Maintenance = 81, 000.00
Taxes and Insurance= 270,000 (0.04) = 10, 800.00
Interest on Capital = 67, 50 0.00
Total Annual Cost ₱ 188, 909.00
Excess - ₱ 3, 509

Since the excess of annual cash inflows over annual cash outflows is less than zero
(- P3, 509), the investment is not justified.

By the present worth method

PW of cash inflows = ₱185, 400 (P/A, 25%, 5) + P27, 000 (P/F, 25%, 5)
= ₱185, 400 (2.6893) + P27, 000 (0.3277)
= 506,370

PW of cash outflows = ₱270,000 + ₱91,800 (P/A, 25%, 5) = 516, 880

Since the PW of the net cash flows is less than zero (-₱10,510), the investment is
not justified.

By Future Worth method

FW of cash inflows = ₱27,000 + ₱185,400 (F/A, 25%, 5)

= ₱27,000 + ₱185,400 (8.207)

FW of cash outflows = ₱91,800 (F/A, 25%, 5) + ₱270, 000(F/P, 25%, 5)

= ₱91,800 (8.207) + ₱270, 000(3.0518)
= ₱1, 577, 390

Since the FW of the net cash inflows is less than zero, ( -₱28, 810), the investment is
not justified.

By the payback period

92
Total annual cost = ₱81, 000 + ₱270, 000(.04) = ₱91, 800
Net annual cash flows = ₱185, 400 - ₱91, 800 = ₱93, 600

Payback period = [investment-salvage value]/net annual cash flows = [₱270, 000 - ₱27,
000]/ ₱93,600
= 2.6 yrs.

In computing the total annual cost, depreciation was not included because the method
does not consider the time value of money or interest. The use of the payback period for
making investment decisions should be avoided as it may produce misleading results.

Example:

A businessman is considering building a 25-unit apartment in a place near a

progressive commercial center. He felt that because of the location of the apartment it
will be occupied 90% at all time. He desires a rate of return of 20%. Other pertinent data
are the following:

Land Investment ₱5, 000, 000

Building Investment ₱7, 000, 000
Study period 20 yrs.
Cost of land after 20 yrs ₱2, 000, 000
Cost of building after 20 yrs ₱20, 000, 000
Rent of unit per month ₱6, 000
Upkeep per unit per year 500
Property taxes 1%
Insurance 0.50%

Is this a good investment?

Solution:

Annual income:
Rental = (6000)(12)(25)(0.90) = ₱1, 620, 000
Land = [20, 000, 000 – 5, 000, 000]/F/A, 20%,20 = [15, 000, 000]/186.688 = ₱80, 350
Total annual income = ₱1, 700, 350

Annual costs:
Depreciation = [7,000,000 – 2,000,000]/F/A, 20%, 20 = ₱26, 780
Upkeep = ₱500 (25) = 12,500
Taxes = ₱12,000,000 (.01) = 120,000
Insurance = ₱7,000,000 (.005) = 35,000
93
Total annual cost ₱194,280
Net annual profit ₱1,506,070

Rate of Return = [1,506,070/12,000,000] x 100 = ₱12.55% < 20%

Other solution:

Investment = ₱5,000,000 + ₱7,000,000 = ₱12,000,000

Amount of investment after 20 yrs = ₱20,000,000 + ₱2,000,000
Annual income = ₱1,620,000
Annual costs:

Depreciation = [12,000,000-22,000,000]/F/A,20%,20 = ₱-53,570

Upkeep = ₱500 (25) = ₱12,500

Taxes = ₱12,000,000 (0.01) = ₱120,000
Insurance = ₱7,000,000 (.005) = ₱35,000
Total annual cost = ₱113,930
Net annual profit = ₱1,506,670
Rate of Return = [1,506,070/12,000,000] x 100 = 12.55% < 20%

(The negative sign for the depreciation means that the value of the investment has
increased after 20 years.)

2 SOURCES: http://www.enge.vt.edu/terpenny/Smart/Virtual_econ/Module4/al
ternatives/concept_FW.htm
faculty.uaeu.ac.ae/w_ahmed/Economy/.../Ex_future_worth_method.htm
http://ec314-pdx-edu.wikidot.com/present-worth-sample-problem
http://bca.transportationeconomics.org/types-of-measures/benefit-cost-ratio
http://www.accountingformanagement.org/payback-method/
http://www2.ensc.sfu.ca/undergrad/courses/ENSC301/Unit05/lecture5.html
http://dept.lamar.edu/industrial/Zaloom/Eng_Econ/Ch4_108_117.htm

THE FUTURE WORTH METHOD

The Future Worth method evaluates the desirability of an alternative relative to

some future point in time, such as the end of the study period.
94
 An alternative is profitable if it’s FW (MARR)>=0. When choosing from a set of
alternatives, the most desirable is the alternative with the most positive annual worth.

The future worth 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 that is generally the
MARR. Also, the FW of a project is equivalent to its PW, that is, FW = PW (F/P, i%, n),
if FW ≥ 0 for a project, it would be economically justified.

The following equation is used to determine a project’s future worth

Example:

You have the opportunity to invest in a new project with the following estimated
cash flows and information:

Investment Cost $5,000

Annual Receipts 1,300
Annual Expenses 350
Expected Life 8 years

If your MARR is 10%, is this project profitable? (Use FW at the end of the study
period)

Solution:

To find the FW at the MARR, we need to find the EOY 8 equivalent of all the
cash flows involved:

FW (MARR) = -$5,000(F/P, MARR, 8) + (1,300 - 350)(F/A, MARR, 8)

FW (10%) = -$5,000(F/P, 10%, 8) + 950 (F/A, 10%, 8)
FW (10%) = -$5,000(2.1436) + 950(11.4359)
FW (10%) = $146.11

Since FW (MARR) > 0, the project is profitable.

95
THE PRESENT WORTH METHOD

The Present Worth method evaluates the desirability of an alternative relative to

some base point in time called the present (usually year 0). Basically, it looks at the
present equivalent of all the cash flows of an alternative's study period.

An alternative is profitable if its PW (MARR)>=0. When choosing from a set of

alternatives, the most desirable is the alternative with the most positive present worth.

To find PW as a function of i % (per interest period) of a series of cash inflows

and outflows, it is necessary to discount future amounts to the present by using the
interest rate over the appropriate study period (years, for example) in the following
manner:

Where,

i = effective interest rate, or MARR, per compounding period

k= index for each compounding period
Fk= future cash flows at the end of period k
N = number of compounding periods in the planning horizon (i.e., study period)

Example:

You are collecting bids for the installation and servicing of a new service elevator
for your company's building, and need to select the cheapest offer as this is your first
chance to impress a new boss. You are looking at a minimum attractive rate of return at
12% and a 15 year life span for all bids. Bid A will cost $15,000 to install and will have a
$1000 per year servicing fee. Bid B has a $24,000 installation package and is so
confident in their product that they will service the elevator free of charge. While, Bid C
will cost only $11,000 to install but has a hefty $2,000 per year servicing fee. Choose the
best bid.

96
Solution:

First organize the information given:

Bid A Bid B Bid C

Initial Cost $15,000 $24,000 $11,000
Yearly Cost $1,000 $0 $2,000
MARR = i 0.12 Life = N 15

Second obtain the appropriate equation for Present Worth:

P = A (((1+i)N - 1) / (i (1+i)N))

Then solve present worth for each bid:

PWA = 15,000 + 1,000(P\A, i=.12, N=15)

PWA = 15,000 + 6,810.86 = $21810.86

PWB = $24,000

PWC = 11,000 + 2,000(P\A, i =.12, N=15)

PWC = 11,000 + 13,621.73 = $24,621.73

Choose the cheapest bid: Bid A

Explanation:

The idea of present worth is to take all the expenses that will accumulate over the
life of the asset and move them to the present date. This allows us to evaluate the best
option without biasing ourselves with nice service plans or a cheap initial installation. If
you look at the given information Bid B and C look awfully tempting, but after the
calculations we see that they will end up costing the company more money over the
course of the plans.

To calculate the Present Worth of each bid, the initial cost, which was not
manipulated because all three are in time period 0 (i.e. the present) and the yearly
expense was added using the equation for Present Worth for a constant series. If you look
at the equation the denominator includes a function to move the value to time period 0
(i.e. the present).

97
THE ANNUAL WORTH METHOD

The Annual Worth method evaluates the desirability of an alternative as an equal

annual series of cash flows during the study period. Basically, it looks at the annual
equivalent of all the cash flows of an alternative.

An alternative is profitable if its AW (MARR)>=0. When choosing from a set of

alternatives, the most desirable is the alternative with the most positive annual worth.

The AW of a project is annual equivalent revenues or savings (R) minus annual

equivalent annual expenses (E), less its annual equivalent Capital Recovery (CR) amount,
which is can be calculated by,

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

Where,

I= initial investment for the project

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

An annual equivalent value pf R, E and CR is computed for the study period, N,

which is usually in years. In equation form the AW, which is a function of i%, is N,
which is usually in years. The AW can be calculated by the following formula,

AW (i %) =R-E-CR (i %)

Also, we need to notice that the AW of a project is equivalent to its PW and FW.
That is, AW=PW(A/P, i%,N) and AW=FW(A/F,i%,N). Hence, it can be computed for a
project from these equivalent values.

The AW worth is most useful when comparing alternatives with unequal expected
lives.

98
Example:

You have the opportunity to invest in a new project with the following estimated
cash flows and information:

Investment Cost $5,000

Annual Receipts 1,300
Annual Expenses 350
Expected Life 8 years

If your MARR is 10%, is this project profitable? (Use AW)

Solution:

To find the AW at the MARR, we need to find the annual equivalent of all the cash flows
involved:

AW (MARR) = -$5,000(A/P, MARR, 8) + (1,300 - 350)

AW(10%) = -$5,000(A/P, 10%, 8) + 950
AW(10%) = -$5,000(0.1874) + 950
AW(10%) = $13.00

Since AW (MARR) > 0, the project is profitable.

BENEFIT-COST RATIO METHOD

The total discounted benefits are divided by the total discounted costs. Projects
with a benefit-cost ratio greater than 1 have greater benefits than costs; hence they have
positive net benefits. The higher the ratio, the greater the benefits relative to the costs.
Note that simple benefit-cost ratio is insensitive to the magnitude of net benefits and
therefore may favor projects with small costs and benefits over those with higher net
benefits. (this problem can be eliminated by the use of the incremental benefit-cost ratio
or the net present value.)

Calculating the Simple Benefit-Cost Ratio

n+1 = the number of years over which benefits and costs are analyzed

99
Bi = the benefits of the project in year i, i=0 to n
Ci = the costs of the project in year i
d = the discount rate

First, discount the costs and benefits in future years.

The discounted benefits of the project in year i are equal to Bi/(1+d)i
The discounted costs of the project in year i are equal to Ci/(1+d)i

Then, sum both the discounted benefits and the discounted costs over all years (0 though
n) and divide the sum of the discounted benefits by the sum of the discounted costs:

Σ(Bi/(1+d)i)/Σ (Ci/(1+d)i), summed over i = 0 to n.

Calculating the Incremental Benefit-Cost Ratio

This method is applicable if there are two or more alternative projects to compare to the
base case. It is also known as the "Challenger-Defender Method."

Bk = the total discounted benefits of an alternative k, calculated as above

Ck = the total discounted costs of an alternative k, calculated as above

First, discount all future costs and benefits to obtain Ck and Bk for each alternative and
for the base case.
Then start by identifying the base case as the defender, represented by the subscript "f."
Pick the alternative with the least value of total discounted costs as the challenger "c."
Calculate the incremental benefit-cost ratio to compare the challenger and defender: (Bf-
Bd)/(Cf-Cd)
If the incremental B/C ratio is greater than 1, the challenger becomes the defender.
Otherwise, the defender remains. In either case, the next alternative in order or increasing
value of Ck is picked as the new challenger.
Continue to compare challenger to defender following the above logic until all
alternatives have been considered. The surviving defender is the economically preferred
alternative.

This procedure is mathematically equivalent to Net Present Value, and it always gives the
same result, but use of this procedure may provide greater insights into the relationships
between costs and benefits of the different projects.

100
PAYBACK PERIOD METHOD

Unlike net present value method and internal rate of return method, payback
method does not consider the present value of cash flows. Under this method, an
investment project is accepted or rejected on the basis of payback period. Payback period
means the period of time that a project requires to recover the money invested in it. The
payback period of a project is expressed in years and is computed using the following
formula:

Formula of payback period:

According to this method, the project that promises a quick recovery of initial
investment is considered desirable. If the payback period of a project computed by the
above formula is shorter than or equal to the management’s maximum desired payback
period, the project is accepted otherwise it is rejected. For example, if a company wants
to recoup the cost of a machine within 5 years of purchase, the maximum desired
payback period of the company would be 5 years. The purchase of machine would be
desirable if it promises a payback period of 5 years or less.

Consider the following example to understand the analysis of a project under this
method:

Example 1:

Due to increased demand, the management of Rani Beverage Company is

considering to purchase a new equipment to increase the production and revenues. The
useful life of the equipment is 10 years and the company’s maximum desired payback
period is 4 years. The inflow and outflow of cash associated with the new equipment is
given below:

The initial cost of equipment $37,500

Annual cash inflow:
Sales $75,000
Annual cash outflow:
Cost of ingredients $45,000
Salaries expenses $13,500
Maintenance expenses $1,500
Non - cash expenses:
Depreciation $5,000
101
Required: Should Rani Beverage Company purchase the new equipment? Use payback
method for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout the
net annual cash inflow by deducting the total of cash outflow from the total of cash
inflow associated with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)

= $15,000

Step 2: Now, the amount of investment required to purchase the equipment would be
divided by the amount of net annual cash inflow (computed in step 1) to find the payback
period of the equipment.

= $37,500/$15,000

= 2.5 years

Depreciation is a non - cash expense and therefore has been ignored.

According to payback method, the equipment should be purchased because the

payback period of the equipment is 2.5 years which is shorter than the maximum desired
payback period of the company.

Comparison of two or more alternatives – choosing from several alternative

projects:

Where funds are limited and several alternative projects are being considered, the
project with the shortest payback period is preferred. It is explained with the help of the
following example:

102
Example 2:

The management of Health Supplement Inc. wants to reduce its labor cost by
installing a new machine. Two types of machines are available in the market – machine X
and machine Y. Machine X would cost $18,000 whereas machine Y would cost $15,000.
Both the machines can reduce annual labor cost by $3,000.

Required: Which is the best machine to purchase according to payback method?

Solution:

Machine X Machine Y
Cost of machine (a) $18,000 $15,000
Annual cost saving (b) $3,000 $3,000
Payback period (a)/(b) 6 years 5 years

According to payback method, machine Y is more desirable than machine X

because it has a shorter payback period than machine X.

Payback method and uneven cash flow:

In the above examples we have assumed that the projects generate even cash
inflow (same cash inflow during each period) but when projects generate uneven cash
inflow (different cash inflow in different periods), the payback period formula given
above cannot be used to compute payback period.

To understand the analysis of a project that generates uneven cash inflow, consider
the following example:

Example 3:

An investment of $200,000 is expected to generate the following cash flows in six years:

Year Net cash flow

1 $30,000
2 $40,000
3 $60,000
4 $70,000
5 $55,000
6 $45,000

103
Required: Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?

Solution:

(1). because, the cash inflow is uneven, the payback period formula cannot be used to
compute the payback period. We can compute the payback period by computing the
cumulative net cash flow as follows:

Cumulative
Net cash
Year net cash
flow
inflow
1 $30,000 $30,000
2 $40,000 $70,000
3 $60,000 $130,000
4 $70,000 $200,000
5 $55,000 $255,000
6 $45,000 $300,000

Payback period is 4 years because the cumulative cash flow at the end of 4th year
becomes equal to initial amount of investment.

(2). as the payback period is longer than the maximum desired payback period of the
management (3 years), the investment should not be made.

Advantages and disadvantages of payback method:

Advantages:

1. An investment project with a short payback period promises the quick inflow of
cash. It is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the
business quickly. The payback period is important for the firms for which liquidity
is very important.
3. An investment with short payback period makes the funds available soon to invest
in another project.
4. A short payback period reduces the risk of loss caused by changing economic
conditions and other unavoidable reasons.
5. Payback period is very easy to compute.
104
Disadvantages:

1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback
period. For example, If two projects, project A and project B require an initial
investment of $5,000. Project A generates an annual cash inflow of $1,000 for 5
years whereas project B generates a cash inflow of $1,000 for 7 years. It is clear
that the project B is more profitable than project A. But according to payback
method, both the projects are equally desirable because both have a payback
period of 5 years ($5,000/$1,000).

INTERNAL RATE OF RETURN

The internal rate of return is designated as i*. It is the interest rate at which the
future worth (or present worth) of a cash flow equals zero. In order to calculate the
internal rate of return for project j, we must set the future worth (or present worth) of the
cash flow equal to zero and solve the equation for i*.

∑ ( )

∑ .

One of the problems with finding the internal rate or return is that the solution to
equation above may not be unique. In other words there might be multiple values of i
which satisfy this equation. A cash flow that has three rates of return is illustrated. A
graph of the future worth of this cash flow as a function of the interest rate is shown.
Note that the future worth equals zero at rates of 20, 40 and 50%. If one desired a rate of
return of at least 30% would this be a good project? One of the internal rates of return is
less than 30% but two others are greater than 30%.

105
EXTERNAL RATE OF RETURN

The external rate of return, denoted i’, is an alternative measure of investment

worth which does have a unique value. The external rate of return is obtained by solving
equation above for i’.

∑ ∑

On the left hand side of equation all revenues in the cash flow are taken out to the
future at the interest rate rt. On the right hand side all costs in the cash flow are taken at
out to the future at rate i’,the external rate of return . The solution to this equation yields
a unique value of i’.

Example:

This is to illustrate how to calculate PW, AW, FW, i* and i’. The cash flow for
this problem is as follows:

Solution:

(a) PW(15%) = -20,000 + (8500 – 2300) (P/A,15,6) + 5000 (P/F,15,6)

= -20,000 + 6200 (3.7845) + 5000 (0.4323)

= -20,000 + 23,464 + 2162

= $ 5,626.

106
 (b) AW(15%) = PW(15%) (A/P,i,n)

= 5,626 (0.2643) = $ 1,487/ yr.

(c) FW(15%) = PW(15%) (F/P,i,n)

= 5626 (F/P,15,6) = $ 13,013.

(d) The internal rate of return is the value of i which solves the following equation.

PW(i*) = 0

-20,000 + 6200(P/A,i*,6) + 5000(P/F,i*,6) = 0

Since in part (a) the present worth was positive $5,626 when the rate was 15%, we
must use a higher rate because the higher the rate the smaller the present worth. We’ll use
a trial and error method and start with i = 20%.

PW(20%) = -20,000 + 6200 (P/A,20,6) + 5000 (1.2)-6

= -20,000 + 6200 (3.3255) + 1674

= -20,000 + 20,618 + 1674 = $ 2,292.

Since PW(20%) is positive we need to try an ever higher rate. Next we’ll try 25%.

PW(25%) = -20,000 + 6200 (P/A,25,6) + 5000 (1.25)-6

= -20,000 + 6200 (2.9514) + 1311

= -20,000 + 18,299 + 1311 = $ -390.

107
 Since the PW(25%) is negative the PW(20%) is positive the PW at some rate between
20% and 25% is zero. The value of i for which the present worth is zero can be
approximated as follows:

i* = 20% + (25% - 20%) { [ 2292 – (0) ] / [ 2292 – (-390) ] }

= 20% + (5%) ( 2292 / 2682) = 20% + 4.3%

i* = 24.3%

3 Source: Engineering Economy, 15th Edition, William G. Sullivan

FUTURE WORTH METHOD

Example:

The ₱110,000 retrofitted space-heating system was projected to save ₱30,000 per
year in electrical power and be worth ₱8,000 at the end of six-year study period. Use the
FW method to determine whether the project is still economically justified if the system
has zero market value after six years. MARR (minimum attractive rate of return) is 15%
per year.

108
Solution:

FW (15%) = -₱110,000 (F/P, 15%, 6) + ₱30,000 (F/A, 15%, 6)

= ₱110,000 (2.3131) + ₱30,000 (8.7537)
= ₱8,170

The heating system will is still profitable since FW is more than 0 even if it has no
market value at the end of the study period.

PRESENT WORTH METHOD

Example:

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 5 years.
Increased productivity attributable to the equipment will be ₱8,000 per year after extra
operating costs have been subtracted from the revenue generated by the additional
production. If the attractive rate of return is 20& per year, is this proposal a good one?

Solution:

PW = PW of cash inflows – PW of cash outflows, or

PW(20%) = ₱8,000(p/a,20%,5) + ₱5,000(P/F,20%,5) - ₱25,000

= ₱934.29

Coz PW(20%) > 0, the equipment is economically justified.

109
ANNUAL WORTH METHOD

Example:

A corporate jet costs ₱1,350,000 and will incur ₱200,000 per year in fixed
costs(maintenance, license, insurance, and hanger 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. (a) Determine the capital
cost of every jet. (b) what is the annual EUAC of the jet?

Solution:

(a) CR = ₱1,350,000 (A/P, 15%, 5) - 650,000(A/P, 20%, 5) = 306,310

(b) The total annual expense for the jet is the sum of the fixed costs and the variable
costs.

E = ₱200,000 + (1,200hrs) (₱277/hr.) = 532,400

EUAC (15%) = ₱532,400 + ₱306,310 = 838,710

THE INTERNAL RATE OF RETURN METHOD

Example:

The Fly-by-night finance company advertises a ―bargain 6% plan‖ for financing

the purchase of automobiles. To the amount of the loan being financed, 6% is added for
each year money is owed. This total is then divided by the number of months over which
the payments are to be made, and the result is the amount of the monthly payments. For
example, a woman purchases 1 ₱10,000, automobile under this plan and makes an initial
cash payment of ₱2,500. She wishes to pay the ₱7,500 balance in 24monthly payments.

Purchase price = ₱10,000

-Initial payment = 2,500
Balance due = 7,500
+6% finance charge = 0.06 x 2yrs x ₱7,500 = 900
=total to be paid = 8,400
Monthly payments (A) = ₱8,400/24 = ₱350

Solution:
110
 Cause there are to be 24 payments each, made at the end of each month, these
constitute an annuity (A) at some unknown rate of interest, i%, that should be computed
only upon the unpaid balance instead of on the entire ₱7,500 borrowed.

In this example, the amount owed on the automobile (i.e., the initial unpaid
balance) is ₱7,500, so the following equivalence expression is employed to compute the
unknown monthly interest rate:

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

₱7,500 = ₱350/month (P/A, i%, 24months),
(P/A, i%, 24) = ₱7,500/₱350 = 21.43

Examine the interest tables for P/A factors at N = 24 that come closest to 21.43,
we find that (P/A, 3/4%, 24) = 21.8891 and (P/A, 1%, 24) = 21.2434.
Using the linear interpolation procedure, the IRR is computed as 0.93% per
month, since payments are monthly. The nominal rate paid on the borrowed money is
0.93 %(12) = 11.16% compounded monthly. This corresponds to an effective annual
interest rate of [(1 + 0.0093)12- 1)] x 100% = 12%. What appeared at first to be real
bargain turns out to involve effective annual interest at twice the stated rate. The reason is
that, on the average, only ₱3,750 over 24 months was charged by the finance company.

THE EXTERNAL RATE OF RETURN METHOD

Example:

A 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 (salvage) value of ₱5,000 at the end of its expected life 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 value of the additional production.
MARR is 20% per year.

Solution:

By utilizing Equation (5-8), we have the following relationship to solve for i’ :

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

(F/P, i%, 5) = (F/P, i%, 5) = 64,532.80/₱25,000 = 2.5813 = (1 + i’)5
i’ = 20.88%
Because i > MARR, the project is justified, but just barely.

111
THE PAYBACK (PAYOUT) PERIOD METHOD

Semiconductor manufacturing involves taking a flat disc of silicon, called a wafer,

and depositing many layers of material on top of it. Each layer has a pattern on that, upon
completion, defines the electrical circuits of the finished microprocessor on it. However,
the typical average yield of the production line is 75% good microprocessors per wafer.

At one local company, the process engineers responsible for the chemical-vapor-
composition (CVD) tool (i.e., process equipment) that deposits one of the many layers
have an idea for improving overall yield. They propose to improve this tool’s vacuum
with a redesign of one of its major components. The engineers believe the project will
result in a 2% increase in the average production yield of non-defective microprocessors
per wafer.

This company has only one CVD tool, and it can process 10 wafers per hour. The
process engineers have determined that the CVD tool has an average utilization rate (i.e.,
―time running‖) of 80%. A wafer costs ₱5,000 to manufacture, and a good
microprocessor can be sold for ₱100. These semiconductor fabrication plants (―fabs‖)
operate 168 hours per week, and all good microprocessors produced can be sold.

The capital investment required for the project is ₱250,000, and maintenance and
support expenses are expected to be ₱25,000 per month. The lifetime of the modified tool
will be five years, and the company uses a 12% MARR per year (compounded monthly)
as its ―hurdle rate‖.

Before implementing the proposed engineering solution, top management has

posed the following questions to you (hired as an independent consultant) to evaluate the
merits of the proposal:

(a) Based on the PW method, should the project be approved?

(b) If the achievable improvement in production yield has been overestimated by the
process engineers, at what percent yield improvement would the project breakeven?

Solution:

Start your economic evaluation of the engineering proposal by first calculating the
production rate of wafers. The average # of wafers per week is

(10 wafers/hour) x (168 hours/week) x (0.80) = 1,344

112
Since the cost per wafer is ₱5,000 and good microprocessors can be sold for ₱100 each,
you determine that profit is earned on each microprocessor produced and sold after the
50th microprocessor on each wafer. Thus, the 2% increase in production yield is all profit
(i.e., from 75 good microprocessors per wafer on the average to 76.5). The corresponding
additional profit per wafer is ₱150. The added profit per month, assuming a month is (52
weeks/year/12 months per year) = 4.333 weeks, is

(1,344 wafers/week)(4.333 weeks/month)( ₱150/wafer) = ₱873,533

Therefore, the PW of the project is

PW (1%) = ₱250,000 - ₱25,000 (P/A, 1% per month, 60 months)

+ ₱873,533 (P/A, 1%, 60)
= ₱37,898,813

You advise company management that, based on PW, the project should be
undertaken.

It is known that the breakeven point, profit equals zero. That is, the PW of the
project is equal to zero, or PW of costs = PW of revenues. In other words,

₱1,373,875 = (1,344 wafers/week) x (4.333 weeks/month) x ₱x/wafer) x (P/A,

1%, 60),
Where X = ₱100 times the number of extra microprocessors per wafer. Then,

₱1,373,875/(1,344)(4.333)(44.955) = X, or X = ₱5.25 per wafer.

Thus, (₱5.25/₱100) = 0.0525 extra microprocessors per wafer (total of 75.0525) equates
PW of costs to PW of revenues. This corresponds to a breakeven increase in yield of

1.5 die per wafer/0.0525 die per wafer = 2.0% increase/breakeven increase
Or breakeven increase in yield = 0.07%
You advise management that an increase of only 0.07% in process yield would
enable the project to breakeven. Thus, although management may believe that the process
engineers have overestimated projected process yield improvement in the past, there is a
quite a bit of ―economic safety margin‖ provided by the engineers in their current
projection of process yield improvement as long as the other assumptions concerning the
average utilization rate of the CVD tool, the wafer production rate of the CVD tool, the
wafer production rate, and the plant operating hours are valid.

113
B-C RATIO METHOD

Columbia 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 a farmland that 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. 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 two air traffic controllers at an annual cost
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 Columbia
₱50,000___Additional Tourism dollars for Columbia

Solution:

Conventional B-C B-C= PW(B) / [PW(MV) + PW(O&M)]

Equation B-C= ₱490,000(P/A,10%,20) / [₱1,200,000 + ₱197,500
(P/A,10%,20)]
B-C = 1.448 > 1 ; extend runways

Modified B-C B-C= PW(B) / [PW(O&M) + PW(MV)]

Equation B-C=₱490,000(P/A,10%,20) – [₱197,500 (P/A,10%,20)] /
₱1,200,000
B-C = 2.075 > 1 ; extend runways

B / C RATIO

Disbenefits reduce B-C = AW(B) – AW(D) / [CR + AW (O&M)]

Benefits, Equation B-C = [₱490,000 - ₱100,000] / [₱1,200,000(A/P,10%,20) +
₱197,500]
B-C = 1.152 > 1 ; extend runways.

Disbenefits treated B-C = AW(B) / [CR + AW (O&M + AW(D)]

As additional costs B-C = ₱490,000 /[ ₱1,200,000(A/P,10%,20) + ₱197,500 +
₱100,000]
B-C = 1.118 > 1 ; extend runways.
114
 BREAKEVEN

1 SOURCE: http://en.wikipedia.org/wiki/Break-even_%28economics%29

THE BREAK-EVEN POINT

The break-even level or break-even point (BEP) represents the sales amount—in
either unit or revenue terms—that is required to cover total costs (both fixed and
variable). Profit at break-even is zero. Break-even is only possible if a firm’s prices are
higher than its variable costs per unit. If so, then each unit of the product sold will
generate some ―contribution‖ toward covering fixed costs.

In economics & business, specifically cost accounting, the break-even point (BEP)
is the point at which cost or expenses and revenue are equal: there is no net loss or gain,
and one has "broken even." A profit or a loss has not been made, although opportunity
costs have been "paid," and capital has received the risk-adjusted, expected return. In
short, all costs that needs to be paid are paid by the firm but the profit is equal to 0.

For example, if a business sells fewer than 200 tables each month, it will make a
loss; if it sells more, it will make a profit. With this information, the business managers
will then need to see if they expect to be able to make and sell 200 tables per month.

115
 If they think they cannot sell that many, to ensure viability they could:

1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better
control of telephone bills or other costs)
2. Try to reduce variable costs (the price it pays for the tables by finding a new
supplier)
3. Increase the selling price of their tables.

Any of these would reduce the break-even point. In other words, the business would
not need to sell so many tables to make sure it could pay its fixed costs.

The purpose of break-even analysis is to provide a rough indicator of the earnings

impact of a marketing activity.

The break-even point is one of the simplest yet least used analytical tools in
management. It helps to provide a dynamic view of the relationships between sales, costs,
and profits. For example, expressing break-even sales as a percentage of actual sales can
give managers a chance to understand when to expect to break even (by linking the
percent to when in the week/month this percent of sales might occur).

The break-even point is a special case of Target Income Sales, where Target Income
is 0 (breaking even). This is very important for financial analysis.

In the linear Cost-Volume-Profit Analysis model (where marginal costs and marginal
revenues are constant, among other assumptions), the break-even point (BEP) (in terms
of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total
Costs (TC) as:

Where:

 TFC is Total Fixed Costs,

 P is Unit Sale Price, and
 V is Unit Variable Cost.

116
 The Break-Even Point can alternatively be computed as the point where
Contribution equals Fixed Costs.

The quantity, is of interest in its own right, and is called the Unit
Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of
each sale that contributes to Fixed Costs. Thus the break-even point can be more simply
computed as the point where Total Contribution = Total Fixed Cost:

To calculate the break-even point in terms of revenue (a.k.a. currency units, a.k.a.
sales proceeds) instead of Unit Sales (X), the above calculation can be multiplied by
Price, or, equivalently, the Contribution Margin Ratio (Unit Contribution Margin over
Price) can be calculated:

R=C, Where R is revenue generated, C is cost incurred i.e. Fixed costs + Variable
Costs or Q * P (Price per unit) = TFC + Q * VC (Price per unit), Q * P - Q * VC = TFC,
Q * (P - VC) = TFC, or, Break Even Analysis Q = TFC/c/s ratio=Break Even.

117
MARGIN OF SAFETY

Margin of safety represents the strength of the business. It enables a business to

know what is the exact amount it has gained or lost and whether they are over or below
the break-even point.

Margin of safety = (current output - breakeven output)

Margin of safety% = (current output - breakeven output)/current output × 100

When dealing with budgets you would instead replace "Current output" with
"Budgeted output." If P/V ratio is given then profit/PV ratio.

BREAK-EVEN ANALYSIS

By inserting different prices into the formula, you will obtain a number of break-
even points, one for each possible price charged. If the firm changes the selling price for
its product, from $2 to $2.30, in the example above, then it would have to sell only
1000/(2.3 - 0.6)= 589 units to break even, rather than 715.

To make the results clearer, they can be graphed. To do this, you draw the total
cost curve (TC in the diagram) which shows the total cost associated with each possible
level of output, the fixed cost curve (FC) which shows the costs that do not vary with
output level, and finally the various total revenue lines (R1, R2, and R3) which show the
total amount of revenue received at each output level, given the price you will be
charging.

The break-even points (A,B,C) are the points of intersection between the total cost
curve (TC) and a total revenue curve (R1, R2, or R3). The break-even quantity at each
selling price can be read off the horizontal axis and the break-even price at each selling
price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves
118
can each be constructed with simple formulae. For example, the total revenue curve is
simply the product of selling price times quantity for each output quantity. The data used
in these formulae come either from accounting records or from various estimation
techniques such as regression analysis.

NOTE:

 Break-even analysis is only a supply-side (i.e., costs only) analysis, as it tells you
nothing about what sales are actually likely to be for the product at these various
prices.
 It assumes that fixed costs (FC) are constant. Although this is true in the short run,
an increase in the scale of production is likely to cause fixed costs to rise.
 It assumes average variable costs are constant per unit of output, at least in the
range of likely quantities of sales. (i.e., linearity).
 It assumes that the quantity of goods produced is equal to the quantity of goods
sold (i.e., there is no change in the quantity of goods held in inventory at the
beginning of the period and the quantity of goods held in inventory at the end of
the period).
 In multi-product companies, it assumes that the relative proportions of each
product sold and produced are constant (i.e., the sales mix is constant).

SOURCE: Engineering Economy, 7th Edition, Leland blank & Anthony

2 Tarquin

BREAKEVEN ANALYSIS FOR A SINGLE PROJECT

Breakeven analysis finds the value of a parameter that makes two elements equal.
The breakeven point is determined from mathematical relations, e.g., product
revenue and costs or materials supply and demand or other parameters that involve the
parameter Q. Breakeven analysis is fundamental to evaluations such as make – buy
decisions.
Fixed Costs (FC). These include costs such as buildings, insurance, fixed overhead, and
some minimum level of labor, equipment capital recovery, and information systems.

119
Variable Costs (VC). These include costs such as direct labor, materials, indirect costs,
contractors, marketing, advertisement, and warranty.
Profit = revenue – total cost
= R – TC
= R – (FC + VC)

A relation for the breakeven point may be derived when revenue and total cost are
linear functions of quantity Q by setting the relations for R and TC equal to each other,
indicating a profit of zero.
R = TC
rQ = FC + vQ
Where, r = revenue per unit
v= variable cost per unit

Solve for the breakeven quantity Q = QBE for linear R and TC functions.

Example:
Idea industries is a major producer of diverter dampers used in the gas turbine
power industry to divert gas exhausts from the turbine to side stack, thus reducing the
noise to acceptable levels for human environments. Normal production level is diverter
systems per month, but due to significantly improved economic conditions in Asia,
production is at 72 per month. The following information is available.
Fixed cost FC = $ 2.4 million per month
Variable cost per unit v = $ 35, 000
Revenue per unit r = $ 75, 000
(a) How does the increased production level of 72 units per month compare with
current breakeven point?
(b) What is the current profit level per month for the facility?
(c) What is the difference between the revenue and variable cost per damper that is
necessary to breakeven at significantly reduced monthly production level of 45
units, if fixed costs remain constant?

120
 Solution:

per month

BREAKEVEN ANALYSIS BETWEEN TWO ALTERNATIVES

Breakeven analysis determines the value of a common variable or parameter

between two alternatives. Equating the two PW or AW relations determines the
breakeven point. Selection of the alternative is different depending upon two facts: slope
of the variable cost curve and the parameter value relative to the breakeven point.
Instead of plotting the total costs of each alternative and estimating the breakeven
point graphically, it may be easier to calculate the breakeven point numerically using
engineering economy expressions for the PW or AW at the MARR. The AW is preferred
when the variable units are expressed on a yearly basis, and AW calculations are simpler
for all alternatives with unequal lives. The following steps determine the breakeven point
of the common variable and the slope of a linear total cost relation.
1. Define the common variable and its dimensional units.
2. Develop the PW or AW relation for each alternative as a function of the common
variable.
3. Equate the two relations and solve for the breakeven value of the variable.

121
Selection between alternatives is based on this guideline:
If the anticipated level of the common variable is below the breakeven value,
select the alternative with the higher variable cost (larger scope).
If the level is above the breakeven point, select the alternative with the lower
variable cost.

Example:
A small aerospace company is evaluating two alternatives: the purchase of an automatic
feed machine and a manual feed machine for a finishing process. The auto feed machine
has an initial cost of $23,000, an estimated salvage value of $ 4000, and a predicted life
of 10years. One person will operate the machine at a rate of $ 12 per hour. The expected
output is 8 tons per hour. Annual maintenance and operating cost is expected to be $
3500.
The alternative manual feed machine has a first cost of $ 8000, no expected
salvage value, a 5 – year life, and an output of 6 tons per hour. However, three workers
will be required at $ 8 per hour each. The machine will have an annual maintenance and
operation cost of $ 1500. All projects are expected to generate a return of 10% per year.
How many tons per year must be finished to justify the higher purchase cost of the auto
feed machine?
Solution:
Use the steps above to calculate the breakeven point between the two alternatives.
1. Let x represent the number of tons per year.
2. For the auto feed machine, the annual variable cost is

The VC is developed in dollars per year. The AW expression for the auto feed machine is

( ) ( )

Similarly, the annual variable cost and AW for the manual feed machine are:
122
 ( )

3. Equate the two cost relations and solve for x.

If the output is expected to exceed 1353 tons per year, purchase the auto feed
machine, since its VC slope of 1.5 is smaller than the manual feed VC slope of 4.

3 SOURCE: Engineering Economy, 3rd Edition, Hipolito Sta. Maria

BREAK-EVEN ANALYSIS

In engineering economy, many situations are encountered where the cost of two or
more alternatives may be affected by a common variable. Break-even point is the value
of the variable for which the costs for alternative will be equal.

C1 = f1(x) and C2 = f2(x)

Where:
C1 = certain specified total cost applicable to Alternative 1
C2 = certain specified total cost applicable to Alternative 2
x = a common independent variable affecting both Alternatives.
The break-even point is where C1 and C2 are equal, f2(x) = f1(x) which may be
solved for x, the break-even point.

123
BREAK-EVEN CHART

Break-even chart is a graphical presentation of break-even analysis. The break-

even point is the quantity of production at which the income is equal with the expenses.
It’s the intersection of the income line and the total cost line on the break-even chart.

When two alternatives are to be compared, the break-even point is the intersection
of the total cost line for each alternative of the break-even chart.

SENSITIVITY

1 SOURCE: Engineering Economy, 15th Edition, William G. Sullivan

Sensitivity analysis is used to explore what happens to a project’s profitability

when the estimated value of study factors are changed.

Example:

Consider a proposal to enhance the vision system by a postal service to sort mail.
The new system is estimated to cost $1.1 million and will incur an additional $20, 000
per year on maintenance costs. The system will produce annual savings of $500, 000 each
year (primarily by decreasing the percentage of misdirected mail and reducing the
amount of mail that must be sorted manually. The MARR is 10% per year, and the study
period is five years at which time the system will be technologically obsolete (worthless).
The PW of this proposal is

( )

Determine how sensitive the decision to invest in the system is to the estimates of
investment cost and annual savings.
124
Solution:

Our initial appraisal of the project shows it to be a profitable venture. Now let’s
look at what happens if we are wrong in our estimates. Essentially, we need to find the
breakeven investment cost that would cause us to reverse our decision. Then

( )

Similarly, let y be the percent change in annual savings.

] ( )

If the investment cost increases by more than 3.4%, the new vision system
would no longer be acceptable. Likewise, if the estimate of annual savings is lower by
more than 2% of its most likely value, the project would be a no – go. The responsible
engineer now needs to take a hard look at how the original estimates were made and
decide whether or not more detailed estimates are required.

2 SOURCE: Engineering Economy, 7th Edition, Leland Blank & Anthony

Tarquin

Sensitivity analysis determines how a measure of worth – PW, AW, FW, OR,
B/C, or CER – is altered when one or more parameters vary over a selected range of
values. Usually one parameter at a time is varied, and independence with other
parameters is assumed. Though this approach is an oversimplification in real – world
situations, since the dependencies are difficult to accurately model, the end results are
usually correct.

Parameters such as MARR and other interest rates (loan rates, inflation rate) are
more stable from project to project. If performed, sensitivity analysis on them is specific
values or over a narrow range of values. This point is important to remember if
simulation is used for decision making under risk.

125
 Here is a general procedure to follow when conducting a thorough sensitivity
analysis.

1. Determine which parameter(s) of interest might vary from the most likely
estimated value.
2. Select the probable range and an increment of variation for each parameter.
3. Select the measure worth.
4. Compute the results for each parameter, using the measure of worth as a basis.
5. To better interpret the sensitivity, graphically display the parameter versus the
measure of worth.

Example:

Wild Rice, Inc. expects to purchase a new asset for automated rice handling.
Most likely estimates are a first cost of $80, 000, zero salvage value, and a cash flow
before taxes (CFBT) per year t that follows the relation $27, 000 – 2000t. The MARR for
the company varies over a wide range from 10% to 25% per year for different types of
investments. The economic life of similar machinery varies from 8 to 12 years. Evaluate
the sensitivity of PW by varying (a) MARR, while assuming a constant n value of 10
years, and (b) n, while MARR is constant at 15% per year. Perform the analysis by hand.

Solution (by hand):

(a) Follow the procedure above to understand the sensitivity of PW to MARR variation.

1. MARR is the parameter of interest.

2. Select 5% increments to evaluate sensitivity of MARR; the range is 10% to
25%
3. The measure of worth is PW.
4. Set up the PW relation for 10 years. When MARR = 10%

( ) ( )

The PW for all MARR values at 5% intervals is as follows:

126
 MARR, 10% PW, $
10 27, 830
15 11, 512
20 - 962
25 - 10. 711

5. A plot of MARR versus PW is shown. The steep negative slope indicates that
the decision to accept the proposal based on PW is quite sensitive to variations in the
MARR. If the MARR is established at the upper and of the range, the investment is not
attractive.
(b) 1. Asset life n is the parameter.
2. Select 2- year increments to evaluate PW sensitivity over the range 8 to 12
years.
3. The measure of worth is PW.
4. Set up the same PW relation as in part (a) at I = 15%. The PW results are

N PW, $
8 7, 221
10 11, 511
12 13, 145

3 SOURCE: Engineering Economy, 3rd Edition, Matias Arreola

Sensitivity is a measure of the degree changes in the factors or parameters used

in an economic analysis will affect an investment decision. If a change in an economic
factor used then that decision is not sensitive to that particular factor. However, if a slight
change in a certain factor causes a reversal in the investment decision, then the project is
definitely sensitive to that factor.

127
 DECISION MAKING

1 SOURCE: Engineering Economy, 7th Edition, Leland Blank & Anthony

Tarquin

INTERPRETATION OF CERTAINTY, RISK & UNCERTAINTY

When there may be two or more observable values for a parameter and it is
possible to estimate the chance that each value may occur, risk is present. Virtually all
decision making is performed under risk.

Decision making under uncertainty means there are two or more values
observable, but the chances of their occurring cannot be estimated or no one is willing to
assign the chances. The observable values in uncertainty analysis are often referred to as
states of nature.

For example:

Consider the states of nature to be rate of national inflation in a particular

country during the next 2 to 4 years:

Remain low, increase 2% to 6% annually, or increase 6% to 8% annually. If

there is absolutely no indication that the three values are equally likely, or that one
uncertainty.

DECISION MAKING UNDER CERTAINTY

This is what we have done in most analyses thus far. Deterministic estimates are
made and entered into measure of worth relations – PW, AW, FW, ROR, B/C – and
decision making is based on the results.

For example:

An asset’s FC estimate made with certainty bar at P = $50,000. A plot of P

versus chance has the general form with one vertical bar at $50, 000 & 100% chance
placed on it.
128
 The term deterministic, in lieu of certainty, is often used when single value or
single – point estimates are used exclusively.

DECISION MAKING UNDER RISK

Now the element of chance is formally taken into account. However, it is more
difficult to make a clear decision because the analysis attempts to accommodate
variation. One or more parameters in an alternative will be allowed to vary. The
estimates will be expressed or in slightly more complex forms. Fundamentally, there are
two ways to consider risk in analysis:

Expected value analysis. Use the chance and parameter estimates to calculate
expected values E(parameter) via formulas. Analysis results in E(cash flow), as E(AOC),
and the like; and the final result is the expected value for a measure of worth, such as
E(PW), E(AW), E(ROR), E(B/C). To select the alternative, choose the most favorable
expected value of the measure of worth. In an elementary form, this is what we learned
about expected values. The computations may become more elaborate, but the principle
is fundamentally the same.

Simulation analysis. Use the chance and parameter estimates to generate

repeated computations of the measure of worth relation by randomly sampling from a
plot for each varying parameter similar. When a representative and random sampleis
complete, an alternative is selected utilizing a table or plot of the results. Usually,
graphics are an important part or decision making via simulation analysis. Basically, this
is the approach discussed in the rest.

DECISION MAKING UNDER UNCERTAINTY

When chances are not known for the identified staes of nature (or values) of the
uncertain parameters, the use of expected value – based decision making under risk as
outlined above is not an option.

In an Engineering Economy study, observed parameter values will vary from the
value estimated at the time of the study. However, when performing the analysis, not all
parameters should be considered as probabilistic (or at risk). Those that are estimable
with a relatively high degree of certainty should be fixed for the study. Accordingly, the
methods of sampling, simulation, and statistical data analysis are selectively used on
parameters deemed important to the decision – making process. Parameters such as P.
AOC, material and unit costs, sales price, revenues, etc., are the targets of decision

129
making under risk. Anticipated variation in in interest rates is more commonly addressed
by sensitivity analysis.

2 SOURCE: Engineering Economy, 15th Edition, William G. Sullivan

SOURCES OF UNCERTAINTY

It is useful to consider some of the factors that affect the uncertainty involved in
the analysis of the future economic consequences of an engineering project. It would be
almost impossible to list and discuss all the potential factors. There are four major
sources of uncertainty, however, that are nearly always present in engineering economy
studies.
The first source that is always present is the possible inaccuracy of the cash flow
estimates used in the study. The accuracy of the cash – inflow estimates is difficult to
determine. If they based on past experience or have been determined by adequate market
surveys, a fair degree of reliance may be placed on them. On the other hand, if they are
based on limited information with a considerable element of hope thrown in, they
probably contain a sizeable element of uncertainty.

The second major source affecting uncertainty is the type of business involved in
relation to the future health of the economy. Some types of business operations are less
stable than others. For example, most mining enterprises are more risky than engineering
project, the nature of the business as well as expectations of future economic conditions
(e.g., Interest rates) should be considered in deciding what risk present.

A third source affecting uncertainty is the type of physical and equipment

involved. Some types of structures and equipment have rather definite lives and market
values.

The fourth important source of uncertainty that must always be considered is the
length of the study period used in the analysis. A long study period naturally decreases
the probability of all the factors turning out as estimated. Therefore, a long study period,
all else being equal, generally increases the uncertainty of a capital investment.

130
 3 SOURCE: Engineering Economy, 3rd Edition, Matias Arreola

Risk is defined as the deviations of actual outcomes from the predicted

outcomes due to chance causes. The economic factors upon which courses of action are
based may vary from estimated values because of the effect of random causes which are
beyond the control of the decision maker. Usually the effects of unforeseen future events
will cause the conclusions to be erroneous.

Uncertainty refers to deviations in actual values caused by various factors, such

as errors of analysis, misinterpretation of available data, and changing external economic
environment which invalidates past experience.

The extent to which risk and uncertainty should be considered in economic

analysis cannot be answered explicitly and categorically. It is obvious that risk and
uncertainty are always present for most investment projects for which analyses are made.
It is not possible to give definitive answers due to the fact that there are variety of causes
of risk with varying degrees for various projects and firms.

CAUSE OF RISK AND UNCERTAINTY

Factors affecting risk and uncertainty are varied. Some of the main causes are as
follows:

1. Insufficiency of Available Data: in certain cases, the decision maker in unaware of

certain factors which may adversely affect the outcome of his decision.

2. Misinterpretation of Data: the possibility exists that certain data relevant to the
decision to be made are misinterpreted due to the personal bias of the person making the
decision, or perhaps, due to complexities in the factors involved which may hava caused
them to be misunderstood.

3. Changes in Economic Conditions: Decisions are usually based on conditions

obtaining in the past. In the event that future economic conditions differ greatly from
those of the past, what may have been a wise decision may turn out to be
disadvantageous to the company.

131
 DECISION TREE

EVALUATION OF ALTERNATIVES USING A DECISION TREE:

Alternative evaluation may require a series of decisions where the outcome from
one stage is important to the next stage of decision making. When each alternative is
clearly defined and probability estimates can be made to account for risk, it is helpful to
perform the evaluation using a decision tree. A decision tree includes:

 More than one stage of alternative selection.

 Selection of an alternative at one stage that leads to another stage.
 Expected results from a decision at each stage.
 Probability estimates of economic value (cost revenue) for each outcome.
 Measure of worth as the selection criterion, such as E(PW).

The decision tree is constructed to left and right and includes each possible decision
and outcome.

A square represents a decision node with the possible alternatives indicated on the
branches from the decision node. (Figure 1)

A circle represents a probability node with the possible outcomes and estimated
probabilities on the branches. (Figure 2)

Since the outcomes always follow decisions, the treelike structure in Figure 3 results.

D Outcomes 0.5
Probabilities
0.3

Figure 1- a decision node Figure 2 – Probability Node

132
 D

D
D

Figure 3 –Tree Structure

Usually each branch of a decision tree has a some estimated economic value(often
referred to as payoff) in cost, revenue, or benefit. These cash flows are expressed in
terms of PW, AW, or FW values and are shown to the right of each final outcome branch.
This process is called solving the tree of fold back.

The Decision Theory:

A decision process is a matter of selecting a single act among all available alternatives. A
sound decision is likely to be arrived at, if a careful deliberation is made. Making use of a
quantities in decision-making helps a great deal I minimizing mistakes.

Mathematical Expectation (ME) or Expected Value (EV)

Mathematical expectation or expected value depends on two factors:

 Probability that the event will occur
 The amount of money to receive

EV = P(x), where P represents the probability value and x represents the amount of
money.

If several events are the expected to happen,

EV = P1X1 + P2X2 + … PnXn

Example:

Suppose a manager has to decide whether to accept a bid or not. If he accepts the
bid, the company may gain Php 2 million if it succeeds, or lose Php 1.5 million if it fails.
The probability that it will succeed is 30%. Find the EV if he accepts the bid.
133
P1 = 0.3% X1 = 2million EV = 0.30(2,000,000) 0.70(1,500,000)
P2 = 0.7% X2 = 1.5million = 600,000 – 1,050,000
= -450,000

THE DECISION TREE:

In making a decision, it’s most helpful to use a decision tree. The branches of the
tree represent the alternatives. A decision tree is a physical representation of a decision
situation. It provides an overview of the total process, thereby helping the decision maker
examine possible outcomes.

Example:

A student has to decide whether to stop his studies and work for a job paying
₱1,500 monthly or continue his studies, after which a job awaits him paying ₱2,500 a
month, provided he passes his remaining subjects. He feels that the probability that he
will pass his remaining subjects is 40%. Which choice is better for the student?

Solution:

Pass(0.40) = ₱2,500

continue
D
Fail(0.60) = 0
not continue
₱1,500

EV = 0.4(2,500) + 0.6(0)
= 1,000

Decision: Choose to stop

Example:

A manager has to decide whether to prepare a bid or not. It costs ₱5,000 to

prepare the bid. If the bid is submitted, the probability that the contract will be awarded is
50%. If the company is awarded with the contract, it may earn an income of ₱100,000 if
134
it succeeds, or pay a fine of ₱8,000 if it fails. The probability of success is estimated to be
80%. Should the manager prepare a bid?

Solution:

Succeeded(0.8)

awarded(0.5) C
Failed(0.2)
prepare B
not awarded(0.5) ₱5,000
D
not prepare0

Succeeded = ₱100,000 – ₱5,000

Failed = -₱8,000 - ₱5,000

EVC = 0.8(95,000) + 0.2(-13,000) EVB = 0.5(73,000) + 0.5(-5,000)

= ₱73,400 = ₱34,200

Decision: Choose to prepare the bid.

To utilize the decision tree for alternative evaluation and selection, the following
additional information is necessary for each branch.

 The estimated probability that each outcome may occur. These probabilities must
sum to 1.0 for each set of outcomes (branches) that result from a decision.
 Economic information for each decision alternative and possible outcome, such as
initial investment and estimated cash flows.

Decisions are made using the probability estimate and economic value estimate for each
outcome branch. This is the general procedure to solve the tree using PW analysis.

1. Start the top right of the tree. Determine the PW value for each outcome branch
considering the time value of money.
135
2. Calculate the expected value for each decision alternative.
E (decision) = Ʃ (outcome estimate)P(outcome)

Where, the summation is taken over all possible outcomes for each decision
alternative.

3. At each decision node, select the best E(decision) value.

4. Continue moving to the left of the tree to the root decision in order to select the best
alternative.

5. Trace the best decision path back through the tree.

136
 REFERRENCES

3rd edition, Matias Arreola

15th Edition, William G. Sullivan.

3rd Edition, Hipolito Sta. Maria

7th Edition, Leland Blank & Anthony Tarquin

http://www.frickcpa.com/tvom/tvom_cashflowdiagram.asp

www.isr.umd.edu/~austin/ence202.d/economics

faculty.uaeu.ac.ae/w_ahmed/Economy/.../Ex_future_worth_method.htm

http://ec314-pdx-edu.wikidot.com/present-worth-sample-problem

http://bca.transportationeconomics.org/types-of-measures/benefit-cost-ratio

http://www.accountingformanagement.org/payback-method/ IRR/ERR:

http://dept.lamar.edu/industrial/Zaloom/Eng_Econ/Ch4_108_117.htm

http://www.enge.vt.edu/terpenny/Smart/Virtual_econ/Module4/alternatives/concept
FW.htm
http://en.wikipedia.org/wiki/Break-even_%28economics%29

http://easycalculation.com/finance/learn-annuity.php

www.valpo.edu/student/asme/FE%20Slides/EngEconSlides.pdf

137