Rate of Return

Rate of return is termed as internal Rate

of Return; yield; marginal efficiency of
capital.
Defn.
1) It is the interest rate earned on
the unpaid balance of an
amortized loan.
2) It is the breakeven interest
rate, which equals the present
worth of projects’ cash
outflows to the present worth of
its cash inflows.

1
 PW (i)  PW cash outflows  PW cash inf lows  0
A A A
 PW (i)  0  1 ..... n n  0
0  1 
 



1 i 




1 i 



1 i 


Multiplying both side by (1+i)n

n
Pw(i)1 i   FW i   0
or
 
 
A  
Pw(i) F / P,i, n 

 0 ..... F / P,i, n   0






  0  
1 i 
 



 

2
Suppose a purchase of an equipment is
made for 1000 birr and repays 402.1 birr
per year for 3 years.

PW (10%)  1000  402.1(P / A,10,3)  0

1000=402.1(P/A, i, 3)
1000 = 402.1{(1+i)-1 + (1+i)-2 + (1+i)-3}
Let (1+i)-1 = x
Therefore, 1000/402.1 = x + x2 + x3
x + x2 + x3 - 2.49 = 0
x=1, 0.51=0 not true
x=0.91, 0=0
i 10%

3
Checking using project balance:
1 2 3 4 5
Unpaid
Year Unpaid Return Payment
balance at year
balance on (2) received end (2+3+4)
0 -1000 0 0 -1000
1 -1000 -100 402.1 -697.9
2 -697.9 -69.8 402.1 -365.6
3 -365.6 -36.5 402.1 0

 The bank can breakeven at 10% rate

of interest.

Therefore the rate of return, equates the

present worth, future worth and annual
equivalent worth of the entire cash flow
series to O.

4
 3) Return on Invested capital
It is the interest rate charged on the
unrecovered project balance of the
investment such that, when the project
terminates the un-recovered project
balance will be zero.

For the previous example, i = 10% is

called IRR

Methods of Finding rate of Return

Defn.
1) Simple Investment (Conventional)
This is a cash flow with one sign change
only

5
2) Non-simple Investment
This is a cash flow with multiple sign
changes
Computational Methods
A) Direct Solution
Direct mathematical solution can be
obtained if:

i) there is only a two flow transaction

of cash flow series

or

ii) the projects' service life does not

exceed 2 yrs.

6
Example:
Consider the following cash flow
n Project A Project B

0 -8000 -16000
1 0 +10400
2 0 +12000
3 0
4 12000

7
Project A

pw(i*)  8000 12000( p ,i,4)  0

F
 
12000 P ,i,4  8000
F 

1  0.67  1 i  4 1.5

4  
1 i 
 
1 i 1.10668  i  0.106681

i 10.6681%

8
Project B

 
Pw i *  1600 10400 p ,i,1 1200 P ,i,2  0
F  F 

1600  10400
1 i 
 12000  0
1 i 
2
 
 
2
16001 i  104001 i  1200
0
1 i 
2
 

161 2i  i 2  10.4 10.4i 12  0

 

16  32i 16i 2 10.4i  22.4  0

16i 2  21.6i  6.4  0
16i 2  21.6i  6.4  0
2
21.6   21.6  416   6.4
i
2 16
  21.6  29.6
32
i  100% has no economic significance
i  25%

9
B. Trial and Error Methods
In the trial and error method, an
estimated guess of i is assumed and
Pw(i*) is equated to zero.

If Calculated Pw(i*) < 0 then i* is

decreased
" " Pw(i*) > 0 " " "
increased
and the computation is repeated until
Pw (i) = 0

10
Example
It is proposed to purchase an
equipment for rental purposes. The
initial cost is 10000 birr for the 1st
year of ownership, 2700 birr is
estimated as the excess of receipts
over disbursements for everything
except income tax. Rental rates
decline with age and up keep costs
increase. The net decrease is 50
birr/yr. The machine has a life time
of 15 yrs and will cost 1000 birr as
salvage. Income taxes are 1050,
975 and will decrease by 75 birr
every year thereafter what is i*?

11
Solution
Cash Flow Diagram

12
  p   1  i   15i  1 
15

Pwi   2700 , i,15   150 

A   i 1  i ) 
15

 
2

100  p  P 
  10,000  1050 , i,14   75 , i,5 
1  i 
15

 A  G 
P 
 P   P   , i ,15 
 2700 , i,15   150 , i,15   1000 F 
A  G   
 
P  P 
 10000  1050 , i,14   75 , i,14   0
A  G 
assume i  10
PW (10%)  27007.6061  15040.152   10000.2394   10000
 10507.3667   7536.8005  221.9275
PW 10%   0 decrase i
Let i  9%
PW i  9%   2700 8.0607   15043.8069  10000.2745
 10000  10507.7862   7539.96633  289.34

PW (9) > 0

13
In such a case one can make a linear
interpolations and,

 289.32  0 
i *  9%  10%  9%  
 289.32   221.93

 9%  1%0.566
 9%  0.566%  9.566%

Graphically

14
Computer Solution Method
The easiest method is to create NPW
profile on a computer. In the graph ,
showings the NPW profile, the vertical
axis represents the NPW values and the
horizontal the corresponding i* values.
Where the graph intersects the zero of
the NPW is the value of i*.
It is also possible to use computer aided
economic analysis softwares of excell.
Using excell
I* can be calculated by

=IRR ( Range, ( guess) )

Range = Cash flow

guess= any assumed value of i

15
Accept/Reject Decisions Using R of R

Relationship with Pw analysis

In the present worth analysis, a given

alternative is said to be better or
acceptable than the other for a given
interest rate. Changing the interest rate
may change the decision.
For an individual project also, Pw > 0 for
a given range of i.

16
The present worth of this profile
indicates that the project is acceptable
for i values between
0 & i*  0  i  i*

In the above case it was a unique i* and

was simple to make accept / reject
decision.
The problem is when we have non
simple investments with multiple i*s.

It is difficult to choose which i* to use to

make accept/reject decision. Therefore,
the i* value fails to give a clue for
decision.

17
Decision Rule for Simple Investments
The i* value obtained by equating
NPW=0 gives the break-even rate of
return. But companies are not interested
break-even only. Thus, they establish,
as a company policy, what they expect
as a minimum attractive rate of return
(MARR) for their investment.
Therefore, for an investment to be
accepted or rejected, the following
criteria is used.

If IRR > MARR - Accept

IRR = MARR - Indifferent
IRR < MARR - Reject

18
This is used when we calculate single
projects.

Example
1) Consider an investment project with
the following cash flow

n Cash flow
0 -500
1 0
2 4840
3 1331
Is this project acceptable at MARR=10%
NPW  5000  0 p / F ,i,1  4840 P / F ,i,2 133 P / F ,i,3

i* 10% IRR  MARR  indifferent

19
2) An investor wants to establish a construction
company. In order to do that he purchased
land at n=o, for 1.5*106 birr. The building
and garage requires 3*106 million birr, which
is completed in one year. As soon as this is
ready, end of first year, equipments worth of
4*106 are purchased to start up.
During the 1st operating year a revenue of
3.5 *106 birr is obtained. This revenue
increases at 5% per year from the previous
year for the next 9 yrs.
After 10 yrs the revenue remained constant
for 3 yrs and the company phased out.
The salvage value at the end its 13 years
service life is

2 * 106 for land

20
 1.4 * 106 for building
0.5 * 106 for equipment

Annual operating and maintenance costs

are about 40% of revenue each year. If the
investor's MARR= 15%, is this a good
investment?
Cash flow diagram

NPW  1.5 *106  7 *106 P / F , i,1  2.1*106 P / 6,5%, i,10P / F , i,1

 3.257 *10P A, i,3P / F , i,10  3.9 *106 P / F , i,14
Assume i  15  NPV  52.6 *106

i  30 
Cost
Year Cash Out Revenue Net Cash Cumulative IRR
flow Cash Inflow Flow Cash flow
0 -1500000 0 -150000 -1500000
1 -7000000 0 -7000000 -8500000
2 -1400000 3500000 2100000 -6400000 26.47%
3 -1470000 3675000 2205000 -4195000
4 -1543500 3858750 2315250 -1879705

21
 5 -1620675 4051688 2431012,5 551262.5
6 -1701709 4254272 2552563.125 3103826
7 -1786794 4466985 2680191.281 5784017
8 -1876134 4690335 2814200.845 8598218
9 -1969941 4924851 2954910.888 11553129
10 -2068438 5171094 3102656.432 14655785
11 -2068438 5171094 3102656.432 17758442
12 -2068438 5171094 3102656.432 20861098
13 -2068438 9071094 7002656.432 27863754

Mutually Exclusive Projects

There are two cases:
Case i) Alternatives with the same
economic life.
Case ii) Alternatives with different lives

General
When evaluating mutually exclusive
alternatives using NPW or AE, the
highest worthy or the least costy

22
projects are selected. But, when one
uses the Rate of Return comparison, it
may not be the highest IRR, which shall
be selected.

Example
Consider the following cash flow

n A B
0 - 1000 - 5000

1 2000 7000
IRR 100% 40%
Pw(10%) 818 1364

- 1000 + 2000/(1+i)=0
1+I = 2 and thus i=1

23
According to PW criteria, B is more
attractive, while IRR of A is greater than
IRR of B.

The reason is that IRR is a relative

measure while NPW, FW, AE are
absolute money (Birr) values. Thus,
IRR does not consider the scale of
Investment.

Thus, to decide using Rate of Return

analysis one has to use another
technique called Incremental
Investment Analysis.

24
For the previous example

n A B B-A
0 - 1000 - 5000 - 4000
1 2000 7000 + 5000

PWiB-A = -4000 + 5000 = 1 i  5000 i  0.25

1 i 4000
=25%

Analysis
project A: 1000 is invested externally &
2000 is obtained the difference 4000
gets @MARR(10%) = 400 and ending
balance = 4400
 Total obtained = 2000 + 4400 = 6400
Pw(10 %) = - 5000 + 6400 ( p/F,10,1) = 818

25
Project B
Pw(10) = -5000 +7000 (p/F,10,1) = 1364

Example
Consider the following case flow. MARR = 10%

n x1 x2 x2 -x1
0 -3000 -12000 -9000
1 1350 4200 2850
2 1800 6225 4425
3 1500 6330 4830
IRR 25% 17.43% 15%

PW(x2 – x1) = 0 and i*x2-x1 = 15%

26
Criteria

IRRx  x  MARR select x

2 1 2

IRRx  x  MARR " x

2 1 1
IRRx  x  " selecte either one.
2 1

Example

Consider the following cash flow for two mutually

exclusive projects.

n A B A- B
0 -120000 -100000 -20000
1 20000 15000 5000
2 20 000 15 000 5000
3 120 000 130000 -10000

a. Compute IRR of each

b. If MARR = 15%, determine the acceptability of

each

c. which one do you select?

27
N A B A-B

0 -120000 - 100000 -20000

1 20000 15000 5000

2 20000 15000 5000

3 120000 130000 -10000

IRR 12% 19%

Alterative with Cost only

In such cases, one can use the

incremental cash flow method and
calculate IRR . Otherwise with out
knowing revenues it will be difficult to
calculate IRR.

28
Example
Consider the following cash flow
representing cash of two mutually
exclusive excavator groups, whose
service life is 6yrs for both. If MARR is
15%, which one would you buy ?
Excavator A Excavator B
Annual -7,412,920 -5,504,100
Op & Maint

Initial Cost -4,500,000 -12,500,000

Salvage 500,000 1,000,000

Solution

n A B B-A
0 -4,500,00 -12,500,00 -8,000,000
1 -7,412,920 -5,504,100 1,908,820
2 " " “
3 " " "
4 " " "
5 " " "
6 " + 500,000 " + 1,000,000 500,000

 8 *10 6  1,90882 *10 6 P / A, i,5  5000,000P / F , i,6  0

 u sin g trial error i  12.43%  15%

29
Therefore A is better .
The saving of 1,908,820 by B does not
justify the additional 8 * 106 investment.

2) Non simple investment:

Cash flow with more than one sign

change & multiple i’s or non multiple i.

Rules to know, whether PW profiles of

non-simple investments have multiple or
unique i.

30
Rule 1
The number of i’s cannot be greater
than the number of sign changes in the
cash flow series.

Rule 2
If the accumulated (cumulative) cash
flow in the series starts negative and
changes signs only once, a unique i
exists.

31
Example
Net cash Flow
Period Project Project Project
A B C
0 -1000 -1000 +1000
1 - 500 3900 - 450
2 800 - 5030 - 450
3 1500 2145 - 450
4 2000

If the cash flow starts with a positive

figure, then, the project is not an
investment, but rather borrowing.

32
Investment Decision for Non-Simple
Project
In case of simple investments, you have
a unique e*. But for non-simple
investments one obtains multiple e* s.
Thus, it will be ambiguous to decide
profitability.

a. NPW Profile Versus i* s

Once you prepare the profile use

NPW or AE to accept or reject as
shown earlier.

33
Example

Assume the following cash flow

n Cash revenue Net Cash Cum

Outflow Flow
0 106 -106 - 106
1 2000000 4300000 +2,3*106 +1.3*106
2 320000 3000000 - 1.3*106 -20,000

a) Compute i*
b) Decide to accept or reject if MARR = 15%
Solution
 10 6  2.3 *6 1  i *   1.3 * 10 6 1  e *   0
1 2

1
let x
1 i
 1.3 x 2  2.3 x  1  0
dpw
 2.6 x  2.3  0
dx
2.3
x  0.885
2.6
1
 0885
1 i
i  13%

34
using i*, it is not possible to decide.
Therefore, use the Pw criteria to
decide.

Pwi  15%   16 6  2.3 *10 6 1  0.15

1

 1.3 * 0 6 1  0.15
2
 1890.0

Project With Different Lives

The principle of comparing mutually

exclusive alternatives with ROR criteria
is the same as that of PW and AE. That
is, the common multiple period will be
used and the computation proceeds as
with equal lives.

35
However, the problem here is the
possibility of having higher degree
equations and also, p[possibly, multiple
i*s.

Thus, one has to first identity whether

the investment is pure or mixed, when i*
is multiple.

Simple investments are always can be

pure or mixed. Pure and mixed
investments can be identified using the
investment test. (Project Balance).

36
Depreciation
The accounting method used to
describe the loss of value of an asset is
called depreciation. The main function
of depreciation accounting is to account
for the cost of fixed assets in a pattern
that matches their decline in value over
time. As a fixed asset (equipment) is
being used, it consumed and due to this
reduction in value, the revenue that it
can generator reduces.

Fixed asset depreciation can be

categorized into two.
1. Physical 2. Functional

37
 A reduction - Occurs as a result of
in changes in the
performance organization or
due to technology, that
- Corrosion decrease or eliminate
Physical the need for an asset
impairment  Obsolescence,
- Wear & etc are factors
tear playing a role
It leads in a here
decline of
performance
and an
increase in
maintenance

38
cost

Description can be classified as

follows

Economic Depreciation = Purchase

P{rice - Market value

Accounting Depreciation
In accounting depreciation, a fraction of
the cost of the asset is chargeable as an
expense during the accounting periods.

One uses here, the matching concept,

when the accounting depreciation

39
allowance generally reflects, to some
extent, the actual economic depreciation
of an asset.

In order to calculate the depreciation

one has to know

- its cost
- its salvage value
- service or depreciable
- what method to use

40
Defn.
Depreciable Asset - properly which
can be depreciate to be deducted from
income.

e.g. budges, machinery, equipment,

vehicles, etc. Land is not depreciable
and implies clearing, grading, planting
landscaping are not depreciable as they
are part of cost of land.

Cost Basis: total cost that is claimed as

an expense over an assets' life.

41
 actual Cost + freight + site
preparation installation & incidental
expenses.

This total cost is to be depreciated. All

these case are to be included as
depreciable cats baked on the matching
principle as all case incurred to acquire
the asset are cats of the services to be
services as revenue from using the
sect.

42
Example:
A company bought a millings machine
at a price of 60000 birr The under
invoice included a sales to of 3000 birr.
Transport feasted 800birr The m/c
formations to folly coasted 4000 birr
ventilation ended Determent .the cost
basis to determine depreciation.
Solution
The cost basis is the sun of the engines.
Price of new m/c -- 60 000
Freight -- 800
Installation -- 2000
Foundation -- 4000

43
Cast of m/c ( cast b basis ) =
66800 birr

If tracings of an asset against another

asset is made due consideration shall
be given to trade in alternate un
recompiled gains or un recognized
losses. to the air basis .

Cost Basis for the new asset

= Book value - trade in Allowance +

Unrecognized gives / losses .

44
Example

For the previous m/c , the company

traded in an old millings m/c and paid
cash for the difference.
Trade in allowance = 5000 birr.

:. Cost of new millings gain / loss

66800  unrecogniz ed gain / loss

Trade in allowance  5000  Cost of new imlling
old purchase  4000 m / c  66800  1000
Unrecognized gain  1000  65800 birr

45
Useful Life and Salvage Value

In order to determine the number of

years over which an asset is to be
depreciated the useful or service life of
an asset used to serve the purpose. But
useful or service life is uncertain to
determine.

Therefore, tax offices issue depreciable

life guidelines for depreciable life
guidelines for depreciable assets.

46
Salvage value: Cash inflow one
receives for an asset at the time
of disposal.

Used equipment prices are difficult to

product as many factors such
as condition, price of new
machines & friends, secondary
services of the m/c play a role.

Whatever the case it must be estimated

when depreciation schedule is
established, with a possible future
adjustment.

47
Depreciation Methods
There are basically two methods:
1) Book Depreciation method ( BDM )
This method is used for financial
analysis or financial reports like
balance sheet or income statement
2) Tax- depreciation method ( TDM )
This is used for the purposes. usually
this permits higher depreciation in
earlier years than book depreciation
method.

The purpose of having these methods

separately is to show or relief the actual
lose in value for stockholders & out

48
sides using the matching concept, in
ease of BDM or to show to what intent
one can defer the and when The final
overall suspense accounted in both
cases is the same, but four depreciation
method allows higher deprecation in
earlier years than do book depreciation
methods.

1) Book Depreciation methods

There are three methods under this
category
a) straying Line Deprecation method
( SL)
In the straight line depreciation, uses

49
Dn = P  S   R2  P  S
N

where D n = Annual Amount of

Deprecation for n, years
N = number of years
P = PURCHASE
S = Salvage value
R n = depreciation rate = 1
N

Book Value at any time n, BVn  P  n * Dn

Example

50
 Consider an execrator Purchased for 3
, 100 , 000 birr shavings a useful life of
5 yrs. Determine the depreciation and
book value for each of the s yrs using
SL. S = 860000 birr
Solution
1 1
Depreciati on Rate    0.2
N 5
3,100,00  860,000
Dn 
5
or  448000 birr
3,100,000  860,000 * 0.2

Year BVn-1 Dn BVn

0 0 0 3100
1 3100 448 2652
2 2652 448 2204
3 2204 448 1756
4 1756 448 1308
5 1308 448 860
Declining Balance Method (DB)

51
This is an accelerated depreciation
method that provides larger portions of
the cost of the asset to be written off in
the early years.

Declining multiplies  , range between

1.25 to 2 (double declining balance)
decided by the life of the asset
1.25  2.0
 
N

as N increase  decreases.

D= 1  BVo

D 2 = BV  D    BV 1  2
o 1 o

D BV
3 o  D1  D2   BVo 1   
2

D 4 BVo  D1  D2  D3   BVo 1    3

52
Dn   BVo 1    n1 deprecation at any time n.

The total sum of deprecation is , thus

TDB = D  D  D  ............  D
1 2 3 n

= BV  BV 1    BV o o o  BVo 1    2 .........  BVo 1  2 n1

= 
 BVo 1  1     1   2  ..............  1   n1 .......  

multiplying both sides by 1   


TDB 1   BVo 1     1     1     ........  1   
2 3 n


Subtracting 1 from
TDB TDB TDBBVo  1  1     n


TDBBVo  1  1   
n


TDB BVo 1  1   
n


53
The book Value at any Time n is,
therefore ,
Bn BVo TDBBVo BVo 1  1   
  
Bn  BV0 1  1  1   n 
Bn  BV0 1   
n

Example

For the previous example apply the DB

method with 1.5 as the multiplier.
1.5
  0.3
5

Dn
Year BYn 1
in  thousends 
BV n

0 0 0 3100
1 3100 930 2170
2 2170 651 1519
3 1519 455.7 1063.0
4 1063.3 318.99 744.31
5 744.31 223.29 521.02

54
 BV n 5  BVo 1   
5

Check 3100 1  0.3

5

 521.02  ok

As one can observe from the examples

above, the savages value and BY are the n

same at the end of the p life times, when

one uses SL.

However, in DB method it could be

more, the Some or less.
Ie
S  BV n
S  BV n
S  BV n

Case1 S  BV n.

55
Case ii S< Bn Bn  S 

In this case an adjustment is required

and a switch from DB to SL at any time
SL is made.

Switching Rule

If depreciation by DB at any time n is

less or equal to that by SL, switch to SL
as of this date and continue computing
depreciation by SL until the end of the
service life.

Book Value at the

begining of year n  Salvage value
Dn 
Re maining Service life N  n 

56
Example

For the previous example, if s = 100 *

106, determine optimal switch time from
DB to sl and compute the resulting
depreciation schedule.

SL DB
Year Dn BYn Dn BYn
0 0 3100 0 3100
1 600 2500 930 2170
2 600 1900 651 1519
3 600 1300 455.7 1063.3
4 600 700 318.99 744.31

57
5 600 100 223.29 521.02

If switch Dn
to SL is BYn-1
made at SL DB
beginning
of year
0 0 0 0
3100  100
1 3100 5
 600  930
2170  100
2 2170 4
 517.5  651
3 1519 455.7
4 1063.3
5 744.31

58
 Thus scuttle
year D n
BV n

0 0 3100
1 930 2170
2 651 1519
3 473 4046
4 473 573
5 473 100 = 5

Sum of Years. Digits ( SOYD) Method

This is ado are accelerated method > In

this method the esteemed services life
1,,2,3,4 ........., N
are added.

59
 N N  1
SOYD  1  2  3  ........  N 
2
SOYD  1  2  3  4  ...........  N
SOYD  N   N  1   N  2  ..........1
N  1  N  1  2  N  2  3  ........  N  1
 N  1   N  1   N  1  .........  N  1  N N  1
2SOYD  N  N  1

 SOYD  N
N  1
2

BVo  10000, N  5 yrs 5  2000.

56
SOYD   15 Bn
Example. 2
5  1  1
 Dn1   10000  2000 2667 7333
2

5  2  1
Dn  8000  5200 7333  2133
15
5  5  1
Dn  8000  533 2000
15

Unit of Production Method

It is imaginable that straight line
depreciation method, we though applied
often does not guarantee the an
equipment is used equally evenly year.

60
Thus, a new concept that relates the
number of service units chummed per
period to cost is used.
In this method.

Seivce units consumed / pend BVo  s 

Dn 
Total Service uits that can be obforined

Example
An equipment is manufactured to give
service for 10000 hrs. If the expend
served 2000 hrs this year find the
depreciation. Initial Cost is 1000 000
and salvage value is 250,000.

Dn 
2000
1,00,000.  250.000
10000
Dn  150000 birr

61
Tax Depreciation Method

The principle of these methods is to

shorten the depreciable lives of assets
and give businesses larger depreciation
deductions to increase available cash
flow (due to less tax payment) for re –
investments.

ACRS – Accelerated Cost recovery

system

MACRS – Modified " " "

62
Depletion

This is the process of amortizing the

cost of natural resources in the
accounting periods. There are basically
two methods, where both need to be
computed and the larger one adopted.

They are:

a) Cost Deprecation (Cost

estimate of the total potential)

Cost Depletion =
Adjusted basis of resiyrce
* Amount exp loted or sold
Total Potential

The adjusted basis is the allowable

depletion. Total potential is the
engineering estimate of the exploitable
natural resource.

63
b) Percentage Depletion

This method bases itself on the

revenue, but not the cost. Thus, total
depletion may exceed the total cost of
property. Therefore, the annual
allowance shall not exceed 50% the
taxable income.

Usually allowable percentages are set

by statutory bodies for different natural
resources.

Example

A gold mine has an estimated deposit of

100,000 kg of gold and has a basis of 8
* 109 birr.

Allowable percentage depletion for gold

= 15%

Calculate the depletion

64
a) Using Cost Depletion
8 x10 9
Dp  * 100  8 *10 6 birr
100,000

b) Using parentage depletion

i)
9 *10 * 0.15  1.35 *10 6
Cross Income  9 *10 6
¡¡) Less Supenses 
1 *10 6
8 *10 6
Tauable income 

Usually allowable percentages are set

by statutory bodies for different natural
resources .

65
Example :

A gold mine has an estimated deposit of

100,000 bgs of gold and has a basis of
8 *10 birr. ( net cost = cost – land Value).
9

The mine has a gross income of 9 *10 6

million birr for the sale of 100 bgs .

Meanings pentagon before depletion for
gold = 15%. Calculate the depletion.

a) Using cot Depletion

8 * 10 9
Dp  * 100  8 *10 6 birr
100,000

b) Using parentage depletion

¡) 9 *10 6
* 0.15  1.35 *10 6
9 * 10 6

¡¡ ) Gross Income = 1 * 10 6
8 * 10 6

Less Suspense =
Tunable income=

66
Deduction = 8 *10 6 * 0.5  4 *10 6 birr

C) As the cost depletion method is

higher, use the cost depletion value of
8 *10 for two purposes.
6

67
Inflation

Inflation is the loss of purchasing power

of money through time.

Deflation is a gain in the purchasing

power of through time. If

Bn  Cost of a com mod ity

at time n
Bo  Cost of a com mod ity at t  0
if  OYg inf lation rate
then ,
Bn  Bo 1  i f n

B n  Bo
If  or for one speific period
Bo
Bn  Bn 
if 
Bn 1
Butgeneral ly
Bn
if  n  1 when n  1 or one specific period
Bo
B n  B0
if 
B0
Bn  Bn  1
if 
Bn  1

68
But generally
Bn
if n 1 when n  1
Bo
B n  Bo
if 
Bo

If the inflation rate varies, and,

If  5%, If 2  8%
B2  Bo 1  0.05 1  0.08  1.134 Bo
if Bo  1000
B2  1000 1.134  1134
B2
B2  Bo 1  if   if  2  1  0.0649
2

B10
 6.49%

 Average Inflation Rate If  6.49%

69
Example

Determine the annual and Avg. Inflation

rates of the following cost cash flow

Year Cash
540  500
0 500 i f1 
500
 0.08  8%
570  540
1 540 i f2 
540
 0.0555  5.55%

2 570
630  570
i f3   0.1052  10.52%
570

3 630 if  3
630
500
 1  0.08

 8%

Actual and Constant ( Birr)

Actual ( current) cash ( An ) – Estimate

of facture cash flows for n years with
inflation or deflation considered

70
Constant ( real) Cash ( an ) –
Purchasing power independent of
passage of time

Example

A Company introduce a new technology

for 250,000 birr. Using this technology
the company produce new units and the
revenues in both constant and birr at if
25% are as follow.

period Unit Net Actual

sales cash
flow
0 1000 -250 000 (H0.5) =
-
2500000
1 1100 100 000 ( ")
105 00
2 1100 110 000 ( ")
121 27

71
 3 1200 120 000 ( ")
138 915
4 1300 130 000 ( ")
158 016
5 1200 120 000 ( ")
153 154

Thus to convent from cons fact to actual

An  An 1  if n
or from actual to cons tan t
An
An 
1  if n

Suppose you rented your house at a

constant rate of 10000 birr per year for 5
yrs. If Lt = 5%, the Real value money
you are collecting will be

72
Yr Acetyl Constant
Revenue

0 60000 60000 1  0.05  60000

0

1 60000 60000 1  0.05

1
 57143

2 60000 600001  0.05

2
 54422

3 60000 60000 1  0.05

3
 51830

4 60000 60000 1  0.05

4
 49362

Actual and Constant Cash (Birr)

Actual ( current) Birr ( (An) ; Future each

flow for n years with inflation or deflation
considered

Constant (Real) Birr (An) : Constant

purchasing power independent of
passage of time.

73
Relation between An and An'
F 
An  Bn 1  Lf   An  , i f , n 
n

P 

Relationship between An & An

An  An 1  if 
1 2

An Constant – Birr expression for cash

flow occur rings at the end of year a

An – Ditto but Actual cash flow

If – average ( general) inflation rate for

specific commodity sporadic inflation
rate particularly if the commodity dose
not follow the general inflation rate.

74
Example:
1) A company introduces a new
technology for 250 ,000 birr Using
this technology the company prod
use new units and the revenues in
constant birr is 100 birr per unit If =
5% compute the actual birr
bearing in mind that prices will be
dented.

Period Unit Net Cash Actual

Sales Flow An  An 1 5%
n

0 -- -250, 000 -250 000

1 1000 100, 000 105 000
2 1100 110, 000 121 275
3 1200 120 , 000 138 915
4 1300 130 , 000 158 016
5 1200 120 , 000 153 154

2) Suppose you rented your house

for 60000 birr per year for 5 yrs.
Collecting in advance. If =5% what
is the actual money you are
collecting.
75
Period Actual Content
An
An 
1  0.05n
N Revenue
1 60 000 60000
2 60 000 57143
3 60 000 54422
4 60 000 51830
5 60 000 49362

Equivalence Calculation Under

Inflation

Defn 1) Market Interest Rate (i) :

Interest rate that takes into account of
the earning power with inflation or
deflation market interest rate is actually
inflation- adjusted MARR for most
business firms.

3) Real or Inflation- free infests rate

(i): This is the true earning power

76
 when inflation or deflation are
subtracted.

Thus in calculation any cash flow

equivalence one made to know the
nature of cash flow, whether it is in
constant or actual cash or missed .

Therefore , before calculating the Pw or

A of the cash flows, all mead to be
converted to one form.

A) Constant Cash Analysis

If the cash flow is in constant cash and if

=0, i=i and i is to be used to calculate
the PW. Thus, PW  1 Ai 
n
n
n

77
Example

Consider the cash flow:

n Net Cash
flow
0 -250, 000
1 100, 000
2 110, 000
3 120, 000
4 130, 000
5 120, 000

If i = 10 % , what would be the PW


PW  250 000  100000 p / Al 10%,5  10000P / 6 10 %
4

Soln  20  P 
 F ,10,5 
 163099

78
Actual Cash Analysis

Consider the example of the leased

house with Actual revenue of 60, 000
per year.

Period Actual
n birr
o 60 000
1 60 000
2 60 000
3 60 000
4 60 000

If Lf = 5% and i = 10% what is the

parent worth.

There are two methods to solve this .

Method 1 – Deflation method

Change all cash flow to constant birr

and using i = 10% , calculate the PW.

79
n Actual Constant
1
0 60000 *
1  y n 60000
1 " 57143
2 " 54422
3 " 51830
4 " 49362

57143 54422
p w  60000  
1  0.1 1  0.12
51830 49362
 
1  0.1 2
1  0.14
 60000  51948  44977  38941
 33715  229581

Method 2 - Adjusted – Discount method

This method is similar to the first, but

instead of using two steps ( calculate
content cash and them pw) pw is dusty
calculated.

80
 An 1 An
PW  * 
1  i n
1  i 
n
1  if n 1  i n
But the present worth of simple
payments, sing the market rate,
An An
PW  
1  i  1  if n 1  i n
n

 1  i   1  if  1  i   1  i  1  i  if  if
n n n

i  i  if  if * i

 i  0.1  0.05  0.1 * 0.05  0.155

 PW  60000 p A,15.5%,4   60000

 60000
1  0.155  1
4

0.1551.1554   60000
 60000
0.77796227   60000
0.2758415
 169 580.57  60000
 229580.57

i  i  if  i  15%
PW  60000 p A, 15,4  60000
If one use  171 300  60000
 231 300

Effect of Inflation on Project Cash

Flow

A) Depreciation & Inflation

81