Benefit-Cost Ratio `Method

The benefit-cost ratio method is not as straightforward and unambiguous

as the net present value method but, if applied correctly, will produce the
same results as the net present value method. While this method is often
used in the evaluation of public projects, the results may be misleading if
proper care is not exercised in its application to mutually exclusive
proposals.

The benefit-cost ratio is defined as the ratio of the discounted benefits to

the discounted cost at the same point in time. It follows that the criterion
for accepting an independent project on the basis of the benefit-cost ratio
is whether or not the benefit-cost ratio is greater than or equal to one:

PW (B)
Conventional B−C Ratio=
I + PW (O∧M )
or
AW (B)
Conventional B−C Ratio=
CR+ AW (O∧M )

PW ( B )−PW (O∧M )
ModifiedB−C Ratio=
I
or
AW ( B )− AW (O∧M )
ModifiedB−C Ratio=
CR

Example:
A city engineer is considering installing an irrigation system. He is trying
to decide which one of two alternatives to select. The two alternatives
have the following cash flow:

If interest is 12%, which alternative should the engineer select? Assume

no salvage value. Use incremental benefit/cost analysis.
Solution

Example:
With interest at 10 %, what is the benefit-cost ratio for this government
project?

$2 00,000 Initial cost

$30,000 Additional costs at end of years 1 & 2
$0 Benefits at end of years 1 & 2
$90,000 Annual benefits at end of years 3 – 10

Solution
Example:
A van is bought for $15,000 in Year 0. It generates revenues of $25,000
per year and expenses of $20,000 per year in each of the Years 1 thru 5.
Its salvage value is zero after 5 years. Ignoring income taxes, compute
the benefit/cost ratio if i = 10%.
Solution

Example:
A tax-exempt municipality is considering the construction of an
impoundment for city water supplies. Two different sites have been
selected as technically, politically, socially, and financially feasible.
The city council has asked you to do a benefit-cost analysis of the
alternatives and recommend the best site. The city uses a 6% interest
rate in all analysis of this type.
 Which should you recommend?
Solution

Example:
A city engineer is deciding which of two bids for a new computer to
accept. Using benefit-cost analysis, which alternative should be selected
if the interest rate is 10% per year?

Solution
Example:
Given four mutually exclusive alternatives, each with a useful life of 20
years and no salvage value have been presented to the city council of any
town in Iraq. Which alternative should be selected?

Solution

Example:
The local city recorder is deciding between two different phone
answering systems for her office.
The information concerning the two machines is presented below.

With an assumed interest rate of 12%, which system would you

recommend?
Solution

Example:
The city council of arson, Michigan is debating whether to buy a new fire
truck to increase protection for the city. The financial analyst has
prepared the following data:

Using the modified B/C ratio method determine whether the city should
buy a new truck, and which one to buy if it will be paid for with money
borrowed at an interest rate 7%.
Solution
Example:
The expansion of the hotel and conference center at Wicker Valley State
Park is under study. The initial investment and annual operating benefits
and cost are very different due to the differing magnitudes of the project
under consideration. These can be summarized as follows:

Using a minimum attractive rate of return (MARR) of 10%, which

alternative should be selected for a ten-year useful life analysis period?
Use benefit/cost ratio analysis.
Solution
DEPRECIATION

Depreciation represents the decline in market value of a piece of

equipment due to age, wear, deterioration, and obsolescence.
Depreciation can result from:
. Physical deterioration occurring from wear and tear of the machine
. Economic decline or obsolescence occurring over the passage of time
In the appraisal of depreciation, some factors are explicit while other
factors have to be estimated. Generally, the asset costs are known which
include:
1. Initial cost: The amount needed to acquire the equipment
2. Useful life: The number of years it is expected to be of utility value
3. Salvage value: The expected amount the asset will be sold at the end
of its useful life.
However, there is always some uncertainty about the exact length of the
useful life of the asset and about the precise amount of salvage value,
which will be realized when the asset is disposed. Any assessment of
depreciation, therefore, requires these values to be estimated.
Among many depreciation methods, the straight-line method, double-
declining balance method, and sum-of-years’-digits method are the most
commonly used in the construction equipment industry and will be
discussed below. At this point, it is important to state that the term
depreciation as used in this chapter is meant to represent the change in the
assets value from year to year and as a means of establishing an hourly
‘‘rental’’ rate for that asset.
It is not meant in the same exact sense as is used in the tax code. The term
‘‘rental rate’’ is the rate the equipment owner charges the clients for using
the equipment, i.e., the project users ‘‘rent’’ the equipment from its
owner.
In calculating depreciation, the initial cost should include the costs of
delivery and startup, including transportation, sales tax, and initial
assembly. The equipment life used in calculating depreciation should
correspond to the equipment’s expected economic or useful life.

2.2.2.1 Straight-Line Depreciation

Depreciation = (Cost - Residual value) / Useful life

Example
 On April 1, 2011, Company A purchased an equipment at the cost of
$140,000. This equipment is estimated to have 5 year useful life. At the
end of the 5th year, the salvage value (residual value) will be $20,000.
Company A recognizes depreciation to the nearest whole month.
Calculate the depreciation expenses for 2011, 2012 and 2013 using
straight line depreciation method.

Depreciation for 2011

= ($140,000 - $20,000) x 1/5 x 9/12 = $18,000

Depreciation for 2012

= ($140,000 - $20,000) x 1/5 x 12/12 = $24,000

Depreciation for 2013

= ($140,000 - $20,000) x 1/5 x 12/12 = $24,000

2.2.2.2 Sum-of-Years’-Digits Depreciation

Depreciation expense = (Cost - Salvage value) x Fraction
Fraction for the first year = n / (1+2+3+...+ n)
Fraction for the second year = (n-1) / (1+2+3+...+ n)
Fraction for the third year = (n-2) / (1+2+3+...+ n)
...
Fraction for the last year = 1 / (1+2+3+...+ n)
n represents the number of years for useful life.
Example
Company A purchased the following asset on January 1, 2011.
What is the amount of depreciation expense for the year ended
December 31, 2011?
Acquisition cost of the asset --> $100,000
Useful life of the asset --> 5 years
Residual value (or salvage value) at the end of useful life --> $10,000
Depreciation method --> sum-of-the-years'-digits method

Calculation of depreciation expense

Sum of the years' digits = 1+2+3+4+5 = 15
Depreciation for 2011 = ($100,000 - $10,000) x 5/15 = $30,000
Depreciation for 2012 = ($100,000 - $10,000) x 4/15 = $24,000
Depreciation for 2013 = ($100,000 - $10,000) x 3/15 = $18,000
Depreciation for 2014 = ($100,000 - $10,000) x 2/15 = $12,000
Depreciation for 2015 = ($100,000 - $10,000) x 1/15 = $6,000

Sum of the years' digits for n years

= 1 + 2 + 3 + ...... + (n-1) + n = (n+1) x (n / 2)
 Sum of the years' digits for 500 years
= 1 + 2 + 3 + ...... + 499 + 500
= (500 + 1) x (500 / 2) = (501 x 500) / 2 = 125,250

2.2.2.3 Declining Balance Depreciation

Depreciation = Book value x Depreciation rate
Book value = Cost - Accumulated depreciation

Depreciation rate for double declining balance method

= Straight line depreciation rate x 200%

Depreciation rate for 150% declining balance method

= Straight line depreciation rate x 150%

Example
On April 1, 2011, Company A purchased an equipment at the cost
of $140,000. This equipment is estimated to have 5 year useful life. At
the end of the 5th year, the salvage value (residual value) will be
$20,000. Company A recognizes depreciation to the nearest whole
month. Calculate the depreciation expenses for 2011, 2012 and 2013
using double declining balance depreciation method.

Useful life = 5 years --> Straight line depreciation rate = 1/5 = 20%
per year

Depreciation rate for double declining balance method

= 20% x 200% = 20% x 2 = 40% per year

Depreciation for 2011

= $140,000 x 40% x 9/12 = $42,000

Depreciation for 2012

= ($140,000 - $42,000) x 40% x 12/12 = $39,200

Depreciation for 2013

= ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520
Double Declining Balance Depreciation Method
Book Value Book Value
Depreciation Depreciation
at the year- at the Year
Expense Rate
end beginning
$98,000 $42,000 (*1) 40% $140,000 2011
 $58,800 $39,200 (*2) 40% $98,000 2012
$35,280 $23,520 (*3) 40% $58,800 2013
$21,168 $14,112 (*4) 40% $35,280 2014
$20,000 $1,168 (*5) 40% $21,168 2015

(*1) $140,000 x 40% x 9/12 = $42,000

(*2) $98,000 x 40% x 12/12 = $39,200
(*3) $58,800 x 40% x 12/12 = $23,520
(*4) $35,280 x 40% x 12/12 = $14,112
(*5) $21,168 x 40% x 12/12 = $8,467

--> Depreciation for 2015 is $1,168 to keep book value same as

salvage value.
--> $21,168 - $20,000 = $1,168 (At this point, depreciation stops

Example
On April 1, 2011, Company A purchased an equipment at the cost of
$140,000. This equipment is estimated to have 5 year useful life. At the
end of the 5th year, the salvage value (residual value) will be $20,000.
Company A recognizes depreciation to the nearest whole month.
Calculate the depreciation expenses for 2011, 2012 and 2013 using
double declining balance depreciation method.

Useful life = 5 years --> Straight line depreciation rate = 1/5 = 20%
per year

Depreciation rate for 150% declining balance method

= 20% x 150% = 20% x 1.5 = 30% per year

Depreciation for 2011

= $140,000 x 30% x 9/12 = $31,500

Depreciation for 2012

= ($140,000 - $31,500) x 30% x 12/12 = $32,550

Depreciation for 2013

= ($140,000 - $31,500 - $32,550) x 30% x 12/12 = $22,785
150% Declining Balance Depreciation Method
Book Value Book Value
Depreciation Depreciation
at the year- at the Year
Expense Rate
end beginning
$108,500 $31,500 (*1) 30% $140,000 2011
 $75,950 $32,550 (*2) 30% $108,500 2012
$53,165 $22,785 (*3) 30% $75.950 2013
$37,216 $15,950 (*4) 30% $53,165 2014
$26,051 $11,165 (*5) 30% $37,216 2015
$20,000 $6,051 (*6) 30% $26,051 2016

(*1) $140,000 x 30% x 9/12 = $31,500

(*2) $108,500 x 30% x 12/12 = $32,550
(*3) $75,950 x 30% x 12/12 = $22,785
(*4) $53,165 x 30% x 12/12 = $15,950
(*5) $37,216 x 30% x 12/12 = $11,165
(*6) $26,051 x 30% x 12/12 = $7,815

--> Depreciation for 2016 is $6,051 to keep book value same as

salvage value.
--> $26,051 - $20,000 = $6,051 (At this point, depreciation stops.)

Depreciation Example 1

$ 110,000 Cost
$ 20,000 Salvage value
5 Useful life
January 1, 2011 Purchase date

Straight line depreciation

Depreciation Year
=($110,000 - $20,000) x 1/5 $ 18,000 2011
=($110,000 - $20,000) x 1/5 $ 18,000 2012
=($110,000 - $20,000) x 1/5 $ 18,000 2013
=($110,000 - $20,000) x 1/5 $ 18,000 2014
=($110,000 - $20,000) x 1/5 $ 18,000 2015
$ 90,000 Total

Double declining balance depreciation

Depreciation rate = 1/5 x 200% = 40%

Book value Accumulate Depreciatio Depreciation Book value at

Year
at year-end d n expense rate the beginning
 depreciation of year
$ 66,000 $ 44,000 $ 44,000 40% $ 110,000 2011
$ 39,600 $ 70,400 $ 26,400 40% $ 66,000 2012
$ 23,760 $ 86,240 $ 15,840 40% $ 39,600 2013
$ 20,000 $ 90,000 (*1) $ 3,760 40% $ 23,760 2014
$ 20,000 $ 90,000 $ - 40% $ 20,000 2015
$ 90,000 Total

(*1) Depreciation stops when accumulated depreciation reaches

depreciation base.
Depreciation base = cost - salvage value = $110,000 - $20,000 = $90,000

150% declining balance depreciation

Depreciation rate = 1/5 x 150% = 30%

Book value
Accumulate
Book value Depreciation Depreciation at the
d Year
at year-end expense rate beginning
depreciation
of year
$ 77,000 $ 33,000 $ 33,000 30% $ 110,000 2011
$ 53,900 $ 56,100 $ 23,100 30% $ 77,000 2012
$ 37,730 $ 72,270 $ 16,170 30% $ 53,900 2013
$ 26,411 $ 83,589 $ 11,319 30% $ 37,730 2014
$ 20,000 $ 90,000 (*2) $ 6,411 30% $ 26,411 2015
$ 90,000 Total

(*2) Depreciation stops when accumulated depreciation reaches

depreciation base.
Depreciation base = cost - salvage value = $110,000 - $20,000 = $90,000

Sum-of-the-years'-digits depreciation

Sum of the years'

=1+2+3+4+5 15 digits
Years'
Year
Depreciation digits
=($110,000 - $20,000) x 5/15 $ 30,000 5 2011
=($110,000 - $20,000) x 4/15 $ 24,000 4 2012
=($110,000 - $20,000) x 3/15 $ 18,000 3 2013
=($110,000 - $20,000) x 2/15 $ 12,000 2 2014
=($110,000 - $20,000) x 1/15 $ 6,000 1 2015
$ 90,000 15 Total