CE 215 – ENGINEERING ECONOMICS

MODULE 1

Chapter 1- Introduction to Engineering Economics

Introduction

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

science gained by study, experience and practice is applied with judgement to develop ways
to utilize economically the materials and forces of nature for the benefit of mankind. In this
definition, the economic aspects of engineering are emphasized, as well as the physical
aspects. That is why, it is essential that the economic part of engineering be accomplished
well. Also, this is the reason why economics is being incorporated in your course as a subject.

Engineering economy is concerned with the economic aspect of engineering. It

involves the systematic evaluation with the economic merits of proposed solutions to the
engineering problems. Engineers take into consideration the most acceptable (most
affordable) solutions in every engineering problems economically.

Engineering economics is the application of economic techniques to the evaluation of

design and engineering alternatives. The role of engineering economics is to assess the
appropriateness of a given project, estimate its value, and justify it from an engineering
standpoint.

Objectives:

At the end of this chapter, students are expected to be able to:

1. Economics and its role in engineering

2. Familiarize with the terms used in engineering economics
3. Learn the law of supply and demand and law of diminishing returns.

Discussion

The General Economic Environment

There are numerous general economic concepts that must be taken into account in
engineering studies.
Consumer goods and services are those products or services that are directly used
by people to satisfy their wants. Examples are foods, clothing, homes, cars, haircuts and
medical services.
 Producer goods and services are used to produce consumer goods and services and
other producer goods. Examples are machine tools, factory buildings, buses and farm
machinery.
Price of goods and services is defined to be the present amount of money or its
equivalent which is given in exchange for it.
Necessities are those products or services that are required to support human life and
activities that will be purchased in somewhat the same quantity even though the price
varies considerably.
Luxuries are those products or services that are desired by humans will be purchased
if money is available after the required to support human life and activities that will be
purchased in somewhat the same quantity even though the price varies considerably.
Demand is a quantity of certain commodity that is bought at a certain price at a given
place and time. (The quantity a consumer wish to buy)
Supply is a quantity of a certain commodity that is offered for sale at a certain price at
a given place and time. (The quantity a commodity that producers wish to sell)
Perfect competition occurs in a situation in which any given product is supplied by a
large number of vendors and there is no restriction in additional suppliers entering the
market. (number of sellers and buyers are very large with same product)
Perfect monopoly exists when a unique product or service is available from a single
supplier and that vendor can prevent the entry of all others into the market. (only 1
suplier)
Oligopoly occurs when there are few suppliers and any action taken by anyone of them
will definitely after the course of action of the others. (there are only few suppliers that
when other suppliers arrived it will affect their sales)
Total Revenue is the product of the selling price per unit and the number of units sold.
Total Cost is the sum of the fixed costs and the variable costs.

Profit/ Loss is the difference between total revenue and the total costs.

Cost Terminology
Cost considerations and comparisons are fundamental aspects of engineering
practice. Before the study of various engineering economic decisions problems, the concept
of various costs must be understand. At the level of plant operations, engineers must make
decisions involving materials, plant facilities and the in-house capabilities of company level.

• Fixed costs are those unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available.
 Examples are insurance and taxes on facilities, general management and
administrative salaries, license fees, and interest costs on borrowed capital.
• Variable costs are those associated with an operation that vary in total with the
quantity of output or other measures of activity level. Examples are the costs of
material and labor used in a product or service.
• Incremental cost is the additional cost (or revenue) that results from increasing the
output of the system by one or more units.
• Recurring costs are those that are repetitive and occur when an organization
produces similar goods or services on a continuing basis. (rents, phone bills,
e=anything you pay regularly)
• Nonrecurring costs are those which are not repetitive even though the total
expenditure may become cumulative over a relatively short period of time. (due to
extraordinary events like natural calamities)
• Direct costs are costs that can be reasonably measured and allocated to a specific
output or work activity. Examples are labor and material costs.
• Indirect costs are those that are difficult to attribute or allocate to a specific output or
work activity. Examples are the costs of common tools, general supplies, and
equipment maintenance.
• Overhead cost consists of plant operating costs that are not direct labor or direct
material costs. Examples are electricity, general repairs, property taxes and
supervision.
• Standard costs are representative costs per unit of output that are established in
advance of actual production or service delivery. (the expected amount paid for
materials for example, standard price per unit)
• Cash costs are that involves payment of cash.

• Noncash costs (book costs) are costs that does not involve a cash payment, but
rather represent the recovery of past expenditures over a fixed period of time. Example
is the depreciation charged.
• Sunk cost is one that has occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course of action. (money spent that
cannot be recovered , ex. Cost of machines that cannot be sold))

• Opportunity cost is incurred because of the use of limited resources such that the
opportunity to use those resources to monetary advantage in an alternative use is
 foregone. (the value of the best next alternative, like for example a farmer choses to
plant corn, the opportunity cost is planting a different crop)

• Life-cycle cost refers to a summation of all the costs, both recurring and nonrecurring,
related to product, structure system, or services during its life span.

• Investment cost is the capital required for most of the activities in the acquisition
phase. (capital cost)

• Working capital refers to the funds required for current assets that are needed for the
startup and support of operational activities. (current asset less current liabilities)

• Operational and Maintenance cost includes many of the recurring annual expense
items associated with the operation phase of the life cycle. (cost of operating and
maintenance)

• Disposal cost includes those nonrecurring costs of shutting down the operation and
the retirement and disposal of assets at the end of the life cycle. These costs will be
offset in some instances by receipts from the sale of assets with remaining value.
(salvage value)

• Economic life coincides with the period of time extending from the date of acquisition
to the date of abandonment, demotion in use, or replacement from the primary
intended service. (life of wich the asset is still useful) may kinikita

• Ownership life is the period between the date of acquisition and the date of disposal
by a specific owner. (span of time of the asset)
• Physical life is the period between original acquisition and final disposal of an asset
over the succession of owner. (an asset remains functional)
• Useful life is the time period that an asset is kept in productive service (either primary
or backup). It is an estimate of how long an asset is expected to be used in a trade or
business to produce income.

The Law of Supply and Demand

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

“Under conditions of perfect competition the price at which a given product will be supplied
and purchased is the price that will result in the supply and the demand being equal”
The Law of Diminishing Returns
“When the use of the one of the factors of the production is limited, either in increasing
cost or by absolute quantity, a point will be reached beyond which an increase cost
or by absolute quantity, a point will be reached beyond which an increase in the
variable factors will result in a less than proportionate increase in output.”
 CE 215 – ENGINEERING ECONOMICS

MODULE 2

Chapter 2- Interest and Money- Time relationship

Introduction

The majority of engineering economy studies involve commitment of capital for

extended periods of time, so effect of time must be considered. It is recognized that a unit of
principal today is worth more than a unit of principal one or more years from now because of
interest (or profits) it can earn. Therefore, money has a time value.

Objectives:

At the end of this chapter, students are expected to be able to:

4. Understand the relationship of interest and money with respect to time.

5. Solve problems involving interest and money.
6. Learn to create cash flow diagrams.

Discussion

Interest
Interests the amount of the money paid for the use of borrowed capital or the income
produced by money which has been loaned.
Interest from the viewpoint of the lender is the income produced by money which has
been borrowed or invested. For the borrower, it is the amount of money paid for the use of
borrowed capital.

Simple Interest
When the total interest earned is linearly proportional to the amount of the loan
(principal), the number of the interest rate per interest periods for which the principal is
committed, and the interest rate per interest period, the interest is said to be simple.
Simple Interest is the 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 = 𝑃𝑛𝑖

𝐹 = 𝑃 + 𝐼 = 𝑃 + 𝑃𝑛𝑖

𝐹 = 𝑃(1 + 𝑛𝑖)

Where:
I = interest
P = principal or present worth
n = number of interest periods
i = rate of interest per interest period
F = accumulated amount or future
Types of Simple Interest
1. Ordinary Simple Interest
Based on one banker’s year which is equivalent to 300 days or 30 days in one
month.
It is computed on the basis of 12 months of 30 days a year.

1 interest period = 360 days

𝐈 = 𝐏𝐧𝐢

Example:

1. Determine the ordinary simple interest on P8,000 for 8 months at 7% per year.

Given:
P = 8,000
i = 7%
n = 8 months
Solution:
I = Pni

8
I = 8000( )(0.07)
12

I = ₱373.33

2. Determine the ordinary simple interest on ₱700 for 8 months and 25 days if the
rate of interest is 15%.
Solution:
Number of days = 8(30) + 25 = 265 days
265
I = 700 ( ) (0.15) = ₱77.29
360

2. Exact Simple Interest

Based in the exact number of days which is 365 days in ordinary year or 366 days for
leap year.
It is based on the exact number of days in year, 365 days for an ordinary year and
366 days for a leap year.
1 interest period = 365 or 366 days

𝐈 = 𝐏𝐧𝐢

𝒏
𝐈 = 𝐏( )𝐢 → 𝑓𝑜𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑦𝑒𝑎𝑟
𝟑𝟔𝟓
 𝒏
𝐈 = 𝐏( )𝐢 → 𝑓𝑜𝑟 𝑙𝑒𝑎𝑝 𝑦𝑒𝑎𝑟
𝟑𝟔𝟔

*A leap year is a year in which an extra day is added to the calendar in order
to synchronize it with the seasons.

*There is a leap year every year divisible by 4 except for years which are both
divisible by 100 and not divisible by 400. (e.g. 1700, 1800, 1900)

Example:
3. Determine the exact simple interest on P500 for the period from January 10 to October
28, 1996 at 16% interest.

Solution:
I = Pni

Jan 10-31 = 21 (excluding Jan 10)

February = 29
March =31
April =30
May =31
June =30
July =31
August =31
September =30
October =28 (including Oct.28)
292 days

292
I = 500 ( ) (0.16) = ₱63.83
366

4. Determine the interest on P15,000 loan at 8% per year made from January 12 to
September 24, 2007. Using:
a. Exact simple interest

Solution:
a. Exact simple interest:

Solving for the number of days, from Jan 12 to September 24, 2007, there are 265 days.
(*Note: for a specific dates, to count the number of days, exclude the first day, include the
last day)
 Jan 12-31 = 19 (excluding Jan 2)
February = 28
March =31
April =30
May =31
June =30
July =31
August =31
September =24
255 days

I = Pni

255
I = (15000)( )(0.08)
365

I = ₱838.36

5. What will be the future worth of money after 14months, if a sum of P10,000 is invested
today at a simple interest rate of 12% per year?
Solution:
𝐹 = 𝑃(1 + 𝑛𝑖)

14
𝐹 = 10000[1 + ( )(0.12)]
12

𝐹 = ₱11400.00

Cash-Flow Diagrams
Cash flow is the sum of money recorded as receipts or disbursements in a project’s
financial records
A cash-flow diagram is simply a 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 mechanics problems.
A cash flow diagram presents the flow of cash as arrows on a time line scaled to
the magnitude of the cash flow, where expenses are down arrows and receipts are up
arrows.

Year-end convention ~ expenses occurring during the year are assumed to occur
at the end of the year.
 Receipt (positive cash flow or cash inflow)

Disbursement (negative cash flow or cash outflow)

Example:
A loan of 100 at simple interest of 10% will become P150 after 5 years.

Cash flow diagram on the viewpoint of the lender

P100

0 1 2 3 4 5

P150

Cash flow diagram on the viewpoint of the borrower

Example:
A mechanical device will cost $20,000 when purchased. Maintenance will cost $1000
per year. The device will generate revenues of $5000 per year for 5 years. The salvage
value is $7000.

Cash flow diagram

 Simplified cash flow diagram

Compound Interest
Whenever the interest charge for any interest period 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 compounded.
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. Thus compound
interest means “interest on top of interest.”

Discrete Compounding
Discrete compounding refers to the method by which interest is calculated and added
to the principal at certain set points in time. For example, interest may be compounded weekly,
monthly, or yearly.
The Formulas assume discrete (i,e., lump sum) cash flows spaced at the end of
equal time intervals on a cash flow diagram.

Derivation of Formula
Interest Principal at Interest Earned Amount at End of Period
Period Beginning of Period During Period

1 𝑃 𝑃𝑖 𝑃 + 𝑃𝑖 = 𝑃(1 + 𝑖)
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)2 𝑖 𝑃(1 + 𝑖)2 + 𝑃(1 + 𝑖)2 𝑖 = 𝑃(1 + 𝑖)3
… … … …
n 𝑃(1 + 𝑖)𝑛−1 𝑃(1 + 𝑖)𝑛−1 𝑖 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 designed by the functional symbol F/P, i%, n. Thus,

𝑭
𝑭 = 𝑷( , 𝒊%, 𝒏)
𝑷
The symbol F/P, i%, n is read as “F given P at i per cent in n interest period.”

𝑷 = 𝑭(𝟏 + 𝒊)−𝒏

The quantity (𝟏 + 𝒊)−𝒏 is commonly called the “single payment present worth factor” and is
designed by the functional symbol F/P, i%, n. Thus

𝑷
𝑷 = 𝑭( , 𝒊%, 𝒏)
𝑭
The symbol P/F, i%, n is read as “P given F at i per cent in n interest period.”

The Five Types of Cash Flows

Whenever patterns are identified in cash flow transactions, these patterns can be used
to develop concise expressions for computing either the present or future worth of the series.
Cash flows can be classified into five categories:
1. Single Cash Flows: The simplest case involves the equivalence of a single cash
present amount and its future worth. Thus, the single-cash flow formula deal with only
two amounts: the single present amount P, and its future worth F.
2. Equal Uniform Series: Probably the most familiar category includes transactions
arranged as a series of equal cash flows at regular intervals, known as an equal-
payment series (or uniform series)
3. Linear Gradient Series: consists of cash flows that increase or decrease by uniform
amount each periods.
4. Geometric Gradient Series: consist of cash flows that increase or decrease by a fixed
percentage.
5. Irregular Series: consists of cash flows that change with no pattern.

Rate of Interest
Is defined as the amount earned by one unit of principal during a unit of time.
a) Nominal rate of interest
 The nominal rate of interest specifies the rate of interest and a number of interest
periods in one year.
𝒓
𝒊=
𝒎
Where: i = rate of interest per interest period
r = nominal interest rate
m = number of compounding periods per year

𝒏 = 𝑻𝒎
Where: n = no. of interest per periods
T = no. of years
m = number of compounding periods per year

If the nominal rate of interest is 10%compounded quarterly, then i= 10%/4= 2.5%, the
rate of interest per interest period.
The following list the different compounding periods and the occurrence in one year
Annually once a year
Semi- annually twice a year
Quarterly every 3 months
Bi – monthly every 2 months
Monthly every month
Semi- monthly twice a month
Weekly
Daily
Continuously
b) Effective rate of interest
Effective rate of interest quotes the exact rate of interest for one year. It should be
noted that the effective interest rates are always expressed on an annual basis.
If P1.00 is invested at a nominal rate of 15% compounded quarterly, after one year
this will become.
0.15 4
1(1 + ) = 1.1586
1
The actual interest actual interest earned is 0.1586, therefore, the rate of interest after
one year is 15.86%. Hence,
𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒓𝒂𝒕𝒆 = 𝑭𝟏 − 𝟏 = (𝟏 + 𝒊)𝒎 − 𝟏
Where: 𝐹1 = the amount of P1.00 will be after one year
Example
1. Consider, one unit of principal for one unit a time invested in a nominal interest of 12%
compounded monthly,
P= 1.00
n= 12
i = 12/12 = 1%/ month
Solution:
The accumulated amount of P for one year will be
𝐹 = 𝑃(1 + 𝑖)𝑛
𝐹 = 1(1 + 0.01)12
𝐹 = 1.1268
The implication is that, for one unit of principal. The interest earned will be
I = 0.1268
and in terms of effective or actual annual interest (ERI) the interest can be rewritten as a
percentage of the principal amount:
𝑖 = 𝐼/ 𝑃 = 0.1268 / 1 = 12.68%
Therefore, to determine the effective rate of interest for a given nominal rate of interest,
𝐸𝑅 = (1 + 𝑖)𝑚 − 1
In other words, paying 1% interest per month for 12 months is equivalent to paying 12.68%
interest just one time each year.

2. Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?
Solution:
Let r = the unknown nominal rate
 For two or more nominal rates to be equivalent, their corresponding effective rates must
be equal.

Nominal Rate Effective Rate

r% compounded quarterly 𝑟
(1 + )4 − 1
4
12% compounded monthly 0.12 12
(1 + ) −1
12

𝑟 0.12 12
(1 + )4 − 1 = (1 + ) −1
4 12

𝑟
1+ = (1.01)3 = 1.0303
4

𝒓 = 𝟎. 𝟏𝟐𝟏𝟐 𝒐𝒓 𝟏𝟐. 𝟏𝟐% 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒆𝒅 𝒒𝒖𝒂𝒓𝒕𝒆𝒓𝒍𝒚

3. Find the amount at the end of two years and seven months if P1000 is invested at 8%
compounded quarterly using simple interest for anytime less than a year interest period.

Solution:
For compound interest:

8
𝑖 = = 2%
4

𝑛 = (2) (4) = 8

For simple interest:

𝑖 = 8%

7
𝑛=
12
 F2

F1

0 1 2 2 years, 7 months

Compound Simple
Interest Interest

P1000
𝐹1 = 𝑃(1 + 𝑖)𝑛 = 1000(1 + 0.02)8 = 1171.66
7
𝐹2 = 𝐹1 (1 + 𝑛𝑖) = 1171.66 [1 + (0.08)] = 𝟏𝟐𝟐𝟔. 𝟑𝟒
12

4. A P2000 loan was originally made 8% simple interest for 4 years. At the end of this period
the loan was extended for 3 years, without the interest being paid, but the new interest rate
was made 10% compounded semiannually. How much should the borrower pay at the end
of the 7 years?
Solution:

𝐹4 = 𝑃(1 + 𝑛𝑖) = 2000[1 + 4(0.08)] = 2640

0.1 2(3)
𝐹7 = 𝐹4 (1 + 𝑖)𝑛 = 2640 (1 + ) = 𝑷𝟑𝟓𝟑𝟕. 𝟖𝟓
2

Equation of Value
If cash flows occur on different periods, comparison of such should be made on a
same focal date. Equation of values is obtained by setting the sum of one set of obligation
on a certain comparison or focal date equal to the sum of another set of obligation on the
same date.
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.
Application of Compound Interest
Deposits ------- withdrawals
Loans ---------- repayments
Investment ---- income
Cash inflow --- cash outflow

Example:
1. A man bought a lot worth P1, 000,000 if paid in cash. On the installment 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%?
Solution:

P800, 000

0 1 2 3 4 5

P300, 000
P400, 000
300000(P/F, 20%, 1)

400000(P/F, 20%, 3)
Q
Q(P/F, 20%, 5)

Using today as the focal date, the equation of value is

𝑃800, 000 = 𝑃300. 000 (𝑃/𝐹, 20%, 1) + 𝑃400,000 (𝑃/𝐹, 20%, 3) + 𝑄 (𝑃/𝐹, 20%, 5)
800, 000 = 300,000 (1.20)−1 + 400,000 (1.20)−3 + 𝑄 (1.20)−5

800, 000 = 300,000 (0.8333) + 4000, 000 (0,5787) + 𝑄 (0.4019)

𝑄 = P792,560
Continuous Compounding and Discrete Payments
In discrete compounding the interest is compounded at the end of each finite- length
period, such as a month, a quarter or a year.
In continuous compounding, it is assumed that cash payments occur once per year,
but the compounding is continuous throughout the year.

𝒓 𝒎𝒏
𝑭 = 𝑷(𝟏 + )
𝒎
Where: r= nominal rate of interest per year
𝑟
= rate of interest per period
𝑚

m = number of interest periods per year

mn = number of interest periods in n years

𝑚
Let = 𝑘,then 𝑚 = 𝑟𝑘, as m increases so must k
𝑟

𝑟 𝑚𝑛 1 1
(1 + ) = (1 + )𝑟𝑘𝑛 = [(1 + )𝑘 ]𝑟𝑛
𝑚 𝑘 𝑘
1
The limit of (1 + 𝑘)𝑘 as k approaches infinity is e.

1
[(1 + )𝑘 ]𝑟𝑛 = 𝑒 𝑟𝑛
𝑘
Thus,
𝑭 = 𝑷𝒆𝒓𝒏

𝑷 = 𝑭𝒆−𝒓𝒏

Example:
1. Compare the accumulated amounts after 5 years of P1,000 invested at the rate of 10% per
year compounded (a) annually, (b) semiannually, (c) quarterly, (d) monthly, (e) daily, and (f)
continuously.
Solution:
Using the formula 𝐹 = 𝑃(1 + 𝑖)𝑛
a. 𝐹 = 1000(1 + 0.10)5 = 𝑷𝟏𝟔𝟏𝟎. 𝟓𝟏
0.10 10
b. 𝐹 = 1000 (1 + ) = 𝑷𝟏𝟔𝟐𝟖. 𝟖𝟗
2

0.10 20
c. . 𝐹 = 1000 (1 + ) = 𝑷𝟏𝟔𝟑𝟖. 𝟔𝟐
4

0.10 60
d. . 𝐹 = 1000 (1 + ) = 𝑷𝟏𝟔𝟒𝟓. 𝟑𝟏
12

0.10 1825
e. . 𝐹 = 1000 (1 + 365 ) = 𝑷𝟏𝟔𝟒𝟖. 𝟔𝟏

f. . 𝐹 = 𝑃𝑒 𝑟𝑛 = 1000𝑒 0.10(5) = 𝑷𝟏𝟔𝟒𝟖. 𝟕𝟐

Discount

Discount is defined as interest deducted in advance. In negotiable paper, it is

the difference between the present worth of the paper and its value sometime in the
future.
Discount on a negotiable paper is the difference between the present worth
(the amount received for the paper in cash) and the worth of the paper at some time
in the future (the face value of the paper or principal). Discount is interest paid in
advance.
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ – 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ
The rate of discount is the discount on one unit of principal for one unit of time.

Rate of Discount
Rate of discount is defined as the discount of one unit of principal for one unit of
time.

𝒅 = 𝟏 − (𝟏 + 𝒊)−𝟏

𝒅
𝒊=
𝟏−𝒅

Where: d = rate of discount for given period

i = rate of interest for the same period
Example
1. A man borrowed P5000 from a bank and agreed to pay the loan at the end of 9
months. The bank discounted the loan and gave him P4000 in cash. (a) What was the
rate of discount? (b) What was the rate of interest? (c) What was the rate of interest
for one year?
Solution:

𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 1000
a. 𝑑 = = = 𝟎. 𝟐𝟎 𝒐𝒓 𝟐𝟎%
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 5000

Another solution:
𝑑 = 1 − (1 + 𝑖)−1

(1 + 𝑖)−1 = 0.80
𝑑 = 1 − 0.80 = 0.20 𝑜𝑟 20%

𝑑 0.20
b. 𝑖 = 1−𝑑 = 1−0.20 = 𝟎. 𝟐𝟓 𝒐𝒓 𝟐𝟓%

Another Solution:
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 1,000
𝑖 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ = 4,000 = 0.25 𝑜𝑟 25%

𝐼 1000
c. 𝑖 = 𝑃𝑛 = 9 = 𝟎. 𝟑𝟑𝟑𝟑 𝒐𝒓 𝟑𝟑. 𝟑𝟑%
4000(12)

Inflation
Inflation is the increase in the prices for goods and services from one year to
another, thus decreasing the purchasing power of money.
𝑭𝑪 = 𝑷𝑪 ( 𝟏 + 𝒇)𝒏

Where:
PC = present cost of a commodity
FC = future cost of the same commodity
f = annual inflation
n = number of years

Example:
An item presently costs P1000. If Inflation is at the rate of 8% per year. What will be
the cost of the item in two years?
 Solution:
𝐹𝐶 = 𝑃𝐶 ( 1 + 𝑓)𝑛 = 1000(1 + 0.08)2 = 𝟏𝟏𝟔. 𝟒𝟎

In an inflationary economy, the buying power of money decrease as cost increase. Thus,
𝑃
𝐹=
( 1 + 𝑓)𝑛
Where: F is the future worth, measured in today’s pesos, of a present amount P.

Example:
An economy is experiencing inflation at the annual rate of 8%. If this continuous, what
will P1000 be worth two years from now, in terms of today’s peso?

Solution:
𝑃 1000
𝐹= 𝑛
= = 𝑃857.34
( 1 + 𝑓) ( 1 + 0.08)2

If interest is being compounded at the same time that inflation is occurring. The future
worth will be

𝑃( 1 + 𝑖)𝑛 1+ 𝑖 𝑛
𝐹= 𝑛
= 𝑃( )
( 1 + 𝑓) 1+ 𝑓

Example:
A man invested P10000 at an interest rate of 10% compounded annually. What will be
the final amount of his investment, in terms of today’s pesos, after five years, if inflation
remains the same at the rate of 8% per year?

Solution:
1+ 𝑖 𝑛 1 + 0.10 5
𝐹 = 𝑃( ) = 10000( ) = 𝑷𝟏𝟎, 𝟗𝟔𝟎. 𝟖𝟔
1+ 𝑓 1 + 0.08

ANNUITY
An annuity is a series of equal payments made at equal intervals of time. Financial
activities like installment payments, monthly rentals, life-insurance premium, monthly
retirement benefits, are familiar examples of annuity.
Annuity can be certain or uncertain. In annuity certain, the specific amount of payments
are set to begin and end at a specific length of time. A good example of annuity certain is the
monthly payments of a car loan where the amount and number of payments are known. In
annuity uncertain, the annuitant may be paid according to certain event. Example of annuity
uncertain is life and accident insurance. In this example, the start of payment is not known and
the amount of payment is dependent to which event.
Annuity certain can be classified into two, simple annuity and general annuity. In simple
annuity, the payment period is the same as the interest period, which means that if the
payment is made monthly the conversion of money also occurs monthly. In general annuity,
the payment period is not the same as the interest period. There are many situations where
the payment for example is made quarterly but the money compounds in another period, say
monthly. To deal with general annuity, we can convert it to simple annuity by making the
payment period the same as the compounding periods by the concept of effective rates.

Types of Annuities
In engineering economy, annuities are classified into four categories. These
are (1) ordinary annuity, (2) annuity due, (3) deferred annuity, and (4) perpetuity.

An annuity is a series of equal payments occurring at equal periods of time.

Symbol and their meaning

P = Value or sum of money at present
F = Value or sum of money at some future time
A = A series I periodic, equal amounts of money
n = Number of interest periods
I = Interest rate per interest period

Ordinary Annuity
An ordinary annuity is a series of uniform cash flows where the first amount
of the series occurs at the end of the first period and every succeeding cash flow
occurs at the end of each period.

An ordinary annuity is one where the payments are made at the end of each
period.

Cash Flow Diagram

P F
𝑖%
0 1 2 3 4 5 6 𝑛−5 𝑛−4 𝑛−3 𝑛−2 𝑛−1 𝑛

A A A A A A A A A A A A A
 To find F, use n as a focal date.

𝐹 = 𝐴 + 𝐴(1 + 𝑖)1 + 𝐴(1 + 𝑖)2 + 𝐴(1 + 𝑖)3 + ⋯ + 𝐴(1 + 𝑖)𝑛−2 + 𝐴(1 + 𝑖)𝑛−1

𝐹 = 𝐴[1 + (1 + 𝑖)1 + (1 + 𝑖)2 + (1 + 𝑖)3 + ⋯ + (1 + 𝑖)𝑛−2 + (1 + 𝑖)𝑛−1 ]

This is a geometric series

𝑟𝑛 − 1
𝑆𝐺 = 𝑎1 [ ]
𝑟−1

Where:

𝑆𝐺 = sum of geometric gradient

𝑎1 = first term
𝑟 = common ratio
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑒𝑟𝑚𝑠
∴ 𝑎1 = 1 r = (1 + i) 𝑛 = 𝑛

(1 + 𝑖)𝑛 − 1
𝑆𝐺 = (1)[ ]
(1 + 𝑖) − 1

(1 + 𝑖)𝑛 − 1
𝑆𝐺 =
𝑖

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴𝑆𝐺 = 𝐴 [ ]
𝑖

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖

𝑟
As consequence, 𝑖 = 𝑚

𝑟 𝑛𝑚
(1 + 𝑚) − 1
𝐹 = 𝐴[ 𝑟 ]
𝑚

To find P, use 0 as a focal date.

𝑃 = 𝐴(1 + 𝑖)−1 + 𝐴(1 + 𝑖)−2 + 𝐴(1 + 𝑖)−3 + ⋯ + 𝐴(1 + 𝑖)−(𝑛−1) + 𝐴(1 + 𝑖)−𝑛

𝑃 = 𝐴(1 + 𝑖)−1 [𝐴(1 + 𝑖)−1 + 𝐴(1 + 𝑖)−2 + ⋯ + 𝐴(1 + 𝑖)−(𝑛−2) + 𝐴(1 + 𝑖)−(𝑛+1)

This is a geometric series

 𝑟𝑛 − 1
𝑆𝐺 = 𝑎1 [ ]
𝑟−1

∴ 𝑎1 = 1 r = (1 + i)−1 𝑛=𝑛

(1 + 𝑖)−𝑛 − 1
𝑆𝐺 = (1)[ ]
(1 + 𝑖)−1 − 1

(1 + 𝑖)−𝑛 − 1
𝑆𝐺 =
(1 + 𝑖)−1 − 1

(1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴(1 + 𝑖)−1 𝑆𝐺 = 𝐴(1 + 𝑖)−1 [ ]
(1 + 𝑖)−1 − 1

(1 + 𝑖)
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑦 𝑏𝑜𝑡ℎ 𝑏𝑦
(1 + 𝑖)

(1 + 𝑖)−𝑛 − 1 (1 + 𝑖)
𝑃 = 𝐴(1 + 𝑖)−1 [ ]∙
(1 + 𝑖)−1 − 1 (1 + 𝑖)

(1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴[ ]
1 − (1 + 𝑖)

(1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴[ ]
−𝑖

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

𝑟
As consequence, 𝑖 = 𝑚

𝑟 −𝑚𝑛
1 − (1 + 𝑚)
𝑃 = 𝐴[ 𝑟 ]
𝑚

(1+𝑖)𝑛 −1 (1+𝑖)𝑛 −1
In 𝐹 = 𝐴 [ ], the factor is called “uniform series compound factor”
𝑖 𝑖
(𝐹/𝐴, 𝑖%, 𝑛) → F given A at i% in n interest periods.

∴ 𝐹 = 𝐴(𝐹/𝐴, 𝑖%, 𝑛)

1−(1+𝑖)−𝑛 1−(1+𝑖)−𝑛
In 𝑃 = 𝐴 [ ], the factor is called “uniform series present worth factor”
𝑖 𝑖
(𝑃/𝐴, 𝑖%, 𝑛) → P given A at i% in n interest periods.

∴ 𝑃 = 𝐴(𝑃/𝐴, 𝑖%, 𝑛)

𝑖 𝑖
Also, in 𝐴 = 𝐹 [(1+𝑖)𝑛 ] the factor (1+𝑖)𝑛 is called “sinking fund factor” (𝐴/𝐹, 𝑖%, 𝑛) →
−1 −1

A given F at i% in n interest periods.

 ∴ 𝐴 = 𝐹(𝐴/𝐹, 𝑖%, 𝑛)

𝑖 𝑖
And in Also, in 𝐴 = 𝑃 [ ] the factor is called “capital recovery factor”
1−(1+𝑖)−𝑛 1−(1+𝑖)−𝑛

(𝐴/𝑃, 𝑖%, 𝑛) → A given P at i% in n interest periods.

∴ 𝐴 = 𝑃(𝐴/𝑃, 𝑖%, 𝑛)

Relationship between capital recovery factor and sinking fund factor:

𝑖 𝑖 + 𝑖(1 + 𝑖)𝑛 − 𝑖
+ 𝑖 =
(1 + 𝑖)𝑛 − 1 (1 + 𝑖)𝑛 − 1

𝑖(1 + 𝑖)𝑛 (1 + 𝑖)−𝑛

= ∙
(1 + 𝑖)𝑛 − 1 (1 + 𝑖)−𝑛

𝑖 𝑖
𝑛
+𝑖 =
(1 + 𝑖) − 1 1 − (1 + 𝑖)−𝑛

∴ 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑 𝑓𝑎𝑐𝑡𝑜𝑟 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑓𝑎𝑐𝑡𝑜𝑟

(𝐴/𝐹, 𝑖%, 𝑛) + 𝑖 = (𝐴/𝑃, 𝑖%, 𝑛)

Example:
What are the present worth and the accumulated amount of a 10-year annuity
paying ₱10000 at the end of each year, with interest at 15% compounded annually?

Solution:
𝐴 = ₱10000
𝑛 = 10
𝑖 = 15%

P F

0 1 2 3 9 10

₱10000 ₱10000 ₱10000 ₱10000 ₱10000

𝑃 10000(𝑃/𝐴, 15%, 10) 𝑃 10000(𝐹/𝐴, 15%, 10)

𝑃 = 𝐴(𝑃/𝐴, 𝑖%, 𝑛) = 10000(𝑃/𝐴, 15%, 10)

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖
 1 − (1 + 0.15)−10
= 10000 [ ] = ₱𝟓𝟎, 𝟏𝟖𝟖
0.15

𝐹 = 𝐴(𝐹/𝐴, 𝑖%, 𝑛) = 10000(𝐹/𝐴, 15%, 10)

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖

(1 + 0.15)10 − 1
= 10000 [ ] = ₱𝟐𝟎𝟑, 𝟎𝟑𝟕
0.15

Example:

What is the present worth of ₱500 deposited at the end of every three months for
6years if the interest rate is 12% compounded semiannually?

Solution:
Solving for the interest rate per quarter,

0.12 2
(1 + 𝑖)4 − 1 = (1 + ) −1
2
1 + 𝑖 = (1.06)0.5
𝑖 = 0.0296 𝑜𝑟 2.96% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
𝑃 = 𝐴(𝑃/𝐴, 2.96%, 24)
1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

1 − (1 + 0.0296)−24
𝑃 = 500 [ ]
0.0296

𝑃 = 500[17.0087]
𝑷 = ₱𝟖𝟓𝟎𝟒. 𝟑𝟕

Example:
The purchase of an equipment of ₱100000 has been made available through a loan
which earns 12% per annum. It has been agreed that the loan be payable in 10 equal
payments. How much then is the yearly due?
Given:
P=₱100000
i = 12%
 n = 10 years
A=?
Solution:
1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

1 − (1 + 0.12)−10
10000 = 𝐴 [ ]
0.12

𝐴 = ₱17698.42

Example:
What is the future worth of ₱600 deposited at the end of every month for 4 years if the
interest rate is 12% compounded quarterly?
Given:
A = ₱600
r = 12%
m=4
n = 4 years
F=?
Solution:
Convert 12% compounded quarterly to r% compounded monthly:
(Effective rate must be equal)

𝑟 12 0.12 4
(1 + ) − 1 = (1 + ) −1
12 4
𝑟 = 0.1188 𝑜𝑟 11.88 % (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑚𝑜𝑛𝑡ℎ𝑙𝑦)
𝑟 𝑛𝑚
(1 + 𝑚) − 1
𝐹 = 𝐴[ 𝑟 ]
𝑚

0.1188 4(12)
(1 + 12 ) −1
𝐹 = 600 [ ]
0.1188
12
𝐹 = ₱36,641.32
Deferred Annuity
A deferred annuity is one where the first payment is made several periods after
the beginning of the annuity (first cash flow of the series is not at the end of the lot period
or it is deferred for some time).
 Finding P when A is given

P Cash flow diagram

P’

k-1 k
0 1 2 0 1 n
2 n-1

A A A A
𝐴(𝑃/𝐴, 𝑖%, 𝑛)(𝑃/𝐹, 𝑖%, 𝑘 − 1) 𝐴(𝑃/𝐴, 𝑖%, 𝑛)

1 − (1 + 𝑖)−𝑛
𝑃′ = 𝐴 [ ]
𝑖

𝑃 = 𝑃′(1 + 𝑖)−(𝑘−1) where k = deferment period

1−(1+𝑖)−𝑛
𝑃 = 𝐴[ ] (1 + 𝑖)−(𝑘−1)
𝑖

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖

Example:
A man loans ₱187,400 from a bank with interest at 5% compounded annually. He
agrees to pay his obligations by paying 8 equal annual payments the first being due at the
end of 10 years. Find the annual payments.
Given:
P = ₱187,400
i = 5%
n=8
k = 10
A=?
Solution:

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

A A A A A A A A

P’

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ] (1 + 𝑖)−(𝑘−1)
𝑖
 1 − (1 + 0.05)−𝑛
₱187,400 = 𝐴 [ ] (1 + 0.05)−(10−1)
0.05

𝐴 = ₱44,980.56

Annuity Due
An annuity due is one where the payments are made at the beginning of each period

Finding F When A is given

𝑃 𝐹’ 𝐹

0 1 2 3 𝑛−3 𝑛−2 𝑛−1 𝑛

𝐴 𝐴 𝐴 𝐴 𝐴 𝐴 𝐴

Cash flow diagram given A to find F

(1 + 𝑖)𝑛 − 1
𝐹′ = 𝐴 [ ]
𝑖

𝐹 = 𝐹′(1 + 𝑖)
(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ] (1 + 𝑖)
𝑖

(1 + 𝑖)𝑛+1 − (1 + 𝑖)
𝐹 = 𝐴[ ]
𝑖

(1 + 𝑖)𝑛+1 − 1 𝑖
𝐹 = 𝐴[ − ]
𝑖 𝑖

(1 + 𝑖)𝑛+1 − 1
𝐹 = 𝐴[ − 1]
𝑖

1 − (1 + 𝑖)−(𝑛−1)
𝑃 = 𝐴 + 𝐴[ ]
𝑖

1 − (1 + 𝑖)−(𝑛−1)
𝑃 = 𝐴 [1 + ]
𝑖
Example:
A man bought an equipment costing P60, 000 payable in 12 quarterly payments, each
installment payable at the beginning of each period. The rate of interest is 24%
compounded quarterly. What is the amount of each payment?
Given:
P = ₱60000
r = 24%
m=4
n = 12
A=?
Solution:

0.24 −(12−1)
1 − (1 + 4 )
₱60000 = 𝐴 [1 + ]
0.24
4
𝐴 = ₱6751.53

Perpetuity
The type of annuity similar to ordinary annuity except that the payments continue
infinitely.
𝑃

0 1 2 3 ∞

𝐴 𝐴 𝐴 𝐴 𝐴 𝐴

Cash flow diagram given A to find F

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

But since n approaches infinity, (1 + 𝑖)−𝑛 ≈ 0

1−0
𝑃 = 𝐴[ ]
𝑖
𝐴
𝑃= 𝐹 𝑐𝑎𝑛𝑛𝑜𝑡 𝑏𝑒 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑
𝑖
Example:
What amount of money invested today at 15% interest can provide the following
scholarships: ₱30,000 at the end of each year for 6 years: ₱40,000 for the next 6 years and
₱50,000 thereafter?
Solution:

𝑖 = 15%

∞
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
P
P P P P P P P P PP P P P P P P

A1=₱30000 A2=₱40000 A3=₱50000

P
P
1 − (1 + 𝑖)−𝑛 1 − (1 + 𝑖)−𝑛 𝐴
𝑃 = 𝐴1 [ ] + 𝐴2 [ ] (1 + 𝑖)−𝑛 + (1 + 𝑖)−𝑛
𝑖 𝑖 𝑖

1 − (1 + 0.15)−6 1 − (1 + 0.15)−6
𝑃 = 30000 [ ] + 40000 [ ] (1 + 0.15)−6
0.15 0.15
50000
+ (1 + 0.15)−12
0.15
𝑃 = ₱241,282.32

Uniform Arithmetic Gradient Payment

A series of payments with common difference.

For Ascending Payments

An
An-1
An-2
An-3
A2
A1
G G G
G
0 1 2 n-3 n-2 n-1 n

P Cash Flow Diagram F

𝐴2 −𝐴1 = 𝐺 ← 𝑐𝑜𝑚𝑚𝑜𝑛 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒

 A1 A A1 A1 A1 A1
1

0 1 2 n-3 n-2 n-1 n

P F

(n-1)G

(n-2)G
(n-3)G
(n-4)G
G

0 1 2 n-3 n-2 n-1 n

P F

∴ 𝑃 = 𝑃𝐴 + 𝑃𝐺
1 − (1 + 𝑖)−𝑛
𝑃𝐴 = 𝐴1 [ ]
𝑖
𝐺 (1 + 𝑖)−𝑛 − 1
𝑃𝐺 = [ − 𝑛](1 + 𝑖)−𝑛
𝑖 𝑖
1 − (1 + 𝑖)−𝑛 𝐺 (1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴1 [ ]+ [ − 𝑛](1 + 𝑖)−𝑛
𝑖 𝑖 𝑖

To get the equivalent annuity for this uniform arithmetic gradient payment:

𝐺 𝑛𝑖
𝐴 𝑇 = 𝐴1 + [1 − ]
𝑖 (1 + 𝑖)𝑛 − 1

To find F:
𝐹 = 𝐹𝐴 + 𝐹𝐺
(1 + 𝑖)𝑛 − 1
𝐹𝐴 = 𝐴1 [ ]
𝑖

𝐺 (1 + 𝑖)𝑛 − 1
𝐹𝐺 = [ − 𝑛]
𝑖 𝑖

(1 + 𝑖)𝑛 − 1 𝐺 (1 + 𝑖)𝑛 − 1
𝐹 = 𝐴1 [ + [ − 𝑛]]
𝑖 𝑖 𝑖
For Descending Payments

A1

A2
A3
An-1
An
G G

0 1 2 3 n-1 n

P F

∴ 𝑃 = 𝑃𝐴 − 𝑃𝐺

1 − (1 + 𝑖)−𝑛 𝐺 (1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴1 [ ]− [ − 𝑛](1 + 𝑖)−𝑛
𝑖 𝑖 𝑖

𝐹 = 𝐹𝐴 − 𝐹𝐺

(1 + 𝑖)𝑛 − 1 𝐺 (1 + 𝑖)𝑛 − 1
𝐹 = 𝐴1 [ − [ − 𝑛]]
𝑖 𝑖 𝑖

𝐺 𝑛𝑖
𝐴 𝑇 = 𝐴1 − [1 − ]
𝑖 (1 + 𝑖)𝑛 − 1

Example:
Find the equivalent annual payment of the following obligations at 20% interest.
End of Year Payment
1 ₱ 8,000
2 ₱ 7,000
3 ₱ 6,000
4 ₱ 5,000
Solution:
Given: 𝐴1 = ₱8,000
𝑛=4
𝑖 = 20%
Since this is a descending payment, we will use the formula:
𝐺 𝑛𝑖
𝐴 𝑇 = 𝐴1 − [1 − ]
𝑖 (1 + 𝑖)𝑛 − 1
₱1000 4(0.20)
𝐴 𝑇 = ₱8,000 − [1 − ]
0.2 (1 + 0.20)4 − 1
𝐴 𝑇 = ₱6725.78
Geometric Gradient
P F
Cash Flow Diagram

i%

A1
A2
A3
An-3
An-2
An-1
An
Where,
𝐴𝑛 = 𝐴1 (1 + 𝑔)𝑛−1
𝑔 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒

Using 0 as focal date:

𝑃 = 𝐴1 (1 + 𝑔)−1 + 𝐴2 (1 + 𝑔)−2 + 𝐴3 (1 + 𝑔)−3 + ⋯ + 𝐴𝑛 (1 + 𝑔)−𝑛
𝐴𝑛 = 𝐴1 (1 + 𝑔)𝑛−1

𝐴1 1 − (1 + 𝑖𝑐𝑟 )−𝑛
𝑃= [ ]
1+𝑔 𝑖𝑐𝑟

1+𝑖
𝑖𝑐𝑟 = −1
1+𝑔

Example:
A ₱1M debt is to be paid in 4 installments, the next payment being 20% larger than
the preceding. If money is worth 10% and the first payment is made 3 years after the debt
has been granted. Compute the first payment during the third year.

Solution:
P F
Given:
P = ₱1M
n=4
g= 20%

A1
1.2A1
1.22 A1
1.23 A1
From the cash flow diagram, setting 0 as focal date:
𝐴1 1 − (1 + 𝑖𝑐𝑟 )−𝑛
𝑃= [ ](1 + 𝑖)−2
1+𝑔 𝑖𝑐𝑟
1+𝑖
𝑖𝑐𝑟 = −1
1+𝑔
−𝑛
1 + 0.1
𝐴1 1 − (1 + 1 + 0.2 − 1)
1,000,000 = [ ](1 + 0.1)−2
1 + 0.2 1 + 0.1
1 + 0.2 − 1
𝐴1 = ₱290,658.08

Continuous Compounding and Continuous Cash Flow

𝑛→∞
𝑚→∞

𝑒 𝑟𝑛 − 1
𝐹 = 𝐴[ ]
𝑟
𝑟
𝐴 = 𝐹[ ]
𝑒 𝑟𝑛−1

1 − 𝑒 𝑟𝑛 𝑒 𝑟𝑛 − 1
𝑃 = 𝐴[ ]=[ ]
𝑟 𝑟𝑒 𝑟𝑛

𝑃𝑟 𝑃𝑟𝑒 𝑟𝑛
𝐴= =
1 − 𝑒 𝑟𝑛 𝑒 𝑟𝑛 − 1

Capitalized Cost
One of the most important applications of perpetuity is in capitalized cost. The
capitalized cost of any property is the sum of the first cost and the present worth of all
costs of replacement, operation and maintenance for a long time or forever.
Capitalized cost is an application for perpetuity. It is one method used in
comparing alternatives. It is defined as the sum of the first cost (FC) and the present
worth of all perpetual maintenance and replacement cost.

Case 1. No replacement, only maintenance and or operation every period.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑𝑜𝑟 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
Example:
Determine the capitalized cost of a structure that requires an initial investment of
₱1,500,000 and an annual maintenance of ₱150,000. Interest is 15%.

Solution:

₱150,000 ₱150,000

0 1 2

𝐴 150,000
𝑃= = = 1,000,000
𝐼 0.15
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝑃
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱1,500,000 + ₱1,000,000
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱2,500,000

Case 2.Replacement only, no maintenance and/ or operation.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡

Let S = amount needed to replace a property every k period
X = amount of principal invested at rate i% the interest on which will amount
to S every k periods

Xi = interest on X every period, the periodic deposit towards accumulation of S

0 1 2 3 k-1 k

Xi Xi Xi Xi Xi
Cash Flow diagram to find X given S

𝑆 = 𝑋𝑖 (𝐹/𝐴, 𝑖%, 𝑘)
𝑆 1 𝑆 𝑖
𝑋= [ ]= [ ]
𝑖 (𝐹/𝐴, 𝑖%, 𝑘) 𝑖 (1 + 𝑖)𝑘 − 1
 𝑆
𝑋=
(1 + 𝑖)𝑘 − 1
Difference between p and X in a perpetuity

A A A S S S

0 1 2 3 0 k 2k 3k

P X
𝐴
𝑃= 𝑆
𝑖 𝑋= 𝑘
(1 + 𝑖) − 1

P is the amount invested now at i% per period whose interest at the end of
every period forever is A while X is the amount invested now at i% per period whose
interest at the end of every k periods forever is S. If k = 1, then X = P.

Example:
A new engine was installed by a textile plant at a cost of ₱300,000 and projected to
have a useful life of 15 years. At the end of its useful life, it is estimated to have a salvage
value of ₱30,000. Determine its capitalized cost if interest is 18% compounded annually.
Solution:

₱30000 ₱30000 ₱30000

0 15 30 45

₱300000 ₱300000
₱300000 ₱300000

₱270000 ₱270000 ₱270000

0 15 30 45

X
𝑆 270000
𝑋= 𝑘
= 15
= ₱24,604
(1 + 𝑖) − 1 (1 + 0.18) −1
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝑋
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱300,000 + ₱24,604
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱324,604
 Case 3. Replacement, maintenance and/or operation every period

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡
= 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡
+ 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑/ 𝑜𝑟 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
+ 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡.
Example:
Determine the capitalized cost of a research laboratory which requires
P5,000,000 for original construction; P100,000 at the end of every year for the first 6
years and then P120,000 each year thereafter for operating expenses, and P500,000
every 5 years for replacement of equipment with interest at 12% per annum?

₱120,000 ₱120,000
Solution 0.12
(𝑃/𝐴, 12%, 6)
0.12

₱100,000 (𝑃/𝐴, 12%, 6)

₱120,000 ₱120,000 ₱120,000

₱100,000 ₱100,000 ₱100,000 ₱100,000 ₱100,000 ₱100,000

∞
1 2 3 4 5 6 7 8 9

Let Q be the present worth of cost of perpetual operation

1 − (1 + 0.12)−6 ₱120,000
𝑄 = ₱100,000 [ ]+ (1.012)−6
0.12 0.12

𝑄 = ₱917,721.85
Replacement:
₱500000 ₱500000 ₱500000

0 5 10 15

Let X = the present worth of cost of perpetual replacement

𝑆 500000
𝑋= 𝑘
= 5
= ₱655,873.88
(1 + 𝑖) − 1 (1 + 0.12) − 1
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑄 + 𝑋
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = ₱5,000,000 + ₱917,721, .85 + ₱655,873.88
 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = ₱6,573,645.73

Amortization
Amortization is any method of repaying a debt, the principal and interest included,
usually by a series of equal payments at equal intervals of time.
Amortization is any mode of paying debt, the principal and interest included, usually
by a series of uniform amount every period.

Amortization Schedule
-is a table showing the payments throughout the total interest period.

Example:
A debt of ₱5,000 with interest at 12% compounded semiannually is to be
amortized by equal semiannual payments over the next 3 years, the first due in 6
months. Find the semiannual payment and construct an amortization schedule.

₱5,000

0 1 2 3 4 5 6

A A A A A A

𝑃 ₱5,000
𝐴= = = ₱1,016.82
𝑃/𝐴, 6%, 6 4.9173
Amortization Schedule

Period Outstanding Interest due Payment Principal repaid

principal at at end pf at end of period
beginning of period period
1 ₱5,000.00 ₱300.00 ₱1,016.82 ₱716.82
2 4,283.18 256.99 1,016.82 759.83
3 3,523.35 211.40 1,016.82 805.42
4 2,717.93 163.08 1,016.82 853.74
5 1,864.19 111.85 1,016.82 904.97
6 959.22 57.55 1,016.82 959.27
Totals ₱1,100.87 ₱6,100.92 ₱5,000.05
Self-Assessment Questionnaire
1. Determine the exact simple interest on P50 000 for the period June 25, 2005 to September
2, 2006, if the rate of interest is 12% per year.
2. A loan of P2000 is made for a period of 13 months, from January 1 to January 31 the
following year, at simple interest rate of 20%. What future amount is due as the end of the
loan period?
3.If you borrow money from your friend with simple interest of 12%, find the present worth of
P20,000, which is due at the end of nine months.
4. A woman borrowed P3,000 to be paid after 1 ½ years with interest at 12% compounded
semiannually and P5,000 to be paid after 3 years at 12% compounded monthly. What single
payment must she pay after 3 ½ years at an interest rate of 16% compounded quarterly to
settle the two obligations?
5. Mr. J. de la Cruz borrowed money from a bank. He received from the bank P1, 342 and
promises to repay P1, 500 at the end of 9 months. Determine the simple interest rate and the
corresponding discount rate or often referred to as the “Banker’s discount.”
6. A man deposits P50, 000 in a bank account at 6% compounded monthly for 5 years. If the
inflation rate of 6.5% per year continues for this period, will this effectively protect the
purchasing power of the original principal?
7. What is the future worth of P600 deposited at the end of every month for 4 years if the
interest is 12% compounded quarterly?
8. A man wishes his son to receive P200, 000 ten years from now. What amount should he
invest if it will earn interest of 10% compounded annually during the first 5 years and 12%
compounded quarterly during the next 5 years?

ASAQ (Answer to Self-Assessment Questionnaire)

1. P7134.25
2. P2433.33
3. P18348.62
4. P12,627.55
5. d=10.53%; i=11.77%
6. P49,225
7. P36,641.32
8. P68,757.82
 CE 215 – ENGINEERING ECONOMICS

MODULE 3

Chapter 3- Depreciation

Introduction

Depreciation is defined as decrease in the value of a physical property or asset with

the passage of time. A physical asset has value because it provides monetary benefits to its
owner. These benefits are in the form of future cash flows resulting from (i) the use of the
asset to produce salable goods or services, or (ii) the ultimate sale of the asset at the end of
its useful life. Depreciation, thus, represents decrease in the value due to lessening in the
ability to produce these future cash flows, as a result of several causes such as wear and tear
and obsolescence.
Although, depreciation does occur, it is really difficult to determine its magnitude well
in advance.
Assets such as machinery and equipment are expensive. Instead of realizing an
asset's entire cost in year one, companies can use depreciation to spread out the cost and
generate revenue from it. This is done through depreciation, which allows a company to write
off an asset's value over a period of time, notably its useful life. It may be used to account for
declines over time in the carrying value, which represents the difference between the original
cost and the accumulated depreciation of the years.

Objectives:

At the end of this chapter, students are expected to be able to:

1. Understand how money or the value of equipment/machines depreciates with

time.
2. Learn the different methods of determining the depreciated value of a physical
property.
3. Solve problems on depreciations, using different methods.

Discussion
Depreciation is the decrease in the value of physical property with the passage
of time. 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 the
asset’s value can be reflected in a firm financial statement. Examples: Properties that
depreciates – Car, computer, refrigerator, etc.

Definitions

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 utility or use value of a 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 seller and buyer.

Book value, sometimes called depreciated book value, is the worth of a property
as shown on the accounting records of an enterprise.
Salvage, or resale, value is the price that can be obtained from the sale of the
property after it has been used.

Scrap value is the amount the property would sell for, if disposed off as junk.

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 changed to the cost of producing
products or services that results from the use of the property.

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 of the demand for the function which the
property was designed to render. Its common causes are inadequacy, changes in
styles, population-center shifts, saturation of markets or more efficient machines
are produced (obsolescence).

Depreciation due to changes in price levels is most impossible to predict and

therefore is not considered in economy studies.

Depletion refers to the decrease in the value of a property due to the gradual
extraction of its contents.

Properties Depreciable Assets:

1. It must have a determinable life and the life must be greater than 1 year.
2. It must be something used in business or held to produce income.
 3. It must be something that gets used up, wears out decays, become obsolete,
or loses its value due to natural causes.
4. It must not be an inventory or stock in trade or investment

Physical and Economical 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 be 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.

Depreciation Methods
We shall use the following symbols for different depreciation methods.

L = useful life of the property in years

Co = the original cost
CL = the value at the end of the life, the scrap value (including gain or
loss due to removal)
d = the annual cost of depreciation
Cn = the book value at the end of n years
Dn = depreciation up to age n years

1. The Straight Line Method (SLM)

This is the simplest depreciation method. The method assumes that

the loss in value is directly proportional to the age of the property. It also
assumes that a constant amount is depreciated each year over the depreciable
(useful) life of the asset.

𝐶𝑜 − 𝐶𝐿
𝑑=
𝐿

𝐷𝑛 = 𝑛𝑑

𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

𝐶𝑜 − 𝐶𝐿
𝐷𝑛 = 𝑛[ ]
𝐿
Examples:
1. An electronic balance costs ₱90,000 and has an estimated salvage value of
₱8,000 at the end of 10 years life time. What would be the book value after three
years, using the straight line method in solving for the depreciation?

Given:

𝐶𝑜 = ₱90,000
𝐶𝐿 = ₱8,000
𝐿 = 10
𝑛=3

Solution:
₱90,000 − ₱8,000
𝑑= = ₱8,200
10
𝐷3 = 𝑛𝑑 = 3(8,200) = 24,600
𝐶3 = 𝐶𝑜 − 𝐷3 = ₱90,000 − ₱24600 = ₱𝟔𝟓, 𝟒𝟎𝟎

2. A machine has an initial cost of ₱50,000 and a salvage value of ₱10,000 after 10
years. What is the straight line depreciation rate as a percentage of initial cost?
Given:

𝐶𝑜 = ₱50,000
𝐶𝐿 = ₱10,000
𝐿 = 10

Solution:
𝐶𝑜 − 𝐶𝐿 ₱50,000 − ₱10,000
𝑑= =
𝐿 10
𝑑 = ₱4,000
𝑑 ₱4,000
= = 𝟎. 𝟎𝟖 𝒐𝒓 𝟖%
𝐶𝑜 ₱50,000
2. Sinking Fund Method (SFM)
This method 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.

Using the formula for the future cost of annuity where A=d and F=Co-CL
(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖
(1 + 𝑖)𝐿 − 1
𝐶𝑜 − 𝐶𝐿 = 𝑑[ ]
𝑖
(𝐶𝑜 − 𝐶𝐿 )𝑖
𝑑=
(1 + 𝑖)𝐿 − 1

Also,
(𝐶𝑜 − 𝐶𝑛 )𝑖
𝑑=
(1 + 𝑖)𝑛 − 1

𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

(1 + 𝑖)𝑛 − 1
𝐷𝑛 = 𝑑[ ]
𝑖

Example:
1. A broadcasting corporation purchased an equipment for ₱53,000 and paid ₱1,500
for freight and delivery charges to the job site. The equipment has a normal life of 10
years with a trade-in value of ₱5,000 against the purchase 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 the sinking fund method. Assume interest
at 6.5% compounded annually.

Solution:
𝐶𝑜 = ₱53,000 + ₱1,500 = ₱54,500
𝐶𝐿 = ₱5,000
 a.) by straight line method:
𝐶𝑜 − 𝐶𝐿 ₱54,500 − ₱5,000
𝑑= = = ₱4,950
𝐿 10
b.) by sinking fund method
(𝐶𝑜 − 𝐶𝐿 )𝑖 (₱54,500 − ₱5,000)(0.065)
𝑑= 𝐿
= = ₱3,668.18
(1 + 𝑖) − 1 (1 + 0.065)10 − 1

2. A firm bought an equipment for ₱56,000. Other expenses including installation

amounted to ₱4,000. The equipment is expected to have a life of 16years with a
salvage value of 10% of the original cost. Determine the book value at the end of 12
years by (a) the straight line method and (b) sinking fund method at 12% interest.

Solution:
𝐶𝑜 = ₱56,000 + ₱4,000 = ₱60,000
𝐶𝐿 = ₱60,000(0.10) = ₱6,000
𝐿 = 16
𝑛 = 12
𝑖 = 12%
a.) by straight line method:
𝐶𝑜 − 𝐶𝐿 ₱60,000 − ₱6,000
𝑑= = = ₱3,375
𝐿 16
𝐷12 = 𝑛𝑑 = 12(₱3,375) = ₱40,500
𝐶12 = 𝐶𝑜 − 𝐷𝑛 = ₱60,000 − ₱40,500 = ₱𝟏𝟗, 𝟓𝟎𝟎

b.) by sinking fund method

(𝐶𝑜 − 𝐶𝐿 )𝑖 (₱60,000 − ₱6,000)(0.12)
𝑑= 𝐿
= = ₱1,263.06
(1 + 𝑖) − 1 (1 + 0.12)16 − 1
(1 + 𝑖)𝑛 − 1 (1 + 0.12)12 − 1
𝐷12 = 𝑑 [ ] = ₱1,263.06 [ ]
𝑖 0.12

𝐷12 = ₱30,481.62
𝐶12 = 𝐶𝑜 − 𝐷12 = ₱60,000 − ₱30,481.62
𝑪𝟏𝟐 = 𝟐𝟗, 𝟓𝟏𝟖. 𝟑𝟖
 3. Declining Balance Method (DBM)
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 year to the book value at the beginning of that year is constant
throughout the life of the property and is designed by k, the rate of depreciation

Year Book value at Depreciation Book value at the end of year

beginning of year during the 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−1 𝑘

𝐶𝐿 𝑛
𝐶𝑛 = 𝐶𝑜 (1 − 𝑘)𝑛 = 𝐶𝑜 [ ] 𝐿
𝐶𝑜

𝐶𝐿 = 𝐶𝑜 (1 − 𝑘)𝐿

𝑛 𝐶𝑛 𝐿 𝐶𝐿
𝑘 =1− √ =1− √
𝐶𝑜 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 C0.
Example:
1. A certain type of machine loses 10% of its value each year. The machine costs
₱2,000 originally. Make out a schedule showing the yearly depreciation, the total
depreciation and the book value at the end of each year for 5years.

Book value at Depreciation Total Book value at

Year beginning of during the depreciation end of year
year year at
10% end of year
1 P2,000.00 P200.00 P200.00 P1,800.00
2 P1,800.00 P180.00 P380.00 P1,620.00
3 P1,620.00 P162.00 P542.00 P1,458.00
4 P1,458.00 P145.80 P687.80 P1,312.20
5 P1,312.20 P131.22 P819.02 P1,180.98

4. Double Declining Balance Method (DDBM)

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

2𝐶𝑜 2
𝑑𝑛 = [1 − ]𝑛−1
𝐿 𝐿

2
𝐶𝑛 = 𝐶𝑜 [1 − ]𝑛
𝐿

2
𝐶𝐿 = 𝐶𝑜 [1 − ]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:
1. Determine the rate of depreciation, the total rate of depreciation up to the end of the
8th year and the book value at the end of 8 years for an asset that costs ₱15,000 new
and has an estimated scrap value of ₱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.) Declining Balance Method

𝐿 𝐶 10 ₱2,000
𝑘 = 1 − √𝐶𝐿 = 1 − √₱15,000 = 0.1825 𝑜𝑟 18.25%
𝑜

𝐶8 = 𝐶𝑜 (1 − 𝑘)𝑛 = ₱15,000(1 − 0.1825)8 = ₱2,992.22

𝐷8 = 𝐶𝑜 − 𝐶8 = ₱15,000 − ₱2,992.22 = ₱𝟏𝟐, 𝟎𝟎𝟕. 𝟒𝟒

b.) Double Declining Balance Method

2 2
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = 0.20 𝑜𝑟 20%
𝐿 20
2 2
𝐶8 = 𝐶𝑜 [1 − ]𝑛 = ₱15,000[1 − ]8 = ₱2,516.58
𝐿 10
𝐷8 = 𝐶𝑜 − 𝐶8 = ₱15,000 − ₱2,516.58 = ₱𝟏𝟐, 𝟒𝟖𝟑. 𝟒𝟐

2. A plant bought a calciner for ₱220,000 and used it for 10 years, the life span of the
equipment. What is the book value of the calciner after 5 years of use? Assume a scrap
value of ₱20,000 for straight line method; ₱22,000 for textbook declining balance
method and ₱20,000 for the double declining balance method.
Solution:
𝐶𝑜 = ₱220,000
𝐿 = 10
𝑛=5
a.) Straight Line Method
𝐶𝐿 = ₱20,000
𝐶𝑜 − 𝐶𝐿 ₱220,000 − ₱20,000
𝐷5 = 𝑛 [ ] = 5[ ] = ₱100,000
𝐿 10
𝐷5 = 𝐶𝑜 − 𝐶5
𝐶5 = 𝐶𝑜 − 𝐷5 = ₱220,000 − ₱100,000 = ₱𝟏𝟐𝟎, 𝟎𝟎𝟎

b.) Declining Balance Method

𝐶𝐿 = ₱22,000
𝐶𝐿 𝑛 ₱22,000 5
𝐶5 = 𝐶𝑜 [ ] 𝐿 = ₱220,000[ ]10 = ₱𝟔𝟗, 𝟓𝟕𝟎. 𝟏𝟏
𝐶𝑜 ₱220,000
c.) Double Declining Balance Method
𝐶𝐿 = ₱20,000
2 2
𝐶5 = 𝐶𝑜 [1 − ]𝑛 = ₱220,000[1 − ]5 = ₱𝟕𝟐, 𝟎𝟖𝟗. 𝟔𝟎
𝐿 10
5. Sum-of-the-Years’-Digits Method (SYDM)
The depreciation charge is computed based on the reverse digit and sum of
the digits.

𝑅𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡
𝑑𝑛 = (𝐶 − 𝐶𝐿 )
𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠 𝑜

𝐿−𝑚+1
𝑑𝑛 = 2 (𝐶 − 𝐶𝐿 )
𝐿(𝐿 + 1) 𝑜

𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

𝐷𝑛 = 𝑑1 + 𝑑2 + 𝑑3 + ⋯ + 𝑑𝑛

𝑚(2𝐿 − 𝑚 + 1)
𝐷𝑛 = (𝐶𝑜 − 𝐶𝐿 )
𝐿(𝐿 + 1)

Example:
1. A structure costs ₱12,000 new. It is estimated to have a life of 5 years with a
salvage value at the end of life of ₱1,000. Determine the book value at the end of
each year of life.

Solution:

𝐶𝑜 − 𝐶𝐿 = ₱12,000 − ₱1,000 = ₱11,000

Year Year in Depreciation during the Book value at

reverse year end of year
1 5 (5/15)(P11,000)= P3,667 P8,333

2 4 (4/15)(P11,000)= P2,933 P5,400

3 3 (3/15)(P11,000)= P2,200 P3,200

4 2 (2/15)(P11,000)= P1,467 P1,733

5 1 (1/15)(P11,000)= P733 P1,000

∑ 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠 =
15
2. A consortium of international telecommunication companies contracted for the
purchase and installation of a fiber optic cable linking two major cities at a total cost
of US $960million. This amount includes freight and installation charges estimated
at 10% of the above contact price. If the cable shall be depreciated over a period
of 15years with zero salvage value:
(a)Given the sinking fund deposit factor of 0.0430 at 6% interest where n= 15, what is
the annual depreciation charge?
(b)What is the depreciation charge during the 8th year using the-sum-of-the-years-
digits method?

Solution:
𝐶𝑜 = $960,000,000
𝐶𝐿 = 0
𝐿 = 15
𝑚=8

a.) by SFM
(𝐶𝑜 − 𝐶𝐿 )𝑖 (960,000,000 − 0)(0.06)
𝑑= 𝐿
= = $𝟒𝟏, 𝟐𝟒𝟒, 𝟐𝟓𝟑. 𝟒𝟎
(1 + 𝑖) − 1 (1 + 0.06)15 − 1

b.) by SYDM
𝐿 15
𝑠𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠 = 2 (𝐿 + 1) = (15 + 1) = 120
2

𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡 = 𝐿 − 𝑚 + 1 = 15 − 8 + 1 = 8
𝑅𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡
𝑑𝑛 = (𝐶 − 𝐶𝐿 )
𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠 𝑜
8
𝑑𝑛 = ($960,000,000 − 0) = $𝟔𝟒, 𝟎𝟎𝟎, 𝟎𝟎𝟎
120
You may also use the derived formula:
𝐿−𝑚+1
𝑑𝑛 = 2 (𝐶 − 𝐶𝐿 )
𝐿(𝐿 + 1) 𝑜
6. The Service-Output Method
This method assumes that the total depreciation that has taken place is
directly proportional to the quantity of output of the property up to that time. This
method has the advantage of making the unit cost of depreciation constant and
giving low depreciation expense during periods of low production.

 Based on output units

𝐶𝑜 − 𝐶𝐿
𝑑𝑛 = [ ] (𝑄𝑛 )
𝑇

𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

𝐷𝑛 = 𝑑1 + 𝑑2 + 𝑑3 + ⋯ + 𝑑𝑛

𝑤ℎ𝑒𝑟𝑒:
𝑇 = 𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑢𝑝 𝑡𝑜 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑙𝑖𝑓𝑒
𝑄𝑛 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟

 Based on hours in service

𝐶𝑜 − 𝐶𝐿
𝑑𝑛 = [ ] (𝐻𝑛 )
𝐻𝑇

𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

𝐷𝑛 = 𝑑1 + 𝑑2 + 𝑑3 + ⋯ + 𝑑𝑛

𝑤ℎ𝑒𝑟𝑒:
𝐻𝑇 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 ℎ𝑜𝑢𝑟𝑠 𝑢𝑝 𝑡𝑜 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑙𝑖𝑓𝑒
𝐻𝑛 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 ℎ𝑜𝑢𝑟𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟

Example:
1. A television Company purchased machinery for ₱100,000 on July 1, 1979. It is
estimated that it will have a useful life of 10years; scrap value of ₱4,000, production
of 400,000 hours and working hours of 120,000.
The company uses the machinery for 14,000 hours in 1979 and 18,000
hours in1980. The machinery produces 36,000 units in 1979 and 44,000 units in
1980. Compute the depreciation for 1980 using each method given below:
a. Straight line

b. Working hours
c. Output method
 Solution:
𝐶𝑜 = ₱100,000
𝐶𝐿 = ₱4,000
𝐿 = 10 𝑦𝑒𝑎𝑟𝑠
𝑇 = 400,000 𝑢𝑛𝑖𝑡𝑠
𝐻 = 120,000 ℎ𝑜𝑢𝑟𝑠

a. SLM

𝐶𝑜 − 𝐶𝐿 ₱100,000 − ₱4,000
𝑑= = = ₱9,600
𝐿 10

b. Working hours
𝐶𝑜 − 𝐶𝐿
𝑑𝑛 = [ ] (𝐻𝑛 )
𝐻𝑇
₱100,000 − ₱4,000
𝑑𝑛 = [ ] (18000) = ₱14,400
120,000

b. Output method
𝐶𝑜 − 𝐶𝐿
𝑑𝑛 = [ ] (𝑄𝑛 )
𝑇
₱100,000 − ₱4,000
𝑑𝑛 = [ ] (44000) = ₱10,560
400,000

Valuation

Valuation or appraisal is the process of determining the value of certain property

for specific reasons. The person engaged in the task of valuation is called an appraiser.

Intangible Values

In the determination of the value of industrial property or equipment, four intangible

items are often encountered.
Goodwill is that element of value which a business has earned through the
favorable consideration and patronage of its customers arising its well-known and well
conducted policies and operation.
 Franchise is an intangible item of value arising from the exclusive right of a
company to provide a specific product or service in a stated region of the company.
Going value is an intangible value which an actually operating concern has due to
its operation.
Organization cost is the amount of money spent in organizing a business and
arranging for its financing and building.

DEPLETION
Depletion is the decrease in the value of a property due to gradual extraction of its
contents. The term is commonly used in connection with mining properties, oils and gas
wells, timberlands and so on. The purpose of determining the depletion per year is to
recover the capital invested in the property. Owners of such properties received two types
of income:
a.) the profit that has been earned
b.) a portion of the owners capital that is being returned, marked as depletion

These are two ways to compute depletion allowances:

1. The Cost Method
In this method, depletion per units is determined.
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦
𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 =
𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦
The depletion allowance for a given year is calculated as:
𝐷 = 𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑥 𝑁𝑜 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑
2. Percentage Method
Depletion allowances on mines and other natural deposits, maybe computed as
percentage of gross income for that year, provided that the amount charged for depletion
does not exceed 50% of the net income (100% of oils and gas property) before deduction
of the depletion allowance.
Self-Assessment Questionnaire
1. An elective saw for cutting small pieces of lumber in a furniture manufacturing plant
has an initial investment of ₱4,000 and a 10 year depreciable life. The estimated
Salvage Value of the saw is zero at the end of 10 years. Determine the annual
depreciation amounts using SL method. Tabulate the annual depreciation amounts
and the book value of the saw at the end of each year.
2. A unit welding machine costs ₱45,000 with an estimated life of 5 years. Its salvage
value is ₱2,500. Find its depreciation using sinking fund method at 8.5%.
3. A machine having a first cost of ₱60,000 will be retired at the end of 8 years.
Depreciation cost is computed using constant percentage method (DBM). What is the
total cost of depreciation up to the time the machine is retired if the annual rate of
depreciation is 28.72%?
4. An asset is purchased for ₱9,000. Its estimated life is 10 years after which it will be
sold for ₱1,000. Find the book value during the second year if SYDM of depreciation
is used.
5. A machine costs ₱7,000, last 8years and has a salvage value at the end of life
of P350. Determine the depreciation charge during the 4th year and the book value
at the end of 4 years by the (a) straight line method, (b) declining balance method,
(c) SYD method, and (d) sinking fund method with interest at 12%.

6. An asset for drilling was purchased and place in service by a petroleum

production company. Its initial investment is ₱60,000 and it has an estimated
salvage value of ₱12,000 at the end of an estimated useful life of 14 years.
Compute the depreciation amount in the third year and the BV at the end of the
5th year of life by each of these methods:
a. Straight Line Method
b. Sinking Fund Method at 5 % per year
c. Declining Balance Method
d. Double Declining Balance Method
e. Sum of the Year’s Digit Method

7. A large profitable corporation has purchased a jet plane for use by its executives.
The cost of the plane is ₱76,000,000. It has a useful life of 5 years. The estimated
resale value at the end of five years is ₱6,000,000. Using SYDM of depreciation,
what is the book value of the jet plane at end of 3 years?
 CE 215 – ENGINEERING ECONOMICS

MODULE 4

Chapter 4 – Capital Financing

Introduction

Capital financing is defined as the methods businesses use to raise money, such as
debt financing. In debt financing, you borrow money to pay for business operations. With
equity financing, you sell an ownership stake in the company – by issuing stock, for example.

Capital financing consists of the methods a business can take to raise money. If you’re starting
small or you have deep pockets, you may be able to survive with only your own resources.
However, most small business rely on raising capital either debt or equity financing. This
module aimed to develop an understanding of the rapidly and exciting theory of finance.

Objectives:

At the end of this chapter, students are expected to be able to:

1. Familiarize with the different types of business organization.

2. Learn the advantage and disadvantages of these business organizations.
3. Solve problems related with capital financing.

Discussion

Capital Financing

Types of business organization:

1. Individual Ownership or Sole Proprietorship
2. Partnership
3. Corporation

Sole Proprietorship
The sole proprietorship or individual ownership is the simplest form of business
organization, wherein the business is owned entirely by one person who is responsible for
the operation. All profits that are obtained from the business are his alone, but he must
also bear all losses should they be incurred.

Equity and Borrowed Capital

Equity capital or ownership funds are those supplied and used by the owners of an
enterprise in the expectation that a profit will be earned.
Borrowed funds or capital are those supplied by others on which a fixed rate of interest must
be paid and the debt must be repaid at a specified time.
Types of Business Organization
A. Individual Ownership
The individual ownership or sole proprietorship is the simplest form of
business organization, wherein a person uses his or her own capital to establish a
business and is the sole owner.

Advantages of the individual ownership.

1. It is easy to organize
2. The owner has full control of the enterprise.
3. The owner is entitled to whatever benefits and profits that accrue from the business.
4. It is easy to dissolve.

Disadvantages of the Individual Ownership

1. The amount of equity capital which can be accumulated limited.
2. The organization cease upon the death of the owner.
3. It is difficult to obtain borrowed capital, owning to the uncertainty of the life of the
organization.
4. The liability of the owner of debt unlimited.

B. Partnership
A partnership is an association of two or more person for the purpose of
engaging in a business for profit.

Advantages of the partnership

1. More capital may be obtained by the partners pooling their resources together.
2. It is bound by few legal requirements as to its account, procedures, tax form and other
items of operation.
3. Dissolution of the partnership may take place at any time by mere agreement of the
partners.
4. It provides an easy method whereby two or more person of differing talents may enter
into business, each carrying those burdens that he can best handle.

Disadvantages of the Partnership

1. The amount of capital that can be accumulated is definitely limited.
2. The life of the partnership is determined by the life of the individual partners. When
any partner dies, the partnership automatically ends.
3. There may be serious disagreement among the individual partners.
4. Each partner is liable for the debts of the partnership.

C. The Corporation
A corporation is a distinct legal entity, separate from the individuals who own
it, and which can engage in almost any type of business transaction in which a real
person could occupy himself or herself.
 Advantages of the Corporation
1. It enjoys perpetual life without regard to any change in the person of its owner, the
stockholders.
2. The stockholders of the corporation are not liable for the debts of the corporation.
3. It is relatively easier to obtain large amounts of money for expansion, due to its
perpetual life.
4. The ownership in the corporation is readily transferred.
5. Authority is easily delegated by the hiring of managers.

Disadvantages of the Corporation

1. The activation of corporation are limited to those stated in its charter.
2. It is relatively complicated in formation and administration.
3. There is a greater degree of governmental control as compared to other types of
business organizations.

Capitalization of a Corporation
The capital of a corporation is acquired through the sales of stock. There are two
principal types of capital stock: common stock and preferred stock.
Common Stock
Common stock represents ordinary ownership without special guarantees of
return. Common stockholders have certain legal rights, among which are the following:

1. Vote at stockholders’ meetings.

2. Elect directors and delegates to them power to conduct the affair of the business.
3. Sell or dissolve the corporation.
4. Make and amend by the laws of the corporation.
5. Subject to government approval, amend, or change the character or capital
structure.
6. Participate in the profits.
7. Inspect the books of the corporation.

Preferred Stock
Preferred stockholders are guaranteed a definite dividend on their stocks. In case
the corporation is dissolved, the assets must be used to satisfy the claims of the preferred
stockholders before those of the holders of the common stock. Preferred stockholders
usually have the right to vote in meetings, but not always.

Financing With Bonds

A bond is a certificate of indebtedness of a corporation usually for a period not less
than ten 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 expansion
of the plant or the services rendered by the corporation.
The face or par value of a bond is the amount stated on the bond. When the face
value has been repaid, the bond is said to have been retired or redeemed. The bond rate
is the interest rate quoted on the bond.

Classification of Bonds
 1. Registered bonds. The name of the owner of this bond is recorded on the record
books of the corporation and interest payments are sent to the owner periodically
without any action on his part.

2. Coupon bonds. Coupon bond have coupon attached to the bond for each interest
payment that will amended during the life of the bond. The owner of the bond can
collect the interest due by surrendering the coupon to the offices of the
corporation or at specified banks.
Methods of Bond Retirement
1. The corporation may issue another set of bonds equal to the amount of bonds due
for redemption.
2. The corporation may set upon sinking fund into which periodic deposits of equal
amount are made. The accumulated amount in the sinking fund is equal to the
amount needed to retire the bonds at the time they are due.

𝐴 = 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑡𝑜 𝑡ℎ𝑒 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑

𝐹 = 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡, 𝑡ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑛𝑒𝑒𝑑𝑒𝑑 𝑡𝑜 𝑟𝑒𝑡𝑖𝑟𝑒 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
𝑖 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑
𝑟 = 𝑏𝑜𝑛𝑑 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
𝐼 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑𝑠 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
𝐴 + 𝐼 = 𝑡𝑜𝑡𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

Bond retirement by sinking fund

𝐹
𝐴= = 𝐹(𝐴/𝐹, 𝑖%, 𝑛)
𝐹/𝐴 , 𝑖%, 𝑛

𝐼 = 𝐹𝑟
Example:
A bond issue of ₱200,000 in 10-year bonds, in ₱1,000 units, paying 16% nominal
interest in semiannual payments must be retired by the use of sinking fund that earns
12% compounded semiannually. What is the total semiannual expense?
Solution:
𝐹 = ₱200,000
16%
𝑟= = 8%
2
12%
𝑖= = 6%
2

𝑛 = 10(2) = 20
 (1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖
(1 + 0.06)20 − 1
200000 = 𝐴[ ]
0.06
𝐴 = ₱5,437.91
𝐼 = 𝐹𝑟
𝐼 = 200000(0.08) = ₱16000
𝑇𝑜𝑡𝑎𝑙 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = ₱5,437.91 + ₱16000 = ₱21,437.91
Bond value

The value of a bond is the present worth of all future amounts that are expected to be
received through ownership of this bond.

𝐿𝑒𝑡
𝐹 = 𝑓𝑎𝑐𝑒, 𝑜𝑟 𝑝𝑎𝑟, 𝑣𝑎𝑙𝑢𝑒
𝐶 = 𝑟𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑜𝑟 𝑑𝑖𝑠𝑝𝑜𝑠𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 (𝑜𝑓𝑡𝑒𝑛 𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 𝐹)
𝑟 = 𝑏𝑜𝑛𝑑 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑟𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛
𝑖 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 𝑜𝑟 𝑦𝑖𝑒𝑙𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
𝑃 = 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑟𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛

Cash flow for a bond investment

𝑃 = 𝐹𝑟(𝑃/𝐴, 𝑖%, 𝑛) + 𝐶(𝑃/𝐹, 𝑖%, 𝑛)
1 − (1 + 𝑖)−𝑛
𝑃 = 𝐹𝑟 [ ] + 𝐶(1 + 𝑖)−𝑛
𝑖

Example
A man wants to make 14% nominal interest compounded semiannually on a bond
investment. How much should the man be willing to pay for a 12%, ₱10,000-bond that will
mature in 10 years and pays interest semiannually?
Solution:
𝐹 = ₱10,000
14%
𝑖= = 7%
2
12%
𝑟= = 6%
2

𝐼 = 𝐹𝑟 = ₱10000(0.06) = ₱600

𝑃 = ₱600(𝑃/𝐴, 7%, 20) + ₱10000(𝑃/𝐹, 7%, 20)

1 − (1 + 0.07)−20
𝑃 = ₱600 [ ] + ₱10000(1 + 0.07)−20
0.07

𝑃 = ₱8940.60

Example
Mr. Romualdo bought a bond having a face value of ₱1,000 for ₱970. The bond rate was
14% nominal and interest payments were made to him semiannually for a total of 7 years.
At the end of the seventh year, he sold the bond to a friend at a price that resulted to a
yield of 16% nominal on his investment. What was the selling price?

Solution:
𝐹 = ₱1,000
16%
𝑖= = 8%
2

14%
𝑟= = 7%
2

𝐼 = 𝐹𝑟 = ₱1000(0.07) = ₱70
 ₱970 = ₱70(𝑃/𝐴, 8%, 14) + 𝐶(𝑃/𝐹, 8%, 14)

1 − (1 + 0.08)−14
₱970 = ₱70 [ ] + 𝐶(1 + 0.08)−14
0.08

𝐶 = ₱1154.03

Example
A ₱1,000-bond which will mature in 10 years and with a bond rate of 8% payable annually is
to be redeemed at par the end of this period. If it is sold at ₱1,030, determine the yield at this
price.

Solution:
𝐶 = ₱1,000
𝑃 = ₱1,030
𝑟 = 8%
𝐼 = 𝐹𝑟 = ₱1000(0.08) = ₱80

₱1030 = ₱80(𝑃/𝐴, 𝑖%, 10) + ₱1000(𝑃/𝐹, 𝑖%, 10)

Try i=8%
= ₱80(𝑃/𝐴, 8%, 10) + ₱1000(𝑃/𝐹, 8%, 10)
 1 − (1 + 0.08)−10
= ₱80 [ ] + ₱1000(1 + 0.08)−10
0.08

= ₱1000
Try i=7%
= ₱80(𝑃/𝐴, 7%, 10) + ₱1000(𝑃/𝐹, 7%, 10)

1 − (1 + 0.07)−10
= ₱80 [ ] + ₱1000(1 + 0.07)−10
0.07

= ₱1070.24

By interpolation:
8% 1000
𝑖 1030
−1 7 − 𝑖 40.24 70.24
7% 1070.24

7 − 𝑖 40.24
=
−1 70.24

𝑖 = 7.57%

Self-Assessment Questionnaire
1. A Corporation sold an issue of 20-year bonds, having a total face value of 10,000,000 for
9,500,000. The bonds bear interest at 16%, payable semiannually. The company wishes to
establish a sinking fund for retiring the bond issue and will make semiannual deposit that will
earn 12%, compounded semiannually. Compute the annual cost for interest and redemption
of these bonds.

2. A company has issued 10-year bonds, with face value of 1,000,000 in 1,000 units. Interest at
16% is aid quarterly. If an investor desires to earn 20% nominal interest on 100,000 worth of
these bonds, what would the selling price have to be?

3. A 1,500-bond which will mature in 10 years and with a bond rate of 15% payable annually is
to be redeemed at par at the end of this period. If it is sold now for 1,390, determine the yield
at this price.

Answer to Self-Assessment Questionnaire

1. ₱1,730,000
2. ₱82,836
3. 16.56%
 CE 215 – ENGINEERING ECONOMICS

MODULE 5

Chapter 5 – Selections on Present Economy

Introduction

Present economy studies are engineering economic analyses where alternatives for
accomplishing a specific task are being compared over one year or less and the influence of
time on money can be ignored. In this chapter, selection of the most economical methods,
design, processes, or alternative will be the main objective.

Objectives:

At the end of this chapter, students are expected to be able to:

1. Relate the present economic conditions to engineering.

2. Select the most economical design, materials or methods between given
alternatives.
3. Solve problems regarding selections on present economy.

Discussion

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.

Two rules shall be followed in conducting present economy studies. These rules, or
criteria, will be used to select the preferred alternative when defect-free output (yield) is
variable or constant among the alternatives being considered.

Rule 1. When revenues and other economic benefit are present, choose alternative
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 product or service output.

Situations where Present Economy Studies are involved

Material Selection
Involves selection among materials available that will result in the most economical
product and give the best result.

Selection of Method
 Involves selection of the most economical way to accomplish operations.
Two or more different methods may give the same satisfactory results.

Selection of Design
The design to be selected must be best suited for the work to be done with particular
care being given to the one which will do the work with the utmost economy.

Site Selection
Cost relevant to selecting sites must be carefully considered (land cost, construction
cost, cost of available labor, cost of transporting equipment and materials).

Proficiency of Workers
Bear in mind that workers have varying efficiency and proficiency. Work proficiency
can be translated into monetary values.

Economy of Tool and Equipment Maintenance

Consider the costs of acquiring tools and equipment and the costs of maintaining them.

Economy in the Utilization of Personnel

Only a certain number of personnel will lead to the highest productivity; increasing this
number will not cause a proportional increase in productivity.

Example:
1. An electrical contractor has a job which should be completed in 100 days. At present,
he has 80 men on the job and it is estimated that they will finish the work in 130 days. If of the
80 men, 50 are paid ₱190 per day, 25 at ₱220 a day, and 5 at ₱300 a day and if for each day
beyond the original 100 days, the contractor has to pay ₱2,000 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 ₱220 a day and the rest at ₱190 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

b. 80 men on the job:

Wages: 50(₱190)(130) = ₱1,235,000

25(₱220)(130) = ₱715,000
5(₱300)(130)= ₱195,000
Damages: ₱2,000(30)= ₱60,000
Total expense= ₱2,205,000
 104 men on the job:
Wages: (50+19)(₱190)(100) = ₱1,311,000
(25+5)(₱220)(100) = ₱660,000
5(₱300)(100)= ₱150,000
Total expense= ₱2,121,000

𝑆𝑎𝑣𝑖𝑛𝑔 𝑏𝑦 𝑒𝑚𝑝𝑙𝑜𝑡𝑖𝑛𝑔 𝑚𝑜𝑟𝑒 𝑚𝑒𝑛 = ₱2,205,000 − ₱2,121,000 = ₱𝟖𝟒, 𝟎𝟎𝟎

Example:
2. The monthly demand for ice cans being manufactured by Mr. Cruz is 3,200 pieces.
With a manually operated Guillotine, the unit cutting cost is ₱25.00. An electrically operated
hydraulic guillotine was offered to Mr. Cruz at a price at ₱275,000 and which will cut by 30%
the unit cutting cost. Disregarding the cost of money, how many moths will Mr. Cruz be able
to recover the cost of the machine if he decides to buy now?
Solution:
Manually operated Guillotine:
𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑐𝑢𝑡𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 3,200(25) = ₱80,000
Electrically operated hydraulic Guillotine:
𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑐𝑢𝑡𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = 3,200(25)(1 − 0.30) = ₱56,000

𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = 80,000 − 56,000 = ₱24,000 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ

₱275,000
𝑁𝑜. 𝑜𝑓 𝑚𝑚𝑜𝑛𝑡ℎ𝑠 𝑡𝑜 𝑟𝑒𝑐𝑜𝑣𝑒𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 = = 𝟏𝟏. 𝟓
₱24,000

Example:
3. The making or rivets holes in structural steel members can be done by two methods.
The first method consists of laying out the position of the holes in the members and using drill
press costing ₱30,000. The machinist is paid ₱35 per hour and he can drill 30 holes per hour.
The second method makes use of a multiple-punch machine costing ₱27,500. The punch
operator is paid ₱30 an hour and he can punch out 4 holes every minute. This method also
requires an expense of ₱1.75 per hole to set the machine.
a. If all other costs are assumed equal, what is the total cost for each machine for ₱6,000
holes, assuming the total cost of each machine to be charged to these holes?
b. For how many holes will the costs be equal?

Solution:
a. Drill press:
6,000
𝑇𝑖𝑚𝑒 𝑡𝑜 𝑑𝑟𝑖𝑙𝑙 6,000 ℎ𝑜𝑙𝑒𝑠 = = 200 ℎ𝑜𝑢𝑟𝑠
30
 𝑤𝑎𝑔𝑒 𝑜𝑓 𝑚𝑎𝑐ℎ𝑖𝑛𝑖𝑠𝑡 = ₱35(200) = ₱7,000
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑟𝑖𝑙𝑙 𝑝𝑟𝑒𝑠𝑠 = ₱30,000
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱7,000 + ₱30,000 = ₱37,000

Multiple punch machine:

6,000
𝑇𝑖𝑚𝑒 𝑡𝑜 𝑝𝑢𝑛𝑐ℎ 6,000 ℎ𝑜𝑙𝑒𝑠 = = 25 ℎ𝑜𝑢𝑟𝑠
4(60)
𝑤𝑎𝑔𝑒 𝑜𝑓 𝑚𝑎𝑐ℎ𝑖𝑛𝑖𝑠𝑡 = ₱30(25) = ₱750
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑒𝑡𝑡𝑖𝑛𝑔 𝑡ℎ𝑒 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 = ₱1.75(6000) = ₱10,500
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 = ₱27,500
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱38,750

b. Let x = number of holes for equal cost

𝑥 7𝑥
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑟𝑖𝑙𝑙 𝑝𝑟𝑒𝑠𝑠 = (₱35) + ₱30,000 = + ₱30,000
30 6
𝑥
𝑐𝑜𝑠𝑡 𝑓𝑜𝑟 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑒 𝑝𝑢𝑛𝑐ℎ 𝑚𝑎𝑚𝑐ℎ𝑖𝑛𝑒 = (₱30) + ₱1.75(𝑥) + ₱27,500
4(60)
𝑥
= + ₱1.75(𝑥) + ₱27,500
8
For equal cost,
7𝑥 𝑥
+ ₱30,000 = + ₱1.75(𝑥) + ₱27,500
6 8
𝑥 = 3,530 ℎ𝑜𝑙𝑒𝑠

Example:
4. The volume of the raw material required for a certain machine part is 2.02 cubic cm.
The finished volume is 1.05 cu.cm. The time for machining each piece is 45 seconds for steel
and 30 seconds for brass. The costs of steel is ₱32.50 per kg and the value of steel scrap is
negligible. The cost of the brass is ₱60.00 per kg and the value of the brass scrap is ₱25.00
per kg. The wage of the operator is ₱40.00 per hour and the overhead cost of the machine is
₱50.00 per hour. The weight of the steel and brass are 0.0081 and 0.0088 kg per cubic cm,
respectively. Which material will you recommend?

Solution:
Steel:
𝑊𝑒𝑖𝑔ℎ𝑡 𝑝𝑒𝑟 𝑝𝑖𝑒𝑐𝑒 = 2.02(0.0081) = 0.01636 𝑘𝑔
Cost per piece:
𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 = 0.01636(₱32.50) = ₱0.5317
 45
𝑤𝑎𝑔𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑜𝑟 = ( )(₱40.00) = ₱0.50
3600
45
𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = ( )(₱50.00) = ₱0.6250
3600
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱0.5317 + ₱0.50 + ₱0.625 = ₱1.6567

Brass:
𝑊𝑒𝑖𝑔ℎ𝑡 𝑝𝑒𝑟 𝑝𝑖𝑒𝑐𝑒 = 2.02(0.0081) = 0.01778 𝑘𝑔
Cost per piece:
𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 = 0.0.1778(₱60) = ₱1.0668
30
𝑤𝑎𝑔𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑜𝑟 = ( )(₱40.00) = ₱0.3333
3600
30
𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = ( )(₱50.00) = ₱0.4167
3600
𝑙𝑒𝑠𝑠 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑐𝑟𝑎𝑝 = (2.02 − 1.05)(0.0088)(₱25.00) = ₱0.2134
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱1.0668 + ₱0.3333 + ₱0.4167 − ₱0.2134 = ₱1.6034

Use brass.

Example:
5. High carbon steel or alloy steel can be used for the set of tools on a lathe. The tools
must be sharpened periodically. Data for each are as follows:
High Carbon steel Alloy steel
Output per hour 60 pcs 70 pcs
Time between tool grinds 4 hours 6 hours
Time required to change the tools 1 hour 1 hour

The wage of the lathe operator is ₱50,000 per hour, based on actual working hours. The tool
changer costs ₱60.00 per hour. Overhead costs for the lathe are ₱45.00 per hour, including
tool-change time. A set of unsharpened high carbon steel costs ₱500 and can be ground ten
times; a set of unsharpened alloy steel costs ₱850 and can be ground 5 times. Which type of
steel should be used?

Solution:
High carbon steel:
𝐶𝑦𝑐𝑙𝑒 𝑡𝑖𝑚𝑒 = 4 + 1 = 5 ℎ𝑜𝑢𝑟𝑠
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑖𝑒𝑐𝑒𝑠 𝑝𝑒𝑟 𝑐𝑦𝑐𝑙𝑒 = 4(60) = 240
𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑐𝑦𝑐𝑙𝑒:
 𝑂𝑝𝑒𝑟𝑎𝑡𝑜𝑟 = ₱50(4) = ₱200
𝑇𝑜𝑜𝑙 𝑐ℎ𝑎𝑛𝑔𝑒𝑟 = ₱60(1) = ₱60
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = ₱45(5) = ₱225
₱500
𝑈𝑛𝑠ℎ𝑎𝑟𝑝𝑒𝑛𝑒𝑑 𝑡𝑜𝑜𝑙 = = ₱50
10
𝑇𝑜𝑡𝑎𝑙 = ₱200 + ₱60 + ₱225 + ₱50 = ₱535
₱535
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑝𝑖𝑒𝑐𝑒 = = ₱2.23
240

Alloy steel:
𝐶𝑦𝑐𝑙𝑒 𝑡𝑖𝑚𝑒 = 6 + 1 = 7 ℎ𝑜𝑢𝑟𝑠
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑖𝑒𝑐𝑒𝑠 𝑝𝑒𝑟 𝑐𝑦𝑐𝑙𝑒 = 6(70) = 420
𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑐𝑦𝑐𝑙𝑒:
𝑂𝑝𝑒𝑟𝑎𝑡𝑜𝑟 = ₱50(6) = ₱300
𝑇𝑜𝑜𝑙 𝑐ℎ𝑎𝑛𝑔𝑒𝑟 = ₱60(1) = ₱60
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = ₱45(7) = ₱315
₱850
𝑈𝑛𝑠ℎ𝑎𝑟𝑝𝑒𝑛𝑒𝑑 𝑡𝑜𝑜𝑙 = = ₱170
5
𝑇𝑜𝑡𝑎𝑙 = ₱300 + ₱60 + ₱315 + ₱170 = ₱845
₱845
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑝𝑖𝑒𝑐𝑒 = = ₱2.01
420

Use Alloy Steel.

Self-Assessment Questionnaire
1. An industrial engineer has designed two alternative methods for accomplishing a
production job. Both methods involve the acquisition of the same place and other
capital equipment to be used for this job only.
Method A calls for a crew consisting of three men each costing ₱30.00 per hour. This
method will result in the production of 10 units per hour of which two will be rejects.
Method B calls for a crew of two men each costing ₱35.00 per hour and should result
in the production of eight units per hour of which one will be reject.
The cost of the direct material lost in each reject is ₱20.00. If a certain total number of
units is to be produced, find which method is not economical.
 2. An executive receives an annual salary of ₱600,000 and his secretary a salary of
₱180,000. A certain task can be performed by the executive working alone in 4 hours.
If he delegates the task to his secretary it will require him 30 minutes to explain the
work and another 45 minutes to check the finished work. Due to the unfamiliarity of the
secretary to do the task, it takes her an additional time of 6 hours after being instructed.
Considering salary cost only, determine the cost of performing the task by each
method, if the secretary works 2,400 hours a year and the executive 3,000 hours a
year.

3. A cement grinding mill “A” with a capacity of 50 tons per hour utilizes forged steel
grinding balls costing ₱12,000 per ton, which have a wear rate of 100 grams per ton
cement milled. Another cement mill “B”: of the same capacity uses high chrome steel
grinding balls costing ₱50,000 per ton with a wear rate of 20 grams per ton cement
milled. Determine the more economical grinding mill, considering other factors to be
the same.

4. A cement kiln with production capacity of 130 tons per day (24 hours) of clinker has
its burning zone about 45 tons of magnesite chrome bricks being replaced periodically,
depending on some operational factors and the life of the bricks. IF locally produced
bricks costs ₱25,000 per ton and have a life of 4 months while certain imported bricks
costing ₱30,000 per ton and have a life of 6 months, determine the more economical
bricks and by how much?

5. A manufacturer has been shipping his product (moderately heavy machines),

mounted only on skids without complete crating. To avoid crating, he must ship in
freight cars which contain only his machines. To do this he must pay freight on a car
capacity load of 42 tons regardless of whether or not the car is completely full. In the
past he actually has shipped only 30 tons in each car. The car load freight rate is ₱4.10
per hundred pounds. If the machines are crated so that they can be shipped in mixed
car lots, along with other merchandise, they can be shipped at a rate of ₱4.20 per
hundred pounds with the freight bill computed only on the actual weight shipped. The
cost of crating would be ₱25.00 per machine and would increase the shipping weight
from 1,200 to 1,220 pounds per machine. Which procedure should be followed?
(1ton=2,200 lbs.)

Answer to Self-Assessment Questionnaire

1. ₱16.25; ₱12.86; Method B
2. ₱800.00; ₱737.50
3. ₱60 per hour; ₱50 per hour; Mill “B” is more economical
4. Imported bricks are more economical by ₱56,250 per month
5. Shipping without crating is cheaper by ₱404.80
 CE 215 – ENGINEERING ECONOMICS

MODULE 6

Chapter 6- Basic Methods for Making Economy Studies

Introduction

All engineering economy studies of capital projects should be made so as to include

consideration of the return that a given project will or should produce. Since the patterns in
capital investment, revenue or saving flows, and cost flows are quite different in various
projects, there is no ideal method for making economy studies.

Consequently, several methods, or patterns are commonly used in practice, and all
will produce equally satisfactory results and will lead to the same decision in cases where th
e inherent assumptions of each are applicable.

In this chapter, various method for making economy studies will be presented and used
in similar situation for justification.

Objectives:

At the end of this chapter, students are expected to be able to:

1. Understand the different methods for economy studies.

2. Learn how to justify whether an investment is good or not.
3. Solve problems on economy studies using different methods.

Discussion

Basic Methods or Patterns for Making Economy Studies

Engineering economy studies are made for the purpose of determining whether capital
should be invested in a project or whether it should be used differently than it presently is
being used. They should consider the return that a given project will or should produce.
The basic question is; whether a proposed capital investment and its associated
expenditures can be recovered by revenue overtime in addition to return on the capital that is
sufficiently attractive in view of the risk involved and the potential alternative uses.

The Rate of Return (ROR) Method

The rate of return on the capital invested is given by the formula,
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
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 method are controlled by the following conditions. A single investment of 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 cash
outflows is not less than zero the proposed investment is justified – is valid. This method
is covered by 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 PRESENT WORHT (PW) METHOD

This pattern for economy studies is based on the concept of present worth. If the
present worth of the net cash flows is equal to or greater than zero, the project is justified
economically. The present worth method is flexible and can be used for any type of
economy study. It is used extensively in making economy studies in the public works field,
where long-lived structures are involved.

THE FUTURE WORHT (FW) METHOD

The future worth method for economy studied is exactly comparable to the present
worth method except that all cash inflows and outflows are compounded forwards 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 justified 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.
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 – 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠) =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

Example:
1. An investment of ₱270,000 can be made in a project that will produce a uniform
annual revenue of ₱185,400 for 5 years and then have a salvage value of 10% of the
investment. Out-of-pocket costs for operation and maintenance will be ₱81,000 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
Annual costs:
₱270,000 − ₱27,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐹/𝐴, 25%, 5
₱243,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = ₱29,609
(1 + 0.25)5 − 1
[ ]
0.25
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = ₱81,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = ₱270,000(0.04) = ₱10,800
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱29,609 + ₱81,000 + ₱10,800 = ₱121,409

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = annual revenue − annual cost = ₱63,991

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑
₱63,991
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = × 100 = 23.70%
₱270,000
Since the rate of return is less than 25%, the investment is not justified.
By the annual worth method:
Annual revenue = ₱185,400
Annual costs:
₱270,000 − ₱27,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = ₱29,609
𝐹/𝐴, 25%, 5
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = ₱81,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = ₱270,000(0.04) = ₱10,800
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = ₱270,000(0.25) = ₱67,500
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱29,609 + ₱81,000 + ₱10,800 + ₱67,500 = ₱188,909
𝐸𝑥𝑐𝑒𝑠𝑠 = ₱185,400 − ₱188,909 = −3,509
Since the excess of annual cash inflows over annual cash outflows is less than zero
(₱−3,509), the investment is not justified.

By the present worth method:

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

1 − (1 + 0.25)−5
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱185,400 [ ] + ₱27,000(1 + 0.25)−5
0.25

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱507,439.87

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = ₱81,000 + ₱270,000(0.04) = ₱91,800

0 1 2 3 4 5

₱91,800 ₱91,800 ₱91,800 ₱91,800 ₱91,800

₱270,000
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑖𝑎𝑔𝑟𝑎𝑚 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱270,000 + ₱91,800((𝑃/𝐴, 25%, 5)

1 − (1 + 0.25)−5
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱270,000 + ₱91,800 [ ] = ₱516,875.90
0.25

Since the present worth of the net cash flows is less than zero (-₱9,436.03), the investment is
not justified.

By the future worth method:

Referring to the cash flow diagrams in the solution by the present worth method:
𝐹𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱27,000 + ₱185,400(𝐹/𝐴, 25%, 5)

(1 + 0.25)5 − 1
𝐹𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱27,000 + ₱185,400 [ ]
0.25

𝐹𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = ₱1,548,583.59

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

(1 + 0.25)5 − 1
𝐹𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = ₱91,800 [ ] + ₱270,000(1 + 0.25)5
0.25

𝐹𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = ₱1,577,380.08

Since the future worth of the net cash flows is less than zero (-₱28,796.49), the investment is
not justified.

By the payback method:

𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱81,000 + ₱270,000(0.04) = ₱91,800

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = ₱185,400 − ₱91,800 = ₱93,600
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 – 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 ₱270,000 − ₱27,000
𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠) = =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 ₱93,600

𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠) = 2.6 𝑦𝑒𝑎𝑟𝑠

Example:
2. 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 P 5, 000, 000
Building investment P 7, 000, 000
Study period 20 years
Cost of land after 20 years 20, 000, 000
Cost of building after 20 years 2, 000, 000
Rent per 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 = (₱6,000)(12)(25)(0.90) = ₱1,620,000
₱20,000,000 − ₱5,000,000 ₱15,000,000
𝐿𝑎𝑛𝑑 = = = ₱80,347.96
𝐹/𝐴, 20%, 20 186.688
𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 = ₱1,620,000 + ₱80,347.96 = ₱1,700,347.96
Annual Cost:
₱7,000,000 − ₱2,000,000 ₱9,000,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱26,782.65
𝐹/𝐴, 20%, 20 186.688
𝑈𝑝𝑘𝑒𝑒𝑝 = ₱500(25) = ₱12,500
𝑇𝑎𝑥𝑒𝑠 = ₱12,000,000(0.01) = ₱120,000
𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = ₱7,000,000(0.005) = ₱35,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱26,782.65 + ₱12,500 + ₱120,000 + ₱35,000 = ₱194,282.65

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = ₱1,700,347.96 − ₱194,282.65 = ₱1,506,065.31

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱1,506,065.31

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 12.55 < 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱12,000,000
The businessman should not invest.
Another solution:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = ₱5,000,000 + ₱7,000,000 = ₱12,000,000
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑎𝑓𝑡𝑒𝑟 20 𝑦𝑒𝑎𝑟𝑠 = ₱20,000,00 + ₱2,000,000 = ₱22,000,000

𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 = ₱6,000(12)(25)(0.90) = ₱1,620,000

Annual Cost:
₱12,000,000 − ₱22,000,000 ₱ − 10,000,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = −₱53,565.31
𝐹/𝐴, 20%, 20 186.688
𝑈𝑝𝑘𝑒𝑒𝑝 = ₱500(25) = ₱12,500
𝑇𝑎𝑥𝑒𝑠 = ₱12,000,000(0.01) = ₱120,000
𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = ₱7,000,000(0.005) = ₱35,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = −₱53,565.31 + ₱12,500 + ₱120,000 + ₱35,000 = ₱113,934.69

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = ₱1,620,000 − ₱113,934.69 = ₱1,506,065.31

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱1,506,065.31

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 12.55 < 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱12,000,000

The businessman should not invest.

(The negative sign for depreciation means that the value of the investment has increased
after 20 years.)
Example:
3. A man is considering investing ₱500,000 to open a semi-automatic auto-
washing business in a city of 400,000 population. The equipment can wash, on the
average, 12 cars per hour, using two men to operate it and to do small amount of hand
work. The man plans to hire two men, in addition to himself, and operate the station on an
8-hour basis, 6 days per week, 50 weeks per year. He will pay his employees P25. 00 per
hour. He expects to charge ₱25.00 for a car wash. Out-of-pocket miscellaneous cost would
be ₱8,500 per month.
He would pay his employees for 2 week for vacations each year. Because of the
length of his lease, he must write off his investment within 5 years. His capital now is
earning 15%, and he is employed at a steady job that pays ₱25,000 per month. He desires
a rate of return of at least 20% on his investment.
Would you recommend the investment?
Solution:
By rate of return method:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 12(25)98)(6)(50) = ₱720,000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡:
₱500,000 ₱500,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱74,157.78
𝐹/𝐴, 15%, 5 6.7424
𝐿𝑎𝑏𝑜𝑟 = 2(48)(50)(₱25.00) = ₱120,000
𝑉𝑎𝑐𝑎𝑡𝑖𝑜𝑛 𝑝𝑎𝑦 = 2(2)(48)(₱25.00) = ₱4,800
𝑀𝑖𝑠𝑐𝑒𝑙𝑙𝑎𝑛𝑒𝑜𝑢𝑠 = ₱8,500(12) = ₱102,000
𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝑠𝑎𝑙𝑎𝑟𝑦 = ₱25,000(12) = ₱300,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 =₱600,957.78

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = ₱720,000 − ₱600,957.78 = ₱119,042.22

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱119,042.22

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 23.81 > 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱500,000
The man should invest.

By the annual worth method:

𝐴𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 12(25)98)(6)(50) = ₱720,000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡:
₱500,000 ₱500,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱74,157.78
𝐹/𝐴, 15%, 5 6.7424
𝐿𝑎𝑏𝑜𝑟 = 2(48)(50)(₱25.00) = ₱120,000
𝑉𝑎𝑐𝑎𝑡𝑖𝑜𝑛 𝑝𝑎𝑦 = 2(2)(48)(₱25.00) = ₱4,800
𝑀𝑖𝑠𝑐𝑒𝑙𝑙𝑎𝑛𝑒𝑜𝑢𝑠 = ₱25,000(12) = ₱102,000
𝑂𝑤𝑛𝑒𝑟 ′ 𝑠 𝑠𝑎𝑙𝑎𝑟𝑦 = ₱25,000(12) = ₱300,000
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = ₱500,000(0.20) = ₱100,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 =₱700,957.78
𝐸𝑥𝑐𝑒𝑠𝑠 = ₱720,000 − ₱700,957.78 = ₱19,042.22
Since the excess of annual revenue over the annual cost is greater than zero, the
investment is justified. The man should invest.

Example
4. A firm is considering purchasing equipment that will reduce cost by ₱400,000.
The equipment costs ₱300,000 and has a salvage value of ₱50,000 and a life of 7 years.
The annual maintenance cost is ₱6,000. While not in use by the firm, the equipment can
be rented to others to generate an income of ₱10,000 per year. If money can be invested
for an 8 percent return, is the firm justified in buying the equipment?

Solution:
Annual savings:
𝑅𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱40,000
𝑅𝑒𝑛𝑡𝑎𝑙 = ₱10,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = ₱40,000 + ₱10,000 = ₱50,000

Annual Cost:
₱300,000 − ₱50,000 ₱250,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱28,018.10
𝐹/𝐴, 8%, 7 8.9228

𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = ₱6,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱28,018.10 + ₱6,000 = ₱34,018.10

𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = ₱50,000 − ₱34,018.10 = ₱15,981.90

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱15,981.90

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 5.33% < 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱300,000
The equipment should not be purchased.

Example:
5. The MGC Company has a contract with a hauler to transport its naptha
requirements of 3,600,000 liters per year from a refinery in Batangas to its site in Paco at
a cost of ₱1.05 per liter. It is proposed that the company buys a tanker with a capacity of
18,000 liters to service its requirements at a first cost of ₱8,000,000 life is 6 years and a
salvage value of ₱800,000. Other expenses are as follows:
(a) Diesel fuel at ₱7.95 per liter and the tanker consumers 120 liters per round trip
from Paco to Batangas and back.
(b) Lubricating oil servicing is ₱3,200 per month.
(c) Labor including overtime and fringe benefits for one driver and one helper is
₱21,000 per month.
(d) Annual taxes and insurance. 5% of first cost.
(e) General maintenance per year is ₱40, 000
(f) Tires cost ₱32,000 per set and will be renewed every 150 round trips.
What should the MGC Company do if a 5% interest rate on investment is included in the
analysis?
Solution:
Hauling:
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = (₱1.05)(3,600,000) = ₱3,780,000
Buying Tanker
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡:
₱8,000,000 − ₱800,000 ₱7,200,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱822,505.73
𝐹/𝐴, 15%, 6 8.7537
3,600,000
𝐹𝑢𝑒𝑙 = (120)(₱7.95) = ₱190,800
18,000
𝑂𝑖𝑙 = ₱3,200(12) = ₱38,400
𝐿𝑎𝑏𝑜𝑟 = ₱21,000(12) = ₱252,000
𝑇𝑎𝑥𝑒𝑠 & 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = ₱8,000,000(0.05) = ₱400,000
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = ₱40,000
3,600,000
𝑇𝑖𝑟𝑒𝑠 = (₱32,000) = 42,666.67
18,000(150)
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱1,786,372.39

𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = ₱3,780,000 − ₱1,786,372.39 = ₱1,993,627.61

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱1,993,627.61

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 24.92% > 15%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱8,000,000
The company should buy the tanker.
Example:
6. A machine that is not equipped with a brake “coasts” 30 seconds after the power
is turned off upon completion of each piece, thus preventing removal of the work from the
machine. The time per piece, exclusive of this stopping time is 2 minutes. The machine is
used to produce 40,000 pieces per year. The operator receives ₱35.00 per hour and the
machine overhead rate is ₱20.00 per hour.
How much could the company afford to pay for a brake that would reduce the stopping
time to 3 seconds, if it would have a life of 5 years? Assume zero salvage value, capital
worth 18% and that repairs and maintenance would total not over ₱300 per month.

Solution:
27
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = (₱35 + ₱20)(40,000) = ₱16,500
3600

Let C = the amount that can be invested for the break

Annual costs:
𝐶 𝐶
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = =
𝐹/𝐴, 10%, 5 6.1051
𝑅𝑒𝑝𝑎𝑖𝑟𝑠 𝑎𝑛𝑑 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = ₱300(12) = ₱3,600
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 0.18𝐶
𝐶
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = + ₱3,600 + 0.18𝐶 = 0.3438𝐶 + ₱3,600
6.1051
Equating annual savings to total annual cost,
₱16,500 = 0.3438𝐶 + ₱3,600
𝐶 = ₱37,522.09

In any problem where the unknown quantity is the investment or capital, the best
method to use is the annual worth method.

Example:
7. A newly-built business property, containing space for a store and two offices,
can be purchased for ₱1,200,000. A prospective buyer estimates that during the next 10
years he can obtain annual rentals of at least ₱458,460 from the property and that the
annual out-of-pocket disbursements will not exceed ₱60,000. He believes that he should
be able to dispose of the property at the end of 10 years at not less than ₱700,000. Annual
taxes and insurance will total 2.5% of the first cost.
(a) Assume he has sufficient equity capital to purchase the property, and that the
average return he is obtaining from his capital is 20%. Would you recommend
the investment?
(b) What recommendation would you make if he had to borrow 25% of the required
capital, on the basis of a 10-year amortization with interest of
18%?

(c) If the entire capital can be obtained by floating bonds at 15% that will mature in
10 years, what would you recommend? Sinking fund interest is 15%

Solution:
a.)
Annual revenue = ₱458,460
Annual costs:
₱1,200,000 − ₱700,000 ₱500,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱19,261.38
𝐹/𝐴, 20%, 10 (1 + 0.20)10 − 1
[ ]
0.20
𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡𝑠 = ₱60,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒𝑠 = ₱1,200,000(0.025) = ₱30,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱19,261.38 + ₱60,000 + ₱30,000 = ₱109,261.38

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = ₱458,460 − ₱109,261.38 = ₱349,198.62

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱349,198.62
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 29.10% > 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱1,200,000
The investment is justified.

b.)
Annual revenue = ₱458,460
Annual costs:
₱900,000 − ₱700,000 ₱200,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱7,704.55
𝐹/𝐴, 20%, 10 (1 + 0.20)10 − 1
[ ]
0.20
 ₱1,200,000(0.25) ₱1,200,000(0.25)
𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = = = ₱66,754.39
𝑃/𝐴, 18%, 10 1 − (1 + 0.18)−10
[ ]
0.18
𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡𝑠 = ₱60,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒𝑠 = ₱1,200,000(0.025) = ₱30,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱7,704.55 + ₱66,754.39 + ₱60,000 + ₱30,000 = ₱164,458.94

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = ₱458,460 − ₱164,458.94 = ₱294,001.06

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱294,001.06
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 24.50% > 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱1,200,000
The investment is justified.

c.)
Annual revenue = ₱458,460
Annual costs:
₱1,200,000 − ₱700,000 ₱500,000
𝑆𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 = = = ₱24,626.03
𝐹/𝐴, 15%, 10 (1 + 0.15)10 − 1
[ ]
0.15
𝐵𝑜𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱1,200,000(0.15) = ₱180,000
𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡𝑠 = ₱60,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒𝑠 = ₱1,200,000(0.025) = ₱30,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱24,626.03 + ₱180,000 + ₱60,000 + ₱30,000 = ₱294,626.03

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = ₱458,460 − ₱294,626.03 = ₱163,833.97

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 ₱163,833.97
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = × 100 = 13.65% < 20%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 ₱1,200,000
The investment is not justified.

Example:
8. A proposed project will require the immediate investment of ₱50,000 and is
estimated to have year-end revenues and costs as follows:
Year revenue costs
1 ₱75,000 ₱60,000
2 ₱90,000 ₱77,500
3 ₱100,000 ₱75,000
4 ₱95,000 ₱80,000
5 ₱60,000 ₱47,500
An additional investment ₱20,000 will be required at the end of the second year.
The project would terminate at the end of the 5th year, and the assets are estimated to
have of ₱25,000 at that time. Is this a good investment?
Solution:
 Solve for the internal rate of return (IRR) and then decide whether the investment
justified. The internal rate of return is that rate of return that will exactly reduce the worth
of the investment to zero at the end of the life of the investment. Thus, present worth of
cash inflows minus the present worth of cash outflows must equal to zero.

𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠: ₱25,000

₱100,000
₱90,000 ₱95,000
₱75,000 ₱60,000

0 1 2 3 4 5

𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠:
0 1 2 3 4 5

₱47,500
₱50,000 ₱60,000
₱75,000
₱77,500
₱80,000

₱20,000

𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠:

₱25,000 ₱37,500
₱15,000 ₱15,000

0 1 2 3 4 5

₱7,500

₱50,000

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠

= −₱50,000 + ₱15,000(1 + 𝑖)−1 − ₱7,500(1 + 𝑖)−2 + ₱25,000(1 + 𝑖)−3
+ ₱15,000(1 + 𝑖)−4 + ₱37,500(1 + 𝑖)−5 = 0

Try i = 15%
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = ₱1,030.73

Try i = 16%
 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = −₱487.64

1030.73 15%
1030.73 15-i
0 i% -1
1518.37
-487.64 16%

1030.73 15 − 𝑖
=
1518.37 −1
𝒊 = 𝟏𝟓. 𝟔𝟖%

The investment is not justified. The internal rate of return of 15.68% is easily obtained in
easy investment.

Self-Assessment Questionnaire
1. A company is considering constructing a plant to manufacture a proposed new product.
The land costs ₱15,000,000, the building costs ₱30,000,000, the equipment costs
₱12,500,000 and ₱5,000,000 additional working capital is required. At the end of 12
years, the land can be sold for₱25,000,000, the building for ₱12,000,000 and the
equipment for ₱250,000 and all of the working capital recovered. The annual
disbursement for labor, materials, and all other items are estimated to total ₱23,750,000.
If the company requires a minimum return of 25%, what should be the minimum annual
sales for 12 years to justify the investment?

2. A young mechanical engineer is considering establishing his own small company. An

investment of ₱400,000 will be required which will be recovered in 15 years.
It is estimated that sales will be ₱800,000 per year and that operating expenses will be
as follows.

Materials ₱160000 per year

Labor ₱280,000 per year
Overhead ₱40,000 +10% of sales per year
Selling expense ₱60,000

The man will give u his regular job paying ₱216000 per year and devote full time to the
operation of the business; this will result in decreasing labor cost by ₱40,000 per year,
material cost by ₱28,000 per year and overhead cost by ₱32,000 per year. If the man
expects to earn at least 20% of his capital, should he invest?
3. A man formerly employed as chief mechanic of an automobile repair shop has saved
₱1,000,000.00 which are now invested in certain securities giving him an annual
dividend of 15%. He now plans to invest this amount in his own repair shop. In his
present job, he is earning ₱25,000.00 a month, but he has to resign to run his own
business. He will need the services of the following: 2 mechanics each earning
₱400.00 a day and 8 helpers each are earning ₱200.00 a day. These men will work
on the average 300 days per year. His other expenses are the following:
Rental ₱30,000.00 a month
Miscellaneous ₱25,000.00 a month
Sales tax 3% of gross income
Insurance 2%
The length of his lease is 5 years. If the average charge for each car repaired by his
shop is ₱1,000.00. Determine the number of cars he must service in one year so that
he will obtain a profit of at least 20% on his investment?
4. A firm is charged P150 per ton for hauling its raw materials by a trucking company.
Forty tons per day are hauled for 300 days a year. It is desired to install a railway
system which would bring down the cost of hauling to ₱6.60 per ton. Maintenance cost
of this is ₱12,000 per month. Tax is 1%. Average rate if earning is 20%.
a. If the company has the cash necessary for the installation, would you recommend
the change?
b. If the company has to float ₱5,000,000 worth of non-callable bonds at 15% that will
mature in 10 years to have the capital for the project, would you recommend the
change?

5. A food processing plant consumed 600,000 kW of electric energy annuallyand pays

an average of ₱2.00 per kWh. A study is being made to generate its own power to
supply the plant the energy required, and that the power plant installed would cost
₱2,000,000. Annual operation and maintenance, ₱800,000. Other expenses ₱100,000
per year. Life of power plant is 15 years; salvage value at the end of life is ₱200,000;
annual taxes and insurances, 6% of first cost; and rate of interest is 15%. Using the
sinking fund method for depreciation, determine if the power plant is justifiable.

Answer to Self-Assessment Questionnaire

1. ₱39,748,560
2. The rate of return is 6.61%, the man should not invest.
3. 2,112
4. (a.) Rate of return is 26.68%, investment is justified.
(b.) Rate of return is 10.61%, investment is not justified.
5. Rate of return is 7.11%, the power plant is not a good investment.
 CE 215 – ENGINEERING ECONOMICS

MODULE 7

Chapter 7 – Comparing Alternatives

Introduction

In chapter 6, the different methods for investment of capital were discussed. In that
chapter, the problem that was resolved was whether the investment of capital in a certain
enterprise was justified or not. However, most engineering and business project can be
accomplished by more than one method or alternative. This chapter will deal with this type of
problems.

The fundamental principle on which alternative should be used is stated as follows.

The alternative that requires the minimum investment of capital and will produce
satisfactory functional result will always be used unless there are definite reasons why an
alternative requiring a larger investment should be adopted.

When the selection of the one of the alternatives excludes the choice of any of the
others, the alternatives are called mutually exclusive alternatives. The basic principle in
selecting among alternatives that requires the minimum investment of the capital and
produces satisfactory functional results will be chosen unless the incremental capital
associated with an alternative having a large investment can be justified with respect to its
incremental benefits.

Objectives:

At the end of this chapter, students are expected to be able to:

4. Understand the different methods in selecting alternatives.

5. Learn to choose between alternatives
6. Solve problems relating to comparing alternatives.

Discussion

Types of projects and alternatives:

a. Investment alternatives are those with initial capital investments that produce positive cash
flows from increased revenues, saving through reduced costs, or both.

b. Cost alternatives are those with all negative cash flows, except for a possible positive cash
flow element from disposal of assets at the end of the project’s useful life.
Rule 1: when revenues and other economic benefits are present and vary among the
alternatives, choose the alternative that maximizes overall profitability. That is, select the
alternative that has the greatest positive equivalent worth at i= MARR and satisfies all project
requirements.
Methods or Patterns in Comparing Alternatives:
There are several methods for comparing alternatives, but only six patterns will be discussed
1. THE RATE OF RETURN ON ADDITIONAL INVESTMENT METHOD
This method assumes that unlimited capital is available; therefore an alternative
requiring a bigger investment may be adopted provided the rate of return on the additional
investment justifies the bigger outlay of capital by savings or benefits. In this method the rate
of return on additional investment is calculated as:

If the rate of return on additional investment is satisfactory, then, the alternative requiring a
bigger investment is more economical and should be chosen.

Example:
A piece of production equipment is to be replaced immediately because it no longer meets
quality requirements for the end product. The two best alternatives are a used piece of
equipment (E1) and a new automated model (E2). The economic estimates for each are
shown below

The MARR is 15% per year. Which alternative is preferred?

Solution:
To compare the two alternatives, determine first the total annual cost for each alternative,
including annual depreciation.
Consider B

Since ROR < MARR Choose E1

2. ANNUAL COST OF METHOD

In this method, the annual cost for each alternative is determine and the alternative
with the least AC should be chosen.
To apply this method, the annual cost of alternatives including interest on investment
is determined. The alternative with the east annual cost is chosen. This pattern, like the rate
of return on additional investment pattern, applies only to alternatives which has a uniform
cost data for each year and a single investment of capital at the beginning of the first year of
the project life.
Example:

Since AC of E1, is less than AC of E2, choose E2.

3. THE EQUIVALENT UNIFORM ANNUAL COST (EUAC) METHOD

The most straightforward technique for comparing mutually exclusive alternatives is to
determine the equivalent worth of each alternative over the same study period based on the
total investment at I=MARR. The for investment alternative, the one with the greatest positive
equivalent worth is selected.
In this method, all cash flows (irregular or uniform) must be converted to equivalent
uniform annual cost, that is, a year-end amount which is the same each year. The alternative
with the least equivalent annual cost is preferred. When the euac method is used, the
equivalent uniform annual cost of alternatives must be calculated for one life cycle only. This
method is flexible and can be used for any type of alternative selection problems. The method
is modification of the annual cost pattern.

Example:
Solve the above problem using EUAC method:

Choose A as alternative.

4. THE PRESENT WORTH COST (PWC) METHOD

In comparing alternatives by this method, determine the present worth of the net cash
outflows for each alternative for the same period of time. The alternative with least present
worth of cost is selected.
In this method, the present worth of all cash flows each alternative is computed for the
same study period.

5. THE CAPITALIZED METHOD

The capitalized cost method is a variation of the present worth cost pattern. This
method is used for alternatives having long lives. To use the method, determine the capitalized
cost of all the alternatives and choose that one with the least capitalized cost.

6. PAYBACK (PAYOUT) PERIOD METHOD

To use this method, the payback period of each alternative is computed. The
alternative with the shortest payback period is adopted. This method is seldom used.
Example:
A company is considering two types of equipment for its manufacturing plant. Pertinent data
are as follows:

If the minimum required rate of return is 15%, which equipment should be selected?
Solution:
By the rate of return on additional investment method

TYPE B
Annual costs:

Type B should be selected.

 ₱129,850

Since AC < AC, TYPE B SHOULD BE SELECTED

By the present worth cost method

Type A
Annual cost (excluding depreciation) = ₱32,000 + ₱50,000 + (₱50,000) (0.04) = (₱200,000)
(0.03) = ₱90,000

0 1 2 9 10

₱90,000 ₱90,000 ₱90,000 ₱90,000

₱200,000
Type B
Annual cost (excluding depreciation) = ₱24,000 + ₱50,000 +₱32,000 + (₱32,000) (0.04) =
(₱300,000) (0.03) = ₱66,280

0 1 2 9 10

₱66,280 ₱66,280 ₱66,280 ₱66,280

₱300,000

Since PWCB< PWCA for the same period of time, type B should be selected.

By equivalent uniform annual cost method

Type A

0 1 2 10 0 1 2 10

₱90,000 ₱90,000 ₱90,000 EUACA EUACA EUACA

₱200,000

UEACA= ₱200,000 (A/P, 15%, 10) + ₱90,000

= (₱200,000) (0.1993) + ₱90,000 = ₱129,860

Type B

0 1 2 10 0 1 2 10

₱66,280 ₱66,280 ₱66,280 EUACB EUACB EUACB

₱300,000

Since EUACB< EUACA, type B is more economical.

Example
Choose from the two machines which is more economical

Machine A Machine B
First Cost ₱8,000 ₱14,000
Salvage Value 0 2,000
Annual Operation 3,000 2,400
Annual Maintenance 1,200 1,000
Taxes and Insurances 3% 3%
Life, years 10 15

Money is worth at least 16%.

Solution:
By rate of return on additional investment method:
Machine A
Annual Cost:
₱8,000 ₱8,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱375
𝐹/𝐴, 16%, 10 21.3215
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 = 3,000
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = 1,200
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = (8,000)(0.03) = 240
𝑻𝒐𝒕𝒂𝒍 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕 = ₱𝟒, 𝟖𝟏𝟓

Machine B
Annual Cost:
₱12,000 ₱12,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱232
𝐹/𝐴, 16%, 15 51.6595
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 = 2,400
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = 1,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = (14,000)(0.03) = 420
𝑻𝒐𝒕𝒂𝒍 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕 = ₱𝟒, 𝟎𝟓𝟐

𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = ₱4,815 − ₱4,052 = ₱763

𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = ₱14,000 − ₱8,000 = ₱6,000
₱763
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = × 100 = 12.72% < 16%
₱6,000
Machine A is more economical.

By the annual cost method:

Machine A
Annual Cost:
₱8,000 ₱8,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱375
𝐹/𝐴, 16%, 10 21.3215
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 = 3,000
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = 1,200
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = (8,000)(0.03) = 240
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = (8,000)(0.16) = 1,280
𝑻𝒐𝒕𝒂𝒍 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕 = ₱𝟔, 𝟎𝟗𝟓

Machine B
Annual Cost:
₱12,000 ₱12,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = = ₱232
𝐹/𝐴, 16%, 15 51.6595
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 = 2,400
𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 = 1,000
𝑇𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = (14,000)(0.03) = 420
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = (14,000)(0.16) = 2,240
𝑻𝒐𝒕𝒂𝒍 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕 = ₱𝟔, 𝟐𝟗𝟐
Since ACA< ACB, Machine A is more economical.

By present worth cost method

Use 30-year study period, which is the least common multiple of 10 and 15.

Machine A
Annual cost = ₱3,000 +₱1,200 + (₱8,000) (0.03) = ₱4,440
 0 1 10 11 20 21 30

₱4,440 ₱4,440 ₱4,440 ₱4,440 ₱4,440 ₱4,440

₱8,000

₱8,000 ₱8,000

PWCA = ₱8,000 + ₱4,440 (P/A,16%,30) + ₱8,000 (P/F,16%,10) + ₱8,000 (P/F,16%,20) =

₱37,652

Machine B
Annual cost = ₱2,400 + ₱1,000 + (₱14,000) (0.03) = ₱3,820

₱2,000 ₱2,000

0 1 15 16 30

₱3,820 ₱3,820 ₱3,820 ₱3,820

₱14,000

₱14,000

PWCB = ₱14,000 + ₱3,820 (P/A,16%,30) + ₱12,000 (P/F,16%,15) – ₱2,000 (P/F,16%,30) =

₱38,869
Machine A should be chosen, since PWCA< PWCB

By the equivalent uniform annual cost method

Machine A

0 1 2 10 0 1 2 10

₱4,440 ₱4,440 ₱4,440 EUACA EUACA EUACA

₱8,000

EUACA = ₱8,000 (A/P,16%,10) + ₱4,440 = ₱6,095

Machine B

₱2,000

0 1 2 15 0 1 2 15

₱3,820 ₱3,820 ₱3,820 EUACB EUACB EUACB

₱14,000

EUACB = ₱14,000 (A/P,16%,15) + ₱3,820 - ₱2,000 (A/F,16%,15) = ₱6,292

Machine A should be chosen, since EUACA< EUACB

Example:
A company is going to buy a new machine for manufacturing its product. Four different
machines are available. Cost, operating and other expenses are as follows:

Money is worth 17% before taxes to the company. Which machine to be chosen?

Solution:
By the annual cost method
Depreciation:
₱24,000 ₱24,000
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐴 = = = ₱3,422
𝐹/𝐴, 17,5 7.0144
₱30,000
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐵 = = ₱4,277
7.0144
₱49,600
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐶 = = ₱7,071
7.0144
₱52,000
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐶 = = ₱7,413
7.0144
Comparative total annual cost for four machines

A B C D
Power ₱1,300 ₱1,360 ₱2,400 ₱2,020
Labor 11,600 9,320 4,200 2,000
Maintenance 2,800 1,900 1,300 700
Taxes and Insurances (3%) 720 900 1,488 1,560
Depreciation 3,422 4,277 7,071 7,413
Total Annual Cost ₱19,842 ₱17,757 ₱16,459 ₱13,693

Comparing Machine A with Machine B.

19,482 − 17,757
𝑅𝑂𝑅 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑛 𝐵 = (100) = 34.75% > 17%
30,000 − 24,000
Machine B is economical than Machine A.

Comparing Machine B with Machine C.

17,757 − 16,459
𝑅𝑂𝑅 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑛 𝐶 = (100) = 6.62% < 17%
49,600 − 30,000
Machine B is economical than Machine C.

Comparing Machine B with Machine D.

17,757 − 13,693
𝑅𝑂𝑅 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑛 𝐷 = (100) = 18.47% > 17%
52,000 − 30,000
Machine D is economical than Machine D.
Choose machine D.

Example
An untreated electric wooden pole that will last 10 years under certain condition costs P20,000.
if treated pole will last for 20 years, what is the maximum justifiable amount that can be paid
for the treated people, if the maximum return on investment is 20%. Consider annual taxes
and insurance amount to be 1% of first cost.
Solution:
Let c = maximum amount that can be invested on the treated pole
Untreated pole
Annual cost:
Example
A company manufacturing acids, upon inspection of the roofing of the plant, found out that it
is badly corroded from the acids fumes and would need to be replaced. To try to get some
more life out of the roofing, The Company consulted a roofing coating constructor who
presented the company with two options. The first option is a coating that will cost ₱200,000
which would extend the life of the roofing for 3 years from date of application, and the second
option will cost ₱30,000 and which would extend the life of the roofing for 5 years from the
date of application. At what rate of return are the two investment equal?
Solution:
First Option

0 1 2 3 0 1 2 3

EUACA EUACA EUACA

₱14,000

EUACA = ₱20,000 (A/P,i%,3)

Second Option

0 1 2 5 0 1 2 5

EUACB EUACB EUACB

₱30,000

EUACB = ₱30,000 (A/P,i%,5)

For the two alternatives to be economical, EUACA = EUACB
20,000(𝐴/𝑃, 𝑖%3) = 30,000(𝐴/𝑃, 𝑖%, 5)
(𝐴/𝑃, 𝑖%, 5) 20,000
=
(𝐴/𝑃, 𝑖%, 3) 30,000

1 − (1 + 𝑖)−5
= 0.6667
1 − (1 + 𝑖)−3

Try i=12%

1 − (1.12)−5
= 0.6667
1 − (.12)−3
0.6662 = 0.6667
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 12%

Example:
The engineer of a medium scale industry was instructed to prepare at least two plans which
is to be considered by management for the improvement of their operations. Plan "a" calls for
an initial investment of ₱200,000 now with a prospective salvage value of 20% of the first cost
20 years hence. The operation and maintenance disbursement are estimated to be ₱15,000
a year and taxes will be 2% of first cost.
Plan b calls for an immediate investment of ₱140,000 and a second investment of ₱160,000
eight years later. The operation and maintenance disbursements will be ₱9,000 a year for
initial installation and ₱8,000 a year for the second installation. At the end of 20 years the
salvage value shall be 20% of the investments. Taxes will be 2% of the first cost.
If money is worth 12%, which plan would you recommend?

Solution:
By present worth cost method
Plan A
Annual cost = ₱15,000 + (₱200,000) (0.02) = ₱19,000
Salvage value = (200,000) (0.20) = ₱40,000

₱40,000

0 1 2 3 20

₱19,000 ₱19,000 ₱19,000 ₱19,000

₱200,000

PWCA = ₱200,000 + (19,000) (P/A,12%,20) - (₱40,000) (P/F,12%,20)

PWCA =337,771

Plan B
Annual cost = ₱9,000 + (₱140,000) (0.02) = ₱11,800
Additional annual cost after 8 years = ₱8,000 + (₱160,000) (0.02) = ₱11,200
Salvage value = (140,000 = 160,000) (0.20) = ₱60,000

₱60,000

0 1 2 8 9 20

₱11,800 ₱11,800 ₱11,800 ₱11,800 ₱11,800

₱140,000
₱11,200 ₱11,200
₱160,000

PWCB = ₱140,000 + ₱11,800(P/A,12%,20) + ₱160,000(P/F,12%,8) +

₱11,200(P/A,12%,12)(P/F,12%8) - ₱60,000(P/F,12%,20) = ₱314,564
Plan B is more economical.

By the equivalent uniform annual cost method

EUACA = ₱200,000 (A/P,12%,20) + ₱19,000 - ₱40,000(A/F,12%,20) = ₱45,224
EUACB = ₱140,000(A/P,12%,20) + 11,800 + ₱160,000(P/F,12',8)(A/P,12%,20) +
₱11,200(F/A,12%,12)(A/F,12%,20) - ₱60,000(A/F,12%,20) = ₱34,019
Plan B is more economical.
Example
The national government is planning to construct a bridge. At present a 4- lane bridge
will be built, but it is expected that at a later date a second 4-lane bridge will be added.
If an 8-lane bridge is built now, it will cost ₱8,100,000. A single 4-lane bridge can be
built now for ₱5,500,000. It is estimated that a second 4-lane bridge at a later date will cost
₱8,000,000. Annual upkeep on each 4-lanr bridge would be ₱91,500 and for the 8-lan bridge
would be ₱115,000. Money to build the bridge will cost 12%. Assume a 50-year functional life
for the project and determine the earliest time at which the additional 4 lanes would be required
to make it equally economical to build the 8 lane bridge immediately.

Solution:
8-lane Bridge

0 1 50
2

₱115,000 ₱115,000 ₱115,000

₱8,100,000
PWC8= ₱8,100,000 + ₱115,000(P/A,12%,50) = ₱9,055,000
4-lane Bridge

0 1 2 n n+1 50

₱91,500 ₱91,500 ₱91,500

₱183,000 ₱183,000
₱5,500,000

₱8,000,000

PWC4 = P5,500,000 + P91,500(P/A,12%,n) + P8,000,000(P/F,12%,n) +

P183,000[P/A,12%,(50-n)](P/F,12%,n)
When n = 10
PWC4 = P5,500,000 + P91,500(P/A,12%,10) + P8,000,000(P/F,12%,10) +
P183,000[P/A,12%,(40)](P/F,12%,10)
PWC4 =₱9,079,000
10 years
Self-Assessment Questionnaire
1. An oil company is being offered a special coating for the gasoline underground tank
installation in its service stations which will increase the life of tank from usual 10 years
to 15 years. The cost of special costing will increase the cost of the tanks is ₱40,000-
tank to ₱58,000. Cost of installation for either of the tank is ₱24,000. If salvage value
for both is zero, and interest rate is 26%, would you recommend the use of the special
coating?

2. An electric cooperative is considering the use of concrete electric pole in the expansion
of its power distribution lines. A concrete pole cost ₱18,000 each and will last 20 years.
The company is presently using creosoted wooden poles which cost ₱12,000 per pole
and will last 10 years. If money is worth 12%, which pole should be used? Assume
annual taxes amount to 1% of first cost and zero salvage value in both cases.

3. In building their plant, the officers of the international leather company had the choice
between alternatives:
One alternative is to build in Metro Manila where the plant would cost ₱2,000,000.
Labor would cost annually ₱120,000 and annual overhead ₱40,000. Taxes and
insurance would total 5% of the first cost of the plant.
The second alternative would be to build in Bulacan a plant costing ₱2,250,000. Labor
would cost annually ₱100,000 and overhead would be ₱55,000. Taxes and insurances
would be 3% of the first cost. The cost of raw materials would be the same in either
plant. If capital must be recovered within 10 years and money is worth at least 20%.
Which site should the officers of the company choose?

4. A utility company is considering the following plans to provide a certain service required
by present demand and the prospective growth of demand for coming 18 years.
Plan R requires an immediate investment of ₱500,000 in property that has an
estimated life of 18years and with 20% terminal salvage value. Annual disbursements
for operation and maintenance will be ₱50,000. Annual property taxes will be 2% of
first costs.
Plan S requires an immediate investment of ₱300,000 in property that has an
estimated life of 18 years with 20% terminal salvage value. Annual disbursements for
its operation and maintenance during the first 6 years will be ₱40,000. After 6 years,
an additional investment of ₱400,000 will be required in property having an estimated
life of 12 years with 40% terminal salvage value. After this additional property is
installed, annual disbursement for operation and maintenance of the combined
property will be ₱60,000. Annual property taxes will be 2% of the first cost of property
in service at any time. Money is worth 12%. What would you recommend?

Answer to Self-Assessment Questionnaire

1. The special coating should not be used.
2. The creosoted wooden poles should be used.
3. Plant in Metro Manila
4. Plant S
 CE 215 – ENGINEERING ECONOMICS

MODULE 8

Chapter 8 – Fixed, Increment and Sunk Cost

Introduction

In this module, we will study fixed, increment and sunk cost.

Objectives:

At the end of this chapter, students are expected to be able to:

7. Differentiate fixed, increment and sunk cost.

8. Apply the concept of these types of cost in the present economy.
9. Evaluate problems relating to the different type of costs.

Discussion

Type of Costs

Fixed costs are those costs which remain constant, whether or not a given change on
operations or policy is adopted.

Variable costs are those costs which vary with output or any change in the activities of an
enterprise.

Increment costs are those that arise as a result of a change in operations or policy.

Marginal cost is the additional cost of producing one more unit of a product.

Sunk cost represents money which has been spent or capital which has been invested and
which cannot be recovered due to certain reasons.

Example:
A machine costing ₱30,000 is expected to produce 10,000 units of a certain product during its
entire life before being replaced. At the end of life, it will have a scrap value of ₱2,000. The
cost of hosing the machine will be ₱900 a year. The power consumption per unit is ₱0.85 and
the maintenance per unit will be ₱0.55. Labor will cost ₱1.10 per unit. If depreciation is by
sinking fund method at 15%, determine the cost per unit produced if the annual production is
(a) 10,000 units and (b) 2,500 units.
Solution:
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = ₱0.85 + ₱0.55 + ₱1.10 = ₱2.50
a. Annual production of 10,000 units
The machine will last for 1 year
Annual Costs:
Depreciation = ₱30,000 − ₱2,000 = ₱28,000
Housing = ₱900
Total = ₱28,900
Total cost per unit = ₱2.50+₱28,900/10000 = ₱5.39
b. Annual production of 2,500 units
The machine will last for 4 years
Annual Costs:
₱30,000 − ₱2,000
Depreciation = = ₱5,607
𝐹/𝐴, 15%, 4
Housing = ₱900
Total = ₱6,507
Total cost per unit = ₱2.50+₱6,507/2500 = ₱5.10

Example
A company having a capacity of 1,600 units per year currently operating at a sales level of
only 1,200 units with a selling price of ₱720 per unit. The fixed costs of the plant are ₱365,000
per year, and the variable costs are ₱416 per unit. It has been estimated that a reduction of
P50 per unit in the selling price would increase sales by 300 units per year.
(a) Would this be a good program to follow?
(b) An alternative being considered is to engage in a modernization plan that would increase
the fixed costs by ₱58,000 per year, but that would reduce the variable costs by ₱56 per unit.
Would this be a better procedure than the price-reduction program?
(c) Can you suggest any other program that might be superior to the foregoing?
Solution:
(a) Present Revenue = ₱720(1,200) = ₱864,000

Present costs:
𝐹𝑖𝑥𝑒𝑑 = ₱365,000
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 = ₱416(1,200) = ₱499,200
𝑇𝑜𝑡𝑎𝑙 = ₱864,200
𝐿𝑜𝑠𝑠 = (−)₱200
New Revenue = ₱670 (1,500) = ₱1,005,000
Costs:
𝐹𝑖𝑥𝑒𝑑 = ₱365,000
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 = ₱416(1,500) = ₱624,000
𝑇𝑜𝑡𝑎𝑙 = ₱989,000
𝐿𝑜𝑠𝑠 = ₱16,000
Reducing the price would be a profitable program.

b. 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = ₱864,000
Costs:
𝐹𝑖𝑥𝑒𝑑 = ₱423,000
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 = ₱416(1,500) = ₱432,000
𝑇𝑜𝑡𝑎𝑙 = ₱855,000
𝐿𝑜𝑠𝑠 = ₱9,000
Modernization would be profitable, but it would not be as good a procedure as the price
reduction.

c. Both programs should be combined.

Example
The ABC Company has two plants in the same city, each having a capacity of ten units of the
same product per month. Fixed costs of plant I are ₱30,000 per month and its variable costs
are ₱1000X−₱10X2. Fixed costs of plant II are ₱50,000 per month and the variable costs are
₱1,200Y −₱5Y2. X and Y are the number of units produced. At present the sales have been
established at 14 units per month with each plant producing 7 units. Should the production
volume at the plant be changed, and to what extent?
Solution
Fixed costs at both plants will be unaffected and are therefore neglected.
Plant I Variable cost ₱1000X−₱10X2
X Variable Cost
4 ₱3,840
5 4,750
6 5,640
7 6,510
8 7,360
9 8,190
10 9,000
Plant II Variable cost ₱1,200Y −₱5Y2

Y Variable Cost
10 ₱7,000
9 7,155
8 7,040
7 6,685
6 6,120
5 5,375
4 4,480
Operate Plant II at full capacity.
The manufacturer should produce the new line of product.
Example
A manufacturing firm has a waste product that is now being dumped into a river. The waste
material could be processed to produce fertilizer. This would require the investment of
₱320,000 in equipment and ₱53,000 per month for other materials. Overhead expenses will
cost ₱55,000 per year. Taxes and insurance amount to 3% of the first cost of the equipment
per year. Payroll taxes and other benefits amount to 4%. The life of the equipment is 5 years
with no salvage value at the end of its life. Money is worth 20% to the firm.
If 3,600 kg of fertilizer are produced per month, which can be sold for ₱22.00 per kg, should
the firm make the investment?
Solution:
Increment revenue = 3,600(12)(₱22.00) = ₱950,400
Increment costs:

₱320,000 ₱320,000
Depreciation = = = ₱43,002
𝐹/𝐴, 20, 5 7.4416
Materials = ₱53,000(12) = ₱636,000
Labor = ₱14,000(12) = ₱168,000
Overhead = ₱56,000
Payroll taxes & benefits = ₱168,000(0.12) = ₱6,720
Taxes and Insurance = ₱320,000(0.03) = ₱9,600
Interest on capital = ₱320,000(0.20) = ₱64,000
𝐓𝐨𝐭𝐚𝐥 𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐨𝐬𝐭 = ₱𝟗𝟖𝟑, 𝟑𝟐𝟐
The firm should not invest.
Example
An old machine was purchased 3 years ago at a cost of ₱50,000. It was estimated to have a
useful life of years, with a salvage value of ₱5,000. It is now going to be replaced by a new
old machine costing ₱70,000 and ₱30,000 trade-in will be allowed for the old machine.
Determine the sunk cost if depreciation has been computed by the (a) straight-line method,
(b) sinking fund method at 16% and, (c) SYD method.
Solution
𝐶𝑜 = ₱50,000
𝐶𝐿 = ₱5,000
𝑛=3
(a) Straight-line method

(b) Sinking fund method

(c) SYD method

The negative sign means that the amount is not a loss but a gain.
Self-Assessment Questionnaire
1. The XYZ Company has two plants producing “ K Specials”. It has the following expected data
for the next month’s operations. Variable incremental costs vary linearly from zero production
to maximum-capacity production

Plant A Plant B
Maximum Capacity, Units 1,000 800
Total Fixed Cost ₱758,000 ₱480,000
Variable (incremental) Cost Maximum ₱900,000 ₱800,000
capacity

(a) Performance has not been good, so the company expects to receive domestic
orders for only 1,200 units next month at a price of 1,400 per unit. How should the
production be distributed between the plants for optimum economic operation?
(b) If a friendly foreign offers to buy 350 additional units at ₱1,100 per unit, should the
company accept the offer? Show the incremental gain or loss.
2. A company has a new Plant A and an old Plant B in the same metropolitan area, each
with a capacity of 12 units of product per month. Fixed expense at A is ₱40,000 per
month and at B is ₱20,000 per month. Variable expense per month at A is ₱1,000xN2
where N = the number of units produced. At B it is ₱2,000xM2, where M = the number
of units produced. At present the sales have been established at 14 units per month
with each plant producing 7 units. Should the interplant load be redistributed? Why?
How?

3. An asset is purchased six years ago at a cost of ₱7,000. It was estimated to have a
useful life of ten years with a salvage value of P300 at the end of the time. It is now of
no future use and can be sold for only ₱800. Determine the sunk cost if depreciation
has been computed by
(a) The straight-line method
(b) The sum-of-the-year’s digits method

Answer to Self-Assessment Questionnaire

1. (a) Plant A should produce 1,000 units and 200 units for Plant B.
(b) Incremental gain is ₱35,000, the company should accept the offer.

2. 9 units and 5 units

Plant A should produce 9 units per month and Plant B should produce 5 units because
it’s more profitable when you have the lowest total Variable Cost.

3. (a) ₱2,180
(b) ₱718.18
 CE 215 – ENGINEERING ECONOMICS

MODULE 9

Chapter 9 – Replacement Studies

Introduction

A decision often encountered in business firms and government organization as well as by

individuals is whether an existing asset should be retired from use continued in service replaced with
new asset. Engineering economy studies of replacement situations are performed using the same
methods involving two or more alternatives. However, the decision is whether to replace an existing
(old) asset called the defender with a new asset called the challenger.

Objectives:
At the end of this chapter, students are expected to be able to:

10. Understand the concept of replacement studies.

11. Analyze for reasons for replacement.
12. Solve problems on replacement studies.

Discussion

Reasons for Replacement Analysis

1. Physical Impairment (Deterioration)
These are the changes that occur in the physical condition of the asset. Normally, continued
use (aging) results in the less efficient operation of the asset. Routine maintenance and breakdown
repair costs increase, energy use may increase, more operator time may require and so forth.
The existing asset is completely or partially worn out and will no longer function satisfactorily
without extensive repairs.

2. Altered Requirement

Capital assets are used to produce goods and services that satisfy human wants. When the
demand for a good or service either increase or decrease or the design of a good service, or changes,
the related assets may have the economics of the use affected.

The existing asset does not have sufficient capacity to meet the present demands that are
placed on it.

3. Technology

The impact of changes in technology varies among different types of assets. In general the
costs per unit of production as well as quality and other factors are favorably impacted by changes in
technology.

This may be caused either by a lessening in the demand for the service rendered by the asset
of the availability of more efficient asset which will operate with lower out of pocket costs.

4. Financing

Financing factors involve economic opportunity changes extended to the physical operation
or use of assets and may involve income consideration.
 It is possible to rent identical or comparable asset or property, thus freeing capital for other
and more profitable use.

SUNK COST DUE TO UNAMORTIZED VALUE

Unamortized value of an equipment or property is the different between its book value and
its resale value when replaced. Unamortized value should be considered as a sunk cost or loss

BASIC PATTERNS FOR REPLACEMENT STUDIES

Replacement economy studies may be made by any of the basic procedures or patterns
which have been discussed previously. However, in most cases either the rate of return method or
the annual cost method is used.

Example

An existing factory must be enlarged or replaced to accommodate new production machinery. The
structure was built at a cost of ₱2.6 million. Its present book value, based on straight line depreciation
is ₱700,000 but it has been appraised at ₱800,000. If the structure is altered, the cost will be ₱1.6
million and its service life will be extended 8 years with a salvage value of ₱600,000. A new factory
could be purchased or built for ₱5.0 million. It would have a life of 20 years and a salvage value of
₱700,000. Annual maintenance of the new building would be ₱160,000 compared with ₱100,000 in
the enlarged structure. However, the improved layout in the new building would reduce annual
production cost by ₱240,000. All other expenses for the new structure are estimated as being equal.
Using an investment rate of 8 per cent, determine which is the more attractive investment for this
firm.

Solution
Construct a new building.

Example

A decision must be made whether to replace a certain engine with a new one, or to rebore the cylinder
of the old engine and thoroughly recondition it. The original cost of the old engine 10 years ago was
₱70,000; to rebore and recondition it will cost ₱28,000, but would extend its useful life for 5 years. A
new engine will have a first cost of ₱62,000 and will have an estimated life of 10 years. It is expected
that the annual cost of fuel and lubricant with the reconditioned engine will be about ₱20,000 and
that this cost will be 15% less with the new engine. It is also believed that repairs will be ₱2,500 a year
less with the new engine than with the reconditioned one. Assume that neither engine has any net
realizable value when retired. If money is worth 16%, what would you recommend?

Solution

The old engine should be replaced.

Example

Four years ago an ore-crushing unit was installed at a mine which cost ₱81,000. Annual operating cost
for this unit are ₱3,540. This unit was estimated to have a life of 10 years. The quantity of ore to be
handled is to be doubled and is expected to continue at this higher rate for at least 10 years. A unit
that will handle the same quantity of ore and have same operating cost as the one now in service can
be installed for ₱75,000. This unit will have a useful life of 6 years.

A unit with double the capacity of the one now in use can be installed for ₱112,000. Its life is estimated
at 6 years and its annual operating cost are estimated at ₱4,950. The present realizable value of the
unit now in use is ₱26,000. All units under consideration will have an estimated salvage value at
retirement age of 12% of the original cost. Interest rate is 20%. Annul taxes and insurance are 2.5% of
the original cost.

What would you recommend?

Solution:

Augmentation

Annual cost:

Old unit
₱26,000 − (81,000)(0.12) ₱16,280
Depreciation = = = ₱1,639
𝐹/𝐴, 20,6 9.9299
Operation = 3,540

Taxes and Insurance (₱81,000)(0.025) = 2,025

New small unit

₱75,000 − (75,000)(0.12) ₱66,000
Depreciation = = = ₱6,647
𝐹/𝐴, 20,6 9.9299
Operation = 3,540

Taxes and Insurance (₱75,000)(0.025) = 1,875

Total Annual cost = 19,266

Replacement

Annual cost:

New big unit

₱112,000 − (112,000)(0.12) ₱98,560
Depreciation = = = ₱9,926
𝐹/𝐴, 20,6 9.9299
Operation = 4,950
 Taxes and Insurance (₱75,000)(0.025) = 2,800

Total Annual cost = 17,676

Annual savings = ₱19,266 – ₱17,676 = ₱1,590

Additional investment = ₱112,000 – ₱75,000 – ₱26,000 = ₱11,000
₱1,590
Rate of Return on additional investment = × 100 = 14.5%
₱11,000
Buy a new small unit to augment the old unit.

Example

A car be purchased for ₱600,000 when new. There follows a schedule of annual operating expenses
for each year and trade in values at the end of each year. Assume that these amounts would be
repeated for future replacements, and that the car will not be kept more than 3 years. if interest on
invested capital is 15% before taxes. Determine at which year's end the car should be replaced so that
cost will be minimized.

Year 1 Year 2 Year 3

Operating expenses for year ₱34,000 ₱38,000 ₱41,000
Trade in value at the end of year ₱408,000 ₱336,000 ₱24,000

Solution

Cost of keeping each year

1 2 3
Operation ₱34,000 ₱38,000 ₱41,000
Depreciation ₱192,000 ₱144,000 ₱96,000
Interest on capital (15%) ₱90,000 ₱61,200 ₱187,400

1 year:
0 1 0 1

₱316,000 EUAC

EUAC = ₱316,000
2 years:
0 1 2 0 1 2

₱243,000
₱316,000 EUAC EUAC

EUAC = [₱316,000 + ₱243,000 (P/F, 15%, 2)] (A/P, 15%, 2) = ₱307,385

3 years:
0 1 2 3 0 1 2 3

₱243,000 ₱187,000
EUAC EUAC EUAC
₱316,000

EUAC = [₱316,000+₱243,000 (P/F,15%,2) + ₱187,400 (P/F, 15%, 3)](A/P,15%,3)=₱272,851

Thus it is cheaper to keep the car three years.

Self-Assessment Questionnaire

1. A recapping plant is planning to acquire a new diesel generating set to replace its present unit
which they run during brownouts. The new set would cost ₱135,000 with a five (5) year-life,
and no estimated salvage value. Variable cost would be ₱150,000 a year.
The present generating set has a book value of ₱75,000 and a remaining life of 5 year. Its
disposal value is now is ₱7,500, but it would be zero after 5 years. Variable operating cost
would be ₱187,500 a year. Money is worth 10%.
Which is profitable, to buy the new generator set or retain the present set? Support your
answer by showing your computation.

2. A company that sells computers has proposed to a small public utility company that it
purchase a small electronic computer for ₱1,000,000 to replace ten calculating machine and
their operators. An annual service maintenance contract for the computer will be provided at
a cost of ₱100.000 per year. One operator will required at a salary of ₱140,000 per year. The
estimated economical life of the computer is 10 years.
The calculating machine cost ₱7,000 each when new, 5 years ago and presently can be sold
for ₱2,000 each. They have an estimated life of 8 years and an expected ultimate trade in
value of ₱1,000 each. Each calculating machines have been P500 each. Taxes and insurance
on all equipment is 2% of the first cost per year.
If capital cost the company about 25%, would you recommend the computer installation?
 3. It is desired to determine the present economic value of an old machine by considering of how
it compares with the best modern machine that could replace it. The old machine is expected
to require out of pocket cost of ₱85,000each year for 4 years and then scrapped for ₱5,000
residual value. The new machine requires an investment of ₱40,000 and would have out of
pocket cost of ₱79,000 a year for 8 years and then zero salvage value. Invested capital should
earn a minimum return of 15% before taxes. Determine the present value of the old machine.

Answer to Self-Assessment Questionnaire

1. Buy the new generating set.

2. The calculators should be replaced.
3. ₱11,200
 CE 215 – ENGINEERING ECONOMICS

MODULE 10

Chapter 10 – Break-even Analysis

Introduction

When sales generated and costs incurred within a specific period are equal, a corporation
breaks even for that period. As a result, the break-even point is the point at which a corporation
generates no net profit or loss.

A company's break-even point can be expressed in terms of dollars of sales revenue or units
produced or sold. It doesn't matter how a business presents its break-even point; it's still the point
when there's no profit or loss.

To appreciate the concept of breakeven, you must first realize that not all costs are created
equal: some are fixed, while others are variable. Fixed costs are expenses that are unaffected by the
quantity of goods or services produced by the company.

Objectives:
At the end of this chapter, students are expected to be able to:

13. Understand the concept of break-even analysis.

14. Define the break-even point.
15. Solve problems on break-even analysis using different methods.

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

An economic breakeven point for an operation occurs when total revenue equals total cost.

Which maybe solve for x, the break-even point.

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

𝑻𝑹 = 𝒑𝒓𝒊𝒄𝒆/𝒖𝒏𝒊𝒕 𝒙 𝒏𝒐 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒔𝒐𝒍𝒅

 Total cost consists of fixed cost and variable cost. Fixed costs remain constant over a wide
range of activities as long as the business does not permanently discontinue operations, but variable
costs vary in total with the volume of output, Thus at any output, total cost is

𝑪𝑻 = 𝑪𝑭 + 𝑪𝒗

Hence to break even,

𝑻𝑹 = 𝑪𝑻

Let N = no of unit sold

𝑷𝒓𝒊𝒄𝒆 / 𝒖𝒏𝒊𝒕 × 𝑵 = 𝑪𝑭 + 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕/ 𝒖𝒏𝒊𝒕 × 𝑵

Therefore, N is the break – even point.

BREAK-EVEN CHART

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

the quantity of production at which the income is equal to total cost. It is the intersection of the
income line and the total cost line on the break-even chart.

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

Example

Two alternatives are being considered for the production of a particular part for which there is a long
term demand. Machine A cost ₱50,000 and is expected to last 3 years and have a ₱10,000 salvage
value. Machine B cost ₱75,000 and is expected to last 6 years and have a zero salvage value. Machine
A can produce a part in 18 seconds; Machine B requires only 12 seconds per part. The out-of-pocket
hourly cost of operation is ₱38 for A and ₱30 for B. monthly maintenance costs are ₱200 for A and
₱220 for B.

If interest on invested capital is 25%, determine the number of parts per year at which the machines
are equally economical. If the expected number of parts per year is greater than this break-even
quantity, which machine would be favored?

Algebraic Solution

Let N = number of parts per year for equal costs

By the Annual cost method

Machine A:

Annual costs:
₱50,000 − ₱10,000 ₱40,000
Depreciation = = = ₱10,492
𝐹/𝐴, 25,3 3.8125
Maintenance = ₱200(12) = ₱2,400
18
Operation = 38(− )(N) = 0.19𝑁
3,600
Interest on Capital = ₱50,000(0.25) = 12,500
Total Annual Cost = ₱𝟐𝟓, 𝟑𝟗𝟐 + 𝟎. 𝟏𝟗𝑵

Machine B:

Annual costs:
₱75,000 ₱75,000
Depreciation = = = ₱6,661
𝐹/𝐴, 25,6 11.2588
Maintenance = ₱220(12) = ₱2,640
12
Operation = 30(− )(N) = 0.10𝑁
3,600
Interest on Capital = ₱75,000(0.25) = 18,750
Total Annual Cost = ₱𝟐𝟖, 𝟎𝟓𝟏 + 𝟎. 𝟏𝟎𝑵
Equating total annual cost,

₱𝟐𝟓, 𝟑𝟗𝟐 + 𝟎. 𝟏𝟗𝑵 = ₱𝟐𝟖, 𝟎𝟓𝟏 + 𝟎. 𝟏𝟎𝑵

𝑵 = 𝟐𝟗, 𝟓𝟒𝟒
Machine B will be more economical for number of parts more than 29,544

GRAPHICAL SOLUTION

Machine A:

Fixed cost = ₱25,392

Variable costs = ₱0.19𝑁
When N = 50,000 parts

Variable costs = (0.19)(50,000) = ₱9,500

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱25,392 + ₱9,500 = ₱34,892
Machine B:

Fixed cost = ₱28,051

Variable costs = ₱0.10𝑁
When N = 50,000 parts

Variable costs = (0.10)(50,000) = ₱5,000

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = ₱28,051 + ₱5,000 = ₱33,051

Break-Even Chart
40

BE ₱34,892
₱33,051
30
Fixed costs (Machine B) ₱28,051
₱25,392
Costs x ₱1000

20

10

0 10 20 30 40 50

No. of parts x 1000

Break-even point = 29,500 parts (approximately)

Example

Two electric motors are being considered to power an industrial hoist. Each is capable of providing
100 hp. Pertinent data for each motor are as follows:

Motor A Motor B
Investment ₱25,000 ₱32,000
Electrical Efficiency 84% 88%
Maintenance per year 400 600
Life, years 10 10

Money is worth 20%. If the expected usage of the hoist is 700 hours per year, what would the cost of
electrical power have to be before Motor A is favored over Motor B?

Solution

Let x = cost of electrical power for both motors to be equally economical

Motor A:
Annual costs:
₱25,000 ₱25,000
Depreciation = = = ₱963
𝐹/𝐴, 20%, 10 25.9587
100(0.746)(700)x
Power = = ₱62,167x
0.84
Maintenance = = ₱400
Interest on Capital = ₱25,000(0.20) = 5,000
Total Annual Cost = ₱𝟔, 𝟑𝟔𝟑 + ₱𝟔𝟐, 𝟏𝟔𝟕𝐱
Motor B:

Annual costs:
₱32,000 ₱32,000
Depreciation = = = ₱1,232
𝐹/𝐴, 20%, 10 25.9587
100(0.746)(700)x
Power = = ₱59,341x
0.88
Maintenance = = ₱600
Interest on Capital = ₱25,000(0.20) = 6,400
Total Annual Cost = ₱𝟖, 𝟐𝟑𝟐 + ₱𝟓𝟗, 𝟑𝟒𝟏𝐱
₱6,363 + ₱62,167 𝑥 = ₱8,232 + ₱59,341 𝑥
𝑥 = ₱0.6614 𝑘𝑤ℎ
Motor A will be more economical for electrical power cost less than ₱0.6614 per kWh.

BREAK-EVEN CHART FOR BUSINESS ENTERPRISE

I

V
Profit
Cost and Revenue

Break-even point

Variable costs

Loss
C’ C

Fixed costs

Line C’C represents

O’ the fixed costs of production. Area C’COO’C’ is the fixed costs
O region.
Units of output or percent production
Line C’V shows the variation in total variable costs since its starting point is at C’. Area C’VCC’ is the
variable costs region and area C’VOO’C’ is the total cost region.

Line OI’ represents the gross income from sales. Area O’IOO’ is the income region. Area BIVB is the
profit region and area BO’C’B’ is the loss region.

Example

The cost of producing small transistor radio set consists of ₱23.00 for labor and ₱37.00 for materials.
The fixed charges in operating the plant are ₱100,000 per month. The variable cost is ₱1.00 per set.
The radio set can be sold for ₱75.00 each. Determine how many sets must be produced per month to
break-even.

Algebraic Solution

Let x = the number of sets to be produced per month to break-even

Total income = ₱75(x)

Total cost = ₱100,000 + (₱23 + ₱37 + ₱1)x
= ₱100,000 + ₱61x
To break-even,

₱75(x) = ₱100,000 + ₱61x

x = 7,143 sets
Example

A company has a production capacity of 500 units per month and its fixed costs are ₱250,000 a month.
The variable cost per unit are ₱1,150 and each unit can be sold for ₱2,000. Economy measures are
instituted to reduce the fixed costs by 10 per cent and the variable cost by 20 per cent. Determine the
old and the new break-even points. What are the old and the new profit at 100 per cent capacity?

Algebraic solution

Income = ₱2,000 per unit

Old fixed costs = ₱250,000 per month
Old variable costs = ₱1,150 per unit
𝐿𝑒𝑡 𝑥 = 𝑜𝑙𝑑 𝑏𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡
Income = ₱2,000x
Total cost = P250,000 + P1,150x
To break-even,

₱2,000x = P250,000 + P1,150x

x = 294 units per month
Old profit = (₱2,000)(500) – ₱250,000 – (₱1,150)(500)
Old profit = ₱175,000 per month

New Fixed costs = (₱250,000)(0.90) = ₱225,000

New variable costs = (₱1,150)(0.80) = ₱920 per unit
𝐿𝑒𝑡 𝑦 = 𝑡ℎ𝑒 𝑛𝑒𝑤 𝑏𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡
Income = ₱2,000y
Total cost = ₱225,000 + ₱920y
To break-even,

P2,000y = P250,000 + P920y

y = 208 units per month
New profit = (₱2,000)( ₱500) – ₱225,000 – (₱920)(500)
New profit = ₱315,000 per month
Old break − even point = 294 units per month
Old profit = ₱175,000 per month
New break − even point = 208 units per month
New profit = P315,000 per month
Example
A local factory assembling calculators produces 400 units per month and sells them at ₱1,800 each.
Dividends are 8% on 8000 shares with par value of ₱250 each. The fixed operating cost per month is
₱25,000. Other costs are ₱1,000 per unit. Determine the break-even point. If only 200 units were
produced per month determine the profit or loss.

Solution

Example

A company manufacturing calculators has a capacity of 200 units a month. The variable costs are
₱1,000 per unit. The average selling price of the calculators is ₱2,500. Fixed cost of the company
amount to ₱150,000 per month, which include all taxes. The company pays an annual dividend of ₱12
per share on each of the 30,000 shares of common stocks.

(a) Determine the number of calculators that must be sold each month to break-even and the sales
volume corresponding to the unhealthy point.

(b) What is the profit or loss if 150 units were produced and sold a month?

(*Unhealthy point* is the sales volume at which the business will be able to pay exactly the desired
rate of dividend)
(a)Break-even point = 100 units per month

Unhealthy point = 120 units per month

(b)Profit = ₱45,000 per month

Self-Assessment Questionnaire

1. A Company is considering two alternatives with regards to an equipment which it needs. The
alternatives are as follows:
Alternative A: Purchase
Cost of equipment ₱700,000
Salvage value 100,000
Daily operating cost 500
Economic life, years 10

Alternative B: Rental at ₱1,500 per day

At 18% interest, how many days per year must the equipment be in use if Alternative A is to
be chosen.

2. Data for two 30 hp motors are as follows:

Alpha Motor Beta motor

Original cost ₱37,500 ₱48,000

Annual maintenance 1,500 750

Life, years 10 10

Efficiency 87% 92%

Taxes and insurance 3% 3%

Power cost is ₱2.00 per kwh. If money is worth 20%, how many hours per year would the
motors have to be operated at full load for them to be equally economical? If the expected number
of hours of operation per year exceeds the break-even point, which motor is more economical?

3. A small shop on Bulacan fabricates portable threshers for palay producers in the locality. The
shop can produce each thresher at a labor cost of ₱1,500. The cost of material for each unit is
₱2,500. The variable costs amount to ₱650 per unit, while fixed charges incurred per annum
totals ₱69,000. If the portable threshers are sold at ₱7,800 per unit, how many units must be
produced and sold per annum to break-even?

4. Compute for the number of blocks that an ice plant must be able to sale per month to break-
even based on the following data:
Cost of electricity per block P20
Tax to be paid per month 2
Real estate tax 3,500/month
Salaries and wages 25,000/month
Others 12,000/month
Selling price of ice 55/block
 5. A local company assembling stereo radio cassette produces 500 units per month at a cost of
P800 per unit. Each stereo radio cassette sells for ₱1,200. If the firm makes a profit of 10% on
its 10,000 shares with par value of P200 per share, and the fixed costs are ₱20,000,000 per
month.
(a) What is the break-even point?
(b) How much is the loss or profit if only 100 units are produced in a given month?

Answer to Self-Assessment Questionnaire

1. 152 days
2. 444 hours, Beta Motor
3. 25 units
4. 1,228 blocks
5. 50 units per month, ₱3,333 per month
 CE 215 – ENGINEERING ECONOMICS

MODULE 11

Chapter 11 – Benefit/Cost Ratio

Introduction

The most common application of benefit-cost ratios (BCRs) in capital planning is to assess the
overall value for money of a new project. However, because there are so many assumptions and
uncertainties that are difficult to quantify, cost-benefit evaluations for huge projects can be difficult
to get right. As a result, there are frequently a variety of possible BCR outcomes.

The BCR also doesn't indicate how much economic value will be created, so it's typically used
to get a rough idea of a project's viability and how much the internal rate of return (IRR) exceeds the
discount rate, which is the company's weighted-average cost of capital (WACC) – the capital's
opportunity cost.

In a cost-benefit analysis, a benefit-cost ratio (BCR) is a ratio that summarizes the overall
relationship between the relative costs and benefits of a proposed project. BCR can be measured in
terms of money or quality. A project with a BCR greater than 1.0 is projected to provide a firm and its
investors with a positive net present value.

Objectives:
At the end of this chapter, students are expected to be able to:

16. Understand the different methods for economy studies.

17. Learn how to justify whether an investment is good or not.
18. Solve problems on economy studies using different methods.

Discussion

The method of selecting of alternatives that is most commonly used by government agencies
for analyzing the desirability of public projects is the benefit/cost ratio (B/C ratio). The B/C method of
analysis is based n the ratio of the benefits to cost associated with a particular project.
𝑩𝑬𝑵𝑬𝑭𝑰𝑻𝑺 − 𝑫𝑰𝑺𝑩𝑬𝑵𝑬𝑭𝑰𝑻𝑺
𝑩/𝑪 =
𝑪𝑶𝑺𝑻
Benefits are advantages, expressed in terms of pesos which happen to the owner. On the other hand,
when the project under consideration involves disadvantage to the owner, these are known as
disbenefits. The costs are anticipated expenditure for construction, operation, maintenance, etc. AB/C
ratio greater than or equal to 1.0 indicates that the project under consideration is economically
advantageous.

Public projects are those authorized financed, and operated by federal, state or local government
agencies. The benefit-cost ratio method is used for the evaluating of such projects. It is also known as
the Savings-investment Ratio (SIR). It involves the calculation of a ratio of benefits to costs. A project
is acceptable when the B-C ratio, is greater than or equal to 1.0.

Definition of Terms:
Project Benefits (B) are defined as the favorable consequence to the public.

Project Cost (C) represents the monetary disbursement required of the government.

Project Disbenefits (D) represents the negative consequences of the project to the public.

Whether evaluating a project in the private sector or in the public sector time value of money must
be considered to account for the timing of cash flows occurring after the inception of the project.

Example

A nonprofit educational research organization, is contemplating an investment of ₱1,500,000 in grants

to develop new ways to teach people the rudiments of profession. The grants would extend over a
ten-year period and would achieve an estimated savings of ₱500,000 per year in professors’ salaries,
student tuition, and other expenses. The program would be an addition to ongoing and planned
activities, thus an estimated ₱100,000 a year would have to be released from other program to
support the education research a rate of return of 15% is expected. Is this a good program?

Solution

Benefit = ₱500,000 per year

Disbenefit = ₱100,000 per year

Cost = ₱1,500,000 (A/P, 5%,10) = ₱298,950 per year

₱500,000 − ₱100,000
𝐵/𝐶 =
₱298,950
The project I justified, since B/C > 1.00.

Comparing Alternatives by B/C Ratio Method

In computing the benefit/cost ratio using the equation presented above for a given
alternative, the benefits and costs used in the calculation represent the difference between the
alternatives.

Example

The routes are under consideration for a new highway route A would be located about five miles from
central business district and would require longer travel distances by local commuter traffic. Route B
would pass directly through the downtown area and although its construction would be higher. It
would reduce the travel time and distance for local commuters.

The costs for two routes are as follows.

ROUTE A ROUTE B

INITIAL COST ₱200,000,000 ₱250,000,000

Maintenance/ year ₱700,000 ₱1,100,000

Road upkeep cost/year 10,000,000 4,000,000

If the roads are assumed to last 30 years w/ no salvage value, which route should be accepted on the
basis of a benefit/cost analysis using an interest rate of 15%.

Solution

EUACA = ₱200,000,000 (A/P,15%,30) + ₱700,000 = 31.56X104

EUACB = ₱250,000,000 (A/P,15%,30) + ₱1,100,000 = 39.175X104

Incremental annual benefit = 10x104 - 4x104 = 6x104

Incremental annual cost = EUACB – EUACA=39.175X104-31.56X104=8.015x104

6 × 104
𝐵/𝐶 =
8.015 × 104
Route A should be selected for construction.

Example

Four alternatives for providing electric supply to a small town have been identified with the ff. annual
benefits and cost.

Alternative Annual benefits Annual cost

A 1,528,000 780,000

B 1,398,000 664,000

C 960,000 742,000

D 810,000 420,000

Solution

Comparing alternative A with alternative B

Self-Assessment Questionnaire

1. The DPWH is considering the construction of a new highway through a scenic rural area. The
road is expected to cost 50 million with annual upkeep estimated at 400,000. The improved
accessibility is expected to result in additional income from tourist of 7 million/ year. The road
is expected to have a useful life of 25 years. If the rate of interest is 15% should the road be
constructed?

2. Det. the B/C ratio for the ff. project.

3. Data for two alternatives are as follows:

Alternative A B
Investment 35,000 50,000
Annual benefit 20,000 25,000
Annual O&M 6,450 13,030
Estimated life years 4 8
Net salvage value 3,500 0

Using an interest rate of 20% which alternative should be chosen?

4. There are 5 alternatives for improvement of a road. Determine which alternative should be
chosen if the highway department is willing to invest money as long there is B/C ratio at least
1.0

Answer to Self-Assessment Questionnaire

1. The road should not be constructed, B/C is 0.86

2. 1.19
3. Alternative A
4. Alternative E should be the choice.