INDEX

S. No Topic Page No.

Week 1
Introduction to Engineering Economy, Physical & Economic Environment,
1 Phases in Engg. process 1
Some economic concepts, Value and utility, Interest and Interest rate, Time
2 value of money 15
3 Interest formulas: Simple and compound interest, Cash flow diagrams 30
Interest formulas for discrete compounding and discrete payments: Single
4 payment (CAF & PWF) 46
Interest formulas for discrete compounding and discrete payments: Equal
5 payment series (CAF, CRF & PWF) 54
Week 2
6 Problem solving on discrete compounding, discrete payment 65
7 Interest formulas for Uniform gradient series 75
8 Interest formulas for geometric gradient series 86
9 Compounding frequency of Interest: Nominal and Effective interest rates 95
Problem solving on frequency compounding of interest and gradient series
10 factors 108
Week 3
11 Economic equivalence: Meaning and principles of equivalence 122
12 Equivalence calculations involving cash flows 137
Methods of comparison of alternatives: Present worth, Annual equivalent,
13 Future worth, Internal rate of 145
comparison of alternatives: Capitalized equivalent amount, Capital recovery
14 with return 154
15 Problem solving on equivalence and comparison of alternatives 164
Week 4
16 Replacement analysis: Reason, Concept of defender and challenger 173
17 Proper treatment of sunk cost in replacement 184
18 Replacement because of improved efficiency, inadequacy, demand etc. 194
19 Problem solving on replacement analysis 203
20 Economic life of the asset 211
Week 5
Depreciation: Definition, Reasons, Types of property, Value time function
21 and book value 220
22 Basic depreciation methods:S 229
23 Depreciation: Declining balance switching to S 238
 Modified accelerated cost recovery system (MACRS) method of
24 depreciation, Depletion 248
25 Depreciation: Units of production method, Depletion 255
Week 6
26 Problem solving based on Depreciation and Depletion 265
27 Elements of cost: types of cost 274
28 Breakeven analysis, Effect of fixed and variable cost on BEP. 283
29 Economic order quantity 290
30 Problem solving based on Breakeven analysis and EOQ 296
Week 7
31 Cost estimation: Methods of cost estimation, Adjustment of data, Learning 302
32 cost estimating relationships 311
33 Introduction to decision under risk Criteria for decision under risk 322
34 Expected value decision making under risk 330
35 Expected variance decision making under risk 336
Week 8
36 Problem solving based on decision under risk 344
37 Income taxes: Principles and calculation of effective income tax rates 352
38 Effect of method of depreciation on income taxes 361
39 After tax economic analysis 368
40 Problem solving based on Income tax analysis 375
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 1
Introduction to Engineering Economy, Physical & Economic Environment, Phases in
Engg. process
Welcome to the online NPTEL course, Engineering Economic Analysis. I am Dr. Pradeep
Kumar Jha, Associate Professor in Department of Mechanical and Industrial Engineering, IIT
Roorkee. We will deal with this course and this is the first lecture of the course and we will
deal with introduction to engineering economy. So, first of all let us see what is the meaning
of engineering?

We all know that we have the resources available and we work on these resources and get
ultimately something which is meaningful, something which is useful for the person. So
basically, we have the materials, we have the resources on which we work. The work on the
materials by using certain procedure, by certain laws, laws of science are applied and
ultimately, we get something, some end product which must be beneficial for mankind.

(Refer Slide Time: 2:43)

So basically, we can define engineering as it is an activity in which materials are acted upon
by forces of nature for getting something beneficial for mankind. So this is the ultimate
objective of engineering activity. We have the materials and resources, we have to transform
it in different shapes and we have to get something which should be useful for the mankind,
which should be beneficial for the mankind.

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This main purpose is to get the satisfaction. Basically we have the resources or materials
which have little value for the person like us. Like the iron ore, we do not have any value for
it because it is just there and we don’t need it. But then once this iron ore is used, it is
extracted, it is further processed and we get iron or steel and we get utensils from it, it is
useful.

So basically, the work is done on that. There are laws of science applied on this and we are
giving a value to this. So basically, we have materials and the forces of nature is combined
and then we get something which is useful for mankind and the purpose is to use it and
satisfy human wants.

(Refer Slide Time: 7:26)

So purpose of engineering is to satisfy our need. So we have the need in various aspects and
by engineering activity our need is satisfied.

Now, why economics is important? In earlier days when this engineering activity started the
purpose was to get something new, to do something innovative. So the purpose was that do
something which gives you some satisfaction, which gives a value to it. Later on as the
resources were depleted, resource constraints came into picture then engineers had to think
how to economize.

So basically in today’s world, when there is energy crisis all over the world, there is stiff
competition in the market. Without keeping economics in mind, any engineering activity will
be a failure from economic point of view because any activity which is started by any
organization, it has to sustain. So economics cannot be sidelined.

2
(Refer Slide Time: 5:51)

So importance of economics in engineering in today’s world, it can be stemmed from the fact
that you might be looking at a number of companies which come into the market, give the
product of similar kind but very few still remain in the market for longer times, because
economically they are not able to sustain themselves.

Although each of the company uses the engineering principles, the laws of science, the other
principles and it gives also the products which is useful for the customer or the end users but
the only one which keeps this economics in the mind which also keeps that what customer
really wants and how they can economize the process, they can give the product at least cost,
only those companies survive and they can flourish.

And also this is a continuing process. It has to think over this again and again. So importance
of economics in engineering is quite high.

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(Refer Slide Time: 9:05)

So ultimately if you keep the economics in mind and try to define engineering, in that case
you can further redefine that engineering deals with materials and forces of nature with
economical use for the benefit of mankind.

So, economics has to be kept in mind. Without economics, the engineering activity will be a
failure. So basically there are a number of decision-making stages where you have to decide
whether this activity is required, what are the decision-making principles so that economics is
not undermined. Ultimately the objective is to earn profit for the company and giving good
satisfaction to the customers, to the end users.

(Refer Slide Time: 8:57)

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(Refer Slide Time: 9:32)

So this is how both the parties are satisfied and this deal goes on. So basically what we see is
that engineers have to work in two environments. What are those two environments? One is
that you have materials and you use the forces of nature and then ultimately you get a
product. So the material which is subjected to a number of operations using the laws of
science, then after certain operations a product is found which is the realisation of the
company.

The company had something in mind, it had the design so it worked upon this and it got this,
then it goes into the market. So this product is basically satisfying the need of the customer.

(Refer Slide Time: 12:24)

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Now the two things which are to be kept in mind are: one is where the physical laws are
applied on the material and it is saved into a certain form. So, this is a kind of environment is
known as physical environment. Engineers are typically concerned with this environment.
Their main job is to see that how they can utilize the different laws and they can transform,
they can alter the physical environment and they can give a product.

So this is the physical environment, once it comes into the market and it is used, it is used
because it has some value. The value is added to it, the value is added because of the working
on this. Because of the work or because of the alteration of the physical environment, its
value and utility is basically increased and now there are many takers for this. So, it has the
value, it has a utility and this is the environment which is nothing but it is an economic
environment.

So what we discussed earlier that in earlier days, the engineers were confining their selves to
physical part. They were thinking that their main job is to work for altering the physical
environment and other is not their job. This is the job of sales and marketing personals or the
administration but then in today’s world you have to be aware about this. In fact, this is to be
kept in mind prior to physical part.

Engineers must know what they are going to produce, what is the overall economy, what is
its life, who are their end-users, what they want and accordingly they have to alter the
physical environment. So basically if you take the total environment, the total environment is
consisting of two environments, physical environment and the economic environment.

Physical environment when you work on this expressed in terms of physical units. You apply
certain forces, you use certain volumes so all these physical units are there to basically say
that how much physically you are changing the environment. The economic environment
when you try to see what is its utility, basically that is expressed in terms of economic units,
mostly in terms of medium of exchange such as money.

So if something is transformed in such a manner that it has a good utility for certain section
of the customers, they will pay more. So in that case you have created utility more for that
segment of customers. So what we mean to say that, before this it has taken the precedence,
working on the economic environment has taken precedence over working on the physical
environment for the venture to be successful which we will discuss later.

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(Refer Slide Time: 15:15)

So that’s what I was telling, that engineers have to see that how you have to add the value,
you have to add the utility value to any product by changing the physical environment, by
altering the physical environment and the product is being accepted by the customers.

Now we talk about efficiency. When we talk about the efficiency, basically efficiency in
economic analysis, you can take it as one is physical efficiency and another is economic
efficiency.

(Refer Slide Time: 16:23)

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(Refer Slide Time: 18:43)

So if we talk about physical efficiency, physical efficiency will be expressed in physical units
and this will be something defined by output by input. So basically we are dealing with
altering the physical environment. Ultimately we have the outputs and inputs in terms of
physical units, maybe in terms of watts, in terms of joules, in terms of velocity, there are
many physical units in that. So physical units once they are divided output by input, that is
known as physical efficiency and it is less than one. So efficiency will be always less than
100 % here.

When we talk about economic efficiency, economic efficiency means you are getting the
ratio worth to cost. What is the worth and how much it cost it to you? So in that case it has to
be more than 100% for the venture to be successful. So for any venture to self-sustain the
economic efficiency has to be more than 100%. If the economic efficiency will be less then
100%, in that case, that economic venture cannot sustain.

So, economic efficiency has to be more than 100% for the venture to be successful. We can
have the example of any plant where if you would look at the physical efficiency, if we
convert any raw material, if we burn the coal and try to get the steam, in that process, the
efficiency which is measured in terms of the physical efficiency that is normally quite less
than 100%.

But if you talk overall, about in what price we had taken the coal and what is the ultimate
output, maybe the steam or the electricity, in that case we will talk about the economic

8
efficiency and ultimately you will you must have the efficiency more than 100% so that you
can run your plant. So this is how you have the two efficiencies defined.

(Refer Slide Time: 19:39)

Now we will talk about different phases in engineering process. So the different phases in
engineering process, we mean by this is that as we have the discussed that when we have the
materials, we have the forces of nature, they work on it and basically you get an end product
which has the utility. What we also discussed is that this economic perspective should come
first, you must know what you need.

(Refer Slide Time: 25:15)

9
So basically in the economic terms or economic analysis terms, it is better, first of all you
should know what is your objective? So first of all you have the market service, you try to see
what people need then only you can proceed. So suppose you need a pen which should be
light, people may have the feeling that they need a pen which should be quite light and what
is the number of users, how many people want that.

Similarly, use of automobiles, what kind of automobiles people prefer at this stage? So all
these things, that is basically the requirement of the person. So first of all for that you have to
have a proper process to know what is your objective.

You have to set your objective and for that you need to have an R&D section, a section which
goes into the market, tries to find what are the emotions of people, what they need, what are
the changes in their thought processes, how to use the material. So first of all you will see
what is the objective, then the thing is that how you will attain this objective. So for that you
have to identify the factors.

So what are these factors? Now once you have set the objectives, certainly the objective
cannot be achieved easily. There will be some factors which are coming in the way of
obtaining the objective. So there is an factor known as limiting factor. The limiting factor is
the one which is coming in the way of attaining the objective. So, the factors coming in the
way of attaining objectives.

So you have to define what are the limiting factors? Once you have located the limiting factor
then the factor on which you can work so that you can overcome this, that is known as
strategic factor. So basically this factor can be altered, those factors which can be altered, so
that you get the desired objective, they are known as strategic factors. Now once you have
located the limiting factor and further the strategic factors. So ultimately you came to a point
where you know the factors, that is strategic factors on which you should work to find the
objective. Now there are many ways by which the strategic factors can be worked upon. So
these ways or these means are to be seen. So you have to identify the ways or means. So there
are many ways by which you can work on these strategic factors and you can get the work
done.

Now among them, there will be some ways or all the ways which basically are governed by
the principles of engineering or they apply the laws of science, they are known as engineering

10
proposals. So basically they are nothing but they are proposals. The way you are working on
the strategic factors, you get different proposals.

Now the proposals which uses the engineering principles, they are the engineering proposals.
So engineers have basically to see what are the kind of engineering proposals, in what way
you can get the work done, you can get rid of the strategic factors, you can work on them and
you can get the objective. So ultimately you get a large amount of proposals or engineering
proposals.

(Refer Slide Time: 28:08)

You have to evaluate, you have to compare the different engineering proposals which are
coming here. Once you compare, while comparing the main factor is to keep the cost in mind.
That particular engineering proposal will be called the best one where you attain the objective
at the minimum cost.

So that will be basically your final engineering proposal which you should use. For that
basically you have to use decision-making tools. Which are the engineering proposal you
should go for? Which will give you the best result at least cost? That has to be decided by a
expert in that particular area.

So there are different kinds of analysis tools by which you can analyse, you can predict about
it and ultimately you can suggest that which of the engineering proposal is the best one. So
that’s how the different phases are there in the engineering process.

11
(Refer Slide Time: 28:49)

Next is engineering using life-cycle approach. The meaning to this is that, as we have seen
that there is more and more competitiveness in the market, there has to be an approach which
talks about the life cycle of the product. What does this mean? Basically, you do anything,
you create something when there is a need. Once the need is realized, then basically you find
a preliminary design, you develop a very basic design of it. How to get it? Further, there will
be experts in that particular area which will again discuss about the consequences and they
will have a detailed design. Then there will be construction process, once you have detailed
design ready, you will have construction of the product and then the product will be ready, it
will go into the market for use.

Once it goes in the market for use, the feedback is taken back, how the product is performing,
what will be the life expected for this product. There will be associated changes in the design
if required or not so in this process goes. And in between it also looks for its disposal when
the company feels that okay it has done its work. The customer feels that they need further a
change in the design then they further go for its disposal, a new design comes.

12
(Refer Slide Time: 33:55)

So basically it is a cycle, in cyclic way it goes on, so that is known as the life cycle, product
life-cycle. So we can have some idea about this. Once we have the need which is felt by the
customer, then you have a preliminary design further you make one detailed design and
analysis then after that you go and construct the product, so construction of product. Now,
product goes into the market for its use, phase out disposal.

Now you have to be aware about this cycle. When you feel that what will be basically the life
of this product, when you need to see that this product now either needs a revision or it needs
to be disposed, the company should see that this product should go away from the market.
Means there is a life of certain product that is known as the product life-cycle approach. So in
that case this phase is known as acquisition phase and other phase is known as utilisation
phase.

So during this process, the product acquisition has taken place, product has come into the
market, once it has gone into the market, it will be used, depending upon its market service,
the feedback by the customers. Further a life is seen, such like you see, we have pen, we used
to have the pen for years, now do not have want to have the pen for years. We take it and
leave it in two months.

The thing is that it is based on the emotional need, people want a pen with some different
design every time. So we have to see that what should be the changes, whether we should go
more for its stubbornness or should go for its aesthetic appearance that basically defines what

13
should be the time of phase out and disposal. So if this aspect is kept in mind by the
engineers, then that venture will be successful.

So we have understood about the concept of economy, the concept of the different stages of
the engineering process, finally, how to see the engineers, the product life-cycle, all this
things in our lecture. Thank you.

Keywords:

Concept of economy
Physical and economic environment
Physical and economic efficiency
Different stages of the engineering process
Product life-cycle

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 Engineering Economic Analysis
Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology, Roorkee
Lecture 2
Some Economic Concepts, Value and Utility, Interest and Interest rate, Time Value of
Money
Welcome to the introduction of economic concepts in engineering economic analysis. In this
class, we will study about some of the economic terms and we will see what they mean in
engineering economic analysis. First of all let us discuss about the value and utility.

(Refer Time Slide 0.45)

Value is a measure of the worth that are person scribes to a good or a service. The value of an
object is inherent not in the object but in the regard that a person has for it.

Now on the other side, utility is measure of the power of a good or a service to satisfy human
wants. Basically value and utility they are related to each other. The utility that an object has
for a person is a satisfaction he or she derives from it.

So you can say value is an appraisal of utility in terms of medium of exchange. So if you
have more utility for a substance you try to give more money for it, you try to pay more
money for it and that is why it is said that you have this in terms of medium of exchange such
as money.

Now evaluation of utility of various items is not ordinarily constant, but it may be expected to
change. Basically the utility of an item will be changing. The utility of a cloth which is to be

15
used in the winter season, its utility will be less in the summer season. So basically with time,
utility of any object changes.

Further, same goods and services can be having different utility by different person. The
same goods which I am giving more utility another person may not give that much utility or
importance so that is why utility is changing from person to person. Now what happens that
this basically leads to exchange of the goods.

So it is said further that possibility of exchange occurs when each of the two persons
possesses utility desired by the other. So it means the two persons are there who have to
exchange. Now they see what utility they have, one person has to leave the object and the
other person has to accept the object. And in that case, the exchange may occur.

All that has utilities, be it tangible or intangible, is physically manifested. It means that
whatever be the item, if it has utility, it is basically seen. Just like any item, automobile or
you say house, if it is having utility you can clearly see that it is useful for someone.
Somebody can pay some amount to buy it for satisfying his wants or emotional needs.

Now it may be either tangible or intangible means it may be item such as music like an
intangible quantity because for music also you pay something, it is pleasant to ears.

Utility can be increased by altering physical condition. Now what happens, if something has
certain utility it can be increased by changing its physical condition. You can work on it and
you can increase its utility so its utility will be more in future.

16
(Refer Time Slide 4.20)

Now we will discuss about two types of goods which are used in economic analysis.
Basically we encounter with two types of goods - consumer goods and producer goods.
Consumer goods are the one which directly satisfy your wants, you are the direct part of this
product. You directly involve yourself. So two classes of goods are recognized that is
consumer and producer goods.

Consumer goods are the goods and services that stais that satisfies you directly. Whereas the
producer goods are the goods and services that satisfy human wants indirectly as part of the
production or construction process. So basically if you use the fridge, it gives you direct
satisfaction. When you use the cold items, you get direct satisfaction. But the parts which are
used to make a fridge, they are producer goods. So basically producer goods are means to the
end. And consumer goods you are directly using to satisfy your wants.

Utility of consumer goods is primarily determined subjectively, while the utility of producer
goods is considered usually objectively. It means that if you have certain consumer goods, if
you want to have the feeling of suppose music, that is subjectively decided. Now for getting
that music suppose you need to press 10,000 of bits or 10,000 of keys, now these are the
producer goods. So basically that is objectively decided only when these 10,000 keys will be
pressed you will hear that particular music which will satisfy your ear, you will be satisfied.
So that is why it is written that utility of consumer goods is primarily determined
subjectively, while for the producer goods it is objectively. You have to objectively define
what you want then only you will get the consumer goods.

17
(Refer Time Slide 6.32)

So now we will see how this exchange occurs. What we see that economy of exchange occurs
when utilities are exchanged by two or more people. We have already seen that when two
persons in business feel that they have utilities, both by exchanging, then only exchange
occurs. Now exchange occurs because of mutual benefit in exchange. What does it mean?
This means that both the persons should feel that they are benefiting by this exchange. Also,
the buyer and seller, the two parties which are there in the exchange process, their perspective
is different.

(Refer Time Slide 8.50)

18
(Refer Slide Time 9.38)

Suppose a buyer is there, he is giving money to the seller, who is giving the object. Now, the
buyer must feel that the utility of money. So from buyer’s point of view, he should feel that
the money which he is paying for the object, its utility is lesser than the object which he is
getting. So from his point of view, utility of money paid by him is smaller than the utility of
the object.

So only when this condition will be satisfied, the buyer will go for exchanging. Similarly,
from the seller’s point of view, now seller will think in his own way he will see that what he
is getting by selling his object. Now he must feel that whatever he is getting, the money, its
utility should be more than the utility of the object which he currently possesses. So for him,
utility of object which is with him is smaller than money he gets from buyer.

So this is known as the perspective of buyers and sellers. Both must feel that they are
benefiting and that is why it is said that it is there should be mutual benefit in the exchange.
Unless both feel that both are benefited, this exchange process cannot occur.

19
(Refer Slide Time 10.02)

Now next is how to enhance, how to increase the possibility of exchange. So for that, there
should be persuasion in exchange. Many a times you are not in a position to go for buying
something so basically there should be a persuasion. Persuasion means a person is there who
is persuading you who is showing you the dreams so that in future you can go for purchasing
that item. It will serve your purpose, it will satisfy your wants.

That is why it consists of taking a person on excursion into future in an attempt to show or
demonstrate the consequences if person acts in accordance. So that is why once he is
persuaded. Earlier he felt that the object had not much of the utility.

But once he is shown the future consequences, the effects or the benefits what he will get in
future or the pleasure what he will get in future, then he can be persuaded to go for the
exchange process and he can take something by exchanging the money or other item.

So the purpose of economic analysis is to estimate consequences of a decision. So in

economic analysis we discuss that that if any decision is taken, if you try to exchange, what
will be the consequences, are you going to be benefited or you are going to be not.

20
(Refer Slide Time 11.41)

Now we will discuss about interest and interest rate. So as we know, interest is a rental
amount charged by financial institution for the use of money. You know that money has
earning power, it has purchasing power. So once you have money, it has earning power and
interest is that rental amount which is charged by financial institution.

Because we have different desires, we want to fulfill our goals, so we need money and we try
to take it from financial institution and for that we have to pay extra. Interest rate is the rate of
gain received from an investment. So similarly in a particular period, whatever is the interest,
on that basis we calculate the interest rate. Now interest, when we talk about, we have two
parties, one is the lender and another is borrower. One person is lending another one is
borrowing. So interest rate is taken differently for both the parties.

21
(Refer Slide Time 12.57)

How it is taken differently for both the parties? So from lender’s viewpoint, means the person
who is lending the money, now what he feels and why he is going to charge the interest? So
what may be the reason?

The first is, he may exchange money for personal satisfaction. Now if the money he has and
if he is not lending it for some purpose, he can use it for purchasing some consumer goods or
some producer goods for his own satisfaction. He can go for purchasing a car, he can go for
purchasing a house, he can go for purchasing certain theatre components. All that will give
him a lot of satisfaction, a lot of pleasure.

So basically he is not going to take the pleasure of that and that is why he is lending so he
must get some return from that. Another aspect is, he may hoard the money and gloat over it.
He can feel happy by looking at the money when he sees it. So if the money is with him and
he sees every day, he may feel the pleasure. Or he can also wait for the opportunity to use. If
the money is with him, whenever an opportunity comes, he can use it.

So it is his money, he can be happy by looking at it or he can further use it in future time.
Now he can lend the money on the condition that may or may not charge interest from the
borrower. Means, if the money is with him, either he may charge interest from someone or he
may not charge interest from someone. He can give it to someone that can give him
satisfaction. So this way a lender has a different perspective, he gives the money to a
borrower assuming all these things.

22
(Refer Slide Time 14.50)

Now what are the factors which decide the interest rate for the lender? Now the factors are
that there is certain probability, if suppose that the borrower is not repaying the loan, now he
has to be sure that certain percent there is certain probability that if the borrower is not
repaying the loan and he has certain fixed assets which he has kept with him, at least he can
get some amount from there, so there will be that component.

Next component is expense in investigating the borrower, loan agreement. While giving the
loan to a borrower, he has to do a lot of formalities, he has to go and see the borrower, he has
to make the papers, he has to do a lot of formalities. All these need cost that is money. So for
that he has to pay from his own side.

And the final thing is, adequate return. Now the thing is he can lend this money to many
options and from the different options, he can get some return. Now he has to see that he is
getting equivalent level of return if he is giving to a borrower. Basically these three factors,
are taken into account. They will be suppose X person, Y person and Z person, these all
together, basically on that basis interest rate is fixed.

23
(Refer Slide Time 16.32)

Now we will talk about time value of money. As we know that money can earn, money has
earning power. Now money can earn at certain interest rate, an amount in hand now is not
equivalent to the same amount at some point in future. So as we see that the money which we
have now, its value will be different at some point in future. That is known as time value of
money means with time the value of money changes.

(Refer Slide Time 18.35)

This relationship between interest and time gives the concept of time value of money. So we
can see that if you have some amount of money X and you go in future, 1 year, 2 year, 3 year,
4, 5, 6 to n years. After n years, this value X will be X + interest earned on it.

24
Means the money which you have now, its value is going to change. The benefit or the
pleasure which you get now, you are having certain money X, which you did not have, so you
have borrowed it from someone. You got the pleasure because you could not have got this
pleasure presently because you did not have the money. Now you have got this pleasure but
for this you have to pay certain extra that is the interest earned.

That is why, with time, the value of the money is changing. That is known as time value of
money.

(Refer Slide Time 18.43)

25
(Refer Slide Time 21.16)

Now there is different perspective for the borrower, what way he is borrowing the loan. So
from borrower’s perspective what will he looks at when he is borrowing a loan from any
lender. So, he has to follow the terms and conditions set by the lender. A borrower has not
much of the option left, he has to borrow the fund to satisfy his want. So the conditions which
are set or the terms which are set by the lender, he has to follow it.

Also, he is aware that if he is not able to fulfill those conditions, he has to face the
consequences. So he is also ready for consequences. Now next comes that at what interest
rate he is getting. So basically he has to see the interest rate on which he is borrowing. He
will have many alternatives and he will see what are the interest rates on which he can get the
amount.

Now the third and the last component is, he has to fulfill his desires at present time rather
than at a future time. Basically this is important point because most of the time we borrow
something because we want to feel the pleasure now. For that we do not have the resources so
we borrow it so that we can have our desires fulfilled now and for that we are able to pay
more at the future time.

So basically from the borrower’s perspective, this is how he looks at the interest rate and then
he goes for taking any amount from a lender.

26
(Refer Slide Time 22.38)

Now we will discuss about time value of money. What is time value of money? Time value
of money means value of money with time. As we know that money is used for satisfying our
wants, if we have money we can purchase something now and it will satisfy our wants. It has
earning power, if we have money, it will give us something extra in course of time.

It means its value is not fixed. Whatever money we have now, it will earn something and it
will give us something more in course of time. So basically it is written that because money
can earn at certain interest rate, an amount in hand now is not equivalent to the same amount
at some point of time in future. So this relationship between interest in time it gives the
concept of time value of money.

27
(Refer Slide Time 25.28)

We can see by looking at this figure that when we will try to elaborate how the time value of
money changes. If we have some amount now X and time is 0, as the time progresses 1 year,
2 years, 3 years, so after n years, the value of money, the amount which we had X, it will earn
something and its value will be X + interest earned.

So this is known as the time value of money. The money which we have now it is not going
to be fixed at some future point of time. Earning and purchasing power of money. We can
purchase any item now and the purchasing power of money will not be same at some point in
future. Now, there is effect of inflation and deflation. What happens to the interest rate when
there is inflation and deflation?

When there is inflation basically it is beneficial for the borrower. So if there is inflation, it
will be beneficial for the borrower because the value of money is anyway going to be
decreased in that particular time. So basically he has to pay some amount of less. Conversely,
if there is deflation, when there is deflation conversely there is extra burden on the borrower.

So while deciding the proper interest rate, you have to take into account the effect of inflation
and deflation. And that’s why this time value of money is important.

We will talk about other things in the next lecture, thank you.

28
Keywords:

Value and Utility

Consumer and producer goods
Interest and interest rate
Time value of money
Inflation and Deflation

29
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 3
Interest Formulas: Simple and Compound Interest, Cash Flow Diagrams
Welcome to the lecture on interest and cash flow diagrams.

(Refer Slide Time: 0:37)

So far we have studied about interest and interest rates. In engineering economic analysis,
different engineering alternatives are evaluated. These alternatives estimate amount and
timing of future receipts and disbursements. So what we have seen that something a lender is
investing and he is getting a return on it from the borrower. It means there are proposals and
from there you have different types of receipts and disbursements.

Receipts means something somebody is getting and disbursement means something

somebody is paying. So in this lecture we will study about the effect of time and interest rate
because it has to be given a importance. Effect of time as well as interest rate has bearing on
the amount which has ultimately to be paid by the borrower.

So basically we are dealing with monetary transactions. Some amount is taken by the
borrower and he has to pay the amount itself after certain amount of time. So in that both
interest rate as well as time plays an important role, ultimately what he has to pay.

Interest may be charged in different way over time by the lender. So basically the lender is
charging the interest in a different way to the borrower. So we will see how it is.

30
(Refer Slide Time: 2:02)

Again, the rental rate for a sum of money is usually expressed as certain percent of the sum to
be paid for its use for a period of one year. We have already discussed about interest rate, it is
nothing but the amount you get. If X amount is being given by the lender, then after one year
he will get X + Y, then Y is the interest. So Y will be certain fraction of X and that will be
interest rate.

Interest rates are also quoted for periods other than one year, known as interest period. So
normally this period can be one year or even different. Usually it is taken as one year and
then that way we call it as annual interest rate.

Simple and compound interest of approaches will be studied for determining the effect of
time value of money. So in this lecture we will also study the simple interest and compound
interest. There are two types of interests and how they affect the amount which is to be paid
by the borrower that will be studied in this lecture.

31
(Refer Slide Time: 3:22)

So first of all let us study what this simple interest. We all know that simple interest, it is the
interest owed upon repayment of a loan and that is basically proportional to the length of time
the principal sum has been borrowed.

So suppose a person is lending certain amount and if he is lending for four years, then he will
get certain interest. And if he is lending the same amount for eight years, he will get the
interest double of that amount. So basically that is linearly varying, in that case it is known as
the simple interest.

Simple interest calculation, as we know interest I will be P (P is the principal amount)

multiplied by n (n is the number of interest period) and i (i is the interest rate).

32
(Refer Slide Time: 5:19)

Suppose a person is lending Rs. 10,000 as P to a borrower and if he is lending it for 1 year, so
n is 1 year and if the interest rate for the one year is 16%, in that case the interest amount can
be calculated by the formula. So I will be equal to P x n x i. So P is 10000 multiplied by n
that is one year because our interest period is also one year and then interest rate is 16%, so
that a 0.16. In that case simple interest comes out to be 1600.

(Refer Slide Time: 5:41)

Now the thing is, the term this one indicates that as the length of time will increase, this
interest amount will go on increasing. If n becomes 2 years, this amount comes out to be
3200. So this way the simple interest amount will be varying as the time is increased.

33
(Refer Slide Time: 5.49)

This simple interest loan may be made for any period of time. Interest and principal become
due only at the end of the time period. So one of the characteristic of this simple interest is
that, the person or the borrower who has taken the money from the lender, he has not to pay
the interest amount in the middle period, he has to pay the accumulated interests.

Every year whatever it is accumulating, at the end of the period plus the principal sum. So
this is one of the characteristic of the simple interest.

(Refer Slide Time: 6:28)

Then now we come to compound interest. Now, what is compound interest? When a loan is
made for several interest periods, interest is calculated and payable at the end of each interest

34
period. Basically there may be conditioned by the lender that you should pay the interest at
the end of every year otherwise the lender may say that this interest amount may be
compounded or it will be added to the principal amount which is owed at the beginning of the
year again.

It means that the interest amount which is generated every year, it will go on increasing, so
that is known as the compounding of the interest.

At the end of the year, one may pay the interest when it is due or may allow the interest
accumulate until the loan is due. So there are two cases, if a person has paid certain amount
or a lender has given certain amount to a borrower, he may tell the borrower to pay the
interest every or he may say the borrower not to pay but the interest every year will be added
to the amount owed every year.

So every year amount owed will be increasing and correspondingly the interest accrued also
will be going on increasing. If the borrower does not pay the interest earned at the end of
each period and is charged interest on the total amount owed. So basically in that case,
interest is charged on total amount owed that is principal + interest. This is known as
compounding of the interest.

The interest owed in previous year becomes part of the total amount owed for this year. So
basically, if you have certain amount and at the certain interest rate at the end of first year,
you will have certain interest generated. This interest is added to the principal amount and
this principal amount + interest generated during the first year becomes the principal amount
at the beginning of the second year.

And in the second year, the interest will be a percentage of this summed amount. So now we
have discussed about the two types of compounding. In one case the interest is paid annually
and in another case, we don’t pay the interest annually, so interest is allowed to compound.
Let us see by an example, these two cases.

35
(Refer Slide Time: 8.47)

(Refer Slide Time: 13.06)

Let us assume that amount of Rs. 10,000 is borrowed by a borrower or a lender has given to a
borrower. Time n is 4 years and annual interest rate i is 20%. Now let us see how this
compounding of interest is done for the two cases.

So since we have taken four years, the year will be 1, 2, 3, 4. Now amount owed at the
beginning of the year that we can take as A. Similarly, interest to be paid of year that will be
taken as B, amount owed at the end of year we can take it as C and amount paid by borrower
at end of year that we can take as D.

36
Now we have taken Rs. 10,000, so in the beginning of the first year, you have Rs. 10,000
which is owed by the borrower. Now borrower is paying interest on this amount and this this
interest amount will be 20% of this amount and this comes out to be 2000. So ultimately the
amount which is owing at the end of first year will be 10,000+2000 and that will be 12,000.

Out of this 12,000, 10,000 the principal sum and 2000 is the interest. The condition is that we
are talking about the case when he is paying the interest annually. So basically out of this, the
interest amount 2000 he has paid. So once he has paid 2000 interest, in that case now he owes
an amount of 12,000-2000, so again it is left out to be 10,000.

So in the beginning of the second year he owes an amount of 10,000. Again he has to pay in
the second year, interest amount of 20% of this sum. Again this comes out to be 2000. So
again the total sum comes out to be 12,000 and he is paying annually the interest charged, so
2000 again he pays back. Third year again, it remains out to be 10,000, he has 2000 interest,
so amount owed at the end of the third year is 12,000, he has paid 2000.

In the fourth year, he has 10,000, 2000 is the interest, so it comes out to be 12,000 and in the
fourth year end he has to pay the complete amount that is the amount he owes towards end of
the period, so it is 12,000. So ultimately he is paying 2000 and the end of first, second and
third year and he is paying 12,000 at the end of four years.

(Refer Slide Time: 13.20)

Now let us see the second case where he is not paying the interest and interest is getting
compounded. So in that case if you look at, so this is a case where he is paying the interest
annually. Now if he is not paying the interest annually, interest is accumulated and that’s how

37
the interest amount goes on increasing every year. In that case, A, B, C and D, these amounts
will be how much, that we have to see.

(Refer Slide Time: 17:04)

So in this first case he has Rs. 10,000, Rs. 2000 is the interest generated, total amount owed
at the end of first year is 12,000 but he is not paying anything. So in the beginning of the
second year, the amount which he is owing is 12,000. This interest is compounded. Now this
interest what he has to pay in the second year will be interest rate multiplied by this sum. So
he will be 20% of 12,000 and he will be paying 2400, so this is the interest generated.

The total amount owed at the end of the second year will be 14400 and still he is not paying
anything towards the end of the second period. So after the end of second year and in the
beginning of the third year, now the principal sum comes out to be 14400. On 14,400, now he
has to pay the interest at the rate of 20%. So that comes out to be 2880. So, it will be 17280
and still he has not paid the interest.

So ultimately in the end of the third year or at the beginning of the fourth year, the amount he
owes is 17,280. On this he will be paying the 20% as the interest charge, so it will be 3456
and this comes out to be 20736. So, ultimately at the end of the fourth year he has to pay the
full amount and this amount comes out to be 20736.

So there are two ways by which he can pay the amount and both are cases of compounding
but in one case he has not paid. He has not paid the interest also at the end of the period. In
another case, he is paying the interest, so ultimately he is only paying 12,000, whereas in this
case, he is paying 20,736.

38
So what we see that this case where the interest is compounded every year and it becomes a
part of the total sum, this is a case of compound interest.

(Refer Slide Time: 17.36)

So we will discuss about the cash flow diagrams. As the name indicates, there is flow of cash
or monetary transactions that is known as cash flow. It is actual inflow or receipts and
outflow that is disbursement at different points in time that occur over the life of an
investment. So for a particular investment, during the course of time, you have sometimes
certain money either coming or sometimes the money is going out.

So when the money is coming there is inflow of money that is known as receipts. And
similarly, at whichever time you are giving the amount to someone that is known as a
disbursement. And this is known as cash flow, so cash is basically flowing either it is coming
in or it is going out.

It depends upon the point of view taken. So you have basically two persons, one is lender and
one is borrower and if we take the viewpoint of the two, it will be different. For the lender, if
he is lending some amount at a particular time, he is losing at that amount of time but at a
future time he will be gaining it but for the borrower viewpoint, at the initial time he’s
gaining something and he has to pay it in the end.

So basically whatever due is taken, it means that if for one case if it is positive, for another
that amount same will be same but it will be negative. Net cash flow at any time Ft, at any
time t that is Ft is arithmetic sum of receipts and disbursements that occurs at same point in
time.

39
(Refer Slide Time: 20:05)

So if at any time if you have a cash flow, you have time, 1, 2, 3, 4, so you may have cash
flow like this, so these are known as receipts, these are receipts and these are disbursements.
So from the viewpoint of either lender or borrower, if the money is shown as positive amount
it is receipts and if it is a negative amount, it is the disbursement.

(Refer Slide Time: 21:03)

And if at any point of time, suppose you have both receipt as well as disbursement, in that
case, the net amount will be A-B and this is known as net cash flow. So that is known as net
cash flow and if it is positive, it is known as net receipt. And if it is negative, then it is known
as net disbursement. So this way you have cash flows occurring over the span of time.

40
Then cash flow diagrams are nothing but the graphical representation of the flow of cash. The
diagram which we have drawn here, this is nothing but a cash flow diagram.

(Refer Slide Time: 21:24)

Similar to body diagram or the circuit diagram what we use. Basically it shows you that at
what point of time what was the flow of cash, what was the receipt and what was the
disbursement, so that is a cash flow diagram.

Cash flow can occur at any point of time during the year. So basically during the year it can
occur at any point of time but we will have certain assumptions that we will discuss later
when we will try to calculate the amount of compound interest or so. So basically, any cash
flow either it can happen sometimes during the third quarter, during the second month or
during the sixth month. So, to avoid any complexity it is assumed that the payment is made at
the end of the year and that is why this end of year convention is normally used. So, all cash
to transactions are placed at end of interest period.

41
(Refer Slide Time: 22:36)

Now types of cash flows. As we will see different types of cash flows. Now, there are
different types of cash flows under that we have single cash flow, let us see what it means.

(Refer Slide Time: 23:44)

So, a single cash flow means, the cash flow diagram having only once the receipt and only
once the disbursement. So you can have the cash flow diagrams as a receipt and certain
disbursement at the end of year i.e. A and B. So this type of cash flows is known as single
cash flow, where you have single receipt and single disbursement.

Example is that somebody a borrower has borrowed certain amount and what he will pay at
the end of certain period, that is an example of single cash flow.

42
(Refer Slide Time: 23:46)

Next is equal uniform cash flow, now in this case many a times what we see is that the
payment is made equally at the end of the year. So that is known as equal uniform cash flow
and the cash flow diagram for such flows are like this.

(Refer Slide Time: 24:56)

This starts from 0. So what is happening, the borrower will be paying certain amount at the
end of every year. So basically he has got certain amount from the lender but he will be
paying a uniform amount to the lender for the rest of the periods. So this is an example of
equal uniform cash flow.

(Refer Slide Time: 26:30)

43
Then we have example of linear gradient series. Under this what happens that, the amount
which is paid by the borrower, they have a linear gradient. It increases by a certain fixed
amount. So what you can see is, if he has taken certain amount, so he will pay as B, B+D, B
+ 2D, B + 3D and B + 4D. So, what we see in this cash flow diagram is that the borrower has
received amount A and he is paying B amount at the end of first year and in the subsequent
years, he is maintaining a gradient of D. A linear gradient of D is maintained, so every year
he is paying amount of D extra, so in the second year B + D, third year B + 2D like that. So
this is an example of linear gradient series.

(Refer Slide Time: 27:38)

Similarly, the next is geometric gradient series. Under this series, this linear amount will be
changing to a geometric factor. So basically in this case like that. So, basically if you have a

44
gradient factor, it will go on increasing in a geometric series. So, this is an example of
geometric gradient series factors.

(Refer Slide Time: 28:09)

And the last is irregular series, it is nothing but the there is no pattern. In irregular series,
there is no pattern. So basically you can have any amount being borrowed and it is paid and
that does not follow any rule. So such as the cash flow diagrams represent a type of irregular
series where no rules are applied. You will have to find the equivalent value by using suitable
methods.

So these are the different kind of cash flows. Thank you.

Keywords:

Simple interest
Compound interest
Receipts and disbursements
Cash flow diagram
Type of cash flow diagram

45
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 04
Interest Formulas for Discrete Compounding Indiscreet Payments: Single Payment
(CAF & PWF)
Welcome to the lecture on interest formulas.

(Refer Slide Time: 00:35)

(Refer Slide Time: 01:51)

So in this lecture, we will discuss about the discrete compounding, discrete payments. In that,
we will come across certain symbols. What does this symbol mean? So in these symbols you
have i, n, P, A and F, where i is the annual interest rate and the n is number of interest

46
periods, then P is present amount at the beginning, A whenever we will discuss this will be
equal annual payment made at the end of the year, F will be the final amount or compounded
amount.

So we will have certain points to remember that we will be following. The concept that end
of one year is beginning of the next year. So if a payment is made at the end of the year, it
means the same amount will be at the beginning of the next year. P means beginning of the
year that at present time at 0 time. F is at the end of n th year. Now occurrence of A, so what it
mean? When A and P are involved, so when A and P are involved.

(Refer Slide Time: 03:46)

If we see at the 0 time, A starts from one year. So every year end you are paying certain
amount A. When A and P is involved, P occurs at the beginning time. So this is when A and
P is involved. P represents the amount one year earlier to first time A occurs.

47
(Refer Slide Time: 05.03)

When A and F is involved, in that case A starts from the first year as usual and F will be
matching with the last A. So when A and F are involved, last A will coincide with F. This
represents the fact that you are starting the payment, the equal annual payment at the end of
first year and it goes till the end of the nth period. P represents here at the initial point and F
represents at the last time.

Now we have to discuss two types of factors, one is Single Payment Compound Amount
Factor and another is Single Payment Present Worth Factor. We will discuss what are these
factors.

Single Payment Compound Amount Factor: This is a factor, as the name indicates, it is a
factor. This factor also is represented by F by P i n. Now what is this factor? This is a factor
which when multiplied with the present amount, it will give you the future amount at some
future time. When multiplied with present amount will give you compound amount and
interest periods hence.

48
(Refer Slide Time: 10:39)

How you can find this factor, so suppose you have year 1, 2, 3, n. You have amount at the
beginning of year, you have interest earned during year and you have compound amount at
end of year. So if you have a present amount of P and interest rate is i, and there are n interest
periods. So during the first year, the interest which will be earned will be P x i. So your
compound amount at the end of year one will be P + (P x i) that is P(1 + i).

At the end of two year, in the second year, your amount is now P(1 + i) because it is a case of
compound interest. So your amount which is at the beginning of year two is P (1 + i). Now
interest will be on this amount, so this will be P(1 + i) x i. So if you add these two, it will give
you the compound amount at the end of year two. So if you add them, P(1 + i) + P(1 + i) x i
is will be P(1 + i)2.

In the beginning of the third year, you have P(1 + i)2, again you have interest accrued as P(1 +
i)2 x i, so it will come out to be P(1 + i)2 x i + P(1 + i)2 that is P(1 + i)3.

So what we see that during the nth year, at the beginning, the amount which is owed is P(1 +
i)n-1 and your interest will be P(1 + i)n-1 x i and your final amount comes out to be P (1 + i) n.
So this is nothing but the amount which will be paid by the borrower.

Now this is the factor (1 + i) n which is multiplied with the principal amount and it gives you
the final amount, the final compound amount. So that is why this factor (1 + i) n, this is known
as Single Payment Compound Amount Factor. So (1 + i) n is Single Payment Compound
Amount Factor and it is represented by a symbol that we will be practicing during the course.

49
This is represented by a symbol (F/P, i, n), means this factor, once it is multiplied with P you
will get F. So this is Single Payment Compound Amount Factor (F/P, i, n).

(Refer Slide Time: 15.08)

Let us see by an example, this factor will be useful for the calculations in the cases when an
investor has to find that if he invests amount now, what he will be getting at the end of certain
interest periods. So suppose an investor wishes to know how much we will get if he invests
now Rs. 10,000 for four years at 16% annual interest rate.

So for these cases you are given that the presently the investor is investing 10,000, so P is Rs.
10000, i is 16% and n is 4. So basically P should be multiplied with Single Payment
Compound Amount Factor that is (F/ P, 16, 4). So, value of this factor is (1 + 0.16) 4 that is
1.811. Means if the present amount is multiplied with this factor, it will give him the amount
which he will receive at the end of four years.

So P multiplied by (F/ P, 16, 4) will be F, it means F will be 10,000 multiplied by 1.811 that
comes out to be 18110. Now we are calculating this because it is a simple calculation but we
have the tables supplied for this type of discrete compounding, discrete payment for a
particular interest rate.

And we can refer these values, value of these factors which is provided at the end of the book
and directly you can get these factors and find the value of F. So this is how we calculate the
Single Payment Compound Amount Factor. We try to calculate the value of compound
amount at the end of certain interest periods.

50
(Refer slide Time: 15:55)

The next is Single Payment Present Worth Factor. Just opposite to the Single Payment
Compound Amount Factor, we have Single Payment Present Worth Factor. It is a factor
which when multiplied with some future amount will give us the present amount for the
investment.

So, as we have seen in the earlier case, a factor when multiplied with P gives you F. In this
case, it is a factor which when multiplied with F will give you P. So, suppose an investor
wants to know that how much he should invest now so that he can get 18110 at the end of
four years.

51
(Refer slide Time: 19:54)

So if investor wishes to know how much he should invest now to get Rs. 18110 four years
hence at interest rate of 16% per annum. In that case a factor should be there which should be
multiplied with the F and that should give him the present amount. So that factor is (P/ F, i,
n). So in this case we have (P/ F, i, n) that is nothing but (P/ F, 16, 4).

This factor is basically the reciprocal of the Single Payment Compound Amount Factor. This
factor is the reciprocal of Single Payment Compound Amount Factor. So (P/ F, i, n) you can
write it as 1/(1 + i)n. And this factor is known as Single Payment Present Worth Factor
because this factor when it is multiplied with F it gives you the present amount.

52
(Refer slide Time: 21:38)

So in the present case, when your F is given as 18110 and i is 16% n is 4, so (P/ F, 16, 4) will
be equal to 1/1.164. So you can calculate P as 18110 multiplied by 1/1.16 4 and this comes out
to be 10000. So what we see that this is a factor which when multiplied with the future
amount, it gives you the present amount.

So that is why it is known as Single Payment Present Worth Factor. In a nutshell, also they
are called as CAF as well as PWF. So this PWF means Single Payment Present Worth Factor
and similarly, CAF means Single Payment Compound Amount Factor.

So this is how once you know the factor values, you can find the values of P or F, either at
the present time or at some future time. Thank you.

Keywords:

Interest formula
Single Payment Compound Amount Factor
Single Payment Present Worth Factor

53
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 05
Interest Formulas for Discrete Compounding and Discrete Payments: Equal Payment
Series (CAF, CRF & PWF)
Welcome to the interest formulas on equal payment series factors. So in this lecture, we will
try to find the factor calculations for equal payment series.

(Refer Slide Time: 0:38)

Many a times we deal with situations when we have to make equal year end payments, they
are also known as annuities. Now we have equal payment series compound amount factor.
This is a factor which when multiplied with amount A that is the equal year end payment, it
will give you a future amount.

54
(Refer Slide Time: 2:10)

So you can define this equal payment series compound amount factor. It is a factor, when
multiplied with equal year end payments, gives a compound amount at some future time. So
it means that you know the equal year end payments, you know the interest rate and also you
know the interest period and once you know that, you wish to calculate the value of final sum
that is F.

(Refer Slide Time: 2:34)

55
(Refer Slide Time: 04:15)

So, the cash flow diagram for the case is shown above. So, you have n years, now every year
end you are paying certain equal year end payment that is denoted by A. A is also termed as
annuity. Now once you deposit this amount at every year end, them what amount of F it will
lead at the end of n years. So this factor is basically (F/A, i, n).

Means this factor when it is multiplied with A, it will give you F. Now, how to get this
factor? Now if you look at the diagram, what you see is that the contribution of A, which is
made at the end of nth year, it is A itself because you are drawing the amount at that time
itself. So its contribution is A itself. The contribution of A which is made at the end of (n –
1)th year , this is nothing but A x (1 + i), where i is the interest rate.

56
(Refer Slide Time: 06.32)

Similarly the contribution will go on changing, the maximum contribution will be the equal
year end payment made at the end of first year. So what you can see in a nutshell that the
contribution is end of year, 1, 2, 3, to it go up to n, we are contributing contribution as every
time we are giving A. Contribution towards F.

So, at the end of nth year the contribution of this A will be A itself. At the time (n – 1), the A
payment which is made, its contribution will be A x (1 + i). So this will go on and this will be
A x (1 + i)(n – 1). So, what we see that we have deposited the equal annual amount A towards
the end of the year, for continuously for n years and we wish to draw F.

(Refer Slide Time: 08:00)

57
Now, this F is nothing but the sum of all these quantities. So it will be A + A x (1 + i) + A x
(1 + i)2, it will go upto A x (1 + i)(n – 1). From this, this is basically a geometric progression
series, GP series whose first term is A and the common ratio is (1 + i).

So, we can write F is nothing but A x [(1 + i) n – 1] / i. So what we have seen that F is A times
this factor.

(Refer Slide Time: 08:23)

This factor when multiplied with A gives you F that is why this factor [(1 + i) n – 1]/i, this is
known as equal payment series compound amount factor.

So this is used for the problems when we are to calculate what amount will be deposited at
the end of suppose 20 years when the interest rate is suppose 10% and you are depositing
every year an equal amount of suppose say 10,000. So in that case 10,000 will be multiplied
by a factor (F/A, i, n). So in this formula we will put the i and n and we will calculate the
factor values. This is the equal payment series compound amount factor.

58
(Refer Slide Time: 09:12)

Next is equal payment series sinking fund factor. This factor is basically the reciprocal of the
previous factor. In this case, basically depositing certain amount every year end so, that you
get something at the end. If you see in the earlier case basically you know A and you find F,
so the factor will be multiplied with A and you will get F.

Whereas, in this factor you know F, you have some target that you need some amount in the
future, for getting that amount how much you should deposit now onwards every year end.
So it is known as equal payment series sinking fund factor.

(Refer Slide Time: 12:40)

59
So our next factor is Equal Payment Series Sinking Fund Factor. It is a factor where basically
you know the F, i.e. the final compound amount known to you, when multiplied with, gives
you the equal year end payment to be made by you.

So basically you are keeping aside certain equal amount every end so that you get certain
compounded amount F at the nth year end and that is why this factor is the reciprocal of equal
payment series compound amount factor. This factor is denoted by (A/F, i, n). So we have got
the expression for (F/ A, i, n), and (A/F, i, n) will be reciprocal of (F/ A, i, n).

(Refer Slide Time: 13:12)

And (F/A, i, n) we have developed as [(1 + i) n – 1]/i, so this will be i/[(1 + i) n – 1]. So this
factor is known as equal payment series sinking fund factor.

60
(Refer Slide Time: 13:19)

The next factor is Equal Payment Series Capital Recovery Factor. Equal payment series
capital recovery factor means you know the capital which you have at present, this capital
will earn interest over time. Now what should be the equal year end payment you should get
in the future so that the capital which you have, the present aid which you have and also the
interest which it earns, all is exhausted over n interest period.

This factor when multiplied with P that is your present investment cost, it will give you the
equal year payment or equal year end income for you. So it is called equal payment series
capital recovery factor and that is why its symbol is (A/P, i, n) means the present worth of the
capital P when multiplied with this factor gives equal year end payments for the life of the
investment so that the capital amount P and interest earned on it is fully recovered.

61
(Refer Slide Time: 18:12)

So this is the meaning of equal payment series capital recovery factor. Now we have seen that
F/A is [(1 + i)n – 1]/i that is F = A x [(1 + i) n – 1]/i. Now we have to find the expression for A
in terms of P. We know that F is P x (1 + i)n. So we get P x (1 + i)n as A x [(1 + i)n – 1]/i.

Now we have to find A/P. So, P should be multiplied with this factor. So what will happen, A
will be equal to P x [i x (1 + i)n]/[(1 + i)n – 1].

Means the factor which is coming here, when multiplied with your present investment, it
gives you the equal year end payment and that is why this factor is known as equal payment
series capital recovery factor.

62
(Refer Slide Time: 18:29)

Now, the next type equal payment series factor is Equal Payment Series Present Worth
Factor. Now in this case, basically you try to find the present worth and you know A. So
basically what investment you should do now, so that you get a known value of equal year
end payment for the n years and the factor which will be multiplied with that known quantity
of equal year end payment that will give you the present investment cost.

So, this factor when multiplied with known value of equal year end payment, will give the
present cost of the investment. That is why, this is known as equal payment series present
worth factor, means you are calculating the present worth value and you know i for a
particular time period n.

Now earlier we have seen that this is basically reciprocal of equal payment series, the earlier
one which we have discussed, Equal Payment Series Capital Recovery Factor. In that case we
knew P and we had to calculate A, in this case, we know A and we have to calculate P. So
basically it is reciprocal of Equal Payment Series Capital Recovery Factor.

63
(Refer Slide Time: 22:15)

So this factor is reciprocal of Equal Payment Series Capital Recovery Factor. It is denoted by
(P/A, i, n). We already know the value of A, we know the interest rate and we also know the
number of interest periods, that is why (P/A, i, n), it will be the reciprocal so it will be [(1 +
i)n – 1]/[i x (1 + i)n. And this is the equal payment series present worth factor.

So, basically we have understood the four different factor values which are applicable
whenever there is a equal payment series, it is also known as uniform series because you are
paying the amount uniformly over the interest periods and that leads to a certain value of
either F or P or so. So in that case we have these four types of factor values.

In the next lecture we will discuss about the problems based on these factor values. Thank
you.

Keywords:

Equal Payment Series Compound Amount Factor

Equal Payment Series Sinking Fund Factor
Equal Payment Series Capital Recovery Factor
Equal Payment Series Present Worth Factor

64
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 06
Problem Solving on Discrete Compounding, Discrete Payment
Welcome to the lecture on problem solving based on interest formulas. In this lecture we will
try to solve problems numerical problems based on the factors of interest what we have so far
study and try to solve it. Let us see the first example.

(Refer Slide Time: 1:04)

Ex. A person 35 years old is planning to invest an equal sum of Rs. 10,000 at the end of every
year for the next 25 years starting from the end of the next year. The banks gives 20% interest
rate, compounded annually. What amount will he get when he will be 60 years old?

So as it indicates, basically we are going to discuss the problems based on equal payments
series factors or uniform series factors.

We have already solved one problem based on single payment series present worth factor and
single payment series compound amount factor. So, we will discuss the problems based on
equal payments series or uniform series factor. Now, let us see in this problem, basically a
person is investing Rs. 10,000 equal sum at the end of every year.

65
(Refer Slide Time: 04:31)

In this problem

A = 10,000.

Then this amount he is depositing for the next 25 years, so n =25

Starting from the end of the first year and the bank is giving 20% interest rate. i = 20% = 0.2.

So, before solving the problems based on these interest factors, it is advisable first of all to
draw the cash flow diagrams. Now, as you know here you have to find the future amount that
is what amount he will get. So you are trying to get F.

So, you need to know a factor which when multiplied with A gives you F. This is a factor
nothing but (F/A, i, n) and we have also termed it as equal payment series compound amount
factor. The cash flow diagram will look as shown in figure.

66
(Refer Slide Time: 06:12)

Starts from 0, 1, 2, 3 and it moves to 25. So every year and he is depositing an equal amount
of Rs. 10,000 and in the end he will get F. So this F for that we know that

F [(1 + 𝑖)𝑛 – 1] [(1 + 0.2)25 – 1]

( , i, n) = = = 471.98
𝐴 𝑖 0.2

So, this is the value of equal payment series compound amount factor. Now this factor is to
be multiplied with the amount 10,000 and it will give you the amount which will be
accumulated at the end of 25 years. So,

F = A x 471.98 = 4719800.

(Refer Slide Time: 07:58)

67
So, the person who is depositing Rs. 10,000 at the end of every year for 25 years at a 20%
interest rate which is compounded annually, he will be able to deposit 4719800 at the end of
25 years. So, this is how we come to say we have used this equal payment series compound
amount factor in this problem. Now, we will move to the problem number two.

(Refer Slide Time: 08:11)

Ex. A company has to replace its present facility after 15 years at a cost of Rs. 1,500,000. It
plans to deposit an equal amount at the end of every. What equal amount should he deposit at
the end of every year for the next 15 years at an interest rate of 18% compounded annually to
meet the cost?

Now, the aim is that what amount they should deposit every year end or what equal amount
he should deposit every year end so that at the end of 15 years he is able to get Rs. 1,500,000
and he can upgrade the facility of his industry or his company.

As usual first of all it is better to draw the cash flow diagrams.

(Refer Slide Time: 12:47)

68
So we will draw the cash flow diagram first (refer the figure). Now for that, what amount (A)
this company should deposit now every year end. So,

F = 15,00,000, i = 18% per annum = 0.18 and n is 15.

So, this is a case of equal payment series sinking fund factor, where the company is setting
aside a certain amount every year so that it is getting some known amount at the end of n
years i.e. 15 years and that is why equal payment series sinking fund factor that is (A/F, i, n)
will be used.

A i 0.18
( , i, n) = = = 0.164
F [(1 + i)𝑛 – 1] 1.1815 – 1

(Refer Slide Time: 14:49)

69
So, this factor when multiplied with F that is 15,00,000 will give the equal year end deposit
made by the company so that at the end of 15 years the company gets Rs. 15,00,000.

So, A = 1500000 x (A/ F, 18, 15) = 1500000 x 0.0164 = 24600

So, it means if the company deposits every year end an amount of Rs. 24,600, it is likely to
get 15,00,000 at the end of 15 years. Now, we will move to our next problem.

(Refer Slide Time: 15:13)

Ex. A bank loan to a company of Rs. 10,00,000 at 18% interest rate compounded annually is
to be repaid in 15 yearly equal installments. Find the installment amount.

Similar cases we come across our everyday life, we take a loan and we try to pay, at month
end, but suppose we are supposed to pay year end, so this represent such case.

The bank is giving the amount P at an interest rate for a number of interest periods 15.

(Refer Slide Time: 18:36)

70
So, we have to find the equal year end payment that is A. So,

P = 10,00,000, i = 0.18 and n = 15.

So, we will again draw the cash flow diagram from the banks perspective, if we look at bank
has given P today a loan of Rs. 10,00,000. Now, the bank will receive every year end a
certain amount (A) from the customer.

So, we required to find the factor (A/P, i, n) because you know P and when we will multiply
this factor with P then this will give you a required amount of A. We know,

A [i(1 + i)𝑛 ] [0.18(1 + 0.18)15 ]

( , i, n) = = = 0.1964
P [(1 + i)𝑛 – 1] [(1 + 0.18)15 – 1]

(Refer Slide Time: 20:28)

71
So this factor when will be multiplied with P, it will give us the equal year end payment.

So, A = P x (A/P, 18, 15) = 10,00,000 x 0.1964 = 196400

(Refer Slide Time: 20:50)

Means the bank has given the company a loan of 10,00,000 now and it will recover an
amount of Rs. 1,96,400 every year end for the next 15 years if the interest rate is given as
18%. Now, we will deal with another problem.

(Refer Slide Time: 21:28)

Ex. A company wants to set up a reserve which will help the company annually with amount
of Rs. 10,00,000 for the next 20 years towards its employees welfare measures. The reserve is

72
assumed to grow at the rate of 15% annually. Find the single payment that must be made now
as the reserve amount.

So if you look at this problem, the company has to set up a reserve, so company has to get the
value of P now, so that it can get annually A amount for the welfare. Here you have known
value of A equal year end payment and you have to find P. So, we use the factor (P/A, i, n).

(Refer Slide Time: 25:18)

Now, A = 10,00,000. n = 20 and i = 15% per annum = 0.15. So, as usual we will try first to
see it through a cash flow diagram. So basically the company wishes to invest certain amount
so for that it has to this is a sign of disbursement, so disbursement will be the negative side
and this so that it gets every year end the amount of 10,00,000.

So, you need to know (P/A, i, n) and this is nothing but the reciprocal of the earlier factor
which we have used.

P [(1 + i)𝑛 – 1] 1.1520 – 1

( , i, n) = = = 6.2593
A [i (1 + i)𝑛 ] 0.15 × 1.152

Now this is a factor which when multiplied with A gives you the present amount which the
company should invest.

So, P = A x (P/A, 15, 20) = 6259300. So, what we see that if the company makes a reserve
fund of Rs. 62,59,300 now and this investment earns 15% of interest per annum, in that case
the company will get every year end and amount of Rs. 1,000,000 for the next 20 years.

73
(Refer Slide Time: 27:40)

So, in this way we can solve the problems of such nature. Thank you.

74
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 07
Problem Solving on Discrete Compounding, Discrete Payment
Welcome to the lecture on interest formulas for uniform gradient series. So we have so far
discussed about the single payment series and equal annual payment series.

(Refer Slide Time: 1:36)

Now this is series where there is gradient but this gradient is linear so this is known as
Uniform Gradient Series or Linear Gradient Series. In this series basically end of year
payment is increasing linearly, means the first year and if you pay F1, the second year end F1
will be increased by a constant value that is suppose G. So this G is the gradient, this G is
uniform every year.

So, in the second year if it is F1 + G, in the third year it becomes F1 + 2G and so on. So in the
nth year end we are paying F1 + (n – 1) x G. Now in this case we have to find what is the
equivalent annual series? So, the aim is to find the equivalent annual end of year payment for
the gradient amount paid every year end.

75
(Refer Slide Time: 03:52)

The cash flow diagrams for such series is shown in figure. We have years 0, 1, 2, 3, 4, n - 1
and n. Now, we pay F1 during the first year end and increases to F1 + G in the second year. So
this G is basically the gradient. So, in the third year this amount will be F1 + 2G. Hence, in
the (n – 1)th year this amount will be F1 + (n – 2) x G and in the nth year it becomes F1 + (n –
1) x G. So, these types of series are known as uniform gradient series. As we see in this series
that F1 is constant for each year. What is varying is G every year.

(Refer Slide Time: 004:45)

So, you can represent this cash flow diagram as sum of two cash flow diagrams. In one cash
flow diagram it can be represented as equal annual payment series that is equal to F1. So it
has two part, one is the fixed amount part, another part is the gradient part.

76
(Refer Slide Time: 05:53)

In the second cash flow diagram, we can see that the gradient value is 0 in the first year. It
starts only from the second year. So in the second year its value is G and then it goes on
increasing. In the second year it is G, in the third year it will be 2G, in the (n – 1)th year it is
(n – 2) x G and in the nth year it is (n – 1) x G.

We have to find an equivalent cash flow diagram which should tell as the annual equivalent
value for the gradient series, so that is what our aim is.

(Refer Slide Time: 6:10)

Now, the gradient series has to be represented by one annual payment series. So, the gradient
series should be equivalent to the series where it has equal year end payment of amount A.

77
So, if you try to find its equivalent, basically summation of all the amounts of gradient series
amount should be summation of all equivalent amounts A, and this way we can find a co-
relationship between A and G. We will equate the total amount. Total amount at a future time
will be summation of all gradient series amounts and its equivalent value at that time and this
will be nothing but A times the factor (F/A, i, n).

(Refer Slide Time: 10:19)

So, we have to calculate the future amount at the end of year n. Now what will be the amount
at the end of year n? Using this annual payment series, we have already discussed that when
the year end equal amount is multiplied by (F/A, i, n), it comes F. This amount should be
equal to the summation of all these G.

So, G will have a value and its component or its contribution towards F will be G times (F/A,
i, 1). What we see here that the series goes like this, 0, 0, G, G + G, G + G + G, G + G + G +
G and in the nth period it will be G + G + G + G + ….G + G.

78
(Refer Slide Time: 10:45)

Now, at the year end of n, this G remains a G itself, so this G is multiplied by (F/A, i, 1).
(F/A, i, 1) is 1 itself, so this G remains as G.

(Refer Slide Time: 11:32)

G + G is nothing but its component at a future will be G times multiplied by (F/A, i, 2). So
this way it will move and it will come up to n - 1. So it will go up to G times (F/A, i, n – 1).

79
(Refer Slide Time: 11:49)

So what we have seen, the expression what we get as A x (F/A, i, n) should be equal to G
times (F/A, i, 1) that is single G. So you can write here, this is nothing but G x (F/A, i, 1).
This G will have component G x (F/A, i, 2). So, it is moving and it is going up to G x (F/A, i,
n – 1).

(Refer Slide Time: 14:41)

Now, you will find the expression and you have to equate them. So, as we have

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

80
 (𝑖 + 1) − 1 (𝑖 + 1)2 − 1 (𝑖 + 1)𝑛−1 − 1
= 𝐺( )+𝐺( ) + ⋯+ 𝐺( )
𝑖 𝑖 𝑖

Using geometric progression, we have

𝐹 𝐺 (𝑖 + 1)𝑛 − 1 𝐺𝑛
𝐴 ( , 𝑖, 𝑛) = ( )−
𝐴 𝑖 𝑖 𝑖

(Refer Slide Time: 15:27)

(Refer Slide Time: 15:37)

81
(Refer Slide Time: 19:09)

We also know that,

𝐹 (1 + 𝑖)𝑛 − 1
( , 𝑖, 𝑛) =
𝐴 𝑖

So, we have

𝑖 𝐺 (1 + 𝑖)𝑛 − 1 𝐺𝑛
𝐴= 𝑛
[ { }− ]
(1 + 𝑖) − 1 𝑖 𝑖 𝑖

Finally we are getting,

1 𝑛
𝐴 = 𝐺 [ 𝑖 − (1 + 𝑖)𝑛 − 1]

1 𝑛
The factor [ 𝑖 − (1+𝑖)𝑛−1] (called linear gradient factor), when multiplied with G (constant

gradient amount) will give you the equal year end amount equivalent value. So, the factor
which is known as linear gradient series factor. Now, this gradient value can be either
positive or negative. So, once you get this gradient value you have another fixed component
that is F1.

So ultimately, your net equal annual equivalent value will be F1 + A which you have
obtained. So from here you can calculate the net value of annual equivalent payment annual
payment either it will be F1 ± A, depending upon the sign of A you get.

82
(Refer Slide Time: 21:43)

The expression can further be written in other form, you can also write this expression what
1 𝑛 1 𝑛
𝐴
you have received 𝐺 [ 𝑖 − (1+𝑖)𝑛−1]. You can also write it as 𝐺 [ 𝑖 − 𝑖 (𝐹 , 𝑖, 𝑛)].

(Refer Slide Time: 21:04)

Now, let us discuss a problem based on this type of gradient series factors.

83
(Refer Slide Time: 24:30)

Q. A person is paying in the first year end a sum of Rs 20000 and for the next 14 years that is
up to 15 years end, the year end payment decreases by Rs 1000. What equivalent annual
payment will represent the same cash flow diagram as that of the gradient series diagram?

Now, let us see many a times we deal with certain situations where the person has paid
certain amount in the first year end and there is a change in that amount. In this case it is
decreasing and also you will be given i = 15% compounded annually.

(Refer Slide Time: 26:41)

So, given G = Rs 1000,

i is 15% and

84
n is 15.

In the first cash flow diagram, where in the first year he is paying 20,000, second year he
pays Rs 1000 less so he will be paying 19,000 like that it will come and in the 15th year he
will be paying 5000.

Basically your job is to find equivalent cash flow with equal annual payment and that is you
have to find what is A. So basically whatever value you get that will be deducted from Rs
20000.

(Refer Slide Time: 28:30)

So what you do is you use the series to find A.

1 15
𝐴 = 1000 [ − ]
0.15 (1.15)15 − 1

Suppose it comes as X then your final answer will be X amount deducted from 20,000, so
your final answer will be 20,000 - X.

So, this way you can solve such problems. Here the gradient amount is a negative amount
that is why we have subtracted it. If it is a positive amount then we will add it here it will be
20,000 + X because the line will go on increasing. So this way we calculate the equivalent
annual amount for a linear gradient series factor. Thank you.

85
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 08
Interest Formulas for Geometric Gradient Series
Welcome to the lecture on Interest Formulas for Geometric Gradient Series. We have earlier
discussed about the interest formula for uniform gradient series factors, where the amount
which is paid in subsequent years, they increases or decreases by a constant amount. Many a
times the change is in the form of percentage, which is known as a geometric gradient series
factor.

(Refer Slide Time: 1:01)

So, in this case end of year payment increases or decreases not by a constant amount but by a
constant percentage from what we have paid in the previous year. It means, if F1 is the
payment at the end of year 1, so at the end of year 2 if g is the percentage increase or
decrease, in that case the second year it will be F1 x (1 + g). In the third year, F1 x (1 + g)2. So
this way it will go on.

86
(Refer Slide Time: 03:54)

Now, in this case we have to find an equivalent cash flow diagram and we will try to find the
equivalent present worth, then we will try to find the expression in terms of the gradient
series. So, let us see how this gradient series looks like. The cash flow diagram for a gradient
series will looks as shown in figure, in the year, 0, 1, 2, 3,….. n - 1 and n. As we have
discussed in the first year you pay F1 and then there is an increase, not in a linear form. So, if
it is F1, in the second year it comes as F1 x (1 + g), in the third year it becomes F1 x (1 + g)2
because g percentage is increasing every year end. So in the (n – 1)th year it will be F1 x (1 +
g)(n -2). And in the nth year and you will be paying F1 x (1 + g)(n - 1).

(Refer Slide Time: 04:05)

87
(Refer Slide Time: 04:33)

So, for this series, we will try to have the contribution at the present time. In the first year we
are paying F1 and our interest rate is i. So, for the first year, this amount which is paid F1 at
the end of one year, its contribution will F1/(1 + i).

(Refer Slide Time: 07:29)

In the second year end, your payment is F1 x (1 + g) and it is two interest periods. So in the
second year amount paid but it will be multiplied by (P/F, i, n) that is 1/(1 + i)2. So this way
in the third year it will be F1 x (1 + g)2/(1 + i)3. So you can see that in the nth year, you are
paying F1 x (1 + g)(n – 1) and its present worth value will be F1 x (1 + g)(n – 1)/(1 + i)n.

88
(Refer Slide Time: 09:31)

So, basically if we add each of these payments contributions, we get the present worth of this
particular cash flow diagram.

F F1 (1 + g) F1 (1 + g)n−1
So, 𝑃 = 1 +1 i + + …+
(1 + i)2 (1 + i)𝑛

P will be nothing but.

F 1+g (1 + g)2 (1 + g)n

So, we can write it as 𝑃 = 1 +1 g [ 1 + i + + ⋯+ ]
(1 + i)2 (1 + i)𝑛

1+g 1
This is a geometric progression series. Let us assume that = 1+g′
1+i

(Refer Slide Time: 11:50)

89
Further, we have

1
F1 1 1 − (1+𝑔′)𝑛
𝑃= [ { }]
1 + g (1 + g′) 1 − 1
1+𝑔′

F1 (1 + 𝑔′)𝑛 − 1 F1
𝑃= [ 𝑛
]= (P/A, g’, n).
1 + g g′(1 + 𝑔′) (1 + g)

So, that will give us the present equivalent amount for this particular series. Now, let us see
the different aspects of the series. So there may be cases, what should be the value of g and
what should be the value of i, how they are matching with each other. Whether g is more than
i or g is less then i or g is equal to i. So basically that will determine the value of g’.

(Refer Slide Time: 13:47)

(Refer Slide Time: 16:13)

90
Now let us say if g’ ˃ 0,

1+g 1 1+g
We know that = 1+g′ So, if g’ ˃ 0, that means ˂1.
1+i 1+i

This will lead to the co-relation i ˃ g.

So, whenever you have i more than equal to g, g’ value will be a positive value and you can
find its value using the normal equation.

(Refer Slide Time: 18:40)

1+g
Second case will be g’= 0, in that case = 1, this implies i = g.
1+i

Now in this case, when there will be i = g, and g’ = 0.

91
 F
Since, 𝑃 = (1 +1 g) (P/A, g’, n)

And when g’ = 0, we have (P/A, 0, n). This value will be nothing but n.

So, that means when there is no interest rate, this is nothing but a cash flow diagram where
equivalent P has to be found out and you have A for n times. So, in this case if 0% interest is
there, thus P = nA.

F 𝑛
Thus, 𝑃 = (1 +1 g)

(Refer Slide Time: 21:01)

The third case is g’ ˂ 0.

1 1+g
Now in this case, since g’ ˂ 0, 1+g′ ˃ 1, that is ˃1. So, i ˂ g.
1+i

So, whenever you will have this condition, the constant percentage increase is more than the
interest rate, in that case you g’ will come as negative.

92
(Refer Slide Time: 25:1)

An example you can see,

Ex. A person wishes to pay the first installment of his loan as Rs. 10,000 and he wishes to
further increase at the rate of 4% per year. The interest rate charged by bank is 12% and he
wishes to complete his payment of loan in 15 years.

In the first year, he is paying 10,000 from the banks perspective. So, bank is gaining Rs.
10,000 in the first year, and in the second year the bank will get 4% increase, bank will get
10,000 x 1.04 = 10,400. In the third year, it will be 10,000 x1.042 = 10816. So this way he
will go on increasing. So, ultimately the present equivalent amount can be found at this time
using the derived formula.

1+g 1 1+0.04
So, from the relation = 1+g′ = 1+0.12
1+i

g' = 0.077

F (1+𝑔′)𝑛 −1
So, from the relation 𝑃 = 1 +1 g [ g′(1+𝑔′)𝑛 ]we get the value of equivalent principal amount P.

These are the type of problems which can be dealt with such type of series factors.

93
(Refer Slide Time: 27:17)

We can discuss some problem solving on such series factors in our next lectures for then bye,
Thank you.

94
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 09
Compounding Frequency of Interest: Nominal and Effective Interest Rates
Welcome to the lecture on compounding frequency considerations. So far we have seen that
normally the interest is compounded once in the year that is known as compounding once in a
year. Many a times in case of loan agreements or many a times when we repay our loan, the
compounding is done more than once.

(Refer Slide Time: 2:20)

That means interest is to be paid more frequently. Normally it is in the practice that you have
to pay the interest once, that can be more than once, it may be four times, it may be six times
or it may be even daily basis. For example, interest period may vary from half of the year or
suppose that the interest rate is calculated every six month that means compounding of
interest is done twice in a year. If you do it 4 times then it is known as compounding done 4
times during the year. So basically after every quarter the interest is charged. Here it can be
on daily basis and sometimes even on continuously. So, in this lecture we will try to see how
this affects basically the interest rate if you calculate on a particular period.

So, if the interest compounding is done suppose 2 times during the year and if you take as a
whole the interest rate will be more. Normally, compounding is expressed as annual basis
with some different convention.

(Refer Slide Time: 02:47)

95
So, the actual or effective interest rate of 8% compounded each six month period. So this is
also expressed as annual or nominal interest rate of 16% compounded semiannually. So, if we
talk about an interest rate of 16% compounded semiannually means, the annual interest rate is
16% that is known as nominal interest rate but this semiannually means the interest rate is
calculated every six month.

So, effective interest rate will be (since it is done two times), we will divide by 2 = 8% per six
month period. So, this is known as effective interest rate. So, likewise suppose effective
interest rate of 4% compounded each quarter of the year you can also term it as a nominal
interest rate of 16% compounded quarterly.

So, these are the different ways by which you express the effective interest rate and the
nominal interest rate. Nominal interest rate is expressed on annual basis and is obtained by
multiplying the effective interest rate per interest period by compounding frequency per year.
So, this is the definition of a nominal interest rate and this is how you express effective
interest rate in terms of a nominal interest rate.

96
(Refer Slide Time: 04:48)

Let us see the relationship between nominal and effective interest rate.

𝑟 𝑙𝑚
𝑖 = (1 + ) − 1
𝑚

i = effective interest rate in time interval,

r = nominal interest rate per year. Since, nominal interest rate is expressed on annual basis so
that is why nominal interest rate is per year

l = length of time interval (in years) and

m = reciprocal of the length of compounding period in years.

(Refer Slide Time: 06:25)

97
So, this relationship is used to calculate the value of effective interest rate for a particular
time period or time interval. When the interest is compounded once in the time interval, in
that case “lm” becomes 1. So, in that case, effective interest rate will be calculated by
dividing the nominal interest rate with m (r/m).

Now, further we will look at different examples and we will see how this effective interest
rate is calculated when there is nominal interest rate.

(Refer Slide Time: 06:58)

So let us see some examples,

Q1. The nominal interest rate of 9% compounded monthly, the effective interest rate per
month (time interval is one month).

98
 𝑟 𝑙𝑚 𝑟 𝑐
Since, 𝑖 = (1 + 𝑚) − 1 = 𝑖 = (1 + 𝑚) − 1

“lm" is the number of compounding during the time interval. It is also expressed sometimes
in another term like c. Where, c = lm and c ≥ 1.

(Refer Slide Time: 11:06)

Now, let us see the example, you have to calculate the effective interest rate per month. It
means, in this case, your time interval is given as one month for which you have to find the
effective interest rate. So, if you express it in years it will be but 1/12. Then m is reciprocal of
the length of compounding period, so it will be reciprocal of 1/12 = 1/(1/12) = 12.

The effective interest rate i will be,

1
𝑟 𝑙𝑚 0.09 12𝑥12
𝑖 = (1 + ) − 1 = (1 + ) − 1 = 0.0075 = 0.75%
𝑚 12

So this way you calculate the effective interest rate in the time interval of one month.

99
(Refer Slide Time: 12:08)

This is also an example of that case where the compounding is done once in the time interval
that is why you can have the value as r/m directly. So, it will be .09/12 directly and you will
0.75%. So, this is also an alternate way to calculate the effective interest rate in this case.

(Refer Slide Time: 12:14)

(Refer Slide Time: 13:45)

100
Let us go to another example. Next example is,

Q2. Nominal rate of 12% compounded monthly with time interval of one year.

So in this case, your time interval is one year. So,

l = 1, m = 1/(1/12) = 12

0.12 12
Effective interest rate,𝑖 = (1 + ) − 1 = 0.1268 = 12.68%
12

(Refer Slide Time: 15:22)

So, when the nominal rate is 12 percent compounded monthly and if you take the time
interval of one year, effective interest rate is more because the compounding is 12/12 that is
1%. Effective interest rate is 1% per month, so this 1% per month when is compounded again

101
and again, after 12 compounding times, the effective interest rate over the year becomes
12.68 percent.

(Refer Slide Time: 14:53)

(Refer Slide Time: 16:54)

Q3. Nominal rate of 18% compounded weekly with a time interval of one year.

In this case, l = 1 year, r = 18, and compounding is weekly. So, m will be reciprocal of 1/52
years = 52.

0.18 52
Effective interest rate, 𝑖 = (1 + ) − 1 = 0.1968 = 19.68%
52

102
So, this is how you calculate the value of effective interest rate when the compounding is
done at different frequencies.

(Refer Slide Time: 17:14)

(Refer Slide Time: 19:35)

Q4. Nominal rate of 14% compounded monthly with a time interval of six months (c=6).

Here, r = 14% = 0.14 compounded monthly, m = 1/(1/12). Your time interval is six months.
So, l = ½, c = lm = 6.

0.14 6
Effective interest rate,𝑖 = (1 + ) − 1 = 0.0721 = 7.21%
12

103
(Refer Slide Time: 19:24)

(Refer Slide Time: 20:38)

Q5. Nominal rate of 10% compounded weekly with a time interval of six months (c=26).

Here, r = 10% = 0.10 compounded weekly, m = 1/(1/52) = 52. Your time interval is six
months. So, l = ½, c = lm = 26.

0.10 26
Effective interest rate,𝑖 = (1 + ) − 1 = 0.0512 = 5.12%
52

(Refer Slide Time: 21:10)

104
(Refer Slide Time: 21:55)

Q6. Nominal rate of 13% compounded monthly with a time interval of two years (c=26)..

Here, r = 13% = 0.13 compounded monthly, m = 1/(1/12) = 12. Your time interval is two
years. So, l = 2, c = lm = 24.

0.13 24
Effective interest rate,𝑖 = (1 + ) − 1 = 0.2951 = 29.51%
12

So, in this way you can have different type of problems and you can solve on your own.

Now, we discuss about the case of continuous compounding. So far we have seen that the
compounding is done for a finite number of times but continuous can be done infinite number
of times, large number of times.

105
(Refer Slide Time: 22:22)

So, that is known as a continuous compounding. In case of continuous compounding, since it

is done infinite number of times during the interval and reciprocal of the time during the
compounding occurs because of this, time interval becomes very-very small limiting to 0.
Then, m will be tending towards infinity. So, number of interest period per year is
approaching infinity and length of compounding periods is approaching 0.

(Refer Slide Time: 26:08)

𝑙𝑟𝑚⁄
𝑟 𝑙𝑚 𝑟 𝑙𝑚 𝑟 𝑟
So, 𝑖 = (1 + 𝑚) − 1 = lim (1 + 𝑚) − 1 = lim (1 + 𝑚) −1
𝑚→∞ 𝑚→∞

𝑚⁄
𝑟 𝑟
Since, lim (1 + 𝑚) = 𝑒 = 2.782
𝑚→∞

106
Thus, 𝑖 = 𝑒 𝑟𝑙 − 1

(Refer Slide Time: 27:06)

If we calculate effective annual interest rate, basically we are limiting l = 1. So, in that case
effective annual interest rate 𝑖𝑎 = 𝑒 𝑟 − 1

So this is how in case of continuous compounding we calculate the value of effective interest
rate over any time interval or annual value.

(Refer Slide Time: 27:41)

Now, we have seen that as the interest rates and its compounding changes, the effective
interest rate values are changing and we can see that how these effective interest rate changes
as the compounding frequency is changed, that we can see in our next lecture. Thanks.

107
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 10
Problem Solving on Frequency Compounding of Interest and Gradient Series Factors
Welcome to the lecture on problem solving based on compounding frequency and effective
interest. In this lecture we will also solve problems based on gradient series. Let us see the
first problem.

(Refer Slide Time: 00:46)

This problem is related to the gradient series.

Q1. A person is planning to save Rs 5000 from his income during this year and can increase
this amount by Rs 1000 for each of the following 9 years. At interest rate of 8% compounded
annually, what equal-annual series beginning at the end of year I would produce the same
accumulation at the end of year 10 as would be realized from the gradient series?

So basically the time span is 10 years, first year he is saving 5000 and from the next year
onwards he is increasing this saving every year by Rs 1000. So G is 1000, this is linear
gradient amount.

Interest rate is 8 percent compounded annually. So basically this is a problem which talks
about the cash flow series as shown.

108
(Refer Slide Time: 03:19)

You have a 10 year time starting from 0, 1, 2, 3 and then it will go year 9 and year 10. Now
the person is basically saving 5000 in the first year. Year end convention is followed. Second
year he will save 1000 more so it will be 6000. Third year 1000 furthermore so 7000 and this
will go on. Accumulation can be realized by annually depositing certain amount, so this
should be equal to a cash flow series which is shown.

(Refer Slide Time: 05:55)

Now what should be basically this amount A? So, in this problem what we will do is, we
have to calculate (as we have already discussed) two components, one is fixed component of
5000 deposited every year and gradient series G value of 1000.

109
Now, first of all for the gradient series, we should calculate the annually deposited (annual
equivalent) amount which will be equal to that paid by gradient series. The amount obtained
has to be added to Rs 5000. This will give basically us the final answer.

(Refer Slide Time: 07:59)

The annual equivalent value for the gradient series, we have the formula and from that we
can calculate this annual equivalent value.

1 𝑛𝑖
Annual equivalent value for the gradient series = 𝐺 [ 𝑖 − (1−𝑖)𝑛−1]

= 1000 x 3.871= 3871

The factor value comes out to be 3.8713 and G is 1000. So the value comes as 3.871. So,
your final A will be nothing but, the fixed component of 5000 + 3871.

So, A = 5000 + 3871 = Rs 8871 (Answer)

So what we see is, what amount you will deposit by depositing rupees 5000 during the first
year end and further increasing this amount every year by rupees 1000. The same amount,
can be depositing if you deposit every year end an amount of Rs 8871.

So, this type of problems can be solved by finding the component of the annual equivalent
value using the formula first and either subtracting or adding to the fixed component.

Let us go to the next problem.

110
(Refer Slide Time: 08:30)

The next problem is related to the geometric gradient series factors, we have basically
discussed two types of gradient series factors, one is the uniform gradient series another is
geometric gradient series. In the geometric gradient series the gradient is not a constant
amount but it is increasing as a percentage. What is there in this question?

Q2. Income from a company is estimated to increase by 7% per year from a first-year base of
Rs 720000. What will be the value of the present worth of 10 years of such income at an
interest rate of 15% compounded annually.

So the income is increasing every year 7% from the base, it means in this problem, it is given
G = 7% = 0.07, this is the percentage increase with respect to the first deposit.

F1 = Rs 720000, F1 is first deposit or first.

i = 15%, annual interest rate is 15%.

So, draw the cash flow diagram as shown.

111
(Refer Slide Time: 12:03)

The cash flow diagram tells that in the first year A is 720000 and it is growing further upto 10
years. So basically it has to increase as shown. Now we have to find the value of the present
worth that will be at 1 whose value is same as what you would deposit in such type of cash
flow. So, we have been i, F1 and g. So, we will use the formula for gradient series factors to
calculate the value of present worth.

We know in such case, first of all we will have to calculate g’.

1+𝑖 1.15
𝑔′ = −1= − 1 = 0.0748
1+𝑔 1.07

1 1+𝑔
Because i = 15%, G = 7%, and 1+𝑔′ = 1+𝑖

(Refer Slide Time: 14:09)

112
Now, once we calculated the g prime, the present worth value can be calculated by the
formula.

𝐹1 (1 + 𝑔′)𝑛 − 1 720000
𝑃= [ ′ 𝑛
]= × 6.8704 = 𝑅𝑠 4623072
1 + 𝑔 𝑔′(1 + 𝑔 ) 1.07

(1+𝑔′)𝑛 −1
Where, [ 𝑔′(1+𝑔′ )𝑛 ] = (𝑃⁄𝐴 , 𝑔′ , 𝑛). This we have already derived while studying the

geometric gradient series factor.

So, this is the amount which is the present worth value of such a geometric gradient series
factor.

So, in such cases what we have seen is, first of all, depending upon the value of i and g you
have to calculate g’. Once you get g’ you get the factorial value of (𝑃⁄𝐴 , 𝑔′ , 𝑛). Once you
𝐹1
calculate these, which when multiplied with will gives you the present worth of such
1+𝑔

geometric series.

(Refer Slide Time: 14:44)

113
Next will be a problem based on the effective interest, already we have solved few problems
before. Now, in this case we are required to calculate the effective interest rate.

Q3. Suppose that you make quarterly deposits in a savings account which earns 9% interest,
compounded monthly. Compute the effective interest rate per quarter.

Here, r = 9%,

You have to find the effective interest rate per quarter. It means l = 1/4 years,

Compounded monthly, it means m is reciprocal of this compounding period in years that is

m = 1/(1/12) = 12.

Now, you can use the formula of effective interest rate calculation.

1
𝑟 𝑙𝑚 0.09 4×12
So, effective interest rate, 𝑖 = (1 + 𝑚) − 1 = (1 + ) − 1 = 0.0227 = 2.27%
12

So what we see is, this is 9% interest per quarter had it been the quarterly compounding in
that case per quarter the effective interest rate would have been 9/4 = 2.25%. But the
compounding is done monthly, due to that the effective interest rate for the 3 months
becomes slightly more than 2.25% and that you get as 2.27%. So this how is you can
calculate the effective interest rate for any time interval.

Now, we will see the comparison of the interest rates when the compounding frequency is
changed. So, this problem talks about the effective annual interest rate, how it changes when
the number of periods per year or compounding frequency changes.

114
Now, let us see when the compounding frequency is annually that it is done only once, in that
case, the effective interest rate per period because it is already a nominal interest rate of 12
percent so your effective interest rate per period is 12% and what the annual interest rate also
is 12.

(Refer Slide Time: 19:25)

Now, when we go for semi-annual compounding frequency, in this case, as we do the semi-
annual compounding we are doing the compounding two times. The number of periods per
year is 2 and basically the effective interest rate is 12/2 = 6%, because 6 percent interest is
levied upon every six month. So for a period of six month the effective interest rate is 6% but
if we try to calculate the effective interest rate or for the year, in that case, it comes out to be
12.36%.

Now, how it comes? So in this case as we are doing the compounding semi-annual basis, you
have number of periods per year as 2, and l is one year, l = 1.

m = 1/(1/2) = 2.

0.12 2
So, effective interest rate, 𝑖 = (1 + ) − 1 = 0.1236 = 12.36%
2

So this is how we calculate when semi-annually interest is levied upon or interest is

calculated on semiannual basis, your effective interest rate for the year comes to 12.36
percent.

(Refer Slide Time: 21:28)

115
If you go for quarterly, in that case l = 1 year, m = 1/(1/4) = 4.
So in this case i will be calculated as
0.12 4
𝑖 = (1 + ) − 1 = 0.1255 = 12.55%
4
So, effective interest rate for the year changes from 12% to 12.36% when it is done semi-
annually and to 12.55% when it is done quarterly.

(Refer Slide Time: 23:10)

116
(Refer Slide Time: 24:02)

Further, if you go for monthly, in that case l = 1 year, m = 1/(1/12) = 12.

So, in this case i will be calculated for 1 year as

0.12 12
𝑖 = (1 + ) − 1 = 0.1268 = 12.68%
12
In this way if you go to calculate on weekly basis, in that case l = 1 year, m = 1/(1/52) = 52.

So, in this case i will be calculated for 1 year as

0.12 52
𝑖 = (1 + ) − 1 = 0.1273 = 12.73%
52
(Refer Slide Time: 24:27)

117
(Refer Slide Time: 24:31)

(Refer Slide Time: 25:27)

Similarly, if you go for daily, in that case l = 1 year, m = 1/(1/365) = 365.

So, in this case i will be calculated for 1 year as

0.12 365
𝑖 = (1 + ) − 1 = 0.12747 = 12.747%
365

118
(Refer Slide Time: 25:15)

(Refer Slide Time: 25:43)

Now if you go for compounding continuously, in that case, we know the formula for annual
effective interest rate as

𝑖 = 𝑒 𝑟 − 1 = 𝑒 0.12 − 1 = 0.12749 = 12.749%

So, what we see is how you can calculate the different value of effective interest rate and
annually the effective interest rate how it changes when the compounding frequency is
changing.

119
(Refer Slide Time: 26:05)

Next there is a question which talks about again the use of gradient series factor.

Q4. A man has purchased a new automobile. He has to set aside enough money in a bank
account to pay the maintenance on the car for the first 5 years. He will have to pay Rs 4800 in
the first year (to be paid at the end of the year) and thereafter the cost will increase by Rs
1200 every year. How much should the car owner deposit in the bank now?

So, this problem tells about the finding present amount of gradient series. We have already
discussed how to calculate the value of the annual equivalent for the gradient series that can
be used further to find the present amount for this gradient series. You can treat this problem
as then assignment problem. To solve the problem you can have the help of some of the
tables as (A/G, 5, 5) = 1.9025 and( P/A, 5, 5) = 4.3295.

The answer is 30665.

So treat this as the assignment problem and we can discuss it in the coming classes. Thanks.

120
(Refer Slide Time: 28:09)

121
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 11
Economic Equivalence: Meaning and Principles of Equivalence
Welcome to the lecture on principles of equivalence. So in engineering economic analysis we
need to find the equivalent amount at different time.

(Refer Slide Time: 00:55)

So far we have discussed about different interest factors, now the equivalence means by
definition two things are said to be equivalent when the produce the same effect. Means if we
try to compare two things which are different we cannot say that they are equivalent unless we
compare them on a certain basis. Suppose we try to find the equivalence between Rs 500 and
10 KGs of sugar, so unless we know the price of 1 KG of sugar, we cannot find the equivalence
between the two.

So, first of all we have to have a basis then only we can have the equivalence. For comparing
two different situations, the parameters to be evaluated must be placed on equivalent basis. So
basically the end effects has to be considered, if suppose there are two different things and they
have to be judged, in that case the effect they produce, they are to be seen with a common eye.

So, in engineering economic analysis, basically we used to see the cash flows at different times.
Now, we have found whether two cash flows are equivalent or what will be the equivalent
amount at a later time based on time value of money.

122
So basically, there are three things which are dictating it, one is the amount of sums. So, in any
cash flow diagram what you see is the amount of monetary transactions. Then the times of
occurrence of these sums, they may occur at same time or at different times and then the third
is the interest rate. So, all these three is to be taken into account. Now, let us see one example
where you are given an option of getting a reward from the organization.

(Refer Slide Time: 03:24)

The organization gives you two options, one is that you get Rs 50,000 now. Another option
which your organization gives you is that you get Rs 8000 per year for the next 10 years. So,
every year the payment will be made at the end of the year. So, in this case you are basically
getting 80,000 but for the next 10 years. Now, how to evaluate which of the option is better
economically?

You will have to see that what is the equivalent amount at a particular time. In this case what
we see is, as we have seen in the earlier case, you have three things, amount of sums, times of
occurrence of sums and interest rate. So, if two of the things are equal, the third thing will
anyway be equal for any cash to diagram.

If there are two cash flow diagrams and if the two of the three is same, the third has to be the
same or fixed for the two cash flow to be equivalent. If not, if the interest rate is fixed and if
the times of occurrence of the sums are different, then certainly the amount of sums will also
be different at different times. So that is how equivalence can be maintained. Now let us see
we have to judge which of the option is better.

(Refer Slide Time: 07:16)

123
So in the option one, you are getting a cash flow diagram as shown, you are getting 50,000
now and in the second option you are getting 8000 for the next 10 years. So, option 2 gives you
a cash flow diagram where every year end you are getting 8000 rupees. Now, these are the two
options which we have. They cannot be compared unless you try to evaluate the amount at a
particular time. Here you can find that you have the interest rate fixed.

The condition is that you are paying 12% interest compounded annually on a bank loan, so this
gives you a consideration of taking the interest rate. So, interest rate is taken as 12%
compounded annually. To compare these two, you have to keep the three factors in mind, as
we discussed. One is the amount of sums which is different here.

You are being paid 50,000 in the option one and you are being paid 10 times 8000 but at
different times. So certainly, the time of occurrence of sum is also different. And the interest
rate is taken as the fixed with 12%. So, if time of occurrence is taken as a fixed point, amount
should be same for the cash flow for the two options to be equivalent.

Once we fix this time of occurrence, if we find the equivalent value at a particular time, in that
case, automatically the amount of sum must be fixed for the two cash flow to be equivalent.
Now, this time can be either the present time or a future time so that you can compare. It is
better to compare using the present worth calculation.

124
(Refer Slide Time: 07:24)

(Refer Slide Time: 09:31)

So, in this case, the present worth is Rs 50,000. Now if you calculate the present worth value
of the option 2, in this case, present worth can be found out by multiplying the annual amount
(A) with the factor (P/A, i, n), where i = 12 and n = 10. This will gives you the equivalent
present worth of the cash flow series at t = 0.

125
(Refer Slide Time: 10:14)

So far, we have used the different types interest factor relationships to find these factor values
but we can now onwards use the interest tables to calculate these interest factor values. These
interest table are supplied at the back of the textbooks. However, you can calculate it on your
own in the excel. Now, how to use this table? Let us see the table for the interest factor value
of 12% for a discrete compounding.

(Refer Slide Time: 12:20)

So, in the table you have n varying from 1 to 18 and you have different factor values. In the
present case, you have to get (P/A, 12, 10). So, if you see column for (P/A, i, n) corresponding
to n = 10, you will find the value as 5.650223.

126
Hence, P = A x (P/A, 12, 10) = 8000 x 5.65 = 45200

So, in this way you have to take any value for any number of years or for any other factors.
You have to just see that which is the row and column and the intersecting point to find the
particularly value, directly from the table. Now what we see is, the two cash flows are giving
you the present worth value at a particular time, t = 0.

Now what we see here, in the option one, you are offered 50,000 whereas in the option 2 at
present you are getting a worth of 45,200. It means, option one is better for you. We can also
find the equivalent value at any future time.

(Refer Slide Time: 14:39)

(Refer Slide Time: 13:26)

127
If suppose you want to calculate the future worth of these two options. For future worth analysis
at n = 10, in first option, 50,000 will be multiplied by the factor (F/P, i, 10),

F = P x (F/P, 12, 10) = 50,000 x 3.1058 = 155290

Similarly, in the second option

F = A x (F/A, 12, 10) = 8000 x 17.548 = 140384

And after calculation you can see that, option one is better than option 2.

So, what we see that, you will have to find the equivalent value at a particular time and then
only you can compare them.

(Refer Slide Time: 15:18)

Equivalence calculation using interest formula.

Now many a times, you have to use the interest formula, in the interest formula normally we
come across the terms like P, A, F, i and n. When we go for annual compounding, we come
across these terms. If one of these is not given and other quantities are given, you can always
find that particular unknown quantity or parameter using the expression.

Sometimes interpolation may be required, when interest rate is to be determined. So sometimes

when the interest rate is to be determined, we have to use the linear interpolation formula.

128
(Refer Slide Time: 19:20)

Now let us see the first case, when we can use the normal interest relationships to find a
particular parameter.

Suppose, you have to find equivalent present sum which gives you Rs 10,000 at the end of
three years at interest rate of 12% compounded annually.

In this case as, you have to find the P value. Here you have to find P when F, i and n is known.

So, in that case you can find P by using the factor (P/F, i, n)

Where, i = 12%, n = 3 and F = 10000.

So, P = F x (P/F, 12, 3) = 10000 x 0.7117 = Rs 7117

This is the equivalent amount at present time which will give you Rs 10,000 and the end of
three years at the particular interest rate. So this is how you use these interest factors to find
one of these A, P, F, i and n from the data given to you.

129
(Refer Slide Time: 19:43)

Now next is when you have to calculate the interest, you may have to go for interpolation. Let
us see the example of this. A problem is given to you where P, F and n is given as 12,000,
21,000 and 9 years and you have to find the equivalent interest rate. So, in this case the
unknown is interest rate.

(Refer Slide Time: 21:51)

So, in this case, we have

F = 21,000, P = 12,000 and n = 9 years.

Now, F = P x (F/ P, i, 9)

130
So, (F/ P, i, 9) = 21000/12000 = 1.75

Now, although this expression is quite simple, it is nothing but (1 + i)-9, so you can directly
calculate i. However, in many cases, the relationship may be complex. So, let us see how you
can solve it using interpolation.

(Refer Slide Time: 22:42)

(Refer Slide Time: 23:22)

So, for interpolation you have to see the table in which corresponding to 9 years, you have to
find a value one value which is less than 1.75 and another value which is more than 1.75. So,
for that you will refer to the table. If we see the 6% interest table, corresponding to the 9 years
we get (F/P, i, n) = 1.6894.

131
(Refer Slide Time: 23:33)

(Refer Slide Time: 25:08)

Further, we have to see for the same number of years that is n = 9, for 7% it comes out to be
1.8384.

That is (F/P, 7, 9) = 1.8384.

So it means the real interest rate lies between 6% and 7%. So, the actual rate of interest will be

i = 6 + (1.75 - 1.69)/(1.84 - 1.69) = 6.41%.

So, this way we can use these interpolation or linear proportion methods to find the equivalent
value of interest rates.

132
(Refer Slide Time: 25:32)

Now we will discuss about some of the other principles of equivalence.

The first principle is, receipt or disbursement can be directly added or subtracted only if they
occur at same point in time. It means, if there is a cash flow and you want to find the equivalent
value at a particular time, all other receipts or disbursements, their equivalent value has to be
found at that particular time then only you can add them or subtract them.

(Refer Slide Time: 27:30)

Unless you convert them to that particular time, you cannot add them. We can understand it by
an example.

133
Suppose there is a cash flow as shown in figure. In such problems, if you have to find the
equivalent value at the present time then you cannot add these quantities directly. You will
have to convert its equivalent value at a particular time. So far, we have understood how we
can get the equivalent value of these amounts at a particular time by using the interest factors.
If the interest rate is taken as 12%, so in this case, what will be the equivalent present worth?

P = 1000 + 200(P/F, 12, 2) + 100(F/A, 12, 3)(P/F, 12, 6) + 750(F/A, 12, 3)(P/F, 12, 10)

In this case what you did is you find the equivalent value at the present time and since 1000 is
there already at the present time, you can directly add.

(Refer Slide Time: 31:18)

(Refer Slide Time: 33:47)

134
(Refer Slide Time: 33:49)

(Refer Slide Time: 36:19)

So, we see that the receipts or disbursements are added but for that you have to convert them
at a particular time in future or in the present time.

So, P = 1000 + 200 x 0.797 + 100 x 3.374 x 0.507 + 750 x 3.374 x 0.322
= 1000 + 159.4 + 171.06 + 814.82 = 2145.28

135
(Refer Slide Time: 35:19)

(Refer Slide Time: 36:43)

Next is when cash flows are converted to their equivalences from one period to another, interest
rate during each period must be taken into consideration. This we will discuss in next lecture
when we will see that how the different rates in different periods have to be taken separately
while calculating their equivalent values at a particular time. For then, thanks.

136
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 12
Equivalence Calculations Involving Cash Flows
Welcome to the lecture on equivalence involving cash flows. In the last lecture we have
discussed that receipts and disbursements can be directly added when they are calculated at the
same point in time.

(Refer Slide Time: 00:54)

Now, the next point is when cash flows are converted to their equivalences from one period to
another, interest rate during each period must be taken into consideration. It means many a
times this happens that the interest rates are changing with time, this is not a very unusual case.

When the interest rates are changing, you have to find the equivalence. Equivalent values can
be converted to a particular time where the interest rate in that time period is fixed. So ,we can
understand this by referring to a cash flow when we will try to find the present worth values.

137
(Refer Slide Time: 03:36)

So, there is a cash flow where you have to find the present worth. The interest rates during the
given periods differ. Between 0 to 2 the interest rate r1 = 12% compounded semi-annually.
Then between 2 to 3 r2 = 7% compounded annually and between 3 to 5 r3 = 12% compounded
annually.

(Refer Slide Time: 04:28)

Now, we will find the equivalent present worth value P for this cash flow diagram. So, for the
equivalent present amount we have to find the equivalent value of the series at the present time.
We cannot find the equivalent present worth directly because interest rate varies in different
zones.

138
So first find F for cash flows at 3, 4 and 5 years = 500 x (F/A, 12, 3)

This amount will be at n = 5. Now, this amount is to be converted to n = 3. So, it has to be

multiplied with factor (P/F, 12, 2) which will be the equivalent amount at n = 3.

(Refer Slide Time: 10:36)

At n = 3, equivalent amount = 500 x (F/A, 12, 3) x (P/F, 12, 2).

Once you get at this particular time, now this amount has to be converted at n = 2. There is one
interest period and the interest rate is 7% compounded annually.

At n = 2, equivalent amount = 500 x (F/A, 12, 3) x (P/F, 12, 2) x (P/F, 7, 1) = A2

Our ultimate aim is to get the value at n = 0. During 0 to 2 years, the interest rate is 12%
compounded semi-annually. So, basically this 12 percent compounded semi-annually. So,
effective interest rate is 6% but your interest period will become 4.

139
(Refer Slide Time: 14:38)

For moving from n = 2 to 1, we have to move two interest periods because each of the interest
period is of six months.

At n = 1, amount = A2 x (P/F, 6, 2) = A1.

Now at n = 1, total amount = 1000 + A1.

So, P = (1000 + A1) x (P/F, 6, 2)

This way we will solve some problems based on this in our coming lectures.

(Refer Slide Time: 15:28)

(Refer Slide Time: 16:31)

140
Other principle of equivalence for cash flow: If two cash flows are equivalent, their equivalent
values must be equal at any point in time.

This principle tells that if there are two cash flows, and if they are equal then if we try to find
the future value at n, they must be equal. And if they are equal, it means these two cash flows
are equivalent.

(Refer Slide Time: 21:16)

For the actual rate of interest and on any investment equivalent value of all the receipts is
equal to that of all the disbursements.

This can be understood by an example,

141
 End of Year Receipt/Disbursement
0 -40000
1 -20000
2 19280
3 19280
4 19280
5 -10000
6 19280
7 19280

You have the negative values as disbursement and the positive values are the receipts. The cash
flow diagram can be drawn as shown in figure.

If we find the equivalent values at a particular time, the equivalent value of all the
disbursements must be equal to equivalent value of all the receipts. So, in this case we will
find the present worth value of all these receipts and the present worth value of all these
disbursements.

(Refer Slide Time: 24:47)

Present worth of all the receipts = 19280 x (F/A, i, 3)(P/F, i, 4) + 19280 x (F/A, i, 2)(P/F, i, 7)

Similarly,

Present worth of all the disbursements = 40,000 + 20,000 x (P/F, i, 1) +10000 x (P/F, i, 5)

(Refer Slide Time: 26:12)

142
Now this principle tells that,

19280 x (F/A, i, 3)(P/F, i, 4) + 19280 x (F/A, i, 2)(P/F, i, 7)

= 40,000 + 20,000 x (P/F, i, 1) +10000 x (P/F, i, 5)

You have to solve this equation using trial and error method and once you solve it, you will get
i = 10%. So this is left upon you to do this exercise and try to find by trial and error.(Refer
Slide Time: 26:56)

Now the third point: If receipts and disbursements of cash flow are equivalent for some interest
rate, the equivalent of all the transactions on one side (at any point of time) is equal in
magnitude but opposite in sign to the equivalent value of all the transactions on the other side.

143
(Refer Slide Time: 29:02)

By looking at the diagram, this principle tells that if you fix any point (suppose you fix n = 4),
the equivalent value of cash flow from n = 0 to 4 should be equivalent value to the cash flow
from n = 4 to 7. So, if we calculate equivalent amount at n equal to 4 using cash flows on either
side of n equal to 4, the magnitude will be equal and opposite in sign.

So,

-40,000 x (F/P, i, 4) - 20,000 (F/P, i, 3) + 19280 x (F/A, i, 3)

= 19280 x (F/A, i, 2) (P/F, i, 3) - 10,000 x (P/F, i, 3)

So, this way if they have to be equal their values are equivalent, so this is how the equivalent
values are calculated. Thank you.

144
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 13
Methods of Comparison of Alternatives: Present Worth, Annual Equivalent, Future
Worth, Internal Rate of Return
Welcome to the lecture on methods of comparison of alternatives. Usually we deal with a
number of investment alternatives in engineering economic analysis and we have to compare
among the alternatives which of the alternative is good or better. We have to compare them
and for comparing their values, there are different basis of comparison.

(Refer Slide Time: 01:05)

Comparison of alternative investments is required for decision of whether to accept or reject

any investment. That means if you are having an investment, it has certain cash flows you need
to decide, whether this cash flow will be beneficial for you or for the investor whether he should
go ahead or he should reject it.

It is required to know how to compare alternatives on an equal basis for selecting the wisest
alternative from an economic standpoint.

You should know which one is the best alternative. From economic point of view, you need to
know about certain terminologies which evaluate the alternatives values.

The most common basis for companies of alternatives are present worth method, annual
equivalent method, future worth method, internal rate of return.

145
(Refer Slide Time: 02:25)

So, coming first to the present worth criterion. Present worth of an investment is the net
equivalent amount at present time. It represents the difference between net receipts and net
disbursements made at present time for a specified interest rate.

Present worth it as PW(i), where i shows rate of interest. If Ft is the net cash flow at time t, n
being the service life of the project,

𝑛
𝑃
PW(i) = ∑ 𝐹𝑡 ( , 𝑖, 𝑡)
𝐹
𝑡=0

(Refer Slide Time: 08:37)

You deal with a cash flow diagram at different time and the transactions are F0, F1, F2, F3,…
Ft, Ft+1,… Fn-1 and Fn.

146
Present worth means, each of these components equivalent value at time t = 0 is to be found
out. So,

PW(i) = F0(P/F, i, 0) + F1(P/F, i, 1) + F2(P/F, i, 2) +… Ft(P/F, i, t) +… Fn(P/F, i, n)

PW(i) is the algebraic sum of the equivalent values of all these net cash flows at the respective
times and their equivalent value is found at time t = 0. Thus, it is written as

𝑛
𝑃
PW(i) = ∑ 𝐹𝑡 ( , 𝑖, 𝑡)
𝐹
𝑡=0

The present worth value should be greater than or equal to zero, for the investment to be
acceptable or the for the investment to run. So that is why it is written that if P W (i) is greater
than 0 then the investment can be accepted.

If PW(i) > 0, Investment is accepted

If, PW(i) = 0, It does not make any difference

If PW(i) < 0, Investor won’t go ahead with the project

This criterion give us the freedom to calculate the present worth value for any cash flow
diagram and based on that we evaluate.

Even we can even the annual equivalent or future worth in place of present worth to evaluate.

(Refer Slide Time: 14:54)

147
For example, if we have a cash flow diagram, where you have certain cash flows as shown in
figure and i = 12%,

PW(12) = 500(P/F, 12, 3) + 800(P/A, 12, 3) (P/F, 12, 3) - 400(P/F, 12, 6) + 550(F/A, 12, 3)
(P/F, 12, 9)

So, this way we get the present worth of any investment.

(Refer Slide Time: 15:04)

Annual equivalent criteria

Annual equivalent worth criterion provides a basis of measuring worth of an investment by

finding equal payments on annual basis.

It is the net sum of annual receipts and annual disbursements.

So, you have receipts as well as disbursements, you have to find the annual equivalent value
of all the receipts and annual equivalent value of the all the disbursements and then you can
then find algebraic sum of it.

148
(Refer Slide Time: 17:57)

If you have any cash flow diagram and once you have calculated the present worth value, so in
that case you can be multiply it with the factor (A/P, i, n) to find the annual equivalent.

AE(i) = PW(i) x (A/P, i, n)

𝑛
𝑖(1 + 𝑖)𝑛
AE(i) = [∑ 𝐹𝑡 (1 + 𝑖)−𝑡 ] × [ ]
(1 + 𝑖)𝑛 − 1
𝑡=0

Same as the present worth criterion, this condition holds good where it can be said that if it is
positive, the investment can be considered as acceptable, if it is zero it is indifferent and if it is
negative you cannot go ahead with the investment.

149
(Refer Slide Time: 21:34)

Now suppose you have a cash flow which is repeating nature, as shown in figure.

So, in such cash flows if we use the present worth criterion it makes cumbersome because it
involves a large number of computations. In that case such annual equivalent value is worthy
because the annual equivalent will remain same.

Next is future worth criterion.

Future worth criterion means you find the net amount of receipts and disbursements at any
future time.

(Refer Slide Time: 22:45)

150
Future worth of an investment is the difference between equivalent receipts and disbursements
at some point of time future.

It can be found by converting present worth of the investment at some future time.

Once you have converted any cash flow and found its present worth then you can directly
convert it to the future time by multiplying with (F/P, i, n).

(Refer Slide Time: 27:04)

FW(i) = 𝐹0 (1 + 𝑖)𝑛 +𝐹1 (1 + 𝑖)𝑛−1 +𝐹2 (1 + 𝑖)𝑛−2 + ⋯ +𝐹𝑡 (1 + 𝑖)𝑛−𝑡 + ⋯ +𝐹𝑛

FW(i) = ∑ 𝐹𝑡 (1 + 𝑖)𝑛−𝑡
𝑡=0

So, what we see is if we see the value of this particular investment basically you have to see
that this F not its contribution towards the nth time that is here, it is F0 multiplied by 1 plus i
raised to the power n. Then F1 can be written as, its contribution at the nth time will be
multiplied with so F1 has to be multiplied with 1 plus i raised to the power n minus 1. So
basically it is earning interest for n minus 1 interest periods.

151
(Refer Slide Time: 27:27)

We have already discussed once we get the present worth, we can directly multiply it with the
factor (F/P, i, n) and we can get the required value of future worth.

So, FW(i) = PW(i) x (F/P, i, n)

So, this is how you calculate the different criterion. It can be seen that FW(i) and AW(i) are
the product of PW(i) times certain factors.

(Refer Slide Time: 28:28)

So,

𝑃𝑊(𝑖)𝐴 𝐴𝑊(𝑖)𝐴 𝐹𝑊(𝑖)𝐴

= =
𝑃𝑊(𝑖)𝐵 𝐴𝑊(𝑖)𝐵 𝐹𝑊(𝑖)𝐵

152
Next is internal rate of return, that gives you the zero present worth value. This we will discuss
in our next lecture and we will see how for a certain cash flow diagram this internal rate of
return can be generated as they are found by trial and error methods. Thank you.

153
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 14
Comparison of Alternatives: Capitalized Equivalent Amount, Capital Recovery with
Return

Welcome to the lecture on comparison of alternatives. So far, we have discussed about different
methods, like present worth criterion, future worth criterion and annual equivalent criterion.
The fourth one which is also important is internal rate of return.

(Refer Slide Time: 00:52)

0
The internal rate of return is that rate of interest at which equivalent value of receipts is equal
to the equivalent value of disbursements. At this rate of interest your present worth value will
be equal to 0 for any investment. If you have Ft as the cash flow at any time t, then the present
worth can be expressed as

𝑛
∗)
PW(i = 0 = ∑ 𝐹𝑡 (1 + 𝑖 ∗ )−𝑡
𝑡=0

Where, i* is known as the internal rate of return at which present worth is zero,.

154
(Refer Slide Time: 02:03)

Let us see it by an example. The cash flow diagram shown in figure has different disbursements
and receipts. Now let us calculate the internal rate of return for this particular cash flow.

(Refer Slide Time: 06:21)

PW(i*) = 0

PW(i*) = -10000 – 8000(P/F, i*, 1) + 5000(P/A, i*, 3)( P/F, i*, 1) + 12000(P/F, i*, 5)

Internal rate of return will be that percentage of interest for which this PW(i*) value should be
zero. This will be solved by trial and error methods.

Trial and error method,

155
If i* = 0,

PW(0) = -10000 – 8000 + 5000 x 3 + 12000 = 9000

(Refer Slide Time: 8:21)

If i* = 5,

PW(5) = -10000 – 8000(P/F, 5, 1) + 5000(P/A, 5, 3)( P/F, 5, 1) + 12000(P/F, 5, 5)

= -10000 – 8000 x 0.9523 + 5000 x 2.7232 x 0.9523 + 12000 x 0.7835

= -10000 – 7618.4 + 12966.5 + 9402 = 4750.1

(Refer Slide Time: 11:25)

156
(Refer Slide Time: 09:27)

(Refer Slide Time: 12:19)

So, if we draw a curve (as shown in figure) of present worth value, we have seen the interest
rate values, at zero, it was coming as 9000 and then at 5 percent, it has come to a decreased
value. Now this value will decrease continuously and ultimately it has to cross somewhere and
this is the point where it crosses this x axis. This point tells the interest rate value for which the
present worth value will be zero and this will be the internal rate of return.

157
(Refer Slide Time: 14:55)

We can further check by taking another interest factor.

If i* = 12,

PW(5) = -10000 – 8000(P/F, 12, 1) + 5000(P/A, 12, 3)( P/F, 12, 1) + 12000(P/F, 12, 5)

= positive value

If i* = 12,

PW(13) = negative value

This indicates that for i* value between 12 and 13%, PW(i) = 0 and this i* will be the internal
rate of return. When we will solve it by using the interpolation methods, we will get i* = 12.8%.
This is how the internal rate of return is calculated.

158
(Refer Slide Time: 15:30)

Now next method of comparison is capitalized equivalent amount.

Many a times it has been seen that basically the type of cash flow is perpetual means it goes
for a very long period. So sometimes we need to have a deposit so that certain amount you can
get for the whole of the life or for a very large duration. In these cases, the n is tending towards
infinity. It is a special case of present worth basis of comparison.

It is useful when the life of proposed project is perpetual.

It represents a basis of comparison in which single amount at present time will be found. This
amount should be equivalent to net difference of receipts and disbursements when cash flow
pattern is repeated in perpetuity.

For example, when we construct a bridge, the bridge is to be maintained in course of time. In
such case you need a fund from where you can get certain amount for the maintenance purpose
of this bridge and that may be required for years continuously, maybe 50 or 100 years. So you
need a fund and that is known as a capitalized amount or capitalized equivalent amount.

159
(Refer Slide Time: 17:40)

The cash flow can first be converted into the equivalent cash flow of equal amounts, that extents
to infinity

Capitalized equivalent is same as the present worth equivalent when n is approaching towards
infinity.

(Refer Slide Time: 20:27)

CE(i) = PW(i) when cash flow extends forever

CE(i) = A(P/F, i, n) when n is approaching towards infinity

(1 + 𝑖)𝑛 − 1 (1 + 𝑖)𝑛 − 1
CE(i) = A [ ] = 𝐴 lim [ ]
𝑖(1 + 𝑖)𝑛 𝑛→∞ 𝑛→∞ 𝑖(1 + 𝑖)𝑛

160
 (1 + 𝑖)𝑛 1 𝐴
= 𝐴 [ lim [ 𝑛
] − lim [ 𝑛
]] =
𝑛→∞ 𝑖(1 + 𝑖) 𝑛→∞ 𝑖(1 + 𝑖) 𝑖

So, you need the present amount, the equivalent present worth when n is moving towards
infinity.

(Refer Slide Time: 21:47)

So, it is that amount which is the interest earned on certain deposit and you are likely to get it
forever, so it is known as capitalized equivalent amount.

Next is capital recovery with return.

Capital recovery with return is under those cases where you have two types of capital
expenditures. One is the initial cost of the asset and another type of cost is the return on this
asset when you are disposing it at the end of its life.

161
(Refer Slide Time: 23:09)

At the end of its life you are getting as the salvage value.

Capital recovery with return, CR(i) for any investment is the equal annual cash flow over its
life that is equivalent to capital cost of the investment.

The capital cost of the investment includes the initial outlay and the final salvage value.

Hence, two transactions are involved, first cost and the salvage value of the asset.

Let us see how the cash flow diagram is represented in the case of capital recovery with return.

(Refer Slide Time: 26:14)

162
In this case, the cash flow diagram will be as shown in figure. Here, you are investing certain
amount now and at the end is your salvage value which you will get while selling all the
property you had. So, that is the equivalent annual amount.

So, CR(i) = P(A/P, i, n) – F(A/F, i, n)

= (P - F)( A/P, i, n) + Fi where, (A/F, i, n) = (A/P, i, n) - i

So, this way we can calculate the capital recovery with return and the formula is used for
finding the capital recovery with return.

We will discuss about the problems in the next lecture to come. Thank you.

163
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 15
Problem Solving on Equivalence and Comparison of Alternatives
Welcome to the lecture on problem solving based on equivalence and methods of comparisons
of alternatives. In this lecture we will try to solve problems based on equivalence as well as on
the different criterion which we have discussed about the comparison of alternatives.

(Refer Slide Time: 00:49)

Q1. A mutual stock fund has grown at a rate of 12% compounded annually since its beginning.
If it is anticipated that it will continue to grow at this rate, how much must be invested every
year so that Rs 60,000 will be accumulated at the end of 12 years?

We have, i = 12% compounded annually, n = 12 years and F = Rs 60,000.

The cash flow diagram will as be shown in figure.

164
(Refer Slide Time: 05:12)

(Refer Slide Time: 04:15)

So, A = F(A/F, 12, 12) = 60000 x 0.04144 = 2486.4

It means if you deposit Rs 2486.4 for 12 years at 12 percent interest, you will get 60,000 rupees.

165
(Refer Slide Time: 05:28)

(Refer Slide Time: 06:24)

Q2. What single amount at the end of fifth year is equivalent to a uniform annual series of Rs
1000 per year for 12 years? The interest rate is 12% compounded annually.

The cash flow diagram can be drawn as shown in figure.

Now for solving such problems, what you have to do is, first of all you have to find the
equivalent value of this series at present time and then you can get the equivalent value at future
time of the present value.

166
(Refer Slide Time: 10:27)

(Refer Slide Time: 08:51)

P0 = A(P/A, i, n) = 1000(P/A, 12, 12) = 1000 x 6.194 = 6194

Now this amount is the equivalent amount at n = 0, we have to find its equivalent amount at n
= 5. So,

P5 = P0 (F/P, 12, 5) = 6194 x 1.7623 = 10915

So, this is how we can solve such problems.

167
(Refer Slide Time: 10:50)

(Refer Slide Time: 10:57)

168
(Refer Slide Time: 16:26)

Now, we will discuss about the problem on internal rate of return that we had discussed earlier,
what will be the internal rate of return for PW(i) = 0. So, let us see what we had the cash flow
diagram, as shown in figure.

(Refer Slide Time: 13:20)

So, we had

PW(12) = -10000 – (P/F, 12, 1) + 5000(P/A, 12, 3)(P/F, 12, 1) + 12000(P/F, 12, 5)

= -10000 – 8000 x 0.8928 + 5000 x 2.402 x 0.8928 + 12000 x 0.5674

= 388

169
(Refer Slide Time: 19:59)

(Refer Slide Time: 17:14)

PW(13) = -10000 – (P/F, 13, 1) + 5000(P/A, 13, 3)(P/F, 13, 1) + 12000(P/F, 13, 5)

= -10000 – 8000 x 0.885 + 5000 x 2.361 x 0.885 + 12000 x 0.543

= -117

170
(Refer Slide Time: 19:33)

For 13%, it has come negative, it means the rate of return can be found by using the
interpolation method. So, PW(i*) = 0, if

0 − 3.88 388
𝑖 ∗ = 12 + = 12 + = 12.8%
−117 − 388 505

So, you can solve the problems based on that and get the confidence more and more.

(Refer Slide Time: 21:35)

Q3. What amount of initial deposit amount which is required for maintaining a park forever.
The park is made by the municipality and the maintenance cost is to be borne by the society.
The maintenance cost every year is approximated as Rs 60,000. Interest rate is taken as 12%.

171
(Refer Slide Time: 24:09)

This is a case of perpetuity type of cash flow where you need amount forever. We will use the
capitalized equivalent concept to find the initial deposit for such cost which have to be incurred
every year for maintaining the park. As we have discussed

CE(i) = A/i

Where, A = 50000, i = 12% = 0.12

The initial deposit which will provide a sum of Rs 60,000 forever that is capitalized equivalent
at 12 % will be

CE(i) = 60000/0.12 = 500000

So, if there is Rs 500000 of initial deposit, it will give you Rs 60,000 forever, which will be
used for maintaining the park.

Thank you.

172
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 16
Replacement Analysis: Reason, Concept of Defender and Challenger
Welcome to the lecture on replacement analysis. We have studied many principles like
equivalence, alternatives, and basis of the comparison of alternatives. In normal times, you
may have many alternatives and the organization has to decide whether they want to go with
the present alternative or they want to switch over to the new alternative. These can be in
terms of a service or an equipment.

(Refer Slide Time: 01:20)

The problem often faced by the management is whether to buy a new equipment which is
supposed to be more efficient or they should continue to use the existing equipment. In
economic terms you will have to evaluate whether you want to continue with the existing
equipment which was purchased maybe few years back and it has still some life or,
sometimes the salesman offers you to purchase new equipment, certainly it adds some higher
cost. But that may be offset by the lower operating costs and the life which is ahead. Now,
decisions of this type are very important in economic analysis because if the decision is not
right, that may lead to loss or failure of certain investment.

Failure to make such decision at appropriate time may result in slowdown or shutdown of
operations.

173
These class of decision problems where you have certain alternatives and you have to decide
whether you should go with the existing alternative or you should switch over to a new
alternative which is suggested to you, these types of problems are coming under the category
of replacement problems. For that you need knowledge of basic concepts and terminologies
which is for replacement analysis hence, they are important. You must be conversant with all
the principles which are to be used for economic analysis for both the alternatives.

Now there are certain basic concepts and terminologies in replacement analysis.

(Refer Slide Time: 03:48)

The two important terms which we come across is defender and a challenger. If you have an
old machine and you have a new machine. The old machine which is supposed to replaced,
the old machine is known as defender because it is existing and it has to defend its value.

Challenger is the new machine which is going to replace the old machine. So the challenger
is the asset proposed to be the replacement in place of defender.

An existing piece of equipment may be removed at some future time, either when the task
performed is no longer to be used or task performed may be carried out with more efficiently
by new machine.

So we have already discussed that if you have an old machine, if its work which it performs
is no longer for the use of the organization, it has to be replaced or sometimes the new
machine which is the challenger one, if it performs more efficiently, then also we think of

174
replacing it. So in the analysis, finally we are to come on the conclusion that which of the
option is the best and which challenger is the best if you have more than two options.

(Refer Slide Time: 05:10)

Reasons of replacement

• Physical deterioration: Physical deterioration is because of the changes in physical

condition of the asset. Some of the moving parts of the equipment, they are rubbing
against each other continuously, so slowly their efficiency is decreased. Because of its
use, it may lead to increased operating and maintenance cost, decrease in value of service
rendered by the equipment. So, this is known as physical deterioration because it is
because of the physical impairment of certain parts of the equipment and then because of
that, the service you are getting from this equipment, basically its value decreases with
time.
• Obsolescence: Obsolescence is effect in changes environment external to the asset. So
obsolescence is not because the equipment is not able to perform to its level but it is
because of the changes in environment external to the asset. So the reasons may be
because of the continuous improvement in tools of production.

This is an era of continuous improvement, so with time new and new machines based on
your technologies are coming up and these machines are better in terms of efficiency and
are having low maintenance and operating costs. It decreases the value of the old asset
and the old asset seems to be obsolete at certain time.

175
Obsolescence basically can be divided into types;

Functional obsolescence which is because of the decrease in demand of the output of the
asset. It is because of the functional inability of the asset because it is not able to perform to a
level what the manufacturer now desires off the machine. So, you this is because of the
decrease in demand for the output.

Economic obsolescence is because of the presence of similar asset capable of producing at

low cost. This is a condition when in the market because of new technology a machine has
come which can produce at lower cost. So, the new machine may make the old machine
obsolete, so that is known as economic obsolescence.

• Inadequacy

It can be said to be an extension of the obsolescence and it is that asset is not having
sufficient capacity to fill current and expected demands. So basically, the asset, the demand
has increased and the asset is not able to fulfill this demand and that is why the asset can no
longer be kept with the organization and it is to be replaced with a new machine which can
meet the demand of the organization.

(Refer Slide Time: 06:10)

176
(Refer Slide Time: 08:48)

There are certain principles of replacement,

• Replacement should be based on economic factor

So, replacement should be judged purely on economical merit, if you find the
terminologies and the values of certain parameters and economic terms, if you see that the
challenger is better one, you will have to go for replacement. There are certain extensions
to it, we will come across it.

• Value of defender should be based on its worth at present. Sunk cost should have no
effect on any decision about it.

This is a very important point that we have to live in present, we have to forget the past.
Sunk costs are those costs which have been incurred on the object in the past and they
have nothing to do with the decision making in present or in future. So basically the
defenders value should be based on its value at present and this evaluation will be done
by the person who is supplying the new machine normally or any person who is outside.
So basically whatever we have incurred on the existing machine in the past, they have
nothing to do with the decision you are going to take in future.

• When a decision is taken not to replace the defender, economic opportunity forgone must
be associated with alternative which lost it.

177
 So, when we are comparing two alternatives, we are given certain opportunity cost, if you
are taking the new machine, the old machine can be taken for some price or you are
losing if not taking the new machine at certain rate. Certainly, some opportunity cost is
forgone and that has to be taken into account when doing their replacement analysis.

• Concept of outsiders view point

When we are comparing two assets there are two parties but then the replacement analysis
is based on outsiders view point. Means you have to be outside per view of these two and
an outsider will only judge whether he should go for the present machine or he should go
for the new machine.

(Refer Slide Time: 11:44)

Replacement analysis for unequal lives

When we compare two assets of equal lives, the analysis of the replacement is easy because
for the equal life period, you can certainly go for any basis of comparison what we have
discussed so far, either be it annual equivalent basis, future worth or present worth basis. But
then many times, the life of the existing asset and the life of the new asset are different.

The time span over with alternative are compared is called the study period or planning
horizon. So basically you will have to have a period over which you have to do the
replacement analysis and this time is known as study period or planning horizon.

178
Length of lives of alternatives being studied can be a basis of determining the study period.
There may be different cases based on which you will have to take the length of the study
period and then you have to do the replacement analysis.

(Refer Slide Time: 13:25)

Methods of estimation of cash flows

Alternative life may be more than the study period. If there are two alternatives, one of the
alternatives has a larger life than the other one and if the study period is lesser than one of the
lives of alternative, in that case you can use the use of implied salvage value concept. The
salvage value is the value which is the residual value of the asset at the end of its complete
life. Since the asset is not being used for full of its life, so it has still more salvage value left
that is known as implied salvage value.

You can also assume the cash flow for the deficit period because either you can go for
calculating the implied salvage value or you can also assume certain cash flow for the deficit
period. Suppose in one case you have 5 years of life, in another case you have 3 years of life,
if you take the study period of 3 years, either you can calculate the implied salvage value and
this being mentioned. Or sometimes for the deficit of two periods, you can assume certain
costs and based on that you can do the replacement analysis taking whole period as the study
period.

There are cases when alternative life is less than study period or study period is more than or
equal to the alternative life. In that case all cash flows are assumed to be reinvested until the
end of study period. So basically, you feel that because study period is larger so and certain

179
alternatives life is smaller, so basically you assume that they are reinvested till we go for the
study period.

In these cases what happens, if you are going for future worth criterion, so what happens in
certain cases, you have the study period and then you have the alternative life. Now, when
one of the periods is small at that point of time, you will have certain future worth and that is
to be again mapped to the larger life period.

So that is what it means, that you can go for future worth criterion and you have to calculate
this FW(i), future worth till the end of the period.

(Refer Slide Time: 16:03)

Implied Salvage Value

It is unused capital cost of the equipment or investment alternative at the point of time prior
to its complete service life. We can solve a problem in which it is given that as an asset which
has the first cost of 15,000 and its salvage value is given as 3000 at the end of 5 years. Now
in another case if the alternatives life is only 3 years, in that case suppose you have to dispose
this asset after 3 years, what should be its salvage value or implied salvage value?

So, for such cases

AE(i) over full-service life = AE(i) over the study period

180
(Refer Slide Time: 22:00)

Let us see how we calculate the implied salvage value.

Fn* = Implied salvage value

Study period = 3 years

For full-service life => AE(i) = 15000(A/P, 12, 5) – 3000(A/F, 12, 5)

For study period => AE(i) = 15000(A/P, 12, 3) – Fn*(A/F, 12, 3)

Fn* is the salvage value which is supposed to be for the equipment when it is assumed to be
disposed at the end of 3 years because we are doing the replacement analysis calculations for
3 years.

So, in that case both AE(i) should be equal. If we equate them, then

15000(A/P, 12, 5) – 3000(A/F, 12, 5) = 15000(A/P, 12, 3) – Fn*(A/F, 12, 3)

15000 x 0.2774 – 3000 x 0.1574 = 15000 x 0.4163 – Fn* x 0.2963

Fn* = ?

181
(Refer Slide Time: 25:20)

(Refer Slide Time: 22:56)

So, this gives you the value of implied salvage value. So, this is how the implied salvage
value calculation is carried out. You must specify that if you are going to use this machine for
3 years, this is the implied salvage value of this particular machine which should be used.

Another aspect which is important in the cases of selecting the alternatives is that you may go
for different lives when the annual equivalent criterion is to be used. When the alternatives
have different lives annual equivalent base of comparison is considered to be the best
comparison method but you should assume that after the end of the life of the short lived
asset, it can further be continued at a rate which is supplied by the another equipment. So in

182
the remaining period there is not going to be much difference in the annual equivalent value
of the asset.

So, these are the aspects which are used in case of replacement analysis.

Thank you.

183
 Engineering Economic Analysis
ProfessorDr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of TechnologyRoorkee
Lecture 17
Proper Treatment of Sunk Cost in Replacement
Welcome to the lecture on replacement analysis II. So, in this lecture we will discuss a case
how to properly treat the sunk cost in cases of replacement analysis.

(Refer Slide Time: 00:59)

We had certain idea about the sunk cost that it is the one that has already been incurred by
past actions and are not considered relevant to decision making. So, we have to forget what
has been incurred in the past and we have to be in present for any decisions to be taken in
future.

These are the money that is gone and no present actions can recover it.

In making economic decision at present time, only possible outcomes are to be considered for
best future results.

It means that the sunk cost has to be forgotten and the value at present only is to be
considered and this valuation has to be done by the person who is supplying you the new
equipment or many by any outsider person.

184
(Refer Slide Time: 02:56)

Let us discuss a case where

Q: Machine P was purchased by a company 4 years ago for Rs.2,20,000 with estimated life of
10 years and salvage value of Rs.20,000 at the end of its life. Operating cost on machine is
Rs.70,000 per year. Presently a salesman has offered new machine Q for Rs.2,40,000 with
estimated life of 10 years, operating cost of Rs.40,000 per year and salvage value of
Rs.30,000 at the end of its life. On purchasing the new machine, supplier will take the old
machine for Rs.60,000. If MARR (minimum attractive rate of return) is taken as 15% (set by
company based on its policy), whether the machine should be replaced. (Assume after 6
years, machine P will be replaced by identical machine to Q)

It is to be decided whether the machine should be replaced or it should be kept intact. Now it
is also assumed that after 6 years, machine P will be replaced with identical machine to Q. It
means the annual equivalent values will be same for that period. So, let us solve this problem
which needs the treatment of proper sunk cost.

(Refer Slide Time: 09:21)

185
Machine P (Defender) Machine Q (Challenger)

Purchased 4 years ago for 220000 (had life P= 240000

of 10 years)
N = 10 years
So, life of machine left from now is 6
F = 30000 (after 6 years)
years (n = 6 years)
OC = 40000 per year
F = 20000 (after 6 years)
i = 15%
OC = 70000 per year

At present, value of the asset is done at

60000

P = 60000

i = 15%

186
(Refer Slide Time: 10:53)

Since the study periods are differing, we will go for taking the study period which is shorter
one that is n equal to 6 years because it is assumed that after 6 years, machine P will be
replaced by identical machine that of Q. So, let us see, based on study period of its life, what
will be the annual cost which will be incurred by these machines.

(Refer Slide Time: 13:10)

You have two components of costs; one is the capital recovery with return cost and another is
the operating cost which is the yearly cost.

For old machine

Capital recovery cost = (P – F)(A/P, i, n) + F.i

187
 = (60000 - 20000)(A/P, 15, 6) + 20000 x 0.15

= 40000 x 0.264+ 20000 x 0.15 = 13560

OC = 70000

Total annual cost = 13560 + 70000 = 83560

(Refer Slide Time: 12:16)

Refer Slide Time: 16:05)

For new machine

CRR(i) = (P – F)(A/P, i, n) + F.i

= (240000 - 30000)(A/P, 15, 10) + 30000 x 0.15

188
 = 210000 x 0.199+ 30000 x 0.15 = 46290

OC = 40000

Total annual cost = 46290 +40000 = 96290

(Refer Slide Time: 17:18)

(Refer Slide Time: 15:27)

189
(Refer Slide Time: 17:30)

We have calculated for old machine and for the new machine. What we see is that the capital
recovery cost for the old machine is coming out to be 13560 and since operating cost is quite
high, your total annual cost comes out to be 83 5 60.

In the new machine, since it is a costly machine, even though it is used for larger time, the
capital recovery cost comes out to be 46290 but its maintenance cost is quite low but in spite
of that, the total annual cost comes out to be 86290. So, we see that there is some difference
in the total annual equivalent cost of the old machine over the new machine.

(Refer Slide Time: 19:41)

190
The annual equivalent for old machine is coming out to be 83560 and annual equivalent of
the new machine is coming out to be 86290. The machine with lesser value of AE(i) should
be preferred, hence there is no need of replacement.

These are the cases that you will come across many a times where you will have the
conditions in which there has been a lot of expenditures on the existing asset but they are not
to be taken. Its value is to be taken as the one for which it is evaluated. Once you purchase
the new machine, certainly there will be trading in and you may be given some value for your
machine that will be actually the present cost of that machine and based on that you can have
the analysis and come to certain decision.

(Refer Slide Time: 20:51)

Next, we can discuss about another problem which will deal with the change in the machine
time and also other considerations like sunk cost.

Q: A manufacturer produces an engine assembly consisting of cylinder and piston. Each part
is machined on a old lathe which was purchased 8 years ago for Rs.4,00,000. It can work for
another 2 years after which its salvage value is estimated to be Rs.12,500. A new lathe is
offered as a replacement of the old one. The machining time on present and new lathe for 100
units of engine assembly are

Part Old Lathe New Lathe

Cylinder 2.92 hrs 2.39 hrs
Piston 1.84 hrs 1.45 hrs

191
The company sells 40,000 units of engine assembly every year. Machine operator is paid
Rs.850 per hour. New lathe is purchased at Rs.1250000 and the salvage value after its
estimated life of 10 years is Rs1,25,000. On purchasing new lathe, old lathe is offered to be
taken back by the salesman for Rs.60,000. At 15% rate of interest, justify the replacement.

(Refer Slide Time: 22:54)

Old Lathe New Lathe

Purchased 8 year ago for Rs 400000 P = 1250000

n = 2 years n = 10 years

F = 12500 (after 2 years) F = 125000

P = Rs 60000 Offer – If you take new lathe, old lathe

will be taken back for Rs 60000
CRR(i) = (60000 - 12500)(P/F, 15, 2)
CRR(i) = (1250000 - 125000)(A/P, 15, 10)
+ 12500(0.15)
+ 125000(0.15)
= 47500 x 0.465 + 1875 = 23962 = 1125000 x 0.199 + 18750
= 242625
Labour Cost = (4.76/100) x 40000
Labour Cost = (3.84/100) x 40000 x 850
x 850
= 1305600
= 1618400
Total Cost = AE(i) = 1548225
Total Cost = AE(i) = 1642362

192
(Refer Slide Time: 29:00)

(Refer Slide Time: 32:27)

So, we have seen that the challenger is operating at a lower cost and that is why replacement
is suggested. This is how you have to tackle the problems which involves the treatment of
sunk cost in appropriate manner and also you have to find the annual equivalent values, the
annual costs which will be consisting of the capital recovery with return cost as well as other
costs like operation and maintenance cost, labour cost and so.

Thank you.

193
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 18
Replacement Because of Improved Efficiency, Inadequacy, Demand etc.
Welcome to the lecture on replacement analysis. In this lecture we will deal with some
situations where replacement is because of inadequacy or obsolescence. You have to evaluate
the proposals based on economic terms such as annual equivalent, present worth or future
worth to solve the problem.

In case of any inadequacy, the company is not able to meet the demand that is with the
company. It has a unit which is having less capacity and it needs to install one more unit so
that it supplements the existing unit or it has the other option to replace it by just disposing
the present asset and take a new asset.

(Refer Slide Time: 01:43)

Q: A building installed a generator 10 years ago at a cost of Rs. 9,20,000 to provide the
necessary backup. Because of more number of users, the existing unit will fulfill only 50% of
the demand requirement. Currently, this old generator has a salvage value of Rs. 360000, and
it is estimated that it can be used for an additional 8-year period, with an annual operating
cost of Rs. 280000 and a zero-salvage value at the end of that time. If the old generator is
retained, a new unit with the same capacity will be purchased at a cost of Rs. 720000. It is
estimated that its service life, final salvage value and operating cost are respectively 10 years,
Rs. 120000 and Rs. 240000 per year. Another possibility is to buy a new generator having the

194
capacity of the two small unit combined. This new unit has an initial cost of Rs. 1280000,
estimated life of 12 years with Rs. 160000 salvage value at the end of that time. Suggest
which option should be selected, considering interest rate of 15% and study period as 8 years.

(Refer Slide Time: 07:42)

It means, we have old generator, it was purchased in 9,20,000 (it is sunk cost), now its value
is 3,60,000. So, its present cost is 3,60,000, life is 8 years and annual operating cost is
2,80,000. Salvage value at the end of the life is zero. If the decision is to retain the old
generator, you need a similar unit which should satisfy the 50% of the demand and this can
be purchased at rupees 720,000.

PLAN 1 PLAN 2

Old generator (50%) + New generator (50%) New generator (100%)

P = 360000 P = 720000 P = 1280000
n = 8 years n = 10 years n = 12 years
OC = 280000 OC = 240000 OC = 440000
SV (F) = 0 F = 120000 F = 160000

Now we have to suggest whether we should keep the old generator and have a new generator
of half the capacity or we should replace this and take the new generator. For such cases, it is
suggested that the annual equivalent basis of comparison. So, we will proceed with finding
the annual equivalent value and the option with lower amount of annual equivalent will be
suggested or will be preferred.

195
(Refer Slide Time: 12:30)

Plan 1
Old generator (50%)
AE(i) = 360000(A/P, 15, 8) + 280000
= 360000 x 0.223 + 280000
= 360280

New generator (50%)

AE(i) = 600000(A/P, 15, 10) + (120000 x 0.15) + 240000
= 600000 x 0.1992 + (120000 x 0.15) + 240000
= 377520

Total AE(i) = 360280 + 377520 = 737800.

(Refer Slide Time: 09:16)

196
(Refer Slide Time: 12:30)

Plan 2
New generator (100%)
AE(i) = 1120000(A/P, 15, 12) + (160000 x 0.15) + 440000
= 1120000 x 0.1845 + (160000 x 0.15) + 440000
= 670640

(Refer Slide Time: 16:02)

Now what we see that, in plan 1, we get the annual equivalent value as 7,37,800 and in the
plan 2 we are getting 6,70,640. So verdict is AE(i)plan 1 > AE(i)plan 2

197
So, it is better to buy new generator and dispose the existing one. Plan 2 is preferred.

So, this is how when we have the question regarding the problem where there is inadequacy
and you are to decide whether to replace or not, we can deal with the problem in such
manner.

(Refer Slide Time: 16:38)

(Refer Slide Time: 17:35)

We will deal with the next problem based on replacement because of the obsolescence.

Q: A manufacturer plans to install a new equipment after replacing one of its present
equipment with an aim that the new equipment will consume less energy and material. The
present equipment in operation was purchased 5 years ago at a cost of Rs, 4,000,000 and can

198
presently be sold at Rs. 14,00,000. Because of the rapid obsolescence of the equipment (as
new energy efficient equipment has come into market), the future salvage value of the present
equipment is expected to decline by Rs 1,60,000 a year. If the present equipment is retained
for one more year, its operating cost are expected to be Rs. 26,00,000 with increases of Rs.
1,20,000 a year thereafter. The new equipment will cost Rs. 5,200,000 installed. Its economic
life is predicted to be 8 years with a salvage value of Rs. 4,00,000. Annual operating cost is
Rs. 19,60,000. If the firm’s MARR is 15%, suggest whether the new equipment should be
installed?

(Refer Slide Time: 20:19)

Plan 1 (Old equipment) i = 15%, n = 8 years

P = Rs. 1400000

F = 1400000 – 8 x 160000 = 120000

OC = 2600000 (1st year) + 120000 increase every year

Annual operating cost (equivalent value) = 2600000 + 120000(A/G, 15, 8)

= 2600000 + 120000 x 2.781 = 2933720

AE(i) = 1280000(A/P, 15, 8) + 120000 x 0.15 + 2933720

= 1280000 x 0.223 + 18000 + 2933720

= 3237160

199
(Refer Slide Time: 24:53)

Plan 2 (New equipment) i = 15%, n = 8 years

P = Rs. 5200000

F = 400000

OC = 1960000

AE(i) = 4800000(A/P, 15, 8) + 400000 x 0.15 + 1960000

= 4800000 x 0.223 + 60000 + 1960000

= 3090400

200
(Refer Slide Time: 22:54)

(Refer Slide Time: 29:28)

So, the plan 1 gives you the annual equivalent cost as Rs. 32,37,160, if we retain the old
equipment and if we purchase the new equipment, the annual equivalent cost is Rs.
30,90,400.

AE(i)plan 1 > AE(i)plan 2

It means Plan 2 is better and so replacement is suggested.

So, in this case it is better to change the old equipment and go for the new equipment which
is basically based on new technology consuming less energy and that is why the replacement

201
is suggested. So, this is how we solve the problems based on inadequacy and because of the
obsolescence.

Thank you.

202
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 19
Problem Solving on Replacement Analysis
Welcome to the lecture on problem solving on replacement analysis. In this lecture, we will
discuss about a problem which is based on replacement analysis and we will see how we take
the different study periods and how the problem is analyzed.

(Refer Slide Time: 01:00)

Q1: An operation is being carried out on a machine P with present salvage value as Rs.
1,00,000 and life of 5 years after which it will have zero salvage value. Operating cost on
machine P is Rs. 60,000 per year. After 5 years, machine P will be replaced by machine Q
with initial cost, life, final salvage value and annual operating cost as Rs. 5,00,000, 15 years,
zero and Rs. 30,000 respectively. It is proposed that machine P should be replaced with
machine R whose estimated initial cost, life, final salvage value and operating cost are Rs.
400,000, 15 years, zero and Rs. 45000 respectively. If interest rate is 10%, suggest the
decision about replacement.

It means, you have a machine P which will work for 5 years and after 5 years it will be placed
with machine Q, another option is you have now machine R. You have to find that you
should go for machine (P + Q) or you should go only for machine R.

Machine P has a life of 5 years and Q has 15 years, so altogether you have 20 years. In case
of machine R, it has a life of 15 years, so we can have the study period of 15 years. In that

203
case machine Q will only be used for 10 years, so its life of 5 years will be remaining and we
have to find the implied salvage value of this machine after 10 years. So, let us see how to
solve this question.

(Refer Slide Time: 09:43)

Machine P: (life 5 years) Machine R: (life 15 years)

First cost = Rs. 100,000, First cost = Rs. 400,000,

Salvage value = zero Salvage value = zero

Annual operating cost = Rs. 60,000 Annual operating cost = Rs. 45,000

Machine Q: (life 15 years)

First cost = Rs. 500,000,

Salvage value = zero

Annual operating cost = Rs. 30,000

The question is whether to go for machine (P + Q) where Q will be coming after 5 years or
we should now go with machine R so that you can use the machine R from today itself.

204
(Refer Slide Time: 12:31)

For finding the present worth, what we do is, we find the annual equivalent value for the
machine. We have 0 to 20 years, up to 5 years you have machine P and after that more 15
years would be machine Q. You have to find the annual equivalent for machine Q,

For Machine Q,

AE(i) = 500000(A/P, 10 15) + 30000 = 65750 + 30000 = 95750

PW = 100000 + 60000(P/A, 10, 5) + 95750(P/A, 10, 10)(P/F, 10, 5)

= 100000 + 60000 x 3.791 + 95750 x 6.144 x 0.621

= 100000 + 227460 + 365326 = 692786

So, this quantity is the present worth for this pan in which the machine P will be followed by
machine Q.

205
(Refer Slide Time: 14:38)

(Refer Slide Time: 13:28)

206
(Refer Slide Time: 19:34)

Now let us go for machine R, using present worth analysis.

For machine R,

PW(i) = 400000 + 45000(P/A, 10, 15)

= 400000 + 45000 x 7.606 = 742270

You can see that plan 1 requires less amount of investment initially so plan 1 should be
preferred. We have taken a study period of 15 years.

Machine Q is not used for its full life. So, we should calculate implied salvage value of
machine Q. For finding the implied salvage value, suppose the implied several value at 10
year of its life is Fn*, then

500000(A/P, 10, 15) = (500000 - Fn*)(A/P, 10, 10) + Fn* x 0.10

500000 x 0.1315 = (500000 - Fn*) x 0.1627 + Fn* x 0.10

Fn* = 500000 x 0.0312/0.0627 = 248803

(Refer Slide Time: 23:59)

207
(Refer Slide Time: 20:41)

What we have seen is, you have this implied salvage value which need to be mentioned
although it does not affect the decision making and you can say that plan one should be
preferred and replacement is not suggested, that is P + Q may be allowed instead of machine
R.

208
(Refer Slide Time: 30:35)

There is other way also this question can be solved.

If it is not sure how machine Q will behave (or about its investment plans), it is reasonably
correct to assume 5 year study period. So, we will compare on the basis of five year and in
that case annual equivalent basis of comparison will be used.

So, for machine P, if we take the annual equivalent basis

AE(i) = 100000(A/P, 5, 5) + 60000

= 100000 x 0.264 + 60000

= 86400

For Machine R,

AE(i) = 400000(A/P, 10, 15)

= 400000 x 0.1315

= 97600

So, machine P should be preferred. Replacement (Machine R is not suggested).

We can find the implied salvage value of machine R (after 5 years of its service).

400000(A/P, 10, 15) = (400000 - Fn*)(A/P, 10, 10) + Fn* x 0.10

209
So, by solving this equation we can find Fn*.

This way you analyze the problems of such nature. You have seen that under different cases
you have to deal by taking the different study periods and you come at different conclusions.
Thank you.

210
 Engineering Economic Analysis
ProfessorDr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of TechnologyRoorkee
Lecture 20
Economic Life of the Asset
Welcome to the lecture on economic life. In this lecture, will discuss about how to find
economic life of an asset. In economic term, when we use any asset, as the asset grows older
the maintenance cost or the operating cost on the machine is increasing. So, how long the
machine should be used so that the annual cost which you incur on the machine is minimum.

(Refer Slide Time: 01:24)

The time for which you should use the machine where to get the minimum annual cost is known
as economic life of the asset.

We need to know how long the machine should be used which minimizes assets total equivalent
annual cost or maximizes the equivalent net income.

Any machine will have certain life or total service life but every year the salvage value of the
machine will go on decreasing. The salvage value is decreasing but the operating and
maintenance cost will go on increasing as the time progresses, this is the general trend when
we use the machines.

To solve such problems, you have to calculate the annual equivalent value for each of the years.
Further, the year in which the annual equivalent value is minimum you can say that the machine
should be used for that many years. Economically, that is the best alternative and that is why

211
that time will be known as economic life of the asset or economic service life of the asset. Let
us see how to solve such problems.

(Refer Slide Time: 03:06)

Q: A machine is to be purchased at a cost of Rs. 10,00,000. The annual operating cost for the
first year is Rs. 1,00,000 which increases Rs. 50,000 thereafter every year. The annual
maintenance cost for first year is Rs. 10,000 which increases Rs. 5,000 thereafter every year.
The salvage value of the equipment after 1 year is Rs. 5,00,000 and it decreases by Rs. 50,000
every year. If the rate of interest is 15%, find the economic life of the equipment.

So, we have to calculate the annual equivalent value for each year. We have,

Year Operating Cost Maintenance Cost Salvage Value

1 100000 10000 500000

2 150000 15000 450000

3 200000 20000 400000

4 250000 25000 350000

5 300000 30000 300000

6 350000 35000 250000

7 400000 40000 200000

All have Uniform Gradient Series

212
(Refer Slide Time: 11:12)

First cost of the asset = 10,00,000

Now, we have to find AE(i) at suppose n years, so that AE(i)min is minimum. That means, we
have to find the time when it can be said that if the machine is used to this many years will give
you the minimum annual equivalent.

AE(i)1 = (1000000 - 500000)(A/P, 15, 1) + (500000 x 0.15) + 100000 + 50000(A/G, 15, 1)

First cost – Salvage Value Capital recovery Operating Cost

with return part

+ 10000 + 5000(A/G, 15, 1)

Maintenance Cost

= 500000 x 1.15 + 75000 + 110000 = 760000

213
(Refer Slide Time: 19:14)

(Refer Slide Time: 14:12)

If you are going to use the machine for two years, then n = 2. So, we have,

AE(i)2 = (1000000 - 450000)(A/P, 15, 2) + (450000 x 0.15) + 100000 + 50000(A/G, 15, 2)

+ 10000 + 5000(A/G, 15, 2)

= 550000 x 0.615 + 67500 + 110000 + 55000 x 0.465= 541325

214
(Refer Slide Time: 18:04)

(Refer Slide Time: 19:14)

If n = 3. So, we have,

AE(i)3 = (1000000 - 400000)(A/P, 15, 3) + (400000 x 0.15) + 110000 + 55000(A/G, 15, 3)

= 600000 x 0.438 + 60000 + 110000 + 55000 x 0.907= 482685

215
(Refer Slide Time: 20:15)

If n = 4. So, we have,

AE(i)4 = (1000000 - 350000)(A/P, 15, 4) + (350000 x 0.15) + 110000 + 55000(A/G, 15, 4)

= 650000 x 0.438 + 52500 + 110000 + 55000 x 1.326= 462930

(Refer Slide Time: 23:10)

So, it is economical to use it for 4 years instead of 3 years but this is not the end, we have to
again check for 5 years.

216
If n = 5. So, we have,

AE(i)5 = (1000000 - 300000)(A/P, 15, 5) + (300000 x 0.15) + 110000 + 55000(A/G, 15, 5)

= 700000 x 0.298 + 45000 + 110000 + 55000 x 1.722 = 458310

Still it has further decreased. So even if you use for 5 years, it’s still economical. Let us again
try for n equal to 6 years.

If n = 6. So, we have,

AE(i)6 = (1000000 - 250000)(A/P, 15, 6) + (250000 x 0.15) + 110000 + 55000(A/G, 15, 6)

= 750000 x 0.264 + 37500 + 110000 + 55000 x 2.097= 460835

(Refer Slide Time: 25:45)

217
(Refer Slide Time: 24:23)

Now what we see is that once you use the equipment for 5 years to 6 years the annual equivalent
value is seen to increase by about 2,500. It means it is economical to use the equipment only
for up to 5 years. So, 5 years is the economic life.

Now let us check for one more year, (for 7 years) we will see further it will increase.

(Refer Slide Time: 28:36)

If n = 7. So, we have,

AE(i)7 = (1000000 - 200000)(A/P, 15, 7) + (200000 x 0.15) + 110000 + 55000(A/G, 15, 7)

= 600000 x 0.24 + 30000 + 110000 + 55000 x 2.45= 466750

218
So, what we see is that the minimum value of annual equivalent is found at n = 5 years and that
is why economic life of the asset is 5 year. This way we calculate the economic life of the asset.
Thank you.

219
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 21
Depreciation: Definition, Reasons, Types of Property, Value Time Function and Book
Value

Welcome to the lecture on depreciation. The equipment which we use, their value decreases
with time. In other words, they are said that they are depreciating.

(Refer Slide Time: 00:44)

Depreciation is a loss in value over the time the property is used.

In economic analysis, this is very important because it is also concerned with the tax
calculations. The investors can take the benefit of this property during the tax payments because
the depreciated amount can be subtracted from their total income. The investors invest a lot on
machines, these machines are used to generate income but simultaneously these machines lose
its value over the time. There are different methods by which depreciation can be calculated.

Requirement for a property to be depreciable.

1. Must be used in business to help to produce income.

Only those items which can be used to give you income, they are treated under the category.
2. Must be something that wears out, decays, obsolete or from natural cause.
3. Must have a determinable useful life longer than one year.

220
Depreciation will be of different types,

• physical depreciation
• functional depreciation
• depreciation because of accidents.

We will only discuss about physical and functional depreciation.

(Refer Slide Time: 03:10)

Physical depreciation

Primary causes are:

• Depreciation due to action of elements including corrosion of pipe, bacterial action
(independent of use)
• Wear and tear (by use, loss in value over time).

Physical depreciation is because of the physical impairment of the asset. The asset, if it is a
running element or a machine which is permanently used or which has the mating parts, then
certainly there will be natural wear and tear. So slowly its value decreases, the ability to produce
the same degree of finish or same accuracy will decrease.

Physical depreciation includes corrosion of pipe, bacterial action, sometimes that we do not
use. Some of the materials we are keeping in the atmosphere and there will be rusting on it or
there will be corrosion even if we do not use it. Physically there is impairment of the property
or the material, so that comes under the physical causes and under physical depreciation.

221
The difference between the two is, in one case you even don’t use, the value is decreasing. In
another case, you are using it and that is why by using there will be wear and tear of the
elements and its value will decrease over time.

Functional depreciation: Because of change in demand or services it can provide.

Because of obsolescence
Inadequacy or inability to meet the demand.

In this case, it’s not that the material is physically inefficient. Material or asset can work
satisfactorily but there are external reasons which affect its demand or its value. Those reasons
are maybe because of change in demand, the demand has changed and that is why the asset has
lost its value.

Because of obsolescence, sometimes because of the technological changes, certain assets lose
its value because an equally same priced asset is available at lower cost but with more accuracy.
You can say that the machine which you have, it has become obsolete because of the
technological enhancement or technological upgradation.

Inadequacy or inability to meet the demand. This is a reason because in course of time, the
company may require a machine which need larger capacity and the existing machine has
somewhat a rated capacity and the machine needs either to be supplemented with another
machine which in one quantity itself can satisfy your demand.

(Refer Slide Time: 07:06)

Now let us see, we have types of property,

222
Tangible: Can be seen or touched (can depreciate due to reasons listed before.

Intangible: That has value but can’t be seen or touched (software, trademark, patent,
copyright).

Buildings or Real property → Tangible personal property

Property temporarily attached to buildings

Tangible properties are those which we can be touched and feel. So, they depreciate due do the
reasons listed before, they depreciate because of the mating of elements, because of wear and
tear, because of corrosion, all these factors are responsible as because of these factors they lose
the value.

Intangible properties, you have the properties which cannot be seen but they can be felt. They
cannot be touched like you have software, trademark, patent, copyright. So, these are the
documents or the properties, these cannot be seen but they have value, these values also change
with time.

You have also a property in the category of real property. You may have a building which has
the tangible part as well as intangible part. So basically, you have a personal property of which
some of them are integral part of the buildings and some of them can be removed out of it.
They are under the category of personal properties. Land is considered to be a non-depreciable
property and building is said to be depreciable property because building loses its value.
Building is said to have a life, so its value changes as the time progresses but land does not
come under depreciable property. So, when we do the depreciation analysis, at that time we
have to keep in mind that the cost of land cannot be taken as the cost whose value will change
with time.

223
(Refer Slide Time: 09:38)

Value time function and book value

• Value of assets changes with time.

• Book value is used to represent the undepreciated value of an asset. It is calculated as first
cost of asset minus the depreciation charge accumulated till that period.

In depreciation we come across certain terms like book value. If you have an asset whose value
is something now, then its value will change with time. The functional relationship which
shows how the value of the asset changes with time, that is known as value time function. So,
you have different kinds of functions which may represent how the book value is changing
with time.

Book value is used to represent the undepreciated value of an asset. Book value is nothing but
the value which you have now but the depreciations will be there every year. So, book value is
the value of the asset at any particular time. If you take at any time t, Bt represents the book
value at the end of year t. It is calculated as first cost of an asset minus the depreciation charge
accumulated till that period.

224
(Refer Slide Time: 22:39)

Let us see how we calculate the book value.

If you have an asset whose first cost is P, the asset has n years of life. After n years it will have
certain value and that is known as the salvage value. If n is the life of the asset, in that case the
value of the asset at the end of its life is known as salvage value. The function can be of any
type and it is known as value time function.

P = First cost of asset

n = Life of the asset
F = Salvage value
Bt = Book value at end of year t
Dt = Depreciation during year t
So, you have
Year Depreciation charge during year Book value at end of year (Bt)
0 P
1 D1 P - D1
2 D2 P - (D1 + D2)
3 D3 P - (D1 + D2 + D3)
- - -
- - -
t Dt P - (D1 + D2 + --- + Dt)

225
What we see is

𝐵𝑡 = 𝑃 − ∑ 𝐷𝑡
𝑗=1

We also have the expression

Bt = Bt - 1 - Dt

If you have to find the book value at the end of any year, the book value in the previous year
minus depreciation charge calculated during that year will give you the book value after that
year.

So, this is how you calculate the book values.

(Refer Slide Time: 18:03)

Depreciation methods

There are different types of depreciation methods. As we have discussed that the value time
function may be different and value time function is used to find the book value of the asset
after any year t. Based on that, there are certain depreciation methods. These methods are
• Straight line method
• Accelerated methods
• Units of Production method
• Tax depreciation methods
• Depletion

226
(Refer Slide Time: 19:07)

Straight-line method tells that value time function is a straight-line, so straight-line means the
amount of depreciation during any year will be constant. So, straight-line method assumes that
the depreciation amount during any year is constant. So, after n years you reach to a finite value
of book value that is given at the end of n years as salvage value.

In many cases it is assumed that the amount of depreciation should not be a constant amount.
When we use the assets for our personal satisfaction or our business to produce income, the
value is decreasing at a larger rate initially. In those cases, we use the accelerated method.
Accelerated methods used for machines in which the depreciation during the previous year is
more and as we go ahead in time, the depreciation amounts decrease.

We will discuss about the different methods of depreciation using the accelerated methods, in
that there is another method known as Sum of years digit methods that is also one of the
accelerated method.

Another method is units of production method. The machine which has come to the investor,
it has certain capacity to produce. Suppose it has the capacity to produce 3,00,000 units over
its life of 5 years. Now the depreciation will depend upon how much you are using that
machine. After 5 years the machine will depreciate to its final salvage value but if during the
first year machine is utilized for large number of production or it is utilized quite heavily, in
that case the depreciation or loss in its value will be more because larger the machine will run,
the more will be wear and tear between the parts or the elements, the more will be loss in its

227
value. So, this production method tells you that as much you use or as much you produce the
depreciation will be proportional to that.

Tax depreciation methods; as we had discussed earlier, depreciation is also used for tax
calculation. The industries are promoted to go for investing more and more. Now industries
use the machines or assets to generate income, in turn they provide the employment. Now they
produce the income out of which they have to give tax. The government gives certain freedom
to the industries, government gives a rebate on tax on those amounts.

Depletion; the depletion is the depreciation of the natural assets. Sometimes we deal with the
assets like asset which are used for mining industries where you do not know the quantity of
the mineral deposit. In those cases, when you use the depreciation methods, they are known as
depletion method. Here there are two methods; cost method and percentage method.

The cost method tells that how much you have generated the income and based on that the
depreciation will be calculated and there is percentage method where depending upon the
mineral which is extracted you generate the depreciation of those natural resources cost.

We will discuss more about these methods in the next lecture.

Thank you.

228
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 22
Basic Depreciation Methods: S-L Method, Declining Balance Method
Welcome to the lecture on depreciation.

In this lecture we will discuss about straight-line method of depreciation and declining
balance method of depreciation.

(Refer Slide Time: 00:50)

Straight-line method of depreciation assumes that the value of an asset decreases at a

constant rate. In the case of straight-line method of depreciation, the time value function is a
straight line. So, the depreciation during any year is a constant

We can have

Dt = (P - F)/n

Bt = P – t(P - F)/n

P is the first cost of the asset, F is the estimated salvage value of the asset after n years.

229
(Refer Slide Time: 06:48)

When we talk about straight-line method of depreciation, your value time function will be as
shown in Figure.

Depreciation during any year = (P – F)/n.

P = first cost of the asset,
n = useful life of the asset and
F = salvage value at the end of its life.
Bt = Book value at end of year t
Dt = Depreciation during year t
Year Depreciation charge during year t (Dt) Book value at end of year (Bt)
0 P = B0
1 𝑃−𝐹 𝑃−𝐹
𝑃− = 𝐵1
𝑛 𝑛
𝑃−𝐹 𝑃−𝐹
2 𝑃 − 2( ) = 𝐵2
𝑛 𝑛
- - -
- - -
t Dt 𝑃−𝐹
𝑃 −𝑡( ) = 𝐵𝑡
𝑛

230
(Refer Slide Time: 08:19)

So, we have

𝑃−𝐹
𝐵𝑡 = 𝑃 − 𝑡 ( )
𝑛

The book value at the end of year its life,

𝑃−𝐹
𝐵𝑛 = 𝑃 − 𝑛 ( )
𝑛

231
(Refer Slide Time: 09:36)

Example: For an asset;

P = 10000, F = 2000, n = 5 years. If we want to calculate the depreciation charges during any
year, then

Depreciation charge during any year = (P – F)/n

= (10,000 – 2000)/5

= 1600.

So, this is how you calculate the depreciation charges in the straight-line methods.

Using straight-line method, the depreciation rate is defined as 1 by n. That means the charge
of depreciation will be calculated by multiplying 1 by n with the difference of first cost of
asset and the salvage value of the asset. So that is why 1 by n is called as the depreciation rate
for the straight-line methods.

232
(Refer Slide Time: 10:51)

Declining balance method of depreciation: In many cases it is assumed that the

depreciation during the early years should be larger, so they are known as accelerated
methods of depreciation. It is also realistic that things depreciate during their early years
more, they lose its value more than in the later portion of its service life. So, in the declining
balance method of depreciation, which is one of the type of accelerated methods of
depreciation, it assumes that, asset decreases in value faster early rather than in the later
portion of its service life.

So how we calculate the depreciation charges in this?

A fixed percentage is multiplied times the book value of the asset at the beginning of the year
to determine the depreciation charge during the year. As book value decreases, depreciation
charge decreases. So basically here, the amount of depreciation will depend upon the book
value at the initiation of the year. Since, book value decreases as the time progresses, so
amount of depreciation also decreases.

If depreciation rate is α,

Dt = α.Bt-1

Bt = (1- α)t.P

233
(Refer Slide Time: 16:19)

So, if alpha is rate of depreciation, then in that case let us find the value of depreciation and
the book value from the table.

Year Depreciation charge during year t (Dt) Book value at end of year (Bt)
0 P
1 αP P(1- α)
2 α.P(1- α) P(1- α)2
- - -
t α.P(1- α)t-1 P(1- α)t
- - -
n α.P(1- α)n-1 P(1- α)n

So, this is how the depreciation charges calculated and also the book value at the end of year
n or year t is calculated in the cases of declining balance methods of depreciation.

Let us discuss about certain facts;

Maximum allowable rate of depreciation (in tax considerations) is taken as 2 times the rate
used for straight-line method of depreciation.

Rate is 2/n, also known as double declining balance method of depreciation. So basically,
when you have the rate as 2 times on 1/n, that is double declining balance method of

234
depreciation, also known as DDB. We may also come across the term known as 150 percent
declining balance method. That is 1.5 times 1/n.

(Refer Slide Time: 19:42)

(Refer Slide Time: 25:22)

Example: Suppose; P = Rs. 10,000, F = Rs. 778, n = 5 years. If you are told to find
depreciation schedule using declining balance method (DDB depreciation schedule).

So, we have:
Depreciation rate = 1/5 = 20%
In the DDB, the percentage of depreciation will be 2 times depreciation rate = 40%.

235
End of year 1 2 3 4 5

Depreciation 40% of 10000 40% of 6000 40% of 3600 40% of 2160 40% of 1296
charge = 4000 = 2400 = 1440 = 864 = 518
during year

Book value 10000 - 4000 6000 - 2400 3600 - 1440 2160 - 864 = 1296 - 518 =
at the end of = 6000 = 3600 = 2160 1296 778
year

So, using the declining balance method of depreciation we have seen that, we have got the
amount of salvage value as the book value at the end of year its life. In many cases, you will
find that the book value at the end of its life, that is the salvage value maybe either more or
less than its value.

(Refer Slide Time: 26:01)

Example: Compute DDB depreciation schedule for P = Rs. 10,000, n = 5 years and final
salvage value Rs. 2,000.

Here, the salvage value seems to be more than the book value. Now under these cases you
have to adjust your depreciation charges so that you get finally the amount of 2000 at the end
of its life.

236
These topics come under the topic of adjustment of depreciation charges during its life so that
the book value and the salvage value become equal. There are 2 ways by which they can
become equal, one is that the simple adjustment. In this case, we can adjust directly come to
2000 book value in the fourth year, for that you have to keep the depreciation charge of only
160 during the fourth year and the value of the asset at the end of fourth year will become
2000. During the fifth year the depreciation charge can be taken as 0 and book value will be
2000.

Another way is by switching to the straight-line method that we will discuss in our next class.
Thank you.

237
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 23
Depreciation: Declining Balance Switching to S-L, SOYD Method
Welcome to the lecture on depreciation. In this lecture we will discuss about adjustment in
declining balance method.

(Refer Slide Time: 00:49)

– In declining balance method, final book value may not necessary be equal to the final
salvage value.

– In such situation’s adjustment is needed so that final book value equals the final salvage
value.

– It can be done either by switching to straight line method at appropriate time or by simple
adjustment towards the end period.

So, if the final book value is not equal, in that case you need to do certain adjustment so that
final book value equals the final salvage value. It can be done either by switching to straight-
line method at the appropriate time or by simple adjustment towards the end period. So, let us
see if we have the question where you have to use the DDB depreciation schedule.

238
(Refer Slide Time: 06:06)

Example: Compute DDB depreciation schedule for P=Rs.10,000, n=5years and final salvage
value Rs.2,000.

P = Rs. 10,000, n = 5 years and F = Rs. 2000.

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

1 40% of 10000 = 4000 6000

2 40% of 6000 = 2400 3600

3 40% of 3600 = 1440 2160

4 40% of 2160 = 864 (need to be 1296 (< 2000)

adjusted)

4 new 160 2000

5 0 2000

During the fourth year at the same rate, if we calculate 40% of 2160 = 864 and then book
value comes out to be 1296. Now this 1296 is less than 2000, which is the salvage value.
Now the book value under the tax schemes, the book value at the end of any year cannot be
less than the salvage value which is mentioned. So, that will be adjusted.

239
Now let us see a case in which the estimated salvage value is given as 0. Using the declining
balance method of the depreciation which is calculated as a certain fraction times the first
cost of the asset or the book value of the asset at any time, in that case we can never achieve
0.

(Refer Slide Time: 07:12)

So, you have to switch to straight-line method so that you come to a value of 0, so that is
known as switching to straight-line method. So, switching occurs when next periods straight-
line depreciation amount on the undepreciated balance of the asset exceeds the next periods
declining balance depreciation charge.

So switching is practiced when it is seen that at this period if you calculate the depreciation
charge based on the life remaining of the asset using the straight-line method and using the
declining balance method or double declining balance method, in that case whichever is
larger that should be taken.

So declining balance depreciation when it is less than the straight-line depreciation on

undepreciated balance in that case you go for switching to straight-line. Now we know that
using the declining balance method, during the tth year the amount of depreciation is α times
the book value at the end of (t -1)th year and for that time the straight-line method of method
of depreciation will calculate the appreciation charge.

– Declining balance depreciation < (SL depreciation on undepreciated balance)

α (Bt-1) < (Bt-1 - F)/{n - (t-1)}

240
(Refer Slide Time: 09:03)

Let us see an example where this is the example of switching.

Example: Compute DDB depreciation schedule for P = Rs.10,000, n = 5years and final
salvage value is zero.

P = Rs.10,000, n = 5years and F = 0 (Rate of depreciation using DDB = 40%)

Now in this case using the normal double declining balance method of depreciation which
was coming out to be 778, so book value is more than the estimated salvage value. So, in this
case you have to switch to the straight-line method. Let us see how to switch?

(Refer Slide Time: 14:57)

241
Year Depreciation charge during year Type of Book value at the
Using DDB Using S-L method depreciation end of year
adopted
0 10000
1 40% of 10000 = 4000 (10000-0)/5 = 2000 DDB 6000
2 40% of 6000 = 2400 (6000-0)/4 = 1500 DDB 3600
3 40% of 3600 = 1440 (3600-0)/3 = 1200 DDB 2160
4 40% of 2160 = 864 (2160-0)/2 = 1080 S-L method 1080
5 -- 1080 S-L method 0
(Refer Slide Time: 17:09)

So, this is an example how to adjust the depreciation schedule by switching to straight-line
from declining balance and this is basically used while we go for calculating the amount of
depreciation in certain tax depreciation methods.

Next to the method of depreciation which we will discuss is Sum of Years Digits Method.

242
(Refer Slide Time: 17:58)

Sum of years digits method (SOYD) is also a type of accelerated method where the
depreciation charge during the early time is larger and as we move ahead, the charge of
depreciation slows down, it decreases. In this case some of years digits means the sum of the
number of years from 1 to that year that is calculated and that comes in the denominator.

(Refer Slide Time: 20:48)

If n is the life of the asset in years, in that case

SOYD = 1 + 2 +-----n = n(n + 1)/2

243
So,

(𝑛 − 𝑡 + 1)
𝐷𝑡 = [𝑃 − 𝐹 ]
𝑆𝑂𝑌𝐷

So, if you see depreciation charge during first year (t = 1),

𝑛
𝐷1 = 𝑛(𝑛+1)
[𝑃 − 𝐹 ]
2

So similarly,

𝑛−1
𝐷2 = 𝑛(𝑛+1)
[𝑃 − 𝐹 ]
2

For nth year,

1
𝐷𝑛 = 𝑛(𝑛+1)
[𝑃 − 𝐹 ]
2

(Refer Slide Time: 23:27)

Example: P = Rs. 10,000, F = Rs. 2000, n = 5 years, depreciation schedule using SOYD
method

244
SOYD = n(n + 1)/2 = (5 x 6)/2 = 15

So, depreciation charge during year 1 = 5/15 x (10,000 – 2000) = Rs. 2667
Depreciation charge during year 2 = 4/15 x (10,000 – 2000) = Rs. 2133
-
-
depreciation charge during year 5 = 1/15 x (10,000 – 2000) = Rs. 533

(Refer Slide Time: 23:46)

We have other methods of depreciation; the next method of depreciation is Units of

Production Method.

Many a times we buy the machine which has certain capacity to produce, so the depreciation
calculated during any year will be based on how much it produces. So in that case the
depreciation charge during any year t will be units consumed during year t multiplied by the
P - F divided by total units of production.

Dt = (Units consumed during year t) x (P - F) / (Total units of productions)

It is applicable for those machines were the depreciation is because of wear and tear of the
machine elements. In that case, larger the machine will be used for production runs, larger
will be its depreciation and smaller we produce, the smaller will be the depreciation charges.
So, we can see one example how can you solve if you have such cases.

245
(Refer Slide Time: 28:52)

(Refer Slide Time: 29:15)

Example: A lathe is there can machine about 1,00,000 units in its estimated life of 5 years. It
has first cost given as Rs. 50,000 and salvage value at the end of its life as Rs. 10,000. If
during the first year about 40,000 units are machined, find depreciation charge during the
year and book value at the end of year.

So, the cases where the capacity is given, first cost and salvage value are given, life is given,
in that cases, the unit of production method will be used.

In this case, the lathe machine is designed on an average to work for 1,00,000 by 5 that is
20,000 units. Now in that case, it has machine about 40,000 units.

246
So, depreciation charge = 40000 x (50,000 – 10000)/100000 = 16,000.

So, so depreciation charge during year 1 = Rs. 16,000

Book value at the end of year 1 = 50,000 - 16,000 = 34,000.

So that is how you calculate the depreciation charge using units of production method.

Thank you.

247
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 24
Modified Accelerated Cost Recovery System (MACRS) Method of Depreciation,
Depletion
Welcome to the lecture on tax depreciation methods. So far, we have discussed about the
methods like Double Declining Balance Method of depreciation or Declining Balance
Method of depreciation, SOYD that is Sum of Years Digits Method and also the Straight-
Line Method.

(Refer Slide Time: 01:02)

Based on the US tax laws, there was a depreciation method which was suggested that was
known as Modified Accelerated Cost Recovery System. In this method there are few
conventions which are used. First is that we have the recovery period rather than the useful
life of the asset. Half-year convention is used to avoid very large depreciation during the first
year because it is assumed that if the capitals asset does not depreciate too large during the
first year, the capital can be used for other investments. So, during the first year only half of
the year’s depreciation charge is taken into account and this is known as half year convention.

In this case switching from declining balance method to straight-line method, is adopted, so
that you can come to a value of 0 salvage value at the end of the period. It is assumed that at
the end of the recovery period whole of the assets cost is recovered.

248
The assets are categorized under a different property class. Depending upon the assets useful
life there are different property classes and the asset is required to depreciate fully during that
period. These different property classes are based on the recovery period and based on the
class life of these properties, which is their average life.

MACRS has defined 6 recovery period classes for personal property and two classes for real
property.

Recovery Class Applicable Property Depreciation Method

Period Life
(Years) (Years)
3 ≤4 Special tools for DDB switching to SL with half
manufacturing, fabricated year convention
metal products, etc.
5 4 < class Automobiles, light trucks, DDB switching to SL with half
life ≤ 10 computers, copiers, etc. year convention

7 10 < Office furniture, fixture, rail DDB switching to SL with half

class life road track year convention
≤ 16
10 16 < Assets used petroleum DDB switching to SL with half
class life refining, in the manufactures year convention
≤ 20 of casting and forging, rail
road cars, etc.
15 20 < Telephone distribution 150% DB switching to SL with
class life equipment, waste water half year convention
≤ 25 plants, etc.

20 25 ≤ Municipal sewers, electrical 150% DB switching to SL with

class life power plants, etc. half year convention

27.5 Residential rental property, SL depreciation with half year

apartment buildings convention

39 Nonresidential real property: SL depreciation with half year

office buildings, elevators and convention
escalators

249
(Refer Slide Time: 02:49)

(Refer Slide Time: 04:20)

Example: We have an equipment with the recovery period of 5 years. (DDB switching to
straight-line half year convention) Half year convention means during the first year the
depreciation charge will be calculated on the basis of only half year. So, if during the first
year only half year is calculated, it means it goes in the sixth year. You have to calculate the
depreciation charge.

Using DDB: Depreciation rate = 1/5 x 2 = 40%

250
Year Depreciation charge during year Type of Book value at the
Using DDB Using S-L method depreciation end of year
adopted
0 100
1 ½ x 40% of 100 = 20% ½ x (100/5) = 10% DDB 100-20 = 80
2 40% of 80 = 32% (80/4.5) = 17.78% DDB 48
3 40% of 48 = 19.2% (48/3.5) = 13.7% DDB 28.8
4 40% of 28.8 = 11.52% (28.8/2.5) = 11.52% S-L method 17.28
5 40% of 17.28 = 6.91% (17.28/1.5) = 11.52% S-L method 5.76
6 5.76% S-L method 0

(Refer Slide Time: 17:35)

So, this is how we calculate the depreciation schedule for MACRS method.

Now in this method some points which we discussed needed to have attention is that, there is
no meaning of having any salvage value because whole the cost is recovered, and your
salvage value is treated as 0.

251
Example: For 3-year property class, in the same method we can calculate the depreciation
schedule.

Rate of depreciation using DDB = 2 x 1/3 = 66.67%

Year Depreciation charge during year Type of Book value at the

Using DDB Using S-L method depreciation end of year
adopted
0 100
1 ½ x 66.67% of 100 = ½ x (100/3) = 16.67% DDB 100-33.33 = 66.67
33.33%
2 66.67% of 66.67 = (66.67/2.5) = 26.67% DDB 66.67 – 44.45 =
44.45% 22.22
3 66.67% of 22.22 = (22.22/1.5) = 14.81% S-L method 22.22 – 14.81 =
14.81% 7.41
4 7.41% S-L method 0

(Refer Slide Time: 24:05)

This is how you compute depreciation charges during the different years.

Now we can compute the depreciation schedule for the different property classes. As we have
seen that for 3, 5, 7 and 10 years of recovery period, we use DDB switching to straight-line.

252
(Refer Slide Time: 25:04)

(Refer Slide Time: 30:06)

Now let us say if we go to the 15-year recovery period.

15-year Property: Recovery period is 15 years (depreciation method adopted is 150 percent
declining balance switching to straight-line half year convention)
Rate of depreciation will be 1/15 x 150 = 10%

Year Depreciation charge during year Type of Book value at the end
Using DDB Using S-L method depreciation of year
adopted
1 ½ x 10% of 100 = 5% ½ x (100/15) = 3.33% DDB 100-5 = 95

253
2 10% of 95 = 9.55% (95/14.5) = 6.55% DDB 95 – 9.5 = 85.5
3 10% of 85.5 = 8.55% (85.5/13.5) = 6.33% DDB 85.55 – 8.55 = 76.95
- - - - -
- - - - -
15 - - - -
16 - - - 0

So, this is the method which is followed for different property classes.

You will have problem, we can solve them based on this in which the equipment will be
given to you, you must be able to know under which property class it belongs to and as per
that the depreciation method is to be used, depreciation schedule is to be used and in every
year by having these known value of percentage of the first cost of the asset you can calculate
the depreciation charges using this MACRS method of depreciation. Thank you.

254
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 25
Depreciation: Units of Production Method, Depletion
Welcome to the lecture on depletion. So, when we talk about the natural resources the term
depletion is used instead of depreciation because in this case there is piecewise removal of
the asset. Suppose we try to talk about the natural resources, oil reservoirs or mines, in that
case process of amortizing cost of natural resources in accounting period is known as
depletion.

(Refer Slide Time: 01:06)

So basically, as the time progresses, the amount of resources is being depleted and for that a
depletion allowance is given for the recovery of the loss which is caused because the natural
resources are lost during the mining process. So, there are two ways of finding these
depletion charges, one is cost method and another is percentage method.

255
(Refer Slide Time: 01:59)

Cost method of depletion: This cost method of depletion is similar to the units of production
method that we have discussed earlier in depreciation. In this case, depletion charge will be
based on amount of resource that is consumed at the initial cost of resource.

When you know that this much amount of resource is to be extracted from the source and you
have extracted certain amount from that source, so based on that this depletion amount will
be calculated. Depletion charge is calculated by multiplying the unit depletion rate with
amount produced during that year.

(Refer Slide Time: 03:00)

256
Percentage method: It allows a fixed percentage of gross income produced by the sale of
resources to be the depletion charge.

In this case, whatever be the gross income, depending upon the type of mineral resources a
percentage is fixed and that is said to be the depletion charge.

Now in that there is a cap, it is required that depletion charge for any period should not
exceed 50 percent of all the taxable income for that period. So basically, what may happen
that it may go to more than that, so basically this is the cap which is given. The depletion
charge which is basically demanded by the investor, it has not to exceed 50 percent of the
taxable income.

(Refer Slide Time: 04:28)

So basically, taxable income will be calculated based on the gross income and also any type
of expenditure which the investor does regarding the operation in that particular area like
mining or reservoir. So, in that based on the US survey there has been certain percentages are
defined.

Deposits Percentage
Oil and gas wells 15
Sulfur, uranium, asbestos, lead, zinc, etc. 22
Gold, silver, copper, iron ore, and oil shale 15
Coal, lignite, and sodium chloride 10

257
Clay and shale to be used in making sewer pipe or bricks 7.5
Clay (used for roofing tile), gravel, sand and stone 5
Most other minerals; includes carbon dioxide produced from well and 14
metallic ores
Once you have the gross income, this much percent is calculated as the depletion allowance.
It is also ensured that this amount should not exceed 50 percent of the taxable income.

So, once you have the taxable income, it should not, you get the 50 percent of that and
whichever of the two is less, that amount is taken as the depletion allowance.

(Refer Slide Time: 05:47)

(Refer Slide Time: 08:42)

258
Example: An oil reservoir is owned containing estimated 10,00,000 liters of oil with initial
investment of Rs.70,00,000. If 50,000 liters of oil are produced during this year find the
depletion allowance.

If the price of oil is Rs.20 per liter and all other expenses associated with operations of oil
reservoir is Rs. 2,00,000. Find depletion charge.

Oil reservoir – 1000000 liters of oil

Initial investment = Rs.70,00,000

Unit depletion charge = 7000000/1000000 = Rs. 7 per liter

Production of oil = 50000 liters

So, Depletion charge during the year = 7 x 50000 = Rs. 350000

This method is known as cost method of depletion calculation

(Refer Slide Time: 10:33)

(Refer Slide Time: 10:07)

259
Percentage method

Now we see that the price of oil is given as Rs. 20 per liter. So, the company has produced
and sold 50,000 liters of oil at rupees 20 per liter and it is the income of the company.

Price of oil is Rs. 20 per liter

Gross income of the company = 20 x 50000 = Rs. 1000000

Using the percentage depletion method,

depletion charge = 15% of Rs. 10,00,000 = Rs. 150000

This is the depletion charge calculated using the percentage method.

The condition with this depletion method by percentage is that not it should not exceed 50
percent of the taxable income.

Taxable income = gross income – other expenses

= 1000000 – 200000 = Rs. 800000

Maximum allowable depletion allowance = 50% of taxable income

= 50% of 8,00,000 = 4,00,000

Now company the can afford to have maximum depletion allowance of Rs. 400,000 whereas
based on percentage basis the depletion amount has come out to be 1,50,000. The minimum
of the two will be taken as the depletion charge.

260
Maximum depletion allowance is Rs. 4,00,000 which is larger than the depletion calculated
using percentage of gross income.

Total depletion will be Rs. 150,000.

This is how you calculate the depletion allowance in case of natural resources.

(Refer Slide Time: 11:07)

(Refer Slide Time: 14:39)

261
(Refer Slide Time: 15:35)

Whenever we are told in the question about any type of materials like if you are mining
Sulphur, uranium or lead or zinc, in that case the percentage which we calculated as 15% in
case of oil and gas, this will be 22%. Similarly, once you go for coal, lignite or sodium
chloride, this will be used as depletion percentage will be based on the 10% of gross income.

Further in the gross income side you have to see what are the other investments which are
required for the mining purposes. These amounts will be subtracted from the gross income
and 50% of that is to be calculated. So, if the 50% of that gross income exceeds then the
smaller value will be taken. If the 50% of the total taxable income is the lower value, in that
case that lower value will be used, so this condition is also to kept in mind.

(Refer Slide Time: 19:43)

262
• So, what we see, if depletion allowance using percentage calculation is less than 50% of
taxable income, depletion charge calculated using percentage will be taken.
• When depletion allowance calculated using percentage method is larger than 50% of the
taxable income, the depletion charge will be same as 50% of the taxable income i.e. in
every case smaller value of the two will be used as the depletion charge.

So, this is how the depletion of these natural assets are taken into account and are used for
getting the tax benefits by the investors who have invested in such industries.

(Refer Slide Time: 25:32)

Example: A Sulphur mine has a gross income of Rs. 5,00,000 during this month. The
expenses incurred by company during the month is Rs. 3,90,000. Calculate depletion
allowance for this case.

So, we have to use the percentage method of depletion in this case.

The percentage depletion charge is 22%,

Depletion amount = 22% of 500,000 = Rs. 1,10,000.

The taxable income = gross income - expenses incurred

= 5,00,000 - 3,90,000 = 1,10,000.

Maximum allowable depletion charge for the month = 50% of taxable income

= 50% of 1,10,000 = Rs. 55,000

263
Now what we see is that using the percentage method you calculate the depletion charge as
Rs 1,10,000. Whereas once you take into account the taxable income, the maximum
allowable depletion charge which the company can afford to get is Rs. 55,000.

Since the maximum allowable depletion charge is Rs. 55,000, the depletion allowance that
the company may charge will be only Rs. 55,000 not by Rs. 1,10,000 calculated using
percentage method.

So, we will deal with such problems also in future when we solve the problems based on the
depreciation as well as depletion and we can calculate the value of these charges depending
upon what type of minerals or materials are being mined, they are under which category and
also during the process what are the different kinds of investments, what are the different
kinds of expenses which are used for mining these resources.

Thank you.

264
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 26
Problem Solving Based on Depreciation and Depletion
Welcome to the lecture on problem solving on depreciation and depletion. So, in this lecture
we will solve problems based on depreciation methods as well as depletion methods.

(Refer Slide Time: 00:40)

Example: A machine was purchased for Rs 1,60,000 with life of 5 years and estimated
salvage value at the end of its life as Rs 17500. If basic declining balance method of
depreciation is used, what rate of depreciation will make the book value at the end of its life
equal to its salvage value at that time.

We have to find the rate of depreciation which will make the book value at the end of its life
equal to its salvage value at that time.

So we have studied the basic depreciation method in which we know that there is a fixed
percentage of the first cost of the asset that is used as a depreciation in the first year and every
time the book value is calculated, that percentage times the book value at the end of previous
year will be the depreciation charge during that year.

First cost of the asset, P = Rs. 1,60,000

Salvage value, F = B5 = Rs. 17,500.

265
n = 5 and

Rate of depreciation = ?, such that, book value at the end of 5 years = 17500

Let rate of depreciation be α

(Refer Slide Time: 07:19)

B5 = P(1 - α)5

17500 = 160000 (1 - α)5

(1 - α)5 = 17500/160000 = 0.1093

(1 - α) = (0.1093)1/5 = 0.642

α = 1 – 0.642 = 0.358

So, this is the rate of depreciation that is 35.8%, if that percentage of depreciation is used you
will get the first cost to depreciate at the value of 17,500. So, this is our answer.

266
(Refer Slide Time: 09:46)

Example: A company got a contract of mica mine for Rs 17,50,000 of which the value of
land was Rs 2,50,000. Approximately 60000 Kg of mica was expected to be mined. During
the first year 4000 Kg of mica was mined. What will be the depletion allowance for the year?

Amount invested (to be taken into account while calculating depletion allowance)

= 1750000 – 250000 = 1500000

Unit depletion rate = 15,00,000/60,000 = Rs. 25 per kg of mica

Depletion allowance during the year = 20 x 4000 = Rs. 100000

So, here it is similar to the cost percentage basis of depletion and also the same concept as
unit of production method is adopted, it has been used here to find the answer.

267
(Refer Slide Time: 10:09)

Example: An office equipment has been purchased at the cost of Rs 6,00,000 and has an
estimated salvage value at the end of its life of 10 years is Rs 1,20,000. Calculate the asset’s
depreciation deductions and book values over its depreciable life S-L method, DDB method
and SOYD method. Also calculate the depreciation deduction and book values at the end of
each year using MACRS if the property belongs to a 7-year property class (class life being 10
years).

So basically, in this question, we will try to have the deduction of depreciation charges
calculation of depreciation charges for every year using the four methods which we have
studied so far.

(Refer Slide Time: 16:12)

268
P = 6,00,000,

n = 10 years (useful life)

F = Rs. 1,20,000

For S-L Method:

Annual depreciation charge = (P - F)/n

= (600000 – 120000)/10 = Rs. 48000

Year Depreciation charge during year Book value at end of year

0 600000
1 48000 552000
2 48000 504000
3 48000 456000
4 48000 408000
5 48000 36000
6 48000 312000
7 48000 264000
8 48000 216000
9 48000 168000
10 48000 120000
(Refer Slide Time: 22:38)

269
For SOYD Method:

SOYD = (10 x 11)/2 = 55

D1 = (600000 - 120000) x 10/55 = 48000 x 10/55

D2 = (600000 - 120000) x 9/55

and so on ………..

Year Depreciation charge during year Book value at end of year

0 600000
1 48000 x 10/55 = 87273 512727
2 48000 x 9/55 = 78545 434182
3 48000 x 8/55 = 69818 364364
4 48000 x 7/55 = 61091 303273
5 48000 x 6/55 =
6 48000 x 5/55 =
7 48000 x 4/55 =
8 48000 x 3/55 =
9 48000 x 2/55 =
10 48000 x 1/55 =

So, this way you can calculate the values. Once we have the depreciation amount that can be
used to get the book value at mentioned time. So, this is how you solve the depreciation
problem based on a SOYD.

270
(Refer Slide Time: 30:02)

For double declining balance method:

P = Rs. 600,000,

n = 10 years,

F = 1,20,000.

Using DDB, rate of the depreciation = 2 x 1/10 = 20%

Year Depreciation charge during year Book value at end of year

0 600000
1 20% of 600000 = 120000 480000
2 20% of 480000 = 96000 384000
3 20% of 384000 = 76800 307200
4 20% of 307200 = 61440 245760
5 20% of 245760 = 49152 196608
6 20% of 196608 = 39322 157286
7 20% of 157286 = 31457 125829
8 20% of 125829 = 25165 120000
5829 (adjusted)
9 0 120000
10 0 120000
So, this is the depreciation schedule for the double declining balance method.

271
(Refer Slide Time: 31:08)

(Refer Slide Time: 35:07)

For MACRS method:

Recovery period = 7 years

MACRS uses the half year convention and DDB with switching to straight line.

Now we can refer to the MACRS table for a seven-year property in that the amount is 14.29
percent of the first cost of the asset. So, it goes for 8 years because this is half year
convention. We can get this table by calculating the values, so the star shows the switching to
straight line.

272
Year Depreciation charge during year Book value at end of year
0 600000
1 14.29% of 600000 = 85740 514260
2 24.49% of 600000 = 146940 367320
3 17.49% of 600000 = 104940 262380
4 12.49% of 600000 = 74940 187440
5 8.93% of 600000 = 53580 133860
6 8.92% of 600000 = 53520 80340
7 8.93% of 600000 = 53580 26760
8 4.46% of 600000 = 26760 0

So, in the MACRS as you see that the whole cost is recovered and you get the final salvage
value as zero. So, this is how the MACRS system works. We solve the problems based on
MACRS for any property class using this table.

Thank you.

273
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 27
Elements of Cost: Types of Cost
Welcome to the lecture on elements of cost. In this lecture we will discuss about different
types of cost. Cost is very important for the organization because there are different type of
expenses which is incurred by the organization. These expenses are categorized under
different names and depending upon the objective of the organization, the organization will
set the cost of the asset or the selling price of the unit piece of the asset or the product and it
will try to have the income as per its own plan.

(Refer Slide Time: 01:53)

Let us discuss about different types of cost which is incurred.

• Manufacturing cost and non-manufacturing cost

• Period costs and product costs
• Fixed and variable cost
• Average unit cost
• Incremental cost
• Opportunity cost

274
(Refer Slide Time: 02:35)

In the manufacturing cost, you use either the direct material cost, direct labour cost and
manufacturing overhead. Now in the direct material cost, the cost of the materials which are
directly used for the production of any product and which is clearly visible like the cost of
rubber or cost of steel for making a pen, the cost of metals used for the ball, all these are the
direct material cost because they are the materials cost which is visible and that is why they
are known as direct material cost. Similarly, direct labour cost, all the cost on the labour who
are directly involved with the production of the product.

Manufacturing overhead: There are many kinds of cost which are going behind the scene to
make the product, that are known as manufacturing overhead. The costs like heat and light,
the electricity used to make the product, the depreciation, etc. are under the manufacturing
overhead type of cost. All these cost except direct material cost and direct labour cost which
are used for the manufacturing of the component, are known as manufacturing overhead.

Nonmanufacturing costs: Apart from the manufacturing costs, there are also
nonmanufacturing costs, the costs which are incurred not directly related to the
manufacturing portion like costs associated with marketing and advertising, sales promotions,
and other similar type of costs. These costs are not directly related to the manufacturing of
the product; however, these are required for selling the product as selling is also an integral
part of the organization to sell the product.

275
Similarly, you have administrative expenses, the administrative expenses like you have
recruitments at different administrative levels, meetings, etc. are under the category of
administrative expenses.

Then you also have nonmanufacturing overhead, all the other costs like heat, light, electricity,
depreciation of machines which are not an integral part of the manufacturing unit are coming
under the nonmanufacturing overheads.

So, all the equipment which are in the manufacturing section, which are dealing with the
production of the product, their depreciation, the premium paid on them, interest, all these
factors are coming under manufacturing overhead and all of those equipment which are used
in the administrative and the marketing divisions, they are under the nonmanufacturing
overhead.

(Refer Slide Time: 07:01)

276
(Refer Slide Time: 07:20)

Period costs and product costs: When we talk about the financial statement perspective,
then the costs can be categorized under two broad names and these are period costs and
product costs. The period costs are those costs which are better to be expressed in a certain
period like the depreciation, taxes are known as period cost. Basically, in financial terms,
these costs are treated as expenses. So, whenever these costs are incurred, then it is felt that
the expense has already been done and we subtract these costs from the statement.

Product costs are the costs which are expressed related to the product. So, all the cost related
to the direct labour costs or direct material cost, are expressed for the product cost because
they are ultimately going to be linked with the production of the product.

(Refer Slide Time: 11:06)

277
Fixed cost and Variable cost: On the basis of cost behaviour there are cost known as fixed
cost and variable cost. Fixed cost is that type of cost which remains fixed irrespective of how
many units of product is being produced up to its capacity. Fixed cost remains constant and
does not depend on units produced. The rent on the building, depreciation of the building,
depreciation of the equipment being used, all these expenses are coming under the fixed cost
because they have nothing to do with the production units produced. Administrative
expenses, expenses on the sales and marketing, advertisements, they have nothing to do with
the units produced, so these expenses are also under the category of fixed cost.

(Refer Slide Time: 13:45)

Variable cost is the cost which varies with the number of units produced. As the number of
units are produced, this cost will go on increasing. So direct material cost and direct labour
cost are the examples of variable cost because as the number of units are produced, these
direct material and direct labour cost will increase.

So, fixed cost per unit item produced is a variable quantity because as we vary the number of
quantities produced the fixed cost per unit of item produced will be varying. While the
variable cost per unit is a fixed quantity because per unit cost is fixed amount

Now another cost which comes in between is the mixed cost. Mixed cost is another variety of
cost which is adjudged by the cost behaviour, so mixed cost means it has both components, a
fixed component as well as a variable cost component.

Now let us see the depreciation of any machine, the machine will depreciate at its own rate
but larger the machine will be used, if the machine is used beyond its capacity, then certainly

278
its depreciation will be more. So, it has a fixed percentage as well as a variable part, so that is
why this type of cost is known as mixed cost.

(Refer Slide Time: 15:25)

Average unit cost: Average unit cost is based on the total cost which has been incurred on
the product. The cost incurred and how many units are produced based on that you calculate
the value of average unit cost.

Incremental cost: Sometimes this incremental cost is also known as differential cost at some
point of time. This cost refers to the cost when you try to increase the production by a unit
quantity. So, the amount of cost which you incur for producing one extra unit that is known
as incremental cost.

So, suppose your production capacity is 3000 units and it is expected that it has to make
another 200 units above the normal values in that case, if for making the 100 units, you are
incurring something close to 5000 rupees in that case 50 rupees per unit is the incremental
cost. So, this incremental cost is the cost which is used for making one extra unit.

Opportunity cost: Opportunity cost is the cost that is basically associated with the situation
when you have alternative course of action and when you choose to go for the alternative
course of action, in that time you have to compromise on certain grounds, so you have to
forego certain benefits and this is known as the opportunity cost.

Suppose for example, if you are studying and while studying you are also doing some part
time jobs, now in the study period you got a break and you want to go to meet your parents,

279
so during the break you have to take the leave from your employer who gives you Rs. 500
every week. Now the employer if he tells you to go, you will be losing Rs. 500 for the week
you want to go during the vacation. So, this type of cost is known as opportunity cost because
you are losing this opportunity to earn Rs. 500 for a week.

(Refer Slide Time: 23:17)

Another cost which is also used when we do the economic analysis is the sunk cost. Sunk
cost is that cost which has been incurred in the past and cannot be recovered. Since they are
incurred in the past, they are not relevant for any kind of decision making.

For example, suppose we have a car which we have to sell, we are going for the advertising
our car. Now while going for advertising, if we are faced with a circumstance in which some
of the part of the car is not working and you have to get repair it and suppose you have
incurred some cost on the car. Now you have gone to sell it and you are able to sell the car.
The value of the car was suppose evaluated as Rs. 2,00,000 and you were able to sell your car
but in between you had to spend some amount say Rs. 5000 on car while going for selling
your car. Now you must be thinking of the amount of which you have incurred on it but you
cannot do anything with this amount which is spent. So basically, the cost incurred of Rs.
5000 is the sunk cost.

280
(Refer Slide Time: 24:40)

We can also come across you cost term, first cost of the asset. First cost of the asset means
the cost on those assets which are used by the industry for the first time while setting up the
industry. So, the cost incurred on the capitalised type of assets, are under the category of first
cost of asset.

(Refer Slide Time: 22:57)

Contrary, there is a cost known as operation and maintenance costs. This is a cost which is
dealing with the cost while running the production. When the production run is going on, at
that time all the kind of cost which are incurred, they are under this operation and
maintenance costs. So, in that the expenses on the electricity, light and also the depreciation,
insurance premium all these costs are under the operation and maintenance cost.

281
So, we have dealt with different types of cost and when we can have a problem solving on
these, we can see that how we categorise these costs under the different categories.

Thank you.

282
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 28
Breakeven Analysis, Effect of Fixed and Variable Cost on BEP
Welcome to the lecture on breakeven analysis. When we manufacture any product for the
organization, it generates the revenue by selling the product. Initially the organisation has
incurred a large amount of cost that will be fixed and variable type of cost.

(Refer Slide Time: 01:32)

Suppose the product is ready to sell and after selling it company gets the income. As the
number of units sold increases, the income increases. So, at what point you feel that you are
at a point where there is no profit or no loss for the company. That number of products or that
point is known as breakeven point. So, the purpose of breakeven analysis is to find the
minimum output which must be exceeded for the business to make profit.

If the organisation is not making the product more than this breakeven point then the
organisation will have loss and if it is going beyond that according it will have the profit.

283
(Refer Slide Time: 09:25)

The fixed cost is the one which does not depend upon the number of units produced and the
variable cost will be changing with the number of units produced.

In the figure, AB is the fixed cost line, AC is the variable cost line, and OD is the income
line.

C = production capacity

N = Number of units to produce in the year

V = variable cost per unit = slope of line AC

Fixed cost is represented by line OA and AB = F

Selling cost per unit = S = slope of line OD

Line OD represent income = I

Income = S x N

Total cost = Fixed cost + Variable cost = F + VN

Profit = Income – Total cost

At breakeven point, Income = Total cost

F + VN = SN

284
 𝐹
𝑁= = 𝑁 ∗ (𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)
𝑆−𝑉

S - V = Marginal contribution

(Refer Slide Time: 11:44)

So, once you know the fixed cost, the selling price per unit and the variable cost per unit, you
can have the value of N* as breakeven point.

Profit = Income – Total Cost

= SN – (F + VN) = -F + (S – V)N

So, this is a function which represents the value of profit in terms of the number of units
produced and this is equation of straight-line.

285
We draw the line showing profit and loss are above and below the horizontal line (refer above
figure). The profit line is shown in figure. Intersection of the two line is the point where profit
is zero and that point corresponds to N*.

(Refer Slide Time: 17:45)

Effect of fixed cost:

If the fixed cost is decreased and variable cost remains the same, the new graph will is shown
by dotted line CD. So, if F is decreased and V remains constant,

(S – V) remains constant, that is slope of line AB remains constant and the line becomes CD.
This results into smaller value of N*, that is breakeven point is reached early with lesser
number of products sold.

Contrarily if F is increased, N* shifts to the right, that is breakeven quantity is increased.

If variable cost per unit is changed keeping fixed cost constant.

Now we will draw the same profit volume function. If the variable cost is increased, the slope
of the line will decrease. So, keeping the fixed cost same if the slope of the line is decreasing,
the line will take the fall. When the variable cost is increased, the N* has come towards the
right. Further at the same time, if the variable cost is decreased, (S – V) will increase which
will shift the line towards the left.

286
Refer Slide Time: 19:58)

(Refer Slide Time: 25:06)

If variable cost is increased and fixed cost remains constant (S – V), that is marginal
contribution decreases and so slope of the line AB decreases and takes the line AC.

In this way it is seen that breakeven point is shifted towards right that is more number of units
are to be produced and sold for coming to position with no profit or loss.

Contrary to that, when V is decreased keeping F constant slope of the line AB increases.
(Slope is S – V). Hence the new line is AD and the breakeven point shifts towards the left. It
means that no profit no loss situation will be achieved with lesser number of units produced
and sold.

287
(Refer Slide Time: 26:42)

(Refer Slide Time: 30:15)

We can discuss a problem based on this breakeven analysis.

Example:

If the fixed cost per year = Rs. 10,00,000

Selling price per unit (S) = Rs. 50

Variable cost per unit = Rs. 10, what will be the breakeven point at which the company will
have no profit no loss situation.

288
Breakeven quantity = F/(S – V) = 10,00,000/(50 – 40) = 25,000

So, when the company produces 25,000 equipment and sell it, it will come to a situation of
breakeven that is no profit no loss.

Now let us say the company has produced 30,000 units, in that case what will be the profit of
the company?

N = 30000

Profit = P = -F + (S – V)N = -10,00,000 + (50 – 40) x 30,000 = 2,00,000 ---- Profit

(Refer Slide Time: 31:45)

If company produces and sells only 20,000 units, in that case we will have

P = -10,00,000 + (50 - 40) x 20000 = -2,00,000 ---- Loss

So, this is how you can calculate the profit and loss using the profit volume function and
using the expression for the breakeven quantity to be produced. Similarly, if you are given
the change in the variable value or the fixed cost value, how it will affect the breakeven point
that also can be calculated and a graph can be plotted and it is seen that how this point shift
towards the left or towards the right.

Thank you.

289
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 29
Economic Order Quantity
Welcome to the lecture on economic order quantity.

(Refer Slide Time: 00:43)

In the production operations, the company has to purchase the inventory items. The inventory
items are purchased for the demand which is required. So, there is some demand of any item
for the whole year. There can be two extreme cases that the purchase can be once in a year or
on daily basis. The cost associated with these purchases and keeping these inventories in our
store, we have to keep certain things in mind. When we order for the purchase of goods, there
is some cost associated with the ordering. So, there is some purchase cost for every order.
The number of times we give the order to purchase the quantity, the purchase cost will go on
increasing. On the other hand, we can take all the demand requirement at one time during the
beginning of the year. When we keep the item in our store, it needs to be maintained, we need
to maintain the cleanliness, etc., so the associated expense is holding cost.

When you purchase all the items once in a year, holding cost will be quite high because the
items in stock is large in number and they are required to be kept in a good condition. While
if we purchase on daily basis, although the holding cost will be very small but since we are
purchasing on daily basis, the ordering cost or the purchase cost will be larger.

290
So, the two extremes will lead to very large cost and the total cost will be very large. So, it is
necessary to the quantity to be purchased in one order resulting into minimum cost. This
quantity is known as economic order quantity.

So, the quantity which we are purchasing in one purchase order that is known as economic
order quantity because it leads to the minimum total cost.

(Refer Slide Time: 08:47)

Now let us see how to get the expression for this economic order quantity.

Let us say there is an item where, the demand of item (throughout the year) = D

Unit cost of the item = Ci

Cost of purchasing (for one order) = Cp

Holding cost per unit per year = Ch

Quantity purchase in one order = Q

Now, you have three types of cost,

Item cost (per year) = Ci x D

Purchase order (per year) = Cp x D/Q

Holding Cost (per year) = Ch x Q/2

291
(Refer Slide Time: 09:29)

We assume that the day you order, you receive the material, so there is no time delay in
receiving the material and it goes accordingly. So, this is how the amount of inventory in the
stock will be there. You have Q at initial time then it slowly comes to 0 and at the time it is 0
the next day you are getting again Q. You do not assume any shortages neither any delay. So,
average inventory will be can be assumed to be Q/2. So,

(Refer Slide Time: 14:43)

Now we have to find for which Q, the total cost will be 0.

Total cost = Item cost + Purchase cost + Holding cost

T = Ci x D + Cp x D/Q + Ch x Q/2

292
 dT
For minimising the total cost, dQ = 0

𝐷 𝐶ℎ
−𝐶𝑝 + =0
𝑄2 2
𝐶ℎ 𝐷𝐶𝑝
= 2
2 𝑄

2𝐶𝑝 𝐷
𝑄=√
𝐶ℎ

The total cost which we get will be minimum and Q is known as economic order quantity.
There are certain assumptions in the study, one is that demand is constant throughout the
year, there is no time lag when the inventory is finished and the next inventory comes.

(Refer Slide Time: 15:14)

(Refer Slide Time: 17:27)

293
Example: Find the economic order quantity for annual demand of an item to be 6000 units,
item cost per unit as Rs 500, ordering cost per purchase order is Rs 1000 and cost of holding
the inventory per unit per year is Rs 48.

D = 6000

Ci = 500

Cp = Rs 1000

Ch = Rs 48

2𝐶𝑝 𝐷
𝐸𝑂𝑄 = √
𝐶ℎ

2 ∗ 6000 ∗ 1000
=√
48

= 500

What we see is that if we order 500 items, the total cost will be minimum. So, the economic
order quantity is 500.

(Refer Slide Time: 27:36)

Let us check it by plotting the graph and looking at the values of total cost against the
numbers.

294
 Total cost = Ci x D + Cp x D/Q + Ch x Q/2

Quantity Total Cost

300 3000000 + 7200 + 20000 = 3027200

400 3000000 + 9600 + 15000 = 3024600

500 3000000 + 12000 + 12000 = 3024000

600 3000000 + 14400 + 10000 = 3024400

1000 3000000 + 24000 + 6000 = 3030000

So, what we see is, that as we increase from 300 up to 500 it decreased and at 500 it was
minimum. Once we went to 600 units of order once then it increased slightly and further
again there is an increasing trend as we move further.

(Refer Slide Time: 27:42)

We can plot the total cost against the quantity ordered. So, we see that if your quantity
ordered in one lot is 500, the total cost is minimum, which can be verified by plotting the
graph.

Thank you.

295
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 30
Problem Solving based on Breakeven Analysis and EOQ
Welcome to the lecture on problem solving on breakeven analysis and economic order
quantity. In this lecture we will solve the problem based on breakeven analysis and on
economic order quantity based on what we have studied in our previous lecture. Let us first
discuss the problem on breakeven analysis.

(Refer Slide Time: 01:30)

Example: Fixed cost of production for an item is Rs 100000 and the variable cost per unit is
Rs 75. The income generated by selling each unit of the item is expected to be Rs 100. What
is the breakeven quantity of units produced and sold? Show graphically the costs incurred
versus units produced. Also show the cost and income per unit against output units.

F = Rs 100,000,

V = Rs 75,

S = Rs 100. So we have to find the breakeven quantity.

BEP = F/(S-V) = 100000/(100 – 75) = 4000 units

296
Let us see in the tabular form.

Quantity Total Cost Income Profit/Loss

(N) (F + VN) (S * N) (Income – Total Cost)
2000 250000 200000 -50000 Loss
3000 325000 300000 -75000 Loss
4000 400000 400000 0 No profit/No loss
5000 475000 500000 25000 Profit
6000 550000 600000 50000 Profit

(Refer Slide Time: 09:12)

So, till we go to the operational capacity, we are going to get the profit. And what we see is,
you are justifying yourself by reaching to the value of zero profit/zero loss for the quantity of
4000 which is produced and sold and that is why it is known as breakeven quantity.

Now we have to find the costs and we have to find the graph of this cost against the units
produced.
Income Line
Total Cost

Cost
or
Income
(in Lakhs)
Fixed Cost

Unit Produced

297
(Refer Slide Time: 11:59)

(Refer Slide Time: 14:16)

Total cost at the point of intersection is equal to the income produced. As we moved to
upside, we get the profit and if you are moving downside we are in the loss. So, this is how
you can draw these costs against the number of units produced. Now let us see we have to
find the graph for cost and income per unit against output units.

298
(Refer Slide Time: 19:15)

Cost
or
Income
Average Cost/Unit Variable Cost/Unit
Per
Fixed Cost/Unit
Unit
Fixed Cost/Unit

Output Unit

(Refer Slide Time: 23:42)

(Refer Slide Time: 25:20)

299
Example: The annual demand of a certain item is 20000. Holding cost is Rs 8 per unit per
year and the item cost is Rs 40 per unit. F For purchase cost per purchase order of Rs 400,
what will be the economic order quantity?

(Refer Slide Time: 28:36)

D = 20000

Ch = Rs 8 per unit per year

Ci = RS 40

Cp = Rs 400 (per purchase order)

300
 2𝐶𝑝 𝐷 2 ∗ 400 ∗ 20000
𝐸𝑂𝑄 = √ =√
𝐶ℎ 8

= 1414 Units = Q

This is the economic order quantity, the quantity which when ordered once, it will lead to
minimum total cost.

(Refer Slide Time: 31:00)

Total Cost = (Ci x D) + (Ch x Q/2) + (Cp x D/Q)

T = (40 x 20000) + (8 x 707) + (400 x 20000/1414)

= 800000 + 5656 + 5658

= 811314

So, this is the total cost which is the minimum total cost of corresponding to this economic
order quantity units.

Thank you.

301
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 31
Cost Estimation: Methods of Cost Estimation, Adjustment of Data, Learning
Welcome to the lecture on cost estimation. In engineering economic analysis, you are
estimating something at present which has to be useful in the future. So, you have to evaluate
how some of the proposals or some of the recommendations will behave in future.

(Refer Slide Time: 01:05)

As engineering economic analysis deals with outcomes of decisions made at present for
outcomes in the future, estimation of cash flows and other market conditions in future is very
important.

It is desirable to have the predicted estimates falling in the acceptable range. (there should
be high probability)

Large deviation between estimated and actual outcomes may be the result of many factors
involved and finally may give unacceptable (and even unrealistic) results.

It deals with outcomes of decisions made at present for outcomes in the future. Estimation of
cash flows and other market conditions in future is very important because if you do not do
the estimation properly, it may lead to unrealistic results. It is desirable to have the predicted
estimate falling in the acceptable range. So, once we do the estimation, it must fall in a
certain range which can be taken as a practical value.

302
The probability of estimating those values which have a realistic meaning and which should
not have very bad accuracy, must be more. Large deviation between estimated and actual
outcomes may be the result of many factors involved. There are many parameters which are
to be taken into account. Now while estimating all these parameters if we do the error in
estimating the parameters then their cumulative effect can be even more. So, if there is large
deviation, it may result into unacceptable type of results. So, estimation is a very important
process and there must be a very good estimator who should estimate more accurately.

(Refer Slide Time: 03:02)

Different aspects cost estimation.

• Elements to be estimated

• Cost estimation types

• Factors affecting accuracy of estimate

• Methods of cost estimation

• Adjustment of data in estimation

Elements to be estimated: You have the estimation of output. Now output can be in terms of
if you say manufacturing operations output can be number of units of liquid metal or number
of forgings to be done, the output even maybe for the satisfaction you have to achieve or for
the number of selling for any particular product, all these are outputs. So first of all, the
output has to be in mind, what output you need. So, these are to be estimated by different

303
processes, if these are the products which are going to the market to be sold, it will be done
by market surveys, by research into that area. If these are in the area of manufacturing, you
can have the idea of these outputs by weighting, by having the idea physically.

Once you have the estimation of output you need estimation of input what is required for
getting this output. So, input can be in terms of raw materials if it is an engineering activity.
Input can be in terms of machines required which is used for the operation. Input can be in
any form.

(Refer Slide Time: 21:50)

Now in cost estimation types, we will discuss about the different situations how at different
stages different types of estimations are to be carried out.

When we want to estimate something and want to have certain output, initially we have
planning stage. In this stage we do the analysis in a very broad manner and the accuracy is
something of the order of ± 50%. Now this is done through the conferences or symposia. We
have some idea in mind, so that we develop some unit. For that there can be meeting,
symposia and conferences and in that very broadly the estimation is done of the order of 50%
deviation.

Then comes the design stage, now once you have given the okay for the project to go ahead,
then comes the design stage where it is all decided which process to be adopted, how to go
ahead. Here accuracy is said to be something of the order of ± 15%.

304
Then comes the implementation stage or construction stage. Once planning and design
stages are finalized then you go for the construction of the project and for that all the minutest
level of details are to be furnished. So here come the expert persons, they will talk about all
the minute details and the deviation here will be not more than about 5%, so accuracy you
can say, it will be something close to ± 5%.

Planning stage Accuracy: ± 50%

Design stage Accuracy: ± 15%

Construction Stage Accuracy: ± 5%

(Refer Slide Time: 09:00)

Now let us see the factors affecting the accuracy of estimate. There are certain factors which
talk how the estimation should be done. So, the first factor is the difficulty of estimation. It
depends that what should be the level of detail which you need, what is the difficulty level of
the estimate, depending upon that you have to find what type of estimate is required, what
should be the expertise of the person, who should be doing that? After you go through the
difficulty level of the estimation, then you have to see which techniques should be applied.
You have to be aware with all the kind of techniques which are required for your estimation.
Further you have to show the justification for time and effort to be given. If any estimation
takes large number of resources, large number of resource time, in that case it must be very
important work. So, depending upon the importance of the work, justification is required to
be given. We also have to check the sensitivity analysis. By sensitivity analysis it is meant

305
that the study is to be carried out to find how the end result is affected by changing the
parameter levels.

So, these are the different areas where you need to focus and you need to decide what level of
estimation is required to be done.

Method of cost estimation.

There are many ways by which we do the cost estimation

1. Using engineering analysis or procedure. If any engineering activity is needed, in that
case you have to specify all the details in the form of blueprints, in the form of the
process chart, you have to give all the details so that proper estimation can be carried out.
Suppose you are doing the estimation related to the selling of the product or related to the
manufacturing of any unit, in that case every detail should be prepared in hand and must
be properly addressed.
2. Using study of analogy. Sometimes very difficult to estimate by engineering procedure,
especially when you are estimating something which is very new. So that time we use our
past experience, we use the study by analogy.

Suppose you are producing certain unit, although it is similar in characteristic to the
existing some of the units but the prediction of cost will be very much difficult. So, in that
case, the person who is expert in that area can have a better estimate by analogy.

Suppose the first time the helicopter is to be made and estimation of the cost of a
helicopter is to be made. The helicopter has not been manufactured earlier and there is no
idea what cost will be incurred in making a helicopter. However, the cost incurred to
make an aeroplane is known. So a person who is expert in the knowledge of aeroplane
making, he will basically model, he will give the idea that if you are making a helicopter
it will have this much capacity, it will have the materials as a fraction of the material used
in the aeroplane or it will have an engine of this much smaller than the engine of
aeroplane In such case, by analogy he can do the analysis and he can give a better
estimate of the product which he is estimating.

306
(Refer Slide Time: 21:50)

Adjustment of data in estimation

You have different categories of data which are to be handled and you need to put the date of
one category at one place. Suppose you are using the materials which are to be used for a
particular part, you should know that it belongs to a certain category. So basically, data
adjustment of different categories is required.

To categorise. So first of all, you should know how to categorise the data. The next important
thing while discussing about the adjustment of data is the effect of inflation or price level
changes.

Price level changes. Since, the economic analysis is done for any estimation in future and
every transaction involves the use of money, so the time value of money has to be kept in
mind. So price level changes are to be kept in mind, for that you need to have certain past
data which talk about the inflationary changes, the change in the value of money in the past
few years and based on that you have to predict certain changes in the value or price.

Adjustment because of learning. It is a process which means that the direct labour hours
required to make any component (when you are making the component for the first time), it
takes certain hours but as you go on increasing the number of units and you are going on
making the units (especially it is more suitable for those items which are very large in size,
which take large amount of direct labour hours), then it is seen that as you go on double the
number of units produced, the direct labour hours is seen to reduce by a certain factor. So,
this is known as a concept of learning.

307
So, the amount of direct labour hours may reduce by any factor, it may reduce by 80%, it
may reduce by 70%. In that case, if it is reducing by 80%, it is known as 80% learning curve.
Means, for the first unit if you are taking 100 direct labour hours, in that case the second unit
(using 80% learning curve) will take 80 hours and the third unit will take 0.8 x 80 = 64 hours.

We will see how this learning curve can be used to adjust the cost data while making any unit
in the future. So, we will discuss about adjustment because of learning.

(Refer Slide Time: 25:56)

Let us say you are making any product where

Ax = number of direct labour hours required to make xth unit (x is the unit number)

So A1 means the labour hours required for making the first unit, A2 will be the labour hour
required the second unit and so on.

F = number of direct labour hours required to make the first unit.

α = learning curve.

Ax =F.α0 , when, x = 20 = 1.

This is based on the assumption that every time you are doubling the production, in that unit
the number of direct labour hours required will be some factor times the labour hour required
which is in the previous time.

Ax =F.α1 , when, x = 21 = 2.

308
(Refer Slide Time: 29:08)

Ax = F.α2 , when, x = 22 = 4
.
.
.
Ax = F.αd , when, x = 2d

log Ax = logF + d.logα

log A𝑥 − logF
𝑑=
logα

Also we have, x = 2d

logx = d.log2

d = logx/log2

Hence,

log A𝑥 − logF logx

=
logα log2

So, we get Ax = F.xn where, n = logα/log2

So this is the expression by which you calculate the value of direct labour hours required to
make the xth unit, when you know the number of direct labour hours required to make the
first unit and x is known to you and you the value of n. Alpha is the percentage value of the
learning curve.

309
(Refer Slide Time: 31:56)

Example: Suppose the first unit takes 150 hours, using 80% learning curve.
Direct labour hours required to make sixth unit?

𝑙𝑜𝑔0.8
𝐴6 = 150 ∗ 6 𝑙𝑜𝑔2

= Answer

So, this is how you can compute the value of the direct labour hours required for the sixth
unit.

Thank you.

310
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture32
Cost Estimating Relationships
Welcome to the lecture on cost estimating relationships. In this lecture, we will talk about
some of the relationships which are used to estimate the cost. When we estimate the total
cost, it is better to estimate the factors which are affecting the cost because there are many
factors which have a say on the total cost. So rather than estimating the cost directly, we
should also try to estimate the factors.

(Refer Slide Time: 01:04)

Estimates will be accurate if estimation of factors affecting the result is done directly rather
than result estimated directly. So, first of all we should try to estimate the factors.

For estimating the factors, functional relationship between cost and the factors on which cost
depends may be used (developed using statistical techniques). The relationships may have
different forms. Let us say you can have linear type of form.

311
(Refer Slide Time: 03:24)

Linear form: y will be varying linearly with independent variable x.

y = ax + b

So, if you have any linear dependence, you can forecast in the future. Suppose you have
relation between the cost and time, in that case if there is a linear dependence, so future can
be forecasted by extending the line. So, this kind of relationships are very common which are
used for the estimation.

Non-linear form: In case of non-linear form the cost may vary in a non-linear manner, so it
may not be purely linear. By extending the curve you can estimate and you can forecast in
future time.

312
(Refer Slide Time: 07:00)

Step function: Many a times in the cost analysis or the economic analysis, the ranges of any
parameter is defined and once you go beyond that range, the values change abruptly. So, in
these cases the step functions are very much used.

(Refer Slide Time: 07:30)

Distribution functions: Many a times we have the past data available. Using the past data,
we try to have a curve, which tells about the frequency over which the cost can be predicted.
So that may come into a special kind of probability distribution functions. Suppose you have
probabilistic cost and you have frequency. So, frequency related to any particular parameter

313
or variable and based on that what we see is, you get a typical type of distribution where you
get the mean value.

(Refer Slide Time: 11:06)

You may use other kind of relations also. We may have estimation based on some parameters
like we may do the estimation of the labour cost based on the area of the floor. So, suppose
we are talking about the construction of the house, construction of an apartment, construction
of a building, in that case the labour cost will be estimated as a function of the area over
which the work will be done. Suppose the cost of plastering, that will be depending upon the
area over which the plastering will be carried out. So, this way those relationships can be
used.

Similarly, the amount of fuel consumed may be dependent upon how much the vehicle has to
be used or what will be the vehicles duration for which it is used as well as the velocity at
which it is used. So, these kinds of special type of functions may be used, it may have the co-
relations, some of the parameters will be there, which will be directly indicative of the cost
total cost which can be estimated. So, these are the different kinds of functional relationships
which can be used for finding the estimated costs and the interdependence of cost and the
factors or in between the different factors can be found and then estimations can be done
correctly.

Now, if we involve the learning process then it also affects the cost. We have already
discussed about learning where it tells that the direct labour hours required to make the first
unit, it is reduced by certain percentage when you make the second unit or the second unit

314
takes suppose some hours, the fourth unit will take the percentage value of that many hours
required for the second unit. So, as learning goes on, the direct labour hours required is going
to be changed.

(Refer Slide Time: 17:20)

How learning affects the item cost? We have seen that Ax is direct labour hours to make xth
unit, F is the time or direct labour hours required to make the first unit and x is the unit
number, n = logα/log 2, α is the learning percentage. So,

Ax = F.xn

Item cost = Direct material cost per unit + direct labour cost per unit + overhead cost
per unit

So, you have three kinds of costs which are there in the industries, you have direct material
cost, you have direct labour cost and apart from that other costs which are not under this
direct material and direct labour cost, they are the overhead cost. Overhead cost basically is
expressed sometimes in percentage of item cost.

315
(Refer Slide Time: 16:48)

So suppose you take as on the basis of direct labour cost, so in that case if you take these
values, you can express the item cost in these functions where basically direct labour cost will
be depending upon Ax because for making number of units, you basically need less number
of hours.

(Refer Slide Time: 20:04)

If you are making N units, cumulative direct labour hours will be calculated,

A1 + A2 + ….. + AN = ∑𝑁 𝑁
𝑥=1 𝐴𝑥 = ∑𝑥=1 𝐹𝑥
𝑛

Approximately this can be written as

316
 𝑁 𝑁
𝑛
𝑥 𝑛+1 𝐹𝑁 𝑛+1
∫ 𝐹𝑥 𝑑𝑥 = 𝐹 [ ] =
𝑛+1 0 𝑛+1
0

So, this is the cumulative direct labour hours required to make N units.

𝐹𝑁 𝑛+1 𝐹𝑁 𝑛
𝐶𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠 = = = 𝐶𝑛
(𝑛 + 1)𝑁 𝑛 + 1

So, when the learning is involved, this is the cumulative average direct labour hours.

(Refer Slide Time: 24:23)

Cn = cumulative average direct labour hours.

DL = direct labour hourly rate

DM = direct material cost per unit

OH = overhead rate expressed as a percentage of direct labour hourly rate

So, we can have the item cost per unit as

Ci = (DL * Cm) + DM + (DL * Cn * OH)

Ci = (DL * Cn)(1 + OH) + DM

𝐹𝑁 𝑛
C𝑖 = [DL ∗ ] (1 + 𝑂𝐻) + 𝐷𝑀
𝑛+1

317
(Refer Slide Time: 24:00)

(Refer Slide Time: 28:53)

Sizing model: Many a times you are estimating something, you know the cost component for
the similar item with smaller size and if you have to estimate the cost for the larger size, in
that case, there is an exponent which is used sizing model. So, this exponent tells us how the
cost can be further estimated.

So, suppose you want to estimate some cost for a particular design, and you have the cost for
any reference size.

Cd = cost for design

318
Cr = Cost for reference size

Cd = Cr.(Size od design/Size of reference)m

Example: Reference, the cost was Rs 500000 & reference sizing have 500 mm diameter. To
design a size of 250 mm diameter using exponent value as 0.4.

Costdesign = 500000(200/500)0.4 = 500000(0.4)0.4 = ?

So, this is how you get the values of such problems.

(Refer Slide Time: 30:49)

Next is, you have to estimates and allocate the indirect costs. This is one of the area which
requires frequent use when we talk about the production operations. So, as we had discussed,
there are many basis by which you are estimate or allocate the indirect cost.

➔Factory overhead

• Direct labour hourly rate

• Direct material cost rate
• Direct labour cost rate

So basically, the overheads can be expressed as the percentage of these. If these percentages
are known to you, you know the direct labour hourly rate and that fixed percentage is known
to you, you can use this for estimation of the factory overhead.

319
So that percentage or that fraction or that number multiplied with direct labour hourly rate or
direct labour hours, that can give you the estimation of factory overhead for any particular
kind of estimation.

So, these are the three ways by which you can allocate or estimate the indirect costs. So, this
is how the estimation is carried out in production operations.

Also, you will have discussed about many methods and this can be used for estimation of the
cost elements.

Thank you.

320
321
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture33
Introduction to Decision under Risk, Criteria for Decision under Risk
Welcome to the lecture on decision under risk and uncertainty.

(Refer Slide Time: 00:30)

The decisions based on assumptions are called as decision-making under uncertainty. When
you know the outcomes of the decision with certainty, then it is known as a decision with
certainty. But in most cases in engineering economic analysis, things are predicted in the
future, and so the outcomes, you do not know what will be the exact outcome. So, there is
uncertainty involved with it, and there is risk involved with it.

Uncertainty refers to variation in actual values due to errors in estimation because of

insufficient information about the factors affecting the final outcome. There are many factors,
and since we do not know about the behavior of the factors and how they are going to affect,
there is a large amount of variation, or there may be a small amount of variation in what you
predict and the actual outcome, and that is basically referred to as uncertainty.

Risk is defined as variation in result because of random causes. When you do not know the
causes, and there may be any cause randomly, then that is defined as risk. So, we will talk
about the decisions when there is risk and uncertainty, what way the decision should be
made. Since the economic decisions are to be made in future always, you attach certain
probability with the outcomes.

322
Suppose you are given certain options; you are to get certain contract and there are 3 types of
contracts and the probability of getting the contracts is known to you. Every contract can be
done using the alternatives, every alternative will give you certain profit or loss if you are
getting the individual contracts.

(Refer Slide Time: 07:11)

So, the first thing what you do is, you look at the alternatives and see that which of the
alternative is least preferred (inferior as compared to all other alternatives). Now the
outcomes in case of every alternative is also having certain associated probabilities. If you
see that the outcomes by any of the alternatives is inferior to each one of the others, in that
case you say that, it is having the least preferred. And they are said to be the least preferred
alternative or to be dominated by others alternatives.

Minimum aspiration levels are set by the company. Now you have different types of
outcomes in the different alternatives. The company would like to go only for those
alternatives where it will see that it should get at least a minimum level of aspiration. They
fix some minimum amount of profit or maximum amount of loss so that if they go to any of
the alternatives, it is likely to get at least some of the minimum level of profit or it can have
maximum some amount of loss.

Expected values: Now we get the expected values by taking probabilities into the account.
All the values of probabilities are given the importance and based on that the mean value of
outcome is found out. Once you get the alternative which gives you the maximum expected
value, we prefer that. So, this is known as expected value criterion of decision-making.

323
Alternative having maximum probability: Sometimes we try to go with those alternatives
which has the maximum probability, that is known as the maximum probable criterion.

Now after that we will have the comparison of the options which are basically achieved by
using the different criterion and then we have to our self-judge or the company has to judge
which one should be preferred.

(Refer Slide Time: 11:03)

Example: The company is applying for getting a contract and the contract company can get
either contact A, contract B or contract C. Probabilities of getting the contract is given;

Profit or Loss Contract A Contract B Contract C

in Lakhs
0.3 0.2 0.5

Alternative 1 5 5 20

Alternative 2 -10 8 25

Alternative 3 0 10 24

Alternative 4 5 15 10

Alternative 5 -15 5 8

Alternative is least preferred: Looking at the values, we have to see which of the alternative
gives you minimum amount of profit or it is giving you the inferior most results, in that case
if you have some rules. The first rule is the dominance rule, it basically tells you that if you
go for alternative 5, the values are inferior or not better than any of the values in the
respective columns. So that way alternative 5 can be removed for considerations.

324
(Refer Slide Time: 14:56)

Minimum aspiration level. Now the minimum aspiration level can be set by the company as
at least 20,00,000 of profit or 5,00,000 of loss. The company says that we cannot go for the
alternatives which are basically likely to give us more than 5,00,000 of loss or less than
20,00,000 of profit. In that case, A1 is okay as it satisfies the condition. If alternative 2 is
chosen, it will give you a loss of 10,00,000. So A2 cannot be preferred because, it is not
meeting the aspiration level set by the company, so A2 will not be okay. Then we see the
alternative 3, it satisfies the conditions, so A3 will be okay. If you go for alternative 4, on the
loss account, it is satisfying but on the profit account it is not satisfying so A4 is also not
okay. Alternative 5, we have already removed because of the dominance criterion. So, you
found that, out of the four, the two is qualifying i.e. A1 or A3.

(Refer Slide Time: 15:36)

325
(Refer Slide Time: 19:35)

Expected values.

Expected values for alternative 1 = 0.3 x 5 + 0.2 x 5 + 0.5 x 20 = 12.5

For alternative 2 = 0.3 x (-10) + 0.2 x 8 + 0.5 x 25 = 11.1

For alternative 3 = 0 x 0.3 + 0.2 x 10 + 0.5 x 24 =14 (maximum)

For alternative 4 = 0.3 x 5 + 0.2 x 15 + 0.5 x 10 = 9.5

Now if you look at the values, you see that, maximum is given by alternative 3 and A3 is
preferred.

(Refer Slide Time: 21:04)

326
Alternative having maximum probability. Now if you take the probability into account then
you find that probability of getting contract C is maximum that is 0.5. Now in this case the
maximum is 25 by alternative 2. So, on that basis of maximum probable criteria, you would
go for the contract C under which A2 was preferred.

(Refer Slide Time: 22:38)

So, if you look at the options which you got, in the first case using the dominance, you have
removed the A5 but using the aspiration level set, you go for A1 or A3. Using the expected
values, you go for A3 and using the most probable criterion, you go for A2.

So ultimately the organization can take any of these criterion and it can decide that the
contract can be given to whom or which alternative will be the best preferred one. Based on
that the estimation can be done, what will be the estimated profit or loss.

Decision Under Uncertainty

Now we will discuss about the decisions under uncertainty when it is not known what should
be the associated probabilities, in that case there are certain criteria which we should know.

Laplace criterion. Using the Laplace criterion, equal probability is given to the outcomes.
So, in that case, since you have 3 values, the alternative A1 will give you,

A1 → (5 + 5 + 20)/3 = 10

A2 → (-10 + 8 + 25)/3 = 7.66

A3 → (0 + 10 + 24)/3 = 11.33

327
A4 → (5 + 15 + 10)/3 = 10

So, alternative A3 is giving you the maximum profit.

(Refer Slide Time: 27:37)

Maximin and Maximax criteria. Maximin is known as something like a pessimistic view
and Maximax is known as an optimistic view. So what Maximin tells that you assume that in
any case, you will get the one which has the minimum outcome or you are going with the
minimum value out of all these and then you are trying to have a maximum of them.

Using Maximin:

A1 → 5

A2 → -10 {Maximum is 5}

A3 → 0

A4 → 5

Using Maximax:

A1 → 20

A2 → 25 {Maximum is 25}

A3 → 15

A4 → 24

328
(Refer Slide Time: 30:06)

The next criterion (Hurwicz criterion) is depending upon certain weightage to the optimism,
we cannot have optimism to a higher value, so we give the optimism to certain value.

Now in the Hurwicz criteria, you give an index of optimism. If this index of optimism is set,
in that case it will have α.

α (Max. Eij) + (1 - α) (Min Eij)

If α = 0.3

A1 → 0.3 x 20 + 0.7 x 5 = 9.5

A2 → 0.3 x 25 + 0.7 x (-10) = 0.5

A3 → 0.3 x 24 + 0.7 x 0 = 7.2

A4 → 0.3 x 15 + 0.7 x 5 = 8

So, using the Hurwicz criteria, your value comes out to be maximum for criterion A1, which
is based on the degree of optimism.

So, these are the different criteria upon which you can have the estimation. You can say that
you can proceed with these criteria and estimate the parameters.

Thank you.

329
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture34
Expected Value Decision Making under Risk
Welcome to the lecture on decisions under risk and uncertainty. In this lecture we will be
studying the case in which the expected value decision making is used.

(Refer Slide Time: 00:41)

Expected values are helpful in making decisions under uncertainty, based on the concept of
probability. We have already discussed that the probability of associated events are taken into
account. The product of probability of a variable will be taken with its numerical outcomes
and it will be summed over all possible outcomes.

These are used for long run conditions when the event is assumed to occur repeatedly and
sometimes also in the cases when you have initial investment and its effect is basically
visualized in the future.

Now let us take a case which has been about a flood damage in a certain area where there has
been history that there is probability that flood may come and if the flood comes then it will
do the damage to the crops. So, there is a proposal that a dam should be built or a levee
should be built before the dam is made maybe later on.

(Refer Slide Time: 08:22)

330
So, you are trying to use this analysis in which there is history that how many years the level
of flood water is how much. The history tells there has been occasions of 15 times during the
last 50 years, the level was zero. So, in that case there was no flood loss.

Water level (A) Numbers of years Chance Loss if water Cost of initial
(cm) the water level is level is above A investment of making
above normal “A” (in lakhs) levee of A (in lakhs)
0 15 0.3 0 0
20 12 0.24 6 20
40 10 0.2 9 30
60 8 0.16 12 50
80 3 0.06 15 65
100 2 0.04 20 80

(Refer Slide Time: 12:44)

331
Your study has to be done for 15 years after which it is assumed that the government will
make a permanent arrangement by making the dam. You have interest rate as 12 percent, so
using this interest rate you have to suggest what should be the height of levee to be built.

This is a case of expected value decision making, we can also use other methods but we will
see how we use this expected value decision making by which you can suggest that what
should be the height of the levee to be made. Also, you have to see that as you go on making
larger levee heights, the initial investment is going to be higher and higher. So, you have to
justify what should be the basically actual height which gives you minimum of the cost.

Study period = 15 years

Interest rate = 12%

0 levee height:

Investment cost = 0

Cost incurred because of flood = 0.24 x 6 + 0.2 x 9 + 0.16 x 12 + 0.06 x 15 + 0.04 x 20

= 6.86 lakhs

(Refer Slide Time: 16:43)

20 cm levee height:

Investment cost (annual)= 20(A/P, 12, 15) = 20 x 0.147 = 2.94 lakhs

332
Now there will be no loss if there is 20 centimeter of water level but if there is 40 centimeter
of water level, in that case loss will be corresponding to 20 centimeter of height and the
probability of coming of 40 centimeter height water level is .2. So, accordingly we will
calculate.

Cost incurred because of flood = 0.2 x 6 + 0.16 x 9 + 0.06 x 12 + 0.04 x 15

= 3.96 lakhs

Total loss = 2.94 + 3.96 = 6.9 lakhs

(Refer Slide Time: 13:48)

(Refer Slide Time: 20:38)

333
40 cm levee height:

Investment cost (annual)= 30(A/P, 12, 15) = 30 x 0.147 = 4.41 lakhs

Cost incurred because of flood = 0.16 x 6 + 0.06 x 9 + 0.04 x 12

= 1.98 lakhs

Total loss = 4.41 + 1.98 = 6.39 lakhs

(Refer Slide Time: 24:35)

60 cm levee height:

Investment cost (annual)= 50(A/P, 12, 15) = 50 x 0.147 = 7.35 lakhs

Cost incurred because of flood = 0.06 x 6 + 0.04 x 9

= 0.72 lakhs

Total loss = 7.35 + 0.72 = 8.07 lakhs

80 cm levee height:

Investment cost (annual)= 65(A/P, 12, 15) = 65 x 0.147 = 9.55 lakhs

Cost incurred because of flood = 0.04 x 6

= 0.24 lakhs

Total loss = 9.55 + 0.24 = 9.79 lakhs

334
100 cm levee height:

Investment cost (annual)= 80(A/P, 12, 15) = 80 x 0.147 = 11.76 lakhs

Cost incurred because of flood = 0 lakhs

Total loss = 11.76 + 0 = 11.76 lakhs

What we see is that on 20 centimeter height you have 6.90 lakhs was the annual cost. On 40
centimeter height, it was 6.39 lakhs. On 60 centimeter height, it was 8.07 lakhs. On 80
centimeter it was 9.79 lakhs and finally if you are making 100 centimeter, it is coming out to
be 11.76 lakhs.

(Refer Slide Time: 28:20)

So the maximum loss is when you are going to make the 100 centimeter levee height and the
minimum loss annually or minimum cost what you have to incur annually is 6.39 lakhs. So, it
is suggested to go for making a 40 centimeter levee which should go for 15 years and in that
case the annual cost is minimum. So, suggested height of levee is 40 centimeter.

So, this is how you solve such problems where you have been given the probability values
and you have to decide what should be the height of the dam in optimum manner.

Thank you.

335
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture35
Expected Variance Decision-Making under Risk
Welcome to the lecture on decision under risk and uncertainty.

In this lecture we will discuss about the expected variance decision-making. We know that
these are the statistical parameters which are used to know how much accurate you are
predicting. Many a times, the mean values alone cannot be the decisive factor because we can
come to a situation where the mean values do not differ much. In that case, the variance of
the variable must be taken into account. There is more realistic representation of uncertainty
when the variability is taken into account. So, we will see it by solving an example which
will show that how variability can tell us more accurate prediction.

(Refer Slide Time: 01:35)

336
(Refer Slide Time: 02:08)

Example: The probability distribution of realizing present worth from three mutually
exclusive projects (P1, P2, and P3) developed by a company are as follows:

Present Worth Projects

(Lakhs)
P1 P2 P3
15 0.3 0.1 0.1
30 0.0 0.2 0.1
45 0.1 0.3 0.2
60 0.2 0.1 0.3
75 0.2 0.1 0.3
90 0.2 0.2 0.0
Which of the project alternative can be considered to be most attractive using the expected
value and the variance for each probability distribution?

So, you have three projects and the probability distribution is shown for this which will yield
this corresponding value of present worth. Now in this case as we will proceed, we will find
first the expected value or the mean value but then we will also find the variance and then we
will see that how you can predict the results using expected value as well as the variance
using each probability distribution. So, let as solved this problem.

337
(Refer Slide Time: 08:47)

Expected value

Project P1: Expected value = 15 x 0.3 + 30 x 0 + 45 x 0.1 + 60 x 0.2 + 75 x 0.2 + 90 x 0.2

= 54 lakhs

Project P2: Expected value = 15 x 0.1 + 30 x 0.2 + 45 x 0.3 + 60 x 0.1 + 75 x 0.1 + 90 x 0.2

= 52.5 lakhs

Project P3: Expected value = 15 x 0.1 + 30 x 0.1 + 45 x 0.2 + 60 x 0.3 + 75 x 0.3 + 90 x 0

= 54 lakhs

Now what we see is, using the expected value criteria, we get the expected values for the
project P1, P2 and P3. Under the given probability distribution, we get the expected value is
54, 52.5 and 54 lakhs. Certainly, we will prefer P1 end P3 but then since they are matching
and you will see that it will be very close, so it is advisable to go for the checking of the
variability and for that we will find the variance.

338
(Refer Slide Time: 12:35)

Find variance.

V = E(PW)2 – [E(PW)]2

Variance for project P1 = (152 x 0.3) + (302 x 0) + (452 x 0.1) + (602 x 0.2) + (752 x 0.2)

+ (902 x 0.2) - 542

= 819

Variance for project P2 = (152 x 0.1) + (302 x 0.2) + (452 x 0.3) + (602 x 0.1) + (752 x 0.1)

+ (902 x 0.2) – 52.52

= 596.25

Variance for project P3 = (152 x 0.1) + (302 x 0.1) + (452 x 0.2) + (602 x 0.3) + (752 x 0.3)

+ (902 x 0) - 542

= 369

339
(Refer Slide Time: 22:00)

So, what we see is, that project P1 was giving us the expected value of 54 lakhs, P2 was
giving 52.5 lakhs, P3 was giving 54 lakhs, so we could have preferred P1 and P3 instead of
P2, however, it is difficult at this stage which one to decide whether P1 or P3. So, in that
case, it is better to go for the variance studies. So, it is seen that the variance value of P3 is
the minimum. In that case, P3 should be preferred. So, we can say that since expected values
of project P1 and P3 are same at 54,00,000, the variance value for P3 is smaller than P1. So
P3 should be preferred, should be the preferred choice.

(Refer Slide Time: 22:00)

This is how when you have this type of cases where the expected values are nearly equal and
you have the difficulty in deciding which one should be preferred, in that case this method of

340
getting the variance and seeing that where the variability is minimum, that should be the
preferred choice.

Next, we will discuss about one of the techniques, when these types of elements are very
uncertain and there are many components. In that case, Monte Carlo technique is also used.
We will discuss in brief about this Monte Carlo technique, how it is used to find these values.

(Refer Slide Time: 27:07)

The Monte Carlo technique, is used under the cases when you have to decide and there are is
chances of risk and uncertainty. And if there are many elements and there is a large amount
of uncertainty, in that case, Monte Carlo technique is used. In Monte Carlo technique, we use
random numbers which follow some kind of probability distributions. So, you first have to
generate the random numbers. Now let us say the time period is not certain.

Time period Probability Random

Number

1 20% 00-19

2 30% 20-49

3 20% 50-69

4 30% 70-99

341
 Present worth Probability

40000 40%

70000 60%

(Refer Slide Time: 26:46)

Now what you can do is generate uniformly distributed random numbers. So there are many
generators of the random numbers, you can generate it using the Microsoft Excel or you can
generate the random numbers following certain rules or following certain typical probability
distribution functions by the random number generators. So, once you generate the random
numbers suppose it comes like this 17, 83, 42, 9, 5 like that it may go.

Random Numbers

17 -----------------------------
83 -----------------------------
42 -----------------------------
09 -----------------------------
05 -----------------------------

342
(Refer Slide Time: 30:21)

Iteration Year Random No. Present worth Results

1 17 1 7 70000

So, this way whatever calculation you have to do, you can further do and get the results. Not
this will basically be continued because as long you go you take larger and larger range of
random numbers. If you continue for large distances, the chances of getting the error is
minimum and you can calculate whatever you have to calculate.

It is a very useful for calculating the cases when we have many elements, the uncertainty is
there in all the elements and you have to take into account the effect of uncertainty of a
greater number of elements.

Thank you.

343
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 36
Problem Solving Based on Decision under Risk

Welcome to the lecture on problem solving on decision under risk and uncertainty. In this
lecture we will solve some problems based on decision under risk and uncertainty.

(Refer Slide Time: 00:44)

Example: An agency gives four alternatives to one of its client. The client after studying
alternatives develops probability distribution describing annual income if invested in particular
alternative. The details about the four alternatives are:

Alternatives Annual Profit/Loss (in Lakhs)

-40 -20 20 40 60
1 0.10 0.20 0.20 0.40 0.10
2 0.05 0.15 0.30 0.40 0.10
3 0.40 0.00 0.10 0.00 0.50
4 0.10 0.10 0.40 0.40 0.00
Find the expected value of the annual profit and variance value. Which alternative should be
preferred?

344
(Refer Slide Time: 06:37)

Expected values

For alternative A1→ (-40 x 0.1) + (-20 x 0.2) + (20 x 0.2) + (40 x 0.4) + (60 x 0.1) = 18

For alternative A2→ (-40 x 0.05) + (-20 x 0.15) + (20 x 0.3) + (40 x 0.4) + (60 x 0.1) = 23

For alternative A3→ (-40 x 0.4) + (-20 x 0) + (20 x 0.1) + (40 x 0) + (60 x 0.5) = 16

For alternative A4→ (-40 x 0.1) + (-20 x 0.1) + (20 x 0.4) + (40 x 0.4) + (60 x 0) = 18

So, these are the values of mean or expected values when we take the probability values into
account. Now we have to see what is the variance value for them.

(Refer Slide Time: 10:47)

345
Variance

For alternative A1→ (-40)2 x 0.1 + (-20)2 x 0.2 + (20)2 x 0.2 + (40)2 x 0.4 + (60)2 x 0.1 - 182

= 996

For alternative A2→ (-40)2 x 0.05 + (-20)2 x 0.15 + (20)2 x 0.3 + (40)2 x 0.4 + (60)2 x 0.1 - 232

= 731

For alternative A3→ (-40)2 x 0.4 + (-20)2 x 0+ (20)2 x 0.1 + (40)2 x 0 + (60)2 x 0.5 - 162

= 224

For alternative A4→ (-40)2 x 0.1 + (-20)2 x 0.1 + (20)2 x 0.4 + (40)2 x 0.4 + (60)2 x 0 - 182

= 676

(Refer Slide Time: 15:46)

So, we have:

Alternative Expected value Variance

1 18 996
2 23 731
3 16 2224
4 18 676
So, what we see is this is preferred one using the expected value and the minimum value of the
variance is 676. However, A2 option looks to be better because the variance value is quite
reasonably in the case of alternative 2.

346
So, depending upon the choice you can go for alternative 2, if the expected value is seen it is
maximum and also the variance value is closer to the minimum so alternative 2 can be
preferred. So, this is how we solve the problem based on the expected value or expected
variance decision making.

(Refer Slide Time: 16:24)

Example: The profits earned by three alternatives under three level of sales are as follows:

Alternatives Level of Sales

L1 L2 L3
1 50 80 80
2 60 70 20
3 90 30 60
Use Laplace principle, Maximin rule, Maximax rule and Hurwicz rule (taking α = 0.6) to
suggest best alternative in each case.

The problem discusses about the different criterion in the case of uncertainty where the profit
earned by 3 alternatives under 3 level of sales are given. The probabilities are not given in this
case and you have to use the Laplace principle, Maximin, Maximax rule and Hurwicz rule and
to suggest the best alternative in each case.

347
(Refer Slide Time: 19:00)

1. Laplace Rule:

Alternative 1: → (50 + 80 + 80)/3 = 70

Alternative 2: → (60 + 70 + 20)/3 = 50

Alternative 3: → (90 + 30 + 60)/3 = 60

So, using Laplace rule you see that alternative 1 should be preferred which gives you maximum
of the profit out of the three alternatives.

(Refer Slide Time: 20:32)

348
 2. Maximin rule:

Max [Min [A1], Min [A2], Min [A3]]

= Max [50, 20, 30]

= 50

So, 50 we have a pessimistic view, we feel that you will get the minimum of the profit for every
alternative and then we try to have the maximum of those minimum values.

(Refer Slide Time: 21:45)

3. Maximax rule:

Max [Max [A1], Max [A2], Max [A3]]

= Max [80, 70, 90]

= 90

You see that the using Maximax the alternative 3 is under consideration.

349
(Refer Slide Time: 25:31)

4. Hurwicz rule: (α = 0.6)

Alternative 1 → 0.6 x 80 + (1 - 0.6) x 50 = 68

Alternative 2 → 0.6 x 70 + (1 - 0.6) x 20 = 50

Alternative 3 → 0.6 x 90 + (1 - 0.6) x 30 = 66

So, what you see is alternative A1 gives you the maximum value.

So, using Laplace → alternative A1

Maximin → alternative A1

Maximax → alternative A3

Hurwicz → alternative A1.

So, this is how you come to the conclusion that which of the alternatives should be selected at
least in the cases when the probability levels are not mentioned.

350
(Refer Slide Time: 27:31)

Hurwicz can be having different values if we change the α.

Suppose we change the α as α = 0.3,

Alternative 1 → 0.3 x 80 + (1 - 0.3) x 50 = 59

Alternative 2 → 0.3 x 70 + (1 - 0.3) x 20 = 35

Alternative 3 → 0.3 x 90 + (1 - 0.3) x 30 = 48

So, for this parameter also again we see that A1 is preferred.

So, this way you can have different value of the degree of optimism α value and based on that
the alternative can be selected which should be the most preferred ones. And you can use any
or either of these methods to suggest the best alternative.

Thank you.

351
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture37
Income Taxes: Principles and Calculation of Effective Income Tax Rates
Welcome to the lecture on income tax analysis. In this lecture we are going to do the tax
analysis, after-tax cash flows, effect of income tax on after-tax cash flows and other things
which are basically the result of the income tax you pay or the income tax which is paid by
the corporation and resultant effect of that on the cash flow of the organization.

(Refer Slide Time: 01:04)

Now as we know that taxes are basically levied by the government, assessed as a function of
gross revenue minus allowable deductions. So, the gross revenue is there or gross income is
there for any organization or for an individual on that we have to pay the tax but then there
are certain allowable deductions and also personal exemptions for individuals for many
causes. So, once you subtract these deductions and exemptions from the gross revenue, then
you get a part which need to be taxed. Now on that the tax rates will be there and depending
upon the amount you earn, you will have to pay certain percentage of that known as the tax
rate. So, for individuals or for the companies, these tax rates are decided by the government.

The tax rates may be governed by the rules of the Centre or by the State as far as the country
tax is concerned for our own country like India. Different type of taxes are there like property
tax, sales tax, excise tax, etc.

352
Once we have the income, on that we have to give the income tax. So, income tax will be
dependent upon the gross income of individual or the net income of the organisation. But the
taxes like property tax, sales tax or excise tax, they are not dependent upon the gross income,
they are related to certain type of transactions in sales or property you have, etc.

Why this tax study is important? So far, we have studied about the effect of interest, the cash
flows, replacements and other things but in that we have studied the before tax studies. Once
you pay the tax, the cash flows are changing. This change is not very large, not very
significant, that is why we do the studies before tax but we cannot ignore the effect of tax.

Once you pay the tax or once the tax is levied, it affects the cash flow and anyway it has
certain effect on the cash flow. So, it is important to study the after-tax cash Now after-tax
cash flow will be based on MARR.

(Refer Slide Time: 04:44)

After-tax there will be MARR (minimum attractive rate of return) and also there is before tax
MARR. The amount which you pay or the effective interest rate on which you pay, that
governs what will be the after-tax MARR.

Taxable income of individuals has to be calculated by deducting personal exemptions and

allowable deductions from individual’s gross income. As we discussed if the person has a
gross income then there are personal exemptions and also the allowable deductions. These are
deducted from the gross income and then you get the taxable income. On that taxable income,
you have to pay the taxes.

353
For business venture net income or loss is calculated for each financial year. In the case of
business venture, you have the income on that the deductions or the expenditure in carrying
out operations, all those are to be deducted then you get the net income and, on that
corporates, or business ventures are taxed at certain rates.

(Refer Slide Time: 06:40)

(Refer Slide Time: 12:03)

Let us see how the calculation of income tax for companies and for individuals are done.

If we talk about our own country, then in the year 2015-16, the rule was like this:

354
Taxable Income Tax

Upto, 2,50,000 NIL

From 2,50,001 to 5,00,000 10% of the income above 2,50,000

From 5,00,001 to 10,00,000 20% of the income above 5,00,000 + 25,000

> 10,00,000 30% of the income above 10,00,001 +

1,25,000

> 1,00,00,000 30% + Surcharge (12% of Income tax)

Now on all that, by the government regulations you also pay other tax like educational cess of
3%.

Then there are other kind of taxes like Swachh Bharat etc.

(Refer Slide Time: 12:53)

For corporations,

upto 10,00,00,000 → 30% + surcharge and

for more than 10,00,00,000 you have different surcharges.

These rates vary from time to time.

355
(Refer Slide Time: 14:24)

We should be aware of certain terminologies, how the income tax is calculated and how it has
bearing on the economic analysis.

Example: You have an income of suppose 7,50,000 (taxable income). In that case your tax
amount will be,

Tax amount = 25,000 + 20% of 2,50,000 = 25,000 + 50,000 = 75,000

So, this is how you calculate the taxes. On this amount further you have to add certain cess,
so that may come to some percentage of 75,000 and then you get the values and total tax is
computed.

(Refer Slide Time: 14:35)

356
(Refer Slide Time: 20:21)

Now let us see we how to calculate the effective income tax rate. What is effective income
tax rate?

The effective income tax rate is the particular percentage of the tax rate which when
multiplied with the income it directly gives the amount to be paid by the individual or by the
organisation.

Suppose a person is having the taxable income of 12,00,000.

Amount of Tax = 25000 + 100000 + 60000 = 185000

Earlier he had taxable income as 9,00,000

Tax = 25000 + 80000 = 105000

So, on additional or incremental income of Rs. 3,00,000, the person is paying Rs. 80,000 as
tax.

Effective tax rate = 80000/300000 = 26.67%

So, in fact it is not the actual amount of the tax what he is paying, he will further be paying
some cess, and other things. But ignoring that if we calculate the taxes for knowing the
effective interest rate concept, we can come to this conclusion that the effective tax rate paid
by the person for these 3,00,000 additional incomes will be 26.67%.

357
So basically, in future whenever we will talk about the tax rates, we will talk in terms of
effective tax rates because we will assume that he comes into a particular category and for
any additional income he has to pay that many percentages of the tax.

(Refer Slide Time: 20:12)

(Refer Slide Time: 20:55)

Now this effective tax rate is also important to get the after-tax MARR.

After tax MARR = (1 – effective tax rate) x Before tax MARR

What happens that many a times we used to invest the money in the bonds. Now in that case
when we invest them in bonds, some of them pay us the interest annually and we have to pay
the tax on those interest. Whereas in some of the corporation bonds or municipal bonds

358
maybe we are exempted from paying the taxes. In that case, you are getting the return
somewhat lesser.

(Refer Slide Time: 28:33)

So, we have to see that how these interest affects the after-tax cash flow.

Example: Suppose a person has to purchase a bond. He has two alternatives that he can
purchase from a company or he can purchase from the government authorized agency. The
condition is that if he is investing Rs. 2,00,000 on the bond, the company will be paying him
12% annually and maturity is 7 years. In the second case, the government authorized agency
will be paying 9% annually and tax exempted. Further, the person has to pay 20% effective
tax rate.

Now if you look at the cash flow diagram for these cases what you see is the cash flow
diagram as shown above.

So, in first case, the person is getting income of 24000 and he will pay tax of 29% on 24000
income earned every year as 6960.

The actual amount which he is getting = 24,000 – 6960 = 17040.

That is 8.52%

359
(Refer Slide Time: 28:09)

Now let us see for the government authorized agency, the case the cash flow diagram will be
as shown above.

So, he is getting income of 18000 every year.

That is 9%.

So, if you look at the effective interest earned by the person is 8.52% for the first case and
9% for the second case. So, this is how the purchasing of the bond from the two agencies
having different conditions affects the cash flow and the effective tax rate.

Thank you.

360
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 38
Effect of Method of Depreciation on Income Taxes
Welcome to the lecture on income tax analysis. In this lecture we will talk about the effect of
depreciation on income taxes.

(Refer Slide Time: 00:48)

We have already studied different depreciation methods; we have also discussed about the
depreciation on the assets is because of the loss in its value and the manufacturer gets its
benefit during the tax paying. There are different methods of depreciation calculation and the
method of calculating depreciation affects income tax paid and the cash flows.

The type of depreciation schedule affects the income tax paid. We will solve an example, in
which we will try to see how the selection of different depreciative session schedule affects
the income tax amount to be paid.

Example: Initial cost of a machine purchased is Rs 200,000.

Machine has useful life = 5 year.

Salvage Value = 0

The machine is expected to produce income of Rs 1,00,000

Effective tax rate = 30%

361
(Refer Slide Time: 07:22)

Now in that case we have to see that how the depreciation schedule which is adopted, how it
will affect the tax amount to be paid. So, let us say we are using two depreciation schedules
using straight-line method and another is accelerated method that is double declining balance
switching to straight-line. So, these are the two kinds of depreciation schedule and we have to
see that how the depreciation schedule adopted affects the tax calculation. In which case we
are paying more amount of tax?

Depreciation Charge Income Depreciated

End of Cost of
Income DDB (Switching S-L DDB (Switching
year Asset S-L
to S-L) to S-L)
0 200000
1 100000 40000 80000 60000 20000
2 100000 40000 48000 60000 52000
3 100000 40000 28800 60000 71200
4 100000 40000 21600 60000 78400
5 100000 40000 21600 60000 78400
For DDB switching to S-L (Depreciation rate = 2*1/5 = 40%)
Year % Depreciation (DDB) S-L
1 40 20
2 24 15
3 14.4 12
4 8.64 10.8
5 10.8

362
So, this is how the depreciation charge will be calculated using the DDB method switching to
straight-line.

(Refer Slide Time: 13:06)

Now let us see, what is the income after having deduction of the depreciated amount? Or,
what is income - depreciation? So, we have calculated the depreciation schedule, or the
amount of the money that is net income of the company or individual on which you have to
pay the tax.

Now, what will be the tax that will be paid by the person?

(Refer Slide Time: 15:35)

363
Tax Paid

Year S-L DDB (Switching to S-L)

1 18000 6000
2 18000 15600
3 18000 21360
4 18000 23520
5 18000 23520

(Refer Slide Time: 18:32)

Now if MARR is 12%,

Present Worth = (PW)S-L Method = 18000 x (P/A, 12, 5)

= 18000 x 3.6

= 64800

(PW)DDB switching to S-L Method = 6000 x (P/A, 12, 1) + 15600 x (P/A, 12, 2) +21360 x (P/A, 12, 3)

23520 x (P/A, 12, 4) + 23520 x (P/A, 12, 5)

= 6000 x 0.893 + 15600 x 0.797 +21360 x 0.712 + 23520 x 0.635 + 23520 x 0.567
= 61270

364
(Refer Slide Time: 19:04)

(Refer Slide Time: 21:18)

Now what we have seen that using the straight-line method, we have paid the present worth
value of money as 64,800 whereas if we use the accelerated method of depreciation, we are
paying 61270. So, if we use the accelerated why this difference has come?

What we see is, we are paying initially in the initial periods smaller amount in case of
accelerated methods of depreciation. Now since there is time value of money whatever we
are paying today the money value basically decreases because of its nature so the amount
which is finally coming as the present worth today because of the time value of money, this
amount the smaller.

365
So, we have the advantage in choosing that depreciation schedule where initially the larger
depreciation is accounted for, you are paying initially less taxes rather than the schedule in
which initially you have to pay more taxes by depreciating less.

Capital Gains and Losses

We purchase different type of assets for the functioning of the organization. These assets
have certain lives, if these assets are disposed either before its life or after its life or in other
sense, if they are disposed at a value lesser than its book value in that case you are losing.
And if you are disposing this asset at a value larger than its book value then in fact it is a
capital gain.

(Refer Slide Time: 29:34)

Capital gains or capital losses occur when an asset is disposed at an amount larger or
smaller than its book value at that time.

If sold at larger price than book value, it is capital gain (treated as income). So, have to pay
tax on this.

If sold at a smaller price than the book value, it is known as a capital loss (you can save tax).

So, this is how the capital gains or losses are taken into account and they are affecting the tax
flow analysis.

Next is when we talked about depreciation in that case, there is depletion also.

Depletion: the depletion is nothing but the depreciation of natural resources.

366
So here are also depending upon the units you are producing, the depletion amount which is
there that can be used so that you get the tax benefit. So, what we see in depletion is, since
there is piece wise removal of the natural resources, as the units are removed you need to get
certain depletion allowance. And basically, first of all you get the value of unit depletion rate
and then once you get the unit depletion rate and that will be multiplied by units produced,
that gives you the depletion allowance.

Unit depletion rate x Unit Produced = Depletion Allowance

And you get the tax rebate on this amount has to be reduced from the gross income and the
taxable income is achieved after this and you get some tax benefit on this.

But there is another condition which is discussed about ceiling.

Ceiling: depletion allowance should not be more than 50% of the taxable income.

So, this condition has to be kept in mind while taking the depletion allowance.

The recovery period is also important. If the recovery period is less, in that case the amount
which is paid by the taxpayer, its worth at present time will be less. For any taxpayer smaller
recovery period is beneficial than a larger recovery period because as you go on increasing
the recovery period basically the amount which is recovered will be at a later time. Since you
are getting the benefits of tax reduction at a later time (because of the time value of money),
the deductions which you get at an early time is beneficial for the taxpayer. So, the taxpayer
tries to keep the asset with smaller recovery period, so that case he has to pay less taxes.
Certainly, the asset loses its value in early time but on tax accounts he gets that benefit and
resultant tax flow or cash flow can be seen that if you use the smaller recovery period it is
better for a taxpayer.

Thank you.

367
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 39
After Tax Economic Analysis
Welcome to the lecture on income tax analysis.

(Refer Slide Time: 1:20)

In this lecture we will discuss about after tax cash flows. After tax economic analysis is
important, it has to be done by taking care of the payments or savings which are because of
the income taxes. Many a times we have the alternatives, so we can see even without
alternative or with alternative what will be the change in the cash flow when the income tax
is applied.

368
(Refer Slide Time: 5:28)

Also, capital gains or losses affect the profitability of an investment. So, we will see in any
business enterprise without any alternative how the after tax analysis brings changes into the
tax amount and the resulting cash flow. Let us deal with a question;

Example: The first cost of an asset is taken as Rs 6,00,000. Its salvage value at the end of its
life is zero. 3 year recovery period is there and 4 year life. The annual income which the asset
is supposed to give is Rs 3,00,000. The operating cost is 50,000 per year. The depreciation
schedule is straight line with half year convention. The effective tax rate is given as 30%.

Now in these cases we have to see what is the change in the tax flow or the cash flow once
you have the depreciation schedule?

End of year Cash flow before Depreciation Taxable Income Tax After tax
depreciation cash flow
0 -600000 -600000
1 250000 100000 150000 45000 205000
2 250000 200000 50000 15000 235000
3 250000 200000 50000 15000 235000
4 250000 100000 150000 45000 205000

369
(Refer Slide Time: 11:53)

So, if we have to compute the rate of return for the cash flow before the tax payment and after
the tax payment, it can be:

Before tax internal rate of return:

600000 = 250000 x (P/A, i*, 4)

Before tax internal rate of return:

600000 = 205000 x (P/A, i*, 4) + 30000 x (P/A, i*, 2)(P/F, i*, 1)

(Refer Slide Time: 13:03)

So, you can get the rate of return by equating the values of the before tax analysis and the
after tax analysis.

370
Further, we will have a study when there is alternative present.

Sometimes, in the plant you may have some alternative to upgrade some existing equipment
or to bring it to more cost into the equipment which will increase the gross income may be at
the expense of increase in the operating expenses. But how that affects the tax flows, the cash
flows after tax analysis that can be further seen by referring to an example.

(Refer Slide Time: 16:29)

Example:

Without alternative With alternative

Gross income 2000000 2200000

Expenses 500000 600000

(operating cost)

Depreciation 200000 250000

Taxable income 2000000 – 500000 – 200000 = 2200000 – 600000 – 250000

1300000 = 1350000

Tax (effective tax 390000 405000

rate = 30%)

After tax profit 1300000 – 390000 = 910000 13500000 – 405000 = 945000

371
(Refer Slide Time: 18:48)

So, we can see that if you have the different alternatives and you have the gross income at
different levels, operating cost at different levels, so after tax profit can be evaluated and
further you can have the decision whether to proceed, how to compare these two alternatives.

Now we will discuss about the effect of capital gains on the tax flow, after tax cash flow.

We have already discussed about the capital gains or losses when we dispose any item. At
that time when we dispose it or if we are selling it at a price more than its book value,
depending upon the book value of the asset then it will have capital gain and you have to pay
tax on it.

(Refer Slide Time: 22:37)

372
So, let us take an example where effect of salvage value will be considered to see what is its
effect on the cash flow.

Example: An asset is there with first cost of 21,00,000.

Salvage value at the end of its life = 5,00,000.

Annual income is Rs 4,00,000 during first year and increase by Rs 25,000 every year.

Depreciation schedule: so 3 year property (half year convention using straight line
depreciation)

Life of the asset = 6 years.

Effective tax rate = 30%

Capital gain tax = 25%

So, here at the end of 6 years you are getting an income of 5,00,000 and this is the capital
gain and you have to pay the tax on capital gain.

End of Cash flow Depreciation Taxable income Tax After tax cash
year before tax flow
0 -2100000 -2100000
1 400000 350000 400000 – 350000 15000 385000
= 50000
2 425000 700000 425000 – 700000 -82500 507500
= -2750000
3 450000 700000 450000 – 700000 -75000 525000
= -250000
4 475000 350000 475000 – 350000 37500 437500
= 125000
5 500000 0 500000 – 0 = 15000 485000
500000
6 525000 0 525000 – 0 = 15750 509250
525000
6 500000 500000 125000 375000

373
(Refer Slide Time: 31:19)

So, this is how the after tax cash flows will be calculated when you have the capital gain at
the end of the period or be so if it is disposed at any other time. Accordingly, the after tax
flow is to be calculated and it will be analyzed.

Thank you.

374
 Engineering Economic Analysis
Professor Dr. Pradeep K Jha
Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 40
Problem Solving Based on Income Tax Analysis
Welcome to the lecture on problem solving on tax analysis. In this lecture we are going to
solve the problem based on the tax calculations and the associated changes in the cash flow
diagrams.

(Refer Slide Time: 00:47)

Example: An asset was purchased for Rs 20 Lakhs with estimated life of 5 years salvage
value at the end of its life as zero. The gross income produced is Rs 7 Lakhs every year
before depreciation and taxes. At 30% effective tax rate and 12% interest rate, compare the
present worth of the income taxes for the three methods namely straight line method, DDB
(switching to SL) and SOYD.

P = 20,00,000

N = 5 years

Income every year = 7,00,000

Effective tax rate = 30%

Interest rate = 12%

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S-L Method:

End of Before tax Taxable After tax cash

Depreciation Tax
year cash flow income flow
0 -2000000 -2000000
30% of 300000 700000 – 90000
1 700000 400000 300000
= 90000 = 610000
30% of 300000 700000 – 90000
2 700000 400000 300000
= 90000 = 610000
30% of 300000 700000 – 90000
3 700000 400000 300000
= 90000 = 610000
30% of 300000 700000 – 90000
4 700000 400000 300000
= 90000 = 610000
30% of 300000 700000 – 90000
5 700000 400000 300000
= 90000 = 610000

So, this is how your after tax cash flows will look like using the Straight Line Method.

(Refer Slide Time: 5:13)

376
(Refer Slide Time: 13:33)

SOYD method:
End of Before tax Taxable After tax cash
Depreciation Tax
year cash flow income flow
0 -2000000 -2000000
30% of 33333 700000 – 10000 =
1 700000 666667 33333
= 10000 690000
30% of 166667 700000 – 50000 =
2 700000 533333 166667
= 50000 650000
30% of 300000 700000 – 90000 =
3 700000 400000 300000
= 90000 610000
30% of 433333 700000 – 130000
4 700000 266667 433333
= 130000 = 570000
30% of 566667 700000 – 170000
5 700000 133333 566667
= 170000 = 530000
So, this is how the after tax cash flow will look like in the case of SOYD method.
(Refer Slide Time: 15:19)

377
(Refer Slide Time: 16:55)

DDB switching to straight line:

End of Before tax Taxable After tax cash

Depreciation Tax
year cash flow income flow
0 -2000000 -2000000
30% of 100000 700000 + 30000
1 700000 800000 -100000
= -30000 = 730000
30% of 220000 700000 – 66000 =
2 700000 480000 220000
= 66000 634000
30% of 412000 700000 – 123600
3 700000 288000 412000
= 123600 = 576400
30% of 484000 700000 – 145200
4 700000 216000 484000
= 145200 = 554800
5 30% of 484000 700000 – 145200
700000 216000 484000
= 145200 = 554800

Year Depreciation

1 40%

2 24%

3 14.4%

4 10.8%

5 10.8%

378
(Refer Slide Time: 20:22)

So, this is how the depreciation schedule looks like.

Now we have to see what is the present worth of the income tax which is paid? So, we can
calculate the present worth of the income taxes using the three methods,

(PW)SL = 90000(P/A, 12, 5) = 90000 x 3.605 = 324450

(PW)SOYD = [10000 + 40000(A/G, 12, 5)] (P/A, 12, 5)

= (10000 + 40000 x 1.774) x 3.605 = 291861

(PW)DDB = -30000(P/F, 12, 1) + 66000(P/F, 12, 2) + 123600(P/F, 12, 3)

+ 145200(P/F, 12, 4) + 145200(P/F, 12, 5)

= -30000 x 0.893 + 66000 x 0.797 + 123600 x 0.7712

+ 145200 x 0.635 + 145200 x 0.567

= 288345

379
(Refer Slide Time: 22:16)

(Refer Slide Time: 29:31)

So, these are the three values of present worth of the income tax which is paid using the three
methods of depreciations cited and the resultant cash flow is also shown. And it is seen that
using the double declining balance method switching to straight line, it gives you the
minimum value of present worth value of the income tax paid followed by SOYD and then
the maximum is paid by the straight line methods. So, we can solve more questions based on
the tax analysis and our confidence will increase as we increase the number of questions
solved.

380
So, this is the end of this lecture and also the end of the course. I hope you have enjoyed. I
feel that more you solve the problems based on these economic analysis you will have more
and more confidence. I hope you have also solved the tutorial and assignment questions.

So, I hope that you will do well if you are appearing in the exam, do better and best of luck
for the exam if you are willing to get the certification for this course.

Thank you very much.

381
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