BATAAN HEROES MEMORIAL COLLEGE

ROMAN SUPER HIGH-WAY BALANGA CITY, BATAAN

In Partial Fulfillment for the Completion of the

Subject course in Engineering Economy with
Accounting

Submitted by: Jose Franco D. Torres

Submitted to: Eng’r. Isagani C. Flores

TABLE OF CONTENTS

1………………. BASIC ECONOMIC PRINCIPLES

2………………. PRESENT ECONOMY
3………………. INTEREST AND DISCOUNT
4………………. ANNUITIES AND CAPITALIZED COST
5………………. FINANCING ANY ENTERPRISE;
DEPRECIATION AND DEPLETION
6……………… DEPRECIATION AND DEPLETION
7……………… VALUATION OF PROPERTIES AND
INVESTMENT OF CAPITAL
8……………… INVESTMENT OF CAPITAL
9……………… COMPARISON OF ALTERNATIVES
10……………. CLASSIFICAATION OF COST AND
REPLACEMENT ANALYSIS
11……………. EFFECTS OF FACTORS ON ECONOMY
12……………. INFLATION AND DEFLATION
13……………. BREAK-EVEN ANALYSIS
14……………. PRINCIPLES OF ACCOUNTING
1. BASIC ECONOMIC PRINCIPLES

Engineering economics, previously known

as engineering economy, is a subset
of economics concerned with the use and
"...application of economic principles" in the analysis
of engineering decisions. As a discipline, it is
focused on the branch of economics known
as microeconomics in that it studies the behavior of
individuals and firms in making decisions regarding
the allocation of limited resources. Thus, it focuses
on the decision making process, its context and
environment. It is pragmatic by nature, integrating
economic theory with engineering practice. But, it is
also a simplified application of microeconomic theory
in that it avoids a number of microeconomic
concepts such as price determination, competition
and demand/supply. As a discipline though, it is
closely related to others such
as statistics, mathematics and cost accounting. It
draws upon the logical framework of economics but
adds to that the analytical power of mathematics and
statistics.
The Principles of Engineering Economy
• The development, study, and application
of any discipline must begin with a basic
foundation.

• We define the foundation for engineering

economy to be a set of principles that
provide a comprehensive doctrine for
developing the methodology.

• These principles will be mastered by

students as they progress through this
course.  Once a problem or need has been
clearly defined, the foundation of the
discipline can be discussed in terms of
seven principles.
PRINCIPLE 1: Develop the Alternatives
• Carefully define the problem! Then the
choice (decision) is among alternatives.
• The alternatives need to be identified and
then defined for subsequent analysis.
• A decision situation involves making a choice
among two or more alternatives.
• Developing and defining the alternatives for
detailed evaluation is important because of the
resulting impact on the quality of the decision.
• Engineers and managers should place a high
priority on this responsibility.
• Creativity and innovation are essential to the
process.
PRINCIPLE 2 : Focus on the Differences
• Only the differences in the future outcomes
of the alternatives are important.
• Outcomes that are common to all alternatives
can be disregarded in the comparison and
decision.
• For example, if your feasible housing
alternatives were two residences with the same
purchase (or rental) price, price would be
inconsequential to your final choice.
• Instead, the decision would depend on other
factors, such as location and annual operating
and maintenance expenses.
• This simple example illustrates Principle 2,
which emphasizes the basic purpose of an
engineering economic analysis: to recommend
a future course of action based on the
differences among feasible alternatives
PRINCIPLE 3: Use a Consistent Viewpoint
• The prospective outcomes of the alternatives,
economic and other should be consistently
developed from a defined viewpoint
• (perspective).
• The perspective of the decision maker, which
is often that of the owners of the firm, would
normally be used. The viewpoint for the
particular decision be first defined and then
used consistently in the description, analysis,
and comparison of the alternatives.
Principle 4: Use a Common Unit of Measure
• For measuring the economic consequences, a
monetary unit such as dollars is the common
measure.
• You should also try to translate other
outcomes (which do not initially appear to be
economic) into the monetary unit.
• Using more than one monetory unit for
Economic Analysis will complicate the over all
analysis of a project.

Principle 5: Consider All relevant Criteria

• The decision maker will normally select the
alternative that will best serve the long-term
interests of the owners of the organization.
• In engineering economic analysis, the primary
criterion relates to the long-term financial
interests of the owners.
• This is based on the assumption that available
capital will be allocated to provide maximum
monetary return to the owners.
• Often, though, there are other organizational
objectives you would like to achieve with your
decision, and these should be considered and
given weight in the selection of an alternative.
PRINCIPLE 6: Make Risk and Uncertainty
Explicit
• Risk and uncertainty are inherent in
estimating the future outcomes of the
alternatives and should be recognized.
• The analysis of the alternatives involves
projecting or estimating the future
consequences Associated with each of them.
• The magnitude and the impact of future
outcomes of any course of action are uncertain.
• the probability is high that today’s estimates
of, for example, future cash receipts and
expenses will not be what eventually occurs.
• Thus, dealing with uncertainty is an important
aspect of engineering economic analysis.
PRINCIPLE 7: Revisit Your Decisions
• A good decision-making process can result in
a decision that has an undesirable outcome.
• Other decisions, even though relatively
successful, will have results significantly
different from the initial estimates of the
consequences.
• Learning from and adapting based on our
experience are essential and are indicators of a
good organization.
2. PRESENT ECONOMY
There are many cases in engineering
economy studies where interest is not a factor.
These studies are frequently called present
economy problems. Such studies usually
involve the selection between alternative
design materials or methods.
PRESENT ECONOMY STUDIES
Present economy studies are engineering
economic analyses where alternatives for
accomplishing a specific task are being
compared over one year or less and the
influence of time on money can be ignored.
Two rules shall be followed in conducting
present economy studies. These rules, or
criteria, will be used to select the preferred
alternative when defect-free output (yield) is
variable or constant among the alternatives
being considered.
RULE 1
When revenues and other economic benefits
are present and vary among alternatives,
choose the alternative that maximizes overall
profitability based on the number of defect-
free units of a product or service produced.
RULE 2
When revenues and other economic benefits
are NOT present or are constant among all
alternatives, consider only the costs and select
the alternatives that minimizes total cost per
defect-free unit of product or service output.
SITUATIONS WHERE PRESENT ECONOMY
STUDIES ARE INVOLVED
MATERIAL SELECTION
Invovles selection among materials available
that will result in the most economical product
and give the best results.
SITUATIONS WHERE PRESENT ECONOMY
STUDIES ARE INVOVLED
SELECTION OF METHOD
Two or more different methods may give the
same satisfactory results
Involves selection of the most economical way
to accomplish operations
SELECTION OF DESIGN
The design to be selected must be best suited
for the work to be done with particular care
being given to the one which will do the work
with the utmost economy.
SITE SELECTION
Costs relevant to selecting sites must be
carefully considered (land cost, construction
cost, cost of available labor, cost of
transporting equipment and materials)
PROFICIENCY OF WORKERS
Bear in mind that workers have varying
efficiency and proficiency
Worker proficiency can be translated into
monetary values
ECONOMY OF TOOL AND EQUIPMENT
MAINTENANCE
Consider the costs of acquiring tools and
equipment and the costs of maintaining them.
ECONOMY IN THE UTILIZATIONS OF
PERSONNEL
Only a certain number of personnel will lead to
the highest productivity; increasing this number
will not cause a proportional increase in
productivity.

EXAMPLE PROBLEM
The monthly demand for ice cans being
manufactured by Mr. Cruz is 3,200 pieces. With
a manually operated guillotine, the unit cutting
cost is P25.00. An electrically operated
hydraulic guillotine was offered to Mr. Cruz at a
price of P275,000 and which will cut by 30% the
unit cutting cost. Disregarding the cost of
money, how many months will Mr. Cruz be able
to recover the cost of the machine if he decides
to buy now?
Solution:
Manually Operated Guillotine
Monthly cutting cost = (3,200)(P25) =
P80,000
Electrically Operated Hydraulic Guillotine
Monthly cutting cost = (3,200)(P25)(1-
0.30) = P56,000
Saving = P80,000 – P56,000 = P24,000 per
month No. of months to recover cost of
machine = P275,000/P24,000 = 11.5 is the
answer.
PROBLEM 1 A construction company is
considering the replacement analysis of a
pump. The old pump has annual operating and
maintenance costs of 50.000 TL/yr. It can be
kept for 5 years more. The old pump can be
sold to the manufacturer of the new pump for
25.000 TL. The new pump will have a purchase
price of 120.000 TL, it will have a value of
50.000 TL in five years time; and it will have
annual operating and maintenance costs of
20.000 TL/yr. Using a MARR of 20%, evaluate
the investment alternative comparing the
present worths in the Receipts and
Disbursements Method.

PWOLD(20) = -50.000 (P/A, 20%, 5) = -50.000 x

2,991 = -149.550 TL PWNEW(20) = 25.000 –
120.000 – 20.000 (P/A, 20%, 5) + 50.000(P/F,
20%, 5) = -95.000 – 20.000 x 2,991 + 50.000x
0,4019 = -95.000 – 59.820 + 20.095 = -134.725
TL  CHANGE THE OLD PUMP

PROBLEM 2 The ABC company has a tower

crane that has an estimated remaining life of 10
years. The crane can be sold for 60.000 TL. If
the crane is kept in service it must have a major
repair immediately at a cost of 30.000 TL.
Operating and maintenance costs will be
20.000 TL/yr after the crane is repaired. After
being repaired, the crane will have a zero
salvage value at the end of the 10 year period.
A new crane will cost 160.000 TL, will last for 10
years, and will have 30.000TL salvage value at
that time. Operating and maintenance costs are
10.000 TL/yr for the new crane. The company
uses a MARR of 10% in evaluating investment
alternatives. Should the company buy the new
crane? Compare the annual equivalents in the
“Outsider Viewpoint” method.
AEE(10) = –20.000 – (60.000 + 30.000) (A/P,
10%, 10) = –20.000 – (90.000) (0,16275) = –
20.000 – 14.647,50 = –34.647,50 TL/yr AEN(10)
= –10.000 – 160.000(A/P, 10%, 10) + 30.000
(A/F, 10%, 10) = –10.000 – 160.000 x 0,16275 +
30.000 x 0,06275 = –10.000 – 23.040 + 1.882,50
= –34.157,50 TL/yr  BUY THE NEW CRANE
20.000

PROBLEM 3 A small compressor can be bought

for 10.000 TL. The salvage value is assumed to
be negligible regard less of the replacement
interval. Annual operating and maintenance
costs are expected to increase by 750 TL/yr,
with the first years cost anticipated to be 1.500
TL. Using a MARR of 8%, determine the years at
which replacement should take place.
MARR = 8% LET N = 1 AE(8) = – 10.000 (A/P, 8%,
1) – 1.500 = – 10.000 x 1,08000 – 1.500 = –
10.800 – 1.500 = – 12.300 TL/yr LET N = 2 AE(8)
= – 10.000 (A/P, 8%, 2) – 1.500 – 750 (A/G, 8%,
2) = – 10.000 x 0,56077 – 1.500 – 750 x 0,48 = –
5.607,70 – 1.500 – 360 = – 7.467,70 TL/yr LET N
= 3 AE(8) = – 10.000 (A/P, 8%, 3) – 1.500 – 750
(A/G, 8%, 3) = – 10.000 x 0,38803 – 1.500 – 750
x 0,95 = – 3.880,30 – 1.500 – 712,50 = –
6.092,80 TL/yr LET N = 4 AE(8) = – 10.000 (A/P,
8%, 4) – 1.500 – 750 (A/G, 8%, 4) = – 10.000 x
0,30192 – 1.500 – 750 x 1,40 = – 3.019,20 –
1.500 – 1.050 = – 5.569,20 TL/yr LET N = 5 AE(8)
= – 10.000 (A/P, 8%, 5) – 1.500 – 750 (A/G, 8%,
5) = – 10.000 x 0,25046 – 1.500 – 750 x 1,85 = –
2.504,60 – 1.500 – 1.387,50 = – 5.392,10 TL/yr
n 10.000 TL 1.500 2.250 3.000 3.750 LET N = 6
AE(8) = – 10.000 (A/P, 8%, 6) – 1.500 – 750
(A/G, 8%, 6) = – 10.000 x 0,21632 – 1.500 – 750
x 2,28 = – 2.163,20 – 1.500 – 1.710 = – 5.373,20
TL/yr LET N = 7 AE(8) = – 10.000 (A/P, 8%, 7) –
1,500 – 750 (A/G, 8%, 7) = – 10.000 x 0,19207 –
1.500 – 750 x 2,69 = – 1.920,20 – 1.500 –
2.017,50 = – 5.438,20 TL/yr We see that the
annual equivalent of costs reaches a MINIMUM
when N=6 years, and that it starts climbing
again starting on the 7th year. Therefore, it is
best to replace the compressor at the end of
6th year.

3. INTEREST AND DISCOUNT

Interest
The amount of money earned for the use of
borrowed capital is called interest. From the
borrower’s point of view, interest is the
amount of money paid for the capital. For the
lender, interest is the income generated by the
capital which he has lent.
There are two types of interest, simple interest
and compound interest.

Simple interest is a quick and easy method of

calculating the interest charge on a
loan. Simple interest is determined by
multiplying the dailyinterest rate by the
principal by the number of days that elapse
between payments.

Compound interest is the addition

of interest to the principal sum of a loan or
deposit, or in other words,interest on interest.
It is the result of reinvestinginterest, rather
than paying it out, so that interest in the next
period is then earned on the principal sum plus
previously accumulated interest.

Simple and Compound

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

Simple Interest
Simple interest is calculated using the principal
only.

Interest = (Principal) (number of periods)

(interest rate)

where the interest rate in this case is in

decimals
EXAMPLE 1
Compound Interest
The interest accrued for each interest period is
calculated on the principal plus the
total amount of interest accumulated in all
previous periods.

Compound interest mean interest on top of

interest.

Interest=(Principal + all accrued interest)

(interest rate)

Total due after a number of years =

Principal (1+interest rate)
EXAMPLE 2
If an engineer borrows $1000 from the
company credit union at 5%
per year compound interest, compute the total
amount due after 3
years.

Terminology and Symbols

P = Value or amount of money at a time
designated as the present or
time 0. P is also referred to as present worth
(PW).
F = value or amount of money at some future
time. F is also referred
to as future worth (FW).
A = series of consecutive, equal, end-of-period
amount of money. A is
also called the annual worth (AW)
n, N= number of interest periods; years,
months, days.i = interest rate
or rate of return per time period; percent per
year, percent per month.
t = time, stated in periods; years, months, days
Terminology
The symbol P and F represents one-time
occurrence.
A occurs with the same value one each interest
period for a
specified number of periods.
It should be clear that a present value P
represents a single
sum of money at some time prior to a future
value F or prior
to the first occurrence of an equivalent series
amount A.
A always represents a uniform value, i.e. same
amount
each period.
 Interest rate “i” is assumed to be compound
rate, unless
specifically stated as simple interest.

Example 3
Last year Smith’s father offered to put enough
money into a saving account togenerate $1000
this year to help pay Smith’s expenses at college.
Identify theengineering economy symbols.
Solution:
Time is in years
P=?
i = 6% per year
n = 1 year
F = P + interest = ? + $1000

Introduction to solution by computer

To find present value P:
PV (i%,n,A,F)
To find future value F:
FV(i%,n,A,P)
To find the equal, periodic value A:
PMT (i%,n,P,F)
To find the number of periods n:
NPER (i%,A,P,F)
To find the compound interest rate i:
RATE (n,A,P,F)
Note that the values of P,F,A should be entered
by
taking in view the borrower and lender. Means
if P,Aare +ive then F should be –ive in the case of
Lenderand vice versa

Minimum Attractive Rate of Return

Engineering alternatives are evaluated upon
the basis that
reasonable ROR can be expected.
Therefore some reasonable rate must be
established for the
selection criteria phase of the engineering
economy study.
The reasonable rate is called Minimum
Attractive Rate of
Return (MARR) and is higher then the rate
expected from abank or some safe investment
that involves minimalinvestment risk.

MARR is also referred to as the hurdle rate for

projects; i.e. to be considered financially viable
theexpected ROR must meet or exceed the
MARR orhurdle rate.
MARR is not a value calculated like ROR. It is
established by (financial) management and used
asa criterion against which an alternative’s ROR
ismeasured, when making the accept/reject
decision.
ROR ≥ MARR > Cost of capital
4. ANNUITIES AND CAPITILIZED COST

Annuities and Capitalized Cost. Annuity.

An annuity is a series of equal payments made
at equal intervals of time. Financial activities
like installment payments, monthly rentals, life-
insurance premium, monthly retirement
benefits, are familiar examples
of annuity. Annuity can be certain or uncertain.

CAPITALIZED COST
A capitalized cost is an expense that is added to
the cost basis of a fixed asset on a company's
balance sheet. Capitalized costs are incurred
when building or financing fixed assets.
Capitalized costs are not expensed in the period
they were incurred but recognized over a
period of time via depreciation or amortization.
ANNUITIES
An annuity is a series of equal payments made
at equal intervals of time. Financial activities
like installment payments, monthly rentals, life-
insurance premium, monthly retirement
benefits, are familiar examples of annuity.

Annuity can be certain or uncertain. In annuity

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

Capitalized cost refers to the present worth of

cash flows which go on for an infinite period of
time. Some public works projects like dams,
bridges and parks fall into this category. In
addition, some permanent endowment
calculations require capitalized cost
considerations. The cash flows involved in the
calculations can be categorized as one of two
types: recurring (i.e. periodic/repeating) and
non-recurring (i.e. finite time interval). The
repainting of a bridge every three years is an
example of a recurring cost. The initial
investment cost or a partial annual series which
occurs only in years 1 thru 10 are examples of
non-recurring cash flows. The basic equation
involved in capitalized cost calculations is:
P=A/i
The validity of this equation can be easily
demonstrated thru an example. Suppose one
wanted to know how much money could be
withdrawn forever from an account which
contains $1000 earning interest at a rate of
10% per year. Obviously, it is the interest ($100
per year in this case) that can be withdrawn
forever. In equation form,
 Interest = Principal * Interest rate
A = Pi, or
P=A/i
The procedure to find the capitalized of cash
flows which contain an infinite series is
1. Find the PW of all finite-interval cash
flows using the regular engineering
economy formulas (P/F, P/A, P/G, etc)
2. Convert all (non-
annual) recurring amounts into annual
worths over one life cycle and add all A
values together
3. Divide the A values obtained in step (2)
by i to get the PW of the annual amounts.
4. Add all PW’s together to get the
capitalized cost.
The next example illustrates the calculations
involved.
EXAMPLE 1
A dam will have a first cost of $5,000,000, an
annual maintenance cost of $25,000 and minor
reconstruction costs of $100,000 every five
years. At an interest rate of 8% per year, the
capitalized cost of the dam is nearest to:
(A) -$213,125 (B) -$525,625 (C) -
$5,312,500 (D) -$5,525,625
Solution:
The $5,000,000 first cost is already a present
worth. The $100,000 which occurs every five
years can be converted into an infinite A value
using the A/F factor for one life cycle. Dividing
the A values by i and adding to the $5,000,000
PW will yield the capitalized cost, CC.
CC = -5,000,000 - 25,000/0.08 - 100,000
(A/F, 8%, 5) / 0.08
= -5,000,000 - 312,500 - 100,000
(0.1705)/0.08
= -$5,525,625
Answer is (D)
Occasionally, it may be necessary to determine
the capitalized cost of an alternative which has
a finite life such as when it is compared against
one which has an infinite-life. In such a case,
the capitalized cost of the finite-life alternative
can be found by first converting all of its cash
flows into an equivalent annual worth (A) over
one life cycle and then dividing by i. The next
example illustrates the calculations involved.

EXAMPLE 2
The first cost of a certain piece of equipment is
$50,000. It will have an annual operating cost
of $20,000 and $5,000 salvage value after its 5
year life. At an interest rate of 10% per year,
the capitalized cost of the equipment is closest
to:
(A) -$32,371 (B) -$122,712 (C) -
$323,710 (D) -$522,710
Solution: Convert all values into an equivalent
A value thru one life cycle and divide by i:
A = -50,000 (A/P, 10%, 5) – 20,000 + 5,000
(A/F, 10%, 5)
= -50,000 (0.26380) – 20,000 + 5,000
(0.16380)
= -$32,371
CC = -32,371 / 0.10
= -$323,710
Answer is (C)
6. DEPRECIATION AND DEPLETION
Pre-feasibility Studies often are completed
prior to having all the information needed or
engineering completed.
Depreciation and Depletion are Non-Cash
deductions from income for tax calculations
with the simplifying assumption that losses can
be taken when incurred against other income
(perhaps from other activities of your company)
Income Taxes
Income taxes are calculated as a percentage of
taxable income
Taxable income is the remaining dollars after
deductions from gross revenue for cash
operating costs, indirect costs, non-capitalized
exploration and development costs, start-up
costs or loss on mine development, tax
depreciation (based on long-term investments)
tax depletion
Income Taxes The federal and state tax rates
and deductions are set by government policy to
control economic activity and raise income for
public projects If deductions (depletion,
depreciation or other) are raised a project is
more attractive, policy encourages mining If
deductions are lowered or eliminated a project
is less attractive
Depreciation
Depreciation is the tax deduction given to
recover the cost of investments over the tax life
of the item as defined by the IRS Pub 946.
The useful life is the time that an asset can
remain in service and provide benefit as
expected; after which it is replaced
At the end of a project’s economic life, the
cumulative remaining depreciation is added to
income as if the item was sold for that amount
for preliminary economics. Depreciation
ignores the time value of money
Depreciation begins?
Depreciation begins when an asset is placed in
service, not when purchased
Use half year convention for most projects „ If
asset is idled, continue to depreciate it
Stop taking depreciation when cost basis is fully
recovered asset is retired from service or
abandoned asset is sold
Depreciation
IRS Reform Act of 1986 changed the way assets
were depreciated. The Modified Accelerated
Cost Recovery System (MACRS) is used since
1986. Double Declining Balance using 200% or
150% switching to Straight Line or the optional
Straight line methods are accepted. Half year
conventions are used in many cases
(depreciation starts in the middle of the year
the asset was placed in service)
MACRS (IRS Publication 946, ch4, Modified
Accelerated Cost Recovery System) „ MACRS is
used by most businesses Two systems are used
with four methods General Depreciation
System (GDS) used for most business, oil & gas
and mining projects 200% double declining
balance changing to straight line 150% DDB
changing to SL Straight line Alternate
depreciation system (ADS) used for taxexempt,
farming, or assets used outside the US. Straight
line – longer cost recovery time than GDS
MACRS MACRS lets you deduct more in the
early years of the recovery period or tax life of
the property than straight line methods
Determine the cost basis and tax life The cost
basis is the total depreciation you can take over
the tax life of the property Multiply the total
depreciation by a yearly factor from IRS tables
for each year from when asset is placed in
service This is the annual depreciation amount
for that year If half year convention is used;
make sure to select the proper table (A-1) from
IRS publication 946
Straight Line Method Straight line depreciation
lets you deduct the same amount each year
over the tax life of the property Determine the
cost or other basis, the percentage of business
use and tax life Multiply the basis by the %
business use to find the total depreciation you
can take over the tax life or recovery period of
the property The annual depreciation amount
is the total depreciation divided by the recovery
period in years If half year convention is used
take ½ the annual depreciation in the first year
and ½ in the year after the last year in the tax
life (total years = 1+tax life)
Basis
Cost as basis – the basis of property you buy is
the first cost plus sales tax, freight, installation
and testing and debt obligations.
Other basis – Other basis is determined by the
way you received the property (IRS 551)
If you exchange property If paid for services
with property
A gift or an inheritance Adjust the basis with
other costs incurred before it is placed in
service
Salvage Value
Salvage value is an estimate of the value of
property at the end of its useful life.
Salvage value is not used under MACRS as a
deduction from the basis unless the property is
intangible
Treat salvage value as a cash inflow in the year
sold (or the project ends assuming assets are
sold for the remaining depreciation. This
assumption is reasonable if the project life is
more than the tax life of most of the initial
investment (usually +7 years)
DEPRECIATION METHODS

Asset Depreciation Recovery Period

39 year – land improvements not associated
with mining (buildings, parking for employees,
warehouse, plant structure) i.e. assets that can
be used after mining is finished
15 year – land improvements associated with
mining, river docks, plant roads, rail spurs
(Asset class 00.3),
10 year – vessels, barges, tugs (Asset class
00.28),
7 year – all mining equipment (Asset class
10.0), large trucks, furniture, capitalized
rebuilding cost, rail loop
5 year – cars, light trucks, information
systems, R&D equipment (Asset class 00.12, 22,
241),
Asset Depreciation Recovery Period
Exploration & Development – 30% is
capitalized and depreciated using straight line
for a 5 year period, 70% is expensed in the year
spent.
 Exploration includes costs to determine the
existence, location, extent or quality of a
mineral deposit.
Development includes costs incurred after
mineral deposits are shown to exist in sufficient
quality and quantity to justify commercial
exploitation and include infill drilling,
temporary power, access roads and shafts,
slopes, face ups, site clearing, permitting
Asset Depreciation Recovery Period
Land – surface land (not mineral rights or
property) is part of working capital, is not
depreciated and the value is recovered at the
end of the project life (this assumes that land’s
intrinsic value can be regained when sold).
Recession of Face (ROF) costs are
development costs incurred after a mine has
reached full production and are treated as
expenses in the current year.
Asset Depreciation Recovery Period
Drilling of Oil and Gas Wells (Asset class 13.1)
GDS recovery period is 5 years, ADS 6 years
Assets used in onshore well drilling and
services to complete wells Exploration for and
Production of Petroleum and Natural Gas
Deposits (Asset class 13.2) GDS recovery period
is 7 years, ADS 14 years Assets used in
gathering, storage, transportation,
compression, treatment
DEPRECIATION RATES

Tax Depletion

Governments recognize the value of

nonrenewable resources Mining a mineral
deposit depletes the asset that can be replaced
only by purchasing another deposit This
assigned value is not taxed (federal) Allowable
depletion is a non-taxable recovery of the value
of the resource which is being extracted and
may ignore the time value of money
Tax Depletion

Allowable Depletion is not less than zero or

the larger of Percentage depletion Cost
depletion Depletion may be deducted after the
cumulative amount of depletion exceeds the
previously expensed exploration costs
associated with the mineral deposit (you can’t
deduct exploration costs twice)

PERCENTAGE DEPLETION
Cost Depletion

Cost depletion is calculated separately for

each mine, on the residual investment using
the unit of production method Residual
investment = original leasehold cost less the
value at the end of operations or basis, less the
cumulative depletion deducted in prior years
(may be called the adjusted basis) Residual
investment is divided by the total units left at
the end of the year to produce over the
remaining mine life, to get the rate per unit,
times the production in that year = cost
depletion

Tax Depletion Summary

Tax Depletion = 0 or the greater of a. cost

depletion or b. percentage depletion which is
the lower of i. 50% taxable net income or ii.
Mineral specific % of gross revenue less
royalties iii. Coal and iron are reduced 20%
Depletion Example

Using the percentage method calculate tax

depletion for a coal project Income tax payable
for the year Cash flow Assume no additional
capital or development costs are incurred in
that year Assume that the coal leasehold has no
value at the end of the operating life (there
may be value in the pillars left, the void created
by mining or wheelage for transporting other
products through the mined area.

Depletion Example DATA

Revenue = $20/t x 100,000t = $2,000,000

Cash cost = $10/t x 100,000t = $1,000,000
Mining equipment Tax Basis = $2,041,000
Tax year = 2, MACRS, half year convention
Royalties = 10% gross revenue = $200,000
Depreciation

Cost basis for mining equipment = $2,041,000

Property asset class 10.0 for Mining
MACRS GDS recovery period = 7 years
Year of service – 2
MACRS GDS factor (table A-1, IRS946) = 24.5%
$2,041,000 x .245 = year 2 depreciation
Depreciation = $500,000

Sample Problem

Given a production rate of 120,000 tons in

year 3 Assume the same realization and cost
increase 10% Using the percentage method
calculate tax depletion for a coal project
Income tax payable for the year Cash flow
Assume no additional capital or development
costs are incurred in that year
Oil and Gas Depletion

Cost Depletion – calculated the same way as

with minerals

Percentage
Depletion –may be
claimed if one of the
following conditions
is met

You are either an

independent
producer or royalty
owner

Gas is sold under a fixed contract signed

before February 1, 1975
Percentage Depletion – Natural Gas

Percentage depletion = the smaller of 15% of

the gross revenue (less royalty) from the well
100% of the taxable net income from the
property before depletion (gross revenue –
operating, selling, and administrative costs –
depreciation – intangible drilling and
development – exploration and development)
65% of your taxable income from all sources

EXAMPLE PROBLEM 1

A depreciable construction truck has a first cost

of $20,000 with a $4,000 salvage value after 5
years. Find the (a) depreciation, and (b) book
value after 3 years using DDB depreciation.

(a) d = 2/n = 2/5 = 0.4 D3 = dB(1 – d)t-1 =

0.4(20,000)(1 – 0.40)3-1 = $2880
(b) BV3 = B(1 – d)t = 20,000(1 – 0.4)3 = $4320
EXAMPLE PROBLEM 2

A finishing machine has a first cost of $20,000

with a $5,000 salvage value after 5 years. Using
MACRS, find (a) D and (b) BV for year 3.

(a) From table, d3 = 19.20 D3 = 20,000(0.1920)

= $3,840

(b) BV3 = 20,000 - 20,000(0.20 + 0.32 + 0.1920)

= $5,760

Note: Salvage value S = $5,000 is not used by

MACRS and BV6 = 0

EXAMPLE PROBLEM 3

A new mixer is expected to process 4

million yd3 of concrete over 10-year life
time. Determine depreciation for year 1
when 400,000 yd3 is processed. Cost of
mixer was $175,000 with no salvage
expected.

Solution: D1 = (175,000 – 0) = $17,500

EXAMPLE PROBLEM 4

A mine purchased for $3.5 million has a total

expected yield of one million ounces of silver.
Determine the depletion charge in year 4 when
300,000 ounces are mined and sold for $30 per
ounce using (a) cost depletion, and (b)
percentage depletion. (c) Which is larger for
year 4?

a) Factor, CD4 = 3,500,000/ 1,000,000 = $3.50

per ounce CDA4 = 3.50(300,000) = $1,050,000

(b) Percentage depletion rate for silver mines is

0.15 PDA4 = (0.15)(300,000)(30) = $1,350,000
(c) Claim percentage depletion amount,
provided it is ≤ 50% of TI

7. VALUATION OF PROPERTIES AND

INVESTMENT OF CAPITAL

THE NATURE OF INVESMENT

Investment may be defined as the

commitment of resources to some economic
activity in anticipation of greater returns or
benefits in the future. Thus, investment
clearly implies foregoing consumption now
with the expectation of more consumption at
a later time. In a strict economic sense,
investment takes place only when natural
resources are converted into real assets such
as the plant and equipment. Thus, an
investment occurs when a user of capital,
such as a private corporation or a public
agency, takes the savings resulting from
foregoing present consumption out of the
capital or financial market and spends them
on the acquisition of new assets. In the
private sector, savings may flow into
investments through the creation of equity or
debt. Equity refers to the value of the stock of
a corporation, and new assets may be added
either by issuing new shares of stocks or by
ploughing back corporate earnings. Debt may
be incurred either by taking loans from banks
or by issuing bonds to the public which are
redeemed at a later date. Individual savings
are channeled into investments through
intermediary financial institutions which
provide a market mechanism to establish the
relative values of various investment
opportunities. For example, when a person
deposits his or her personal savings in a bank,
no real investment is made until someone
borrows the money from the bank and
spends it for home building, plant expansion,
and similar activities. In the public sector,
present consumption may be deferred
involuntarily through taxation by the
government for the purpose of investment.
The investments in public projects may also
be financed by public debt in order to achieve
socially desired goals. In each case, the
market mechanism for capital formation is
either replaced or influenced by the action of
the government.

TIME PREFERENCE

Investment in new real assets, whether in the

private or public sector, is referred to as
capital investment. An investment project of
this nature requires a longterm commitment
of resources with returns to be realized over
the life of the real asset. The purpose of an
economic evaluation of an investment in a
project is to determine whether the benefits
will outweigh the costs. What constitutes a
satisfactory return depends on investor
attitudes and on the resources available. On
the other hand, the commitment of savings
into investment through various means
provided by financial institutions is referred
to asfinancing. Stocks, bonds, and bank notes
representing claims on real assets which are
financed by the issuance of these papers are
csdledfinancial assets or securities. The
purchase of such assets or securities for
investment is referred to âsfinancial
investment. It is therefore important to
distinguish between an economic evaluation
of a project and a feasibility study of its
financing. The former refers to an analysis to
determine whether a capital investment is
economically worthwhile, assuming that the
resources are available. The latter refers to an
investigation to find the means of obtaining
necessary funds to acquire a specified capital
asset. These two types of anafysis are
different and they will be treated separately
EXAMPLE 1

Mr. Wilbur recently bought 100 shares of

existing stock of Michigan Mining Company in
the stock market. In a strict economic sense,
is this purchase a new investment? Mr.
Wilbur merely acquired the ownership of the
shares that were relinquished by someone
else. The purchase is a financial investment
and not a capital investment. In a strict
economic sense, it is not a new investment.

EXAMPLE 2

The Manor County Sanitary Authority plans to

construct a new sewage treatment plant
which will cost $5 million. It has engaged the
professional services of a consultant to
investigate the possibility of raising the
money for construction through issuing public
bonds. After a careful analysis of the bond
market, the consultant recommends an
annual interest rate of 6% for the bonds in
order to attract enough buyers. Is this
analysis an economic evaluation? The
consultant has analyzed the feasibility of
financing the construction by borrowing. It
has nothing to do with the question of
whether the project is worthwhile in terms of
future returns of the proposed investment.
Therefore, this analysis is not an economic
evaluation.

TIME PREFERENCE

Although we are primarily interested in the

analysis of capital investments in a strict
economic sense, it is often easier to illustrate
the basic principles by using simple examples
in personal financial transactions familiar to
most people. We shall therefore discuss the
time preference of investors in this context.
The time period to which an investor wishes
to look ahead is called the planning horizon. A
person planning to make an investment is
interested in the return that will produce the
greatest satisfaction. Generally speaking, one
can be induced to postpone consumption
beyond basic necessities if one is promised a
greater amount of money at some future
time which will produce greater satisfaction.
The preference between consumption in
different periods is measured by the rate
oftimepreference. For example, an investor
who is indifferent regarding either the
prospect ofreceiving $100 now or receiving
$110 a year later is said to have a rate of time
preference of 10% per year. In general, if an
investor has a rate of time preference of / per
time period, then he or she is indifferent
toward either the prospect of consuming P
units now or consuming P(I + i) units at the
end of the period. Put differently, the rate of
time preference of an investor is reflected by
the interest rate that the investor is willing to
accept for the period in lieu of immediate
consumption. Consider the simplest situation
of a single sum P at the beginning of a time
period and a single sum F at the end of this
period. If / is the interest rate for this period,
then the amount F is related to the amount P
in this cash flow profile as follows: F = P + Pi =
P(I + i) (2.1) in which Pi represents the
interest accrued during this period.
Conversely, P = F(I + i)-` (2.2) where / is
sometimes referred to as the discount rate
because the present sum P may be regarded
as a discounted value of the future sum F.
Furthermore, the interest rate or discount
rate / may be obtained as follows: F – P
A SIMPLIFIED VIEW ON THE MARKET
ECONOMY

An important aspect of economics that

concerns the evaluation of capital investment
is the study of the allocation of scarce
resources among alternative uses. The
allocation process is said to be economically
efficient when the total amount of benefits
received by members of society from the
consumption of all commodities is maximized
under the prevailing income distribution. In a
production and exchange economy, the
economic efficiency is dependent on the
following premises: 1. The objective of
production is the satisfaction of individual
wants so that the goods and services desired
by the members of society are produced. 2.
An interconnected market system sets the
prices of goods and services according to
individual preferences and productive
technology. The actual functioning of a
production and exchange economy is
extremely complex, and the possibilities of
market failure will not be considered here.
However, it is possible to examine a highly
simplified view of the market system in order
to understand the role of the financial
institutions as intermediaries for production
and exchange. The demand of investment
capital can be described by a demand curve
or schedule which represents the relationship
between the interest rate for borrowing and
the amount of capital demanded. Similarly,
the supply of investment capital can be
described by a supply curve or schedule
which represents the relationship between
the interest rate for lending and the amount
of capital supplied. These curves are shown in
Fig. 2.1. The willingness of the users of capital
to borrow at certain interest rates depends
on the rate of productivity in their potential
uses of the
capital. As the interest rate for borrowing
decreases, more users of capital are willing to
borrow and thus the aggregate demand for
capital increases. Conversely, the willingness of
the suppliers of capital to lend at certain
interest rates depends on their rates of time
preference. As the interest rate for lending
increases, more suppliers of capital are willing
to lend and thus the aggregate supply of capital
increases. Since the users of capital must bid
for what they want and the suppliers of capital
will try to maximize their satisfaction, the
equilibrium of supply and demand is reached
when the amount of capital supplied and the
amount demanded are equal. Hence, under the
conditions of perfect competition, the point of
equilibrium must be at the intersection of the
supply and demand curves in Fig. 2.1. The
interest rate corresponding to the point of
equilibrium in a perfectly competitive market is
referred to as the market interest rate. In a
perfectly competitive market, investors can
borrow or lend freely at the market interest
rate. However, investors will borrow only if
investment opportunities exist that will earn a
higher return than the market interest rate.
Similarly, they will loan the money to others
only if they cannot receive a greater
satisfaction in their time preferences than the
market interest rate. Hence, the market
interest rate may be regarded as the minimum
attractive rate of return for an investor. In
reality, the market is imperfect and different
interest rates may exist because of transaction
costs in borrowing and lending. For example,
investors may not be able to find willing lenders
for worthwhile projects if they are already
heavily committed to other projects, or a
lender may impose a higher interest rate for
financing projects involving greater risks for
fear of the bankruptcy of the investor. Such
conditions which prevent the free flow of
investment capital are referred to as capital
rationing. These conditions may cause
complications in economic evaluation.
Nevertheless, they can be taken into
consideration in the analysis.
THE CLASSIFICATION OF INVESTMENT
PROJECTS

Before a new capital investment is undertaken,

an extensive search is usually made to spot
potential investment opportunities. It is
important to recognize the characteristics of
investment projects that appear to be
attractive, particularly their interrelationships
with other potential projects. An investment
project may be economically independent of or
dependent on other projects. An investment
project is said to be economically independent
if it is technically feasible to undertake this
project alone and if its expected profit or net
benefit will not be affected favorably or
adversely by the acceptance or rejection of any
other projects; otherwise an investment project
is said to be economically dependent. For
example, replacing a small, deteriorating bridge
with a new one may be regarded as an
economically independent project if no other
alternative or supporting actions related to the
replacement are anticipated. In reality, a
project is seldom totally economically
independent; however, if the effects from
other possibilities are small, then for all
practical purposes the project is considered
independent.

Other hand, a proposed bridge for river

crossing at a given site may be economically
dependent on a network of access roads to the
site which is not presently in existence, since
without the network of access roads, the net
benefit of the bridge cannot be realized.
Alternatively, if an underwater tunnel instead
of a bridge is proposed near the same site, then
neither one is economically independent of the
other since the construction of one will affect
the expected net benefit of the other. When
two projects are dependent on each other, they
may either complement each other or
substitute for each other to some degree. For
example, a proposed bridge and a proposed
network of access roads complement each
other. Suppose that the network of access
roads can serve the community near the bridge
site regardless of the acceptance or rejection of
the bridge proposal, but the bridge will be
inaccessible without the road network. Then
the proposed network of access roads is said to
be the prerequisite of the proposed bridge. On
the other hand, a proposed bridge and a
proposed underwater tunnel near the same site
of the river crossing may have a substituting
effect for each other for lack of sufficient traffic
volume to justify the construction of both. In
fact, if the construction of one makes it
technically infeasible to construct the other or
if the net benefit expected from one proposed
project will be completely eliminated by the
acceptance of the other, then they are said to
be mutually exclusive. In economic evaluation,
we arrange the potential projects in the form of
a set of investment proposals so that they are
not economically interdependent. If the
investment proposals are independent, we can
analyze each proposal on its own merit since its
net benefit will not be affected by the
acceptance or rejection of other proposals. If all
investment proposals are mutually exclusive,
the acceptance of one investment will
automatically lead to the rejection of all others.
Hence, we can rank the merits of various
investment proposals and select the best
among them. To appreciate the importance of
preparing independent or mutually exclusive
investment proposals for evaluation, we need
to understand the decision structure of the
organization which will finance the investment.
In most organizations, the funds available for
investment are limited by the management. AIl
capital investment proposals above a certain
spending level are subject to review and
approval by higher levels of management. If the
set of investment proposals submitted for
review and approval contains some dependent
projects with complementary effects but only
one of them is selected, the net benefit
expected of the selected project cannot be
realized because of the rejection of the
remaining dependent projects. On the other
hand, if the set of investment projects consists
of some dependent projects with substituting
effects and more than one of them is selected,
the net benefit of each of the selected projects
will be adversely affected by the acceptance of
dependent projects. By presenting investment
proposals as a set of projects that are not
interdependent, we can make the appropriate
choice according to the specified criteria of
selection. This approach is applicable whether
the decision is made by the person who
conducts the analysis or by higher levels of
management in the organization.
THE CASH FLOW PROFILE OF AN INVESTMENT
PROPOSAL

An investment proposal can be described by

the amount and timing of expected costs and
benefits in the planning horizon. Here, the
terms benefits and costs are used in a broad
sense to denote receipts and disbursements,
respectively. The term net benefit is usually
associated with public projects encompassing
all social benefits less costs, while the term
profit is used to denote receipts less
disbursements in the private sector. Generally,
the costs refer to the expected outlays and
benefits to the expected proceeds over the life
of an investment. When the outlays are paid in
cash and the proceeds are also received in cash,
an investment proposal can be represented by
a stream of cash disbursements and receipts
over time. For example, in the acquisition of a
new machine, the typical costs are determined
by the cash disbursements for the initial
purchase price and the annual expenditure for
operating and maintenance. The salvage value
of the machine, which represents its market
price at the time when it is disposed of, may be
regarded either as a benefit or as a negative
cost. The benefits may be measured by the
cash value of the amount of labor saved. The
investment proposal will thus be converted into
a series of cash flows. The stream of
disbursements and receipts for an investment
proposal over the planning horizon is said to be
the cashflow profile of the investment. For
private corporations, the cash flows may be
estimated from expected gross revenues and
expenses. Since some of the cash receipts are
subject to taxation, the series of cash flows
representing each investment alternative refers
to after-tax values. In public investment
projects, estimated benefits include only those
that are quantifiable in monetary terms, and
estimated costs represent the price to the
society for obtaining the desired benefits. The
series ofcash flows representing such an
investment alternative refers to the before-tax
values since government agencies are tax-
exempt. Although the amount and timing of the
cash flows associated with each investment
proposal can only be estimated in advance,
they are generally assumed to be known with
certainty for analysis. In reality, the future is
uncertain, and various factors affecting the
cash flows, such as inflation, change in tax rate,
etc., must also be considered in making an
investment. It is sufficient to point out at this
time that an investment proposal can be
appropriately represented by its cash flows at
regular time periods, say years. Then, the cash
flow at each time period is said to have a time
value corresponding to the timing of its receipt
or disbursement. The subject of the time value
of money will be treated in detail in Chapter 3.
EXAMPLE 3

Office copying equipment that costs $6,000

now is expected to be kept for 5 years. At the
end of 5 years, it will have a salvage value of
$800. The annual operating and maintenance
cost is $1,000 per year, and the annual benefit
generated by the equipment is $3,000 per year.
Assuming that the receipts and disbursements
are made at the end of the year, except the
initial cost which is paid at present (end of year
0), describe this investment proposal in terms
of its cash flows.

The series of cash flows describing this

investment proposal may be represented by
the annual net benefits, i.e., annual benefits in
excess of annual costs as shown in Table 2.1.
Note that at the end of year 5, the annual
benefit is $3,800 because the salvage value of
$800 is regarded as a benefit such that 3,000 +
800 - 3,800.
The series of cash flows describing this
investment proposal may be represented by
the annual net benefits, i.e., annual benefits in
excess of annual costs as shown in Table 2.1.
Note that at the end of year 5, the annual
benefit is $3,800 because the salvage value of
$800 is regarded as a benefit such that 3,000 +
800 - 3,800.
EXAMPLE 4
Suppose that the salvage value of $800 in
Example 2.3 is treated as a negative cost
instead of an additional benefit. What is the
cash flow at the end of year 5? In this case, the
cost will be 1,000 + (-800) = 200 and the benefit
will be 3,000 at the end of year 5. Hence, the
net benefit for the year will be 3,000 - 200 =
2,800.

OBJECTIVE OF CAPITAL INVETMENT

The primary objective of capital investment is
to maximize profit or net benefit within a
planning horizon. The term profit is used to
denote net gain from investment in a private
firm, whereas in the public sector the term net
benefit is used in the sense of social benefit less
social cost. Given the difficulty and uncertainty
involved in estimating benefits and costs, and
in choosing an appropriate time frame and a
minimum attractive rate of return, factors
other than maximization of profit or net profit
must be considered in the selection of capital
projects. Social, political, and environmental
concerns as well as economic factors may be
significant in influencing project selection. Once
the objective of profit maximization is
accepted, imperfect though it may be, a
decision criterion reflecting the stated objective
may be established for the economic
evaluation of proposed capital projects. An
investment decision criterion consists of two
elements: a merit measure and a set of decision
rules associated with this measure. Historically,
many merit measures have been introduced,
each requiring a set of decision rules to
implement the stated objective.
We consider here only elementary examples to
illustrate two basic types of merit measures:
the net future value and the internal rate of
return in the context of one-period
investments. In this section, we examine the
nature of these two merit measures and their
associated decision rules to accept or reject a
proposed project. In the following two sections,
we consider separately the decision rules
related to these two merit measures for the
selection of the best among a group of mutually
exclusive proposals. It is important to realize
that real assets are size-dependent and hence
require investments of different magnitudes.
Since the concept of profit maximization is
based on the assumption of perfect capital
markets in which an investor can lend or
borrow freely, the size of investment on a
proposed project is not at issue in establishing
the decision criteria. In other words, as long as
an investor can borrow or lend at the minimum
attractive rate of return (MARR), it is
worthwhile to invest in a proposed project that
will generate a profit greater than the MARR
regardless of the size of the investment. The
net future value (NFV) is a direct measure of
the size of profit or net benefit at the end of
the investment period that the investor would
have gained by having invested in the proposed
project instead of investing in the foregone
opportunity. Hence, the comparison between
the gross profit resulting from a proposed
project and that obtained by investing at the
MARR has already been taken into
consideration in this measure. In that sense,
the NFV is a relative measure of profit
dependent on the MARR. Suppose that an
investor invests a sum P0 in a proposed project
now and expects to receive a sum Fi a year
later, and that the minimum attractive rate of
return of the investor is /* per year. Then, by
letting / = /* in Eq. (2.1), we find F* at the end
of 1 year as follows: F* = P0(I + i*) where F* is
the amount that the investor could have
obtained by investing in the foregone
opportunity. The difference between Fi and F*
is referred to as the netfuture value (NFV): NFV
= F1 - F* = F1 - P0(I + i*) (2.4) For example,
consider a sum of $1,000 banked at an interest
rate of 6% per year. At the end of a year, your
bank account will grow to an amount of F* =
(l,000)(l + 0.06) = $1,060. Now suppose a friend
has invented a gadget and asked you to invest
$1,000 to help bring the gadget to market.
Suppose that she first offers to pay you back
$1,050 a year later but when you demur, she
raises the offer to $1,100. Clearly when you
compare F1 = $1,050 in the first offer with the
$1,060 that you could have received from the
bank, you wonder if you could afford to make
the sacrifice for a friend. However, when the
offer is raised to Fi = $1,100, you are better off
financially by accepting it. In general, a positive
NFV indicates a net gain at the end of 1 year,
and a negative NFV indicates a net loss relative
to the foregone opportunity. The case of NFV =
0 is neutral but may be treated as the limiting
condition for accepting a proposed project.
Using the NFV as the merit measure, the
decision rule for accepting or rejecting a
proposed project can be stated as follows:
"Accept the project if NFV > 0; reject it
otherwise."

The internal rate of return (IRR) is an indirect

measure of profit or net benefit because it
indicates the percentage rate rather than the
size of the profit at the end of the investment
period. However, the IRR is an absolute
measure in the sense that it is independent of
the foregone opportunity. The IRR measure by
itself does not indicate whether or not a
proposed project is worthwhile. A comparison
with the minimum attractive rate of return
(MARR) is necessary in making that decision.
Consider again that you have deposited $1,000
in a bank that pays an interest rate of 6% per
year. Your parents have a larger sum deposited
in a different type of account that pays an
interest rate of 10% per year. An
entrepreneurial classmate who knows your
family well comes up with a new invention and
promises to repay the principal plus 8% per
year of dividend for whatever amount either
you or your parents may invest in his invention.
One can expect different reactions from you
and your parents because of different foregone
opportunities. In your case, a rate of return /' =
8% is better than your MARR of /* = 6%, but for
your parents /' = 8% is lower than their MARR
of /* = 10%. According to Eq. (2.3), the rate of
return /' for 1 year from an investment P0
which yields an amount F\ at the end of the
year is i ' = ^ 2 (2.5) "o More specifically, the
quantity /' represents the rate of return from
investing in the proposed project internally
without considering any external opportunity
foregone, and is therefore referred to as the
internal rate ofreturn. If IRR is used as a merit
measure, the decision rule for accepting or
rejecting a proposed project in the one-period
investment becomes: "Accept the investment
project if IRR > MARR; reject it otherwise." The
case of IRR = MARR is included as the limiting
condition for accepting a proposed project.
Example 2.5 The City of Blacksboro owns a
vacant lot and has agreed to sell it to a builder a
year later for development. In the interim
period, the city can spend $10,000 for
improving the ground and rent it to a parking
lot operator for a rent of $12,100 to be paid at
the end of the year. The city requires a
minimum attractive rate of return of 10% per
annum, which represents the foregone
opportunity. Is it worthwhile to improve the
vacant lot? The net benefit of the proposed
project at the end of the year is represented by
the net future value, which can be obtained
from Eq. (2.4): NFV = 12,100 - 10,000(1 + 0.10)
= $1,100 Thus, the city will gain an amount of
$1,100 at the end of the year by investing
$10,000 in parking lot improvement instead of
investing in the foregone opportunity which
would yield a return at the minimum attractive
rate of return at 10%. Hence, the NFV merit
measure indicates that the proposed project is
worthwhile.
On the other hand, the rate of return from the
proposed project can be obtained from Eq.
(2.5): '' ¯ ' M S ^ = - = *· The internal rate of
return of 21% is clearly higher than the
minimum attractive rate of return of 10%.
Hence, the IRR merit measure also indicates
that the project is worthwhile in comparison
with the opportunity foregone.

DECISION CRITERIA FOR DIRECT MERIT

MEASURES

The net future value (NFV) is not the only direct

merit measure regarding profit or net benefit.
However, since it represents the net amount
that an investor would gain by having invested
in the proposed project over the foregone
opportunity at the end of the investment
period, it is most easily understood. The NFV
decision rule for ranking the merits of a set of
mutually exclusive proposals will simply be
based on the ranks of a direct merit measure
since NFV is a measure of the size of net profit
relative to that of the foregone opportunity at
the end of the investment period. This decision
rule, which is applied to one-period
investments here, is applicable to investments
involving multiperiod cash flows without
modification. The application of this concept
can also be extended to other direct merit
measures introduced in later chapters. If an
organization can obtain additional funds or
invest its excess funds in the capital market at a
market interest rate, then the investment
decision criterion for accepting noncompeting
or independent investment proposals is to
accept each independent project that produces
an overall net benefit or profit. Under the same
conditions, the investment decision criterion
for selecting the best project among a set of
mutually exclusive alternatives is to select the
project with the highest overall net benefit or
profit. When a spending limit or borrowing limit
is imposed for whatever reasons, under capital
rationing, each problem must be treated on the
basis of additional information available. Let iV
denote the net benefit or profit of an
investment, B denote the total benefit realized,
and C denote the total cost incurred, all of
which are based on the same point in time, i.e.,
expressed in future values. The decision
criterion for accepting an independent project
without capital rationing is that the net future
value N must be nonnegative. That is, N = B - C
> O (2.6) For mutually exclusive proposals, the
objective is to maximize profit potential by
accepting only the best of all proposals.
Then, the decision criterion for profit
maximization without capital rationing is to
select the alternative with the highest
nonnegative net future value. That is, if B, C,
and N are again expressed in future values
which satisfy Eq. (2.6), the criterion becomes
Maximize N = B – C

EXAMPLE 5

Suppose that three mutually exclusive

proposals are examined for improving the
vacant lot in Example 2.5. Depending on the
extent of grading, each proposal requires a
different initial cost and yields a different rent.
Their cash flow profiles are given below. Time
Proposal 1 Proposal 2 Proposal 3 0 -$10,000 -
$20,000 -$14,800 1 year +$12,100 +$23,21O
+$17,600 Note that time 0 denotes the present
or the beginning of the time horizon and 1 year
denotes the end of the investment period. The
city requires a minimum attractive rate of
return (MARR) of 10% per annum. Which
proposal should be selected? It is important to
emphasize that the proposed projects for
utilizing the vacant lot are capacity dependent.
While proposal 1 will cost half as much as
proposal 2 because of less grading, it is not
possible to invest in two parking lots similar to
proposal 1. Otherwise, doubling the investment
of proposal 1 at a cost of $20,000 would result
in a return of $24,200 at the end of the year,
and such an action would clearly be superior to
proposal 2. Under the assumption of a perfect
capital market, the city can lend or borrow
moneyfreely at a MARR of 10%, and can
therefore select any proposal irrespective of
the size of the investment. Using Eq. (2.4), it
can be found that the net future values of the
three proposals are, respectively, [NFV]1 =
12,100 - (10,000)(l + 0.1) = $1,100 [NFV]2 =
23,210 - (20,000)(l + 0.1) = $1,210 [NFV]3 =
17,600 - (14,800)(l + 0.1) = $1,320 The NFV of
each of these proposals is nonnegative, and
each of them is acceptable. However, the NFV
of proposal 3 is highest, and according to the
decision criterion in Eq. (2.7), proposal 3 is the
best. If the city imposes capital rationing in the
form of a budget constraint, the decision
criterion can easily be modified to meet the
constraint. For example, ifthe budget constraint
is $15,000, then the city should select the
proposal with the highest NFV, provided that
the initial investment is not above $15,000.
Under such a constraint, proposal 2 will be
eliminated from consideration, but proposal 3
will still be selected
DECISION CRITERIA FOR INDIRECT MERIT
MEASURES

If the objective of profit maximization is

accepted as the basis for investment decision,
the decision criterion associated with an
indirect merit measure must lead to the same
conclusion reached by using an appropriate
decision criterion associated with a direct merit
measure. More specifically, a decision criterion
associated with an IRR merit measure must
yield the same conclusion as that reached by
the decision criterion associated with a direct
merit measure. Although a number of indirect
merit measures will also be introduced in later
chapters, the IRR merit measure is
distinguished among others by its
independence of the MARR. We confine our
discussion here to the decision criterion
associated with IRR to illustrate its application.
The internal rates of return of the three
mutually exclusive proposals in Example 2.6
may be computed as follows

Does this mean that proposal 1 is the best

choice among the three proposals because it
has the highest IRR? No, that is generally not
true. In this case, such an inference is plainly
incorrect because it is in conflict with the
conclusion reached by the net future value
criterion in Example 2.6. Although proposal 1
has the highest IRR, the size of the investment
is smallest. Under the assumption of a perfect
capital market, the city can lend or borrow
money freely at a MARR of 10%. Hence, it pays
to increase the size of investment in improving
the vacant lot as long as the IRR from additional
investment exceeds the MARR. Initially, it
appears logical to calculate the return of the
proposal with the lowest initial cost. If the IRR
for this investment is less than the MARR, then
reject this proposal and try the proposal with
the next lowest cost until a proposal is found
for which the IRR is greater than the MARR. The
basic objective of this approach is to spend as
little money as possible but to insure that it will
receive at least a satisfactory return. Once this
minimum requirement is satisfied, the city
wants to find out if it can get a larger return by
investing in another proposal with higher initial
cost. Let proposal No. O be the status quo of
doing nothing, which incurs no cost and
generates no benefit. If proposal Nos. 1, 2, 3, . .
. are arranged in the ascending order of their
initial costs, then successive pairwise
comparisons ofthe proposals can be carried
out, as shown in Fig. 2.2, by using a rational
procedure for making choice. At the beginning
of the process, the pairwise comparison of the
lowest cost proposal to the status quo is simply
to find the internal rate of return of the lowest
cost proposal. In each subsequent comparison,
let the proposal tentatively accepted from the
previous step be identified as y and the next
higher cost proposal

incremental costs and benefits resulting from

selecting x instead of y are given respectively by
the following relations: AC-, = Cx - Cy (2.8) ABx-
y = Bx - By (2.9) The IRR resulting from each
additional investment or increment for larger
real assets is referred to as the incremental
internal rate ofretum (IIRR). Thus, the
incremental rate of return resulting from an
increase in investment from lower cost
proposal v to higher cost proposal x is «·;-, = Afi
'¯;: Ac '¯' (2.io) Z\L-j:-_v If i'x-y is greater than
MARR, the additional investment of ACx-y is
better than the alternative of investing in the
foregone opportunity; otherwise the additional
investment is not justified. We must make such
comparisons by pairs of proposals starting from
the one with the lowest initial cost and
reaching the one with the highest cost before
we can decide which proposal will produce the
maximum return. A set of decision rules can be
established for the IRR decision criterion
involving a set of mutually exclusive proposals
for one-period investments: 1. List the mutually
exclusive proposals in an ascending order of the
initial costs. 2. Screen the proposals in
ascending order and find the first proposal for
which the IRR is greater than or equal to the
MARR. Accept this proposal as a tentative
choice and reject prior proposals on the list, if
any, for which the IRR is less than the MARR. 3.
Starting with the proposal having the lowest
initial cost as a tentative choice, find the
increments of the initial costs and the
anticipated benefits resulting from investing in
the proposal with the next higher initial cost. If
the HRR obtained from this incremental
analysis of costs and benefits is better than or
equal to the MARR, accept the proposal with
the next higher initial cost better tentative
choice; otherwise, retain the original tentative
choice and reject the proposal with the higher
initial cost. 4. Repeat the pairwise incremental
analysis of costs and benefits between the
current tentative choice and the next higher
cost proposal until the list of all proposals in the
ascending order of initial costs has been
exhausted. The last tentative choice resulting
from successive pairwise incremental analyses
is the best proposal. This set of decision rules
involving one-period investments is illustrated
schematically in Fig 2.3. This set of rules may
seem complicated, but the complete set of
rules for investments needed to provide an
ironclad procedure for analyzing cases in
volving multiperiod cash flows would require
far greater complexity. The causes and
consequences of these decision rules are
discussed in later chapters. Example 2.7 For the
data given in Example 2.6, select the best
proposal on the basis of IRR decision criterion.
The three mutually exclusive proposals are first
arranged in the ascending order of their initial
costs. Thus, proposal 1 is the first to be
considered, proposal 3 is the next, and proposal
2 is the last. The IRR for proposal 1 has been
found to be 21%, which is greater than the
MARR of 10%. Hence, proposal 1 is the
tentative choice. By a pairwise comparison for
the increments of costs and benefits between
proposal 1 and proposal 3, we find from Eqs.
(2.8) and (2.9), A C3 1 = 14,800 - 10,000 = 4,800
Aß.,-i = 17,600 - 12,100 = 5,500 Then, according
to Eq. (2.10), the incremental rate of return
(IIRR) is given by 5,500 - 4,800 700 ' " = 4,800 =
4¿õõ = 14 · 5 8 % This result indicates that the
additional investment of $4,800 will yield an
HRR of 14.58%, which is still greater than 10%.
Hence, proposal 3 is superior to proposal 1
since the city can earn more at the end of the
year by investing in proposal 3. Similarly, by
comparing the increments of costs and benefits
between proposal 3 and proposal 2, we find
from Eqs. (2.8) and (2.9) A C2 3 = 20,000 -
14,800 = 5,200 Afi2-3 = 23,210 - 17,600 = 5,610
Then, according to Eq. (2.10), the IIRR is given
by ., _ 5,610 - 5,200 _ 410 l2 ¯ 3 ¯ 53Õ 5^00 - 7 ·
8 8 % This result indicates that the additional
amount of $5,200 will yield an IIRR of only
7.88%, which is less than 10%. Hence, proposal
2 is inferior to proposal 3 and should be
rejected. After completing successive pairwise
incremental analyses, proposal 3 is found to be
the best choice. The same conclusion was
reached in Example 2.6 on the basis of NFV
decision criterion. Example 2.8 Suppose that
proposal 3 in Example 2.6 is eliminated from
consideration and a choice is made between
proposals 1 and 2, plus a new proposal 4 as
shown below. Determine the best proposal for
investment.

If the NFV decision criterion is used, we can

compute the NFV for proposal 4 as follows:
[NFV]4 = 8,500 - (8,000)(l + 0.1) = -$300 With
this additional information and the results in
Example 2.6 for proposals 1 and 2, a choice can
be made on the basis of the NFV. Proposal 2
was found to have a NFV of $1,210, which is
greater than $1,100 for proposal 1. Since the
NFV of proposal 4 is negative, proposal 2 is the
best solution. However, if the IRR decision
criterion is used, the computation in Example
2.7 will not help at all. We must rearrange the
proposals in ascending order of their initial
costs. Since proposal 4 has the lowest initial
cost, compute the IRR for proposal 4 as follows:
, 8,500 - 8,000 ^ " = 8,000 = 625 % Since this IRR
is less than the MARR of 10%, we reject
proposal 4 and move on to proposal 1, which
has the next higher initial cost. After verifying
that the IRR for proposal 1 is 21%, which is
greater than the MARR of 10%, we make the
incremental analysis ofcosts and benefits
between proposals 1 and 2. Thus, from Eqs.
(2.8) and (2.9) AC2-, = 20,000 - 10,000 = 10,000
Aß2-1 = 23,210 - 12,100 = 11,110 Then, from
Eq. (2.10), the HRR between the two proposals
can be computed: ., _ 11,110 - 10,000 _ 1,110 _
l 2 ¯' ¯ ïõm> ¯ To^Oo ¯ lll % This result indicates
that the additional investment of $10,000 will
yield an HRR of 11.1%, which is still greater
than the MARR of 10%. Hence, proposal 2 is
superior to proposal 1 since the city can earn
more at the end of the year by investing in
proposal 2. For the sake of argument, suppose
that you have omitted the step of checking the
IRR of the lowest cost proposal 4 and proceed
directly to compute the HRR between proposals
4 and 1. Thus, from Eqs. (2.8) and (2.9) A C1 4 =
10,000 - 8,000 = 2,000 Aß,-4 = 12,100 - 8,500 =
3,600

Then, fromEq. (2.10) 3,600 - 2,000 OArw ¾l ¯* =

2,000 =8 ° % Because this IIRR is greater than
the MARR, proposal 1 is superior to proposal 4.
If the IIRR between proposals 1 and 2 is
computed as before, what is the use of the
information i'2-\ = 11.1%? Well, it tells you that
proposal 2 is better than proposal 1 because
11.1% is greater than the MARR of 10%.
However, if you cannot show that proposal 4 is
acceptable, there is no guarantee that proposal
2 is good enough for acceptance even if it is
better than proposal 1, and proposal 1 is better
than proposal 4. Worse yet, suppose that you
have omitted the step of arranging the
proposals in the ascending order of their initial
costs, but place proposal 2 first and proposal 1
second. By computing the IIRR between
proposals 1 and 2 blindly, you get from Eqs.
(2.8) and (2.9) AC,-2 = 10,000 - 20,000 = -10,000
Aß,-2 = 12,100 - 23,210 = -11,110 Then, from
Eq. (2.10), ., _ (-11,110) - (-10,000) _ -i,ii o _ ¾1
yn " ¯2 ¯ =ïõ¿õõ ¯ ^oo o ¯ 111% What does the
information i¦-2 = 11.1% tell you? Nothing!
Certainly it does not mean that proposal 1 is
better than proposal 2 because you have
violated the concept of increasing the size of
investment incrementally when you omit the
step of arranging the proposals properly
according to the ascending order of initial costs.
This step is necessary even when you have only
two proposals under consideration. That is why
it is so important to provide robust or ironclad
decision rules when you use incremental
analysis for the IRR.

8. INVESTENT OF CAPITAL
Capital investment refers to funds invested in a
firm or enterprise for the purpose of furthering
its business objectives. Capital investment may
also refer to a firm's acquisition
of capital assets or fixed assets such as
manufacturing plants and machinery that is
expected to be productive over many years.
While capital investment is usually earmarked
for capital or long-life assets, a portion may also
be used for working capital purposes. Capital
investment encompasses a wide variety of
funding options. While funding for capital
investment is generally in the form of common
or preferred equity issuances, it may also be
through straight or convertible debt. It may
range from an amount of less than $100,000 in
seed financing for a start-up to amounts in the
hundreds of millions for massive projects in
capital-intensive sectors such as
mining, utilitiesand infrastructure.
Uses of Capital
Capital investment is concerned with the
deployment of capital for long-term uses.
Companies make continual capital investment
to sustain existing operations and expand their
businesses for the future. The main type of
capital investment is in fixed assets to allow
increased operational capacity, capture a larger
share of the market and in the process,
generate more revenue. Companies may also
make capital investment in the form of equity
stakes in other companies' operations, which
indirectly benefits the investor companies by
building business partnerships or expanding
into new markets.
Sources of Capital
Companies make conscious decisions about
what kind of capital investment and how much
of it they should have over time. This spells out
the funding requirements and therefore affects
the choice of financing sources. The first
funding option is always a company's own
operating cash flow, which sometimes may not
be enough to satisfy the amount of capital
expenditures required. It is more likely than not
that companies will resort to outside financing,
debt or/and equity to make up for any internal
cash flow shortfall.
Capital investment is meant to benefit a
company in the long run, but it nonetheless has
some short-term downsides. Intensive, ongoing
capital investment tends to reduce earnings in
the interim, strain on liquidity from payment
demand on interest and maturing principals,
and dilute earnings and ownership if new
equity is used.
Working Capital
Funds raised as long-term capital should be for
long-term purposes of capital investment to
make comparable returns and adequately cover
related financing costs. However, to maintain
uninterrupted operations, companies need to
have extra current assets over total current
liabilities as an added assurance for meeting
any due obligations. Short-term funds set aside
as such are commonly referred to as working
capital and may come from long-term capital,
whose longer maturity dates are typically
beyond the due dates of any current liabilities.
As a result, companies sacrifice some long-term
return to ensure short-term liquidity.
The term capital investment has two usages in
business. First, capital investment refers to
money used by a business to purchase fixed
assets, such as land, machinery, or buildings.
Secondly, capital investment refers to money
invested in a business with the understanding
that the money will be used to purchase fixed
assets, rather than used to cover the business's
day-to-day operating expenses. For example, to
purchase additional capital assets a growing
business may need to seek a capital investment
in the form of debt financing from a financial
institution or equity financing from angel
investorsor venture capitalists.
Objectives
There are typically three main reasons for a
business to make capital investments:
 to acquire additional capital assets for
expansion, enabling the business to, for
example, increase unit production, create
new products, or add value;
 to take advantage of new technology or
advancements in equipment or machinery
to increase efficiency and reduce costs;
 to replace existing assets that have reached
end-of-life - for example, a high-mileage
 delivery vehicle or an aging laptop
computer.
Capital Investment and the Economy
Capital investment is considered to be a very
important measure of the health of the
economy. When businesses are making capital
investments it means they are confident in the
future and intend to grow their businesses by
improving existing productive capacity. On the
other hand, recessions are normally associated
with reductions in capital investment by
businesses.
Capital is an asset that is used to produce goods
and services. Machinery, equipment, tools, and
buildings directly used to manufacture goods
and services are capital goods. Financial or
investment capital is the money used to
purchase the needed capital goods.

Sources of investment capital can be grouped

into debt and equity. Debt includes bank loans
and corporate bonds. Debt must be paid back
with interest. The advantage of debt is the
lender does not have an ownership position in
the business. Investment capital can also be
secured by selling an ownership interest in a
company. This is equity. Investors may be
willing to invest money in a company if they
believe in the company's strategy and expect
an acceptable return on their investment.
Companies may then use the money to acquire
the capital goods they need to generate a
profit. As owners, equity investors share the
risks and profits. Unlike lenders, these investors
are not guaranteed any payments.

Entrepreneurs may have trouble borrowing

enough money to start a company. For
example, an entrepreneur may need more
money than she can personally borrow to
acquire some large equipment. Banks may be
unwilling to lend enough money because they
feel uncomfortable with the risk. Instead the
entrepreneur may rely on an equity investor
such as an angel investor (investors who
provide seed money for start-ups, usually
family members or wealthy individuals), or a
venture capitalist to provide the financial
capital to grow her business.

When her business becomes well established it

may be able to have an initial public offering to
tap the public markets for the financial capital it
needs. Once established, the company can
continue to sell stock to raise money. However,
the owners give up an ownership interest, or
dilute the value of their shares each time new
shares are sold. This is why business owners
frequently prefer debt to equity because they
do not give up an ownership interest when they
borrow money. Large profits are shared with
the owners. Only interest is paid to the lenders.
9. COMPARISSON OF ALTERNATIVES
For most of the engineering projects,
equipments etc., there are more than one
feasible alternative. It is the duty of the project
management team (comprising of engineers,
designers, project managers etc.) of the client
organization to select the best alternative that
involves less cost and results more revenue. For
this purpose, the economic comparison of the
alternatives is made. The different cost
elements and other parameters to be
considered while making the economic
comparison of the alternatives are initial cost,
annual operating and maintenance cost, annual
income or receipts, expected salvage value,
income tax benefit and the useful life. When
only one, among the feasible alternatives is
selected, the alternatives are said to be mutually
exclusive.
As already mentioned in module-1, the cost or
expenses are generally known as cash outflows
whereas revenue or incomes are generally
considered as cash inflows. Thus in the
economic comparison of alternatives, cost or
expenses are considered as negative cash flows.
On the other hand the income or revenues are
considered as positive cash flows. From the view
point of expenditure incurred and revenue
generated, some projects involve initial capital
investment i.e. cash outflow at the beginning
and show increased income or revenue i.e. cash
inflow in the subsequent years. The alternatives
having this type of cash flow are known as
investment alternatives. So while comparing the
mutually exclusive investment alternatives, the
alternative showing maximum positive cash flow
is generally selected. In this case, the investment
is made at the beginning to gain profit at the
future period of time. Example for such type
alternatives includes purchase of a dozer by a
construction firm. The construction firm will
have different feasible alternatives for the dozer
with each alternative having its own initial
investment, annual operating and maintenance
cost, annual income depending upon the
production capacity, useful life, salvage values
etc. Thus the alternative which will yield more
economic benefit will be selected by the
construction firm. There are some other projects
which involve only costs or expenses throughout
the useful life except the salvage value if any, at
the end of the useful life. The alternatives having
this type of cash flows are known as cost
alternatives. Thus while comparing mutually
exclusive cost alternatives, the alternative
showing minimum negative cash flow is
generally selected. Example for such type
alternatives includes construction of a
government funded national highway stretch
between two regions. For this project there will
be different feasible alternatives depending
upon length of the stretch, type of pavement,
related environmental, social and regulatory
aspects etc. Each alternative will have its initial
cost of construction, annual repair and
maintenance cost and some major repair cost if
any, at some future point of time. The
alternative that will exhibit lowest cost will be
selected for the construction of the highway
stretch.
The differences in different parameters namely
initial capital investment, annual operation cost,
annually generated revenue, expected salvage
value, useful life, magnitude of output and its
quality, performance and operational
characteristics etc. may exist among the
mutually exclusive alternatives. Thus the
economic analysis of the mutually exclusive
alternatives is generally carried out on the
similar or equivalent basis since each of the
feasible alternatives will meet the desired
requirements of the project, if selected.
The economic comparison of mutually exclusive
alternatives can be carried out by different
equivalent worth methods namely present
worth method, future worth method and annual
worth method. In these methods all the cash
flows i.e. cash outflows and cash inflows are
converted into equivalent present worth, future
worth or annual worth considering the time
value of money at a given interest rate per
interest period.
In this method, the mutually exclusive
alternatives are compared on the basis of
equivalent uniform annual worth. The
equivalent uniform annual worth represents the
annual equivalent value of all the cash inflows
and cash outflows of the alternatives at the
given rate of interest per interest period. In this
method of comparison, the equivalent uniform
annual worth of all expenditures and incomes of
the alternatives are determined using different
compound interest factors namely capital
recovery factor, sinking fund factor and annual
worth factors for arithmetic and geometric
gradient series etc. Since equivalent uniform
annual worth of the alternatives over the useful
life are determined, same procedure is followed
irrespective of the life spans of the alternatives
i.e. whether it is the comparison of equal life
span alternatives or that of different life span
alternatives. In other words, in case of
comparison of different life span alternatives by
annual worth method, the comparison is not
made over the least common multiple of the life
spans as is done in case of present worth and
future worth method. The reason is that even if
the comparison is made over the least common
multiple of years, the equivalent uniform annual
worth of the alternative for more than one cycle
of cash flow will be exactly same as that of the
first cycle provided the cash flow i.e. the costs
and incomes of the alternative in the successive
cycles is exactly same as that in the first cycle.
Thus the comparison is made only for one cycle
of cash flow of the alternatives. This serves as
one of greater advantages of using this method
over other methods of comparison of
alternatives. However if the cash flows of the
alternatives in the successive cycles are not the
same as that in the first cycle, then a study
period is selected and then the equivalent
uniform annual worth of the cash flows of the
alternatives are computed over the study
period.
Now the comparison of mutually exclusive
alternatives by annual worth method will be
illustrated in the following examples. First the
data presented in Example-2 will be used for
comparison of the alternatives by the annual
worth method.
Example -10 (Using data of Example-2)
There are two alternatives for purchasing a
concrete mixer and following are the cash flow
details;
Alternative-1: Initial purchase cost = Rs.300000,
Annual operating and maintenance cost =
Rs.20000, Expected salvage value = Rs.125000,
Useful life = 5 years.
Alternative-2: Initial purchase cost = Rs.200000,
Annual operating and maintenance cost =
Rs.35000, Expected salvage value = Rs.70000,
Useful life = 5 years.
The annual revenue to be generated from
production of concrete (by concrete mixer) from
Alternative-1 and Alternative-2 are Rs.50000
and Rs.45000 respectively. Compute the
equivalent uniform annual worth of the
alternatives at the interest rate of 10% per year
and find out the economical alternative.
Solution:
The cash flow diagram of Alternative-1 i.e. Fig.
2.3 is shown here again for ready reference.
 Fig. 2.3 Cash flow diagram of Alternative -1
The equivalent uniform annual worth of
Alternative-1 i.e. AW1 is computed as follows;

Here Rs.20000 and Rs.50000 are annual

amounts.
Now putting the values of different compound
interest factors;

AW1= - Rs.28665
10. CLASSIFICATION OF COSTS AND
REPLACEMENT ANALYSIS
An engineering economic analysis may involve
many types of costs. Here is a list of cost types,
including definitions and examples.
A fixed cost is constant, independent of the
output or activity level. The annual cost of
property taxes for a production facility is a fixed
cost, independent of the production level and
number of employees.
A variable cost does depend on the output or
activity level. The raw material cost for a
production facility is a variable cost because it
varies directly with the level of production.
The total cost to provide a product or service
over some period of time or production volume
is the total fixed cost plus the total variable
cost, where:
Total variable cost = (Variable cost per unit)
(Total number of units)
A marginal cost is the variable cost associated
with one additional unit of output or activity. A
direct labor marginal cost of $2.50 to produce
one additional production unit is an example
marginal cost.
The average cost is the total cost of an output
or activity divided by the total output or activity
in units. If the total direct cost of producing
400,000 is $3.2 million, then the average total
direct cost per unit is $8.00.
The breakeven point is the output level at
which total revenue is equal to total cost. It can
be calculated as follows:
BEP = FC/(SP - VC)
where
BEP = breakeven point
FC = fixed costs
 SP = selling price per unit
VC = variable cost per unit
A sunk cost is a past cost that cannot be
changed and is therefore irrelevant in
engineering economic analysis. One exception
is that the cost basis of an asset installed in the
past will likely affect the depreciation schedule
that is part of an after-tax economic analysis.
Although depreciation is not a cash flow, it
does affect income tax cash flow. Three years
ago, an engineering student purchased a
notebook PC for $2,800. The student now
wishes to sell the computer. The $2,800 initial
cost is an irrelevant, sunk cost that should play
no part in how the student establishes the
minimum selling price for the PC.
An opportunity cost is the cost associated with
an opportunity that is declined. It represents
the benefit that would have been received if
the opportunity were accepted. Suppose a
product distributor decides to construct a new
distribution center instead of leasing a building.
Leasing a building immediately would have
resulted in a $12,000 product distribution cost
savings during the next 6 months while the new
warehouse is being constructed. By forgoing
the warehouse leasing alternative, the
distributor experiences an opportunity cost of
$12,000.
A recurring cost is one that occurs at regular
intervals and is anticipated. The cost to provide
electricity to a production facility is a recurring
cost.
A nonrecurring cost is one that occurs at
irregular intervals and is not generally
anticipated. The cost to replace a company
vehicle damaged beyond repair in an accident
is a nonrecurring cost.
An incremental cost represents the difference
between some type of cost for two
alternatives. Suppose that A and B are mutually
exclusive investment alternatives. If A has an
initial cost of $10,000 while B has an initial cost
of $12,000, the incremental initial cost of (B - A)
is $2,000. In engineering economic analysis we
focus on the differences among alternatives,
thus incremental costs play a significant role in
such analyses.
A cash cost is a cash transaction, or cash flow. If
a company purchases an asset, it realizes a cash
cost.
A book cost is not a cash flow, but it is an
accounting entry that represents some change
in value. When a company records a
depreciation charge of $4 million in a tax year,
no money changes hands. However, the
company is saying in effect that the market
value of its physical, depreciable assets has
decreased by $4 million during the year.
Life-cycle costs refer to costs that occur over
the various phases of a product or service life
cycle, from needs assessment through design,
production, and operation to decline and
retirement.
Replacing equipment is an important decision
that nearly all entities must face, generally
motivated by rising operating and maintenance
costs of current assets or the technological
advances of available assets in the market. The
problem has been studied for nearly a century.
In this article, we survey single and multiple
asset solution approaches under a variety of
settings, including technological change,
variable utilization, tax, and various
uncertainties. Furthermore, we illustrate a
number of open problems that are worthy of
future study.
REPLACEMENT ANALYSIS
Replacement analysis is carried out when there
is a need to replace or augment the currently
owned equipment (or any asset). There are
various reasons that result in replacement of a
given equipment. One of the reasons is the
reduction in the productivity of currently owned
equipment. This occurs due to physical
deterioration of its different parts and there is
decrease in operating efficiency with age. In
addition to reduced productivity, there is also
increase in operating and maintenance cost for
the construction equipment due to physical
deterioration. This necessitates the replacement
of the existing one with the new alternative.
Similarly if the production demands a change in
the desired output from the equipment, then
there is requirement of augmenting the existing
equipment for meeting the required demand or
replacing the equipment with the new one.
Another reason for replacement of the existing
equipment is obsolescence. Due to rapid change
in the technology, the new model with latest
technology is more productive than the
currently owned equipment, although the
currently owned equipment is still operational
and functions acceptably. Thus continuing with
the existing equipment may increase the
production cost. The impact of rapid change in
technology on productivity is more for the
equipment with more automated facility than
the equipment with lesser automation.
In replacement analysis, the existing (i.e.
currently owned) asset is referred
as defender whereas the new alternatives are
referred as challengers. In this analysis the
‘outsider perspective' is taken to establish the
first cost of the defender. This initial cost of the
defender in replacement analysis is nothing but
the estimated market value from perspective of
a neutral party. In other words this cost is the
investment amount which is assigned to the
currently owned asset (i.e. defender) in the
replacement analysis.
The current market value represents the
opportunity cost of keeping the defender i.e. if
the defender is selected to continue in the service. In other words, if the defender is selected, the
opportunity to obtain its current market value is
forgone. Sometimes the additional cost required
to upgrade the defender to make it competitive
for comparison with the new alternatives is
added to its market value to establish the total
investment for the defender. Along with the
market value, there will be revised estimates for
annual operating and maintenance cost, salvage
value and remaining service life of the defender,
which are expected to be different from the
original values those were estimated at the time
of acquiring the asset. The past estimates of
initial cost, annual operating and maintenance
cost, salvage value and useful life of defender
are not relevant in the replacement analysis and
are thus neglected. The past estimates also
incorporate a sunk costwhich is considered
irrelevant in replacement analysis. Sunk cost
occurs when the book value (as determined
using depreciation method) of an asset is
greater than its current market value, when the
asset (i.e. defender) is considered for
replacement. In other words it represents the
amount of past capital investment which can not
be recovered for the existing asset under
consideration for replacement. Sunk cost may
occur due to incorrect estimates of different
cost components and factors related
productivity of the defender, those were made
at the time of original estimates in the past with
uncertain future conditions. Since sunk cost
represents a loss in capital investment of the
asset, the income tax calculations can be done
accordingly by considering this capital loss. In
replacement analysis the incorrect past
estimates and decisions should not be
considered and only the cash flows (both
present and future) applicable to replacement
analysis should be included in the economic
analysis. For replacement analysis, it is
important know about different lives of an asset,
as this will assist in making the appropriate
replacement decision. The different lives are
physical life, economic life and useful
life. Physical life of an asset is defined as the
time period that is elapsed between initial
purchase (i.e. original acquisition) and final
disposal or abandonment of the
asset. Economic life is defined as the time
period that minimizes the total cost (i.e.
ownership cost plus operating cost) of an asset.
It is the time period that results in minimum
equivalent uniform annual worth of the total
cost of the asset. Useful life is defined as the
time period during which the asset is
productively used to generate profit. In
replacement analysis the defender and
challenger is compared over a study period.
Generally the remaining life of the defender is
less than or equal to the estimated life of the
challenger. When the estimated lives of the
defender and challenger are not equal, the
duration of the study period has to be
appropriately selected for the replacement
analysis. When the estimated lives of defender
and challenger are equal, annual worth method
or present worth method may be used for
comparison between defender and the
challengers (new alternatives).
In the following example, replacement analysis
involving equal lives of defender and challenger
is discussed.
A construction company has purchased a piece
of construction equipment 3 years ago at a cost
of Rs.4000000. The estimated life and salvage
value at the time of purchase were 12 years and
Rs.850000 respectively. The annual operating
and maintenance cost was Rs.150000. The
construction company is now considering
replacement of the existing equipment with a
new model available in the market. Due to
depreciation, the current book value of the
existing equipment is Rs.3055000. The current
market value of the existing equipment is
Rs.2950000. The revised estimate of salvage
value and remaining life are Rs.650000 and 8
years respectively. The annual operating and
maintenance cost is same as earlier i.e.
Rs.150000.
The initial cost of the new model is Rs.3500000.
The estimated life, salvage value and annual
operating and maintenance cost are 8 years,
Rs.900000 and Rs.125000 respectively.
Company's MARR is 10% per year. Find out
whether the construction company should
retain the ownership of the existing equipment
or replace it with the new model, if study period
is taken as 8 years (considering equal life of both
defender and challenger).
Solution:
For the replacement analysis, initial cost
(Rs.4000000), initial estimate of salvage value
(Rs.850000) and remaining life (12 – 3 = 9 years)
and current book value (Rs.3055000) of the
existing equipment (i.e. defender) are
irrelevant. Similarly sunk cost of Rs.105000
(Rs.3055000 – Rs.2950000) is also not relevant
for the replacement analysis. For the
replacement analysis the current revised
estimates of the existing equipment will be
used.
For existing equipment (defender),
Current market value (P) = Rs.2950000, Salvage
value (F) = Rs.650000,
Annual operating and maintenance cost (A) =
Rs.150000, Study period (n) = 8 years.
For new model (challenger),
Initial cost (P) = Rs.3500000, Salvage value (F) =
Rs.900000,
Annual operating and maintenance cost (A) =
Rs.125000, Study period (n) = 8 years.
Now the equivalent uniform annual worth of
both defender (i.e. the existing equipment) and
challenger (i.e. the new model) at MARR of 10%
(i.e. i = 10%) are calculated as follows;
For defender;

For challenger;

From the above calculations, it is observed that

equivalent uniform annual cost of the defender
is less than that of the challenger. Thus the
construction company should continue in
retaining the ownership of the defender against
the challenger with above details. Since the
useful lives of defender and challenger are
equal, the same conclusion will also be obtained
by using present worth method for economic
evaluation.
11. EFFECTS OF FACTORS ON ECONOMY
Investment decisions on large-scale engineering
projects demand the closest attention to
economic and financial factors. For electricity or
other reticulated services the economic and
financial effects of new installations on the
whole system must be ascertained. Economic
studies should be based entirely on future cash
flows, since sunk costs are irrelevant to
investment decisions. Financial studies, as
distinct from economic studies directed to the
evaluation of real costs, preferably should
include appropriate allowance for future
inflation to specify liquidity movements.
Although it is difficult to choose discount rates
for economic evaluations in public enterprise,
which neither seeks absolutely to maximize
profits nor absolutely to minimize costs, the
 opportunity cost of retained earnings must be
defined. Inflation accounting can significantly
aid the managerial decision-maker even in the
absence of acceptance for taxation purposes.
Key points

 Privately owned firms are motivated to earn

profits. Profit is the difference between
revenues and costs.
 Private enterprise is the ownership of
businesses by private individuals.
 Production is the process of combining inputs
to produce outputs, ideally of a value greater
than the value of the inputs.
 Revenue is income from selling a firm’s
product; defined as price times quantity sold.
 Accounting profit is the total revenues minus
explicit costs, including depreciation.
 Economic profit is total revenues minus total
costs—explicit plus implicit costs.
 Explicit costs are out-of-pocket costs for a
firm—for example, payments for wages and
salaries, rent, or materials.
 Implicit costs are the opportunity cost of

resources already owned by the firm and used

in business—for example, expanding a factory
onto land already owned.
Explicit and implicit costs and accounting and
economic Profit

Private enterprise—the ownership of

businesses by private individuals—is a hallmark
of the US economy. When people think of
businesses, often giants like Wal-Mart,
Microsoft, or General Motors come to mind.
But firms come in all sizes, as you can see in the
table below.
The vast majority of US firms have fewer than
20 employees. As of 2010, the US Census
Bureau counted 5.7 million firms with
employees in the US economy. Slightly less
than half of all the workers in private firms are
at the 17,000 large firms, firms that employ
more than 500 workers. Another 35% of
workers in the US economy are at firms with
fewer than 100 workers.
These small-scale businesses include everything
from dentists and lawyers to businesses that
mow lawns or clean houses. There are also
millions of small, non-employer businesses
where a single owner or a few partners are not
officially paid wages or a salary but simply
receive whatever they can earn—there is not a
separate category in the table for these
businesses.
Throughout this book we have repeatedly
emphasized that the engineer is a decision
maker and that engineering design is a process
of making a series of decisions over time. We
also have emphasized from the beginning that
engineering involves the application of science
to real problems of society. In this authentic
context, one cannot escape the fact that
economics may play a role as big as, or bigger
than, that of technical considerations in the
decision making process of design. In fact, it
sometimes is said, although a bit facetiously,
that an engineer is a person who can do for
$1.00 what any fool can do for $2.00. The
major engineering infrastructure that built this
nation—the railroads, major dams, and
waterways—required a methodology for
predicting costs and balancing them against
alternative courses of action. In an engineering
project, costs and revenues will occur at various
points of time in the future. The methodology
for handling this class of problems is known as
engineering economy or engineering economic
analysis. Familiarity with the concepts and
approach of engineering economy generally is
considered to be part of the standard
engineering toolkit. Indeed, an examination on
the fundamentals of engineering economy is
required for professional engineering
registration in all disciplines in all states. The
chief concept in engineering economy is that
money has a time value. Paying out $1.00 today
is more costly than paying out $1.00 a year
from now. A dollar invested today is worth a
dollar plus interest a year from now.
Engineering economy recognizes the fact that
the use of money is a valuable asset. Money
can be rented in the same way one can rent an
apartment, but the charge for using it is called
interest rather than rent. This time value of
money makes it more profi table to push
expenses into the future and bring revenues
into the present as much as possible. Before
proceeding into the mathematics of
engineering economy, it is important to
understand where engineering economy sits
with regard to related disciplines like economics
and accounting. Economics generally deals with
broader and more global issues than
engineering economy, such as the forces that
control the money supply and trade between
nations. Engineering economy uses the interest
rate established by the economic forces to
solve more specifi c and detailed problems.
However, it usually is a problem concerning
alternative costs in the future. The accountant
is more concerned with determining exactly,
and often in great detail, what costs have been
incurred in the past. One might say that the
economist is an oracle, the engineering
economist is a fortune teller, and the
accountant is a historian.
MATHEMATICS OF TIME VALUE OF MONEY If
we borrow a present sum of money or principal
P at a simple interest rate i , the annual cost of
interest is I Pi . If the loan is repaid in a lump
sum F at the end of n years, the amount
required is F P nI P nPi P ni =+ =+ = + (1 ) (18.1)
where F future worth P present worth I annual
cost of interest i annual interest rate n number
of years If we borrow $1000 for 6 years at 10
percent simple interest rate, we must repay at
the end of 6 years: F P ni = + ( ) = + ⎡ ( ) ⎣ ⎤ ⎦ 1
1000 1 6 0 10 1600 $ .$ = Therefore, we see
that $1000 available today is not equivalent to
$1000 available in 6 years. Actually, $1000 in
hand today is worth $1600 available in only 6
years at 10 percent simple interest. We can also
see that the present worth of $1600 available
in 6 years and invested at 10 percent is $1000.
P F ni = + = + = 1 1600 1 06 1000 $ . $ In making
this calculation we have discounted the future
sum back to the present time. In engineering
economy the term discounted refers to
bringing dollar values back in time to the
present. 18.2.1 Compound Interest However,
you are aware from your personal banking
experiences that fi nancial transactions usually
use compound interest. In compound interest,
the interest due at the end of a period is not
paid out but is instead added to the principal.
During the next period, interest is paid on the
total sum. First period: Second period: F PP P i F
1 i 2 =+ = + (1 ) = + ( ) + + ( ) = + ⎡ ( ) ⎣ ⎤ ⎦ P i iP i P
i i P i 1 1 11 1 ( + ) = + ( ) 2 Third period: F P i iP i
P i 3 22 2 = + (11 1 ) + + ( ) = + ( ) ⎡ ⎣⎢ ⎤ ⎦⎥( + ) = + (
) = + ( ) 1 1 1 3 iP i n FP i n n th period: (18.2)
We can write Eq. (18.2) in a short notation that
is convenient to use when the engineering
economy relationships become more complex.
F P i P F Pin n n = + (1 / ,, ) = ( ) (18.3) In Eq.
(18.3) the function ( F / P, i, n ) has the
meaning: Find the equivalent amount F given
the amount P compounded at an interest rate i
for n interest periods. EXAMPLE 18.1 How long
will it take money to double if it is compounded
annually at a rate of 10 percent per year? F PFP
n F P = ( / but we want to find the d ,, , 10 2 o )
=ubling time / ( ) 2 10 P PFP n = ( , , ) Therefore,
the answer clearly is found in a table of single-
payment compound-amount factors at the year
n for which F PS 2.0. Examining the table in
Appendix 2 we see that, for n 7, F PS 1.949 and,
for n 8, F PS 2.144. Linear extrapolation gives us
F PS 2.000 at n 7.2 years. We can generalize the
result to establish the fi nancial rule of thumb
that the number of years to double an
investment is 72 divided by the interest rate
(expressed as an integer). Usually in
engineering economy, n is given in years and i is
an annual interest rate. However, in banking
circles the interest may be compounded at
periods other than one year. Compounding at
the end of shorter periods, such as daily, raises
the effective interest rate. If we defi ne r as the
nominal annual interest rate and p as the
number of interest periods per year, then the
interest rate per interest period is i r / p and the
number of interest periods in n years is pn .
Using this notation, Eq. (18.2) becomes F P r p p
n = + ⎛ ⎝ ⎜ ⎞ ⎠ ⎟ ⎡ ⎣ ⎢ ⎢ ⎤ ⎦ ⎥ ⎥ 1 (18.4) Note
that when p 1, the above expression reduces to
Eq. (18.2). Standard compound interest tables
that are prepared for p 1 can be used for other
than annual periods. To do so, use the table for
i r / p and for a number of years equal to p n .
Alternatively, use the interest table
corresponding to n years and an effective rate
of yearly return equal to (1

r / p ) p 1.
Cash fl ows occur frequently and take place at
varying times within the time period of the
problem. In the cash fl ow diagram, Fig. 18.1,
the horizontal axis represents time and the
vertical axis is cash fl ow. Cash infl ows are
positive and are represented by arrows above
the x-axis. Cash outfl ows are negative and are
below the x-axis. It has been mentioned that
engineering economy is chiefl y concerned with
assisting decision making about future fi nancial
decisions in an engineering project. Since future
prediction of cash fl ows is likely to be
imprecise, it is not worth carefully locating each
cash fl ow on the diagram in time. Instead, the
end-of-period convention is used in which the
cash fl ows within a period are assumed to
occur at the end or the interest period.
In many situations we are concerned with a
uniform series of receipts or disbursements
occurring equally at the end of each period.
Examples are the payment of a debt on the
installment plan, setting aside a sum that will
be available at a future date for replacement of
equipment, and a retirement annuity that
consists of a series of equal payments instead
of a lump sum payment. We will let A be the
equal end-of-theperiod payment that makes up
the uniform annual series. Figure 18.2 shows
that if an annual sum A is invested at the end of
each year for 3 years, the total sum F at the end
of 3 years will be the sum of the compound
amount of the individual investments
With a sinking fund we put away each year a
sum of money that, over n years, together with
accumulated compound interest, equals the
required future amount F . With capital
recovery we put away enough money each year
to provide for replacement in n years plus we
charge ourselves interest on the invested
capital. The use of capital recovery is a
conservative but valid economic strategy. The
amount of money invested in capital
equipment ($10,000 in Example 18.2)
represents an opportunity cost, since we are
forgoing the revenue that the $10,000 could
provide if invested in interest-bearing
securities. A summary of the compound
interest relationships among F, P, and A is given
in Table 18.2 Table 18.2 gives relationships for a
uniform series of payments or receipts. Two
other series often used in engineering economy
are a gradient series in which the cash fl ow
increases (or decreases) by a fi xed increment
at each time period, and a geometric series in
which the cash fl ow changes by a fi xed
percentage at each time period. 1 Using
symbolic notation, as shown in Table 18.2,
simplifi es writing the equations and aids in
making calculations. For example, many
compound interest tables do not contain a
table for determining A (sinking fund factor)
when F is known. However, using the symbolic
factors this can be obtained by simply
multiplying factors.
Payment at the Beginning of the Interest Period
In working with a uniform series of payments of
receipts, A, it is conventional practice to
assume that A occurs at the end of each period.
However, sometimes a series of payments
begins immediately so that the payments are
made at the beginning of each time period
COST COMPARISON
Having discussed the usual compound interest
relations, we now are in a position to use them
to make economic decisions. A typical decision
is which of two courses of action is less
expensive when the time value of money is
considered. Generally the rate of interest to be
used in these calculations is set by the
minimum attractive rate of return, MARR. This
is the lowest rate of return a company will
accept for investing its money. The MARR is
established by the corporate fi nance offi cer
based on current market opportunities for
investing money or on the importance of the
project to advancing the company.
Present Worth Analysis
When the two alternatives have a common
time period, a comparison on the basis of
present worth is advantageous.
12. INFLATION AND DEFLATION
Inflation
What is Inflation
Inflation is the rate at which the prices for
goods and services increase. Inflation often
affects the buying capacity of consumers.
Most Central banks try to limit inflation in order
to keep their respective economies functioning
efficiently.
There are advantages and disadvantages to
inflation.
Causes of Inflation
Inflation is caused by multiple factors, here are
a few:
1. Money Supply
Excess currency (money) supply in an economy
is one of the primary cause of inflation. This
happens when the money supply/circulation in
a nation grows above the economic growth,
therefore reducing the value of the currency.
In the modern era, countries have shifted from
the traditional methods of valuing money with
the amount of gold they possessed. Modern
methods of money valuation are determined by
the amount of currency that is in circulation
which is then followed by the public’s
perception of the value of that currency.
2. National Debt
There are a number of factors that influence
national debt, which include the nations
borrowing and spending. In a situation where a
country’s debt increases, the respective
country is left with two options:
Taxes can be raised internally
Additional money can be printed to pay off the
debt
3. Demand-Pull Effect
The demand-pull effect states that in a growing
economy as wages increase within an economy,
people will have more money to spend on
goods and services. The increase in demand for
goods and services will result in companies to
raise prices that consumers will bear in order to
balance supply and demand.
4. Cost-Push Effect
This theory states that when companies face
increased input costs on raw materials and
wages for manufacturing consumer goods, they
will preserve their profitability by passing the
increased production cost to the end consumer
in the form of increased prices.
5. Exchange Rates
An economy with exposure to foreign markets
mostly functions on the basis of the dollar
value. In a trading global economy, exchange
rates play an important factor in determining
the rate of inflation.

The plus side to Inflation

A healthy inflation rate (2-3%) is considered
positive because it directly results in increasing
wages and corporate profitability and maintains
capital flowing in a growing economy.
Steps to offset Inflation and its effects on Your
Retirement
Factoring for inflation is an essential process for
financial planning. The question is how much
will you actually need when you retire? Here
are a few ways you can retire financially sound
keeping inflation in mind.
1. Invest in long-term investments.
When it comes to long-term investments,
spending money now can allow you to benefit
from inflation in the future..
2. Save More
Retirement requires more money than one
might imagine. The two ways to meet
retirement goals are to save more or invest
aggressively.
3. Make balanced investments
Though investing in bonds alone feel safer,
invest in multiple portfolios. Do not put all your
eggs in one basket to outpace inflation.

Deflation
Deflation is generally the decline in the prices
for goods and services that occur when the rate
of inflation falls below 0%. Deflation will take
place naturally, if and when the money supply
of an economy is limited.
Deflation in an economy indicates deteriorating
conditions. Deflation is normally linked with
significant unemployment and low productivity
levels of good and services. The term
“Deflation” is often mistaken with
“disinflation.” While deflation refers to a
decrease in the prices of goods and services in
an economy, disinflation is when inflation
increases at a slower rate.
Deflation can be caused by multiple factors:
1. Structural changes in capital markets
When different companies selling similar goods
or services compete, there is a tendency to
lower prices to have an edge over the
competition.
2. Increased productivity
Innovation and technology enable increased
production efficiency which leads to lower
prices of goods and services. Some innovations
affect the productivity of certain industries and
impact the entire economy.
3. Decrease in supply of currency
The decrease in the supply of currency will
decrease the prices of goods and services to
make it affordable to people.

Effects of Deflation
Deflation may have the following impacts on an
economy:
1. Reduction in Business Revenues
In an economy faced with deflation, businesses
must drastically reduce the prices of their
products or services to stay profitable. As
reducing in prices take place, revenues begin to
drop.
2. Lowered Wages and Layoffs
When revenues begin to drop, businesses need
to find means to reduce their expenses to meet
objectives. One way is by reducing wages and
cutting jobs. This adversely affects the economy
as consumers would now have less to spend.
Deflation, or negative inflation, happens when
prices fall because the supply of goods is higher
than the demand for those goods. ... The only
time deflation can work without hurting the
rest of the economy is when businesses are
able to cut the costs of production in order to
lower prices, such as with technology.
Inflation occurs when the price of goods and
services rise, while deflation occurs when those
prices decrease. The balance between the
two economic conditions, opposites of the
same coin, is delicate, and an economy can
quickly swing from one condition to the other.
Inflation is caused when goods and services are
in high demand, creating a drop in availability.
Supplies can decrease for many reasons: A
natural disaster can wipe out a food crop; a
housing boom can exhaust building supplies,
etc. Whatever the reason, consumers are
willing to pay more for the items they want,
causing manufacturers and service providers to
charge more.
What's The Difference Between Inflation And
Deflation?
Deflation occurs when too many goods are
available or when there is not
enough money circulating to purchase those
goods. For instance, if a particular type of car
becomes highly popular, other manufacturers
start to make a similar vehicle to compete.
Soon, car companies have more of that vehicle
style than they can sell, so they must drop the
price to sell the cars. Companies that find
themselves stuck with too
much inventory must cut costs, which often
leads to layoffs. Unemployedindividuals do not
have enough money available to purchase
items; to coax them into buying, prices get
lowered, which continues the trend.
When credit providers detect a decrease in
prices, they often reduce the amount of credit
they offer. This creates a credit crunch where
consumers cannot access loans to purchase big-
ticket items, leaving companies with
overstocked inventory and causing further
deflation. Deflation can lead to an
economic recession or depression, and
the central banks usually work to stop deflation
as soon as it starts.
Deflation, or negative inflation, happens when
prices fall because the supply of goods is higher
than the demand for those goods. This is
usually because of a reduction in money, credit
or consumer spending.
13. BREAK-EVEN ANALYSIS
The break-even point (BEP)
in economics, business—and specifically cost
accounting—is the point at which total cost and
total revenue are equal, i.e. "even". There is no
net loss or gain, and one has "broken even",
though opportunity costs have been paid and
capital has received the risk-adjusted, expected
return. In short, all costs that must be paid are
paid, and there is neither profit nor loss.
The break-even point (BEP) or break-even level
represents the sales amount—in either unit
(quantity) or revenue (sales) terms—that is
required to cover total costs, consisting of both
fixed and variable costs to the company. Total
profit at the break-even point is zero. It is only
possible for a firm to pass the break-even point
if the dollar value of sales is higher than the
variable cost per unit. This means that the
selling price of the good must be higher than
what the company paid for the good or its
components for them to cover the initial price
they paid (variable and fixed costs). Once they
surpass the break-even price, the company can
start making a profit.
The break-even point is one of the most
commonly used concepts of financial analysis,
and is not only limited to economic use, but can
also be used by entrepreneurs, accountants,
financial planners, managers and even
marketers. Break-even points can be useful to
all avenues of a business, as it allows
employees to identify required outputs and
work towards meeting these.
The break-even value is not a generic value and
will vary dependent on the individual business.
Some businesses may have a higher or lower
break-even point. However, it is important that
each business develop a break-even point
calculation, as this will enable them to see the
number of units they need to sell to cover their
variable costs. Each sale will also make a
contribution to the payment of fixed costs as
well.
For example, a business that sells tables needs
to make annual sales of 200 tables to break-
even. At present the company is selling fewer
than 200 tables and is therefore operating at a
loss. As a business, they must consider
increasing the number of tables they sell
annually in order to make enough money to
pay fixed and variable costs.
If the business does not think that they can sell
the required number of units, they could
consider the following options:
1. Reduce the fixed costs. This could be done
through a number or negotiations, such as
reductions in rent payments, or through better
management of bills or other costs.
2. Reduce the variable costs, (which could be
done by finding a new supplier that sells tables
for less).
Either option can reduce the break-even point
so the business need not sell as many tables as
before, and could still pay fixed costs.
PURPOSE
The main purpose of break-even analysis is to
determine the minimum output that must be
exceeded for a business to profit. It also is a
rough indicator of the earnings impact of a
marketing activity. A firm can analyze ideal
output levels to be knowledgeable on the
amount of sales and revenue that would meet
and surpass the break-even point. If a business
doesn't meet this level, it often becomes
difficult to continue operation.
The break-even point is one of the simplest, yet
least-used analytical tools. Identifying a break-
even point helps provide a dynamic view of the
relationships between sales, costs, and profits.
For example, expressing break-even sales as a
percentage of actual sales can help managers
understand when to expect to break even (by
linking the percent to when in the week or
month this percent of sales might occur).
The break-even point is a special case of Target
Income Sales, where Target Income is 0
(breaking even). This is very important for
financial analysis. Any sales made past the
breakeven point can be considered profit (after
all initial costs have been paid)
Break-even analysis can also provide data that
can be useful to the marketing department of a
business as well, as it provides financial goals
that the business can pass on to marketers so
they can try to increase sales.
Break-even analysis can also help businesses
see where they could re-structure or cut costs
for optimum results. This may help the business
become more effective and achieve higher
returns. In many cases, if an entrepreneurial
venture is seeking to get off of the ground and
enter into a market it is advised that they
formulate a break-even analysis to suggest to
potential financial backers that the business has
the potential to be viable and at what points.
This is also known as cost analysis. Break even
analysis is concerned with finding the point at
which revenues and costs are exactly equal.
This point is known as BREAK-EVEN-POINT.
Thus this is a volume of output at which neither
a profit is made nor a loss is incurred. Therefore
production or sale must not be allowed to fall
beyond this point. This analysis can be carried
out either algebraically or graphically.
A breakeven chart is a graphical representation
of the relationship between costs and revenue
at a given time, and determines the break-
even-point and profit potential under varying
conditions of output and cost.
Break even analysis not only highlights the
areas of economic strength and weaknesses in
the firm but also helps in finding out the ways
which can enhance its profitability.

1. Safety Margin:
It refers the extent to which the concern can
afford to decline in sales upto the break-even
point. It can be represented by the percentage
ratio of sales over break-even point volume to
the sales volume.
... Safety margin = Sales volume – Sales at
B.E.P./Sales volume × 100
2. Quantity Needed to have Desired Profit:
This is the most common application of break-
even analysis and the desired quantity is given
by
Target quantity = Fixed cost + Target
profit/Contribution per unit
3. The Effect of Change in Price:
Sometimes management is required to
consider whether to reduce price of a product
or not.
Management has to consider the following
facts in this regard:
If the sales price is reduced then contribution
margin will reduce and this will increase the
sales volume. But this increased volume may or
may not receive increase in demand because it
depends on elasticity of demand.
The change in break-even point due to rate
variation in sales price is drawn below (Fig
69.3). At different price levels total revenue line
can be plotted and the chart shows that as the
price of a product is reduced the break-even
point shifts towards right side and vice versa.
From the chart, one can then estimate the
volume that will be sold and profit at each price
level.
 Variable Cost Change:
An increase in variable cost leads to reduction
in the contribution margin. This increase in
variable cost will reduce the profit. Therefore,
what should be the new price to maintain the
present profit without any change in sales
volume.
Whether to Accept an Order or Not:

If extra capacity to produce a product is

variable then sometimes management has to
decide whether to accept another order at a
price with less than the initial selling price. For
example, a plant is operating on its 50% of full
capacity. A buyer offered to buy 4000 units at
Rs.5 per unit while the average cost is Rs.6.
Now the problem is whether to accept this
order or not.
As there is reduction in contribution margin, it
will cause increase in sales volume. Therefore,
what should be the sales volume to maintain
the present profit without change in the price.
So, it would be profitable to accept anything
more than Rs.2 per unit which is the direct cost
per unit. There is only danger that, if other
consumers come to know that this product is
being sold at a lower price, they may also then
demand supply at the lower price or otherwise
they may not be further interested to buy from
this concern. Therefore, in such cases
acceptance should be kept secret.
The breakeven analysis is used to calculate the
value of a factor (or variable) at which the
expenditures and revenues of a project or
alternative are equal. This value of the variable
is known as the breakeven point.
Corresponding to the breakeven point, profit or
loss can be determined if the expected value of
the variable is higher or lower than the
breakeven value. In this regard the breakeven
point governs the economic acceptability of the
project or the alternative. The breakeven
analysis is also used for comparing two
alternatives by determining the breakeven
point i.e. the quantity of a factor (common to
both the alternatives) at which the total
equivalent worth of both alternatives are equal.
The examples of some of the factors which are
used in the breakeven analysis are quantities
produced per year, hours of operation per year,
rate of return per year and useful life etc. and
the breakeven value of these factors are
calculated to find out the economical
acceptability of a single alternative or to select
the best one between the alternatives. The
breakeven point between expenditure and
revenue for a single alternative is shown in Fig.
2.32. Here ‘x' is the factor that mainly affects
the expenditure and revenue of the alternative.
Example
A concrete mixer has the following cash flow
details;
Initial purchase price = Rs.750000,
Annual operating and maintenance cost =
Rs.45000
Salvage value = Rs.210000,
Useful life = 10 years
In addition one operator is required to operate
the concrete mixer at cost of Rs.30 per hour. The
production (preparation) rate of concrete of the
mixer is 0.1 m3 per hour. The revenue to be
generated from production of 1 m3 of concrete
is Rs.1000. The interest rate is 11% per year.
How many ‘m3' of concrete need to be produced
per year so that the revenue generated
breakevens with the expenditure?
Solution:
In order to find out the breakeven value of the
concrete volume (in ‘m3' ) per year, the
equivalent uniform annual worth of expenditure
will be equated to that of revenue.
Let ‘x' m3 is the volume of concrete produced by
the concrete mixer per year.
The operator cost is Rs.30 per hour.
The operator cost (Rs.) per year is given by;

Now the equivalent uniform annual worth (Rs.)

of expenditure is given by;

The equivalent uniform annual worth (Rs.) of

revenue is calculated as follows;
Now equating equivalent uniform annual worth
of expenditure with that of revenue;

Thus the volume of concrete to be produced by

the concrete mixer per year i.e. the breakeven
quantity at which the expenditure incurred is
equal to the revenue generated is 228.274 m3. If
the volume of concrete produced per year is
different from the breakeven value, then there
will change in the net cash flow as shown below;
If x is equal to 200 m3 (i.e. less than breakeven
value), the equivalent uniform annual worth of
expenditure and revenue are given by;
Expenditure
Revenue

AWe > AWr

If x is equal to 250 m3 (i.e. greater than
breakeven value), the equivalent uniform
annual worth of expenditure and revenue are
given by;
Expenditure

Revenue
AWr > AWe
Thus from above calculations it is observed that,
equivalent annual worth of revenue is less than
that of expenditure, when the volume of
concrete produced per year is less than the
breakeven value and on the other hand,
equivalent annual worth of revenue is more
than that of expenditure, when the volume of
concrete produced per year is greater than the
breakeven value.
The breakeven point can also be calculated by
equating the equivalent present worth of
expenditures to that of revenues as shown
below.
Present worth of expenditure:

Present worth of revenue:

Now equating equivalent present worth of
expenditure with that of revenue;

Thus the breakeven value of volume of concrete

to be produced by the concrete mixer per year
is 228.275 m3 which is same as the value
obtained by annual worth method stated
earlier.
14. PRINCIPLES OF ACCCOUNTING
Accounting and Engineering Economy 18-1
Engineers and managers make better decisions
when they understand the “dollar” impact of
their decisions. Accounting principles guide the
reporting of cash flows for the firm. Engineers
and managers can access this information
through formal and informal education means,
both within and outside the firm. 18-2 The
accounting function is the economic analysis
function within a company it is concerned with
the dollar impact of past decisions. It is
important to understand, and account for, these
past decisions from management, operational,
and legal perspectives. Accounting data relates
to all manner of activities in the business. 18-3
Balance Sheet – picture of the firm’s financial
worth at a specific point in time. Income
Statement – synopsis of the firm’s profitability
for a period of time. 18-4 Short-term liabilities
represent expenses that are due within one year
of the balance sheet, while long-term liabilities
are payments due beyond one year of the
balance sheet. 18-5 The two primary general
accounting statements are the balance sheet
and the income statement. Both serve useful
and needed functions. 18-6 Today’s weather is
not a good basis to pack for a 3-month trip, and
local and recent financial data is not a complete
basis for judging a firm’s performance. Historical
and seasonal trends and a context of industry
standards are also needed. 18-7 Not necessarily.
The current ratio will provide insight into the
firm’s solvency over the short term and although
a ratio of less than 2 historically indicates there
could be problems, it doesn’t mean the
company will go out of business. The same is
true with the acid-test ratio. If the company has
a low ratio, then it probably doesn’t have the
ability to instantly pay off debt. That doesn’t
necessarily indicate the firm will go bankrupt.
Both tests should be used as an indicator or
warning sign. 18-8 Assets = $1,000,000 Total
liabilities = $127,000 + 210,000 = $337,000
Equity = assets – liabilities = $1,000,000 –
337,000 = $663,000 18-9 6 days/week * 52
weeks/year = 312 days/year in operation $1000
profit/day * 312 days/year = $312,000
profit/year Revenues – expenses = $500,000 –
312,000 = $188,000 18-10 a. Working capital =
current assets - current liabilities = $5,000,000 –
2,000,000 = $3,000,000 b. Current ratio =
(current assets / current liabilities) =
$5,000,000/2,000,000 = 2.5 18-11 Net profit
(loss) = revenues – expenses = $100,000 –
60,000 = $40,000 18-12 a. Working capital =
($90,000 + 175,000 + 210,000) – (322,000 +
87,000) = $475K – 409K = $66,000 b. Current
ratio = ($475K/409K) = 1.161 c. Acid test ratio =
($90,000 + 175,000)/409,000 = 0.648 18-13
Operating Revenues and Expenses Revenue
Sales 30,000 Total 30,000 Expenses
Administrative 2750 Cost of goods sold 18,000
Development 900 Selling 4500 Total 26,150
Total operating income 3,850 Non-operating
revenues & expenses Interest paid 200 Income
before taxes 3650 Taxes (@27%) 985.50 Net
profit (loss) 2664.50 18-14 Assets = $100,000 +
45,000 + 150,000 + 200,000 + 8,000 = $503,000
Liabilities = $315,000 + 90,000 = $405,000 a.
Working capital = $503,000 – 405,000 = $98,000
b. Current ratio = $495,000/405,000 = 1.22 c.
Acid test ratio = $295,000/405,000 = 0.73 18-15
a. Working capital = current assets – current
liabilities = ($110K + 40K + 10K + 250K) – (442K)
= $118,000 b. Current ratio = current assets /
current liabilities = $560K/442K = 1.27 c. Acid
test ratio = quick assets / current liabilities =
$310K/442K = 0.701 A good current ratio is 2 or
above, and a good acid test ratio is 1 or above.
This company is in major trouble unless they
move inventory quickly. 18-16 Total revenues =
$51 + 35 = $86 million Total expenses = $70 + 7
= $77 million a. Net income before taxes =
revenue – expenses = $86 – 77 = $9 million b.
Net profit = net income before taxes – taxes = $9
– 1 = $8 million Interest coverage = (total
revenues – total expenses) / interest = ($86 –
70)/7 = 2.28 This interest coverage is not
acceptable because it should be at least 3.0 for
industrial firms. 18-17 Profit = $50,000 – 30,000
– 5,000 = $15,000 Net income = profit – taxes =
$15,000 – 2,000 = $13,000 18-18 a. Current ratio
= current assets / current liabilities =
(1.5million)/50,000 =30 b. Acid test ratio = quick
assets / current liabilities = (1.0 million)/50,000=
20 While it may be tempting to think that a
higher ratio is better, this is not always the case.
Such high ratios as these could mean that an
excessive amount of capital is being kept on
hand. Excess capital does very little for the
company if it is just sitting in the bank – it could
and/or should be used to make the company
more profitable through investing, automation,
employee training, etc. 18-19 Total current
assets = $1740 + 900 + 2500 – 75 = $5065 Total
current liabilities = $1050 + 500 + 125 = $1675
Current ratio = $5065/1675 = 3.0238 This
company’s financial standing is good because
the current ratio is greater than 2.0. 18-20 a.
Current ratio = current assets / current liabilities
= $2670/1430 = 1.87 This is below the
recommended ratio of 2.0 and may indicate that
the firm is not solvent, especially since the
height of the nursery business is the spring and
summer and this is a June balance sheet. b. Acid
test ratio = (cash + accounts receivable) / current
liabilities = ($870 + 450)/1430 = 0.92 This
indicates that 92% of the current liabilities could
be paid out within the next thirty days, which is
not a bad situation, although a little higher
would be preferable. 18-21 a. Interest coverage
= total income / interest payments = ($455 – 394
+ 22)/22 = 3.77 This is a good ratio, indicating the
company’s ability to repay its debts. It should be
at least 3.0. b. Net profit ratio = net profits / sales
revenue = $31/(395 – 15) = 0.08 This is a very
small ratio, indicating that the company needs
to assess their ability to operate efficiently in
order to increase profits. The company should
compare itself to industry standards. 18-22
Activity Model S Model M Model G Direct
material cost $3,800,000 $1,530,000 $2,105,000
Direct labor cost $600,500 $380,000 $420,000
Direct labor hours 64,000 20,000 32,000
Allocated overhead 64,000 X 137 = $8,768,000
20,000 X 137 = $2,740,000 32,000 X 137 =
$4,384,000 Total costs $131,685,000 $4.650,100
$6,909,000 Units produced 100,000 50,000
82,250 Cost per unit $132 $93 $84 18-23 a. Total
direct labor = 50,000 + 65,000 = $115,000
Allocation of overhead OverheadStandard =
(50,000/115,000)(35,000) = $15,217
OverheadDeluxe = (65,000/115,000)(35,000) =
$19,783 Total CostStandard = 50,000 + 40,000 +
15,217 = $105,217 Total CostDeluxe = 65,000 +
47,500 + 19,783 = $132,283 Net
RevenueStandard = 1800(60) - 105,217 = $2783
Net RevenueDeluxe = 1400(95) - 132,283 = $717
b. Total materials = 40,000 + 47,500 = $87,500
Allocation of overhead OverheadStandard =
(40,000/87,500)(35,000) = $16,000
OverheadDeluxe = (47,500/87,500)(35,000) =
$19,000 Total CostStandard = 50,000 + 40,000 +
16,000 = $106,000 Total CostDeluxe = 65,000 +
47,500 + 19,000 = $131,500 Net
RevenueStandard = 1800(60) - 106,000 = $2000
Net RevenueDeluxe = 1400(95) - 131,500 =
$1500 In both cases the total net revenues equal
$3500, but the deluxe bag appears far more
profitable with materials-based allocation. 18-
24 a. $60,000,000/12,000 hours = $5000/hour b.
Total cost = $1,000,000 + $600,000 +
200hours*$5000/hour = $2,600,000 18-25 RLW-
II will use the ABC system to understand all of
the activities that drive costs in their
manufacturing enterprise. Based on the
presence and magnitude of the activities, RLW-
II will want to assign costs to each. In doing this,
RLW-II will gain a more accurate view of the true
costs of producing their products. Potential
categories of indirect costs that RLW-II will want
to account for include costs for: ordering from
and maintaining a relationship with specific
vendors/suppliers; shipping, receiving, and
storing raw materials, components and sub-
assemblies; retrieval and all material handling
activities from receiving to final shipment; all
indirect manufacturing and assembly activities
that support the direct costs; activities related to
requirements for specific and unique machinery,
tools and fixtures, and engineering and technical
support; all indirect quality related activities in
areas such as testing, rework and scrap;
activities related to packaging, documentation
and final storage; shipping, distribution and
warehousing activities, and customer
support/service and warranty activities. 18-26
Direct Costs Indirect Costs Machine operator
wages Machine labor Overtime expenses Cost of
materials Insurance costs Utility costs Material
handling costs Engineering drawings Cost to
market the product Cost of storage Cost of
product sales force Support staff salaries Cost of
tooling and fixtures Machine run costs
The fields of economics and accounting deal
with financial matters, but aside from sharing
this general interest, they’re not closely related.
Economists are social scientists, while
accountants are business majors with special
training in business finance.
The Difference Between Economists and
Accountants
The fields of macroeconomics and
microeconomics consider the role accountants
play in the overall economy, but the jobs of
these two professions are otherwise almost
completely unrelated. Accountants don’t
usually work with economists in their day-to-
day activities, and economists usually don’t
know anything about income statements,
balance sheets or business management.
Economists are professional academics, and
they spend most of their time doing research
and publishing articles in journals. Universities
and governments hire economists, while
businesses and governments hire accountants.
The two main fields economists study are
microeconomics and macroeconomics.
Microeconomics is the study of individual
decisions in relation to the economy as a
whole, and macroeconomics is the study of the
overall economic outcomes of a nation or
society. Economics is a social science because it
deals with many issues that can’t be quantified,
such as human behavior and psychology.
However, most economic principles are based
on mathematics, especially calculus and linear
algebra.
Employment of Economists and Accountants
Economists can earn bachelor of science or
bachelor of arts degrees in their fields. They
take a mix of business, liberal arts and science
courses as undergraduates, and when they
finish, they can continue to graduate school to
obtain master’s or doctoral degrees. Without
advanced education, economists can’t do
professional research, but they can often find
jobs in other fields, particularly in business.
However, they aren’t qualified to work as
accountants because they haven’t learned the
methods that accountants use to balance
budgets and record expenses.
Accountants are business majors, and they can
get master’s and doctoral degrees, as well.
There is also a special one-year postgraduate
degree that lets accountants become Certified
Public Accountants. It’s possible for an
accountant to go to graduate school and do
academic research, but this career path is
uncommon. Most accountants work for
businesses handling their credit, payroll, assets,
payables and taxes. They uses balance sheets,
retained equity reports, statements of profits
and loss, and assets and liabilities reports to
keep track of their employers’ money.
Controllers and Comptrollers
An accountant with many years of experience
can eventually be promoted to the position of
controller or comptroller. These similarly
named jobs are actually one and the same, but
businesses call them controllers and
governments call them comptrollers. A
comptroller is an elected city official, while a
controller is hired by the board of directors of a
company. In both cases, they work as the lead
accountants of an organization. A controller
answers to the Chief Financial Officer, and a
comptroller answers to the city treasurer or
mayor.
The closest relationship accountants and
economists may have is in the allocation of
resources by economists to pay accountants’
salaries and the calculation of payroll by
accountants to pay economists salaries. This
relationship is indirect and could only happen in
an organization that hires both economists and
accountants, such as a government.
The world of business and finance becomes
more sophisticated as new financial
instruments are developed and regulations
passed to protect the economy. If you’re
interested in academic research of financial
matters, you may prefer economics, but if
you’re more interested in working in industry,
you may prefer accounting.
What is accounting?
Accounting is the act of gathering and reporting
the financial history of an organization
(company).
This requires a continuous process of o
Capturing financial data,
Organizing it,
o Producing financial reports.
• Framework for understanding accounting
information
Information in accounting reports are
determined by o Economic concepts.
Determine what is being actually reported?
E.g., financial value, wealth, income. o
Accounting conventions. Dictate how to report
financial transactions to measure the desired
economic criteria. o Institutional context. This
reflects the effect of human judgment in
adopting accounting conventions.
REFRENCES:
ENGINEERING ECONOMY BY: MATIAS
ARREOLA
ENGINEERING ECONOMY BY: HIPOLITO B. STA
MARIA

https://www.oreilly.com/library/view/engine
ering-economics-
for/9781606500040/chapter6.xhtml

http://www.businessmanagementideas.com/
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