Mod1 Merged

NPTEL – Civil Engineering – Construction Economics & Finance
Construction Economics & Finance
Module 1
Engineering economics
Lecture-1
Basic principles:–
Time value of money:
The time value of money is important when one is interested either in investing or
borrowing the money. If a person invests his money today in bank savings, by next year
he will definitely accumulate more money than his investment. This accumulation of
money over a specified time period is called as time value of money.
Similarly if a person borrows some money today, by tomorrow he has to pay more money
than the original loan. This is also explained by time value of money.
The time value of money is generally expressed by interest amount. The original
investment or the borrowed amount (i.e. loan) is known as the principal.
The amount of interest indicates the increase between principal amount invested or
borrowed and the final amount received or owed.
In case of an investment made in the past, the total amount of interest accumulated till
now is given by;
Amount of interest = Total amount to be received – original investment (i.e. principal
amount)
Similarly in case of a loan taken in past, the total amount of interest is given by;
Amount of interest = Present amount owed – original loan (i.e. principal amount)
In both the cases there is a net increase over the amount of money that was originally
invested or borrowed.
When the interest amount is expressed as the percentage of the original amount per unit
time, the resulting parameter is known as the rate of interest and is generally designated
as „i‟.
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The time period over which the interest rate is expressed is known as the interest period.
The interest rate is generally expressed per unit year. However in some cases the interest
rate may also be expressed per unit month.
Example: 1
A person deposited Rs.1,00,000 in a bank for one year and got Rs.1,10,000 at the end of
one year. Find out the total amount of interest and the rate of interest per year on the
deposited money.
Solution:
The total amount of interest gained over one year = Rs.1,10,000 - Rs.1,00,000 =
Rs.10,000
The rate of interest ‘i’ per year is given by;
Rs.10,000
i(%)   100  10%
Rs.1,00,000
Similarly if a person borrowed Rs.1,50,000 for one year and returned back Rs.1,62,000 at
the end of one year.
Then the amount of interest paid and the rate of interest are calculated as follows;
The total amount of interest paid = Rs.1,62,000 - Rs.1,50,000 = Rs.12,000
The rate of interest ‘i’ per year is given by;
Rs.12,000
i(%)   100  8%
Rs.1,50,000
Simple interest:
The interest is said to simple, when the interest is charged only on the principal amount
for the interest period. No interest is charged on the interest amount accrued during the
preceding interest periods. In case of simple interest, the total amount of interest
accumulated for a given interest period is simply a product of the principal amount, the
rate of interest and the number of interest periods. It is given by the following expression.
IT  P  n  i
Where
IT = total amount of interest
P = Principal amount

n = number of interest periods

i = rate of interest
Simple interest reflects the effect of time value of money only on the principal amount.
Compound interest:
The interest is said to be compound, when the interest for any interest period is charged
on principal amount plus the interest amount accrued in all the previous interest periods.
Compound interest takes into account the effect of time value of money on both principal
as well as on the accrued interest also.
The following example will explain the difference between the simple and the compound
interest.
Example: 2
A person has taken a loan of amount of Rs.10,000 from a bank for a period of 5 years.
Estimate the amount of money, the person will repay to the bank at the end of 5 years for
the following cases;
a) Considering simple interest rate of 8% per year
b) Considering compound interest rate of 8% per year.
Solution:
a) Considering the simple interest @ 8% per year;
The interest for each year  Rs.10,000  0.08  Rs.800
The interest for each is year is calculated only on the principal amount i.e. Rs.10,000.
Thus the interest accumulated at the end of each year is constant i.e. Rs.800.
The year-by-year details about the interest accrued and amount owed at the end of each
year are shown in Table1.1.

Table 1.1 Payment using simple interest
End of year Amount of interest Total amount owed

(EOY) (Rs.) (Rs.)
1 800 10,800
2 800 11,600
3 800 12,400
4 800 13,200
5 800 14,000*
* The amount repaid to the bank at the end of year 5 (since the person has to repay at
EOY 5).
The total amount owed at the end of each year using simple interest is graphically shown
in Fig. 1.1.
Simple interest
16000
Total amount owed (Rs.)
12000
8000
4000
0
1 2 3 4 5
End of year (EOY)
Fig. 1.1 Total amount owed (using simple interest)
b) Considering the compound interest @ 8% per year;

The amount of interest and the total amount owed at the end of each year, considering
compound interest are presented in Table 1.2.

Table 1.2 Payment using compound interest
End of year Amount of interest Total amount owed

(EOY) (Rs.) (Rs.)
1 800.00 10,800.00
2 864.00 11,664.00
3 933.12 12,597.12
4 1007.77 13,604.89
5 1088.39 14,693.28**
** The amount repaid to the bank at the end of year 5.

The year-by-year values of amount of interest and the total amount owed (as shown in
Table 1.2) are calculated as follows;
Amount of interest accumulate d at the end of Year 1  Rs.10,000  0.08  Rs.800
Total amount owed at the end of Year 1  Rs.10,000  Rs.800  Rs.10,800
Amount of interest accumulate d at the end of year 2  Rs.10,800  0.08  Rs.864
Total amount owed at the end of Year 2  Rs.10,800  Rs.864  Rs.11,664
Similarly the interest amount and the total amount owed at the end of year 3, year 4 and
year 5 can be calculated in the same manner.
From these calculations it is clear that, in case of compound interest the interest for each
year is calculated on the principal amount plus the interest amount accumulated till that
period.
The total amount owed at the end of each year using compound interest is also
graphically shown in Fig. 1.2.

Compound interest
16000
Total amount owed (Rs.)

12000
8000
4000
0
1 2 3 4 5
End of year (EOY)
Fig. 1.2 Total amount owed (using compound interest)
The accrued interest at the end of each year considering both simple and compound
interest is also shown in Fig. 1.3.
From Fig. 1.3, one can see that in case of simple interest, the amount of interest
accumulated each year is constant. However in case of compound interest, the interest
amount accumulated at the end of each year is not constant and increases with interest
period as evident from Fig. 1.3. Thus considering compound interest, the total amount to
be repaid at the end of year 5 is Rs.14,693.28, which is greater as compared to Rs.14,000
that is to be repaid on the basis of simple interest.

1200
Constant value
Amount of interest (Rs.)

800
Simple
Compound
400
0
1 2 3 4 5
End of year (EOY)
Fig. 1.3 Accumulated interest at the end of each year

Lecture-2
Equivalence:
Equivalence indicates that different amount of money at different time periods are
equivalent by considering the time value of money. The following simple example will
explain the meaning of equivalence.
Example: 3
What are the equivalent amounts of Rs.10000 (today) at an interest rate of 10% per year
for the following cases?
a) 1 year from now (future)
b) 1 year before
Solution:
a) At interest rate of 10% per year, Rs.10000 (now) will be equivalent to Rs.11000 one
year from now as shown below;
Amount accumulate d at the end of one year  Rs.10000 1.10  Rs.11000
b) Similarly Rs.10000 now was equivalent to Rs.9090.90 one year ago at interest rate of
10% per year.
Amount one year before  Rs. 10000 1.10

 Rs.9090.90
Thus due to the effect of time value of money, these amounts Rs.9090.90 (one year
before), Rs.10000 (today) and Rs.11000 (one year from now) are equivalent at the
interest rate of 10% per year. It is shown in Fig. 1.4.

Equivalence
12000
9000
Amount (Rs.)
6000
3000
0
One year before Today One year from now
Interest period
Fig 1.4 Schematic representation of equivalence
The equivalent value of an amount that is borrowed now, at future time period at a given
interest rate depends on the type of interest whether simple or compound and the different
loan repayment arrangements like payment of accumulated interest annually and
principal at the end of the stipulated interest periods or payment of both the principal and
interest at the end interest periods or payment of uniform amounts annually that
comprises a portion towards the payment of principal amount and remaining for the
accumulated interest throughout the interest periods.
Quantifying alternatives for decision making:

Quantifying alternatives for any item is the most important aspect of decision making for
selecting the best option. For example, a construction company is planning to purchase a
new concrete mixer for preparing concrete at a construction site. Let‟s say there are two
alternatives available for purchasing the mixer; a) an automatic concrete mixer and b) a
semi-automatic concrete mixer. Then the task is to find out best alternative that the
company will purchase that will yield more profit. For this purpose one has to quantify
both the alternatives by the following parameters;
 The initial cost that includes purchase price, sales tax, cost of delivery and cost of
assembly and installation.

 Annual operating cost.

 Annual profit which will depend on the productivity i.e. quantity of concrete
prepared.
 The expected useful life.
 The expected salvage value.
 Other expenditure or income (if any) associated with the equipment.
 Income tax benefit
Then on the basis of the economic criteria, the best alternative is selected by calculating
the present worth or future worth or the equivalent uniform annual worth of both
alternatives by incorporating the appropriate interest rate per year and the number of
years (i.e. the comparison must be made over same number of years for both
alternatives). Then the concrete mixer with least cost or higher net income is considered
for purchase. In addition to economic parameters as mentioned above, the non-economic
parameters namely environmental, social, and legal and the related regulatory and
permitting process must also be considered for the evaluation and selection of the best
alternative. These non-economic parameters are essentially required (in addition to the
economic factors) for the selection of the best alternative for the infrastructure and heavy
construction projects like dams, bridges, roadways etc. and other publicly and privately
funded projects namely office buildings, hospitals, apartment building and shopping
malls etc. When the available alternatives exhibit the same equivalent cost or same net
income, then the non-economic parameters may play a vital role in the selection of the
best alternative. It may be noted here that the non-economic parameters cannot be
expressed in numerical values.

Lecture-3
Cash flow diagram:
The graphical representation of the cash flows i.e. both cash outflows and cash inflows
with respect to a time scale is generally referred as cash flow diagram.
A typical cash flow diagram is shown in Fig. 1.5. The cash flows are generally indicated
by vertical arrows on the time scale as shown in Fig. 1.5.
The cash outflows (i.e. costs or expense) are generally represented by vertically
downward arrows whereas the cash inflows (i.e. revenue or income) are represented by
vertically upward arrows.
In the cash flow diagram, number of interest periods is shown on the time scale. The
interest period may be a quarter, a month or a year. Since the cash flows generally occur
at different time intervals within an interest period, for ease of calculation, all the cash
flows are assumed to occur at the end of an interest period. Thus in Fig. 1.5, the numbers
on the time scale represent the end of year (EOY).
Cash inflow End of year 1 35000 80000 45000
End of year 10
Time 0 1 2 3 4 5 6 7 8 9 10
Year 1 Year 7
Cash outflow 100000 15000 25000
Fig 1.5 Cash flow diagram
In Fig. 1.5 the cash outflows are Rs.100000, Rs.15000 and Rs.25000 occurring at end of
year (EOY) „0‟ i.e. at the beginning, EOY „4‟ and EOY „7‟ respectively. Similarly the
cash inflows Rs.35000, Rs.80000 and Rs.45000 are occurring at EOY „3‟, EOY „6‟ and
EOY „10‟ respectively.
Compound interest factors:
The compound interest factors and the corresponding formulas are used to find out the
unknown amounts at a given interest rate continued for certain interest periods from the

known values of varying cash flows. The following are the notations used for deriving
the compound interest factors.
P = Present worth or present value
F = Future worth or future sum
A = Uniform annual worth or equivalent uniform annual worth of a uniform series
continuing over a specified number of interest periods
n = number of interest periods (years or months)
i = rate of interest per interest period i.e. % per year or % per month
Unless otherwise stated, the rate of interest is compound interest and is for the entire
number of interest periods i.e. for „n‟ interest periods.
The present worth (P), future worth (F) and uniform annual worth (A) are shown in Fig.
1.6.
In this figure the present worth, P is at the beginning and the uniform annual series with
annual value „A‟ is from end of year 1 till end of year 5. Both „P‟ and „A‟ are cash
outflows. It may be noted that the uniform annual series with annual value „A‟ may be
also continued throughout the entire interest periods i.e. from beginning till end of year
10 or for some intermediate interest periods like commencing from end of year 3 till end
of year 8.
The future worth „F‟ is occurring at end of year 4 (cash outflow), at end of year 6 (cash
inflow) and at the end of year 10 (cash inflow). F
F
0 1 2 3 4 5 6 7 8 9 10
P
F
A = Uniform annual worth
from EOY „1‟ till EOY „5”
Fig 1.6 Cash flow diagram showing P, F and A

While deriving the different compound interest factors, it is assumed that the interest is
compounded once per interest period i.e. discrete compounding. Further the cash flows
are assumed to be discrete i.e. they occur at the end of interest period.
Single payment compound amount factor (SPCAF)

The single payment compound amount factor is used to compute the future worth (F)
accumulated after “n” years from the known present worth (P) at a given interest rate ‘i’
per interest period. It is assumed that the interest period is in years and the interest is
compounded once per interest period.
The known present worth (P), unknown future worth (F) and the total interest period „n‟
years are shown in Fig. 1.7.
End of year F = unknown

(EOY)
0 1 2 3 4 5 n-4 n-3 n-2 n-1 n
P = known
Fig 1.7 Cash flow diagram for ‘known P’ and ‘unknown F’
The future worth (F1) accumulated at the end of year 1 i.e. 1st year is given by;
F1  P  P  i  P1  i  …………………………………. (1)
The future worth accumulated at the end of year 2 i.e. F2 will be equal to the amount that
was accumulated at the end of 1st year i.e. F1 plus the amount of interest accumulated
from end of 1st year to the end of 2nd year on F1 and is given by;
F2  F1  F1  i  F1 1  i  ……………………….. (2)
Putting the value of F1 from equation (1) in equation (2), the value of F2 is given by;
F2  F1 1  i   P1  i 1  i   P1  i 
2
………………………. (3)
Similarly, the future worth accumulated at the end of year 3 i.e. F3 is equal to the amount
that was accumulated at the end of 2nd year i.e. F2 plus the amount of interest
accumulated from end of 2nd year to the end of 3rd year on F2 and is given by;

F3  F2  F2  i  F2 1  i  ………… (4)
Putting the value of F2 from equation (3) in equation (4), the value of F3 is given by;
F3  F2 1  i   P1  i  1  i   P1  i  ………… (5)
2 3
Similarly, the future worth accumulated at the end of year 4 i.e. F4 is given by;
F4  F3 1  i   P1  i  1  i   P1  i  ………… (6)
3 4
Thus the generalized formula for the future worth at the end of „n‟ years is given by;
F  P1  i 
n
…………… (7)
The factor 1  i  in equation (7) is known as the single payment compound amount
n
factor (SPCAF). Thus if the value of „P‟ is known, one can easily calculate the future
worth F at the end of „n‟ years at interest rate of „i‟ (per year) by multiplying the present
worth with the single payment compound amount factor.

Lecture-4
Single payment present worth factor (SPPWF):

The single payment present worth factor is used to determine the present worth of a
known future worth (F) at the end of “n” years at a given interest rate ‘i’ per interest
period.
The present worth (P), future worth (F) and the total interest period „n‟ years are shown
in Fig. 1.8.
From equation (7), the expression for the present worth (P) can be written as follows;
 1 
P  F n 
………………… (8)
 1  i  
End of year F = known
(EOY)
0 1 2 3 4 5 n-4 n-3 n-2 n-1 n
P = unknown
Fig 1.8 Cash flow diagram for ‘known F’ and ‘unknown P’
The factor 1 / 1  i  in equation (8) is known as single payment present worth factor
n
(SPPWF). Thus if future worth (F) at the end of „n‟ years is known, the present worth (P)
at interest rate of „i‟ (per year) can be calculated by multiplying the future worth with the
single payment present worth factor.
Uniform series present worth factor (USPWF):

The uniform-series present worth factor is used to determine the present worth of a
known uniform series. Let „A‟ be the uniform annual amount at the end of each year,
beginning from end of year „1‟ till end of year „n‟.
The known „A‟, unknown „P‟, and the total interest period „n‟ years are shown in Fig.
1.9. This cash flow diagram refers to the case; if a person wants to get the known uniform
amount of return every year, how much he has to invest now.

The present worth (P) of the uniform series can be calculated by considering each „A‟ of
the uniform series as the future worth. Then by using the formula in equation (8), the
present worth of these future worth can be calculated and finally taking the sum of these
present worth values.
A = known
0 1 2 3 4 5 n-4 n-3 n-2 n-1 n
End of year (EOY)

P = unknown
Fig 1.9 Cash flow diagram for ‘known A’ and ‘unknown P’
The present worth (P) of the uniform series is given by;

A A A A A A A
P        
1  i  1  i  1  i  1  i 
2 3 4
1  i n2
1  i n 1
1  i n
………… (9)
 1 1 1 1 1 1 1 
P  A        
 1  i  1  i 
2
1  i  1  i 
3 4
1  i n2
1  i n 1
1  i n 
…….. (10)

P  A (1  i) 1  (1  i) 2  (1  i) 3  (1  i) 4            (1  i) ( n2)  (1  i) ( n1)  (1  i)  n 
.. (11)
The expression in the bracket is a geometric sequence with first term equal to (1+i)-1 and
common ratio equal to (1+i)-1. Then the present worth (P) is calculated by taking the sum
of the first „n‟ terms of the geometric sequence (at i ≠ 0) and is given by;
 1  (1  i)  n 
P  A(1  i) 1   ………………….. (12)
 1  (1  i) 1 

The simplification of equation (12) results in the following the expression;

 1  i n  1
P  A n 
………………………….. (13)
 i 1  i  
The factor within the bracket in equation (13) is known as uniform series present worth
factor (USPWF). Thus if the value of „A‟ in the uniform series is known, then the present
worth P at interest rate of „i‟ (per year) can be calculated by multiplying the uniform
annual amount „A‟ with uniform series compound amount factor.
The present worth (P) of a uniform annual series of known „A‟ can also be calculated in
the following manner;
Dividing both sides of equation (10) by (1+i) results in the following equation;
P  1 1 1 1 1 1 1 
 A        
1  i   1  i 
2
1  i  1  i  1  i 
3 4 5
1  i n 1
1  i  1  i n1 
n
… (14)
Subtracting equation (14) from equation (10) results in the following expression;
P  1 1 
P  A  n 1 
…………….. (15)
1  i   1  i  1  i  
Equation (14) can be rewritten as;
Pi  1 1 
 A  ………………...
1  i   1  i  1  i n1 
(16)
Multiplying both sides of equation (15) by (1+i)/i and further simplification results in the
following expression for the present worth „P‟;
 1  i n  1
P  A n 
 i1  i  
Capital recovery factor (CRF):
The capital recovery factor is generally used to find out the uniform annual amount „A‟
of a uniform series from the known present worth at a given interest rate ‘i’ per interest
period.

The cash flow diagram is shown in Fig. 1.10. This cash flow diagram indicates, if a
person invests a certain amount now, how much he will get as return by an equal amount
each year.
A = unknown
0 1 2 3 4 5 n-4 n-3 n-2 n-1 n
End of year (EOY)

P = known
Fig 1.10 Cash flow diagram for ‘known P’ and ‘unknown A’
From equation (12), the expression for the uniform annual amount (A) can be written as
follows;
 i1  i n 
A  P  ………………. (17)
 1  i   1
n
The factor within bracket in equation (17) is known as the capital recovery factor (CRF).
Thus the uniform annual amount „A‟ at interest rate of „i‟ (per year) can be determined by
multiplying the known present worth „P‟ with the capital recovery factor.
It may be noted here that the expressions for uniform series present worth factor and
capital recovery factor are derived with present worth „P‟ located one interest period
before the occurrence of first „A‟ of the uniform series.

Lecture-5
Uniform series compound amount factor:
The uniform series compound amount factor is used to determine the future sum (F) of a
known uniform annual series with uniform amount „A‟. The cash flow diagram is shown
in Fig. 1.11. This cash flow diagram states that, if a person invests a uniform amount at
the end of each year continued for „n‟ years at interest rate of „i‟ per year, how much he
will get at the end of „n‟ years.
Putting the value of present worth (P) from equation (8) in equation (13) results in the
following;
 1   1  i n  1
F n 
 A n 
………………….. (18)
 1  i    i1  i  
 1  i n  1
F  A  ………………………… (19)
 i 
End of year (EOY)

F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
A = known
Fig 1.11 Cash flow diagram for ‘known A’ and ‘unknown F’
The factor within bracket in equation (19) is known as uniform series compound amount
factor (USCAF). Hence the future worth „F‟ can be computed by multiplying the uniform
annual amount „A‟ with the uniform series compound amount factor.
Sinking fund factor:

The sinking fund factor is used to calculate the annual amount „A‟ of a uniform series
from the known future sum „F‟. The cash flow diagram is shown in Fig. 1.12. This cash
flow diagram indicates that, if a person wants to get a known future sum at the end of „n‟

years at interest rate of „i‟ per year, how much he has to invest every year by an equal
amount.
End of year (EOY)

F = known
1 2 3 4 5 n-4 n-3 n-2 n-1 n
A = unknown
Fig 1.12 Cash flow diagram for ‘known F’ and ‘unknown A’
From equation (19), the expression for the uniform annual amount (A) can be written as
follows;
 i 
A  F  …………………………….. (20)
 (1  i)  1
n
The factor within bracket in equation (20) is known as sinking fund factor (SFF). Thus
one can find out the annual amount „A‟ of a uniform series by multiplying the future
worth „F‟ with the sinking fund factor.
The derivation of expressions for both uniform series compound amount factor and
sinking fund factor is based on the fact that, the future sum „F‟ occurs at the same time as
the last „A‟ of the uniform series.
The compound interest factors with details are presented Table 1.3.

Table 1.3 Interest factors (Discrete compounding) with rate of interest ‘i’ (%) and number of interest periods ‘n’
Name of the
Abbreviation Functional Mathematical Given To find out
factor
representation expression (6)
(2) (3) (4) (5) = (4) x (5)
(1)
Single payment
compound SPCAF  F / P, i, n  1  i 
n
P F
amount factor
Single payment 1
present worth SPPWF  P / F , i, n  F P
1  i 
n
factor
Uniform series 1  i   1
n
present worth USPWF  P / A, i, n  A P

i 1  i 
n
factor
i 1  i 
n
Capital recovery
CRF  A / P, i, n  P A
1  i   1
n
factor
Uniform series
1  i  1
n
compound USCAF  F / A, i, n  A F
amount factor i
i
Sinking fund
SFF  A / F , i, n  F A
1  i  1
n
factor
Using this information, one can easily find out the required expenditure or income i.e.
may be „P‟, „F‟ or „A‟ from the know cash flows. For example if it is required to find out
the uniform annual amount „A‟ of a uniform series from the know value of present worth
i 1  i 
n
„P‟, then multiply the capital recovery factor (CRF) i.e. with „P‟ to get the
1  i  1
n
required uniform annual amount „A‟ (highlighted in the above table).
In addition, the use of functional representations of the compound interest factors

presented in this table can be used to find out the unknown amounts. For illustration, if it
is required to find out „A‟ from known „P‟, then expression for „A‟ can be written as
follows;
A 
A  P , i , n 
P 

Further the functional representation of a compound interest factor can be obtained by

multiplying the other relevant compound interest factors at a given rate of interest „i‟ and
number of interest periods „n‟ and is given as follows;
A  A  F 
 , i, n    , i, n    , i, n  ………………………………. (21)
P  F  P 

Lecture-6
Cash flow involving arithmetic gradient payments or receipts:
Some cash flows involve the payments or receipts in gradients by same amount. In other
words, the expenditure or the income increases or decreases by same amount. The cash
flow involving such payments or receipts is known as uniform gradient series. For
example, if the cost of repair and maintenance of a piece of equipment increases by same
amount every year till end of its useful life, it represents a cash flow involving positive
uniform gradient. Similarly if the profit obtained from an investment decreases by an
equal amount every year for a certain number of years, it indicates a cash flow involving
negative uniform gradient. The cash flow diagrams for positive gradient and negative
gradient are shown in Fig. 1.3 and Fig. 1.4 respectively.
End of year (EOY)
0 1 2 3 4 5 6 7 8 9 10
0
0
5000* 6000 7000 8000 9000 10000

11000
12000 13000
14000
* Amount in Rupees.
A positive gradient of Rs.1000.
Fig 1.13 Cash flow diagram involving a positive uniform gradient
End of year (EOY)
0 1 2 3 4 5 6 7 8 9 10
0
0
16000 14000 12000

20000 18000
26000 24000 22000
30000* 28000
* Amount in Rupees.
A negative gradient of Rs.2000.
Fig 1.14 Cash flow diagram involving a negative uniform gradient

The present worth, future worth and the equivalent uniform annual worth of the uniform
gradient can be derived using the compound interest factors. The generalized cash flow
diagram involving a positive uniform gradient with base value „B‟ and the gradient „G‟ is
shown in Fig. 1.15a. The cash flow shown in Fig. 1.15a can be split into two cash flows;
one having the uniform series with amount „B‟ and the other having the gradient series
with values in multiples of gradient amount „G‟ and is shown in Fig. 1.15b. This gradient
series is also know as the arithmetic gradient series as the expense or the income
increases by the uniform arithmetic amount „G‟ every year.
End of year (EOY)
F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
B B+G B+2G B+3G B+4G

B+ B+
(n-5)G (n-4)G B+ B+
(n-3)G (n-2)G B+
(n-1)G
Fig 1.15a Generalized Cash flow diagram involving a positive uniform gradient
with ‘unknown F’
End of year (EOY)

=
F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
B
End of year (EOY) +
F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
0
G 2G 3G 4G
(n-5)G (n-4)G
(n-3)G (n-2)G
(n-1)G
Fig 1.15b Cash flow diagram (positive uniform gradient) for ‘unknown F’

The future worth of the cash flow shown in Fig. 1.15a can be obtained by finding the out
the individual future worth of the cash flows shown in Fig. 1.15b and then taking their
sum. As already stated, the future worth of the cash flow involving an uniform series can
be determined by multiplying the uniform annual amount „B‟ with the uniform series
compound amount factor. The future worth (F) of the gradient series shown in Fig 1.15b
can be determined by finding out the individual future worth of the gradient values (i.e. in
multiples of gradient amount „G‟) at the end of different years at interest rate of „i‟ per
year and then taking the sum of these individual futures values. Then „F‟ is given as
follows;
 n2 n 3 n4
G(1  i)  2G(1  i)  3G(1  i)  4G(1  i)        
n 5


F   …….

                 (n  4)G(1  i)  (n  3)G(1  i)  (n  2)G(1  i)  (n  1)G 
3 2

(22)
Dividing both sides of equation (22) by (1+i)n results in the following equation;
 1 2 3 4 
 1  i 2  1  i 3  1  i 4  1  i 5                  
F  
 G …
1  i n   
n4

n3

n2

n 1 

 1  i n3 1  i n2 1  i n1 (1  i) n 
…. (23)
Multiplying both sides of equation (23) by (1+i) results in the following expression;
 1 2 3 4 
 1  i   1  i 2  1  i 3  1  i 4                      
F (1  i )  
 G 
1  i n
  
n4

n3

n2

n 1 

 1  i n4 1  i n3 1  i n2 (1  i) n1 
….….. (24)
Subtracting equation (23) from equation (24) results in the following expression;
 1 1 1 1 
      
 (1  i )  1  1  i  1  i  1  i  1  i 
2 3 4

F n 
 G  
 1  i      1

1

1

1

1

n 

 1  i n4 1  i n3 1  i n2 (1  i) n1 (1  i) n (1  i) n 
... (25)

The equation (25) can be rewritten as follows;

 1 1 1 1 
      
 i   1  i  1  i  1  i  1  i 
2 3 4
 nG
F n 
 G  
 1  i          1

1

1

1

1  (1  i) n

 1  i n4 1  i n3 1  i n2 (1  i) n1 (1  i) n 
….. (26)
The expression in the bracket is a geometric sequence with first term equal to 1/(1+i) and
common ratio equal to 1/(1+i). Thus equation (26) is rewritten by taking sum of the first
„n‟ terms of the geometric sequence (at i ≠ 0) and is given by;
 1 
 1 
 i  1 (1  i ) n nG
F n 
G    ……………………….. (27)
 1  i    (1  i ) 1  1  (1  i )
n
 (1  i ) 
The expression for future worth „F‟ can be written as follows:

 (1  i ) n  1 n 
F  G   ……………………………….…….. (28)
 i2 i
The expression in the bracket is known as the uniform gradient future worth factor
(UGFWF). With functional representation equation (28) can be rewritten as follows;
F 
F  G , i, n 
G 
Thus the functional representation of uniform gradient future worth factor (UGFWF) can
be written as follows;
F   (1  i)  1 n 
n
 , i, n      ……………… (29)
G   i2 i
It may be noted here that the future worth „F‟ occurs in the same year as that of the last
gradient amount. Further the functional representations of other gradient factors can be
found out by multiplying the relevant gradient factor with the compound interest factor at
the given rate of interest „i‟ per interest period and number of interest periods „n‟.

Lecture-7
Arithmetic gradient:
The present worth factor of a uniform gradient series (i.e. arithmetic gradient series) with
values in multiples of gradient amount „G‟ can be obtained by multiplying the uniform
gradient future worth factor (UGFWF) with the single payment present worth factor
(SPPWF) and the functional representation is given as follows
P  F  P 
 , i, n    , i, n    , i, n  ……………… (30)
G  G  F 
P 
 , i, n  is known as the uniform gradient present worth factor (UGPWF).
G 
Now putting the expressions for uniform gradient future worth factor (UGFWF) and
single payment present worth factor (SPPWF) in equation (30) results in the following
expressions;
P   (1  i)  1 n   1 
n
 , i , n 
     …………. (31)
G   i2 i   (1  i) n 
On further simplification results in the following equation;
P  1  (1  i) n  1 
 , i, n     n …………….. (32)
G  i(1  i)
n
 i 
Thus the expression of the present worth „P‟ can be written as follows
P 
P  G  , i, n 
G 
The cash flow diagram is shown in Fig. 1.16. It may be noted here that the gradient starts
at the end of year „2‟ whereas the present worth occurs at the beginning i.e. in year 0.

End of year (EOY)

P = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
0
G 2G 3G 4G
(n-5)G (n-4)G
(n-3)G (n-2)G
(n-1)G
Fig. 1.16 Cash flow diagram involving a uniform gradient with ‘unknown P’
Similarly the annual worth factor of a uniform gradient series can be obtained by
multiplying the uniform gradient future worth factor (UGFWF) with the sinking fund
factor (SFF) and the functional representation is presented as follows;
A  F  A 
 , i, n    , i, n    , i, n  ……………… (33)
G  G  F 
A 
 , i, n  is known as the uniform gradient annual worth factor (UGAWF).
G 
Thus the expression for the uniform gradient annual worth factor is obtained by putting
the expressions for uniform gradient future worth factor (UGFWF) and sinking fund
factor (SFF) in equation (33) and is given as follows;
A   (1  i)  1 n   
n
i
 , i, n       ………… (34)
G   i 2
i   (1  i)  1
n
A  1 n 
 , i, n      ……………………. (35)
G   i (1  i)  1
n
The expression of the equivalent uniform annual worth „A‟ of the uniform gradient series
can be written as follows;
A 
A  G  , i, n 
G 
The cash flow diagram is shown in Fig. 1.17. It may be noted here that, the equivalent
uniform annual worth „A‟ occurs from end of year „1‟ to end of year „n‟ whereas the
gradient starts at the end of year „2‟.

End of year (EOY) A = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n

0
G 2G 3G 4G
(n-5)G (n-4)G
(n-3)G (n-2)G
(n-1)G
Fig. 1.17 Cash flow diagram involving a uniform gradient with ‘unknown A’
Now one cane easily find out the present worth, future worth and equivalent uniform
annual worth of the cash flow shown in Fig. 1.15a (a positive uniform gradient with base
value „B‟ and the gradient „G‟) by taking the sum of the corresponding values from the
uniform series with uniform annual amount „B‟ i.e. base value and the gradient series
with values in multiples of gradient amount „G‟. Similarly the present worth, future worth
and equivalent uniform annual worth of a cash flow involving a negative uniform
gradient can be calculated by subtracting the corresponding values of the gradient series
(with values in multiples of gradient amount „G‟) from the uniform series with uniform
annual amount „B‟ i.e. base value as shown Fig. 1.18a and Fig. 1.18b.

End of year (EOY)

F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
B- B-
B- B- (n-1)G
B- (n-2)G
B-3G B-4G (n-5)G (n-4)G (n-3)G
B-G B-2G
B
Fig 1.18a Generalized Cash flow diagram involving a negative uniform gradient
with ‘unknown F’
End of year (EOY) = F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
B
-
End of year (EOY)
F = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
0
G 2G 3G 4G
(n-5)G (n-4)G
(n-3)G (n-2)G
(n-1)G
Fig 1.18b Cash flow diagram (negative uniform gradient) for ‘unknown F’

Lecture-8
Cash flow involving geometric gradient series:
Sometimes the cash flows may have expenses or incomes being increased by a constant
percentage in the successive time periods i.e. in successive years. Such kind of cash flow
is known as geometric gradient series. The generalized cash flow diagram involving
geometric gradient series with expense or receipt „C‟ at the end of year „1” and geometric
percentage increase „g‟ is shown in Fig. 1.19.
End of year (EOY)
P = unknown
1 2 3 4 5 n-4 n-3 n-2 n-1 n
C C(1+g) C(1+g)2
C(1+g)3
C(1+g)4
C(1+g)n-5
C(1+g)n-4 C(1+g)n-3
C(1+g)n-2 C(1+g)n-1
Fig 1.19 Cash flow diagram involving geometric gradient with ‘unknown P’
The present worth (P) of the geometric gradient series can be calculated by considering
each amount as the future worth and then taking sum of these present worth values.
 C C 1  g  C 1  g  C 1  g  C 1  g  C 1  g  C 1  g  
2 3 n 3 n2 n 1
P                 
 1  i  1  i  1  i 3 1  i 4 1  i n2 1  i n1 1  i n 
2
…………. (36)
Equation (36) can be rewritten as follows;
 1
P  C 
1  g  1  g 

2

1 g
3
  
1 g
n 3

1 g
n2

1 g 
n 1

 1  i  1  i  1  i 3 1  i 4 1  i n2 1  i n1 1  i n 
2
……….… (37)
Dividing both sides of the equation (37) by (1+i) results in the following expression;

P  1
 C 
1  g   1  g 2  1  g 3            1  g n3  1  g n2  1  g n1 

1  i   1  i 2 1  i 3 1  i 4 1  i 5 1  i n1 1  i n 1  i n1 
……….… (38)
Now multiplying both sides of equation (38) by (1+g) results in the following expression;
P1  g   1  g  1  g 2 1  g 3 1  g 4 1 g 1 g 1 g 

n2 n 1 n
 C         
1  i   1  i 
2
1  i 3 1  i 4 1  i 5 1  i n1 1  i n 1  i n1 
……….… (39)
Subtracting equation (37) from equation (39) results in the following;
P g  i   1  g n 1 
 C  …………………. (40)
1  i   1  i 
n 1
1  i 
Equation (40) can be rewritten as follows;
 1  g n 
C  1
1  i  n
P   …………….. (41)
g  i 
The expression in equation (41) is valid when g  i. When „g‟ is equal to „i‟ then right
0
hand side of the equation (41) takes the indeterminate form of . In this case the
0
expression for the present worth „P‟ can be obtained by applying L‟Hospital‟s rule as
follows;
  1  g n 
d C   1
 1  g   Cn 1  g 
n 1
 
n

n
C  
 
 1 i 
1 
 1  i  1 i
n n
 dg Cn
lim  lim  lim  …….. (42)
g i  g  i g i d  g  i   g i 1 1  i 
dg
Then the expression for the present worth „P‟ is given as follows;
Cn
P ………………………………………………………. (43)
1  i 

Similarly the future worth and equivalent uniform annual worth of the geometric gradient
series can be obtained by multiplying its present worth „P‟ with the compound interest
factors namely single payment compound amount factor (SPCAF) and capital recovery
factor (CRF) respectively at the given rate of interest „i‟ per interest period and the
number of interest periods.
Now using the above expressions, one can easily calculate the present worth, future
worth and equivalent uniform annual worth of the cash flow involving either expenditure
or income or both increasing in the form of geometric gradient.
It may be noted here that the expressions for compound interest factors can also be
obtained by using beginning of year (interest period) convention.
The values of discrete compound interest factors at different values of interest rate and
interest period can be calculated by using the expressions of these factors as mentioned
earlier and the interest tables can thus be generated. The interest tables are available in
the relevant texts (cited in the list of references for this course). The values of different
discrete compound interest factors from these interest tables can directly be used in the
engineering economy calculations.
The use of different compound interest factors discussed so far will be illustrated by
solving various examples for comparison of different alternatives in Module 2. Further
the use of discrete compound interest factors from interest tables will also be illustrated in
Module 2.

Module 2
Lecture-1
Comparison 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.

Comparison of alternatives by present worth method:

In the present worth method for comparison of mutually exclusive alternatives, the future
amounts i.e. expenditures and incomes occurring at future periods of time are converted
into equivalent present worth values at a certain rate of interest per interest period and are
added to present worth occurring at „0‟ time. The converted equivalent present worth
values are always less than the respective future amounts since the rate of interest is
normally greater than zero. The cash flow of the mutually exclusive alternatives may
consist of future expenditures and incomes in different forms namely randomly placed
single amounts, uniform amount series commencing from end of year 1, randomly placed
uniform amount series i.e. commencing at time period other than end of year 1, positive
and negative uniform gradient series starting either from end of year 1 or at different time
periods and geometric gradient series etc. The different compound interest factors namely
single payment present worth factor, uniform series present worth factor and present
worth factors for arithmetic and geometric gradient series etc. will be used to convert the
respective future amounts to the equivalent present worth values for different alternatives.
The methodology for the comparison of mutually exclusive alternatives by the present
worth method depends upon the magnitude of useful lives of the alternatives. There are
two cases; a) the useful lives of alternatives are equal and b) the useful lives of
alternatives are not equal. The alternatives having equal useful lives are designated as
equal life span alternatives whereas the alternatives having unequal life spans are referred
as different life span alternatives.
a) Equal life span alternatives

The comparison of mutually exclusive alternatives having equal life spans by present
worth method is comparatively simpler than those having different life spans. In case of
equal life span mutually exclusive alternatives, the future amounts as already stated are
converted into the equivalent present worth values and are added to the present worth
occurring at time zero. Then the alternative that exhibits maximum positive equivalent
present worth or minimum negative equivalent present worth is selected from the
considered feasible alternatives.

a) Different life span alternatives

In case of mutually exclusive alternatives, those have different life spans, the comparison
is generally made over the same number of years i.e. a common study period. This is
because; the comparison of the mutually exclusive alternatives over same period of time
is required for unbiased economic evaluation of the alternatives. If the comparison of the
alternatives is not made over the same life span, then the cost alternative having shorter
life span will result in lower equivalent present worth i.e. lower cost than the cost
alternative having longer life span. Because in this case, the cost of the short span
alternative is considered only for a shorter period of time, even though this alternative
may not be economical. In case of mutually exclusive investment alternatives, the
alternative with longer life span will result in higher equivalent present worth i.e. higher
positive equivalent worth, as the costs, revenues, savings through reduced costs is
considered over a longer period of time than the alternative with shorter life span. Thus in
order to minimize the effect of such kind of discrepancy on the selection of best
alternative from the considered feasible alternatives, the comparison is made over the
same life span.
The two approaches used for economic comparison of different life span alternatives are
as follows;
i) Comparison of mutually exclusive alternatives over a time period that is equal to least
common multiple (LCM) of the individual life spans
ii) Comparison of mutually exclusive alternatives over a study period which is not
necessarily equal to the life span of any of the alternatives.
In the first approach the comparison is made over a time period equal to the least
common multiple of the life spans of mutually exclusive alternatives. The cash flow of
the alternatives i.e. cash flow of the first cycle is repeated and the number of repetitions
depends upon the value of least common multiple of life spans between the mutually
exclusive alternatives. It may be noted here that the cash flow i.e. all the costs and
revenues of the alternatives in the successive cycle will be exactly same as that in the first
cycle. For example if there are two alternatives with useful lives of 4 years and 5 years.

Then the alternatives will compared over a period of 20 years (least common multiple of
life spans) at the given rate of interest per year. Thus the cash flow of the alternative
having the life span of 4 years will be repeated 5 times including the first cycle whereas
the cash flow of the alternative with life span of 5 years will be repeated 4 times
including the first cycle. After that the most economical alternative will be selected.
Taking another example, there are two alternatives with life spans of 5 years and 10
years. In this case the alternatives will be compared over a period of 10 years (LCM).
Thus the alternative with life span of 5 years will be analyzed for 2 cycles whereas the
alternative with 10 year life span will be analyzed for one cycle only at the given rate of
interest per year.
In the second approach, a study period is selected over which the economic comparison
of mutually exclusive alternatives is carried out. The length of the study period will
depend on the overall benefit of the project i.e. it may be shorter or longer (as compared
to useful lives of the individual alternatives) depending upon the short-term or long-term
benefits as desired for the project. Thus the cash flows of the alternatives occurring
during the study period are only considered for the economic comparison. However if
any alternative possesses salvage value at the end of its useful life and that occurs after
the study period, then its equivalent value must be included in the economic analysis. The
values of equivalent present worth of the mutually exclusive alternatives are calculated
over the selected study period and the alternative showing maximum positive equivalent
present worth or minimum negative equivalent present worth is selected.

Lecture-2
Comparison by present worth method:-
Now some examples showing the use of present worth method for comparison of
mutually exclusive alternatives are presented. First the comparison of equal life span
mutually exclusive alternatives by present worth method will be illustrated followed by
comparison of different life span alternatives. The following examples are formulated
only to demonstrate the use of different methods for comparison of alternatives. The
values of different cost and incomes mentioned in the examples are not the actual ones
pertaining to a particular item. In addition it may also be noted here that the cash flow
diagrams have been drawn not to the scale. These are merely graphical representations.
Example -1
There are two alternatives for purchasing a concrete mixer. Both the alternatives have
same useful life. The cash flow details of alternatives are as follows;
Alternative-1: Initial purchase cost = Rs.3,00,000, Annual operating and maintenance
cost = Rs.20,000, Expected salvage value = Rs.1,25,000, Useful life = 5 years.
Alternative-2: Initial purchase cost = Rs.2,00,000, Annual operating and maintenance
cost = Rs.35,000, Expected salvage value = Rs.70,000, Useful life = 5 years.
Using present worth method, find out which alternative should be selected, if the rate of
interest is 10% per year.
Solution:
Since both alternatives have the same life span i.e. 5years, the present worth of the
alternatives will be compared over a period of 5 years. The cash flow diagram of
Alternative-1 is shown in Fig. 2.1.
As already mentioned Module-1, the cash outflows i.e. costs or expenditures are
represented by vertically downward arrows whereas the cash inflows i.e. revenue or
income are represented by vertically upward arrows. The same convention is adopted
here.

Income Rs.1,25,000
0 1 2 3 4 5
Time (Year)
Expenditure
Rs.3,00,000
Rs.20,000
Fig. 2.1 Cash flow diagram of Alternative-1
The equivalent present worth of Alternative-1 i.e. PW1 is calculated as follows;

The initial cost, P = Rs.3,00,000 (cash outflow),
Annual operating and maintenance cost, A = Rs.20,000 (cash outflow),
Salvage value, F = Rs.1,25,000 (cash inflow).
PW1 = - 3,00,000 – 20,000(P/A, i, n) + 1,25,000(P/F, i, n)
PW1 = - 3,00,000 – 20,000(P/A, 10%, 5) + 1,25,000(P/F, 10%, 5)
Now putting the mathematical expressions of different compound interest factors (as
mentioned in Module-1) in the above expression for PW1 (in Rs.) results in the following;
PW1   3,00,000  20,000 

1  i n  1  1,25,000  1
i1  i  1  i n
n
PW1   3,00,000  20,000 

1  0.15  1  1,25,000  1
0.11  0.1 1  0.15
5
PW1   3,00,000  20,000  3.7908  1,25,000  0.6209

PW1 = - 3,00,000 -75,816 + 77,613
PW1 = - Rs.2,98,203

The cash flow diagram of Alternative-2 is shown in Fig. 2.2.
Rs.70,000
0 1 2 3 4 5
Time (Year)
Rs.2,00,000
Rs.35,000
Now the equivalent present worth of Alternative-2 i.e. PW2 (in Rs.) is calculated as
follows;
The initial cost, P = Rs.2,00,000 (cash outflow),
Annual operating and maintenance cost, A = Rs.35,000 (cash outflow),
Salvage value, F = Rs.70,000 (cash inflow).
PW2 = - 2,00,000 – 35,000(P/A, i, n) + 70,000(P/F, i, n)
PW2 = - 2,00,000 – 35,000(P/A, 10%, 5) + 70,000(P/F, 10%, 5)
PW2   2,00,000  35,000 

1  i n  1  70,000  1
i1  i  1  i n
n
PW2   2,00,000  35,000 

1  0.15  1  70,000  1
0.11  0.1 1  0.15
5
PW2   2,00,000  35,000  3.7908  70,000  0.6209

PW2 = - 2,00,000 – 1,32,678 + 43,463
PW2 = - Rs.2,89,215
Comparing the equivalent present worth of both the alternatives, it is observed that
Alternative-2 will be selected as it shows lower negative equivalent present worth
compared to Alternative-1 at the interest rate of 10% per year.
The equivalent present worth of both the alternatives can also be calculated by using the
values of compound interest factors from interest tables. The equivalent present worth of
Alternative-1 i.e. PW1 is calculated as follows;
PW1 = - 3,00,000 – 20,000(P/A, i, n) + 1,25,000(P/F, i, n)

PW1 = - 3,00,000 – 20,000(P/A, 10%, 5) + 1,25,000(P/F, 10%, 5)

The values of compound interest factors i.e. (P/A, i, n) and (P/F, i, n) can be obntained
from the interest tables (discrete compounding) available in texts cited in the list of
references [1, 7, 14]. Now referring to the interest table for 10% interest rate, the values
of compound interest factors i.e. (P/A, 10%, 5) and (P/F, 10%, 5) at interest rate („i’ ) of
10% and for interest period („n’) of 5 years are obtained at the intersection of these
factors and interest period „n‟ equal to 5 i.e. the values are obtained from P/A column and
P/F column at „n‟ equal to 5 from the interest table (discrete compounding)
corresponding to 10% interest rate. The obtained values of (P/A, 10%, 5) and (P/F, 10%,
5) are 3.7908 and 0.6209 respectively (same as those obtained using mathematical
expressions of these factors).
Now putting the values of compound interest factors in the above expression, the
equivalent present worth of Alternative-1 i.e. PW1 is calculated as follows;
PW1   3,00,000  20,000  3.7908  1,25,000  0.6209
PW1 = - 3,00,000 -75,816 + 77,613
PW1 = - Rs.2,98,203
Now the calculation of equivalent present worth of Alternative-2 i.e. PW2 (in Rs.) is
presented below.
PW2 = - 2,00,000 – 35,000(P/A, i, n) + 70,000(P/F, i, n)
PW2 = - 2,00,000 – 35,000(P/A, 10%, 5) + 70,000(P/F, 10%, 5)
Now putting the values of compound interest factors in the above expression (same as
above) the equivalent present worth of Alternative-2 i.e. PW2 is calculated as follows;
PW2   2,00,000  35,000  3.7908  70,000  0.6209
PW2 = - 2,00,000 – 1,32,678 + 43,463
PW2 = - Rs.2,89,215
It may be noted that in the above example only cost components and the salvage value of
the alternatives were considered for comparison. In the next example, same problem as
mentioned in Example-1 will be discussed by taking into account the annual revenues of
the alternatives.

Example -2
Alternative-1: Initial purchase cost = Rs.300000, Annual operating and maintenance cost
= Rs.20000, Expected salvage value = Rs.125000, 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 present worth of the alternatives at the same rate of interest as in Example-
1 i.e. 10% per year and find out the economical alternative.
Solution:
Rs.125000
Rs.50000
0 1 2 3 4 5
Time (Year)
300000
Rs.20000
The equivalent present worth of Alternative-1 is calculated as follows;

PW1 = - 300000 - 20000(P/A, i, n) + 50000(P/A, i, n) + 125000(P/F, i, n)
PW1 = - 300000 - 20000(P/A, 10%, 5) + 50000(P/A, 10%, 5) + 125000(P/F, 10%, 5)
PW1 = - 300000 + (50000 – 20000) (P/A, 10%, 5) + 125000(P/F, 10%, 5)
PW1 = - 300000 + 30000(P/A, 10%, 5) + 125000(P/F, 10%, 5)
PW1   300000  30000 

1  i n  1  125000  1
i1  i  1  i n
n
PW1   300000  30000 

1  0.15  1  125000  1
0.11  0.1 1  0.15
5
PW1   300000  30000  3.7908  125000  0.6209

PW1 = - 300000 + 113724 + 77613

PW1 = - Rs.108663
Rs.70000
Rs.45000
0
0 1 2 3 4 5
Time (Year)
200000
Rs.35000
Now the equivalent present worth of Alternative-2 i.e. PW2 (in Rs.) is calculated as
follows;
PW2 = - 200000 - 35000(P/A, i, n) + 45000(P/A, i, n) + 70000(P/F, i, n)
PW2 = - 200000 - 35000(P/A, 10%, 5) + 45000(P/A, 10%, 5) + 70000(P/F, 10%, 5)
PW2 = - 200000 + (45000 – 35000) (P/A, 10%, 5) + 70000(P/F, 10%, 5)
PW2 = - 200000 + 10000(P/A, 10%, 5) + 70000(P/F, 10%, 5)
PW2   200000  10000 

1  i n  1  70000  1
i1  i  1  i n
n
PW2   200000  10000 

1  0.15  1  70000  1
0.11  0.1 1  0.15
5
PW2   200000 10000  3.7908  70000  0.6209

PW2 = - 200000 + 37908 + 43463
PW2 = - Rs.118629
Comparing the equivalent present worth of the both the alternatives, it is observed that
Alternative-1 will be selected as it shows lower cost compared to Alternative-2. The
annual revenue to be generated by the alternatives made the difference as compared to the
outcome obtained in Example-1.

When there are more than two alternatives for the selection of the best economical
alternative by present worth method, the same procedure as mentioned earlier for the case
of two alternatives is followed and illustrated in the next example.
Example -3
A construction contractor has three options to purchase a dump truck for transportation
and dumping of soil at a construction site. All the alternatives have the same useful life.
The cash flow details of all the alternatives are provided as follows;
Option-1: Initial purchase price = Rs.2500000, Annual operating cost Rs.45000 at the
end of 1st year and increasing by Rs.3000 in the subsequent years till the end of useful
life, Annual income = Rs.120000, Salvage value = Rs.550000, Useful life = 10 years.
Option-2: Initial purchase price = Rs.3000000, Annual operating cost = Rs.30000,

Annual income Rs.150000 for first three years and increasing by Rs.5000 in the
subsequent years till the end of useful life, Salvage value = Rs.800000, Useful life = 10
years.
Option-3: Initial purchase price = Rs.2700000, Annual operating cost Rs.35000 for first
5 years and increasing by Rs.2000 in the successive years till the end of useful life,
Annual income = Rs.140000, Expected salvage value = Rs.650000, Useful life = 10
years.
Using present worth method, find out which alternative should be selected, if the rate of
Solution:
The cash flow diagram of Option-1 is shown in Fig. 2.5.

Rs.120000 Rs.550000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.45000
Rs.48000
Rs.2500000 Rs.51000
Rs.54000
Rs.57000
Rs.60000
Rs.63000
Rs.66000
Rs.69000
Rs.72000
Fig. 2.5 Cash flow diagram of Option-1
For Option-1, the annual operating cost is in the form of a positive uniform gradient
series with gradient starting from end of year „2‟. The operating cost at the end of
different years can be split into the uniform base amount of Rs.45000 and the gradient
amount in multiples of Rs.3000 as shown in Fig. 2.6.
Rs.120000 Rs.550000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.3000
Rs.2500000 Rs.6000
Rs.9000
Rs.12000
Uniform amount Rs.15000
Rs.45000
Rs.18000
Rs.21000
Rs.24000
Rs.27000
with annual operating cost split into uniform base amount and gradient amount
The present worth of the uniform gradient series will be located at the beginning i.e. in
year „0‟ i.e. 2 years before the commencement of the uniform gradient.

Now the equivalent present worth (in Rs.) of Option-1 is calculated as follows;
PW1 = - 2500000 - 45000(P/A, i, n) - 3000(P/G, i, n) + 120000(P/A, i, n) + 550000(P/F,
i, n)
PW1 = - 2500000 - 45000(P/A, 8%, 10) - 3000(P/G, 8%, 10) + 120000(P/A, 8%, 10) +
550000(P/F, 8%, 10)
PW1 = - 2500000 + (120000 - 45000) (P/A, 8%, 10) - 3000(P/G, 8%, 10) + 550000(P/F,
8%, 10)
Now putting the values of different compound interest factors (the expressions in terms
of ‘i’ and ‘n’ already stated in Module-1) in the above expression for PW1 results in the
following;
PW1   2500000  75000  6.7101 3000  25.9768  550000  0.4632
PW1 = - 2500000 + 503258 - 77930 + 254760
PW1 = - Rs.1819912
Rs.800000
Rs.185000
Rs.180000
Rs.175000
Rs.170000
Rs.150000 Rs.165000
Rs.160000
Rs.155000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.3000000
Rs.30000

For Option-2, the annual income is in the form of a positive uniform gradient series with
gradient starting from end of year „4‟. The annual income can be split into the uniform
base amount of Rs.150000 and the gradient amount in multiples of Rs.5000 starting from
end of year „4‟ and is shown in Fig. 2.8.
Rs.800000
Rs.35000
Rs.30000
Rs.25000
Rs.150000
Rs.15000
Pg Rs.10000
Rs.5000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.3000000
Rs.30000
Fig. 2.8 Cash flow diagram of Option-2 with
annual income split into uniform base amount and gradient amount
The equivalent present worth of the gradient series (of the annual income) starting from
end of year „4‟ will be located at the end of year „2‟ i.e. 2 years before the start of the
gradient. Further the present worth of this amount at beginning i.e. at time „0‟ will be
obtained by multiplying the equivalent present worth „Pg’ (shown in Fig. 2.8) at the end
of year „2‟ (which is a future amount) with the single payment present worth factor (P/F,
i, n).
Now the equivalent present worth (in Rs.) of Option-2 is determined as follows;
PW2 = - 3000000 - 30000(P/A, 8%, 10) + 150000(P/A, 8%, 10) + Pg (P/F, 8%, 2) +
800000(P/F, 8%, 10)
Now in the above expression, Pg will be replaced by G (P/G, i, n) i.e. 5000(P/G, 8%, 8).

PW2 = - 3000000 - 30000(P/A, 8%, 10) + 150000(P/A, 8%, 10) + 5000(P/G, 8%, 8) (P/F,
8%, 2) + 800000(P/F, 8%, 10)
PW2 = - 3000000 + (150000 - 30000) (P/A, 8%, 10) + 5000(P/G, 8%, 8) (P/F, 8%, 2) +
800000(P/F, 8%, 10)
Now putting the values of different compound interest factors in the above expression for
PW2 results in the following;
PW2   3000000 120000  6.7101 5000 17.8061  0.8573  800000  0.4632
PW2 = - 3000000 + 805212 + 76326 + 370560
PW2 = - Rs.1747902
Rs.140000 Rs.650000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.37000
Rs.2700000 Rs.39000
Rs.35000 Rs.41000
Rs.43000
Rs.45000
For Option-3, the annual operating cost is in the form of a positive uniform gradient
series with gradient starting from end of year „6‟. The annual operating cost can thus be
split into the uniform base amount of Rs.35000 and the gradient amount in multiples of
Rs.2000 starting from end of year „6‟ (shown in Fig. 2.10).
The equivalent present worth of the gradient series for the annual operating cost starting
from end of year „6‟ will be located at the end of year „4‟. Further the present worth of
this amount at time „0‟ will be determined by multiplying the equivalent present worth
„Pg’ (shown in Fig. 2.10) at the end of year „4‟ with the single payment present worth
factor (P/F, i, n).

Rs.140000 Rs.650000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.2700000 Rs.2000
Pg Rs.4000
Rs.6000
Rs.35000
Rs.10000
Fig. 2.10 Cash flow diagram of Option-3 with

annual operating cost split into uniform base amount and gradient amount
The equivalent present worth (in Rs.) of Option-3 is obtained as follows;

PW3 = - 2700000 - 35000(P/A, 8%, 10) - Pg (P/F, 8%, 4) + 140000(P/A, 8%, 10) +
650000(P/F, 8%, 10)
Now in the above expression, Pg will be replaced by G (P/G, i, n) i.e. 2000(P/G, 8%, 6).
PW3 = - 2700000 - 35000(P/A, 8%, 10) - 2000(P/G, 8%, 6) (P/F, 8%, 4) + 140000(P/A,
8%, 10) + 650000(P/F, 8%, 10)
PW3 = - 2700000 + (140000 - 35000) (P/A, 8%, 10) - 2000(P/G, 8%, 6) (P/F, 8%, 4) +
650000(P/F, 8%, 10)
Now putting the values of different compound interest factors in the above expression,
the value of PW3 is given by;
PW3   2700000 105000  6.7101 2000 10.5233  0.7350  650000  0.4632
PW3 = - 2700000 + 704561 - 15469 + 301080
PW3 = - Rs.1709828
From the comparison of equivalent present worth of all the three mutually exclusive
alternatives, it is observed that Option-3 shows lowest negative equivalent present worth
as compared to other options. Thus Option-3 will be selected for the purchase of the
dump truck.

Lecture-3
Comparison by present worth method:-
After the illustration of comparison of equal life span mutually exclusive alternatives,
now some examples illustrating the use of present worth method for comparison of
different life span mutually exclusive alternatives are presented.
Example -4
A material testing laboratory has two alternatives for purchasing a compression testing
machine which will be used for determining the compressive strength of different
construction materials. The alternatives are from two different manufacturing companies.
The cash flow details of the alternatives are as follows;
Alternative-1: Initial purchase price = Rs.1000000, Annual operating cost = Rs.10000,
Expected annual income to be generated from testing of different construction materials =
Rs.175000, Expected salvage value = Rs.200000, Useful life = 10 years.
Using present worth method, find out the most economical alternative at the interest rate
of 10% per year.
Solution:
The alternatives have different life spans i.e. 10 years and 5 years. Thus the comparison
will be made over a time period equal to the least common multiple of the life spans of
the alternatives. In this case the least common multiple of the life spans is 10 years. Thus
the cash flow of Alternative-1 will be analyzed for one cycle (duration of 10 years)
whereas the cash flow of Alternative-2 will be analyzed for two cycles (duration of 5
years for each cycle). The cash flow of the Alternative-2 for the second cycle will be
exactly same as that in the first cycle.


Rs.175000 Rs.200000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.1000000
Rs.10000
The equivalent present worth PW1 (in Rs.) of Alternative-1 is calculated as follows;
PW1 = - 1000000 - 10000(P/A, i, n) + 175000(P/A, i, n) + 200000(P/F, i, n)
PW1 = - 1000000 - 10000(P/A, 10%, 10) + 175000(P/A, 10%, 10) + 200000(P/F, 10%,
10)
PW1 = - 1000000 + (175000 - 10000) (P/A, 10%, 10) + 200000(P/F, 10%, 10)
Putting the values of different compound interest factors in the above expression for PW1;
PW1   1000000 165000  6.1446  200000  0.3855
PW1 = - 1000000 + 1013859 + 77100
PW1 = Rs.90959
The cash flow diagram of Alternative-2 is shown in Fig. 2.12. As the least common
multiple of the life spans of the alternatives is 10 years, the cash flow of Alternative-2 is
shown for two cycles with each cycle of duration 5 years.

Rs.165000
Rs.250000
Rs.250000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.700000
Rs.700000
Rs.15000
First Cycle Second Cycle
Fig. 2.12 Cash flow diagram of Alternative-2 for two cycles
In the cash flow diagram of Alternative-2, the initial purchase price of Rs.700000 is again
located at the end of year „5‟ i.e. at the end of first cycle or the beginning of the second
cycle. In addition the annual operating cost and the annual income are also repeated in the
second cycle from end of year „6‟ till end of year „10‟. Further the salvage value of
Rs.250000 is also located at end of year „10‟ i.e. at the end of second cycle.
The equivalent present worth PW2 (in Rs.) of Alternative-2 is determined as follows;
PW2 = - 700000 - 15000(P/A, 10%, 10) + 165000(P/A, 10%, 10) + 250000(P/F, 10%, 5) -
700000(P/F, 10%, 5) + 250000(P/F, 10%, 10)
PW2 = - 700000 + (165000 - 15000) (P/A, 10%, 10) - (700000 – 250000) (P/F, 10%, 5) +
250000(P/F, 10%, 10)
Putting the values of different compound interest factors in the above expression for PW2
results in the following;
PW2   700000 150000  6.1446  450000  0.6209  250000  0.3855
PW2 = - 700000 + 921690 - 279405 + 96375
PW2 = Rs.38660
Thus from the comparison of equivalent present worth of the alternatives, it is evident
that Alternative-1 will be selected for purchase of the compression testing machine as it
shows the higher positive equivalent present worth.

In the following example, the comparison of different life span mutually exclusive
alternatives having expenditure or income in the form of gradient series by present worth
method is illustrated.
Example -5
A construction firm has decided to purchase a dozer to be employed at a construction site.
Two different companies manufacture the dozer that will fulfill the functional
requirement of the construction firm. The construction firm will purchase the most
economical one from one of these companies. The alternatives have different useful lives.
The cash flow details of both alternatives are presented as follows;
Company-A Dozer: Initial purchase cost = Rs.3050000, Annual operating cost Rs.40000
at end of 1st year and increasing by Rs.2000 in the subsequent years till the end of useful
life, Annual income = Rs.560000, Expected salvage value = Rs.1050000, Useful life = 6
years.
Company-B Dozer: Initial purchase cost = Rs.4000000, Annual operating cost =
Rs.55000, Annual revenue to be generated Rs.600000 at the end of 1st year and
increasing by Rs.5000 in the subsequent years till the end of useful life, Expected salvage
value = Rs.1000000, Useful life = 12 years.
Using present worth method, find out the most economical alternative at the interest rate
of 7% per year.
Solution:
Since the alternatives have different life spans i.e. 6 and 12 years, the comparison will be
made over a time period equal to the least common multiple of the life spans of the
alternatives i.e. 12 years. The cash flow of Company-A Dozer will be analyzed for two
cycles i.e. duration of 6 years for each cycle. The cash flow of Company-B Dozer will be
analyzed for one cycle i.e. duration of 12 years.
The cash flow diagram of Company-A Dozer is shown in Fig. 2.13. Since the least
common multiple of the life spans of the alternatives is 12 years, the cash flow is shown
for two cycles.

Rs.560000
Rs.1050000 Rs.1050000
Time
(Year) 0 3 4 6 7
1 2 5 8 9 10 11 12
Rs.40000 Rs.40000
Rs.42000 Rs.42000
Rs.44000 Rs.44000
Rs.3050000 Rs.46000 Rs.46000
Rs.48000 Rs.48000
Rs.50000
Rs.50000
Rs.3050000
Fig. 2.13 Cash flow diagram of Company-A Dozer for two cycles
For Company-A Dozer, the annual operating cost is in the form of a positive uniform
gradient series which can be split into the uniform base amount of Rs.40000 and the
gradient amount in multiples of Rs.2000 starting from end of year „2‟ for first cycle as
shown in Fig. 2.14. The equivalent present worth of this gradient for cycle one will be
located at the beginning i.e. in year „0‟. However for second cycle, the equivalent present
worth of the gradient for the annual operating cost starting from end of year „8‟ (shown in
Fig. 2.14) will be located at the end of year „6‟. Further the present worth of this amount
at time „0‟ will be determined by multiplying the equivalent present worth of the gradient
at the end of year „6‟ with the single payment present worth factor (P/F, i, n).

Rs.560000
Rs.1050000 Rs.1050000
0 3 4 6 7
Time 1 2 5 8 9 10 11 12
(Year)
Rs.2000 Rs.2000
Rs.4000 Rs.4000
Rs.3050000 Rs.6000 Rs.6000
Rs.8000 Rs.8000
Rs.10000 Rs.10000
Rs.3050000
Uniform amount
Rs.40000
Fig. 2.14 Cash flow diagram of Company-A Dozer for two cycles
with annual operating cost split into uniform base amount and gradient amount
The equivalent present worth PWA (in Rs.) of Company-A Dozer is calculated as follows;
PWA = - 3050000 - 40000(P/A, 7%, 12) - 2000(P/G, 7%, 6) + 560000(P/A, 7%, 12) +
1050000(P/F, 7%, 6) - 3050000(P/F, 7%, 6) - 2000(P/G, 7%, 6) (P/F, 7%, 6) +
1050000(P/F, 7%, 12)
PWA = - 3050000 + (560000 - 40000) (P/A, 7%, 12) - 2000(P/G, 7%, 6) - (3050000 -
1050000) (P/F, 7%, 6) - 2000(P/G, 7%, 6) (P/F, 7%, 6) + 1050000(P/F, 7%,
12)
Putting the values of different compound interest factors in the above expression;
PWA   3050000  520000  7.9427  2000  10.9784  2000000  0.6663 
2000 10.9784  0.6663  1050000  0.4440
PWA = - 3050000 + 4130204 - 21957 - 1332600 - 14630 + 466200
PWA = Rs.177217

The cash flow diagram of Company-B Dozer is shown in Fig. 2.15.
Rs.1000000
Rs.655000
Rs.650000
Rs.645000
Rs.640000
Rs.635000
Rs.630000
Rs.625000
Rs.620000
Rs.615000
Rs.610000
Rs.605000
Rs.600000
0 1 2 3 4 5 6 7 8 9 10 11 12
Time
(Year)
Rs.4000000
Rs.55000
Fig. 2.15 Cash flow diagram of Company-B Dozer
For Company-B Dozer, the annual revenue is in the form of a positive uniform gradient
series that can be split into the uniform base amount of Rs.600000 and gradient amount in
multiples of Rs.5000 as shown in Fig. 2.16. The equivalent present worth of this gradient
amount will be located at the beginning i.e. in year „0‟.

Rs.1000000
Rs.55000
Rs.50000
Rs.45000
Rs.40000
Rs.35000
Rs.30000

Rs.600000
Rs.20000
Rs.15000
Rs.10000
Rs.5000
0 3 4 6 7
Time 1 2 5 8 9 10 11 12
(Year)
Rs.4000000
Rs.55000
Fig. 2.16 Cash flow diagram of Company-B Dozer

with annual revenue split into uniform base amount and gradient amount
The equivalent present worth PWB (in Rs.) of Company-B Dozer is determined as
follows;
PWB = - 4000000 - 55000(P/A, 7%, 12) + 600000(P/A, 7%, 12) + 5000(P/G, 7%, 12) +
1000000(P/F, 7%, 12)
PWB = - 4000000 + (600000 - 55000) (P/A, 7%, 12) + 5000(P/G, 7%, 12) +
1000000(P/F, 7%, 12)
PWB results in the following;
PWB   4000000  545000  7.9427  5000  37.3506 1000000  0.4440
PWB = - 4000000 + 4328772 + 186753 + 444000
PWB = Rs.959525
Thus from the comparison of equivalent present worth of the alternatives, it is evident
that the construction firm should select Company-B Dozer over Company-A Dozer, as it
shows higher positive equivalent present worth i.e. PWB > PWA .

Lecture-4
Comparison of alternatives by future worth method:

In the future worth method for comparison of mutually exclusive alternatives, the
equivalent future worth (i.e. value at the end of the useful lives of alternatives) of all the
expenditures and incomes occurring at different periods of time are determined at the
given interest rate per interest period. As already mentioned, the cash flow of the
mutually exclusive alternatives may consist of expenditures and incomes in different
forms. Therefore the equivalent future worth of these expenditures and incomes will be
determined using different compound interest factors namely single payment compound
amount factor, uniform series compound amount factor and future worth factors for
arithmetic and geometric gradient series etc.
The use of future worth method for comparison of mutually exclusive alternatives will be
illustrated in the following examples. Similar to present worth method, first the
comparison of equal life span alternatives by future worth method will be illustrated
followed by comparison of different life span alternatives. Some of the examples already
worked out by the present worth method will be illustrated using the future worth method
in addition to some other examples.
Example -6 (Using data of Example-1)

There are two alternatives for purchasing a concrete mixer. Both the alternatives have
same useful life. The cash flow details of alternatives are as follows;
Using future worth method, find out which alternative should be selected, if the rate of
Solution:
The future worth of the mutually exclusive alternatives will be compared over a period of
5 years. The equivalent future worth of the alternatives can be obtained either by

multiplying the equivalent present worth of each alternative already obtained by present
worth method with the single payment compound amount factor or determining the future
worth of expenditures and incomes individually and adding them to get the equivalent
future worth of each alternative.
The equivalent future worth of Alternative-1 is obtained as follows;
FW1  PW1 F / P, i, n
PW1 is the equivalent present worth of Alternative-1 which is equal to - Rs.298203
(referring to Example-1). (F/P, i, n) is the single payment compound amount factor.
FW1   298203F / P,10%, 5
Now putting the value of single payment compound amount factor in the above
expression;
FW1   298203  1.6105
FW1 = -Rs.480256
The equivalent future worth of Alternative-1 can also be determined in the following
manner (Referring to cash flow diagram of Alternative-1, Fig. 2.1);
FW1   300000F / P,10%, 5  20000F / A,10%, 5  125000
Now putting the values of different compound interest factors in the above expression;
FW1   300000 1.6105  20000  6.1051 125000
FW1   483150  122102  125000
FW1 = -Rs.480252
Now it can be seen that the calculated future worth of Alternative-1 by both ways is
same. The minor difference between the values is due to the effect of decimal points in
the calculations.
The equivalent future worth of Alternative-2 is calculated as follows;

FW2  PW2 F / P, i, n
PW2 is the equivalent present worth of Alternative-2 which is equal to - Rs.289215
(referring to Example-1).
FW2   289215F / P,10%, 5

Now putting the value of single payment compound amount factor in the above
expression;
FW2   289215  1.6105
FW2 = -Rs.465781
The equivalent future worth of Alternative-2 can also be determined in the same manner
as in case of Alternative-1 and is presented as follows (Referring to cash flow diagram of
Alternative-2, Fig. 2.2);
FW2   200000F / P,10%, 5  35000F / A,10%, 5  70000
FW2   200000 1.6105  35000  6.1051 70000
FW2   322100  213679  70000
FW2 = -Rs.465779
Thus the future worth of Alternative-2 obtained by both methods is same. In this case
also the minor difference between the values is due to the effect of the decimal points in
the calculations.
Comparing the equivalent future worth of the both the alternatives, it is observed that
Alternative-2 will be selected as it shows lower negative equivalent future worth as
compared to Alternative-1. This outcome of the comparison of the alternatives by future
worth method is same as that obtained from the present worth method (Example-1). This
is due to the equivalency relationship between present worth and future worth through
compound interest factors at the given rate of interest per interest period.
Example -7
There are two alternatives for a construction firm to purchase a road roller which will be
used for the construction of a highway section. The cash flow details of the alternatives
are as follows;
Alternative-1: Initial purchase cost = Rs.1500000, Annual operating cost = Rs.35000
starting from the end of year „2‟ (negligible in the first year) till the end of useful life,
Annual revenue to be generated = Rs.340000 for first 4 years and then Rs.320000

afterwards till the end of useful life, Expected salvage value = Rs.430000, Useful life = 8
years.
Alternative-2: Initial purchase cost = Rs.1800000, Annual operating cost = Rs.25000,
Annual revenue to be generated = Rs.365000, Expected salvage value = Rs.550000,
Useful life = 8 years.
Find out the most economical alternative on the basis of equivalent future worth at the
interest rate of 9.5% per year.
Solution:
Rs.340000
Rs.430000
Rs.320000
0 1 2 3 4 5 6 7 8
Time (Year)
Rs.1500000
Rs.35000
From Fig. 2.17, it is observed that there are two uniform amount series for the annual
income i.e. first series with Rs.340000 from end of year „1‟ till end of year „4‟ and second
one with Rs.320000 from end of year „5‟ till end of year „8‟. For the first series, the
equivalent present worth at time „0‟ will be calculated first and then it will be multiplied
with single payment compound amount factor i.e. (F/P, i, n) to calculate its equivalent
future worth. For the second uniform series with Rs.320000, the future worth will be
calculated by multiplying the uniform amount i.e. Rs.320000 with uniform series
compound amount factor by taking the appropriate „n’ i.e. number of years.
The annual operating cost is in the form of a uniform amount series, which starts from
end of year „2‟ till the end of useful life i.e. the uniform amount series is shifted by one
year.
The equivalent future worth of the Alternative-1 i.e.FW1 is computed as follows;

FW1   1500000F / P, 9.5%, 8  35000F / A, 9.5%, 7   340000P / A, 9.5%, 4F / P, 9.5%, 8 

320000F / A, 9.5%, 4  430000
Putting the values of different compound interest factors in the above expression results
in the following;
FW1   1500000  2.0669  35000  9.3426  340000  3.2045  2.0669  320000  4.6070  430000
FW1   3100350  326991  2251950  1474240  430000
FW1 = Rs.728849
Rs.365000 Rs.550000
0 1 2 3 4 5 6 7 8
Time (Year)
Rs.1800000
Rs.25000
The equivalent future worth of the Alternative-2 i.e.FW2 is calculated as follows;

FW2   180 0000F / P, 9.5%, 8  25000F / A, 9.5%, 8  365000F / A, 9.5%, 8  550000
Now putting the values of different compound interest factors in the above expression
FW2   1800000 2.0669  365000  25000 11.2302  550000
FW2   3720420  3818268  550000
FW2 = Rs.647848
Comparing the equivalent future worth of the alternatives, it is observed that Alternative-
1 shows higher positive equivalent future worth as compared to Alternative-2. Thus
Alternative-1 will be selected for purchase of the road roller.

Lecture-5
Comparison by future worth method:-
In the following example, the comparison of three mutually exclusive alternatives by
future worth method will be illustrated. The data presented in Example-3 will be used for
comparison of the alternatives by the future worth method.

A construction contractor has three options to purchase a dump truck for transportation
and dumping of earth at a construction site. All the alternatives have the same useful life.
The cash flow details of all the alternatives are presented as follows;
Option-1: Initial purchase price = Rs.2500000, Annual operating cost Rs.45000 at the
end of 1st year and increasing by Rs.3000 in the subsequent years till the end of useful
life, Annual income = Rs.120000, Salvage value = Rs.550000, Useful life = 10 years.
Option-2: Initial purchase price = Rs.3000000, Annual operating cost = Rs.30000,
Annual income Rs.150000 for first three years and increasing by Rs.5000 in the
subsequent years till the end of useful life, Salvage value = Rs.800000, Useful life = 10
years.
Option-3: Initial purchase price = Rs.2700000, Annual operating cost Rs.35000 for first
5 years and increasing by Rs.2000 in the successive years till the end of useful life,
Annual income = Rs.140000, Expected salvage value = Rs.650000, Useful life = 10
years.
Using future worth method, find out which alternative should be selected, if the rate of

Solution:
The cash flow diagram of Option-1 is shown here again for ready reference.
Rs.120000 Rs.550000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.3000
Rs.2500000 Rs.6000
Rs.9000
Rs.12000
Rs.45000
Rs.18000
Rs.21000
Rs.24000
Rs.27000
Fig. 2.6 Cash flow diagram of Option-1 with annual operating cost split into
uniform base amount and gradient amount (shown for ready reference)
The equivalent future worth (in Rs.) of Option-1 is determined as follows;

FW1   2500000F / P, 8%,10  45000F / A, 8%,10  3000F / G, 8%,10 
120000F / A, 8%,10  550000
FW1   2500000F / P, 8%,10  120000  45000F / A, 8%,10  3000F / G, 8%,10  550000

FW1 results in the following;
FW1   2500000  2.1589  75000 14.4866  3000  56.0820  550000
FW1   5397250 1086495  168246  550000
FW1 = - Rs.3929001

The cash flow diagram of Option-2 is shown again for ready reference.
Rs.800000
Rs.35000
Rs.30000
Rs.25000
Rs.150000
Rs.15000
Pg Rs.10000
Rs.5000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.3000000
Rs.30000
Fig. 2.8 Cash flow diagram of Option-2 with annual income split into
The equivalent present worth of the gradient series (of the annual income) starting from
end of year „4‟ will be located at the end of year „2‟. The future worth of this amount at
end of year „10‟ will be obtained by multiplying the equivalent present worth „Pg’ (shown
in Fig. 2.8) at the end of year „2‟ with the single payment compound amount factor (F/P,
i, n).

FW2   3000000F / P, 8%,10  30000F / A, 8%,10  150000F / A, 8%,10  Pg F / P, 8%, 8
 800000
Now replacing Pg with G (P/G, i, n) i.e. 5000(P/G, 8%, 8) in the above expression;
FW2   3000000F / P, 8%,10  150000  30000F / A, 8%,10  5000P / G, 8%, 8F / P, 8%, 8
 800000
It may be noted here that, in the above expression, 5000(P/G, 8%, 8) (F/P, 8%, 8) can be
replaced by 5000(F/G, 8%, 8) and will result in the same value.

FW2   3000000  2.1589 120000 14.4866  5000 17.8061 1.8509  800000

FW2 = - 6476700 + 1738392 + 164787 + 800000
FW2 = - Rs.3773521
The cash flow diagram of Option-3 is shown here again for ready reference.
Rs.650000
Rs.140000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.2700000 Rs.2000
Pg Rs.4000
Rs.6000
Rs.35000
Rs.10000
Fig. 2.10 Cash flow diagram of Option-3 with annual operating cost split into
For the annual operating cost, the equivalent present worth of the gradient series starting
from end of year „6‟ will be located at the end of year „4‟. The future worth of this
amount at end of year „10‟ will be determined by multiplying the equivalent present
worth „Pg’ (shown in Fig. 2.10) at the end of year „4‟ with the single payment compound
amount factor (F/P, i, n).

FW3   2700000F / P, 8%,10  35000F / A, 8%,10  Pg F / P, 8%, 6 140000F / A, 8%,10
 650000
Now replacing Pg with G (P/G, i, n) i.e. 2000(P/G, 8%, 6) in the above expression;
FW3   2700000F / P, 8%,10  140000  35000F / A, 8%,10  2000P / G, 8%, 6F / P, 8%, 6
 650000
In the above expression, 2000(P/G, 8%, 6) (F/P, 8%, 6) can also be replaced by
2000(F/G, 8%, 6).
FW3   2700000  2.1589 105000  14.4866  2000 10.5233 1.5869  650000

FW3   5829030 1521093  33399  650000
FW3 = - Rs.3691336
Comparing the equivalent future worth of all the three alternatives, it is evident that
Option-3 shows lowest negative equivalent future worth as compared to other options.
Thus Option-3 will be selected for the purchase of the dump truck. This outcome
obtained by future worth method is same as that obtained from the present worth method
(Example-3) i.e. Option-3 is the most economical alternative.
After carrying out the comparison of equal life span mutually exclusive alternatives, now
the illustration of future worth method for comparison of different life span mutually
exclusive alternatives is presented.

A material testing laboratory has two alternatives for purchasing a compression testing
machine which will be used for determining the compressive strength of different
construction materials. The alternatives are from two different manufacturing companies.
The cash flow details of the alternatives are as follows;
Find out the most economical alternative at interest rate of 10% per year by future worth
method.
Solution:
As the alternatives have different life spans i.e. 10 years and 5 years, the comparison will
be made over a time period equal to the least common multiple of the life spans of the
alternatives i.e. 10 years. Thus the cash flow of Alternative-1 is analyzed for one cycle

(duration of 10 years) whereas that of cash flow of Alternative-2 is analyzed for two
cycles of duration 5 years each (already mentioned in Example-4).
The cash flow diagram of Alternative-1 is shown here again for ready reference.
Rs.175000 Rs.200000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.1000000
Rs.10000
Fig. 2.11 Cash flow diagram of Alternative-1 (shown for ready reference)
The equivalent future worth FW1 (in Rs.) of Alternative-1 is determined as follows;
FW1   1000000F / P,10%,10  10000F / A,10%,10  175000F / A,10%,10  200000
FW1   1000000F / P,10%,10  175000  10000F / A,10%,10  200000
Putting the values of different compound interest factors in the above expression;
FW1   1000000 2.5937 165000 15.9374  200000
FW1   2593700  2629671 200000
FW1 = Rs.235971
The equivalent future worth FW2 (in Rs.) of Alternative-2 is determined as follows;
FW2   700000F / P,10%,10 15000F / A,10%,10  165000F / A,10%,10 

250000F / P,10% 5  700000F / P,10%, 5  250000

Rs.165000
Rs.250000
Rs.250000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.700000
Rs.700000
Rs.15000

Fig. 2.12 Cash flow diagram of Alternative-2 for two cycles
FW2   700000F / P,10%,10  165000 15000F / A,10%,10  700000  250000F / P,10% 5 

250000
Putting the values of different compound interest factors in the above expression for FW2
FW2   700000  2.5937 150000 15.9374  4500001.6105  250000
FW2  1815590  2390610  724725  250000
FW2 = Rs.100295
Thus Alternative-1 will be selected for purchase of the compression testing machine, as it
shows the higher positive equivalent future worth as compared to Alternative-2.

Lecture-6
Comparison of alternatives by annual worth method:
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.


There are two alternatives for purchasing a concrete mixer and following are the cash
flow details;
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.
Rs.125000
Rs.50000
0 1 2 3 4 5
Time (Year)
300000
Rs.20000
Fig. 2.3 Cash flow diagram of Alternative -1
The equivalent uniform annual worth of Alternative-1 i.e. AW1 is computed as follows;
AW1   300000 A / P, i, n  20000  50000 125000 A / F , i, n
AW1   300000 A / P,10%, 5  20000  50000 125000 A / F ,10%, 5
Here Rs.20000 and Rs.50000 are annual amounts.
Now putting the values of different compound interest factors;
AW1   300000 0.2638  50000  20000 125000  0.1638
AW1   79140  30000  20475
AW1 = - Rs.28665

Rs.70000
Rs.45000
0
0 1 2 3 4 5
Time (Year)
200000
Rs.35000
Fig. 2.4 Cash flow diagram of Alternative -2
Now the equivalent uniform annual worth of Alternative-2 i.e. AW2 is calculated as
follows;
AW2   200000 A / P, i, n  35000  45000  70000 A / F , i, n
AW2   200000 A / P,10%, 5  35000  45000  70000 A / F ,10%, 5
For alternative-2, Rs.35000 and Rs.45000 are annual amounts.
AW2   200000 0.2638  45000  35000  70000  0.1638
AW2   52760 10000 11466
AW2 = - Rs.31294
From this comparison, it is observed that Alternative-1 will be selected as it shows lower
negative equivalent uniform annual worth compared to Alternative-2. This outcome is in
consistent with the outcome obtained by present worth method in Example-2.
Example -11
A material supply contractor has two options (i.e. from two different manufacturing
companies, Company-1 and Company-2) to purchase a tractor for supply of construction
materials. The details of cash flow of the two options are given below;
Company-1 Tractor: Initial purchase cost = Rs.2000000, Annual operating cost
including labor and maintenance = Rs.50000, Cost of new set of tires to be replaced at the

end of year „3‟, year „6‟and year „9‟ = Rs.110000 each, Expected salvage value =
Rs.520000, Useful life = 10 years.
Company-2 Tractor: Initial purchase cost = Rs.2200000, Annual operating cost
including labor and maintenance = Rs.27000, Cost of new set of tires to be replaced at the
end of year „4‟ and year „8‟ = Rs.120000 each, Expected salvage value = Rs.700000,
Useful life = 10 years.
Determine which company tractor should be selected on the basis of equivalent uniform
annual worth at the interest rate of 12% per year.
Solution:
The cash flow diagram of Company-1 tractor is shown in Fig. 2.19.
Rs.520000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.2000000
Rs.110000 Rs.110000 Rs.110000
Rs.50000
Fig. 2.19 Cash flow diagram of Company-1 Tractor
From the cash flow diagram it is noted that three single amounts i.e. Rs.110000 each are
located at the end of year „3‟, year „6‟ and year „9‟. For these amounts, first the
equivalent present worth at time „0‟ is determined and then equivalent annual worth of
this present worth is computed using the appropriate compound interest factor.
The equivalent uniform annual worth of Company-1 tractor is determined as follows;

AW1   2000000 A / P,12%,10 50000 110000P / F ,12%, 3 A / P,12%,10
110000P / F ,12%, 6 A / P,12%,10110000P / F ,12%, 9 A / P,12%,10 520000 A / F ,12%,10
AW1   2000000  0.1770  50000 110000  0.7118  0.1770 110000  0.5066  0.1770
110000  0.3606  0.1770  520000  0.0570
AW1   354000  50000  13859  9864  7021  29640

AW1 = - 405104

The cash flow diagram of Company-2 tractor is shown in Fig. 2.20.

Rs.700000
0 1 2 3 4 5 6 7 8 9 10
Time (Year)
Rs.2200000
Rs.120000 Rs.120000
Rs.27000
Fig. 2.20 Cash flow diagram of Company-2 Tractor
From Company-2 tractor, two single amounts i.e. Rs.120000 each are located at the end
of year „4‟, and year „8‟. Similar to first alternative, first the equivalent present worth at
time „0‟ of these amounts is determined and then equivalent annual worth is computed.
The equivalent uniform annual worth of Company-2 tractor is computed as follows;
AW2   2200000 A / P,12%,10  27000 120000P / F ,12%, 4 A / P,12%,10 
120000P / F ,12%, 8 A / P,12%,10  700000 A / F ,12%,10
AW2   2200000  0.1770  27000 120000  0.6355  0.1770 120000  0.4039  0.1770 
700000  0.0570
AW2   389400  27000 13498  8579  39900

AW2 = - 398577
From the above comparison, it is observed that Company-2 Tractor shows lower negative
equivalent uniform annual worth as compared to Company-1 tractor. Thus the contractor
should select Company-2 Tractor for purchase.

Lecture-7
Comparison by annual worth method:

Now the comparison of alternatives with cash flows involving gradient series and
randomly placed single amount by annual worth method will be illustrated followed by
the comparison of different life span alternatives.
Example -12
Compare the following equipment on the basis of the equivalent uniform annual worth
and find out the most economical one at the interest rate of 9.5% per year.
Equipment-A
Cash flow details:
Initial purchase cost = Rs.5000000
Annual operating cost = Rs.60000 at the end of year „1‟ and increasing by Rs.3000 in the
subsequent years till the end of useful life.
Annual income = Rs.770000
Cost of one time major repair = Rs.200000 at the end of year „8‟
Expected salvage value = Rs.1400000
Useful life = 12 years
Equipment-B
Cash flow details:
Initial purchase cost = Rs.4600000
Annual operating cost = Rs.75000
Annual income = Rs.710000 for the first 5 years and increasing by Rs.5000 in the
subsequent years till the end of useful life.
Cost of one time major repair = Rs.230000 at the end of year „6‟

Solution:
The cash flow diagram of Equipment-A is shown in Fig. 2.21.
Rs.770000 Rs.1400000
0 1 2 3 4 5 6 7 8 9 10 11 12
Time
(Year)
Rs.60000
Rs.63000
Rs.66000
Rs.5000000 Rs.69000
Rs.72000
Rs.75000
Rs.78000
Rs.81000
Rs.84000
Rs.87000
Rs.90000
Rs.200000
Rs.93000
Fig. 2.21 Cash flow diagram of Equipment-A
The annual operating cost is in the form of a positive uniform gradient series. This can be
split into the uniform base amount of Rs.60000 and gradient amount in multiples of
Rs.3000 starting from end of year „2‟ till the end of useful life as shown in Fig. 2.22.

Rs.770000 Rs.1400000
0 1 2 3 4 5 6 7 8 9 10 11 12
Time
(Year)
Rs.3000
Rs.5000000 Rs.6000
Rs.9000
Rs.60000 Rs.12000
Rs.15000
Rs.18000
Rs.21000
Rs.24000
Rs.27000
Rs.200000 Rs.30000
Rs.33000
Fig. 2.22 Cash flow diagram of Equipment-A with annual operating cost split into
uniform base amount and gradient amount
The equivalent uniform annual worth of Equipment-A is determined as follows;

AW A   5000000 A / P, 9.5%,12  60000  3000 A / G, 9.5%,12 
200000P / F , 9.5%, 8 A / P, 9.5%,12  770000  1400000 A / F , 9.5%,12
AW A   5000000  0.1432  60000  3000  4.4394  200000  0.4838  0.1432  770000 
1400000  0.0482
AW A   716000  60000 13318 13856  770000  67480

AWA = Rs.34306

The cash flow diagram of Equipment-B is shown in Fig. 2.23.

Rs.1200000
Rs.745000
Rs.740000
Rs.735000
Rs.710000
Rs.730000
Rs.725000
Rs.720000
Rs.715000
0 1 2 3 4 5 6 7 8 9 10 11 12
Time
(Year)
Rs.4600000
Rs.75000
Rs.230000
Fig. 2.23 Cash flow diagram of Equipment-B
For Equipment-B, the annual income is in the form of a positive uniform gradient series
with gradient starting from end of year „6‟. The annual income is split into the uniform
base amount of Rs.710000 and the gradient amount in multiples of Rs.5000 starting from
end of year „6‟ till the end of useful life as shown in Fig. 2.24. Rs.1200000
Rs.35000
Rs.30000
Rs25000
Rs.710000 Rs.20000
Rs.15000
Rs.10000
Rs.5000
0 1 2 3 4 5 6 7 8 9 10 11 12
Time
(Year)
Rs.4600000
Rs.75000
Rs.230000
Fig. 2.24 Cash flow diagram of Equipment-B with annual income split into uniform base amount and gradient amount

For the gradient series (of annual income), the equivalent present worth will be located at
the end of year „4‟ i.e. 2 years before the start of the gradient. Then the present worth of
this amount at time „0‟ will be calculated and after that the equivalent annual worth of
this amount will be determined.
The equivalent uniform annual worth of Equipment-B is determined as follows;
AW B   4600000 A / P, 9.5%,12  75000  230000P / F , 9.5%, 6 A / P, 9.5%,12 
710000  5000P / G, 9.5%, 8P / F , 9.5%, 4 A / P, 9.5%,12  1200000 A / F , 9.5%,12
AW B   4600000  0.1432  75000  230000  0.5801  0.1432  710000 
5000  16.4510  0.6956  0.1432 1200000  0.0482
AWB   658720  75000 19106  710000  8193  57840
AWB = Rs.23207
From the comparison by annual worth method, it is observed that Equipment-A exhibits
higher positive equivalent uniform annual worth as compared to Equipment-B. Thus the
Equipment-A is the most economical alternative.
Example -13
Using the annual worth method, compare the following machines having different life
spans at an interest rate of 11.5% per year.
Machine-1
Cash flow details:
Initial purchase price = Rs.1200000
Annual revenue = Rs.210000 for first 6 years and then Rs.225000 afterwards till the end
of useful life.
Machine-2
Cash flow details:
Initial purchase price = Rs.1400000

Annual revenue = Rs.290000

Solution:
The cash flow diagram of Machine-1 is shown in Fig. 2.25.
Rs.320000
Rs.210000 Rs.225000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Time
(Year)
Rs.1200000
Rs.38000
Fig. 2.25 Cash flow diagram of Machine-1
It may be noted here that the annual revenue is in the form of two uniform annual amount
series i.e. one with annual amount of Rs.210000 from beginning till end of year „6‟ and
the second one with annual amount of Rs.225000 from end of year „7‟ till the end of
useful life (as shown in Fig. 2.25). The annual revenue in the cash flow diagram can also
be represented as annual amount of Rs.210000 from beginning till the end of useful life
and the annual amount of Rs.15000 from end of year „7‟ till the end of useful life as
shown in Fig. 2.26.
Rs.320000
Rs.15000
Rs.210000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Time
(Year)
Rs.1200000
Rs.38000
Fig. 2.26 Cash flow diagram of Machine-1 with simplified representation of annual revenue

For the annual revenue of Rs.15000 from end of year „7‟ till the end of useful life, first
the equivalent future worth is calculated followed by the calculation of the equivalent
annual worth.
The equivalent uniform annual worth of Machine-1 is computed as follows;
AW1   1200000 A / P,11.5%,14  38000  210000 15000F / A,11.5%, 8 A / F ,11.5%,14 
 320000 A / F ,11.5%,14
Now putting the values of different compound interest factors;

AW1   1200000  0.14703  38000  210000 15000 12.07744  0.03203  320000  0.03203
AW1  176436  38000  210000  5803 10250
AW1 = Rs.11617
The cash flow diagram of Machine-2 is shown in Fig. 2.27.

Rs.450000
Rs.290000
0 1 2 3 4 5 6 7
Time
(Year)
Rs.1400000
Rs.26000
Fig. 2.27 Cash flow diagram of Machine-2
The equivalent uniform annual worth of Machine-2 is calculated as follows;

AW2   1400000 A / P,11.5%, 7  26000  290000  450000 A / F ,11.5%, 7
AW2   1400000 0.21566  26000  290000  450000 0.10066
AW2   301924  26000  290000  45297
AW2 = Rs.7373
As already stated, the equivalent uniform annual worth for more than one cycle of cash
flow will be same as that for the first cycle provided the cash flow in the successive

cycles is exactly same as that in the first cycle. For illustration of this note, the cash flow
of Machine-2 is repeated for two cycles with life span of 7 years each (least common
multiple of life spans of the alternatives is 14 years).
The cash flow diagram of Machine-2 for two cycles is shown in Fig. 2.28
Rs.450000 Rs.450000
Rs.290000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Time
(Year)
Rs.1400000
Rs.26000
Rs.1400000
Fig. 2.28 Cash flow diagram of Machine-2 repeated for two cycles
The equivalent uniform annual worth of Machine-2 is determined as follows;

AW2   1400000 A / P,11.5%,14  26000  290000  450000P / F ,11.5%, 7  A / P,11.5%,14
1400000P / F ,11.5%, 7  A / P,11.5%,14  450000 A / F ,11.5%,14
AW2   1400000  0.14703  26000  290000  450000  0.46674  0.14703 
1400000  0.46674  0.14703  450000  0.03203
AW2   1400000  0.14703  26000  290000  1400000  450000  0.46674  0.14703 
450000  0.03203
AW2   205842  26000  290000  65194 14414
AW2 = Rs.7378
Now it can be seen that, the calculated equivalent uniform annual worth of Machine-2 for
two cycles of cash flow is same as that with only one cycle i.e. first cycle. The minor
difference among the values is due to the effect of decimal points in the above
calculations.

Lecture-8
Rate of return:-
The rate of return technique is one of the methods used in selecting an alternative for a
project. In this method, the interest rate per interest period is determined, which equates
the equivalent worth (either present worth, future worth or annual worth) of cash
outflows (i.e. costs or expenditures) to that of cash inflows (i.e. incomes or revenues) of
an alternative. The rate of return is also known by other names namely internal rate of
return (IRR), profitability index etc. It is basically the interest rate on the unrecovered
balance of an investment which becomes zero at the end of the useful life or the study
period. In the following lectures, the rate of return is denoted by “ir”.
Using present worth, the equation for rate of return can be written as follows;
PWC  PWI ……………………………… (2.1)
PWC = Present worth of cash outflows (cost or expenditure)
PWI = Present worth of cash inflows (income or revenue)
As already stated in earlier lectures, cost or expenditures are considered as negative cash
flows whereas income or revenues are considered as positive cash flows.
Equation (2.1) can be rewritten as;

0   PWC  PWI ………………………….. (2.2)
In the above equation the net present worth is zero.
Now putting the expressions for present worth of cash outflows and that of cash inflows
in equation (2.1) results in the following expression;
Po  FC P / F , ir , n  AC P / A, ir , n  FI P / F , ir , n  AI P / A, ir , n ……………. (2.3)
On left hand side of the above equation, Po is the initial cost at time zero and FC (single
amount) and AC (uniform amount series) are the expenditures occurring at future period
of time. Similarly on the right hand side of the equation, FI (single amount) and AI
(uniform amount series) are the incomes or revenues occurring at future period of time.
The value of interest period „n‟ will vary depending upon the occurrence of the future
amounts (either expenditure or income).

Equation (2.3) can be rewritten as follows;

0   Po  FC P / F , ir , n  AC P / A, ir , n FI P / F , ir , n  AI P / A, ir , n ……………..
(2.4)
The value of rate of return „ir’ can be calculated by solving the above equation. The
equation (2.4) can be solved either manually through trial and error process or using
Microsoft Excel spreadsheet. The first method i.e. trial and error process for
determination of the rate of return consumes more time whereas the second method is
faster. However the trial and error method gives a clear understanding of the analysis of
calculation for the rate of return. Similar to equivalent present worth, the rate of return
can also be determined by finding out the interest rate at which the net future worth or net
annual worth is zero.
After determination of the rate of return for a given alternative, it is compared with
minimum attractive rate of return (MARR) to find out the acceptability of this alternative
for the project. If the rate of return i.e. ir is greater than or equal to MARR, then the
alternative will be selected or else it will not be selected. The MARR is the minimum rate
of return from the investment, which is acceptable. In other words it is the minimum rate
of return below which the investment alternatives are economically not acceptable. The
minimum attractive rate of return (MARR) serves as an important criteria while selecting
a single alternative or comparing mutually exclusive alternatives whenever the
investments are made. For an organization, it is governed by various parameters namely
availability of financially viable projects, amount of fund available for investment along
with the associated risk, and type of organization (i.e. government, public sector, private
sector etc.).
The difference between equivalent worth methods (present worth method/future worth
method/annual worth method) and rate of return method is that; in case of former, the
equivalent worth of the cash inflows and cash outflows are determined at MARR whereas
in case of latter, a rate is determined which equates the equivalent worth of cash inflows
to that of the cash outflows and the resulting rate is compared against MARR. The rate of
return and MARR are expressed in terms of percentage per period i.e. mostly percentage
per year.

In the following example, the illustration of the procedure for determination of rate of
return for an alternative is presented.
Example -14
A construction firm is planning to invest Rs.800000 for the purchase of a construction
equipment which will generate a net profit of Rs.140000 per year after deducting the
annual operating and maintenance cost. The useful life of the equipment is 10 years and
the expected salvage value of the equipment at the end of 10 years is Rs.200000.
Compute the rate of return using trial and error method based on present worth, if the
construction firm‟s minimum attractive rate of return (MARR) is 10% per year.
Solution:
The cash flow diagram of the construction equipment is shown in Fig. 2.29.
Rs.140000 Rs.200000
Time (Year)
0 1 2 3 4 5 6 7 8 9 10
Rs.800000
Fig. 2.29 Cash flow diagram of the construction equipment
For determination of rate of return „ir‟ of the construction equipment, first the equation
for net present worth of cash inflows and cash outflows is equated to zero. Then using the
trial and error method the value of „ir‟ is determined. The net present worth of cash
inflows and cash outflows of the construction equipment is given by the following
expression. PW   800000 140000P / A, ir ,10  200000P / F , ir ,10
For determining the value of „ir‟ the net present worth is equated to zero.
0   800000 140000P / A, ir ,10  200000P / F , ir ,10
Now the above equation will be solved through trial and error process to find out the
value of ir. Basically a positive value and a negative value of the net present worth will be

determined at rate of return values close to the actual one and then by linear interpolation
between these two values, the actual rate of return will be calculated. For finding out the
rate of return values (close to the actual one), those will give a positive value and a
negative value of net present worth, one has to carry out a number of trial calculations at
various values of ir.
Since MARR is 10%, first assume a value of ir equal to 8% and compute the net present
worth. Now putting the values of different compound interest factors in the expression for
net present worth at ir equal to 8% results in the following;
PW   800000 140000P / A, 8%,10  200000P / F , 8%,10

PW   800000  140000  6.7101  200000  0.4632
PW = Rs.232054
The above calculated net present worth at ir equal to 8% is greater than zero, now assume
a higher value of ir i.e. 12% for the next trial and compute the net present worth.
PW  800000  140000P / A,12%,10  200000P / F ,12%,10
PW   800000  140000  5.6502  200000  0.3220
PW = Rs.55428
As observed from this calculation, the net present worth is decreased at higher value of ir.
Thus for getting a negative value of net present worth, assume further higher value of ir
than the previous trial and take 14% for the next trial and determine the net present
worth.
PW   800000 140000P / A,14%,10  200000P / F ,14%,10

PW  800000 140000  5.2161  200000  0.2697
PW = -Rs.15806
Since a negative value of net present worth at ir equal to 14% is obtained (as above), the
actual value of rate of return is less than 14%. The actual rate of return is now obtained
by doing linear interpolation either between 8% and 14% or between 12% and 14%.
However for obtaining a more accurate value of rate of return, the linear interpolation is
carried out between 12% and 14% and is given as follows;

55428
PW (Rs.)
ir
12% 13% 14%
-15806
PW = Rs.55428 at ir = 12%
PW = - Rs.15806 at ir = 14%
55428   15806 55428  0

14%  12% ir  12%
On solving the above expression, the value of ir is found to be 13.55% per year which is
greater than MARR (10%). Now using the using Microsoft Excel spreadsheet and
entering year-wise cash inflows and cash out flows, the value of rate of return is found to
be 13.53% (using the function „IRR‟). However this minor difference in the value of ir
obtained from both the methods can be minimized by finding out the net present worth at
narrow range of interest rate values and carrying out linear interpolation between these
values (trial and error method) to find out the more precise value close to the actual rate
of return.
The net present worth of the construction equipment at MARR i.e. 10% is given by;
PW  800000 140000P / A,10%,10  200000P / F ,10%,10
PW  800000 140000  6.1446  200000  0.3855
PW = Rs.137344 at MARR (10%)
The net present worth of the construction equipment at MARR is greater than zero and
the rate of return is greater than MARR. Thus the purchase of the construction equipment
is economically justified. It may be noted here that when the equivalent worth of an
investment is greater than zero at interest rate equal to MARR, then the rate of return of
the investment is greater than MARR.

The rate of return „ir‟ can also be determined by equating the net annual worth to zero.
For the above construction equipment, the net equivalent annual worth at different values
of ir are calculated as follows;
At ir = 12%
AW  800000 A / P,12%,10  140000  200000 A / F ,12%,10
AW  800000  0.1770  140000  200000  0.0570
AW = Rs.9800
At ir = 14%
AW  800000 A / P,14%,10  140000  200000 A / F ,14%,10
AW  800000  0.1917  140000  200000  0.0517
AW = -Rs.3020
Now carrying out the linear interpolation between 12% and 14%;
9800
AW (Rs.)
ir
12% 13% 14%
-3020
AW = Rs.9800 at ir = 12%
AW = - Rs.3020 at ir = 14%
9800   3020 9800  0

14%  12% ir  12%
On solving the above expression, the value of ir is found to be 13.52% per year. The
minor difference in the values of ir from present worth and annual worth methods is due
to the effect of decimal points in the calculations. Similar to present worth and annual
worth methods, the rate of return „ir‟ can also be determined by equating the net future
worth to zero.

From the above example, a unique value of rate of return was obtained for the
construction equipment (on the basis of its cash inflow and cash outflow). This is due to
the fact that, there was only one sign change in the cash flows i.e. minus sign at time zero
for the cash outflow followed by plus sign for cash inflows during the remaining periods.
However in some cases, depending upon the cash flow it is possible to get multiple
values of rate of return, those satisfy the rate of return equation of the equivalent worth of
cash inflows and cash out flows. This may happen due to more than one sign change in
the cash flows e.g. cash outflow (negative) at beginning (time zero) followed cash
inflows (positive) at end of year 1 and 2 and then cash outflow (negative) at end of year 3
etc. Thus while selecting an alternative that has multiple values of rate of return
(depending on the cash flow), other method of economic evaluation may be adopted to
find out the economical suitability of the alternative.

Lecture-9
Incremental Rate of return:-
When the best alternative (economically suitable) is to be selected from two or more
mutually exclusive alternatives on the basis of rate of return analysis, the incremental
investment analysis is used. In incremental rate of return method, the alternative with
larger investment is selected, provided the incremental (extra) investment over the lower
investment alternative produces a rate of return that is greater than or equal to MARR. In
other words if the additional benefits i.e. increased productivity, increased income,
reduced operating expenditure etc. achieved at the expense of extra investment
(associated with larger investment alternative) are more than that could have been
obtained from the investment of same amount at MARR elsewhere by the organization,
then this additional capital should be invested.
In incremental rate of return method, the economically acceptable lower investment

alternative is considered as the base alternative against which the higher investment
alternative is compared. The cash flow of higher investment alternative is considered
equal to the cash flow of lower investment alternative plus the incremental cash flow i.e.
difference in cash flow between the higher investment and lower investment alternatives.
When using rate of return method for comparing two or more mutually exclusive
alternatives, the analysis must be done correctly, otherwise it may lead to incorrect
ranking of the alternatives. However this problem is avoided in incremental investment
rate of return analysis. In this technique, the individual rate of return values on total cash
flow of the mutually exclusive alternatives are not compared against each other rather the
rate of return (or IRR) of the mutually exclusive alternatives or the rate of return of the
incremental investment is compared against MARR.
The procedures for comparison of mutually exclusive cost alternatives and that of
mutually exclusive investment alternatives using incremental investment rate of return
analysis are mentioned below. The details about cost and investment alternatives are
already stated in Lecture-1 of Module 2.

Steps for comparison of cost alternatives:

i) First arrange the mutually exclusive cost alternatives on the basis of increasing initial
capital investment. The lowest capital investment alternative is considered as the base
alternative (B).
ii) The incremental cash flow is calculated between the base alternative (B) and the next
higher capital investment alternative (H) over the useful life.
iii) Then the rate of return „ir(H-B)‟ of this incremental investment is calculated (procedure
as stated earlier) by equating the net equivalent worth (present worth or annual worth or
future worth) to zero.
iv) If the calculated „ir(H-B)‟ is greater than or equal to MARR, then alternative „B‟ is
removed from further analysis. Alternative „H‟ now becomes the new base alternative
and is compared against the next higher capital investment alternative. If „ir(H-B)‟ is less
than MARR, then alternative „H‟ is removed from further analysis and alternative „B‟
remains as the base alternative and is compared against the next higher investment
alternative (alternative with investment higher than „H‟).
v) Steps ii) to iv) are repeated till only one alternative is left i.e. the best alternative which
justifies the incremental investment associated with.
Steps for comparison of investment alternatives:

i) Arrange the mutually exclusive investment alternatives on the basis of increasing initial
capital investment.
ii) Then the rate of return (IRR) on total cash flow of the lowest investment alternative is
determined (procedure already stated earlier) to find out its acceptability as the base
alternative. If the calculated rate of return is greater than or equal to MARR, this is
selected as the base alternative. If the calculated rate of return is less than MARR, then
this alternative is not considered for further analysis and the acceptability of the next
higher investment alternative as base alternative is found out by calculating the rate of
return on its total cash flow and comparing against MARR. This process is continued till
the base alternative „B‟ (acceptable alternative for which rate of return greater than or
equal to MARR) is obtained. If no alternative is obtained in this manner i.e. rate of return
less than MARR, then do-nothing alternative is selected. The do-nothing alternative

indicates that all the investment alternatives are rejected. Similar to the comparison of
cost alternatives, the incremental cash flow is now calculated between the base
alternative (B) and the next higher investment alternative (H) over the useful life.
Steps iii) to v) as mentioned above for the comparison of cost alternatives are then
followed to select the best alternative.
The comparison of cost alternatives is illustrated in the following example.
Example -15
The development authority of a city has to select a pumping unit from four feasible
mutually exclusive alternatives for supply of water to a particular location of the city. The
details of cash flow and the useful life of all the alternatives are presented in the
following table. The minimum attractive rate of return (MARR) is 20% per year. Select
the best alternative using the incremental investment rate of return analysis.
Solution:
The cash flow and useful life of all the alternatives are presented in Table 2.1.
Table 2.1 Cash flow of alternatives
Alternative
Alternative-1 Alternative-2 Alternative-3 Alternative-4
Cash flow A1 A2 A3 A4
Initial capital 7800000 6600000 8100000 7400000

investment (Rs.)
Annual operating and 850000 1185000 800000 970000

maintenance cost (Rs.)
Salvage value (Rs.) 2050000 1780000 2200000 1865000
Useful life (Years) 10 10 10 10
As seen from the above table, these are cost alternatives involving all cash outflows
(negative cash flows) except for the salvage value (positive cash flow) at the end of
useful life. The alternatives are not in the increasing order of capital investment as

observed from Table 2.1. The alternatives are now arranged in the increasing order of
capital investment as shown in Table 2.2 and cash outflows and cash inflows are shown
with negative and positive signs respectively.
Table 2.2 Cash flow of alternatives in increasing order of initial capital investment
Alternative
A2 A4 A1 A3
Cash flow
Initial capital
-6600000 -7400000 -7800000 -8100000
investment (Rs.)
Annual operating and
-1185000 -970000 -850000 -800000
Salvage value (Rs.) +1780000 +1865000 +2050000 +2200000
After arranging the alternatives in increasing order of capital investment, alternative-2

(A2) now becomes the base alternative (lowest capital investment with Rs.6600000) and
it is compared with the next higher investment alternative i.e. alternative-4 (A4) with
capital investment of Rs.7400000. The incremental cash flow between the two
alternatives A2 and A4
is given as follows;
Incremental capital investment = -Rs.7400000 – (-Rs.6600000) = -Rs.800000 at
beginning i.e. at time zero.
Incremental annual operating and maintenance cost from end of year 1 till end of year 10
= -Rs.970000 – (-Rs.1185000) = Rs.215000
Incremental salvage value = Rs.1865000 – Rs.1780000 = Rs.85000 at end of year 10
In order to find out the rate of return (IRR) of this incremental cash flow, the net present
worth is equated to zero.
PW  0  800000  215000P / A, ir ,10  85000P / F , ir ,10

The value of rate of return „ir’ is now calculated by solving the above equation either
manually through trial and error process with linear interpolation or using Microsoft
Excel spreadsheet (already mentioned earlier). For faster calculation, the rate of return is
calculated using Microsoft Excel spreadsheet after entering year-wise cash inflows and
cash out flows. The value of rate of return is found to be 24.06% (using the function
„IRR‟ in Excel spreadsheet). As rate of return of the incremental cash flow is greater than
MARR (20%), the incremental investment associated with alternative-4 (A4) is justified
and alternative-2 (A2) is now removed from further analysis. Alternative-4 now becomes
the new base alternative and is compared with next higher capital investment alternative
i.e. alternative-1 (A1) with investment of Rs.7800000. The rate return of this incremental
investment is calculated in same manner as above. The entire calculation is now
presented in the Table 2.3.
Table 2.3 Comparison of cost alternatives using incremental rate of return analysis
Comparison
Between Between Between
A4 and A2 A1 and A4 A3 and A1
Incremental cash flow
Incremental capital investment -800000 -400000 -300000
(Rs.)
Incremental annual operating and 215000 120000 50000
maintenance cost i.e. savings (Rs.)
85000 185000 150000
Incremental salvage value (Rs.)
10 10 10
Useful life (Years)
Rate of return on incremental 24.06% 28.65% 14.09%

investment ( > MARR) ( > MARR) ( < MARR)
Yes Yes No
Incremental investment justified
Present worth of incremental cash 115115 ( > 0) 132978 ( > 0) -66150 ( < 0)
flow at MARR, 20% (Rs.)
In Table 2.3 the incremental values between the alternatives indicate the difference in
cash flows between them.

The outcomes of the incremental investment analysis for the comparison of cost
alternatives as presented in Table 2.3 are briefly described below.
 Comparison between alternatives A2 (base alternative) and A4 (next higher capital
investment alternative). The obtained rate of return form the incremental investment
analysis is 24.06% which is greater than MARR (20%). Alternative-2 (A2) is
eliminated from further analysis and alternative-4 (A4) is the new base alternative.
 Now comparison between alternatives A4 and A1 (next higher capital investment

alternative). The obtained rate of return form the incremental investment is 28.65%
and is greater than MARR. Thus alternative-4 (A4) is eliminated from further
analysis and alternative-1 (A1) is the new base alternative.
 Finally comparison between alternatives A1 and A3 (next higher capital investment

alternative). The rate of return obtained from the incremental investment analysis is
14.09% which is less than MARR (20%). Thus the incremental investment
associated with alternative-3 (A3) i.e. largest capital investment alternative is not
justified and hence alternative-1 (A1) is selected as the best alternative, as no
other alternative is left for comparison. In addition, the present worth of the
incremental investment associated with alternative-1 (A1) over alternative-4 (A4) at
MARR i.e. 20% is greater than zero i.e. Rs.132978 > 0.
 It can be seen here that, the largest capital investment alternative (A3) is not selected
because the incremental investment associated with it results in a rate of return
which is less than MARR. In addition the present worth of the incremental
investment associated with alternative-3 (A3) over alternative-1 (A1) at MARR i.e.
20% is less than zero i.e. –Rs.66150 < 0.
Now the values of equivalent present worth of the total cash flow of the cost alternatives
at MARR (20%) are found to be -Rs.11280643, -Rs.11165528, -Rs.11098700 and -
Rs.11032550 for alternatives A2, A4, A3 and A1 respectively. Thus alternative A1 (the
best alternative) exhibits lowest negative equivalent present worth as compared to other
cost alternatives.

Lecture-10
Incremental Rate of return:-

The comparison of investment alternatives using incremental investment rate of return
analysis is illustrated in the following example.
Example -16
A construction company is planning to invest for the purchase of a heavy construction
equipment which will be used at a construction site. There are four feasible alternatives
and the detailed cash flow of all the alternatives are presented in Table 2.4. Each
alternative has the useful life of 8 years. If the company‟s MARR is 12% per year, select
the best alternative using the incremental investment rate of return analysis.
Solution:
The cash flow and useful life of all the alternatives are presented in Table 2.4.
Table 2.4 Cash flow of alternatives
Alternative
B1 B2 B3 B4
Cash flow
Initial investment (Rs.) 2400000 3400000 2700000 3200000
Annual profit (after deducting 415000 680000 525000 640000

expenditures) (Rs.)
Salvage value (Rs.) 590000 990000 710000 860000
As observed from Table 2.4, these are investment alternatives having positive cash flows
(cash inflows). As the alternatives are not in the increasing order of investment, they are
now arranged in the increasing order of investment as shown in Table 2.5.

Table 2.5 Cash flow of alternatives in increasing order of investment
Alternative Alternative-1 Alternative-3 Alternative-4 Alternative-2

B1 B3 B4 B2
Cash flow
Initial investment (Rs.) -2400000 -2700000 -3200000 -3400000
Annual profit (after deducting 415000 525000 640000 680000

expenditures) (Rs.)
Salvage value (Rs.) 590000 710000 860000 990000
After arranging the alternatives in increasing order of investment, the acceptability of the
lowest investment alternative i.e. alternative B1 as base alternative is checked by finding
out the rate of return on its total cash flow. The rate of return is found out by equating net
present worth of alternative B1 to zero.
PW  0   2400000  415000P / A, ir , 8  590000P / F , ir , 8
As already stated, the value of rate of return „ir’ is calculated by solving the above
equation either manually through trial and error process with linear interpolation or using
Microsoft Excel spreadsheet. The value of rate of return is found to be 10.91% (using the
function „IRR‟ in Excel spreadsheet), which is less than company‟s MARR i.e. 12%.
Thus alternative B1 is eliminated from further calculation and the acceptability of next
higher investment alternative i.e. B3 is checked in the same manner as above. The rate of
return on total cash flow of alternative B3 is determined by equating the net present
worth to zero.
PW  0   2700000  525000P / A, ir , 8  710000P / F , ir , 8
From this equation the value of rate of return is found to be 13.84% (using the function
„IRR‟ in Excel spreadsheet), which is greater than company‟s MARR i.e. 12%. Thus
Alternative B3 becomes the base alternative and it is compared with the next higher
investment alternative B4. Now the rate of return of the incremental cash flow between

the two alternatives B3 and B4 is calculated and compared with MARR to check
suitability of the incremental investment associated with alternative B4. The entire
calculation for selecting the best alternative is now presented in Table 2.6.
Table 2.6 Comparison of investment alternatives using incremental rate of return analysis
Alternatives
B1 B3 B4 – B3 B2 – B4
Cash flow
Initial investment / Incremental value (Rs.) -2400000 -2700000 -500000 -200000
Annual profit (after deducting expenditures)/ 415000 525000 115000 40000

Incremental value (Rs.)
Salvage / Incremental value (Rs.) 590000 710000 150000 130000
Rate of return on total cash flow/ Rate of 10.91% 13.84% 18.52% 17.69%
return on incremental investment ( < MARR) ( > MARR) ( > MARR) ( > MARR)
Acceptable as base alternative / Incremental No Yes Yes Yes

investment justified
Present worth of incremental cash flow at - - 131859 ( > 0) 51211 ( > 0)

MARR 12% (Rs.)
In the above table the incremental values between the alternatives indicate the difference
in their cash flows.
In Table 2.6, the total cash flows of the individual alternatives and incremental cash flows
(comparison between two alternatives) are written in different colour fonts for ease of
understanding. For alterative B1 and B3, total cash flows and for comparison between B4
– B3
and B2 – B4 the incremental cash flows are provided in the above table.

The outcomes of the incremental investment analysis for comparison of investment

alternatives (presented in Table 2.6) are briefly described below.
 Checking the acceptance of lowest investment alternative B1 as base alternative by
calculating the rate of return on its total cash flow. The obtained rate of return is
10.91% which is less than MARR (12%). Alternative B1 is now eliminated from
further analysis.
 Now checking the acceptance of next higher investment alternative B3 as the base
alternative by finding out the rate of return on its total cash flow. The obtained rate
of return is 13.84% which is greater than MARR (12%). Thus alternative B3 now
becomes the base alternative.
 Now comparison between alternatives B3 and next higher investment alternative B4.
The rate of return form the incremental investment analysis is found to be 18.52%
which is greater than MARR (12%). Thus alternative B3 is eliminated from further
analysis and alternative B4 is the new base alternative as the incremental investment
is justified.
 Finally comparison between alternatives B4 and B2 (next higher investment
alternative). The obtained rate of return from the incremental investment is 17.69%
which is greater than MARR (12%). Thus the incremental investment associated
with alternative B2 is justified and alternative B2 is selected as the best
alternative, as there is no other alternative remaining for comparison. Further the
present worth of the incremental investment associated with alternative B2 over
alternative B4 at MARR (12%) is greater than zero as observed from Table 2.6.
Now the values of equivalent present worth of the total cash flow of individual
alternatives at MARR (12%) are found to be -Rs.100145, Rs.194759, Rs.326618 and
Rs.377829 for alternatives B1, B3, B4 and B2 respectively. Thus alternative B2 exhibits
highest positive equivalent present worth as compared to other alternatives which is in
agreement with outcome obtained from the incremental investment analysis.
For comparison of mutually exclusive alternatives, those have different life spans, the
comparison using incremental rate of return analysis must be made over the same number

of years i.e. least common multiple of the individual life spans as in case of comparison
using present worth method in earlier lectures.
The important points to be noted for comparison of mutually exclusives alternatives using
incremental investment rate of return analysis are as follows.
 The alternative with larger investment should be selected if the incremental (extra)
investment associated with it over the lower investment alternative produces a rate of
return that is greater than or equal to MARR.
 While comparing the alternatives, at first instance the alternative with highest rate of
return on its total cash flow should not be selected as the best alternative. After
carrying out the incremental investment rate of return analysis, the selection of the
best alternative may match (depending on the cash flow) with the alternative with
highest rate of return on its total cash flow. The rate of return of the alternatives B1,
B2, B3 and B4 (Example 16) on their total cash flows are found to be 10.91%,
14.80%, 13.84% and 14.59% respectively (calculations not shown in the example).
Thus Alternative B2 having highest rate of return (also greater than MARR i.e.
14.80% > 12%) was not selected as the best alternative at first instance. However
from outcome of incremental investment rate of return analysis, alternative B2 was
selected as the best alternative that matched with the alternative having highest rate of
return.
 Similarly the alternative with highest capital investment and has rate of return (on its
total cash flow) greater than or equal to MARR, should not be selected as the best
alternative at first instance. However the outcome of the incremental investment rate
of return analysis for the best alternative may coincide with the highest investment
alternative (with rate of return on its total cash flow greater than or equal to MARR).
From incremental investment rate of return analysis, alternative B2 (Example 16)
was selected as the best alternative, which happened to be the highest investment
alternative with rate of return on its total cash flow greater than MARR.

 The higher capital investment alternative associated with the incremental capital
investment that exhibits highest rate of return should not be selected as the best
alternative. As observed from Example 16, incremental investment having highest
rate of return (18.52%) was between alternatives B4 and B3 and the higher
investment alternative associated with this incremental investment was B4. On the
other hand, the rate of return on the incremental capital investment between B2 and
B4 was 17.69% and the higher investment alternative associated with this
incremental investment was B2. From the incremental rate of return analysis,
alternative B2 was selected as the best alternative in place of B4, even though the
rate of return on incremental investment associated with B4 (comparison between B4
and B3) was greater than the rate of return on the incremental investment associated
with B2 (comparison between B2 and B4) i.e. 18.52% > 17.69%.

Lecture-11
Capitalized cost analysis:-

Capitalized cost represents the present worth of an alternative for a project that is going
to serve for a longer period of time i.e. for an infinite period of time. As the name
indicates, it refers to the present worth of mainly cost or expenditures (cash outflows) of
the alternative over infinite period of time. Capitalized worth refers to present worth of
expenditures and revenues of an alternative over infinite period of time.
The capitalized cost method is used for comparison of mutually exclusive alternatives
which have perpetual service life (assumed to serve forever). The examples of this kind
of projects are bridges, dams, irrigation projects, water supply systems for cities, pipeline
projects etc. This method an also be used for finding out the capitalized cost of permanent
fellowship/scholarship endowment in educational institutes and other organizations.
As already stated, capitalized cost/worth is the present worth of an alternative that has a
perpetual or permanent cash flow series. The capitalized cost/worth of a perpetual cash
flow having uniform amount series with end of year payments „A‟ is obtained as follows.
The present worth of a uniform amount series is given by;
 1  i n  1
P  A n 
 i1  i  
P = present worth, A = end of year payment of uniform amount series, i = interest rate per
year and n = number of interest periods (already stated in Module 1)
The above equation can be rewritten as;
A  1  i  1 
n
P   
i  1  i n 1  i n 
A 1 
P 1  
i  1  i n 
In the above expression, when „n‟ approaches infinity (i.e. for perpetual cash flow series),
the term “1/(1+i)n” gets neglected and present worth „P‟ becomes capitalized cost/worth,
the expression of which is given by;
A
P
i

A  Pi
Thus the above expression can be explained by a simple example.
If a person deposits an amount of Rs.100000 in a bank at an interest rate of 10% per year,
then how much money the person can withdraw from the bank every year without
reducing the original deposit.
- The amount of interest accumulated (i.e. amount of money the person can withdraw
without reducing the deposit) at the end of 1st year is Rs.10000 (100000 x 0.10).
- After withdrawal of Rs.10000 at the end of 1st year, the amount that will remain in his
bank account is Rs.100000, which will again earn an interest amount of Rs.10000 at the
end of 2nd year. After withdrawal of Rs.10000 at the end of 2nd year, the person will have
again the same amount of Rs.100000 in his bank account that will further earn the same
interest amount at the end of 3rd year. This process can be continued perpetually
generating an interest amount of Rs.10000 (A = P x i) without changing the original
deposit of Rs.100000. This example is similar to creating a scholarship endowment in a
university that will give a scholarship of Rs.10000 every year indefinitely, by depositing
Rs.100000 in a saving bank account at interest rate of 10% per year compounded
annually.
The capitalized cost of a single amount occurring at regular intervals in future period of
time is calculated by first finding out the equivalent uniform annual worth „A‟ of the
uniform series and then dividing by the interest rate „i‟.
The calculation of capitalized cost of an alternative is illustrated in the following
example.
Example -17
A public project has an initial cost of Rs.11000000 and annual operating and maintenance
cost of Rs.700000. Further the project will have one time major repair work of
Rs.2000000 at the end of 15 year. Find out the capitalized cost of the alternative if
interest rate is 12% per year.
Solution:
The capitalized cost of the alternative is equal to sum of the initial cost, present worth of
one time major repair cost and capitalized cost of the annual operating and maintenance
cost.

The total capitalized cost of the alternative is given by;
Capitalize d Cost   11000000  2000000P / F , i, n  700000

i
Capitalize d Cost   11000000  2000000P / F ,12%,15  700000
0.12
Capitalize d Cost   11000000  2000000  0.1827  5833333
Capitalized cost = -Rs.17198733
Therefore the capitalized cost of the alternative for the public project is found to be
Rs.17198733.

Lecture-12
Capitalized cost analysis:-
The capitalized cost can also be used for comparison of two or more mutually exclusive
alternatives which are assumed to serve perpetually. In this case the comparison of the
alternatives is made over same time period i.e. infinite period of time. The alternative that
shows lowest capitalized cost is selected as the best alternative.
In the following examples, the calculation of capitalized cost of an alternative and the
comparison of mutually exclusive alternatives on the basis of capitalized cost are
illustrated.
Example -18
The initial cost of an infrastructure development project which is expected to serve
residents of a city perpetually is Rs.15000000. The annual operating cost is Rs.800000
for first 10 years and Rs.900000 in the subsequent years (i.e. from year 11 onwards). The
expected cost of renovation at the end of every 15 years is Rs.1800000. Find out the
capitalized cost of the project at interest rate of 8% per year.
Solution:
The cash flow diagram of the project for a part of service life is shown in Fig. 2.30
The total capitalized cost of the project is equal to sum of the initial cost and capitalized
cost of annual operating cost and renovation cost.
Time (year) approaching infinity

Time 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
(Year)
Rs.15000000
Rs.800000
Rs.100000
Rs.1800000
Fig. 2.30 Cash flow diagram of the project
The annual operating cost is Rs.800000 for first 10 years followed by Rs.900000
thereafter. This can be represented as Rs.800000 from end of year 1 to infinite period of

time and Rs.100000 from end of year 11 to infinity as shown in Fig. 2.30. Thus the
capitalized cost of the annual operating cost is equal to the sum of capitalized cost of
these two components.
Capitalized cost of the annual operating cost:
Capitalize d Cost  
800000 100000
 P / F , i,10
i i
In the above expression, the capitalized cost of Rs.100000 from end of year 11 till
infinity is located at the end of year 10. Now the present worth (i.e. amount at time zero)
of this amount is calculated by multiplying it with single payment present worth factor.
Capitalize d Cost  
800000 100000
 P / F , 8%,10
0.08 0.08
100000  0.4632
Capitalize d Cost   10000000 
0.08
The capitalized cost of the annual operating cost can also be calculated by considering
Rs.800000 from end of year 1 till end of year 10 and Rs.900000 from end of year 11 till
infinity. The calculation is shown below.
Capitalize d Cost   800000P / A, i,10  P / F , i,10

900000
i
In this expression, first the present worth of uniform series with annual amount of
Rs.800000 for first 10 years is calculated. Then the capitalized cost of Rs.900000 from
end of year 11 till infinity is calculated in the same manner as for Rs.100000 in the first
approach.
Capitalize d Cost   800000P / A, 8%,10  P / F , 8%,10

900000
0.08
900000  0.4632
Capitalize d Cost   800000  6.7101 
0.08
Thus it can be seen that the capitalized cost of annual operating cost by both ways is
same. The minor difference between the values is due to the effect of decimal points in
the calculations.

Capitalized cost of renovation component:

The renovation will take place at the end of every 15 years i.e. at the end of 15th year, 30th
year, 45th year etc. In order to calculate the capitalized cost of renovation component
(Rs.1800000) at the end of every 15 years, first the uniform annual amount „A‟ of the
equivalent uniform series for the first 15 years is calculated. This amount „A‟ will be
same for the subsequent intervals i.e. from end of year 16 till end of year 30, from end of
year 31 till end of till year 45 and so on (shown in Fig. 2.31). Then the uniform amount
„A‟ is divided by the interest rate.
A Time (year) approaching infinity
Time
(Year) 0 1 2 3 13 14 15 16 17 18 28 29 30 31 32 33 43 44 45
Rs.1800000 Rs.1800000 Rs.1800000
Fig. 2.31 Cash flow diagram for periodic renovation cost of the project
 1800000 A / F , 8%,15
Capitalize d Cost 
0.08
 1800000  0.0368
Capitalize d Cost 
0.08
Now the total capitalized cost of the project is equal to initial cost plus capitalized cost of
annual operating cost and renovation cost.
Capitalized cost = -Rs.15000000 -Rs.10579000 -Rs.828000

Therefore the capitalized cost of the infrastructure development project is Rs.26407000.

Example -19
There are two alternatives for a water supply project in a city. The details of cash flow of
the alternatives are shown below.
Alternative-1
Initial cost = Rs.20000000
Cost of renovation = Rs.2500000 at the end of every 17 years
One time upgrading cost = Rs.3200000 at the end of 22 year
Alternative-2
Cost of renovation = Rs.3500000 at the end of every 20 years
Compare the alternatives on the basis of capitalized cost and find out the economical
alternative if the rate of interest is 9% per year
Solution:
The capitalized cost of Alternative-1 will be equal to initial cost plus the capitalized cost
of annual operating cost, periodic renovation cost and one time upgrading cost.
The capitalized cost of Alternative-1 is calculated as follows;
1600000 2500000 A / F , i,17
Capitalize d Cost   20000000    3200000P / F , i, 22
i i
1600000 2500000 A / F , 9%,17 
Capitalize d Cost   20000000    3200000P / F , 9%, 22
0.09 0.09
2500000  0.0270
Capitalize d Cost   20000000 17777778   3200000  0.1502
0.09
Capitalize d Cost   20000000 17777778  750000  480640
Capitalized cost = -Rs.39008418 (Alternative-1)
The capitalized cost of Alternative-2 will be equal to initial cost plus the capitalized cost
of annual operating cost and periodic renovation cost.
The capitalized cost of Alternative-2 is obtained as follows;
1200000 3500000 A / F , i, 20
Capitalize d Cost   26000000  
i i

1200000 3500000 A / F , 9%, 20

Capitalize d Cost   26000000  
0.09 0.09
3500000  0.0195
Capitalize d Cost   26000000 13333333 
0.09
Capitalize d Cost   26000000 13333333  758333
Capitalized cost = -Rs.40091666 (Alternative-2)
The capitalized cost of altenative-1 and Alternative-2 are found to be Rs.39008418 and
Rs.40091666 respectively. Thus Alternative-1 is the economical as it shows lower
capitalized cost (lower negative value) as compared to Alternative-2.

Lecture-13
Benefit-cost analysis:-
The benefit-cost analysis method is mainly used for economic evaluation of public
projects which are mostly funded by government organizations. In addition this method
can also used for economic evaluation of alternatives for private projects. The main
objective of this method is used to find out desirability of public projects as far as the
expected benefits on the capital investment are concerned. As the name indicates, this
method involves the calculation of ratio of benefits to the costs involved in a project.
In benefit-cost analysis method, a project is considered to be desirable, when the net

benefit (total benefit less disbenefits) associated with it exceeds its cost. Thus it becomes
imperative to list out separately the costs, benefits and disbenefits associated with a
public project. Costs are the expenditures namely initial capital investment, annual
operating cost, annual maintenance cost etc. to be incurred by the owner of the project
and salvage value if any is subtracted from the costs. Benefits are the gains or advantages
whereas disbenefits are the losses, both of which are experienced by the owner in the
project. In case of public projects which are funded by the government organizations,
owner is the government. However this fund is generally taxpayers‟ money i.e. tax
collected by government from general public, thereby the actual owners of public
projects are the general public. Thus in case of public projects, the cost is incurred by the
government whereas the benefits and disbenefits are mostly experienced by the general
public.
In order to know the costs, benefits and disbenefits associated with a public project,
consider that a public sector organization is planning to set up a thermal power plant at a
particular location. The costs to be incurred by the public sector organization are cost of
purchasing the land required for the thermal power plant, cost of construction of various
facilities, cost of purchase and installation of various equipments, annual operating and
maintenance cost, and other recurring costs etc. The benefits associated with the project
are generation of electric power that will cater to the need of the public, generation of
revenue by supplying the electricity to the customers, job opportunity for local residents,
development other infrastructure in the nearby areas etc. The disbenefits associated with
project are loss of land of the local residents on which the thermal power plant will come

up. If it is agricultural land, then the framers will lose their valuable land along with the
annual revenue generated from farming, even though they get money for their land from
the public sector organization at the beginning. The other disbenefits to the local residents
are greater likelihood of air pollution in the region because of the thermal power plant,
chances of contamination of water in the nearby water-bodies etc.
In benefit-cost analysis method, the time value of money is taken in to account for
calculating the equivalent worth of the costs and benefits associated with a project. The
benefit-cost ratio of a project is calculated by taking the ratio of the equivalent worth of
benefits to that of the costs associated with that project. Either of present worth, annual
worth or future worth methods can be used to find out the equivalent worth of costs and
benefits associated with the project.
The benefit-cost ratio of projects is determined in different forms namely conventional

benefit-cost ratio and modified benefit-cost ratio. The benefit-cost ratio is generally
designated as B/C ratio.
Conventional B/C ratio
The conventional benefit-cost ratio of a project is mentioned as follows;
Equivalent worth of Benefits  Equivalent worth of Disbenefits

Conventional B/C ratio 
Equivalent worth of total cost - Equivalent worth of salvage value
The disbenefits associated with the project are subtracted from the benefits in the
numerator of the ratio to obtain the net benefit associated with the project. Similarly the
equivalent worth of salvage value of the initial investment is subtracted from equivalent
worth of cost in the denominator of the ratio. The total cost mainly consists of initial cost
(initial capital investment) plus the operating and maintenance cost.
As already stated the equivalent worth may be calculated either by present worth method,
annual worth method or future worth method. Thus the expression for conventional
benefit-cost ratio (B/C ratio) is mentioned as follows;

PW of Benefits  PW of Disbenefits
Initial cost  PW of operating and maintenance cost - PW of salvage value
Or
AW of Benefits  AW of Disbenefits
AW of initial cost  AW of operating and maintenance cost - AW of salvage value
Or
FW of Benefits  FW of Disbenefits
FW of initial cost  FW of operating and maintenance cost - Salvage value
In the above expressions, PW, AW, and FW refer to equivalent present worth, annual
worth and future worth respectively.
Modified B/C ratio
In the modified benefit-cost ratio method, the operating and maintenance cost is
subtracted from the benefits in the numerator of the ratio. In other words, operating and
maintenance cost is considered similar to the disbenefits. The expression for modified
benefit-cost ratio using PW, AW or FW is given as follows;
PW of Benefits  PW of Disbenefits - PW of operating and maintenance cost

Modified B/C ratio 
Initial cost - PW of salvage value
Or
AW of Benefits  AW of Disbenefits - AW of operating and maintenance cost

AW of initial cost - AW of salvage value
Or
FW of Benefits  FW of Disbenefits - FW of operating and maintenance cost

FW of initial cost - Salvage value
A project is considered to be acceptable when the conventional or modified B/C ratio is

greater than or equal to 1.0. The illustration of conventional and modified B/C ratio
methods is described in the following example.

Example -20
The cash flow details of a public project is as follows

Worth of annual benefits = Rs.5000000
Worth of annual disbenefits = Rs.1100000
Salvage value = Rs.4000000
Interest rate per year = 8% and useful lie = 30 Years
Using benefit-cost ratio method (both conventional and modified), find out the
economical acceptability of the public project. Use PW, AW and FW methods to find out
the equivalent worth of costs, benefits and disbenefits.
Solution:
First the conventional benefit-cost ratio (B/C ratio) of the project is computed.
Conventional B/C ratio using Present worth:
The conventional benefit-cost ratio of the public project is calculated as follows;
PW of benefits  PW of disbenefit s
Initial cost  PW of operating cost  PW of salvage value
5000000P / A, i, n  1100000P / A, i, n 
Conventional B / C ratio 
21000000 1600000P / A, i, n   4000000P / F , i, n 
5000000P / A, 8%, 30 1100000P / A, 8%, 30

21000000 1600000P / A, 8%, 30  4000000P / F , 8%, 30
5000000 11.2578 1100000 11.2578

21000000 1600000 11.2578  4000000  0.0994
Conventional B/C ratio = 1.137

Conventional B/C ratio using Annual worth:
AW of benefits  AW of disbenefit s
AW of initial cost  AW of operating cost  AW of salvage value
5000000 1100000
21000000 A / P, i, n   1600000  4000000 A / F , i, n 
5000000 1100000
21000000 A / P, 8%, 30 1600000  4000000 A / F , 8%, 30
5000000 1100000
21000000  0.0888 1600000  4000000  0.0088
Conventional B/C ratio using Future worth:
FW of benefits  FW of disbenefit s
FW of initial cost  FW of operating cost  Salvage value
5000000F / A, i, n  1100000F / A, i, n 
21000000F / P, i, n  1600000F / A, i, n   4000000
5000000F / A, 8%, 30 1100000F / A, 8%, 30

21000000F / P, 8%, 30 1600000F / A, 8%, 30  4000000
5000000  113.2832 1100000  113.2832

21000000  10.0627 1600000  113.2832  4000000
As calculated above, the conventional benefit-cost ratio is found to be same by using any
of the equivalent worth methods i.e. PW method, AW method or FW method. As the
benefit-cost ratio of the public project is 1.137 (i.e. greater than 1.0), the project is
acceptable.

Now the modified benefit-cost ratio (B/C ratio) of the project is calculated.
Modified B/C ratio using Present worth:
The modified benefit-cost ratio of the public project is calculated as follows;
PW of benefits  PW of disbenefit s  PW of operating cost

Initial cost  PW of salvage value
5000000P / A,i , n  1100000P / A,i , n  1600000P / A,i , n 

Modified B / C ratio 
21000000  4000000P / F ,i , n 
5000000P / A,8%,30 1100000P / A,8%,30 1600000P / A,8%,30

21000000  4000000P / F ,8%,30
5000000  11.2578 1100000  11.2578 1600000  11.2578

21000000  4000000  0.0994
Modified B/C ratio = 1.257
Modified B/C ratio using Annual worth:
AW of benefits  AW of disbenefit s  AW of operating cost

AW of initial cost  AW of salvage value
5000000 1100000 1600000

21000000A / P, i, n   4000000A / F, i, n 
5000000 1100000  1600000

21000000 A / P ,8%,30  4000000 A / F ,8%,30
5000000 1100000 1600000

21000000  0.0888  4000000  0.0088
Modified B/C ratio using Future worth:
FW of benefits  FW of disbenefit s  FW of operating cost

FW of initial cost  Salvage value

5000000F / A,i , n  1100000F / A,i , n  1600000F / A,i , n 

21000000F / P ,i , n   4000000
5000000F / A,8%,30 1100000F / A,8%,30 1600000F / A,8%,30

21000000F / P ,8%,30  4000000
5000000  113.2832 1100000  113.2832 1600000  113.2832

21000000  10.0627  4000000
Modified B/C ratio = 1.257

The modified benefit-cost ratio of the public project is found to be 1.257.
As observed from above calculations, the B/C ratio of the project from both methods
(conventional and modified) is greater than 1.0, although the value is different. It may be
noted here that, although the magnitude of benefit-cost ratio differs between two methods
i.e. conventional B/C ratio and modified B/C ratio, but the decision to select or not a
project is not changed by use of any of the two methods.

Lecture-14
Incremental benefit-cost ratio analysis:-
The incremental benefit-cost ratio analysis is used to select the best alternative from a set
of mutually exclusive alternatives. Similar to incremental rate of return analysis, in this
method also the incremental cash flow between the alternatives i.e. the differences in
benefits and costs between the alternatives are calculated and then the ratio of the
equivalent worth of incremental benefits to that of incremental costs is found out. In this
method, the alternative with large cost is selected, if the incremental benefits justify the
extra cost associated with it. In other words if the incremental B/C ratio is greater than or
equal to 1.0, then the larger cost alternative is selected. If incremental B/C ratio is less
than 1.0, then lower cost alternative is selected. While comparing the mutually exclusive
alternatives, the alternative with maximum B/C ratio (on its total cash flow) should not be
selected as the best alternative at first instance because the maximization of B/C ratio
may not guarantee that, best alternative is selected. However after carrying out the
incremental B/C ratio analysis, the selection of the best alternative may match with the
alternative with maximum B/C ratio on its total cash flow.
The incremental benefit-cost ratio analysis for comparison of mutually exclusive

alternatives is carried out in the following steps;
i) First, all the alternatives are arranged in increasing order of equivalent worth of costs.
The equivalent worth of cost of alternatives may be determined either by present
worth method, annual worth method or future worth method.
ii) The alternative with lowest equivalent cost is now compared with do-nothing
alternative (initial base alternative). In other words the B/C ratio of lowest equivalent
cost alternative on its total cash flow is calculated. If calculated B/C ratio is greater
than or equal to 1.0, then the lowest equivalent cost alternative becomes the new base
alternative. On the other hand if B/C ratio is less than 1.0, then this alternative is
removed from further analysis and the acceptability of the next higher equivalent cost
alternative as base alternative is found in the same manner as that was carried out for
the alternative with lowest equivalent cost. This process is continued till the base
alternative (acceptable alternative for which B/C ratio is greater than or equal to 1.0) is

obtained. If no alternative is obtained in this manner, then do-nothing alternative is

selected i.e. none of the alternatives are selected, if this is an option.
iii) Now the incremental benefit, B and incremental cost, C (i.e. difference in benefits
and costs) between next higher equivalent cost alternative and the base alternative are
calculated and then incremental B/C ratio (B/C) i.e. ratio of the equivalent worth of
incremental benefits to that of incremental costs is obtained. If the incremental B/C
ratio (B/C) is greater than or equal to 1.0, then the base alternative is removed from
further analysis and the next higher equivalent cost alternative becomes the new base
alternative. On the other hand if B/C is less than 1.0, then the higher equivalent
cost alternative is eliminated form further analysis and base alternative remains the as
the base. Then the incremental B/C ratio is calculated between the next higher
equivalent cost alternative and the base alternative. This process is continued till the
last alternative is compared and in this way the best alternative is selected which
justifies the extra cost associated with it from the incremental benefits.

The incremental B/C ratio analysis is illustrated in the following example.
Example -21
There are four mutually exclusive alternatives for a public project. Select the best
alternative using incremental B/C ratio analysis if interest rate is 7% per year. The cash
flow details of the alternatives are shown in the following table. Each alternative has the
useful life of 40 years.
Table 2.7 Cash flow of alternatives for the project
Alternative
A1 A2 A3 A4
Cash flow
Initial investment (Rs.) 101000000 112000000 145200000 122800000
Annual operating and 6700000 6450000 5780000 6135000

Worth of annual benefits (Rs.) 16420000 17200000 19100000 17900000
Solution:
First the conventional B/C ratio will be used for the incremental benefit-cost analysis
for the comparison of above mutually exclusive alternatives. Present worth method will
be used for the calculation of equivalent worth of benefits and costs.
In order to arrange the alternatives in the increasing order of equivalent cost, first the
equivalent worth (present worth) of the costs of all the four alternatives are calculated.
Present worth of costs of Alternative-1 (A1):
PW of cos ts of A1101000000  6700000P / A, i, n 
PW of cos ts of A1101000000  6700000P / A, 7%, 40
PW of cos ts of A1101000000  6700000 13.3317
PW of costs of A1 = 190322390


PW of cos ts of A2 112000000  6450000P / A, i, n 
PW of cos ts of A2 112000000  6450000P / A, 7%, 40
PW of cos ts of A2 112000000  6450000 13.3317
PW of cos ts of A3 145200000  5780000P / A, i, n 
PW of cos ts of A3 145200000  5780000P / A, 7%, 40
PW of cos ts of A3 145200000  5780000 13.3317
PW of cos ts of A4 122800000  6135000P / A,i , n
PW of cos ts of A4 122800000  6135000P / A,7%, 40
PW of cos ts of A4 122800000  6135000 13.3317
As observed from the above calculations, the order of alternatives from lowest equivalent
cost to highest equivalent cost is A1, A2, A4 and A3.
The lowest equivalent cost alternative A1 is first compared against do-nothing alternative
i.e. the B/C ratio of alternative A1 on its cash flow is calculated.
PW of benefits
B/C ratio of A1 
Initial investment  PW of operating and maintenanc e cost
16420000P / A, 7%, 40
B / C ratio of A1 
101000000  6700000P / A, 7%, 40
16420000  13.3317
B / C ratio of A1 
101000000  6700000  13.3317
B/C ratio of alternative A1 = 1.150
As the B/C ratio of alternative A1 is greater than 1.0, A1 now becomes the base
alternative and is compared against the next higher equivalent cost alternative i.e.

alternative A2. Now the incremental benefits and incremental costs between A2 and A1
are calculated and the incremental B/C ratio is obtained.
Incremental annual benefits (between A2 and A1)  17200000 -16420000  780000
Present worth (PW) of incrementa l annual benefits  780000P/A, 7%, 40
 780000  13.3317 10398726
PW of incremental benefits (between A2 and A1) = Rs.10398726
Incremental initial investment (between A2 and A1)  112000000 - 101000000  11000000
Incremental annual operating and maintenanc e cost (between A2 and A1)

 6450000 - 6700000  - 250000
Present worth (PW) of incrementa l costs  11000000 - 250000P/A, 7%, 40
11000000  250000 13.3317  7667075
PW of incremental costs (between A2 and A1) = Rs.7667075
ΔB PW of incrementa l benefits 10398726

Incremental B/C ratio    1.356
ΔC PW of incrementa l costs 7667075
Incremental B/C ratio (between alternative A2 and A1) = 1.356

The incremental B/C ratio between alternatives A2 and A1 can also be calculated by
finding out the ratio of the differences in present worth of benefits of alternatives to that
of costs. This calculation is shown below.
PW of benefits of alternative A1  16420000P/A, 7%, 40
16420000  13.3317  218906514
PW of costs of alternative A1  101000000  6700000P/A, 7%, 40
101000000  6700000  13.3317 190322390
PW of benefits of alternative A2  17200000P/A, 7%, 40
17200000  13.3317  229305240
PW of costs of alternative A2  112000000  6450000P/A, 7%, 40
101000000  6450000  13.3317 197989465

ΔB Difference in PW of benefits between A2 and A1

Incremental B/C ratio (between A2 and A1)  
ΔC Difference in PW of cos ts between A2 and A1
229305240 - 218906514
 1.356
197989465 -190322390
Thus same incremental B/C ratio is obtained.
As the incremental B/C ratio is greater than 1.0, alternative A2 becomes the new base
alternative and alternative A1 is removed from further analysis. Alternative A2 is now
compared against the next higher equivalent cost alternative i.e. alternative A4. The
incremental B/C ratio between alternatives A4 and A2 is determined in the same manner
as that was determined between alternatives A2 and A1.
Now the entire calculation for selecting the best alternative using incremental B/C ratio
analysis is presented in Table 2.8.
Table 2.8 Comparison of alternatives using incremental B/C ratio* analysis
Comparison of Alternatives Between A1

and do-nothing
Cash flow alternative
Incremental initial investment (Rs.) 101000000 11000000 10800000 22400000
Incremental annual operating and

6700000 -250000 -315000 -355000
Incremental annual benefit (Rs.) 16420000 780000 700000 1200000
PW of incremental benefit (Rs.) 218906514 10398726 9332190 15998040
PW of incremental cost (Rs.) 190322390 7667075 6600515 17667247
Incremental B/C Ratio 1.150 1.356 1.414 0.906
Increment justified Yes Yes Yes No
* Conventional B/C ratio
The comparison of above alternatives using incremental B/C ratio analysis as shown in
Table 2.8 is briefly presented below.
 The lowest equivalent cost alternative A1 is compared against the do-nothing
alternative (initial base alternative). In other words B/C ratio of alternative A1 on

its total cash flow is calculated. The obtained B/C ratio is 1.150 which is greater
than 1.0. Thus alternative A1 now becomes the new base alternative.
 Now alternative A1 is compared against the next higher equivalent cost
alternative i.e. A2. The incremental B/C ratio between alternatives A2 and A1 is
calculated. The calculated incremental B/C ratio is 1.356 which is greater than
1.0. Thus alternative A2 now becomes the base alternative and alternative A1 is
eliminated from further analysis.
 Alternative A2 is now compared against the next higher equivalent cost
alternative i.e. alternative A4. The calculated incremental B/C ratio between
alternatives A4 and A2 is 1.414 (greater than 1.0). Alternative A4 now becomes
the base alternative and alternative A2 is eliminated.
 Alternative A4 is now compared against the next higher equivalent cost
alternative i.e. alternative A3 (last alternative). The incremental B/C ratio between
alternatives A3 and A4 is 0.906 which is less than 1.0. Thus the incremental cost
associated with alternative A3 is not justified. Hence alternative A4 is selected
as the best alternative as no other alternative is left for comparison. In other
words alternative A4 is the highest equivalent cost alternative which is associated
with the last justified increment i.e. incremental B/C ratio greater than 1.0.
It may be noted here that the B/C ratios of the alternatives on their individual cash flows
could have been calculated at the beginning of the analysis to eliminate any alternative(s)
that has a B/C ratio less than 1.0 and that alternative(s) need not be considered further in
the incremental benefit-cost ratio analysis. However this step is not necessary because the
alternative with B/C ratio less than 1.0 on its cash flow will eliminated in the process of
incremental analysis. In this example the values of B/C ratio of the alternatives A1, A2,
A3 and A4 on their individual cash flows are 1.150, 1.158, 1.146 and 1.166 respectively
(all greater than 1.0). The calculation of B/C ratio is shown only for alternative A1. The
B/C ratio of other alternatives can be similarly calculated.
The above incremental B/C ratio analysis was carried out using conventional B/C ratio.
The same analysis can also be carried out by using modified B/C ratio. As already stated,
in modified B/C ratio, the operating and maintenance cost is subtracted from the benefits

in the numerator. The incremental B/C ratio analysis using modified B/C ratio for the
comparison of above mutually exclusive alternatives is describe below.
The order of alternatives from lowest to highest equivalent cost (present worth of cost)
will depend only on the initial investment as the annual operating and maintenance cost
(considered similar to disbenefits) is subtracted from the benefits in the numerator of
modified B/C ratio. Thus the order of alternatives from lowest to highest equivalent cost
(i.e. initial investment) is A1, A2, A4 and A3 (same as earlier). Now the incremental
benefit-cost analysis using modified B/C ratio is carried out in the same manner as that
was done using conventional B/C ratio and is presented in Table 2.9.
Table 2.9 Comparison of alternatives using incremental B/C ratio** analysis
Comparison of Alternatives Between A1

and do-nothing
Cash flow alternative
Incremental initial investment (Rs.) 101000000 11000000 10800000 22400000
Incremental net annual benefit*** (Rs.) 9720000 1030000 1015000 1555000
PW of incremental net benefit (Rs.) 129584124 13731651 13531676 20730794
PW of incremental cost i.e. incremental

101000000 11000000 10800000 22400000
initial investment (Rs.)
Incremental B/C Ratio 1.283 1.248 1.253 0.925
Increment justified Yes Yes Yes No
** Modified B/C ratio

*** Net annual benefit for an alternative is obtained by subtracting the annual operating
and maintenance cost from its annual benefits. Incremental net annual benefit is the
difference in net annual benefits between two alternatives. Considering the comparison
between alternatives A4 and A2, the calculation of incremental net annual benefit is
shown below.

The net annual benefit of alternative A2  annual benefits - annual operating and maintenanc e cost
 17200000 - 6450000  10750000
The net annual benefit of alternative A4  annual benefits - annual operating and maintenanc e cost
 17900000 - 6135000  11765000
The incremental net annual benefit between alternatives A4 and A2  11765000 - 10750000  1015000
Thus the incremental net annual benefit between two alternatives A4 and A2 is
Rs.1015000, which is shown in Table 2.9.
From Table 2.9, it is observed that the best alternative is A4, which is same as the
outcome obtained from incremental B/C ratio analysis using the conventional B/C ratio.
In other words the same outcome regarding the best alternative is obtained, however the
values of B/C ratios obtained were different. Similar to present worth, the incremental
B/C ratio analysis can also be carried out by calculating the annual worth (AW) or future
worth (FW) of benefits and costs of alternatives.

Lecture-15
Breakeven analysis:-
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.
Revenue
Breakeven
Equivalent
worth (Rs.)
Expenditure
Breakeven point
Quantity of ‘x’
Fig. 2.32 Schematic diagram for breakeven point of a single alternative
In Fig. 2.32, the equivalent worth of expenditure and revenue are plotted as functions of
the quantity of factor „x‟. The breakeven point corresponds to that value of the factor „x‟

at which the equivalent worth of expenditure and revenue of the alternative are equal i.e.
the relationships representing the expenditure and revenue as functions of „x‟ intersect
each other (shown in Fig. 2.32).
The breakeven point between two alternatives is shown in Fig. 2.33.
Alternative-1
Breakeven
Total equivalent
worth (Rs.)
Alternative-2
Breakeven point
Quantity of ‘x’
Fig. 2.33 Schematic diagram of breakeven point between two alternatives
In this figure the total equivalent worth i.e. equivalent worth of net cash flow (i.e.
expenditures and revenues) of the alternatives are plotted at various values of the
common factor „x‟. The intersection of the total equivalent worth of two alternatives
gives the breakeven point i.e. the value of the common factor „x‟ at which the values of
total equivalent worth of the two alternatives are equal. If the expected value of „x‟ is less
than the breakeven value, Alternative-1 is selected as its total equivalent worth (assuming
it as negative cash flow i.e. cost greater than revenue) is less than that of Alternative-2 as
evident from Fig. 2.33. Similarly when the expected value of „x‟ is greater than the
breakeven value, Alternative-2 is selected as it shows lower equivalent worth (i.e. lower
cost) compared to Alternative-1. In Fig. 2.32 the variations of equivalent worth of
expenditure and revenue of the single alternative and in Fig. 2.33 the variations of total
equivalent worth of two alternatives are considered as linear functions of the value of
factor „x‟. Sometimes these relationships may also be non-linear. In the breakeven

analysis, the equivalent worth of expenditures and revenues can be calculated either by
present worth method, future worth method or annual worth method by taking into
account the time value of money. The annual worth method is normally used when the
quantities of the variable (on which the expenditures and the revenues mostly depend) are
expressed on annual basis.
The following example will illustrate the breakeven analysis for a single alternative.
Example -22
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,
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 0.1m3 per hour. The
revenue to be generated from production of 1m3 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;
Rs.30 1 hour x m 3
   Rs.300x
1 hour 0.1 m 3 year
Now the equivalent uniform annual worth (Rs.) of expenditure is given by;
AWe  750000A / P, i, n   45000  300x
AWe  750000A / P,11%,10  45000  300x
AWe  750000  0.1698  45000  300x 172350  300x

The equivalent uniform annual worth (Rs.) of revenue is calculated as follows;

AWr  210000A / F, i, n  1000x
AWr  210000A / F,11%,10 1000x
AWr  210000  0.0598 1000x 12558 1000x
Now equating equivalent uniform annual worth of expenditure with that of revenue;
AWe  AWr
172350  300x  12558 1000x
x  228.274 m 3
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
AWe  750000A / P,11%,10  45000  300x
AWe  750000  0.1698  45000  300  200  Rs.232350

Revenue
AWr  210000A / F,11%,10 1000x
AWr  210000  0.0598 1000  200  Rs.212558
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
AWe  750000A / P,11%,10  45000  300x
AWe  750000  0.1698  45000  300  250  Rs.247350

Revenue
AWr  210000A / F,11%,10  1000x
AWr  210000  0.0598 1000  250  Rs.262558

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 is also graphically shown in Fig. 2.34.
450000
Equivalent uniform annual worth (Rs.)
400000
350000
300000
250000 Expenditure
200000 Revenue
150000
100000
50000
Breakeven value
0
0 50 100 150 200 250 300 350 400 450
3
Volume of concrete (m )
Fig. 2.34 Equivalent uniform annual worth of expenditure and revenue

and breakeven point
The equivalent uniform annual worth of expenditure and revenue are calculated at
different values of volume of concrete produced per year using the respective expressions
as mentioned earlier and are shown in the above figure.
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:
PWe  750000  45000P / A, i, n   300xP / A, i, n 
PWe  750000  45000P / A,11%,10  300xP / A,11%,10

PWe  750000  45000  5.8892  5.8892  300x 1015014 1766.76x

Present worth of revenue:
PWr  210000P / F, i, n  1000xP / A, i, n 
PWr  210000P / F,11%,10 1000xP / A,11%,10
PWr  210000  0.3522  5.8892 1000x  73962  5889.2x
Now equating equivalent present worth of expenditure with that of revenue;
PWe  PWr
1015014 1766.76x  73962  5889.2x
x  228.275 m 3
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.

Lecture-16
Breakeven analysis for two and more than two alternatives:-

Breakeven analysis between two alternatives
The breakeven analysis between two alternatives is carried out by equating the equivalent
worth of cash flows of both the alternatives. For determining the breakeven point
between the alternatives, a factor or variable (as required) must be common to both the
alternatives and the corresponding cost or revenue element is expressed in terms of this
common variable. As already stated, the total equivalent worth of alternatives can be
calculated either by present worth method, future worth method or annual worth method
by considering the time value of money. The breakeven analysis between two alternatives
is presented in the following example.
Example -23
A construction company has two alternatives to purchase an excavator which is to be

employed at a construction site for excavation of earth. The cash flow details of the two
alternatives are presented as follows;
Alternative-1: Initial purchase cost = Rs.4865000
Operating cost:
The operating cost for excavating 1m3 of earth is Rs.11.0. The excavator (Alternative-1)
can excavate 52 m3 of earth in one hour.
Operating cost:
The company‟s minimum attractive rate of return (MARR) is 10.5% per year. How many
hours the excavators have to operate per year, for the equivalent uniform annual worth of
cash flows of both the alternatives to be equal?
Solution:
Let „y‟ is the number of operating hours per year.
The annual operating cost (Rs.) for Alternative-1 is given by;
Rs.11 52 m 3 y hour
   Rs.572 y
1 m 3 1 hour year
Now the equivalent uniform annual worth (Rs.) of Alternative-1 is given by;
AW1   4865000A / P, i, n   572y 1250000A / F, i, n 
AW1   4865000A / P,10.5%,12  572y 1250000A / F,10.5%,12
AW1   4865000  0.1504  572y 1250000  0.0454   674946  572y
Rs.8 60 m 3 y hour
   Rs.480 y
1 m 3 1 hour year
The equivalent uniform annual worth (Rs.) of Alternative-2 is given by;
AW2   5350000A / P, i, n   480y 141000A / F, i, n 
AW2   5350000A / P,10.5%,12  480y 1410000A / F,10.5%,12
AW2   5350000  0.1504  480y 1410000  0.0454   740626  480y
Now equating equivalent uniform annual worth Alternative-1 to that of Alternative-2;
AW1  AW2
 674946  572y  740626  480y
y  713.9 hours
Thus the breakeven value of number of operating hours per year is 713.9 hours, at which
the equivalent uniform annual worth of Alternative-1 is equal to that of Alternative-2.
The breakeven point is also shown in Fig. 2.35. The equivalent uniform annual worth of
both the alternatives are determined at different values of annual operating hours and are
shown in Fig. 2.35.
1400000
Equivalent uinform annual worth (Rs.)
1200000
1000000
800000
600000
Alternative-1
Alternative-2
400000
200000
Breakeven point
0
0 100 200 300 400 500 600 700 800 900 1000 1100 1200
Annual operating period (Hours)
Fig. 2.35 Equivalent uniform annual worth and breakeven point between Alternative-1 and Alternative-2
The equivalent uniform annual worth of both the alternatives is negative as cash outflows
(i.e. expenditures) are greater than the cash inflows (i.e. revenues). Thus the equivalent
uniform annual worth of both the alternatives shown in Fig. 2.35 can also be stated as
equivalent uniform annual cost. The line representing the equivalent uniform annual cost
of Alternative-1 has greater slope than Alternative-2 as observed from this figure. In
other words Alternative-1 has higher annual variable cost (Rs.572y) as compared to
Alternative-2 (Rs.480y). Similarly Alternative-2 has higher constant equivalent annual
cost (Rs.740626) than Alternative-1 (Rs.674946), as observed from expressions of
equivalent uniform annual worth of both the alternatives and also from the above figure.
If the expected annual operating hours are less than the breakeven value (i.e. 713.9
hours), then the construction company should select Alternatives-1 as its equivalent
annual cost is less than that of Alternative-2 (as evident from Fig. 2.35). Similarly if the
expected annual operating hours are greater than breakeven value, then Alternative-2
should be selected as it shows lower equivalent annual cost as compared to Alternative-1.
Breakeven analysis for more than two alternatives

The breakeven analysis can also be carried out for more than two alternatives. Similar to
the case of two alternatives, the required factor or variable must be common to all the
alternatives. In this analysis the pair-wise comparison between the alternatives is carried
out to determine the corresponding breakeven point. The schematic diagram of breakeven
analysis between three alternatives (A1, A2 and A3) is shown in Fig. 2.36. In this figure
the lines represent the total equivalent worth (i.e. equivalent worth of net cash flow) of
the alternatives at different values of the common variable „x‟.
A3
A1
A2
Total equivalent
worth (Rs.)
x2
x1 x3
Quantity of common variable ‘x’

Fig. 2.36 Schematic diagram of breakeven points for three alternatives
In this figure the total equivalent worth is assumed as the equivalent annual cost of the
alternatives. Further „x1‟, „x2‟ and „x3‟ represent the breakeven points between
alternatives A1 and A3, between A2 and A3 and between A1 and A2 respectively. As
already mentioned, the breakeven points „x1‟, „x2‟ and „x3‟ can be calculated by equating
the equivalent worth of the corresponding pair of the alternatives. If the expected or
estimated value of common variable „x‟ is less than „x1‟ (i.e. the breakeven value between
A1 and A3), then alternative A3 is selected as it shows lowest equivalent annual cost as
evident from Fig. 2.36. Similarly if the expected value of common variable „x‟ lies in
between „x1‟ and „x3‟, then alternative A1 is selected as its equivalent annual cost is
lowest within this range of the common variable. Further if the expected value of
common variable is greater than „x3‟, then alternative A2 is preferred over other
alternatives as it shows lowest equivalent annual cost as compared to other alternatives.
In this analysis, „x2‟ (the breakeven point between alternatives A2 and A3) lies between
the breakeven points „x1‟ and „x3‟ and alternative A1 has lowest equivalent annual cost
between breakeven points „x1‟ and „x2‟ and between „x2‟ and „x3‟ (i.e. between „x1‟ and
„x3‟ as already stated).
The breakeven analysis between three alternatives is presented in the following example.

In this example, details about third alternative are mentioned along with the two
alternatives stated in Example-23 for carrying out breakeven analysis between three
alternatives.
A construction company has three alternatives to purchase an excavator which is to be
employed at a construction site for excavation of earth. The cash flow details of all the
three alternatives are presented as follows;
Operating cost:
Operating cost:

Operating cost:
The company‟s minimum attractive rate of return (MARR) is 10.5% per year. Determine
the economical alternative at different values of annual operating hours.
Solution:
In this case the pair-wise comparison between the alternatives is carried out to determine
the corresponding breakeven point.
Let „y‟ is the number of operating hours per year.
As already determined in Example-23, the equivalent uniform annual worth of
Alternative-1 and Alternative-2 are as follows;
AW1   674946  572y
AW2   740626  480y
Rs.6 67 m 3 y hour
   Rs.402 y
1 m 3 1 hour year
Now the equivalent uniform annual worth (Rs.) of Alternative-3 is given by;
AW3   5975000A / P, i, n   402y 1500000A / F, i, n 
AW3   5975000A / P,10.5%,12  402y 1500000A / F,10.5%,12
AW3   5975000  0.1504  402y 1500000  0.0454   830540  402y

The equivalent uniform annual worth of all the alternatives can also be stated as
equivalent uniform annual cost, as it is negative. Now the equivalent uniform annual
worth of all the three alternatives are determined at different values of annual operating
hours and are shown in Fig. 2.37.
1600000
Equivalent uniform annual worth (Rs.) 1400000
1200000
1000000
Alternative-1
800000 Alternative-2
Alternative-3
600000
400000 P2
P1 P3
200000
0
0 200 400 600 800 1000 1200 1400 1600 1800
Annual operating period (Hours)
Fig. 2.37 Equivalent uniform annual worth and breakeven points between the alternatives
From this figure, it is observed that there are three breakeven points i.e. P1 between
Alternative-1 and Alternative-2, P2 between Alternative-1 and Alternative-3 and P3
between Alternative-2 and Alternative-3. The breakeven points are determined by
equating the equivalent uniform annual worth of the corresponding alternatives.
For breakeven point P1, equating the equivalent uniform annual worth Alternative-1 to
that of Alternative-2;
AW1  AW2
 674946  572 y  740626  480 y
y  713.9 hours
AW1  AW3
 674946  572y   830540  402y
y  915.3 hours
AW2  AW3
 740626  480y   830540  402y
y  1152.7 hours
If the expected annual operating hours are less than the 713.9 hours (breakeven point P1),
then the construction company should select Alternatives-1 as it shows lowest equivalent
annual cost as compared to other alternatives as observed from Fig. 2.37. Similarly
Alternative-2 should be selected, if the expected annual operating hours lie between
713.9 and 1152.7 hours (between breakeven points P1 and P3) as its equivalent annual
cost is lowest than other alternatives. Further, Alternative-3 should be selected, if the
expected annual operating hours are greater than 1152.7 hours (breakeven point P3), as it
shows lowest equivalent annual cost as compared to other alternatives as evident from
Fig. 2.37.
It is to be noted here that, similar to Example-1 (Lecture-2 of this module), commas at

appropriate places for the numbers can be placed in other examples presented in different
lectures.
Module 3
Lecture-1
Depreciation:-
It represents the reduction in market value of an asset due to age, wear and tear and
obsolescence. The physical deterioration of the asset occurs due to wear and tear with
passage of time. Obsolescence occurs to due to availability of new technology or new
product in the market that is superior to the old one and the new one replaces the old even
though the old one is still in working condition. The tangible assets for which the
depreciation analysis is carried out are construction equipments, buildings, electronic
products, vehicles, machinery etc. Depreciation amount for any asset is usually calculated
on yearly basis. Depreciation is considered as expenditure in the cash flow of the asset,
although there is no physical cash outflow. Depreciation affects the income tax to be paid
by an individual or a firm as it is considered as an allowable deduction in calculating the
taxable income. Generally the income tax is paid on taxable income which is equal to
gross income less the allowable deductions (expenditures). Depreciation reduces the
taxable income and hence results in lowering the income tax to be paid.
Before discussing about different methods of depreciation, it is necessary to know the

common terms used in depreciation analysis. These terms are initial cost, salvage value,
book value and useful life. Initial cost is the total cost of acquiring the asset. Salvage
value represents estimated market value of the asset at the end of its useful life. It is the
expected cash inflow that the owner of the asset will receive by disposing it at the end of
useful life. Book value is the value of asset recorded on the accounting books of the firm
at a given time period. It is generally calculated at the end of each year. Book value at the
end of a given year equals the initial cost less the total depreciation amount till that year.
Useful life represents the expected number of years the asset is useful in terms of
generating revenue. The asset may still be in working condition after the useful life but it
may not be economical. Useful life is also known as depreciable life. The asset is
depreciated over its useful life.

The commonly used depreciation methods are straight-line depreciation method,

declining balance method, sum-of-years-digits method and sinking fund method.
Straight-line (SL) depreciation method:-

It is the simplest method of depreciation. In this method it is assumed that the book value
of an asset will decrease by same amount every year over the useful life till its salvage
value is reached. In other words the book value of the asset decreases at a linear rate with
the time period.
The expression for annual depreciation in a given year ‘m’ is presented as follows;
P  SV
Dm  …………………………………. (3.1)
n
Where
Dm = depreciation amount in year ‘m’ (m = 1, 2, 3, 4, ………., n, i.e. 1  m  n)
P = initial cost of the asset
n = useful life or depreciable life (in years) over which the asset is depreciated.
In equation (3.1), 1 is the constant annual depreciation rate which is denoted by the
n
term ‘dm’.
Since the depreciation amount is same every year, D1 = D2 = D3 = D4 = ……… = Dm
The book value at the end of 1st year is equal to initial cost less the depreciation in the 1st
year and is given by;
BV1  P  Dm ………………………………… (3.2)
Book value at the end of 2nd year is equal to book value at the beginning of 2nd year (i.e.
book value at the end of 1st year) less the depreciation in 2nd year and is expressed as
follows;
BV2  BV1  Dm ………………………………. (3.3)
As already stated depreciation amount is same in every year.
Now putting the expression of ‘BV1’ from equation (3.2) in equation (3.3);
BV2  P  Dm   Dm  P  2Dm ……………….. (3.4)
Similarly the book value at the end of 3rd year is equal to book value at the beginning of
3rd year (i.e. book value at the end of 2nd year) less the depreciation in 3rd year and is
given by;

BV3  BV2  Dm ……………………………… (3.5)
BV3  P  2Dm   Dm  P  3Dm …………….. (3.6)

In the same manner the generalized expression for book value at the end of any given
year ‘m’ can be written as follows;
BVm  P  mDm ………………………………. (3.7)
Declining balance (DB) depreciation method:-

It is an accelerated depreciation method. In this method the annual depreciation is
expressed as a fixed percentage of the book value at the beginning of the year and is
calculated by multiplying the book value at the beginning of each year with a fixed
percentage. Thus this method is also sometimes known as fixed percentage method of
depreciation. The ratio of depreciation amount in a given year to the book value at the
beginning of that year is constant for all the years of useful life of the asset. When this
ratio is twice the straight-line depreciation rate i.e. 2 , the method is known as double-
n
declining balance (DDB) method. In other words the depreciation rate is 200% of the
straight-line depreciation rate. Double-declining balance (DDB) method is the most
commonly used declining balance method. Another declining balance method that uses
depreciation rate equal to 150% of the straight-line depreciation rate i.e. 1.5 is also
n
used for calculation of depreciation. In declining balance methods the depreciation during
the early years is more as compared to that in later years of the asset’s useful life.
In case of declining balance method, for calculating annual depreciation amount, the
salvage value is not subtracted from the initial cost. It is important to ensure that, the
asset is not depreciated below the estimated salvage value. In declining-balance method
the calculated book value of the asset at the end of useful life does not match with the
salvage value. If the book value of the asset reaches its estimated salvage value before the
end of useful life, then the asset is not depreciated further.
Representing constant annual depreciation rate in declining balance method as ‘dm’, the
expressions for annual depreciation amount and book value are presented as follows;
The depreciation in 1st year is calculated by multiplying the initial cost (i.e. book value at
beginning) with the depreciation rate and is given by;
D1  P  d m  P1  d m   d m
0
……………………….…. (3.8)

Where
D1 = depreciation amount in 1st year
P = initial cost of the asset as already mentioned
dm = constant annual depreciation rate
year and is calculated as follows;
BV1  P  D1
Now putting the expression of ‘D1’from equation (3.8) in the above expression;
BV1  P  D1  P  P  d m  P1 d m  .………………… (3.9)
The depreciation in 2nd year i.e. ‘D2’ is calculated by multiplying the book value at the
beginning of 2nd year (i.e. book value at the end of 1st year) with the depreciation rate ‘dm’
and is given as follows;
D2  BV1  d m ……………...…………………………. (3.10)
Now putting the expression of ‘BV1’from equation (3.9) in equation (3.10) results in the
following;
D2  BV1  d m  P1  d m   d m …………………….... (3.11)
book value at the end of 1st year) less the depreciation in 2nd year and is expressed as
follows;
BV2  BV1  D2
Now putting the expressions of ‘BV1’ and ‘D2’from equation (3.9) and equation (3.11)
respectively in above expression results in the following;
BV2  BV1  D2  P1  d m   P1  d m   d m   P1  d m 1  d m   P1  d m  ... (3.12)

2
Similarly the depreciation in 3rd year i.e. ‘D3’ is calculated as follows;

D3  BV2  d m ……………...…………………………. (3.13)
Now putting the expression of ‘BV2’from equation (3.12) in equation (3.13);
D3  BV2  d m  P1  d m   d m
2
……………………. (3.14)
Book value at the end of 3rd year is calculated as follows;
BV3  BV2  D3

 2
  2

BV3  BV2  D3  P1  d m   P1  d m   d m  P1  d m  1  d m   P1  d m 
2 3
…….….. (3.15)
In the same manner the generalized expression for depreciation in any given year ‘m’ can
be written as follows (referring to equations (3.8), (3.11) and (3.14));
Dm  P1 - d m 
m1
 d m ………………………………... (3.16)
Similarly the generalized expression for book value at the end of any year ‘m’ is given as
follows (referring to equations (3.9), (3.12) and (3.15));
BVm  P1  d m 
m
………………………………….. (3.17)
The book value at the end of useful life i.e. at the end of ‘n’ years is given by;
BVn  P1  d m 
n
…………………………………... (3.18)
The book value at the end of useful life is theoretically equal to the salvage value of the
asset. Thus equating the salvage value (SV) of the asset to its book value (BVn) at the end
of useful life results in the following;
SV  BVn  P1  d m 
n
…………………………..... (3.19)
Thus for calculating the depreciation of an asset using declining balance method,
equation (3.19) can be used to find out the constant annual depreciation rate, if it is not
stated for the asset. From equation (3.19), the expression for constant annual depreciation
rate ‘dm’ from known values of initial cost ‘P’ and salvage value (SV  0) is obtained as
follows;
SV  P1  d m 
n
 1  d m 
SV n
P
1
 SV  n
dm  1   ……………………………….…... (3.20)
 P 
In double-declining balance (DDB) method, for calculating annual depreciation amount

and book value at the end of different years, the value of constant annual depreciation
rate ‘dm’ is replaced by ‘ 2 ’ in the above mentioned equations.

n

Example -1
The initial cost of a piece of construction equipment is Rs.3500000. It has useful life of
10 years. The estimated salvage value of the equipment at the end of useful life is
Rs.500000. Calculate the annual depreciation and book value of the construction
equipment using straight-line method and double-declining balance method.
Solution:
Initial cost of the construction equipment = P = Rs.3500000
Estimated salvage value = SV = Rs.500000
Useful life = n = 10 years
For straight-line method, the depreciation amount for a given year is calculated using
equation (3.1).
3500000  500000
Dm  D1  D2          D9  D10   Rs.300000
10
The book value at the end of a given year is calculated by subtracting the annual
depreciation amount from previous year’s book value.
Book value at the end of 1st year = BV1  Rs.3500000  Rs.300000  Rs.3200000
Book value at the end of 2nd year = BV2  Rs.3200000  Rs.300000  Rs.2900000
Similarly the book values at the end of other years have been calculated in the same
manner. The annual depreciation amount and book values at end of years using straight-
line depreciation method are presented in Table 3.1. For straight-line method, the book
value at the end of different years can also be calculated by using equation (3.7). For
example, the book value at the end of 2nd year is given by;
BV2  3500000  2  300000  Rs.2900000
For double-declining balance method, the constant annual depreciation rate ‘dm’ is
given by;
2 2
dm    0.2
n 10
The depreciation amount for a given year is calculated using equation (3.16).
Depreciation for 1st year = D1  3500000  1  0.2  0.2  Rs.700000
11
Depreciation for 2nd year = D 2  3500000  1  0.2

21
 0.2  Rs.560000

The book value at the end of a given year is calculated by subtracting the annual
depreciation amount from previous year’s book value.
Book value at the end of 1st year = BV1  Rs.3500000  Rs.700000  Rs.2800000
Book value at the end of 2nd year = BV2  Rs.2800000  Rs.560000  Rs.2240000
Similarly the annual depreciation and book value at the end of other years have been
calculated in the same manner and are presented in Table 3.1.
The book value at the end of different years can also be calculated by using equation
(3.17). Using this equation, the book value at the end of 2nd year is given by;
BV2  35000001  0.2  Rs.2240000
2
Table 3.1 Depreciation and book value of the construction equipment using straight-line method and double-declining balance
method
Straight-line method Double-declining balance method

Depreciation (Rs.) Book value (Rs.) Depreciation (Rs.) Book value (Rs.)
Year Dm BVm Dm BVm
0 - 3500000 - 3500000
1 300000 3200000 700000 2800000
2 300000 2900000 560000 2240000
3 300000 2600000 448000 1792000
4 300000 2300000 358400 1433600
5 300000 2000000 286720 1146880
6 300000 1700000 229376 917504
7 300000 1400000 183500.80 734003.20
8 300000 1100000 146800.64 587202.56
9 300000 800000 117440.51 469762.05
10 300000 500000 93952.41 375809.64
From Table 3.1 it is observed that the book value at the end of useful life i.e. 10 years in
double-declining balance method is less than salvage value. Thus the equipment will be
depreciated fully before the useful life. In other words the book value reaches the
estimated salvage value before the end of useful life. As the book value of the equipment
is not depreciated further after it has reached the estimated salvage value, the depreciation

amount is adjusted accordingly. The book value of the construction equipment at the end
of 8th, 9th, and 10th years are Rs.587202.56, Rs.469762.05 and Rs.375809.64 respectively
(from Table 3.1, Double-declining balance method). Similarly the depreciation amounts
for 9th and 10th years are Rs.117440.51 and Rs.93952.41 respectively. Thus to match the
book value with the estimated salvage value, the depreciation in 9th year will be
Rs.87202.56 (Rs.587202.56 – Rs.500000) and that in 10th year will be zero. This will lead
to a book value of Rs.500000 (equal to salvage value) at the end of 9th year and 10th year.
For this case, the switching from double-declining balance method to straight-line
method can be done to ensure that the book value does not fall below the estimated
salvage value and this procedure of switching is presented in Lecture 3 of this module.

Lecture-2
Depreciation:-
Sum-of-years-digits (SOYD) depreciation method:-

It is also an accelerated depreciation method. In this method the annual depreciation rate
for any year is calculated by dividing the number of years left (from the beginning of that
year for which the depreciation is calculated) in the useful life of the asset by the sum of
years over the useful life.
The depreciation rate ‘dm’ for any year ‘m’ is given by;
dm 
n  m  1 ………………………………....... (3.21)
SOY
Where n = useful life of the asset as stated earlier
nn  1
SOY = sum of years’ digits over the useful life =
2
Rewriting equation (3.21);
dm 
n  m  1 ……………………….…………. (3.22)
nn  1
2
The depreciation amount in any year is calculated by multiplying the depreciation rate for
that year with the total depreciation amount (i.e. difference between initial cost ‘P’ and
salvage value ‘SV’) over the useful life.
Thus the expression for depreciation amount in any year ‘m’ is represented by;
Dm  d m  P  SV  …………………….………... (3.23)
Putting the value of ‘dm’ from equation (3.21) in equation (3.23) results in the following;
Dm 
n  m  1  P  SV  ………………………. (3.24)
SOY
The depreciation in 1st year i.e. ‘D1’ is obtained by putting ‘m’ equal to ‘1’ in equation
(3.24) and is given by;
D1 
n  1  1  P  SV   P  SV   n ….…….... (3.25)
SOY SOY

year and is given by;
BV1  P  D1
Now putting the expression of ‘D1’from equation (3.25) in the above expression results in
following;
BV1  P 
P  SV   n .………………………....… (3.26)
SOY
The depreciation in 2nd year i.e. ‘D2’ is given by;
D2 
n  2  1  P  SV   P  SV   n  1 …..… (3.27)
SOY SOY
book value at the end of 1st year) less the depreciation in 2nd year and is given by;
BV2  BV1  D2
Now putting the expressions of ‘BV1’ and ‘D2’from equation (3.26) and equation (3.27)

BV2  BV1  D2   P 
P  SV   n   P  SV   n  1
  SOY 
 SOY   
 P  SV   P  SV   2n  1
BV2  P    n  n  1  P  ……….… (3.28)
 SOY  SOY
Similarly the expressions for depreciation and book value for 3rd year are presented
below.
D3 
n  3  1  P  SV   P  SV   n  2 ……………………..… (3.29)
SOY SOY

BV3  BV2  D3   P 
P  SV   2n  1   P  SV   n  2
  SOY 
 SOY   
 P  SV   P  SV   3n  3
BV3  P    2n  1  n  2  P  ……. (3.30)
 SOY  SOY
The expressions for depreciation and book value for 4th year are given by;
D4 
n  4  1  P  SV   P  SV   n  3 ………………………… (3.31)
SOY SOY


BV4  BV3  D4   P 
P  SV   3n  3   P  SV   n  3
  SOY 
 SOY   
 P  SV   P  SV   4n  6
BV4  P    3n  3  n  3  P  …..… (3.32)
 SOY  SOY
Similarly the expressions for depreciation and book value for 5th year are given by;
D5 
n  5  1  P  SV   P  SV   n  4 ……………………...… (3.33)
SOY SOY

BV5  BV4  D5   P 
P  SV   4n  6   P  SV   n  4
  SOY 
 SOY   
 P  SV   P  SV   5n  10
BV5  P    4n  6  n  4  P  …… (3.34)
 SOY  SOY
The expressions for book value in different years are presented above to find out the
generalized expression for book value at end of any given year. Now referring to the
expressions of book values BV1, BV2, BV3, BV4, BV5 in above mentioned equations, it is
observed that the variable terms are ‘n’, ‘(2n-1)’, ‘(3n-3)’, ‘(4n-6)’ and ‘(5n-10)’
respectively. These variable terms can also be written ‘(n+1-1)’, ‘(2n+1-2)’, ‘(3n+1-4)’,
‘(4n+1-7)’ and ‘(5n+1-11)’ respectively. The numbers 1, 2, 4, 7, and 11 in these variable
terms follow a series and it is observed that value of each term is equal to value of
previous term plus the difference in the values of current term and previous term. On this
note, the general expression for value of ‘m’ term of this series is given by;
mm  1
value of ' m' term  1  ……………………………………… (3.35)
2
Now the generalized expression for book value for any year ‘m’ is given by;
BVm  P 
P  SV    mn  1  1  mm  1 
  
SOY   2 
BVm  P 
P  SV   mn  mm  1 …………………………….… (3.36)
 
SOY  2 
In this method also, the annual depreciation during early years is more as compared to
that in later years of the asset’s useful life.

Sinking fund (SF) depreciation method:-

In this method it is assumed that money is deposited in a sinking fund over the useful life
that will enable to replace the asset at the end of its useful life. For this purpose, a fixed
amount is set aside every year from the revenue generated and this fixed sum is
considered to earn interest at an interest rate compounded annually over the useful life of
the asset, so that the total amount accumulated at the end of useful life is equal to the total
depreciation amount i.e. initial cost less salvage value of the asset. Thus the annual
depreciation in any year has two components. The first component is the fixed sum that is
deposited into the sinking fund and the second component is the interest earned on the
amount accumulated in sinking fund till the beginning of that year.
For this purpose, first the uniform depreciation amount (i.e. fixed amount deposited in
sinking fund) at the end of each year is calculated by multiplying the total depreciation
amount (i.e. initial cost less salvage value) over the useful life by sinking fund factor.
After that the interest earned on the accumulated amount is calculated. The calculations
are shown below.
The first component of depreciation i.e. uniform depreciation amount ‘A’ at the end of
each year is given by;
A  P  SV    A / F , i, n   P  SV  
i
………………… . (3.37)
1  i n  1
Where i = interest rate per year
Depreciation amount for 1st year is equal to only ‘A’ as this is the amount (set aside every
year from the revenue generated) to be deposited in sinking fund at the end of 1st year and
hence there is no interest accumulated on this amount.
Therefore D1  A  A1  i 
0
…………………………………….…. (3.38)
Now book value at the end of 1st year is given by;
BV1  P  D1  P  A1  i 
0
……………………………….……. (3.39)
Depreciation amount for 2nd year is equal to uniform amount ‘A’ to be deposited at the
end of 2nd year plus the interest earned on the amount accumulated till beginning of 2 nd
year i.e. on depreciation amount for 1st year. Thus depreciation for amount for 2nd year is
given by;

D2  A  D1  i
Now putting ‘D1’ equal to ‘A’ in the above expression results in;
D2  A  A  i  A1  i  ………………………………………..… (3.40)
Book value at the end of 2nd year is given by;
BV2  BV1  D2
Now putting the expressions of ‘BV1’ and ‘D2’ from equation (3.39) and equation (3.40)
0

BV2  BV1  D2  P  A1  i   A1  i   P  A 1  i   1  i 
0 1
 …… (3.41)
Depreciation amount for 3rd year is equal to uniform amount ‘A’ to be deposited at the
end of 3rd year plus the interest earned on the amount accumulated till beginning of 3rd
year i.e. on sum of depreciation amounts for 1st year and 2nd year. Thus depreciation for
amount for 3rd year is given by;
D3  A  D1  D2   i
Putting the expressions of ‘D1’ and ‘D2’from equation (3.38) and equation (3.40)
D3  A  D1  D2  i  A  A  A1  i  i  A  A  i  A1  i  i  A1  i   A1  i  i
On simplifying the above expression;

D3  A1  i   1  i   A1  i 
2
…………………………………… (3.42)
Now book value at the end of 3rd year is given by;
BV3  BV2  D3
Putting the expressions of ‘BV2’ and ‘D3’ from equation (3.41) and equation (3.42)
respectively in above expression results in;
 0 1
 2

BV3  BV2  D3  P  A 1  i   1  i   A1  i   P  A 1  i   1  i   1  i 
0 1 2

……………….... (3.43)
Now the generalized expression for depreciation in any given year ‘m’ can be written as
follows (referring to equations (3.38), (3.40) and (3.42));
Dm  A1  i 
m1
……………………………………………………... (3.44)
Putting the value of ‘A’ from equation (3.37) in equation (3.44) results in the following;

Dm  A1  i   P  SV    1  i 
m 1 i m 1
……………….… (3.45)
1  i  n
1
Similarly the generalized expression for book value at the end of any year ‘m’ is given by
(referring to equations (3.39), (3.41) and (3.43));

BVm  P  A 1  i   1  i   1  i   1  i             1  i 
0 1 2 3 m2
 1  i 
m1

…………….. (3.46)
The expression in the square bracket of equation (3.46) is in the form of a geometric
series and its sum represents the factor known as uniform series compound amount factor
(stated in Module-1). Therefore replacing the expression in square bracket of equation
(3.46) with uniform series compound amount factor results in;
BVm  P  AF / A, i, m …………………………………………….. (3.47)
Putting the value of ‘A’ from equation (3.37) and expression for uniform series
compound amount factor in equation (3.47) results in the following generalized
expression for book value at the end of any year ‘m’ (1  m  n).
 1  i m  1
BVm  P  AF / A, i, m  P  P  SV  
i
 
1  i n 1  i 
 1  i m  1
BVm  P  P  SV     ….………………………....... (3.48)
 1  i   1 
n
In this method, the depreciation during later years is more as compared to that in early
years of the asset’s useful life.
Example -2
Using the information provided in previous example, calculate the annual depreciation
and book value of the construction equipment using sum-of-years-digits method and
sinking fund method. The interest rate is 8% per year.
Solution:
P = Rs.3500000
SV = Rs.500000
n = 10 years

For sum-of-years-digits method, the depreciation amount for a given year is calculated
using equation (3.24).
10  10  1
SOY = sum of years’ digits over the useful life =  55
2
Depreciation for 1st year = D1 

10  1  1  3500000  500000  Rs.545454.55
55
st
Book value at the end of 1 year:
BV1  Rs.3500000  Rs.545454.55  Rs.2954545.45
Depreciation for 2nd year = D2 

10  2  1  3500000  500000  Rs.490909.09
55
Book value at the end of 2nd year:
BV2  Rs.2954545.45  Rs.490909.09  Rs.2463636.36
Similarly the annual depreciation and book value at the end of other years for the
construction equipment have been calculated and are presented in Table 3.2.
The book value at the end of different years can also be calculated by using equation
(3.36). Using this equation, the book value at the end of 2nd year is calculated as follows;
BV2  3500000 
3500000  500000  2 10  2  2  1  Rs.2463636.36
 
55  2 
For sinking fund method, the depreciation amount for a given year is calculated using
equation (3.45).
The interest rate per year = i = 8%
Depreciation amount for 1st year:
D1  3500000  500000  1  0.08  Rs.207088.47

0.08 11
1  0.08  1
10
Book value at the end of 1st year:

BV1  Rs.3500000  Rs.207088.47  Rs.3292911.53
Depreciation amount for 2nd year:
D2  3500000  500000   1  0.08

0.08 2 1
 Rs.223655.55
1  0.08
10
1
Book value at the end of 2nd year:
BV2  Rs.3292911.53  Rs.223655.55  Rs.3069255.98

Similarly the annual depreciation and book value at the end of other years are calculated
in the same manner and are given in Table 3.2.
The book value at the end of a given year can also be calculated by using equation (3.48).
Using this equation, the book value at the end of 2nd year is given by;
 1  0.082  1 
BV2  3500000  3500000  500000    Rs.3069255.99
 1  0.08 10
 1 
Table 3.2 Depreciation and book value of the construction equipment using sum-of-years-digits method and sinking fund
method
Sum-of-years-digits method Sinking fund method

Year Depreciation (Rs.) Book value (Rs.) Depreciation (Rs.) Book value (Rs.)
Dm BVm Dm BVm
0 - 3500000 - 3500000
1 545454.55 2954545.45 207088.47 3292911.53
2 490909.09 2463636.36 223655.55 3069255.98
3 436363.64 2027272.73 241547.99 2827707.99
4 381818.18 1645454.55 260871.83 2566836.16
5 327272.73 1318181.82 281741.58 2285094.58
6 272727.27 1045454.55 304280.90 1980813.68
7 218181.82 827272.73 328623.38 1652190.30
8 163636.36 663636.36 354913.25 1297277.06
9 109090.91 554545.45 383306.31 913970.75
499999.94*
10 54545.45 500000 413970.81 = 500000
* This minor difference is due to effect of decimal points in the calculation.

The book value at the end of all years over the useful life of the construction equipment
obtained from different depreciation methods (Example 1 and Example 2) are shown in
Fig. 3.1.

Book Value from different depreciation methods

4000000
3500000
SL Method
3000000
DDB Method
Book value (Rs.)
2500000 SOYD Method

SF Method
2000000
1500000 Line representing

salvage value
1000000
500000
0
0 1 2 3 4 5 6 7 8 9 10 11 12
End of Year
Fig. 3.1 Book value of the construction equipment using

different depreciation methods
In the above figure, the line representing the salvage value is also shown. In double-
declining balance method only, the calculated book value at the end of useful life i.e. 10th
year is not same as the estimated salvage value.

Lecture-3
Switching between different depreciation methods:-
Switching from one depreciation method to another is done to accelerate the depreciation
of book value of the asset and thus to have tax benefits. Switching is generally done when
depreciation amount for a given year by the currently used method is less than that by the
new method. The most commonly used switch is from double-declining balance (DDB)
method to straight-line (SL) method. In double-declining balance method, the book value
as calculated by using equation (3.17) never reaches zero. In addition the calculated book
value at the end of useful life does not match with the salvage value. Switching from
double-declining balance method to straight-line method ensures that the book value does
not fall below the estimated salvage value of the asset.
In the following examples the procedure of switching from double-declining balance
method to straight-line method is illustrated.
Example -3
The initial cost of an asset is Rs.1000000. It has useful life of 9 years. The estimated
salvage value of the asset at the end of useful life is zero. Calculate the annual
depreciation and book value using double-declining balance method and find out the year
in which the switching is done from double-declining balance method to straight-line
method.
Solution:
Initial cost of the asset = P = Rs.1000000
Salvage value = SV = 0
For double-declining balance (DDB) method, the constant annual depreciation rate ‘dm’ is
given by;
2 2
dm    0.222
n 9
The annual depreciation and the book value at the end different years are calculated using
the respective equations stated earlier and are presented in Table 3.3.

Table 3.3 Depreciation and book value from double-declining balance method
Year Depreciation (Rs.) Book value (Rs.)

0 - 1000000
1 222000 778000
2 172716 605284
3 134373.05 470910.95
4 104542.23 366368.72
5 81333.86 285034.86
6 63277.74 221757.12
7 49230.08 172527.04
8 38301 134226.04
9 29798.18 104427.86
From the above table it is observed that the book value at the end of useful life is
Rs.104427.86, which is more than the estimated salvage value i.e. 0. The asset is not
completely depreciated. Thus switching is done from double-declining balance method to
straight-line method and is shown in Table 3.4.
Table 3.4 Double-declining balance method and switching to straight-line method
Year Depreciation Depreciation Selected Book value

amount (Rs.) amount (Rs.) depreciation (Rs.)
(DDB method) (SL method) amount (Rs.)
0 - - - 1000000
1 222000 111111.11 222000 778000
2 172716 97250 172716 605284
3 134373.05 86469.14 134373.05 470910.95
4 104542.23 78485.16 104542.23 366368.72
5 81333.86 73273.74 81333.86 285034.86
6** 63277.74 71258.72 71258.72 213776.15
7 49230.08 71258.72 71258.72 142517.43
8 38301 71258.72 71258.72 71258.72
9 29798.18 71258.72 71258.72 0
** Switching from DDB method to SL method

In the above table, annual depreciation values from double-declining balance (DDB)
method are also presented to compare with those obtained from straight- line method. For
straight-line (SL) method the depreciation amount for a given year ‘m’ is calculated by
dividing the difference of the book value (at the beginning of that year) and salvage value
by the number of years remaining from beginning of that year till the end of useful life
and is shown below;
BVm1  SV
Dm 
(n  m  1)
For illustration, the straight-line depreciation in 4th year (m = 4) is calculated as follows;
470910.95  0
D4   Rs.78485.16
(9  4  1)
From the annual depreciation values by straight-line method as shown in 3rd column of
above table, it is observed that, the annual values are not uniform. This is because when
switching is done from DDB method to SL method, the larger depreciation amount
between the two the methods for a given year is subtracted from the previous year’s book
value to calculate the book value at the end of desired year and this book value is used for
calculating the depreciation amount for next year in straight-line method. The larger
annual depreciation values (i.e. selected depreciation amount) between DDB method and
SL method are provided in 4th column of Table 3.4. The book value at the end of a given
year presented in 5th column of above table is obtained by subtracting ‘selected
depreciation amount’ of that year from the previous year’s book value. From the above
table it is observed that the annual depreciation amount in DDB method is greater than
that in SL method from 1st year to 5th year and from 6th year onwards the annual
depreciation is greater in SL method than that in DDB method. Thus switching from
DDB method to SL method takes place in 6th year. With switchover from DDB method to
SL method the book value at the end of useful life i.e. 9th year is equal to zero (same as
the estimated salvage value) as compared to Rs.104427.86 without switching to straight-
line method. In addition the total depreciation amount over the useful life of the asset
(initial cost minus salvage value) with switchover from DDB method to SL method is
Rs.1000000 (i.e. sum of values in 4th column of Table 3.4) as desired whereas the total

depreciation amount without switchover is Rs.895572.14 (sum of values in 2nd column of

Table 3.4).
Example -4
A piece of construction equipment has initial cost and estimated salvage value of
Rs.1500000 and Rs.200000 respectively. The useful life of equipment is 10 years. Find
out the year in which the switching from double-declining balance method to straight-line
method takes place.
Solution:
Initial cost of the asset = P = Rs.1500000, Salvage value = SV = Rs.200000
The constant annual depreciation rate ‘dm’ for double-declining balance (DDB) method is
calculated as follows;
2 2
dm    0.2
n 10
The annual depreciation amount and the book value at the end different years using DDB
method are presented in Table 3.5.
Table 3.5 Depreciation and book value using double-declining balance method
Year Depreciation (Rs.) Book value (Rs.)

0 - 1500000
1 300000 1200000
2 240000 960000
3 192000 768000
4 153600 614400
5 122880 491520
6 98304 393216
7 78643.20 314572.80
8 62914.56 251658.24
9 50331.65 201326.59
10 40265.32 161061.27

From the above table it is noted that the book value at the end of useful life i.e. 10th year
is Rs.161061.27, which is less than the estimated salvage value i.e. Rs.200000. Thus the
total depreciation amount over the useful life is more than the desired. Hence switching is
done from double-declining balance method to straight-line method and is presented in
Table 3.6.
In Table 3.6, annual depreciation by SL method, selected depreciation amount and book
values are calculated in the same manner as that in the previous example. The annual
depreciation for 10th year in DDB method is Rs.40265.32 and subtracting this amount
from 9th year book value results in a book value (at the end of 10th year) less than the
estimated salvage value (As seen from Table 3.5). Further the book value at the end of 9th
year (i.e. Rs.201326.59) is greater than salvage value. Thus switching from DDB method
to SL method takes place in 10th year. With switching from DDB method to SL method,
the book value at the end of 10 years is equal to Rs.200000 (same as the estimated
salvage value) as compared to Rs.161061.27 without switching to straight-line method.
Table 3.6 Double-declining balance method with switching to straight-line method
Year Depreciation Depreciation Selected Book value

amount (Rs.) amount (Rs.) depreciation (Rs.)
(DDB method) (SL method) amount (Rs.)
0 - - - 1500000
1 300000 130000 300000 1200000
2 240000 111111.11 240000 960000
3 192000 95000 192000 768000
4 153600 81142.86 153600 614400
5 122880 69066.67 122880 491520
6 98304 58304 98304 393216
7 78643.20 48304 78643.20 314572.80
8 62914.56 38190.93 62914.56 251658.24
9 50331.65 25829.12 50331.65 201326.59
10** 40265.32 1326.59 1326.59 200000
** Switching from DDB method to SL method
Further the total depreciation amount (i.e. initial cost less estimated salvage value) with
switchover from DDB method to SL method is Rs.1300000 (i.e. sum of values in 4th

column of Table 3.6) as desired whereas the total depreciation amount without
switchover is Rs.1338938.73 (sum of values in 2nd column of Table 3.6).

Lecture-4
Inflation:
Inflation is defined as an increase in the amount of money required to purchase or acquire

the same amount of products and services that was acquired without its effect. Inflation
results in a reduction in the purchasing power of the monetary unit. In other words, when
prices of the products and services increase, we buy less quantity with same amount of
money i.e. the value of money is decreased. For example, the quantity of items we
purchase today at a cost of Rs.1000 is less than that was purchased 5 years ago. This is
due to a general change (increase) in the price of the goods and services with passage of
time. On the other hand deflation results in an increase in the purchasing power of the
monetary unit with time and it rarely occurs. Due to effect of deflation, more can be
purchased with same amount of money in future time period than that can be purchased
today. The inflation rate (f) is measured as the rate of increase (per time period) in the
amount of money required to obtain same amount of products and services. Till now, the
interest rate ‘i’ that was used in the economic evaluation of a single alternative or
between alternatives by different methods as mentioned in earlier lectures was assumed
to be inflation-free i.e. the effect of inflation on interest rate was excluded. This interest
rate ‘i’ is also known as also real interest rate or inflation-free interest rate. It represents
the real gain in money of the cash flows with time without the effect of inflation.
However if inflation is there in the general market, then effect of inflation on the interest
rate needs to be taken into account for the economic analysis. The interest rate that
includes the effect of price inflation which is occurring in general economy is known as
the market interest rate (ic). It takes into account the adjustment for the price inflation in
the market. Market interest rate is also known as inflated interest rate or combined
interest rate as it combines the effect of both real interest rate and the inflation.
In addition to above parameters, it is also required to define two parameters namely

actual monetary units and constant value monetary units while considering the effect of
inflation in the cash flow of the alternatives. The monetary units can be Rupees, Dollars,
Euros etc. The actual monetary units are also referred as future or inflated monetary units.
The purchasing power of the actual monetary units includes the effect of inflation on the

cash flows at the time it occurs. The constant value monetary units are also called as real
or inflation-free monetary units. The constant value monetary units are expressed in terms
of the same purchasing power for the cash flows with reference to a base period. Mostly
in engineering economic studies, the base period is taken as ‘0’ i.e. now. But it can be of
any time period as required.
The effect of inflation on cash flows is demonstrated in the following example.
Example -5
The present (today’s) cost of an item is Rs.20000. The inflation rate is 5% per year. How
does the inflation affect the cost of the item for the next five years?
Solution:
The calculations are shown in Table 3.7.
Table 3.7 Effect of inflation on future cost of the item
Cost of the item in inflated

Increase in cost of item Cost of the item in inflated monetary units expressed as
Year due to inflation @ 5% monetary units i.e. inflated function of today’s cost (i.e. in
per year (Rs.) cost (Rs.) inflation-free monetary units)
and inflation rate, (Rs.)
0 - 20000 20000
1 20000 x 0.05 = 1000 20000 + 1000 = 21000 20000 x (1 + 0.05)1 = 21000
2 21000 x 0.05 = 1050 21000 + 1050 = 22050 20000 x (1 + 0.05)2 = 22050
3 22050 x 0.05 = 1102.50 22050+ 1102.5 = 23152.50 20000 x (1 + 0.05)3 = 23152.50
4 23152.5 x 0.05 = 1157.63 23152.5 + 1157.62 = 24310.13 20000 x (1 + 0.05)4 = 24310.13
5 24310.13 x 0.05 = 1215.50 24310.13 + 1215.5 = 25525.63 20000 x (1 + 0.05)5 = 25525.63
From above table, the relationship between cost in actual monetary units (inflated) in
time period ‘n’ and cost in constant value monetary units (inflation-free) can be
represented as follows;
Cost in actual monetary units (inflated) = Cost in constant value monetary units  (1+f)n
…………. (3.49)

From equation (3.49), the expression for cost in constant value monetary units (inflation-
free) is written as follows
Cost in actual monetary units (inflated)
Cost in constant value monetary units (inflation - free) 
1  f n
……………. (3.50)
In the above expressions, ‘f’ is the inflation rate per year i.e. 5% and the base or reference
period is considered as ‘0’. However the above relationship between constant value
monetary units and actual monetary units can also be written for any base period ‘b’.
Cost in constant value monetary units (inflation - free)  n b
 1  ……….. (3.51)
Cost in actual monetary units (inflated)   
1 f 
In the above relationship, the base period ‘b’ defines the purchasing power of constant
value monetary units. As shown in Table 3.7, the actual cost (inflated) of the item in
years 1, 2, 3, 4 and 5 are Rs.21000, Rs.22050, Rs.23152.50, 24310.13 and Rs.25525.63
respectively. However the cost of the item in inflation-free or constant value rupees in all
the years is always Rs.20000 [i.e. 21000/(1+0.05)1, 22050/(1+0.05)2, etc.] i.e. equal to the
cost at the beginning. In this example, effect of interest rate i.e. effect of time value of
money is not considered.

Lecture-5
Equivalent worth calculation including the effect of inflation:-

For calculations of equivalent worth of cash flows of alternatives with price inflation in
action, the interest rate to be adopted (i.e. real interest rate or combined interest rate)
depends on whether the cash flows are expressed in inflated rupees or inflation-free
rupees. When the cash flows are calculated in constant value monetary units, inflation-
free interest rate (real interest rate) ‘i’ is used. Similarly when the cash flows are
estimated in actual monetary units, combined interest rate (inflated interest rate) ‘ic’ is
used.
The relationship between present worth and future worth considering the time value of
money is given by;
Fc
P …………………………….. (3.52)
1  i n
P = present worth (at base period ‘0’)
Fc = future worth in constant value monetary units (inflation-free)
In the above equation, future worth in constant value monetary units (inflation-free) can
be represented in terms of future worth in actual monetary units (inflated) by using the
relationship stated in equation (3.50). Equation (3.52) can be rewritten by including the
inflation rate.
Fa 1
P  ………………………..… (3.53)
1  f  n
1  i n
In equation (3.53), Fa is the future worth in actual monetary units (inflated) and ‘f’ is the
inflation rate as stated earlier.
1
P  Fa  ……….……………… (3.54)
1  i  f  f  i
n
1
P  Fa  ……………………..... (3.55)
1  i  f  f  i 
n

The expression i  f  f  i  in the above equation that combines the effect of real
interest rate ‘i’ and inflation rate ‘f’ is termed as combined interest rate or market interest
rate (ic) as stated earlier.
ic  i  f  f  i  ……………………………….. (3.56)
1
P  Fa  …………………………….…… (3.57)
1  ic n
Using equation (3.57), the future worth in inflated monetary units can be calculated from
known value of present worth ‘P’.
Equation (3.57) can also be written in functional representation as follows;

P  Fa P / F , ic , n ……………………………....…. (3.58)
Similarly the relationship between annual worth ‘A’ and present worth ‘P’ and that
between ‘A’ and future worth ‘F’ of the cash flows considering the effect of inflation can
be obtained.
From known values of combined interest rate ‘ic’ and inflation rate ‘f’, the real interest
rate ‘i’ can be obtained from equation (3.56) and is given as follows;
ic  i  f  f  i   f  i1  f 
ic  f 
i …………………………………... (3.59)
1  f 
The real interest rate ‘i’ (inflation-free) in equation (3.59) represents the equivalence
between cash flows occurring at different periods of time with same purchasing power.
In the following examples the effect of inflation on equivalent worth of cash flows is
illustrated.
Example -6
A person has now invested Rs.500000 at a market interest rate of 14% per year for a
period of 8 years. The inflation rate is 6% per year.
i) What is the future worth of the investment at the end of 8 years?
ii) What is the accumulated amount at the end of 8 years in constant value monetary unit
i.e. with the same buying power when the investment is made?

Solution:
The market or combined interest rate per year (ic) and inflation rate per year (f) are14%
and 6% respectively.
i) The future worth i.e. amount of money accumulated at the end of 8 years will include
the effect of inflation and the interest amount accumulated will be calculated using
market or combined interest rate.
FW  PF / P, ic , n
Putting ‘P’, ‘ic’, ‘n’ equal to Rs.500000, 14% and 8 years respectively in the above
expression;
FW  500000F / P,14%, 8
FW  500000  2.8526 1426300
Thus the future worth of the investment at the end of 8 years in actual monetary unit
(inflated) is Rs.1426300.
ii) The future worth in constant value monetary unit i.e. with same buying power when
the investment is made (i.e. now) can be obtained by excluding the effect of inflation
from the inflated future worth. Thus the future worth in constant value monetary unit is
calculated by putting the values of time period ‘n’, base period ‘b’, inflation rate ‘f’ and
the future worth (inflated) as calculated above in equation (3.51). In this case, the value
of base period ‘b’ is zero.
FW in constant value monetary unit (inflation - free)  n b
 1 
' FW' in actual monetary unit (inflated)   
1 f 
8
 1 
FW in constant value monetary unit (inflation - free)  1426300   
 1  0.06 
FW in constant value monetary unit (inflation - free)  Rs.894861
Thus the future worth of the investment at the end of 8 years in constant value monetary
unit (inflation-free) is Rs.894861.
The future worth of the investment with same buying power as now i.e. when the
investment is made can also be calculated by using the real interest rate. The real interest
rate can be calculated from market interest rate and inflation rate using equation (3.59).
ic  f 
i
1  f 

i
0.14  0.06  0.07547
1  0.06
i = 7.547%
Now the future worth of the investment with same buying power as now is calculated as
follows;
FW  PF / P, i, n .
FW  500000F / P, 7.547%, 8  500000 1.7897  894850
The calculated future worth of investment is same as that calculated earlier. The minor
difference between the values is due to the effect of decimal points in the calculations.
Example -7
The cash flow of an alternative consists of payment of Rs.100000 per year for 6 years
(uniform annual series). The real interest rate is 9% per year. The inflation rate per year is
5%. Find out the present worth of the uniform series when the annual payments are in
actual monetary units (inflated).
Solution:
For determination of present worth of the uniform annual series payment, which is in
actual monetary units (inflated), first the combined interest rate (ic) is calculated from the
known values of real interest rate (i) and inflation rate (f) using equation (3.56).
i = 9%, f = 5%
ic  i  f  f  i 
ic  0.09  0.05  0.05  0.09  0.1445

ic = 14.45%
Now the present worth of the uniform series payment (in actual monetary units) with
uniform annual amount ‘A’ (Rs.100000) is given by;
PW  AP / A, ic , n
PW  100000P / A,14.45%, 6  100000  3.8412  384120

PW = Rs.384120
The present worth of the uniform series payment (in actual monetary unit) can also be
calculated by converting the uniform annual amount ‘A’ occurring in different years into
constant value monetary units (inflation-free) and then determining the present worth of
the series at real interest rate (i) by using ‘P/F’ factor.

The values of uniform annual amount ‘A’ (Rs.100000) occurring in different years in
constant value monetary units (inflation-free) are calculated as follows;
In year ‘1’
100000 100000
  Rs.95238.1
1  f 1
1  0.051
In year ‘2’
100000 100000
  Rs.90702.9
1  f 2
1  0.052
In year ‘3’
100000 100000
  Rs.86383.8
1  f 3
1  0.053
In year ‘4’
100000 100000
  Rs.82270.2
1  f 4
1  0.054
In year ‘5’
100000 100000
  Rs.78352.6
1  f 5
1  0.055
In year ‘6’
100000 100000
  Rs.74621.5
1  f 6
1  0.056
Now the present worth of above amounts at real interest rate i.e. 9% per year is calculated
as follows;
PW  95238.1P/F, i,1  90702.9P/F, i, 2  86383.8P/F, i, 3  82270.2P/F, i, 4 

78352.6P/F, i, 5  74621.5P/F, i, 6
PW  95238.1P/F, 9%,1  90702.9P/F, 9%, 2  86383.8P/F, 9%, 3  82270.2P/F, 9%, 4 
78352.6P/F, 9%, 5  74621.5P/F, 9%, 6
PW  95238.1 0.9174  90702.9  0.8417  86383.8  0.7722  82270.2  0.7084 
78352.6  0.6499  74621.5  0.5963
PW = Rs.384120
Thus the present worth of the uniform series payment (in actual monetary unit) is same as
that calculated earlier.

Taxes:
In the economic comparison of mutually exclusive alternatives, it is possible to select the
best alternative without considering the effect of taxes, as all the alternatives are
evaluated on the same basis of not taking into account the effect of taxes on the cash
flows. However the inclusion of taxes in the economic evaluation of alternatives results
in improved estimate of cash flows and the estimated return on the investment. There are
different types of taxes which are imposed by central/state governments on the firms.
These are income taxes (on taxable income), property taxes (on value of assets owned),
sales taxes (on purchase of goods/services), excise taxes (on sale of specific
goods/services), etc. Among these taxes, income tax is the most important one, which is
considered in the engineering economic analysis. Usually property taxes, excise taxes and
sales taxes are not directly associated with income of a firm.
The calculation of income taxes is based on taxable income of the firm and the income
tax to be paid by a firm is equal to taxable income multiplied with the applicable income
tax rate. The taxable income is calculated at the end of each financial year. For obtaining
the taxable income, all allowable expenses (excluding capital investments) and
depreciation cost are subtracted from the gross income of the firm. It may be noted here
that depreciation is not the actual cash outflow but it represents the decline in the value of
the asset (depreciable) and is considered as an allowable deduction for calculating the
taxable income. The taxable income is also known as net income before taxes. The net
income after taxes is obtained by subtracting the income taxes from taxable income (i.e.
net income before tax).
The expression for taxable income is shown below.
Taxable income = gross income - all expenses (excluding capital expenditur es) - depreciati on
The details about revenues, expenses and profit or loss of a firm are presented in Lecture
2 of Module 6. The capital investments are not included in the expenses for calculating
the taxable income, as this does not affect the income of the firm directly; however the
mode of financing the capital investment may have an effect on the taxes. The income tax
to be paid is calculated as a percentage of the taxable income and is given as follows;
Income tax = taxable income× income tax rate

The applicable annual tax rate is usually based on range or bracket of taxable income and
the taxable income is charged as per the graduated tax rates wherein higher tax rates are
applied to higher taxable income. A different marginal tax rate is applied to each of the
taxable income bracket. Marginal tax rate indicates the rate that is applied on each
additional unit of currency (Rupees, Dollars or Euros) of the taxable income. Higher
marginal tax rate is applied to higher taxable income range. The taxable income in a
certain bracket is charged at the specified marginal tax rate that is fixed for that particular
bracket. Sometimes depending upon the taxable income, a single tax rate (i.e. flat tax
rate) is applied to calculate the income tax. Capital gain and loss which represent the gain
and loss on the disposal or sale of depreciable assets/property are also considered in the
income tax analysis. The after-tax economic analysis of an alternative can be carried out
by calculating the annual cash flows after taxes and after-tax rate of return. The after-tax
rate of return depends on the before-tax rate of return and the tax rate. The annual cash
flows after taxes is obtained by subtracting the taxes from annual cash flows before taxes.
The calculation of income tax using marginal tax rates for different taxable income
brackets is presented in the following example.
Example -8
For a given financial year, the gross income of a construction contractor is Rs.11530000.
The expenses excluding the capital investment and the depreciation are Rs.4170500 and
Rs.2080000 respectively. Calculate the taxable income and income tax for the financial
year with the following assumed marginal tax rates for different taxable income ranges.
Taxable income range Income tax rate

(Rs.) (%)
1 - 1000000 10
1000001 - 3000000 20
3000001 - 5000000 30
Over 5000000 35

Solution:
For the financial year, the taxable income of the construction contractor is calculated
using the expression stated earlier.
Taxable income = gross income - expenses (excluding capital expenditures) - depreciation
Taxable income = Rs.11530000 - Rs.4170500 - Rs.2080000 = Rs.5279500
The income tax will be equal to the sum of income taxes calculated over the taxable
income ranges at the specified tax rates. The construction contractor will pay 10% on first
Rs.1000000 of taxable income, 20% on next Rs.2000000 (i.e. Rs.3000000 – Rs.1000000)
of taxable income, 30% on next Rs.2000000 (i.e. Rs.5000000 – Rs.3000000) of taxable
income and 35% on the remaining Rs.279500 (Rs.5279500 – Rs.5000000) of taxable
income.
Income tax = 0.1×1000000 + 0.2 × 2000000 + 0.3 × 2000000 + 0.35 × 279500 = Rs.1197825
The taxable income and income tax for the financial year are Rs.5279500 and
Rs.1197825 respectively. For the construction contractor with the above taxable income,
the average tax rate fore the financial year is calculated as follows;
taxes paid Rs.1197825
Average tax rate = = = 0.2269 = 22.69%
taxable income Rs.5279500

Module 4
Lecture-1
Equipment costs:-
For construction firms, it is important to accurately estimate the equipment cost as part of
the total cost of the construction project. Inaccurate estimation of construction equipment
cost may adversely affect the profit margin of the firms especially engaged in projects
with more involvement of different types of construction equipments. The total cost of a
piece of construction equipment consists of two components namely ownership cost and
operating cost. This is also referred as O&O cost of the construction equipment. The
selection of a piece of equipment in a construction project depends on the total cost
associated with that equipment. The details about equipment ownership cost and
operating cost are presented below.
Ownership cost:-
Ownership cost is the total cost associated with the construction equipment for owning it
irrespective of the equipment is employed or not in the project. The ownership cost
consists of the following;
a) Initial cost, b) Salvage value, c) Interest cost or cost of capital investment, d) Taxes,
e) Insurance cost, and f) Storage cost
a) Initial cost
Initial cost is the capital investment required to own the equipment. It includes purchase
cost, sales tax, transportation cost (or freight charges) to bring the equipment to
company’s storage yard or construction site and cost of assembly and installation of the
equipment. If the equipment is mounted on rubber tires (pneumatic tires), then the tire
cost is deducted from the initial cost for calculating ownership cost. This is because the
expected service life of pneumatic tires is less than that of the remaining of the
equipment. Accordingly the rate of deprecation of tires is different from that of the
equipment. Cost of tires is considered as a part of operating cost of the equipment. As the
equipment is used in the project, there is depreciation in value of the equipment with time

due to wear and tear and obsolescence. The total amount of depreciation for the
construction equipment over the useful life is equal to the initial cost less the estimated
salvage value. The details about different methods for calculation of depreciation of the
asset are already presented in Module 3.
b) Salvage value
As already mentioned in Module 3, salvage value represents expected cash inflow that
will be received by disposing of equipment at the end of its useful life. The estimation of
expected salvage value of the equipment can be carried out by referring to the data
obtained from past projects wherein same (or similar) equipment was used or information
obtained from other relevant sources.
c) Interest cost or cost of capital investment

It is the annual cost of interest charged on the borrowed money or that of capital
investment to acquire the ownership of the equipment. If the equipment is purchased by
borrowing money from a lender, then interest cost is the interest charged (at interest rate
charged by lender) on the borrowed amount. On the other hand if the equipment is
purchased using construction firm’s own funds, then cost of capital investment is the
interest charged on capital investment at interest rate equal to construction firm’s rate of
return. Even though the construction firm uses its own funds to purchase the equipment,
cost of capital investment is charged as part of the ownership cost because the
construction firm could have invested the funds elsewhere to earn the return instead of
purchasing the equipment.
The interest cost on borrowed money or cost of capital investment can be exactly
calculated by considering time value of money and using appropriate compound interest
factors. However the interest cost or cost of capital investment can also be calculated
approximately as percentage of constant average annual investment (cost) over the useful
life of the equipment. The annual interest rate or the rate of return is multiplied to the
average annual investment to find out the annual interest cost or cost of capital
investment. The average annual investment can be calculated by finding out the average
value of the equipment over the useful life of the equipment. It may be noted here that the
value of the equipment depreciates with time. By considering straight-line depreciation,

the average annual investment can be found out by calculating average of the book value
at the beginning of 1st year and that at beginning of last year of useful life i.e. at the
beginning of ‘n’ year.
From module 3, the expression for constant annual depreciation from straight-line
method (equation (3.1)) is given as follows;
P  SV
Dm 
n
Where, P is the initial cost of equipment, n is the useful life and SV is the estimated
salvage value of the equipment.
The book value at the beginning 1st year is equal to the initial cost i.e. ‘P’. Now the book
value at beginning of last year (i.e. ‘n’), which is equal to book value at the end of ‘(n-1)’
year, can be calculated by using equation (3.7) from module 3.
 P  SV 
BVn-1  P  n  1Dm  P  n  1 
 n 
Now the average annual investment (AAI) is calculated by taking the average of the book
value at the beginning of 1st year and that at beginning of last year of useful life i.e. BVn-1.
P  BVn1
AAI  ………..………………………. (4.1)
2
Putting the expressions of BVn-1 in equation (4.1) results in;

 P  SV 
P  P  n  1 
 n  2nP  nP  n  SV  P  SV 
AAI  
2 2n
On simplifying the above expression;
Pn  1  SV n  1
AAI  ………………………. (4.2)
2n
It may be noted here that while calculating average annual investment (AAI) for
equipments mounted on pneumatic tires using the equation (4.2), cost of pneumatic tires
is subtracted from initial cost of the equipment. The annual interest cost or cost of capital
investment annual can be calculated by multiplying the average annual investment (AAI)
as mentioned in equation (4.2) by the annual interest rate or rate of return.

d) Taxes
It represents the property taxes to be paid to the state or central government. It depends
on the value of the equipment owned and the applicable tax rate for a given location. The
property tax can be calculated as a percentage of the average annual investment or a
percentage of the book value in a given year. Generally it ranges from 2 to 5% of the
average annual investment or book value of equipment.
e) Insurance cost
It represents the annual premium to be paid to insurance companies to cover the cost
incurred due to accident, fire, theft etc. for the construction equipment. In other words, it
represents the cost that protects the owner of the equipment against these damages.
Similar to taxes, the insurance cost can be calculated as a percentage of the average
annual investment or the book value in a given year. It is generally about 1 to 3% of the
average annual investment or book value of equipment.
f) Storage cost
It is the cost of keeping the equipment in storage yards when it is not operating at the
work site. Storage cost includes the rental and maintenance charge for storage yards,
wages of security guards and wages of workers employed for bringing in and out of the
storage yards. It is around 0.5 to 1.5% of the average annual investment or book value of
equipment. The annual storage cost can be calculated for the entire fleet of equipment
and is then prorated to individual equipment requiring the storage facility.
Similar to storage cost, the tax and insurance cost can be calculated for the equipment
fleet and then prorated to individual equipment. It may be noted here that the annual rates
(%) mentioned above for taxes, insurance and storage costs are typical values. However
the actual rates will vary depending on the type and size of equipment, place of purchase,
location of project site etc.
After calculating the different components, the total annual ownership cost of the
construction equipment is calculated by summing up depreciation cost, investment (or
interest) cost, tax, insurance and storage costs. Then the hourly cost of ownership can be
calculated by dividing the annual ownership cost by the number of operating hours the
equipment will operate annually. The hourly ownership cost can also be calculated by

first determining the components of ownership cost individually on hourly basis followed
by adding these hourly costs to get the total hourly ownership cost.

Lecture-2
Operating cost:-
Operating cost is incurred only when the equipment is operated. The operating cost of the
equipment is influenced by various parameters namely number of operating hours,
location of job site, operating conditions, category of equipment etc. The operating cost
consists of the following;
a) Repair and maintenance cost, b) Fuel cost, c) Cost of lubricating oil, filter and grease,
d) Tire cost e) Equipment operator wages, f) Cost of replacing high-wear items and g)
Cost of mobilization, demobilization and assembly.
a) Repair and maintenance cost
Repair and maintenance cost is incurred as the construction equipment is subjected to
wear and tear due to the operations it performs. The repair and maintenance cost includes
the cost of replacement parts, labor charges and the cost of setting up and operating
facilities to carry out major repair and maintenance operations. The repair and
maintenance cost varies from one year to another over the service life of the equipment,
however it increases with age of the equipment. This cost contributes a substantial
portion of the operating cost. The increase in service life and decrease in repair and
maintenance cost of construction equipment can be achieved by carrying out timely
recommended maintenance and repair operations. The minor repairs can be carried out at
the job site where the equipment is operating, however the major repairs can be carried
out in the facilities set up by the equipment owner or in the workshop of authorized
dealers for the equipment. The annual repair and maintenance cost can be calculated as a
percentage of the annual depreciation cost of the equipment. Past information available
from company records or from other relevant sources for similar equipment under similar
working conditions can be used for estimating the repair and maintenance cost. If this
data is not available, equipment manufacturer’s guidelines can be used for calculating
this cost. The hourly repair and maintenance cost can be calculated by dividing the
annual cost by the number of operating hours per year.

b) Fuel cost
The construction equipments are generally powered by internal combustion engines
which use either gasoline (petrol) or diesel as the fuel. The fuel consumption depends on
the rated flywheel horsepower (fwhp) of the engine and the nature of working conditions.
The flywheel horsepower represents the power available for operating a piece of
equipment. A gasoline engine consumes about 0.06 gal (gallon) of fuel per flywheel
horsepower hour whereas a diesel engine consumes about 0.04 gal of fuel per flywheel
horsepower hour when operating under standard conditions. Historical data about the
quantity of fuel consumed by similar equipment under similar working conditions can be
used to estimate the hourly fuel consumption by the equipment. If these records are not
available, equipment manufacturer’s fuel consumption data can be used to estimate the
fuel cost. The hourly fuel cost can be calculated by multiplying the hourly fuel
consumption by its unit price.
c) Cost of lubricating oil, filter and grease
The quantity of lubricating oil, filter and grease required depends on operating hours,
frequency of changes, engine characteristics and working conditions at the job site. The
equipment manufacturer guidelines or past data from experience of similar equipment in
similar working conditions can be used to estimate of time period between the changes.
The quantity of lubricating oil required by an engine is equal to the amount added during
complete change plus the small amount added between the changes. The quantity of
lubricating oil required by engine can be calculated by using the following relationship.
hp  f  0.006 lb / hp  h c
ql   t ……………… (4.3)
7.4 lb / gal
Where
ql = quantity of oil required in gal/h
hp = rated horsepower of the engine
f = operating factor
c = capacity of crankcase in gallons
t = number of hours (i.e. duration) between the oil changes
The term 0.006 lb/hp-h in the above equation is based on the assumption that the quantity
of lubricating oil required per rated horsepower hour between the changes is 0.006 lb and

7.4 lb/gal is the conversion factor. The operating factor (f) in the above equation depends
on throttle load factor and the efficiency factor i.e. operating efficiency. Manufacturer’s
guidelines or past experience from similar equipment under similar working conditions
can be used to calculate the cost of these items. The hourly cost of lubricating oil, filter
and grease can be calculated from hourly consumption quantities. It may be noted here
that the quantity of oil required in SI unit system can also be obtained by using the
appropriate conversion factors in the above equation.
d) Tire cost
The cost of pneumatic tires (rubber tires) is considered as a part of operating cost. The
tire cost includes the tire repair and replacement charges. The service life of tires is
generally shorter than that of the equipment as the tires wear out at a faster rate than the
equipment. The life of tires varies according to extent of wear it is subjected to, which
depends on the job site conditions. Tire repair charges can be calculated as a certain
percentage of tire depreciation cost. The past data from similar operating and project site
conditions and tire and equipment manufacturer guidelines can be used to estimate the
expected life of tires. The hourly tire repair and replacement cost can be calculated by
dividing the sum of the cost of a set of tires and repair charges by the life of tires in
hours.
e) Equipment operator wages
The operator cost includes the hourly wages and benefits paid by the company to the
operators. It includes normal wages, workmen’s compensation insurance premium, fringe
benefits, bonus etc. The operator wages vary from project to project. The operator cost is
normally calculated as a separate cost category and is added to other components of
operating cost.
f) Cost of replacing high-wear items
It represents the cost of high-wears items and these items have a shorter life as compared
to the service life of the equipment. The high-wear items include blades, cutting edges,
drill bits, bucket teeth etc. The expected life of these items can be estimated from past
records or from manufacture guidelines. The hourly cost can be calculated by dividing
the unit cost by estimated life (in hours).

g) Cost of mobilization, assembly and demobilization

This cost includes transportation charges from one project site to another, cost required
for getting road permits, unloading charges, cost of assembly at the project site etc. The
hourly cost can be calculated by dividing the total cost by the number of operating hours.
In the following examples, the calculation of equipment ownership and operating costs is
demonstrated.
Example -1
The initial cost of a piece of construction equipment (pneumatic tire mounted) is
Rs.5500000. The estimated salvage value of the equipment is Rs.900000. The useful life
of the equipment is 10 years. The equipment will operate 2000 hours per year. The cost
of one set of tires is Rs.400000. A new set of tires will be replaced at the end of every 3
years of operation. In addition a repair work of cost Rs.450000 is expected at the end of
year ‘6’. The interest rate is 8% per year. Find out the total cost per hour for the
construction equipment considering time value of money.
Solution:
For calculating the hourly ownership and operating cost by considering time value of
money, first the equivalent uniform annual cost is calculated at the given interest rate and
is then divided by the number of operating hours per year.
As the initial cost includes cost of tires, tire cost is subtracted from initial cost of the
equipment for calculating ownership cost, as cost of tires is considered as an element of
operating cost.
Equivalent uniform annual worth of initial cost: A1
Initial cost less cost of tires = Rs.5500000 – Rs.400000 = Rs.5100000
A1  Rs.5100000 A / P, i , n  Rs.5100000 A / P, 8%,10
A1  Rs.5100000  0.1490
A1  Rs.759900
Equivalent uniform annual worth of salvage value: A2
A2  Rs.900000 A / F , i , n  Rs.900000 A / F , 8%,10

A 2  Rs.900000  0.0690
A2  Rs.62100
(A1  A 2 ) Rs.759900  Rs.62100
Hourly ownership cost    Rs.348.90 / h
Yearly operating hours 2000 hours
In the above expression, (A1-A2) is the equivalent uniform annual worth of the
depreciation cost of the equipment considering time value of money.
Equivalent uniform annual worth of tire cost: A3

The equipment will require 3 sets of replacement tires in addition to the original set. The
first replacement set will be required at the end of 3rd year, second set at the end of 6th
year and third set at the end of 9th year. In order to find out the equivalent uniform annual
worth of tire cost, first the equivalent present worth of cost of replacement tires is
calculated using the appropriate compound interest factor followed by adding it to the
cost of original set (initial set) of tires and then converting the equivalent present worth to
equivalent uniform annual cost over the entire useful life of 10 years using the
appropriate compound interest factor.
A3  400000  400000P / F , 8%, 3  400000P / F , 8%, 6  400000P / F , 8%, 9 A / P, 8%,10
A3  400000  400000  0.7938  400000  0.6302  400000  0.50020.1490
A3  Rs.174282
Equivalent uniform annual worth of repair cost: A4
Cost of repair work at the end of year ‘6’ = Rs.450000.
A4  Rs.450000P / F , 8%, 6 A / P, 8%,10
A 4  Rs.450000  0.6302  0.1490  Rs.42255
A3  A 4 Rs.174282  Rs.42255
Hourly operating cost    Rs.108.3 / h
Yearly operating hours 2000 hours
The total hourly cost for the construction equipment:
Hourly ownership cost + hourly operating cost = Rs.348.90/h + Rs.108.3/h
= Rs.457.2/h

Example -22
For a piece of construction equipment mounted on pneumatic tires, find out the hourly
ownership cost using average annual investment method with straight line depreciation
from the following data;
Initial cost = Rs.8000000, Estimated salvage value = Rs.1350000,
Useful life of the equipment = 11 years, Cost of a set of tires = Rs.600000.
The equipment will operate 1800 hours per year. The interest rate on investment is 7.5%
per year. The annual rates for taxes, insurance and storage cost are 3%, 2.5% and 1%
respectively. For this equipment, also calculate the hourly tire cost by not considering
time value of money, if a new set of tires will be replaced at the end of every 4 years of
operation and the estimated tire repair cost is 15% of straight-line depreciation.
Solution:
As the initial cost includes cost of tires, tire cost is subtracted from initial cost of the
equipment for calculating ownership cost.
Initial cost less cost of tires (P) = Rs.8000000 – Rs.600000 = Rs.7400000
Salvage value (SV) = Rs.1350000, Useful life (n) = 11 years
The average annual investment (AAI) is calculated using equation (4.2) and is presented
below.
Pn  1  SV n  1
AAI 
2n
Rs.740000011  1  Rs.135000011  1
AAI 
2  11
AAI  Rs.4650000
Annual interest or investment cost: A1
The average annual interest or investment cost is calculated by multiplying average
annual investment (AAI) by the annual interest rate (7.5%).
A1  AAI  0.075  Rs.4650000  0.075  Rs.348750
Annual depreciation cost: A2
The annual depreciation cost is calculated by straight-line depreciation method.
P  SV Rs.7400000  Rs.1350000
A2    Rs.550000
n 11

The annual expenses for taxes (A3), insurance (A4) and storage (A5) are calculated by
multiplying average annual investment (AAI) by the respective annual rates (%).
A3  AAI  0.03  Rs.4650000  0.03  Rs.139500
A4  AAI  0.025  Rs.4650000  0.025  Rs.116250
A5  AAI  0.01  Rs.4650000  0.01  Rs.46500
Then the hourly ownership cost for the construction equipment is calculated as follows;
(A1  A 2  A 3  A 4  A 5 )
Hourly ownership cost 
Annual operating hours
Rs.348750  Rs.550000  Rs.139500  Rs.116250  Rs.46500
  Rs.667.2 / h
1800 hours
Hourly tire cost (by not considering time value of money)

The hourly tire cost is equal to the sum of hourly tire use (replacement) cost and hourly
tire repair cost. The hourly tire use cost is obtained by dividing the cost of a set of tires by
the life of tires in hours. The hourly tire repair cost is equal to 15% of the hourly
depreciation (straight-line) cost of tires. The total depreciation cost of a set of tires over
its estimated life is equal to its initial cost as its salvage value is assumed as zero. As
mentioned in the question, a new set of tires will be replaced at the end of every 4 years
of operation and the equipment will operate 1800 hours per year. Thus the life of a set of
tires is equal to 7200 hours 1800 4 .
Hourly tire cost = hourly tire use cost + hourly tire repair cost
Rs.600000 Rs.600000  0.15
Hourly tire cost    Rs.95.8 / h
7200 hours 7200 hours
Thus for the construction equipment, the hourly ownership cost is Rs.667.2/h and the
hourly tire cost (by not considering time value of money) is Rs.95.8/h.
Similar to the calculation of hourly cost of equipment as mentioned in above examples,

other components of equipment operating cost can also be calculated by using already
mentioned guidelines and equations.

Lecture-3
Buy, Rent and Lease Options

There are different methods of acquiring the construction equipment required for a
project. These are namely buying, renting and leasing. There are advantages and
disadvantages associated with each of these methods. Before acquiring the equipment, it
is essential to explore all the options by considering various parameters namely
company’s cash flow, working capital, equipment utilization and its maintenance,
obsolescence and replacement of equipment, operating conditions etc.
Buying
Buying results in direct ownership of the equipment. Acquisition of equipment by buying
is done either through cash purchase by using company funds or through financing
purchase. The outright cash purchasing is done when sufficient funds are available.
However cash purchase can have an adverse effect on company’s cash flow as it reduces
the liquid asset thus affecting company’s working capital. When sufficient funds are not
available for outright cash purchase, the equipment can be acquired by finance
purchasing wherein the purchasing is done through loan arrangements from lenders i.e.
banks or other financial institutions that includes the payment of loan through
installments along with an initial down payment. One of the main advantages of owning
the equipment by outright cash purchase is that it may result in lowest cost per operating
hour as compared to renting or leasing. Other advantages associated with buying include,
complete control of the owner over use of the equipment and its maintenance and
replacement of equipment when it is no more economical. In addition, there is also
income tax benefit associated with depreciation of the equipment. Acquiring the
equipment through buying is an economically attractive option when there is more work
load leading to higher utilization rate of the equipment over its useful life. Otherwise it
will lead to the risk of not getting the required return on the capital investment if there is
not enough utilization of the equipment. This is one of the disadvantages associated with
buying. If the equipment is purchased through finance purchasing, the equipment owner
has to pay the required loan installment to the lender even when the equipment is not

operational. Acquisition through buying may sometimes force the owner to use the
obsolete equipment due to financial constraints.
Renting
Renting is a method of acquiring the equipment for a shorter duration. It is an alternative
to direct ownership (i.e. through buying) of the equipment for a shorter period.
Acquisition of equipment through renting is suitable when the contractor or the
construction company requires the equipment for a project task of shorter duration. In
addition through renting, the company can select the equipment that is exactly suited for
the project task and it is possible to acquire the equipment based on latest technology
which is more productive than older models. In these circumstances, renting of the
equipment is more beneficial than direct ownership even though the rental charges are
higher than the direct ownership charges. Since the equipment is not owned by the user,
there is no tax benefit associated with depreciation of the equipment. However tax benefit
is gained as the rental cost is considered as an expense that reduces the income of the
company using the equipment. The capital that is tied up when the equipment is acquired
through buying can be used in other investment if the equipment is rented. Among the
three methods of acquiring the equipment, typically the hourly rental cost is higher as
compared to that of lease or direct ownership. Rental period may a day, a week or a
month and may go up to one year. The rental rates are generally established on daily
basis, weekly basis or monthly basis. The daily rate on hourly basis is higher than the
weekly rate on hourly basis and the weekly rate (on hourly basis) is higher than the
monthly rate (on hourly basis). The repair and maintenance cost of the equipment to be
paid either by the user or owner of the equipment (i.e. renting company) is stated in the
rental contract. In case of major repair work, generally the cost is paid by the renting
company whereas the cost of minor repair and maintenance that is incurred at the project
site is usually paid by the user of the equipment. The cost fuel and lubricants is mostly
paid by the user of the equipment. By renting, it is possible to reduce the downtime
experienced due to breakdown of the equipment followed by repair as the equipment is
replaced by the rental service. Further in order to check the suitability of specific
equipment in actual job site conditions, the equipment can be rented and its performance

can be tested before taking a decision to purchase the equipment that involves a major
capital investment. In addition, the user of the equipment can get rid of the cost of
transporting the equipment from one project site to another by renting it. However the
user mostly pays the transportation charges for bringing the equipment from renting
company’s yard to the work site and also pays the cost of assembly, loading etc.
Leasing
Leasing is another method of acquiring the equipment, for a longer period of time as
compared to renting. It is a long term alternative to direct ownership of the equipment.
The leasing company (i.e. owner of the equipment) is known as lessor whereas the user
of the equipment is known as lessee. Lease is a contract between the lessor and the lessee
wherein the lessee uses the equipment owned by lessor by paying the rentals over the
lease period. Mostly the lease period is more than six months and may run up to years. It
is important for the lessee to know about the details of past and ongoing leases in which
lessor is involved and also to check the terms and conditions of the lease agreement
before entering into lease contract with lessor. Most of the equipment leases are
noncancellable. During lease period the lessor retains the ownership of the equipment and
also gets the tax benefits from depreciation of the equipment. Thus there is no tax benefit
to lessee from depreciation of the equipment. However similar to renting, lessee gains tax
benefits as the lease payments are considered as an expense. Due to leasing, the capital of
lessee is not tied up in purchasing the equipment and lessee can use it for other
investment. Even if the equipment is purchased through loan arrangement, the owner has
to pay an initial down payment. However leasing can provide 100% financing, including
the cost delivery and installation of the equipment. Lease payments can be made
monthly, yearly or at other time intervals as agreed upon between the two parties. The
lease payments need not necessarily be uniform over the lease period and there is
flexibility of coordinating the schedule of payment (to be made by the lessee) to that of
revenue generated from use of the equipment by the lessee. Generally, the cash inflow
due to use of the equipment at the beginning may be low and thus the lessee prefers to
pay less amount at the beginning of lease period. This type of payment arrangement may

be accepted by the lessor from tax considerations as the lessor receives less payment at
the beginning.
Two types of commonly offered leases through which construction equipments acquired
are finance lease and operating lease. The finance lease is generally offered by a financial
institution (usually a bank or a finance company) and the equipment is leased to the
lessee. The lease period may extend up to the operating life of the equipment. The rental
paid by the lessee over the lease period covers the cost of the equipment less the
estimated residual value at the end of lease period, along with the profit margin of the
lessor. The lessee has the option to purchase the equipment with a discounted price or a
predetermined price at the end of the lease period. Usually the lease contract can not be
cancelled till the lessor has recovered the investment cost at the end of the lease period.
The finance lease is stated on lessee’s balance sheet.
The operating lease is offered by the manufacturer or dealer of the equipment. In
operating lease, payment charges are lower as compared to finance lease. In this type of
lease, lessor (manufacturer or dealer of the equipment) provides the skilled service
personnel required for carrying out the repair and maintenance operations and this type of
arrangement is more suitable for sophisticated equipments requiring specialized repair
and maintenance. Thus in this type of lease, lessee does not hire service personnel
required for carrying out servicing and maintenance operations. Usually lessee returns the
equipment to lessor at the end of lease period. Unlike finance lease, operating lease is not
stated on lessee’s balance sheet and is often referred to as off-balance-sheet financing.

Lecture-4
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 cost which 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.
Example -33
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;
AWdef  2950000A / P, i, n   150000  650000A / F, i, n 
AWdef  2950000A / P,10%, 8  150000  650000A / F,10%, 8
AWdef  2950000  0.1874  150000  650000  0.0874
AWdef  646020
For challenger;
AWcha  3500000A / P, i, n   125000  900000A / F, i, n 
AWcha  3500000A / P,10%, 8  125000  900000A / F,10%, 8
AWcha  3500000  0.1874  125000  900000  0.0874
AWcha  702240
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.

Lecture-5
Replacement Analysis
When useful lives of defender and challenger are not same i.e. remaining life of defender
is not equal to useful life of the challenger (new alternative), mostly the duration of the
longer life span alternative is selected as the study period. In other words the useful life
of the challenger (which is generally greater than remaining life of defender) is taken as
the study period. In this case it is assumed that the equivalent uniform annual cost of the
defender (i.e. the shorter life span alternative) will be same after its remaining life and till
the end of the study period. In other words the shorter life span alternative will function
at the same equivalent annual cost throughout the study period. However if realistic
estimate of the equivalent annual cost of the shorter life span alternative (i.e. defender)
after its remaining life is available, the same can be used appropriately in the economic
analysis over the study period.
Sometimes the use of longer study period may not be beneficial because of the fact that
the rapid obsolescence may force the replacement of longer life span alternative, due to
availability of new models with latest technology which are more productive. In addition
inaccurate estimate of different cost components with uncertain future conditions for
longer life span alternative is also another factor which may adversely affect the selection
of longer study period. These reasons may force the management of the company to
select a shorter study period for replacement analysis between defender and challenger.
However the use of a shorter study period will force the recovery of initial capital
investment of the longer life span alternative (i.e. challenger) at company’s MARR in a
shorter period of time which is less than its estimated useful life and this may affect the
unbiased selection of the most economical alternative in the replacement analysis. When
a shorter study period is used, the use of a realistic estimate of the salvage value or
market value of the longer life span alternative (i.e. challenger) will result in an unbiased
selection of the most economical alternative.
In the following example, the effect of longer and shorter study period on the selection of
the most economical alternative between defender and challenger is discussed.

Example -4
For the replacement analysis of an asset of a construction company, the following
information is available;
For defender (existing asset);
The original estimate includes, initial cost 4 years ago = Rs.5000000, Estimated salvage
value and useful life at the time purchase = Rs.1200000 and 12 years respectively,
Annual operating cost = Rs.115000.
The revised estimate includes, current market or trade-in value = Rs.3600000, remaining
life = 7 years, Salvage value = Rs.780000, Annual operating cost = Rs.115000 (same as
earlier).
For challenger (new alternative);
Initial cost = Rs.4500000, Estimated salvage value and useful life = Rs.1040000 and 14
years respectively, Annual operating cost = Rs.100000, Estimated value of the asset at the
end of 7 years = Rs.2500000.
Carry out the replacement analysis using 14 year study period and 7 year study period at
MARR of 8% per year.
Solution:
Replacement analysis using 14 year study period;
For defender (existing asset);
Current market or trade-in value = Rs.3600000, Salvage value = Rs.780000,
For challenger (new alternative);
Initial cost = Rs.4500000, Salvage value = Rs.1040000,
The equivalent uniform annual worth of defender is calculated at MARR of 8% over a
period of 7 years (its remaining life) by using its revised estimates and it is assumed that,
the calculated equivalent uniform annual worth of defender will be same after its
remaining life and over the study period of 14 years. The equivalent uniform annual
worth of challenger is calculated over the study period of 14 years (its estimated useful
life) at MARR of 8%.
For defender;

AWdef  3600000A / P, i, n   115000  780000A / F, i, n 
AWdef  3600000A / P, 8%, 7  115000  780000A / F, 8%, 7
AWdef  3600000  0.1921  115000  780000  0.1121
AWdef  719122
For challenger;
AWcha  4500000A / P, i, n   100000  1040000A / F, i, n 
AWcha  4500000A / P, 8%,14  100000  1040000A / F, 8%,14
AWcha  4500000  0.1213  100000  1040000  0.0413
AWcha  602898
From the above calculation, it is observed that the new alternative is the most economical
one over the study period of 14 years as it shows lower equivalent annual cost. Thus the
construction company should replace the existing asset with the new one.
Replacement analysis using 7 year study period;
For defender (existing asset) the equivalent uniform annual cost will be same i.e.
Rs.719122 as calculated above for the period of 7 years.
The equivalent uniform annual worth of challenger is calculated by considering its
estimated value (i.e. Rs.2500000) at the end of 7 years.
For challenger;
AWcha  4500000A / P, i, n   100000  2500000A / F, i, n 
AWcha  4500000A / P, 8%, 7  100000  2500000A / F, 8%, 7
AWcha  4500000  0.1921  100000  2500000  0.1121
AWcha  684200
The new alternative again shows lower equivalent annual cost as compared to the
defender (existing asset) over the study period of 7 years.
If a study period of 6 years is considered and it is assumed the equivalent annual cost of
the defender remains same i.e. Rs.719122 over the study period, then the equivalent
annual cost of the challenger is calculated over this study period. Assuming the same
estimated value of the challenger i.e. Rs.2500000 at the end of 6 years, its equivalent
annual cost over the study period of 6 years is calculated as follows;

AWcha  4500000A / P, i, n   100000  2500000A / F, i, n 
AWcha  4500000A / P, 8%, 6  100000  2500000A / F, 8%, 6
AWcha  4500000  0.2163  100000  2500000  0.1363
AWcha  732600
From this calculation it is observed the new alternative (challenger) is exhibiting higher
equivalent annual cost as compared to the existing asset (defender) when the study period
of 6 years is used. This is due to the fact that the challenger is allowed only 6 years to
recover the same investment as compared to the study period of 7 or 14 years and thus
resulting in an increased equivalent annual cost.
As already mentioned (in Lecture 4 of this module), if there is requirement of a change in

the desired output from the existing equipment, then the enhanced production capacity
can be achieved by augmenting the existing equipment or replacing it with a new one. In
some cases construction firms plan for major overhaul or retrofitting of the existing
equipment in order to met the required demand. In the following example replacement
analysis involving the major overhaul of the currently owned asset i.e. defender and its
comparison against challenger is presented.
Example -5
A construction firm has purchased an excavator 3 year ago at a cost of Rs.6000000 and
the estimated life and salvage value at the time of purchase were 11 years and
Rs.1600000 respectively. The annual operating cost was Rs.195000. The current market
value of the equipment is Rs.4400000. The construction firm is planning for a major
overhaul of the equipment now at a cost of Rs.1000000. After overhaul, the revised
estimate of salvage value, annual operating cost and remaining life of the excavator are
Rs.1250000, Rs.175000 and 9 years respectively.
However the construction firm has the option to replace the current excavator with a new
model. The initial cost of the new model is Rs.6300000. The estimated life, annual
operating cost and salvage value are 9 years, Rs.150000 and Rs.1800000 respectively.
Determine whether the construction firm should continue with the existing excavator

with the planned overhaul or replace it with the new model if the firm’s MARR is 10%
per year.
Solution:
For the replacement analysis the revised estimates of the existing excavator (defender)
are as follows.
Current market value (P) = Rs.4400000, Salvage value (F) = Rs.1250000, Cost of major
overhaul, now = Rs.1000000, Annual operating cost (A) = Rs.175000.
For new model (challenger),
Initial cost (P) = Rs.6300000, Salvage value (F) = Rs.1800000,
Annual operating cost (A) = Rs.150000.
The estimated lives of both defender and challenger are same i.e. 9 years. Now the
equivalent uniform annual cost of both the existing excavator and the new model at
MARR of 10% per year (i.e. i = 10%) are calculated over the study period of 9 years and
are presented as follows;
For existing excavator (defender);
AWdef  4400000A / P, i, n   1000000A / P, i, n   175000  1250000A / F, i, n 
AWdef  4400000A / P,10%, 9  1000000A / P,10%, 9  175000  1250000A / F,10%, 9
AWdef  4400000  0.1736  1000000  0.1736  175000  1250000  0.0736
AWdef  1020440
For new model (challenger);
AWcha  6300000A / P, i, n   150000  1800000A / F, i, n 
AWcha  6300000A / P,10%, 9  150000  1800000A / F,10%, 9
AWcha  6300000  0.1736  150000  1800000  0.0736
AWcha  1111200
From the above calculations, it is noted that equivalent uniform annual cost of the
existing excavator with the planned overhaul is less than that of the new model. Thus the
construction firm should continue with the existing excavator. Similarly the replacement
analysis involving comparison of defender with augmentation against the challenger can
also be carried out.

Further in replacement analysis, the remaining economic life of the defender can be
found out by determining the number of years, which minimizes the total cost of owning
and operating the asset. For this purpose, the equivalent uniform annual cost of the
defender is determined year by year by considering the time value of money. The
remaining economic life of the defender is taken as the year which results in the
minimum equivalent uniform annual cost. Similarly the economic life of the challenger
can also be determined in the same manner by considering the time value of money.
Further replacement analysis involving the comparison of total cost of defender for
retaining it for one additional year in service with the minimum equivalent uniform
annual cost of challenger can also be carried out and accordingly the decision of retaining
or replacing the defender can be taken.
It may be noted that the calculation of equipment cost and replacement analysis using the
information from real life construction projects can be carried out in the same manner.

Module 5
Lecture-1
Cost Estimating:-
The purpose of cost estimating is to forecast the cost of a project prior to its actual
construction. Cost estimating is a method of approximating the probable cost of a project
before its construction. The exact cost of a project is known after completion of the
project. Cost estimate is prepared at various stages during the life of a project on the basis
of the information available during the time of preparation of the estimate. Generally for
any construction project, three parties are involved namely owner, design professionals
and construction professionals. In some cases the design professional and construction
professional are from the same company or they form a team through a joint venture for
providing service to the owner in the project. It is the responsibility of each party
involved in the project to estimate the costs during various stages of the project. An early
estimate helps the owner to decide whether the project is affordable within the available
budget, while satisfying the project’s objectives. For cost estimating, work breakdown
structure (WBS) serves as an important framework for organized collection project cost
data and preparing the cost estimates at different levels. It is a technique that involves the
hierarchical breakdown of the project into different work elements at successive levels
and defines the interrelationships between them. For preparation of cost estimates, the
estimator performs quantity take-off to quantify each item of work by reviewing the
contract drawings and specifications. In cost estimation, quantity take-off is an important
task that is carried out before pricing each item of work and quantities should be
represented in standard units of measure. Before bidding for a project, the estimator
(along with his or her group) of a construction firm needs to determine the total cost of
the project in accordance with contract documents consisting of drawings, specifications
and all other technical documents and requirements. The total project cost consists of two
components namely direct cost and indirect cost. Direct cost includes cost of materials,
equipment and labor associated with each item of work and also includes cost of

subcontracted works. Indirect costs are the costs which are not associated with each item
of work rather these costs are calculated for the entire construction work and includes
overhead costs (both job office or site office overhead and general head office overhead),
contingency i.e. cost for any unforeseen work and profit. It is important to accurately
estimate all the cost components of the project before bidding. The material cost for each
item of work can be calculated by multiplying required quantity of materials by its unit
price. The material quantity take-off or the quantity of materials for an item of work can
be easily calculated by using the information from contract drawings and specifications.
The current unit price of materials can be obtained from the material suppliers. In
addition, the estimator has to add a certain percentage for wastage of materials while
calculating the material cost. The equipment cost consists of two components i.e.
ownership cost and operating cost. Generally the equipment cost is expressed on hourly
basis. As already mentioned (in Module 4), equipment operator wages which vary from
project to project are normally calculated as a separate cost category and are added to
other components of equipment operating cost. The procedure of calculating hourly
equipment cost is already stated in Lecture-1 and Lecture-2 of Module 4. The hourly
equipment cost and production rate of the equipment are used to calculate the cost per
unit production of the equipment. The production rate of the equipment depends on its
rated capacity, production cycle time, efficiency and also on job site conditions. The
labour cost depends on the productivity of labourers which vary with the nature of work.
The productivity of labourers depends on various factors namely their skill, number of
working hours in a day, supervision, nature of job, job site conditions etc. The portion of
work that is to be accomplished by the labourers can be found out form project
documents i.e. from contract drawings and specifications. The labour cost is generally
expressed on hourly basis. Historical data from past projects can also be referred for
calculating the cost of materials, equipment and labor. For the contractors, the calculated
bid price (sum of direct cost and indirect cost) for the project must have a balance with
the associated profit margin such that the bid price should be low enough to be within the
owner’s budget and to win the bid and at the same time, it should be high enough to
complete the project with the expected profit.

Lecture-2
Types of Estimates
As already stated in the previous lecture (Lecture-1 of this module), there are different
types of estimates which are prepared at various stages during the life of a project starting
from the initial phases to its final phase on the basis of the available information at the
time of preparation of the estimates. The range of expected accuracy is more in the
estimates which are prepared during initial stages and it narrows down as the project
progresses with the availability of more detailed information and increase in the level of
project definition. In addition to the project parameters, the degree accuracy of an
estimate also depends on the experience, ability and judgment of the estimator. The
construction cost estimate is broadly classified into two types approximate estimates and
detailed estimates. The approximate estimates are prepared during initial stages of the
project life cycle. These estimates are also known as preliminary, budget or order-of-
magnitude estimates and are prepared to determine the preliminary cost of the project.
From the approximate cost estimates, the owner of the project can be able to know
whether the project can be undertaken within the available budget. There may be more
than one design alternative for a project depending on the location, site conditions, type
of structure etc. The estimator can determine the approximate cost of various alternatives
for the project by taking preliminary design information from designer and can obtain the
economical alternative that is affordable within the available budget for the project.
Detailed estimates are prepared in accordance with the complete set of contract
documents. As already stated, the contractors prepare the detailed estimates before biding
for the project by thoroughly reviewing the contract documents. Project site visit by the
contractor personnel may be required to identify the parameters that can influence project
cost and accordingly the estimate can be adjusted. The detailed cost estimate showing the
bid price of the project is important to both the project owner and the contractor, as the
bid price represents the amount the contractor will receive from the owner for completing
the project in accordance with contract documents. The different types of cost estimates
which are prepared during various phases of a project are described below.

Estimates during conceptual planning:

This estimate is prepared at the very initial stage i.e. during conceptual planning stage of
a project. It is based on little information and on broad parameters namely size of the
project, location and job site conditions and the expected construction quality of project
as a whole. The size of the project may be expressed in terms of its capacity namely
number of rooms for a hostel, number of beds for a hospital, length (km) of a highway
etc. Owner of the project provides adequate input for defining scope of the project and
this scope of the project forms the basis on which the conceptual estimate is prepared.
This estimate is prepared to establish the preliminary budget of the project and
accordingly project funding can be arranged. The degree of accuracy of this estimate is
lowest among all the estimates those are prepared during various stages of a project.
Estimates during schematic design:

During this phase of the project, the cost estimate is prepared on the basis of preliminary
design information along with required schematic documents. The designer may
incorporate different design alternatives and the cost estimate is prepared for these design
alternatives by the estimators depending on the available information. The cost estimates
of different design alternatives are reviewed keeping in view the project scope and budget
and the acceptable alternative(s) selected in this phase is analyzed in a detailed manner in
the next phase of the project. This cost estimate is prepared by calculating the cost of
major project elements by unit pricing from the available preliminary design information.
Subcontractors or material suppliers may be asked to furnish information while pricing
the major project elements. As the cost estimate is prepared using preliminary design
information, a contingency may be added in the estimate to accommodate for the
unknown design details. With the improved scope of the project, the expected degree of
accuracy in this estimate is more as compared to that in conceptual estimate.
Estimates during design development:

During design development phase of the project, the cost estimate is prepared on the
basis of more detailed design information and schematic documents. With the improved
level of information, the most of the major project items namely volume of earthwork
(m3), volume of concrete (m3), weight of steel (tons) etc. can be quantified and the cost

estimate is prepared using the known unit prices. Detailed information from
subcontractors or material suppliers should be obtained and used in pricing the major
project items. During this phase, all the identified major systems of the project namely
structural systems (reinforced concrete vs. structural steel), masonry (clay brick units vs.
concrete masonry units), pile foundation (concrete pile vs. steel pile) etc. are priced and
then cost of each system is compared with that obtained from past similar projects. The
project elements costing too high or too low as compared to past data should be reviewed
and accordingly adjusted. With the availability of detailed design information and
improved system definition, the expected degree of accuracy in this estimate is higher as
compared to that in estimate prepared during schematic design phase of the project.
Estimates during procurement (i.e. estimates for construction of the project):

During this phase of the project, the cost estimate is prepared on the basis of complete set
of contract documents that defines the project. The contractors bidding for the project
prepare the cost estimate in accordance with contract documents by taking into
consideration the estimated project duration. As already mentioned in the previous lecture
(Lecture-1 of this module), the total cost of project can be divided into two categories
namely direct cost and indirect cost. Direct cost includes cost of materials, equipment and
labor associated with each item of work and cost of subcontracted works. Indirect costs
are the costs which are not attributed to each item of work and are calculated for the
entire project and include overhead cost, contingency and profit. The owner team also
prepares the cost estimate to check the accuracy of the bid prices quoted by the
contractors and negotiate a reasonable price with the contractor. As this cost estimate is
prepared in accordance with complete set of contract documents of the project, the degree
of accuracy of this estimate is extremely high.
Estimates for change orders during construction:

This estimate is prepared to cater the changes in the project scope as required by the
owner during construction phase of the project.

Lecture-3
Approximate estimates
The different types of cost estimates, those are prepared during various phases of a
project are already stated in Lecture 2 of this module. As already mentioned in Lecture 2
of this module, the approximate estimates (also known as order-of-magnitude estimates)
are prepared during initial stages of the project life cycle. The different methods used in
the preparation of approximate estimates are described below. In addition to use in the
preparation of estimates during early stages of project development, these methods may
also be sometimes used for cost estimating in the detailed design phase.
Unit estimate
This technique is used for preparing preliminary estimates (i.e. order-of- magnitude type
estimate). This estimate is generally prepared during the conceptual planning phase of a
project, with less information available with the estimator. In this method, the total
estimate of cost is limited to a single factor. The examples of some of the ‘per unit factor’
used in construction projects are construction cost per square meter, housing cost per
boarder of a hostel, construction cost per bed for a hospital, maintenance cost per hour,
fuel cost per kilometer, construction cost per kilometer for a highway etc. The total cost
is calculated by multiplying the cost per unit factor with the number of units of the
corresponding factor. For example, a preliminary estimate is required to estimate the cost
of constructing a new house with floor area of 170 square meter. If the cost per square
meter is Rs.26,900 (assumed), then the cost of constructing the house will be
Rs.45,73,000 (Rs.26,900170) . Similarly the preliminary cost estimate of constructing a
given length of highway can be calculated by multiplying the unit cost i.e. construction
cost per kilometer by the length of highway (in km).
The details of unit cost of different factors can be obtained from records of past projects.
The ‘per unit factor’ obtained from past similar projects can be adjusted by taking into
account different parameters namely location and size of the project, prevailing market
conditions etc. The accuracy of this technique depends on the quality and reliability of
the data available with the estimator.

Factor estimate
In this method, the estimate is divided into individual segments and then the cost of each
segment is calculated followed by adding all the individual costs to estimate the total
cost. Unlike unit technique, the factor technique includes separate factors for different
cost items. Thus compared to unit technique, factor technique is a more detailed method
of preparing the cost estimate and shows improved accuracy. The factor method is useful
when several components are involved in the preparation of cost estimate.
Considering a simple example, a preliminary estimate is required to find out the cost of
constructing a new multi-storey hostel of an educational institute. By unit method, the
preliminary cost will be simply the cost per square meter multiplied with the total floor
area (square meter) of the hostel. However a comparatively improved estimate can be
prepared by using factor method wherein the total cost estimate is divided into different
components. The hostel will consist of individual living rooms for students, hostel office,
a kitchen cum dining room, a reading room, a common room, an indoor sports room,
lavatories on each floor and other common amenities. The estimate of the total cost of the
hostel will comprise of cost of these components. The cost of residing rooms for the
students can be calculated by multiplying the cost of constructing one room (the
information can be obtained from past similar projects with adjustment for different
parameters as mentioned in unit estimate technique) by the required number of rooms.
The estimate of the construction cost of the kitchen cum dining room can be calculated
by multiplying its area in square meter by construction cost per square meter. Similarly
the estimate of the construction cost of other common areas (i.e. reading room, common
room etc.) can be calculated by multiplying the respective areas (in square meter) by
construction cost per square meter. Then the total estimate of the construction cost of the
hostel will be equal to the sum of all the cost components. As already mentioned the
information about construction cost per square meter of common amenities can be
obtained from past data on similar projects. In this example the estimate of construction
cost of living rooms of students can also be calculated by multiplying the total area to be
occupied by the rooms (square meter) by the cost per square meter.

Taking another example with more details, a preliminary cost estimate is required obtain
the cost of materials to be used in constructing reinforced concrete sections of a structure.
For reinforced concrete sections, the total cost estimate will comprise of cost of concrete
and cost of steel reinforcement bars. For estimating the cost of concrete (considering
normal strength concrete), the quantities of different ingredients namely cement, coarse
aggregate and sand are calculated from known volume of concrete by using the mix
proportion (either known or using data of similar grade of concrete from past projects).
The cost of the individual ingredients of concrete can now be calculated by multiplying
the quantities of the ingredients in the appropriate units with the respective unit cost. For
example, the required quantity of cement can be expressed in kg or in terms of number of
bags (i.e. total quantity of cement in kg divided by quantity of cement in kg per bag).
Similarly the required quantities of both coarse aggregate and sand can be expressed in
m3 (i.e. quantity of aggregate in kg divided by bulk density in kg/m3). The information
about unit cost of different materials can be obtained from material suppliers. Similarly
the cost of steel reinforcement can be obtained by multiplying the quantity of steel in tons
with its unit price. Now the total cost of materials to be used in constructing reinforced
concrete sections is calculated by summing the cost of concrete and cost of steel
reinforcement. Similarly the preliminary estimate of other cost items can be obtained by
using factor estimate method.
Cost indexes
The method involving cost indexes is used for obtaining preliminary cost estimate by
considering the historical data of similar past projects. Cost indexes (or indices) are
dimensionless numerical values which represent the price change of individual or
multiple cost items over time with respect to a reference year. Cost indexes are used to
update the historical cost figures and to obtain the current cost estimates. The relationship
used for updating the historical cost figures to the cost at another point of time using cost
index is presented below.
Cr I n
Cn =
Ir
Where
Cn = estimated cost of the item in year ‘n’

Cr = cost of the item in year ‘r’ (at earlier point of time and n > r)
In = index value in year ‘n’
Ir = index value in year ‘r’
Here ‘r’ is the reference year (i.e. at earlier of point of time) at which the cost of the item
known and ‘n’ is the year for which cost of the item is to be estimated. Cost indexes are
periodically published by various public and private agencies.
Cost indexes are generated for an individual item or for wider variety of items. For a
single item, cost index can be calculated as the ratio of cost of the item today (i.e. in
current year) to the cost of the same item at some point of time in past (i.e. reference
year) multiplied with cost index value of the reference year. Similarly for multiple items,
a weighted-average index or composite index for a specific year can be obtained from
known cost of the selected group of items in the given year and in reference year and the
composite index of these items in the reference year by assigning the appropriate
weightage factors to these items. In construction, the expected cost estimate of materials,
equipment and labour for new projects can be obtained from the known cost of these
items from similar past projects and cost indexes (in reference year and current year)
using the above relationship.
Example -1
For estimating the expected cost of materials for a new construction project, the
following information is available;
The material cost of a similar construction project that was completed four years ago was
Rs.1,12,64,000 and the material cost index was 512. Calculate the approximate material
cost for the new project, if material cost index now is 625.
Solution:
The approximate material cost for the new project ‘Cn’ is calculated using the above
relationship and is presented below.
Cr I n
Cn =
Ir
Where

Cn = approximate material cost (present cost estimate)

Cr = = material cost of similar project four years ago = Rs.1,12,64,000
In = material cost index now = 625
Ir = material cost index four years ago = 512
Rs.1,12,64,000  625
Cn   Rs.1,37,50,000
512
Thus the approximate material cost for the new construction project is Rs.1,37,50,000.

Lecture-4
Parametric estimate
Parametric cost estimate is prepared during early stages of project development. The cost
estimate is based on various parameters which define characteristics of the project and
includes physical attributes such as size, capacity, weight etc. The parametric cost
estimate is based on cost-estimating relationships those use past cost data to obtain the
current cost estimate. Cost estimating relationships are statistical models those relate the
cost of a product or system to the physical attributes those define its characteristics. One
of the most commonly used cost-estimating relationships is power-sizing model.
Power-sizing model
Power-sizing model is most commonly used for obtaining preliminary cost estimate of
industrial plants and equipment. The power sizing model relates the cost of a plant or
system to its capacity or size and uses the following relationship for cost estimate.
x
C1  Q1 
= 
C 2  Q 2 
Where
C1 = cost of Plant 1
C2= cost of Plant 2
Q1 = capacity or size of Plant 1
Q2 = capacity or size of Plant 2
x = power-sizing exponent or the cost-capacity exponent
In the above expression C1 and C2 are the costs at the same point in time, at which the
estimate is required. Both Q1 and Q2 are in same physical units. The power-sizing
exponent ‘x’ represents the economies of scale. The economies of scale indicate that the
cost per unit output decreases as the size of operation increases. The decrease in cost per
unit output occurs as the fixed cost is distributed over more number of output units as the
scale of output increases and in addition the efficiency grows in production with
increasing size of operation. Taking a simple example, the cost of constructing a four-
storey hostel building will normally be less than twice the cost of constructing a similar

two-storey hostel building. One of the factors that gives rise to cost advantage in case of
four-storey building is the cost of land (fixed cost), which is same for both buildings.
If the value of power-sizing exponent ‘x’ is less than 1, it indicates economies of scale
whereas greater than 1 indicates diseconomies of scale. When the value of power-sizing
exponent is equal to 1, it indicates a linear relationship between cost and capacity or size.
While using this technique to predict the current cost of an industrial plant of a given
capacity (Q1) from known past cost of the same plant of a different capacity (Q2), first it
is required to update the known past cost of the plant with capacity (Q2) to the present
time by using the relationship for cost index (as stated in previous lecture) from the
known values of cost indexes in past and in current time. After that, the cost of the plant
with capacity Q1 is estimated using the power-sizing model (as stated above) from the
updated cost of plant with capacity Q2 (i.e. cost at current time) and value of the power-
sizing exponent for this particular plant.
Learning curve is also another cost estimating relationship and it is based on the
principle that with increase in number of repetitions, the performance becomes faster
with increase in efficiency. In other words the time or cost of producing a unit output of a
product/system reduces, each time it is produced. Learning curve relates to improvement
in performance with increase in repetitions. A learning curve model is based on the
assumption that, the time to produce a unit output reduces by a constant percentage as the
number output unit is doubled. The reduction in time depends on the learning curve rate.
Taking a simple example, if the time required to complete the production of first output
unit is 20 hours, then the time required to complete the production of the second output
unit at 80% learning curve rate will be 16 hours (20 hours × 0.80) . This 80% learning
curve rate indicates a 20% reduction in production duration, each time the output is
doubled Similarly the time required to produce the fourth output unit will be 12.8 hours
(16 hours × 0.80) . The reduction in production time for fourth unit as compared to the
second unit is 3.2 hours (16 hours – 12.8 hours) which is 20% of production time for the
second output unit.

Life cycle cost

Life cycle cost is equal to sum of all the estimated costs associated with a product,
service or system over its life span starting from conceptual planning at the beginning to
schematic design, detailed design, construction or production, operation and maintenance
till its disposal at the end of the life span. The concept of life cycle costing lies in
designing/producing the products, services or systems with systematic identification of
both recurring and nonrecurring costs during various phases of their life cycle and
estimating the cash flows during these phases over the life cycle. The economic
evaluation of an alternative on the basis of life cycle cost results in a detailed analysis of
the of both present and future costs and thus helps in taking the right decision regarding
the selection of the most economical alternative. For construction projects, it is important
to accurately estimate all the cost components during various stages of the project life
cycle.
The life span of a product, service or system depends on the different phases starting
from conceptual planning to its disposal. The end of life cycle may be governed by
economic requirement or by functional requirement and depends on specific product,
service or system. The economic life of a product/system is normally shorter than its
physical life. The product/system may still be functional (over physical life) but may not
be economical for the entire life period and may be replaced. The details about the
replacement analysis of an asset are already stated in Module 4.
The life cycle cost of a product, service or system increases, if the design changes are
made during later stages of the life cycle. The cost of design change increases with each
stage of life cycle with lower cost during the early stages. Further the flexibility in design
changes during the early stages is more as compared to that in the later stages of life
cycle. Thus the potential for cost savings is more during the early stages of the life cycle
and thus the selection of the most economical alternative and the effective design
procedure during the design stage results in higher cost savings. Thus it is essential to
have a detailed design of the product/system (as per the required technical specifications
and operational requirements) during the design stage of life cycle and to avoid or
minimize the design changes during production and operation stages of life cycle to have
a minimum impact on the life cycle cost of the product/system.

The life cycle cost analysis is more useful for selecting the alternatives for products,
services or systems having longer life periods namely, infrastructure projects and projects
involving more research and development components. The economic evaluation of
alternatives using life cycle cost analysis can be carried out by finding out the equivalent
worth of the each alternative by including all the cash flows occurring over various stages
of life cycle by present worth analysis and selecting the most economical alternative that
results in minimum life cycle cost.

Module 6
Lecture-1
Financial management:
Financial management involves planning, allocation and control of financial resources of
a company. Financial management is essential as it controls the financial operations of a
company. For a construction company, the decision to bid for a project will depend on its
financial status which in turn will be governed by financial management principles. The
decision to bid for a project will depend on various factors namely whether the company
have enough funds or require outside financing, whether to acquire the equipment
through purchase or acquisition through renting or leasing, whether to carry out the entire
work or subcontract a portion of the work etc. If the company uses its own funds for the
project, it may have an adverse effect on its financial status as it will reduce the liquid
asset thus affecting company’s working capital. The construction industry differs from
other industries because of its unique characteristics and accordingly the financial
management principles are applied for using the financial resources of the company.
Generally the construction companies receive the payments from the owners at specified
time intervals as the construction work progresses and owners often retain certain amount
subject to the satisfactory completion of the project. Thus the terms and conditions for
receipt of payments from owners affect the cash flow of the construction companies and
need the changes in allocation of financial resources. Further construction companies
often subcontract some portion of the work (as required) to the subcontractors, which in
turn affect the cash flow. The financial management decisions include the decisions for
investment, financing and distribution of earnings. For construction companies the
investment decisions relate to investment in the business i.e. investment of funds in
acquiring the assets (both current assts and long-term assets) to be utilized in the projects
for the expected return along with the risk of cash flows associated with uncertain future
conditions. The financing decisions depend on decision to investment the funds and the
resources possessed by the construction companies. In addition the financing decisions

are also controlled by other factors namely source of financing (from banks or other
financial institutions), cost of financing i.e. interest cost on the loan and the financing
duration. The decision for distribution of earnings or profits of the company depends on
the dividends to be paid to the stockholders and the retained earnings to be reinvested in
the business to increase the return. Thus for any company or organization, financial
management has to ensure the supply of funds in acquiring the assets and their effective
utilization in business activities, to ensure the expected return on the investment
considering the risk associated and optimal distribution of the earnings.
Construction accounting
Construction accounting involves collecting, organizing, recording and reporting the
financial data of a construction firm. It helps in identifying the problems encountered in
effective management of financial resources of the firm and taking the corrective
measures in time. The accounting system allows for the systematic recording and
reporting the financial information form one period to another in accordance with the
accounting principles. Financial data relates to assets, liabilities, net worth, cost incurred,
revenue earned etc. and is required for preparing the financial statements of the
construction firm. The most important financial statements which are used to represent
the financial status and evaluate the performance of the firm are balance sheet and
income statement. The financial statements are also used to communicate the financial
status of the firm to the shareholders and financial institutions. The shareholders and
financial institutions can get the useful information about the utilization of financial
resources in the business activities, costs incurred, revenues earned and other financial
information of the firm from period to period. In addition the financial information is also
required for calculating the income tax to be paid by the firm.
Construction firms use different types of accounting methods for recognition of the
revenues, costs and profit while preparing the financial statements. These accounting
methods are cash method, accrual method, percentage-of-completion method and
completed contract method. For obtaining the most accurate picture of financial status,
the construction firm has to use the best suitable accounting practice for recognition of
the revenue and expenses.

In cash method, revenue is recognized when construction firm actually receives the
payments from the owner of the project for the services provided. Similarly the cost
(expenses) is recognized when the construction firm actually pays the bills (to
subcontractors, material suppliers etc.). Normally the cash method is not used for
preparing the financial statements of the construction firm as the revenues or costs are
recognized when these are actually received or paid rather than the revenues billed to date
or the costs incurred to date. Due to this delay in the recognition of revenues and costs,
this method does not provide accurate financial status of the firm.
In accrual method, revenue is recognized when construction firm bills the owner of the
project i.e. before the actual receipt of payments from the owner and expenses are
recognized as the construction firm receives the bills from subcontractors, material
suppliers etc. i.e. before the bills are actually paid. This method of accounting is used for
preparing the financial statements of the firm as it provides more accurate information
about the financial status of the firm.
In percentage-of-completion method, the revenue and expenses are recognized as
percentage of work that is complete during the course of the project. This method of
accounting normally used for long-term construction projects. The revenue is recognized
as the construction firm bills the owner of the project and expenses are recognized as the
construction firm receives the bills from subcontractors, material suppliers etc. The
percentage complete till date can be calculated by dividing the cost incurred to date by
the total estimated cost at completion. Corresponding to this percentage completion, the
revenue and profit to date are calculated. The percentage-of-completion method is used
for preparing the financial statements and it provides the most accurate picture of the
firm’s financial status.
In completed contract method, the revenue and expenses are recognized when the
project is complete. This method of accounting does not provide accurate information
about the construction firm’s financial condition as the recognition of revenue and
expenses are deferred till the completion project rather than in the periods when the
revenues are billed to date or the costs are incurred to date. The revenue recognized to
date for the project at any stage within the project duration is zero, as the project is not
complete. This method of accounting can be used for construction contracts having

higher uncertainty about the construction cost and revenue until the completion of the
project, involving higher financial risks in the business. Further completed contract
method causes large fluctuations in the profit as the cost and revenue are not recognized
till the completion of the project.
Example -1
The following table presents the information about the financial data of a construction
project.
Description of financial data Amount (Rs.)
Contract amount 3,85,00000
Original estimated cost of the contract 3,46,50,000
Billed to date 2,57,95,000
Payments received to date 2,34,85,000
Costs incurred to date 2,07,90,000
Costs paid to date 1,84,03,000
Estimated or forecasted cost to complete 1,31,28,500
Calculate the revenue to date for the project using different methods of revenue
recognition.
Solution:
Cash method
By using the data from above table, revenue to date for the project using cash method is
calculated as follows;
Revenue to date  Paymentsreceived to date  Costs paid to date
Revenue to date  Rs.2,34,85,000  Rs.1,84,03,000  Rs.50,82,000
Accrual method
The revenue to date for the project by using accrual method is calculated as follows;
Revenue to date  Billed to date  Costsincurred to date
Revenue to date  Rs.2,57,95,000  Rs.2,07,90,000  Rs.50,05,000

Percentage-of-completion method
For calculating the revenue to date by using percentage-of-completion method, first the
percentage of work that is complete is calculated.
Costs incurred to date
Percentage of completion  100
Total estimated cost at completion
Total estimated cost at completion is equal to costs incurred to date plus estimated or
forecasted cost to complete.
Costs incurred date
Percentage of completion   100
Costs incurred to date  Estimated cost to complete
Rs.2,07,90,000
Percentage of completion   100  61.29%
Rs.2,07,90,000  Rs.1,31,28,500
The revenue to date for the project is now calculated by multiplying the contract amount
with the percentage of completion and is given by;
Revenue to date  Rs.3,85,00000  0.6129  Rs.2,35,96,650
Now gross profit to date is calculated by subtracting costs incurred to date from revenue
to date and is given by;
Gross profit todate  Re venue to date  Costsincurred to date
Gross profit todate  Rs.2,35,96,650  Rs.2,07,90,000  Rs.28,06,650
Completed contract method
By using completed contract method, revenue to date for the project would be zero as the
project has not yet been completed.

Lecture-2
Chart of accounts:
Chart of accounts lists all the accounts which are required to organize the financial
information of a construction firm. The accounts mentioned in chart of accounts are used
to prepare the financial statements namely income statement and balance sheet of the
firm. The accounts listed in chart of accounts are assets, liabilities, net worth, revenue,
expenses and tax. In chart of accounts the components of balance sheet i.e. assets,
liabilities and net worth are listed first followed by the components of income statement
i.e. revenue, expenses and tax. Each account in the chart is assigned by a reference
number for easy identification.
Financial statements
As already stated in Lecture 1 of this module, financial statements are used to indicate the
financial status and evaluate the performance of a firm. The most important financial
statements are income statement and balance sheet (already mentioned).
Income statement (or Profit and Loss statement)

Income statement is a summary of revenues, expenses and the resulting profit or loss of a
firm for a stated period of time, usually the fiscal year. The income statement is also
referred as profit and loss statement. It records the revenues and expenses in the interval
between two balance sheets. It provides information about net profit or loss of the firm,
thus indicating whether the firm is running the business with profit or loss. Profit is the
excess of revenue over the expense. Through income statement, it is possible to track the
performance of the firm during the stated period of time by analyzing the revenues and
the expenses. Revenues represent the cash inflows earned in the exchange of services
provided whereas the expenses represent the cash outflows, the firm spent for providing
the services. In income statement the operating revenues and expenses represent the
income and the expenditures those are associated with the core operations of the firm
whereas the nonoperating revenue and expenses represent the income and expenditures
from sources other than the core operations. For construction firms the operating
revenues represent the earnings against the services provided i.e. earnings against the
completion of portion of work or entire work of the projects. The operating expenses

represent the construction costs (both direct and indirect costs) i.e. material cost,
equipment cost, labor cost, cost of subcontracted work and the overhead cost. As already
mentioned in Lecture 1 of Module 5, the direct cost includes cost of materials, equipment
and labor associated with each item of work, along with subcontracted costs whereas the
indirect cost (overhead costs) is calculated for the entire construction project rather than
allocating for each item of work in the project. In income statement, the nonoperating
revenues include the interest earned and the revenue earned from sources other than the
core operations (i.e. construction operations) of the firm. The nonoperating expenses
include interest payments on loans and other expenditures which are not associated with
the construction operations of the firm.
In the income statement, the operating revenues and expenses are shown first. From these
records, the gross profit from operations is calculated. After that the net profit from
operations is calculated by the subtracting the overhead cost from the gross profit (from
operations). The nonoperating revenue and expenses are then recorded. The profit before
tax is then equal to net profit from operations less the nonoperating revenue and
expenses. It may be noted here that the nonoperating revenue is added whereas
nonoperating expense is subtracted from net profit from operations. After that the net
profit after tax is calculated by subtracting the income tax (at an appropriate income tax
rate) from profit before tax.

A typical income statement of a construction firm is shown as follows.
XY Construction Firm
Income Statement
Year Ended March 31, 2012
Operating Revenues Rs.45260700
Operating Expenses
Equipment 6338400
Materials 10304150
Labor 8067200
Subcontract 9185700
Total operating expenses 33895450
Gross profit from operations 11365250
General and administrative overhead cost 4661800
Net profit from operations 6703450
Nonoperating Revenues
Interest receipts 769500
Nonoperating Expenses
Interest payments 407850
Profit before tax 7065100
Income tax 2119530
Net profit after tax Rs.4945570
For the above income statement, the calculations of gross profit from operations, net
profit from operations, profit before tax and net profit after tax are presented below.
Gross profit from operations  operating revenues  operating expenses
 Rs.45260700  Rs.33895450  Rs.11365250
Net profit from operations  gorss profit from operations  general and adminstrative overhead cost
 Rs.11365250  Rs.4661800  Rs.6703450
Profit before tax  net profit from operations  nonoperating revenues  nonoperating expenses
 Rs.6703450  Rs.769500  Rs.407850  Rs.7065100
Net profit after tax  profit before tax  income tax
 Rs.7065100  Rs.2119530  Rs.4945570

Lecture-3
Balance sheet
A balance sheet shows details about the financial status of a firm at a particular point in
time. A balance sheet is a summary of the firm’s assets, liabilities and owners’ equity or
net worth (i.e. worth that the firm owes to its owners i.e. stockholders or shareholders) at
a given point in time. In other words for a firm, a balance sheet provides details about the
assets it owns, liabilities it owes and the equity it owes to its owners. Balance sheet
represents a snapshot of firm’s financial position. It is commonly prepared at the end of
financial year (i.e. fiscal year). But it may also be prepared at other time intervals i.e.
quarterly, semiannually within a financial year or calendar year as required by the firm.
The fundamental relationship between assets, liabilities and owners’ equity on the
balance sheet is as follows;
Assets  Liabilitie s  Owners' equity
As observed from above relationship, on the balance sheet the assets of a firm must be
equal to the sum of its liabilities and owners’ equity. The categories of assets, liabilities
and owners’ equity are presented as follows.
Assets are the resources of monetary value those are owned by the firm. The assets of a
typical construction firm are cash, plant and equipment, land, buildings, construction
materials, receivables etc. Assets are classified into three categories namely current
assets, long-term assets and other assets.
Currents assets are defined as the assets which are likely to be converted into cash
within one year. The categories of current assets are cash, accounts receivable, notes
receivable, costs and profits in excess of billings, inventory, prepaid expenditures etc.
Cash is the primary current asset. It includes cash in bank i.e. bank deposits (savings,
term deposits with maturity less than one year) and petty cash. Accounts receivable
include the amount that the owner of the project (i.e. client) owes to the firm for
providing service or for the job done. For example the monthly bill to be paid by the
client of a project to the construction firm is an account receivable till the payment
against the bill is received. It also includes the retentions receivable. The retentions
receivable represent the amount that is held up by the client of the project and is released

to the construction firm subject to fulfillment of requirements of the project. Notes

receivable are the formal written notes that represent the amount that is expected to be
received by the firm within a year. The formal note serves as written promise to receive
the amount of money from the party obliged to make the payment. It includes bill
payments to be received through a formal written promise within a year. Costs and
profits in excess of billings are also known as underbillings and are recorded as current
assets on the balance sheet. Costs and profits in excess of billings occur when the firm
bills the clients (project owners) less than the sum of costs incurred and estimated profits
for the portion of the work that is complete. The firms using percentage-of-completion
method of accounting are required to recognize the revenues, expenses and estimated
profits on the basis of percentage of project work that is complete and costs and profits in
excess of billings are accordingly recorded on the balance sheet. Percentage-of-
completion method is one of accounting methods that the construction firms use for
preparing the financial statements. Underbillings may occur due to more cost incurred
than the estimated on the completed work or due to non-proportionate distribution of
profit. Inventory represents resources (mostly the materials) that are with the firm and
are likely to be used in the project within a short period of time and its monetary value is
entered in the balance sheet as current asset. For a construction firm, inventory includes
the construction materials to be used in a project. The material suppliers (subcontractors)
generally carry inventory of the construction materials which they supply to the
construction firms. Prepaid expenditures represent the amount of money paid for future
services and include prepaid insurance premium, prepaid taxes, advance rental payments
etc.
Long-term assets represent the resources which can not readily be converted into money
(cash) and these assets provide future benefits. Fixed or tangible assets (a category of
long-term assets) include land, building, plant and equipment and other tangible assets
with longer service life. Fixed assets are shown on the balance sheet at their original cost
(i.e. purchase price) less the accumulated depreciation (except for land). The recorded
accumulated depreciation on the balance sheet represents the loss in value of the fixed
assets till date.
Other assets include other investments and equity in other enterprises.

Liabilities represent the obligations (i.e. debts) that the firm owes to other parties.
Liabilities include bank loans, debts to subcontractors, advances from project owners (i.e.
clients), taxes payable both current and deferred etc. Liabilities are classified into two
categories namely current liabilities and long-term liabilities and are according shown on
the balance sheet.
Current liabilities represent the obligations which are likely to be paid within one year.
The categories of current liabilities are accounts payable, billings in excess of costs and
profits, accrued payables, lease payments etc. Current liabilities are usually paid by using
current assets. Accounts payable include the debts that the firm owes to other parties for
services provided. For example the monthly bills received by the construction firm from
subcontractors and suppliers represent the accounts payable till the payment of the bills.
It also includes the retentions payable which represents the amount of money that is held
up by the construction firm and is released to subcontractors or suppliers subject to the
fulfillment of the requirements. Billings in excess of costs and profits also known as
overbillings are recorded as current liabilities on the balance sheet. Billings in excess of
costs and profits occur when the firm bills the clients (project owners) more than the sum
of costs incurred and estimated profits. Overbillings may occur due to less cost incurred
than the estimated on the completed project work or due to non-proportionate distribution
of profit. Accrued payables are the expenses which the firm owe and include accrued
wages, accrued taxes, accrued interest and accrued rents which are not paid. Lease
payments are recorded as a current liability on balance sheet and for construction firms it
represents rental payments for acquiring the construction equipment. In addition to these
current liabilities, notes payable (include the debts which are likely to be paid through a
formal written promise within a year) and dividends payable (portion of the profits or
earnings that a firm pays to its stockholders) are also recorded as current liabilities on the
balance sheet.
Long-term liabilities also known as non-current liabilities are the debts which are not
expected to be paid within a year and normally refer to loans from banks or other
financial institutions. Long-term liabilities include loans taken to purchase construction
plant and equipment and other assets, payment of mortgage for buildings etc.

Owners’ equity or net worth of the firm represents the excess of assets of a firm over its
liabilities and is recorded on the balance sheet. For the companies, the owners’ equity
consists of three components namely common stock, preferred stock and retained
earnings. Common stock represents the major source of investment by the stockholders in
the company and provides the stockholders with voting rights to exercise in company
decisions. Preferred stock that represents the ownership in a company usually do not
provide the stockholders the voting rights to exercise in company affairs, however it
ensures a dividend to be received by stockholders (holders of preferred stock) before any
dividend is paid to holders of common stock. Retained earnings represent the profits or
earnings which are reinvested in the company rather than being distributed as dividends
to the stockholders. These earnings are retained by the company to reinvest in the
business to increase the income and thus to increase the value of stock.
A typical balance sheet of a construction firm is shown below. In the balance sheet the
total assets of the construction firm is equal to the sum of total liabilities and owners’
equity.

AB Construction Firm
Balance Sheet
As of 31 March 2012
Assets Liabilities
Current assets Current liabilities
Accounts payable
Cash Rs.1050000 Rs.5981400
including retentions
Accounts receivable Billings in excess of
6860000 2736500
including retentions costs and profits
Costs and profits in
4263000 Accrued payables 1371600
excess of billings
Inventory 3925000 Notes payable 1264900
Total current assets Rs.16098000 Dividends payable 981200
Fixed assets Total Current liabilities Rs.12335600
Land Rs.2362000 Long-term debts Rs.4610700
Building 10152000 Total liabilities Rs.16946300
Construction and other
equipment
10572000 Owners’ equity
Total fixed assets Rs.23086000 Common stock Rs.3150600

Less accumulated Preferred stock
7046160 2569040
depreciation
Net fixed asset Rs.16039840 Retained earnings 9471900
Total assets Rs.32137840 Total owners’ equity Rs.15191540
Total liabilities and
Rs.32137840
owners’ equity

Lecture-4
Financial ratios
Financial ratios are used to evaluate the financial status of a company. These ratios
provide information about the company’s ability to meet the financial obligations (i.e.
ability to pay the bills, debt payment ability), profitability, liquidity and effective use of
its assets. Financial ratios represent the relationship between the financial data shown on
the financial statements (i.e. balance sheet and income statement). These ratios are
calculated by dividing a category of financial data by another category shown on
financial statements and are then compared with other companies within the industry.
Through financial ratios, it is easy to identify the changes in the financial status of the
company which are not evident, by only referring to the values of different categories of
assets, liabilities net worth, revenue and expenses shown on the financial statements. The
different financial ratios which are used to assess the financial status of a company are
presented below.
Current ratio
Current ratio indicates the ability of a company to meet the short-term financial
obligations. In other words it is a measurement company’s ability to pay the current
liabilities by using the current assets and is given by;
Current assets
Current ratio =
Current liabilities
Current assets and current liabilities shown on balance sheet are used to calculate this
ratio and the details about the current assets and current liabilities are already stated in
Lecture 3 (Balance sheet) of this module. This ratio gives information about working
capital status of a company. A current ratio of less than 1.0 to 1 (i.e. 1.0:1) indicates that
the current assets of the company is not sufficient to pay its current liabilities whereas a
greater value of current ratio is a strong indicator of the ability of the company to pay its
current liabilities. However on the other hand a considerably higher value of current ratio
indicates that much of the assets of the company might have tied up in the current assets
and can be invested in other business to increase the earnings of the firm.

Quick ratio (or acid-test ratio)

Quick ratio measures the ability of a firm to pay current liabilities using cash or other
assets that can be readily converted into cash. Quick ratio is also referred as acid-test
ratio. It is a measure of short-term liquidity of a firm and provides information about its
immediate financial status. This ratio is calculated by dividing quick assets (categories of
current asset) of a firm by its current liabilities. The quick assets include cash and
accounts receivable. Quick ratio is given by the following relationship.
Cash  accounts receivable
Quick ratio 
Current liabilities
Inventories and retentions receivable (of accounts receivable) are excluded from quick
assets because these assets can not be converted into cash quickly. A quick ratio equal to
or greater than 1.0:1 indicates the ability of a firm to pay the current liabilities with the
quick assets. A quick ratio of less than 1.0:1 requires that the firm needs to convert
inventories and other assets into cash for payment of current liabilities.
Debt to worth ratio

This ratio is calculated by dividing total liabilities of a company by its net worth or
owners’ equity. It is also referred as debt to equity ratio and is given by;
Total liabilities
Debt to worth ratio=
Net worth
This ratio is a measure of a company’s leverage and the desired value of this ratio should
be less than or equal to 2.0:1. A debt to worth ratio less than 1.0:1 indicates that the firm
is not utilizing the debt in the business to increase the return on the investment. Further a
lower value of this ratio indicates that there is more protection to the creditors as the
owners of the firm are contributing majority of the funds to the business of the firm. A
debt to worth ratio of greater than 2.0:1 may result in a greater risk for the repayment of
debt along with interest during recession in the construction industry.
Return on assets ratio

The return on assets ratio is calculated by dividing the net profit after taxes by the total
assets of the company. This ratio is expressed as a percentage and is given by:

Net profit (after taxes)

Return on assets ratio =
Totalassets
The net profit after tax from income statement and total assets from balance sheet of a
company are used to calculate this ratio. Return on assets ratio measures how efficiently a
company uses its assets to earn the return and indicates profitability of a company. For a
company, the efficient use of assets earns a higher return (higher value of this ratio)
whereas there is low return on assets (lower value of this ratio) for a poorly run company.
Return on sales ratio

This ratio is calculated by dividing the net profit after taxes by the net sales revenue.
Return on sales ratio is expressed as a percentage. It is given by:
Return on sales ratio =
Net sales revenue
The operating revenues (net sales revenue) and net profit after tax from income statement
are used to calculate this ratio. This ratio indicates the profit margin for a company and
measures how efficiently a company can meet the adverse market conditions such as
decline in demand, falling prices and increased costs. An increasing value of this ratio
(%) indicates higher profit margin due to increased revenue and lowered company
expenses. Similarly a lower value of this ratio (%) indicates lower profit margin due to
decline in revenue and increase in the costs.
There are also other financial ratios such as current liabilities to net worth ratio, fixed
assets to net worth ratio, assets to revenues ratio etc. (calculated from data of financial
statements) can be used to assess the financial status of a company. The calculation of
some of the financial ratios is presented in the following example.
Example -2
Calculate the current ratio and debt to worth ratio for ‘AB Construction Firm’ (Balance
Sheet, Lecture 3 of Module 6) and return on sales ratio for ‘XY Construction Firm’
(Income Statement, Lecture 2 of Module 6).
Solution:
From the balance sheet of ‘AB Construction Firm’, the values of current assets and
current liabilities are Rs.1,60,98,000 and Rs.1,23,35,600 respectively. Further the values

of total liabilities and net worth (or owners’ equity) are Rs.1,69,46,300 and
Rs.1,51,91,540 respectively.
The current ratio for ‘AB Construction Firm’ is given by;
Current assets
Current ratio =
Current liabilities
Rs.1,60,98,000
Current ratio =  1.30
Rs.1,23,35,600
Thus the current ratio for the construction firm is 1.30.
The debt to worth ratio for ‘AB Construction Firm’ is given by;
Total liabilitie s
Debt to worth ratio =
Net worth
Rs.1,69,46,300
Debt to worth ratio =  1.11
Rs.1,51,91,540
Thus the debt to worth ratio for the construction firm is 1.11.
From the income statement of ‘XY Construction Firm’, the values of operating revenues
(net sales revenue) and net profit (after taxes) are Rs.4,52,60,700 and Rs.49,45,570
respectively.
The return on sales ratio for ‘XY Construction Firm’ is given by;
Return on sales ratio =
Net sales revenue
Rs.49,45,570
Return on sales ratio =  0.109  10.9%
Rs.4,52,60,700
Thus the return on sales ratio for the construction firm is 10.9%.

Lecture-5
Working capital management
Working capital represents the excess of current assets over the current liabilities. The
details about current assets and current liabilities are already presented in Lecture 3 of
this module. Working capital includes the cash or near-cash assets which are required for
the daily operations in the business. Adequate working capital is required for ensuring
regular supply of raw materials and other consumables, timely payment of wages and for
meeting other short-term expenses so as to have smooth running of the operations in the
business. Working capital measures the sort-term financial strength and a company must
have sufficient working capital to meet the short-term financial obligations. Insufficient
working capital may result in difficulty in meeting the cash requirement for the
operations in the business. On the other hand, much of assets tied up in working capital
reduces the profit level of the company as excessive working capital makes the funds
idle. Thus working capital management aims at establishing the optimum level of
working capital for smooth running of the operations in the business by maintaining the
desired liquidity and profitability of the company. For a company, the main objective lies
in increasing the profit level so as to maximize the wealth of stockholders and increase
the market value of stock and at the same time maintaining the liquidity for meeting the
short-term financial obligations. Liquidity and profitability are inversely related as higher
investment in current assets with lesser short-term borrowings increases the liquidity and
reduces the profitability of the company whereas, for a company lesser investment in
current assets with higher short-term borrowings decreases the liquidity and increases the
profitability. Thus it is essential to have a balance between liquidity and profitability by
maintaining the satisfactory level of working capital with the help of working capital
management which assists in managing the desired level of current assets and current
liabilities of the company.
Working capital is represented in a continuous cycle known as operating cycle and a

typical operating cycle is shown in Fig. 6.1. The operating cycle is also referred to as
working capital cycle or current assets and current liabilities cycle. The operating cycle
starts with acquiring raw materials and consumables using cash (or on credit),
maintaining their inventory, use in production, obtaining finished goods (or service)

followed by sales, receipt of payment against the bill and finally realizing the cash, which
completes the operating cycle and the same process is again continued. In other words in
the operating cycle, there is continuous flow from cash to suppliers, to inventory, to
finished goods (or service), to accounts receivable and then to cash again. The length of
an operating cycle (i.e. duration) depends on the number of stages involved (as
mentioned above) and the average length (i.e. duration) of each stage. For a construction
company undertaking a project, the operating cycle begins with procurement of
construction materials and other consumables with cash (either available or from advance
if any received from the owner of the project) or on credit from the suppliers. The
quantities of these items to be purchased depend on how much to be used during a given
period of time and how much to be kept in stock. Further cash is used for payment of
wages to labourers employed in the project and payment of equipment rental charges to
the equipment renting firm along with the payment of overhead expenses. If the
equipment is owned by the construction company, then cash is utilized for meting the
operating cost of the equipment employed in the project. The construction material
suppliers and equipment renting firm are regarded as creditors if the company acquires
these items on credit. After completion of a portion of work, the construction company
raises the bill against the activities carried out during that period of time i.e. billing period
which may be one month or two months (i.e. as per conditions of contract between the
owner and the construction company). The billed amount becomes accounts receivable
and owner of the project is regarded as debtor to the construction company till the receipt
of payment against the bill. The receipt of payment against the bill and realization of cash
completes the operating cycle and the process continues. The construction company must
have sufficient working capital to meet expenses of materials, equipment, labour and
overhead till the receipt of payment from the client (i.e. owner of the project). The
estimation of working capital requirement is an important aspect of working capital
management. The factors those affect the working capital requirement are nature and size
of the business, type of raw materials, production process, credit policy, duration of
operating cycle, volume of production and sales etc.

Cash
Raw materials,
Debtors
wages, expenses
Revenue
Stock
(Sales)
Finished goods/service Work in progress
Fig. 6.1 Operating cycle
In the construction projects, there is usually a time lag between completion of a portion of
work and the receipt of payment from owner of the project and thus production (sales) is
not converted into cash instantaneously. Therefore working capital is required to meet the
financial requirement in daily operations in the project. Often material suppliers and the
equipment renting firm also allow a credit period to the construction company. Thus the
credit period allowed by material suppliers and equipment renting firm to the
construction company and that allowed by the construction company to the owner of the
project are to be considered while calculating working capital requirement of the
construction company.
The calculation of working capital requirement of a construction company is presented in
the following example.
Example -3
The estimated annual revenue of a construction company from a project is Rs.51000000.
In the project, the proportions of material cost, labour cost, equipment cost, overhead cost
and profit are 37%, 23%, 16%, 14% and 10% of the estimated annual revenue

respectively. On an average two months’ credit (i.e. average time period between
commencement of a portion of work and receipt of payment from owner of the project) is
allowed to the owner of the project. The materials are purchased from material suppliers
and equipment is hired on rental charges from the equipment renting company. The credit
period allowed by material suppliers and equipment renting firm to the construction
company is one month. On average, two and half months’ supply of materials is kept in
stock at all the times. Calculate the working capital requirement of the construction
company for the operations in the project.
Solution:
The working capital requirement will be calculated for meting the expenses of material,
labour, equipment and overhead.
The annual material cost, labour cost, equipment cost and overhead with the
corresponding percentages of annual revenue are Rs.18870000, Rs.11730000,
Rs.8160000 and Rs.7140000 respectively.
Materials
Materials held in construction work (i.e. in work in progress) = 2 months
(i.e. average time period between the use of materials in the work and receipt of payment
from owner of the project)
Materials in stock = 2.5 months
Credit from suppliers = 1 month
The construction company must have the working capital to meet the expense of 4.5 (i.e.
2 + 2.5) months’ materials requirement. However the material suppliers allow 1 month
credit to the company. Thus the construction company requires the working capital to
meet the expense of 3.5 (i.e. 4.5 - 1) months’ materials requirement. The working capital
requirement for the materials is calculated as follows;
(2 + 2.5 - 1) months × Rs.18870000

Working capital requiremen t for materials = = Rs.5503750
12 months

Similarly the working capital requirement for labour, equipment and overhead are
calculated and are shown below.
Labour
In work in progress = 2 months
(i.e. average time period between employment of labourers in the work and receipt of
payment from owner of the project)
2 months × Rs.11730000
Working capital requiremen t for labour = = Rs.1955000
12 months
Equipment
(i.e. average time period between use of equipment in the work and receipt of payment
from owner of the project)
Credit from renting company = 1 month
(2 - 1) months × Rs.8160000
Working capital requiremen t for equipment = = Rs.680000
12 months
Overhead
(i.e. average time period between commencement of work and receipt of payment from
owner of the project)
2 months × Rs.7140000
Working capital requiremen t for overhead = = Rs.1190000
12 months
The working capital requirement of the construction company in the project till the
receipt of payment from the owner of the project is given by;
Working capital = Rs.5503750 + Rs.1955000 + Rs.680000 + Rs.1190000 = Rs.9328750
Working capital financing

Financing of working capital is an important aspect of working capital management. The
different sources of financing of working capital are short-term sources (bank financing
such as loan facility, overdraft facility etc., trade credit, short-term sources other than
banks etc.) and long-term sources (retained earnings, shares, debentures, long-term loans
from banks and other sources, government development grants etc.). One of the
important aspects in working capital financing lies in determining the suitable mix of

long-term and short-term finances as this is likely to affect the balance between liquidity
and profitability of the company and the associated cost and risk of financing. The long-
term finances are more costly as compared to short-term finances.
There are three basic approaches of financing working capital such as matching or
hedging approach, conservative approach and aggressive approach. In matching or
hedging approach, the permanent part of working capital requirement is financed by
funds from long-term sources whereas the variable component is financed through short-
term sources. Thus in this approach, the source of finance matches with the nature of the
current assets. In conservative approach, the permanent part of working capital
requirement and part of variable working capital are financed from long-term sources and
short-term sources are used only to meet the emergency requirements. As majority of
working capital financing is from long-term sources, this approach makes the financing
more costly, less risky and leading to more liquidity and less profitability. In aggressive
approach, the variable part of working capital requirement and even part of permanent
working capital requirement are financed from short-term sources. As major sources of
finances are short-term, this approach makes the financing less costly, more risky and
results in low liquidity and high profitability.
It may be noted that, for further reading of various topics presented in lectures of
different modules, the texts mentioned in the list of references for this course can be
referred.

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NPTEL – Civil Engineering – Construction Economics & Finance

Construction Economics & Finance

Joint initiative of IITs and IISc – Funded by MHRD Page 1 of 33

Joint initiative of IITs and IISc – Funded by MHRD Page 2 of 33

n = number of interest periods

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Table 1.1 Payment using simple interest

End of year Amount of interest Total amount owed

Fig. 1.1 Total amount owed (using simple interest)

b) Considering the compound interest @ 8% per year;

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Table 1.2 Payment using compound interest

End of year Amount of interest Total amount owed

** The amount repaid to the bank at the end of year 5.

Joint initiative of IITs and IISc – Funded by MHRD Page 5 of 33

Total amount owed (Rs.)

Fig. 1.2 Total amount owed (using compound interest)

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Amount of interest (Rs.)

Fig. 1.3 Accumulated interest at the end of each year

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Amount one year before  Rs. 10000 1.10

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Fig 1.4 Schematic representation of equivalence

Quantifying alternatives for decision making:

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 Annual operating cost.

Joint initiative of IITs and IISc – Funded by MHRD Page 10 of 33

Cash inflow End of year 1 35000 80000 45000

Cash outflow 100000 15000 25000

Fig 1.5 Cash flow diagram

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Fig 1.6 Cash flow diagram showing P, F and A

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Single payment compound amount factor (SPCAF)

End of year F = unknown

0 1 2 3 4 5 n-4 n-3 n-2 n-1 n

Fig 1.7 Cash flow diagram for ‘known P’ and ‘unknown F’

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Joint initiative of IITs and IISc – Funded by MHRD Page 14 of 33

Single payment present worth factor (SPPWF):

0 1 2 3 4 5 n-4 n-3 n-2 n-1 n

Fig 1.8 Cash flow diagram for ‘known F’ and ‘unknown P’

Uniform series present worth factor (USPWF):

Joint initiative of IITs and IISc – Funded by MHRD Page 15 of 33

0 1 2 3 4 5 n-4 n-3 n-2 n-1 n

End of year (EOY)

Fig 1.9 Cash flow diagram for ‘known A’ and ‘unknown P’

The present worth (P) of the uniform series is given by;

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The simplification of equation (12) results in the following the expression;

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0 1 2 3 4 5 n-4 n-3 n-2 n-1 n

End of year (EOY)

Fig 1.10 Cash flow diagram for ‘known P’ and ‘unknown A’

Joint initiative of IITs and IISc – Funded by MHRD Page 18 of 33

End of year (EOY)

1 2 3 4 5 n-4 n-3 n-2 n-1 n

Fig 1.11 Cash flow diagram for ‘known A’ and ‘unknown F’

Sinking fund factor:

Joint initiative of IITs and IISc – Funded by MHRD Page 19 of 33

End of year (EOY)

1 2 3 4 5 n-4 n-3 n-2 n-1 n

Fig 1.12 Cash flow diagram for ‘known F’ and ‘unknown A’