ENGINEERING ECONOMY Book

Colegio San Agustin-Bacolod Engineering Economy
College of Engineering by Nilo T. Aldon
ENGINEERING ECONOMY
by : Eng’r Nilo T. Aldon ChE

Colegio San Agustin-Bacolod
March 11.2021
N.1. Introduction
1.1 Principles of Engineering Economy 4
1.2 Engineering Economic Decisions 5
1.3 Engineering Economy and Design Process 6
1.4 Cost Concepts for Decision Making 7
N.2 Selection and Equivalence in Present Economy 8

2.1 Problems
N.3. Money-Time Relationship

3.1. Time Value of Money 13
3.2. Types of Interest
A. Simple Interest
1. Ordinary Simple Interest
2. Exact Simple Interest
3. Discounted Interest
B. Compound Interest
1. Nominal Interest
2. Effective Interest
3. Continuous Interest
4. Future Worth
5. Present Worth
C. Average Interest
3.3. Inflation/Deflation 20
1. Effect of Inflation/Deflation on Cost of Commodity
2. Differential Inflation/Deflation Rate
3. Total Price Escalation/Descalation Rate
4. Real Interest Rate
5. Effect of Real Interest Rate on Investment
N.3.4. Annuity 24
A. Ordinary Annuity
B. Annuity Due
C. Deferred Annuity
D. Continuous Cash Flow Continuous Compounding
E. Gradient
1. Uniform Gradient
2. Geometric Gradient
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F. Interest Factors
1. Single Payment Future-Worth factor
2. Single Payment Present-Worth factor
3. Future-Worth Annuity factor
4. Present-Worth Annuity factor
5. Present-Worth Uniform Arithmetic Gradient factor
6. Present-Worth Geometric Gradient factor
7. Continuous Compounding and Discrete Cash Flow factor
8. Continuous Compounding, Continuous Uniform Cash Flow factor
9. Discounted rate factor
N.3.5. Bonds 34
A. Introduction
B. Retirement of Bonds
C. Bond Value
N.4. Depreciation 37
N.4.1. Introduction
A. Types of depreciation
B. Purposes of Depreciation
C. Definition of Terms
N.4.2 Estimated Life of Equipment
A. General Business Assets
B. Non-Manufacturing Activities
C. Manufacturing
D. Transportation, Communications, and Public Utilities
N.4.3. Methods of Depreciation
A. Uniform Depreciation
1. The Straight Line Method
2. The Sinking Fund Method
B. Non-Uniform Depreciation
1. The Declining Balance Method
2. The Double Declining Balance Method
3. The Sum-Of-The-Years’-Digit Method
4. The Service-Output Method
5. Working Hours Method
C. Depletion
1. Unit Method
2. Percentage Method
D. Modified Accelerated Cost Recovery System (MACRS)
1. General depreciation System (GDS)
2. Alternative Depreciation System (ADS)
3. Depreciation Methods, Time Conventions, Recovery Rates
N.5. Capital Investments 57
N.4.1. Introduction
N.4.2. Fixed-Capital Investment
N.4.3. Working Capital
N.4.4. Total Capital Investment
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N.6. Operational Costs 60

N.5.1. Introduction
N.5.2. Typical Distribution of Product Costs
A. Variable Costs
B. Fixed Costs
N.5.3. Detailed Distribution of Product Costs
N.5.4 Whole-Life-Cost
N.7. Accounting Fundamentals 64
N.6.1 Introduction
N.6.2 Income Statement
N.6.3 Cash Flow
N.6.4 Balance Sheet
N.8 Methods of Profitability Analysis 73
N.7.1. Return on Investment (MARR)
N.7.2. Annual Cost Method
N.7.3. Discounted Cash Flow (IRR)
N.7.4. Payout Period Method
A. Without Interest
B. With Interest
N.7.5. Present Worth (Net Present Worth) Method
N.7.6. Future Worth method
N.7.7. Capitalized Cost Method
N.7.8. Capital Recovery method
N.7.9. Break-even Analysis
N.9. Methods of Financial Analysis 88
N.8.1. Tests of Liquidity
N.8.2. Tests of Debt-Service
N.8.3. Tests of Profitability
N.8.4. Funds-Flow Analysis
N.8.5. Tests of Operating leverage
N.8.6. Asset Management Ratios
N.8.7. Market Value Ratios
N.8.8. Benefit-Cost Ratio
N.8.9. Life-Cycle Cost
N.10. Optimization 101
N.9.1. Optimum Production Rates in Plant Operation
N.9.2. Optimum Production Rate for Minimum Cost Per Unit of Production
N.9.3. Optimum Production Rate for Maximum Total Profit Per Unit of Time
N.9.4. Optimum Conditions in Cyclic Operations
N.10.5. Economic Over Quantity
N.11 Glossary 105
N.12 More Sample Problems 122
N.13 Derivation of Equations 131
N.14 References 134
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N. ENGINEERING ECONOMY
N1. INTRODUCTION
Engineering Economy _ study of economic theories and their applications to engineering
problems with the concept of obtaining maximum benefit at the least cost.
Time value of money is central to this study.
But first of all, what is economics? Borrowing the words of Jodie Beggs, PhD (Harvard U)
“Economics_ is the study of scarcity. Resources are limited, and every society wants to figure
out how to allocate its resources for maximum benefit. “
The field of economics serves in large part to help answer this resource allocation
question.
Economists study topics such as:
 How prices and quantities of items are determined in market economies

 How much value markets create for society
 How taxes and regulation affect economic value
 Why some goods and services are under-supplied in a market economy
 How firms compete and maximize profit
 How households decide what to consume, how much to save, and how much to work (or,
more generally, how people respond to incentives)
 Why some economies grow faster than others
 What effect monetary and fiscal policy has on economic well-being
 How interest rates are determined
In order to fully understand what economics is, it’s important to also understand a bit about
what economics isn’t. For example, economics and finance are related but separate fields,
and it’s not an economist’s job to tell people what stocks and bonds they should be
investing in.
It is, on the other hand, an economist’s job to understand the relationship between interest
rates and bond prices. In a similar fashion, many of the topics discussed in The Economist
deal with politics and current events and are not specifically economic-related, despite the
title of the publication.
Understanding what economists do and don’t study is important, since sometimes

economists are called on to answer questions that they are not technically qualified to
analyze, and this can have unsatisfactory results.
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1.1 Principles of Engineering Economy

Reasons for Studying Engineering Economy:
1. Engineering designs and operations must be equated with costs for practical applications
2. Engineers evolve into managers of their own or other enterprises
Uses of Engineering Economy

1. Application on various fields of engineering
2. Determining of limiting factors
3. Tool in selection of alternates
4. Investment of capital
5. Tool in decision making
Course Objectives
After completing this course, the student must be able to:
1. Solve problems involving interest and the time value of money;
2. Evaluate project alternatives by applying engineering economic principles and methods and select
the most economically efficient one; and
3. Deal with risk and uncertainty in project outcomes by applying the basic economic decision making
concepts.
1.2 Engineering Economic Decisions

What do engineers play within a firm? What specific tasks are assigned to the engineering staff,
and what tools and techniques are available to it to improve a firm’s profits. Engineers are called upon
to participate in a variety of decision making processes, ranging from manufacturing, through
marketing decisions.
The term engineering economic decision refers to all investment decisions relating to engineering
projects. The facet of an economic decision of most interest from an engineer’s point of view is the
evaluation of costs and benefits associated with making a capital investment.
The five main types of engineering economic decisions are
1. Equipment and process selection
2. Equipment replacement
3. New product and product expansion
4. Cost reduction
5. Service improvement
The factors of time and uncertainty are the defining aspects of any investment project
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1.3 Engineering Economy and Design Process

An engineering economy study is accomplished using a structured procedure and
mathematical modeling techniques. The economic results are then used in a decision situation that
involves two or more alternatives and normally includes other engineering knowledge and input.
Engineering Economic Analysis Procedure Engineering Design Process

1. Problem recognition, definition and 1. Problem/ need definition
evaluation 2. Problem/ need formulation and evaluation
2. Development of feasible alternatives 3. Synthesis of possible solutions (alternatives)

3. Development of the outcomes and cash flows
for each alternative. 4. Analysis, optimization, and evaluation
4. Selection of criterion (or criteria)

5. Analysis and comparison of alternatives
6. Selection of the preferred alternatives. 5. Specification of preferred alternative
7. Performance monitoring and post-evaluation of 6. Communication
results
The design process

Needs definition
Recognition
of a problem
to be solved
Problem Formulation
Possible Solution
Analysis
Specification
(Preferred
Alternative)
Completely
Communication specified
solution
Approaches to Design Problems

The idea of design and development is what distinguishes engineering from science, which
concerns itself principally with understanding the world as it is. Decisions made during engineering design
phase of a product’s development determine the majority of the costs of manufacturing that product. As
design and manufacturing processes become more complex, the engineer, increasingly, will be called upon
to make decisions that involve money.
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1.4 Cost Concepts for Decision Making

The term cost estimating is frequently used to describe the process by which the present
and future cost consequences of engineering designs are forecast. A primary difficulty in
estimating for economic analyses is that most prospective projects are relatively unique; that is,
substantially similar design efforts have not been previously undertaken to meet the same
functional requirements and economic constraints. Hence, accurate past data that can be used
in estimating costs and benefits directly, without substantial modification, often does not exists.
It may be possible, however, to develop data on certain past design outcomes that are related to
the outcomes being estimated and to adjust that data based on design requirements and expected
future conditions.
Following are some of the basic uses of cost estimation

1. Providing information used in setting selling price of quoting, bidding or evaluating
contracts,
2. Determining whether a proposed product can be made and distributed at a profit,
3. Evaluating how much capital can be justified for process changes or other
improvements, and
4. Establishing benchmarks for productivity improvement programs.
 Six-tenths-factor rule_ If a cost of given unit at one capacity is known, the cost of a similar
unit with X times the capacity of the first is approximately (X)0.6 times the cost of the initial
unit.
0.6
 CapA 
CostA  Cost B  
 CapB 
 Consumer price index (CPI)_ measures changes in the price level of
consumer goods and services purchased by households. The CPI is a
statistical estimate constructed using the prices of a sample of representative
items whose prices are collected periodically
 Index A 
 Index B 
 Combination of Price Cost Index and Sixteenth Rule:

0.6
 Index A  CapA 
CostA  Cost B   
 Index B  CapB 
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N.2 SELECTION AND EQUIVALENCE IN PRESENT ECONOMY

Present economy involves the analysis of problems for manufacturing a product or rendering a service upon
the basis of present or immediate costs. It is highlighted when the effects of time such as interest and depreciation are
negligible. Present economy is employed when the alternatives to be compared will provide the same result and the
period involved in the study is relatively short.
When alternatives for accomplishing a specific task are being compared over one year or least-and influence
of time on money can be ignored, engineering economic analyses are referred to as present economy studies.
Present economy studies occur in the following situations:
a. Selection of material_ In many cases, economic selection among materials cannot be based solely on the costs of
materials. Frequently, a change in materials will affect the design and processing costs, and shipping costs may
also be altered.
b. Selection of method to be used_ In mechanical or chemical operations a product may be made by two or more
methods giving equivalent results. Some goods may be delivered by various methods such as using different
capacity trucks, and the results would still be the same regardless of the truck used. These are but a few of the
examples that may be cited to show that certain operations are capable of being done by two or more methods.
c. Selection of design_ In the design of a machine to produce a certain product, the engineer responsible for the work
will usually make as many designs as possible and from which, by a process of elimination, he will select the
design best fitted for the work to be done with particular care being given to the one which will do the work with
most economy.
d. Selection location or site for a project_ In the choice of a factory site many factors are often considered such as the
cost of the land, the cost of construction in the different sites, and the difference in transportation cost, and many
other factors.
e. Comparison of proficiency among workers_ In industrial operations where the efficiency of the workers is a factor
affecting costs, it is usually observed that workers have varying efficiencies. In some occupations only those with
better average proficiencies are acceptable. In teaching for example, other factors being equal, preference should
be given to those teachers who did better than average in their studies.
f. Economy of tool and equipment maintenance_ In many activities, tools have to be sharpened from time to time,
and equipment have to be kept in good operating condition all the time. In certain cases, experience will show the
best time to perform certain operations to maintain equipment at the optimum operating efficiency.
g. Economy of number of laborers_ In certain industrial operations it is observed that a certain number of workers
cooperating on a certain phase of work will lead to the highest efficiency. An increase beyond this number will
usually cause the taking into effect of the law of diminishing returns. In certain cases, the excess of laborers will
result in some laborers not working at certain times while waiting for the work of other laborers to be finished.
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SAMPLE PROBLEMS:
1. The ore of a gold mine contains an average of 14 grams of gold per ton. One method of processing costs
P1,000 per ton and recovers 93% of the gold, while another method costs only P900 per ton and recovers 81%
of the gold. If gold can be sold at P90/gram, which method is better and by how much?
Solution: Basis 1-ton ore
First Method Second Method
Recovered Gold 14 (0.93) = 13.02 gm 14 (0.81) = 11.34 gm
Sales from gold (13.02 gm) (P90/gm) = P 1,171.80 (11.34 gm) (P90/gm) = P1,020.60
Cost P 1000 P 900
Net receipt P 171.80 P120.60
Answer: First method of processing is better by P51.20/ton ore! (171.80-120.60)
2. A certain masonry dam requires 200,000 m3 gravel for its construction. The contractor found two possible
sources for the gravel with following data: Determine which of the two sites will give lesser cost
Data:
Source A Source B
Distance, gravel pit to dam 3.0 km 1.2 km
Gravel Cost @ pit, P/m3 None P100.00
Purchase price of pit P 8,000,000 None
Cost of Road construction P 4,500,000 None
Overburden costs P3,700,000
Hauling Costs, P/km/m3 P40.00 P40.00
Solution:
Source A Source B
Gravel Cost @ pit, P/m3 None P100.00 (200,000 m3) P20,000,000
Cost of Road P 4,500,000 None
construction
Overburden costs P 3,700,000
Hauling Costs, P/km/m3 (3)(40)(200,000) P 24,000,000 (1.2) (40) (200,000) P 9,600,000
Total Costs P 36,500,000 P 33,300,000

Source B is cheaper by P 3,200,000 (36,500,000-33,300,000)
3. Two workers, A and B, produce the same product on identical machines. Worker A receives P50/h and he
produces 100 units/h. Worker B is able to produce 120 units/h. The machine cost of operation used by them is P
250/h.
a. Determine the cost per piece for worker A
b. Determine the hourly wage of worker B in order that his cost per piece will equal that of A.
Solution:
a. Cost per piece for Worker A
P 50  P 250 P3.00
P / piece  
100 units unit
b. Cost per piece for Worker B = Cost per piece for Worker A
Let X = hourly wage of worker B
X  P 250 P3.00

120 units unit
P 110.00
X 
h
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4. The monthly demand for ice cream cans being manufactured by a company is 3,200 pieces. With a manually
operated guillotine, the unit cutting cost is P25.00. An electrically operated hydraulic guillotine was offered to
the company at a price of P 300,000 which will cut by 30% the unit cutting cost. Disregarding the cost of money,
how many months will the company be able to recover the cost of the machine if he decides to buy now?
Solution:
Manually operated machine
Monthly Cutting Cost 253,200  P80,000
Electrically Operated Hydraulic Guillotine
Monthly Cutting Cost  253,2001  0.3  P56,000
Savings  80,000  56,000  P24,000 / month
P 300,000
Number of months to recover   12.5 months
P 24,000/month
5. A company has been selling a soap containing 30% by weight water at a price of P150 per kilo f.o.b. (i.e., freight
on board, which means the laundry pays the freight charges). The company offers an equally effective soap
containing 5% water. The water content is to no important to the laundry, and it is willing to accept the soap
containing 5% water if the delivered costs are equivalent. If the freight rate is P0.70 per kilo, how much should
the company charge the laundry per kilo f.o.b. for the soap containing 5% water?
Solution:
For Soap containing 30% water, the Cost delivered per kg of 100% dry soap:
P 150  0.70 P 215.29

1  0.3 kg kg
For Soap containing 5% water, the Cost per kg FOB = X

 X  0.70  P215.29
1  0.05 kg kg
P 203.82
X
kg
6. Powdered coal having a heating value of 10,000 BTU per pound is to be compared with bunker fuel priced at
P26.80/liter having a heating value of 18,600 BTU/lb. If the efficiency of conversion of fuel to power is 83%
for coal and 88% for bunker, with all other costs being equal, what is the allowable selling price for coal per
metric ton? Specific gravity of bunker is 0.96.
Solution:
Using bunker, the cost per BTU net of losses:
 P 26.80  l  kg  lb  1  P 773.50
      6
 l  0.96 kg  2.205 lb  18.600 BTU  0.88  10 BTU
Solving for equivalent cost of coal per metric ton = Z
 mt  lb  1  P 773.50
Z     6
 2,205 lb  10,000 BTU  0.83  10 BTU
P 14,156
Z
mt
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N.2 PROBLEMS
1. A group from Bacolod is planning a six-day trip to Dumaguete. For transportation, the group will rent a car from
either the school motor pool or a local car dealer. The school charges P26 per kilometer, has no daily fee, and the
motor pool pays for the gas. The car dealer charges P2500 per day and P14 per km, but the group must pay for the
gas. The car’s fuel rating is 10 km per liter, and the price of the gas is estimated to be P28 per liter.
(a) At what point, km is the cost of both options equal? (nearest value)
a. 717 km b. 1200 km c. 1448 km d. 1,630 km e. 1,913 km
(b) The car dealer has offered a special student discount and will give the students 100 free km per day.
What is the new break-even point?
a. 717 km b. 1200 km c. 1448 km d. 1,630 km e.1,913 km
2. One method for developing a mine containing an estimated 100,000 tons of ore will result in the recovery of 62%
of the available ore deposit and will cost USD 23 per ton of material removed. A second method of development
will recover only 50% of the ore deposit, but it will cost only USD 15 per ton of material removed. Subsequent
processing of the removed ore recovers 300 pounds of metal from each ton and costs USD 40 per ton of ore
processed. The recovered metal can be sold for USD 0.80 per pound. What is maximum profit that could be
expected if method A is used to develop the mine?
a. USD10.974 M b. USD9.25 M c. USD7.50M d. USD6.75M e. USD2.68M
3. What is the increase in profit if instead of Method A, Method B is used? (Pls refer to the preceding problem)
a. $1.724 M b.(-) $1.724. M c. (-)$1.55M d. $1.55M e. USD2.68M
4. Two currently owned machines are being considered for the production of a part. The capital investment
associated with the machine is about the same and can be ignored. The important differences between the
machines are their production capacities (production rate x available production hours) and their rejects
(percentage of parts produced that cannot be sold) Consider the following table:
Machine A Machine B
Production Rate 100 parts/h 130parts/h
Hours Available for Production 7 h/day 6 h/day
Percent Parts Rejected 3% 10%
The material cost is P6 per part and all defect-free parts produced can be sold for P12 each (rejected parts have
negligible scrap value). For either machine, the operator is P25 per hour and the variable overhead rate for traceable
costs is cost P5 per hour. Assume that the daily demand for this part is large enough that all defect-free parts can be
sold. What is the maximum profit per day using machine A?
a. P3,738 b. P6,763 c. P5,670 d. P4,520 e. P2,350
5. What is the increase in profit if Machine B is used instead of Machine A?
a. P338 b. P174 c. (-P174) d. P420 e. (-P420)
6. A machine part to be machined may be made either from an alloy of aluminum or steel. There is an order for 8000
units. Steel costs P380/kg, while aluminum costs P870/kg. If steel is used, the steel per unit weighs 110 grams; for
aluminum, 30 grams. When steel is used, 50 units can be produced per hour; for aluminum, 80 units per hour with the
aid of a tool costing P64,000, which will be useless after 8,000 units are finished. The cost of the machine and the
operator is P1080 per hour. If all other costs are identical, determine which material will be more economical.
a. Steel cheaper by P15.80 unit b. Aluminum cheaper by P15.50 c. None of these
7. The ore of a gold mine contains an average of 14 grams of gold per ton. One method of processing costs P1,000 per
ton and recovers 93% of the gold, while another method costs only P900 per ton and recovers 81% of the gold. If gold
can be sold at P90/gram, which method is better and by how much?
a. 1st method is better by P51.20/ton ore b. 2nd method is better by P51.20/ton ore
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8. A certain masonry dam requires 200,000 m3 gravel for its construction. The contractor found two possible sources
for the gravel with following data: Determine which of the two sites will give lesser cost.
Data:
Source A Source B
Distance, gravel pit to dam 3.0 km 1.2 km
Gravel Cost @ pit, P/m3 None P100.00
Cost of Road construction P 4,500,000 None
Overburden costs P3,700,000
Hauling Costs, P/km/m3 P40.00 P40.00
a. A is cheaper by P3,200,000 b. Source B is cheaper by P3,200,000 c. None of these
9. A company manufactures 1 million units of a product annually. A new design of the product will reduce material
cost by 12%, but will increase processing cost by 2%. If materials cost is P 12//unit and processing will cost P4/unit,
how much can the company afford to pay for the preparation of the new design and making changes in equipment?
a. P 1.36 M b. P800,00 c. P600,000 d. P 505,000
10. In the design of an automobile radiator, an engineer has a choice of using either a brass-copper alloy casting (A) or
plastic molding (B). Either material provides the same service. However, the brass-copper alloy casting weighs 25
pounds, compared with 20 pounds for the plastic molding. Every pound of extra weight in the automobile has been
assigned a penalty of P600 to account for increased fuel consumption during the life cycle of the car. The brass-
copper alloy costs P335 per pound, whereas the plastic molding costs P740 per pound. Machining costs per casting
are P600 for the brass-copper alloy. Which material should the engineer select, and what is the savings in unit costs.
a. A, P2,825 b. B, P2,825 c. A, P2,225 d. B, P2,225
11. A machine used for cutting materials in a factory has the following outputs per hour at various speeds and requires
periodic tool regrinding at intervals cited.
Speed Output per hour Tool regrinding
A 200 pieces Every 8 h
B 250 pieces Every 7 h
C 280 pieces Every 5 h
A set of tools costs P4200 and can be ground 20 times. Each regrinding and change costs P180 and the
time needed to regrind and change tools is 1 h. The machine operator is paid P50/h, including the time the tool is
changed. The tool grinder who also sets the tools to the machine is paid P45/h. The hourly rate chargeable against
the machine is P150/h, regardless of speed.
Which speed should the engineer select for minimum costs?
a. A b. B c. C
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N.3. MONEY-TIME Relationship
N.3.1. Introduction
Time value of money_ is the value of money figuring in a given amount of interest earned over
a given amount of time. The time value of money is the central concept in finance theory.
Theoretical economy calculations are based on the idea that a given amount of capital becomes
more valuable as time passes. This increase in value is the amount of interest that could be earned
by the original capital during the time period considered.
Engineers define interest as the compensation paid for the use of the borrowed capital. This
definition permits distinction between profits and interest.
The rate at which interest will be paid is usually fixed at the time the capital is borrowed, and a
guarantee is made to return the capital at some set of time in the future or on an agreed-upon pay-
off schedule; profit is not.
Interest __ the time value of money

__ money paid for the use of money
__ compensation paid for the use of borrowed capital.
Elements of Interest
1. Principal, P = the sum of money lent or borrowed
2. Interest, I = the price paid or charge made for the use of money
3. Time, n = the period of time during which interest is charged, measured in

some specific unit. The unit may be day, week, month, 3 months,
6 months, or a year.
4. Rate, i = the price paid for the use of money for a unit of time. It is given as
a percentage of the original amount.
N.3.2. Types of Interest

A. Simple Interest
Requires compensation payment at a constant interest rate based only on the original amount
I = (P)(i)(n) (N – 1)
The principal P must be repaid eventually; therefore the entire amount F, of principal plus simple
interest due after n periods is;
F=P+ I (N – 2)
F  P1  i n (N – 3)
In the payment of simple interest, it makes no difference whether interest is paid at the end
of each time unit or after any number of time units. The same total amount of money is paid during
a given length of time, no matter which method is used. Under these conditions, there is no
incentive to pay the interest until the end of the total loan period.
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1. Ordinary Simple Interest

The time unit used to determine the number of interest period is usually one year, and the
interest rate is expressed on a yearly basis. When an interest period of less than one year is
involved, the ordinary way to determine the simple interest is to assume the year consists of
twelve 30-day months, or 360 days.
( P)(i )(d )
I= (N – 4)
360
Example 1: Determine the ordinary simple interest on P1000 for 8 months and 15 days if the rate of interest is 15%.
Number of days = (8) (30) + 15 = 255 days
 255 
I  Pin  10000.15   P 106.25
 360 
Example 2: Determine the ordinary simple interest on P1000 from Jan 1, 2012 to May 15, 2012, if the rate of interest
is 15%.
 4.530 
I  Pin  10000.15   P 56.25 or
 360 
 4.5 
I  Pin  10000.15   P 56.25
 12 
2. Exact Simple Interest

The exact method accounts for the fact that there are 365 days in a normal year and 366 days in
a leap year.
( P)(i)(d )
I (N – 5)
365
Example:
Determine the exact simple interest on P1000 for the period January 10 to October 28, 2012 if the rate of
interest is 15%.
Solution: (2012 is a leap year = 366 days)
Jan 10-31 21 August 31
February 29 September 30
March 31 October 28
April 30
May 31
June 30
July 31
203 89 292 days
Solution:
Exact Simple interest:
( P)(i)(d ) 10000.15292
I   P 199.67
366 366
4/29/2021 N - 14 of 138 nilo t. aldon

3. Discounted Interest, id
The interest for the money borrowed (discount) is deducted from the principal in advance.
I d  P id n  (N – 6)
P = amount loaned
P’ = actual amount received
Id = interest payment deducted in advance
P’ = P - Id (N – 7)
i I
id   d (N – 8)
1 i P
Effective interest rate, i

id I
i  d (N – 9)
1  id P '
Example:
A man borrowed P10,000 from a bank and agreed to pay the loan at the end of 9 months. The bank discounted
the loan and gave him P8,000
a. What was the discounted rate?
b. What was the rate of interest?
c. What was the effective interest rate?
Solution:
a. Discounted rate (9 months)
I 10,000  8,000
id  d   20%
P 10,000
b. Rate of interest (9 months)

I 10,000  8,000
i d   25%
P' 8,000
c. Effective interest rate? (1 year)

 12  I 10,000  8,000
i  25%   33.33% also, i    33.33%
 9 Pn
8,000  9 
 12 
4/29/2021 N - 15 of 138 nilo t. aldon

B. Compounded Interest
Stipulates that interest is due regularly at the end of each interest period. If payment is not
made, the amount due is added to the principal, and the interest is charged on this converted
principal during the following unit time.
Thus an initial loan of P at an annual interest rate i would require payment of Pi as interest
at the end of the first year. If this payment were not made, the interest for the second year would
be ( P + Pi ) i and the total amount due for interest after 2 years would be :
I T  Pi  ( P  Pi )
2
Therefore, the total amount of principal plus interest after 2 years equals
F2 = P + Pi + (P+Pi)i
= P (1+ i )2
or (total amount due at the end of nth period)
Fn  P1  i 
n
(N – 10)
1. Nominal Interest Rates, r

Interests are compounded other than on annual basis. It always includes a qualifying statement
indicating the compounding period. Example, 12% per annum compounded quarterly.
2. Effective Interest Rates, i

Are always compounded on an annual basis.
Conversion of Nominal Interest rate to Effective Interest Rate:

i  1  r / m   1
m
(N – 11)
where: r = nominal interest rate per year
m = number of interest periods per year
3. Continuous Interest
Although in practice the basic time interval for interest accumulation is usually taken as one year,
shorter time periods can be used as, for example, one month, one day, one hour, or one second. The
extreme case, of course is when time interval becomes infinitesimally small so that the interest is
compounded continuously.
The concept of continuous interest is that the cost or income due to interest flows regularly.
If we let the change in the accumulated amount, F over the change in the unit period, n a function of
both the accumulated amount F, and rate, r, then;
dF
 rF (N – 12)
dn
4/29/2021 N - 16 of 138 nilo t. aldon

dF

F
 r  dn
n
(N – 13)
P F 0
Integrating and substituting the limit of F from P to F, and that of n, from 0 to n,
F
Ln  rn (N – 14)
P
Fn  Pe rn (N – 15)
To convert nominal continuous interest rate to effective interest rate:
Equating (N –10) and (N-15) Pi 1n  Pe rn (N – 16)
i  er 1 (N – 17)
Also:
m
 r
 r   r  r 
m
i  1    1  1   1
 m  m
α
 
 r  r 
as m approachesinfinity:  1    e;
 α
i  e 1
r
4. Future Worth, F
It is equal to the sum of the capital plus the compensation paid for the use of the borrowed
capital.
Normally, i, is the effective interest rate while n, is the number of years. However, other
periodic units may be used as long as the units of n (number of interest periods) and i, (interest
rate) are constant
For example if i = % per month, n, should be in months.
Fn  P1  i 
n
(N – 18)
Example:
 How much is P100,000 worth 5 years from now if money earns 6% per annum compounded monthly?
12 5 
 0.06 
Fn  P1  i   100,000 1    134,885.02
n
 12 
4/29/2021 N - 17 of 138 nilo t. aldon

5. Present Worth, P
It is the amount which must be available at the present time in order to have a certain
amount accumulated at some definite time in the future. Element of time is involved therefore
interest must be taken into consideration.
The present worth of a future amount is the present principal which must be deposited at
a given interest rate to yield the desired amount at some future date.
Fn
P (N – 19)
(1  i ) n
Example:
1. A person wishes to accumulate P100,000 in the bank after 5 years. How much is he going to deposit now
assuming that his money earns 6% per annum compounded annually?
F 100,000
P   P 74,726
1  i  1  0.06 
n 5
If interest is compounded monthly:

F 100, 000
P   P 74,137
1  i  1  0.005
n 60
If interest is compounded continuously:

100, 000
P  P74, 082
e 0.06 5
2. A nominal interest rate of 12% per annum compounded monthly is equal to what nominal interest compounded
quarterly?
m 4
 r  r
i  1    1  1  0.12 / 1212  1  1    1
 m  4
r  0.1212  12.12%
3. What is the effective interest rate? (refer to the previous problem)

i  1  r / m   1  1  0.12 / 12  1
m 12
i  0.1268  12.68%
4. A credit card company charges an interest rate of 1.375% per month on the unpaid balance of all accounts. The
annual interest, they claim, is 12(1.375%) =16.5%. What is the effective interest rate per year being
charged by the company?
i  1  r / m   1  1  0.01375  1  0.1781  17.81%
m 12
5. Find the nominal interest compounded monthly which is equivalent to 12% compounded quarterly?
i  1  r / m m  1  1  r / 1212  1  1  0.12 / 44  1
r  11.88% pa compounded monthly
6. It is desired to have a certain sum of money 12 years from now. When the present value is 0.5 times the
compounded value, what is the discreet value of interest to attain this value?
F  P1  i  ; butP  0.5F therefore F  0.5F 1  i  ; 2  1  i  ;
n 12 12
2
1
12
 1  i ; i  0.05946  5.946% pa
7. What will be the future worth after 18 months if a sum of P1,000 is invested at a simple interest of 10% per
year?
F  P  I  P  Pin  1,000  1,0000.1018 / 12  1,150
4/29/2021 N - 18 of 138 nilo t. aldon

C. Average Interest, iave

Interest is often considered as one of the components of annual operating costs. This is not much of a
problem if the payment of the principal plus interest is in the form of annuity.
Normally, the amortization of principal is paid through a uniform amount thus the beginning loan balance
decreases each year, and so is the interest.
If we want to consider interest as an operating cost we need to express it as fixed percentage of the original
loan or principal rather than a percentage of the balance which varies every year because of the payment.
Thus, the necessity to express it as an average interest.
r (n  1)
iave = (N – 20)
2n
where: r = rate of interest per interest period
n = number of repayment period
Example:
Given: Loan = P100,000, Interest =10% pa, payable in 5 years
Beginning Payment, Payment, Total
balance Principal Interest Payment
100,000 20,000 10,000 30,000

80,000 20,000 8,000 28,000
60,000 20,000 6,000 26,000
40,000 20,000 4,000 24,000
20,000 20,000 2,000 22,000
Total 100,000 30,000 130,000
REQUIRED: Average interest payments

SOLUTION:
30, 000
Average Interest Payments   6, 000 / year
5
6,000
i ave   0.06  6%
100,00
r n  1 105  1
i ave    6%
2n 25
4/29/2021 N - 19 of 138 nilo t. aldon

N.3.3. Inflation/Deflation, f
Inflation and Deflation, in economics, terms used to describe, respectively, a decline or an increase
in the value of money, in relation to the goods and services it will buy.
Inflation is the pervasive and sustained rise in the aggregate level of prices measured by an index of the cost
of various goods and services. Repetitive price increases erode the purchasing power of money and other financial
assets with fixed values, creating serious economic distortions and uncertainty. Inflation results when actual economic
pressures and anticipation of future developments cause the demand for goods and services to exceed the supply
available at existing prices or when available output is restricted by faltering productivity and marketplace constraints.
Sustained price increases were historically directly linked to wars, poor harvests, political upheavals, or other unique
events.
Deflation involves a sustained decline in the aggregate level of prices, such as occurred during the Great
Depression of the 1930s; it is usually associated with a prolonged erosion of economic activity and high
unemployment. Widespread price declines have become rare, however, and inflation is now the dominant variable
affecting public and private economic planning.
Demand-pull inflation occurs when aggregate demand exceeds existing supplies, forcing price increases and
pulling up wages, materials, and operating and financing costs. Cost-push inflation occurs when prices rise to cover
total expenses and preserve profit margins. A pervasive cost-price spiral eventually develops as groups and institutions
respond to each new round of increases. Deflation occurs when the spiral effects are reversed.
To explain why the basic supply and demand elements change, economists have suggested three substantive
theories: the available quantity of money; the aggregate level of incomes; and supply-side productivity and cost
variables. Monetarists believe that changes in price levels reflect fluctuating volumes of money available, usually
defined as currency and demand deposits. They argue that, to create stable prices, the money supply should increase
at a stable rate commensurate with the economy's real output capacity. Critics of this theory claim that changes in the
money supply are a response to, rather than the cause of, price-level adjustments.
The aggregate level of income theory is based on the work of the British economist John Maynard Keynes,
published during the 1930s. According to this approach, changes in the national income determine consumption and
investment rates; thus, government fiscal spending and tax policies should be used to maintain full output and
employment levels. The money supply, then, should be adjusted to finance the desired level of economic growth while
avoiding financial crises and high interest rates that discourage consumption and investment.
Government spending and tax policies can be used to offset inflation and deflation by adjusting supply and
demand according to this theory.
The third theory concentrates on supply-side elements that are related to the significant erosion of productivity.
These elements include the long-term pace of capital investment and technological development; changes in the
composition and age of the labor force; the shift away from manufacturing activities; the rapid proliferation of
government regulations; the diversion of capital investment into nonproductive uses; the growing scarcity of certain
raw materials; social and political developments that have reduced work incentives; and various economic shocks
such as international monetary and trade problems, large oil price increases, and sporadic worldwide crop disasters.
These supply-side issues may be important in developing monetary and fiscal policies.
General price inflation is the increase in the price of goods and services from one year to the other,
thus decreasing the purchasing power of money. Deflation involves a decrease in the average price of
goods and services resulting to the increase in the purchasing power of money. Some measures of price
changes in our economy are the Consumer Price Index (CPI) and Producer Price Index (PPI).
Consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by
households. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose
prices are collected periodically. Sub-indexes and sub-sub-indexes are computed for different categories and sub-
categories of goods and services, being combined to produce the overall index with weights reflecting their shares in
the total of the consumer expenditures covered by the index. It is one of several price indices calculated by most
national statistical agencies. The annual percentage change in a CPI is used as a measure of inflation. A CPI can be
used to index (i.e., adjust for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices
and for deflating monetary magnitudes to show changes in real values.
Indexn  Indexn 1
Annual Change Rate  f  100% (N – 21)
Indexn 1
4/29/2021 N - 20 of 138 nilo t. aldon

Example:
1. An item presently costs P500. If inflation is at the rate of 5% per year, what will be the cost of the item in 2
years?
F  P1  f   5001  0.05  551.25
n 2
2. An economy is experiencing inflation at an annual rate of 5%. If this continues, what will P500 be worth
two years from now in terms of today’s pesos?
F 500
P   453.51
1  f n 1  0.052
Sixteenth Rule: The cost of the equipment at a new capacity can be computed if the cost of the same
equipment is known at a given capacity. The cost adjustment is the ratio of the two capacities raised to
the power 0.6
S 
0.6
CB  C A  A 
 SB 
Combination of Price Cost Index and Sixteenth Rule:

I  S A 
0.6
C B  C A  n  
 IK  S B 
Example: Six years ago, an 80-kw diesel electric generator costs P400,000. The cost index for this class of equipment
six years ago was 187 and is now 194. Determine the cost of a 120 kw unit now?
X
 I  S 
0.6
 197  120 
C B  C A  n  A   400,000  
 K  B 
I S  187  80 
 P 537,451.61
Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary
units with which that currency can be exchanged. ‘Devaluation’ means official lowering of the value of a
country's currency within a fixed exchange rate system, by which the monetary authority formally sets a
new fixed rate with respect to a foreign reference currency. In contrast, depreciation is used for the
unofficial decrease in the exchange rate in a floating exchange rate system. Under the second system central
banks maintain the rates up or down by buying or selling foreign currency, usually USD.
In common modern usage, it specifically implies an official lowering of the value of a country's
currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed
rate with respect to a foreign reference currency. In contrast, depreciation is used for the unofficial increase
in the exchange rate in a floating exchange rate system. The opposite of devaluation is called revaluation.
Depreciation and devaluation are sometimes incorrectly used interchangeably, but they always
refer to values in terms of other currencies.
Inflation, on the other hand, refers to the value of the currency in goods and services (related to its
purchasing power). Altering the face value of a currency without reducing its exchange rate is a
redenomination, not a devaluation or revaluation.
A. Effect of Inflation on Future Cost of Commodity

FC  PC 1  f 
n
(N – 22)
4/29/2021 N - 21 of 138 nilo t. aldon

B. Differential Price Inflation or Deflation Rate, e 'j

The differential price inflation rate is a price change in good or service caused by various
factors in the market. It is the increment (%) of price change above or below the general inflation
rate f, during a period (normally a year). The increase or decrease in price is in REAL pesos.
1 ej ej  f
e 'j  1  e 'j  (N – 23)
1 f 1 f
C. Total Price Escalation or De-escalation Rate, ej

The price escalation or de-escalation rate is total rate (%) of price change in the unit price, or
cost for a fixed amount during the period (normally) a year for good or service. It is the sum of the
general price inflation rate and the differential inflation rate plus their product. The increase or
decrease in price is in ACTUAL pesos.

FC  PC 1  e 'j  1  f 
n n
(N – 24)
FC  PC 1  e j 
n
(N – 25)
where:
 
e j  1  e 'j 1  f   1 (N – 26)
Sample problem:
The unit price of the goods is P100. The company plans to increase its selling price by 10% (ej’ ).
What will be its actual unit selling price if inflation projected for the year is 5%.
 
FC  PC 1  e j ' 1  f   100 1  0.10 1  0.05   P 115.50
D. Real Interest Rate, i '

Real interest rate is computed by using the market interest rate i, and the general inflation rate, f
1  i'  1  i 
From the relationship: 1  f 
1 i i f
i'  1 i'  (N – 27)
1 f 1 f
4/29/2021 N - 22 of 138 nilo t. aldon

E. Effect of Real Interest Rate on Investment

F  P1 i '
n
(N – 28)
Where: PC = present worth of a commodity
FC = future cost of the commodity
P = present worth of investment
F = future worth of investment
f = annual inflation rate
n = number of years
i = market interest rate
i’ = real interest rate
e 'j = increment (%) of price change of commodity
ej = total rate (%) of price change of commodity
Example: What is the worth of P100, five years from now if invested at 10% pa, and inflation is expected at 8%
pa? What is the real interest rate?
Solution:
Considering time value of money and inflation, 5 years from now, P100 is equivalent to:
n
 1 i 
Fn  P 
1  f 
 1  0.10 
n
F5  100   P 109.61
 1  0.08 
Solving for Real interest
F  P 1  i ' = 109 .61  100 1  i'5 ; i'  5 1.0961  1  0.0185  1.85%
n
Also:
Real interest rate, i'  i  f  0.10  0.08  0.0185  1.85%
1 f 1  0.08
also i'  1  i  1  1  0.10  1  0.0185  1.85%
1 f 1  0.08
 A company borrowed P100,000 today to be repaid after 3 years at a market interest rate of 11%. What
is the actual amount owed at the end of 3 years.
a. What is the real interest earned by the lender if the general inflation rate is 5% per year
b. What is the real peso equivalent in purchasing power to the actual-peso amount at the end of the third year?
SOLUTION:
a. F  P1  i   100,0001  0.11  P136,763
n
5
i  f 0.11  0.05
b. i '    0.0571428  5.71428% per year
1 f 1  0.05
Also: i'  1  i  1  1  0.11  1  0.057128  5.71428%
1 f 1  0.05
n
 1 i   1  0.11 
3
c. F  P 1  i '  100, 000 1  0.0571428  P 118,141; F  P 

n
3
  100, 000    P 118,141
 1  f   1  0.05 
4/29/2021 N - 23 of 138 nilo t. aldon

N.3.4. Annuity
It is a series of equal PAYMENTS, A occurring at equal time intervals. Interest is paid on
all accumulated amounts, and the interest is compounded each payment period. The amount of an
ANNUITY F, is the sum of all payments A, plus interest if allowed to accumulate at a definite
rate of interest from the initial payment up to the end of the annuity term.
An annuity term is the time from the beginning of the first payment period to the end of
the last payment period.
It must be noted that the sum F, is expressed at the end of the last payment period
A. Ordinary Annuity
The most common type of annuity. It involves the payment of amount, A at the end of
each interest period.
P
0 1 2 3 4 n
Future Worth of Ordinary Annuity A A A A A
Fn
 1  i n  1
Fn  A  (N – 29)
 i 
Present Worth of Ordinary Annuity

 1  i n  1
P  A n 
(N – 30)
 i 1  i  
B. Annuity Due
The uniform payments, A are made at the beginning of each interest period.
P
0 1 2 3 4 n
Future Worth of Annuity Due
A A A A A
Fn
 1  i n 1  1  i   1  i n 1  1  (N – 31)
Fn  A  A  1
 i   i 
Present Worth of Annuity Due
 1  i n 1  1  i  A  1  i   1 
n 1
(N – 32)
P  A  n 
 1
i1  i   1  i  
n
 i 
4/29/2021 N - 24 of 138 nilo t. aldon
C. Deferred Annuity
It is also an ordinary annuity but the payment of the first amount is deferred a certain
number of periods after the first. For example, the first annuity payment could be made after 3
annuity terms instead of after the first annuity term.
P
A A A A
1 2 3 n
Present Worth of Deferred Annuity 1 2 3 m
Fn
 1  i n  1
P  A mn 
 i1  i   (N – 33)
D. Continuous Cash Flow Continuous Compounding

Continuous flow of funds means a series of cash flows occurring at infinitesimally short
intervals of time, corresponding to an annuity having an infinite number of short periods. This
model could apply to companies having receipts and expenses that occur frequently during each
working day. In such cases, the interest is normally compounded continuously. Using nominal
interest as r and there are m payments per year equal to the number of compounding periods per
year, using equation (N -29), the accumulated amount of the continuous cash flows plus interest
at the end of the nth year is:
  r      r   m
   rn  
 1    1  1      1
mn  r 
A    m     m 
Fn    A   (N – 34)
m r   r 

 m 
  
 
Where A is the sum of continuous cash flows in one year
m
  r  r
As m approaches infinity, 1   m   e (N – 35)
  
Future Worth of the Continuous Cash Flows Continuous Compounding:

 e rn  1
Fn  A  (N – 36)
 r 
Present Worth of the Continuous Cash Flow Continuous Compounding:
A  e rn  1
P   (N – 37)
e rn  r 
4/29/2021 N - 25 of 138 nilo t. aldon

E. Gradient
1. Uniform Arithmetic Gradient
It is also an ordinary annuity but disbursement or payment A increases or decreases by a
uniform amount G each period.
P
0 1 2 3 n
A A+G A+2G A+(n-1)G
Fn
Future Worth of Annuity A, and Arithmetic Gradient, G : Fn

Fn  FAn  FGn (N – 38)
Future Worth of Annuity, A : FA n

 1  i n  1
FAn  A  (N – 39)
 i 
Future Worth of Arithmetic Gradient, G : FGn

G  1  i   1 
n
FGn    n (N – 40)
i  i 
Present Worth of Arithmetic Gradient, G : PG
G  1  i n  1 
PG    n (N – 41)
i1  i 
n
 i 
2. Geometric Gradient
It is also an ordinary annuity but disbursement or payment A increases or decreases by a
uniform rate g each period.
P
0 1 2 3 n
A A(1+g) A(1+g)2 A(1+g)(n-1)
Fn
Future Worth of Annuity A, and Geometric Gradient, g: Fn

 1  i n  1  g  n 
Fn  A  (N – 42)
 ig 
When: g = i
Fn  nA 1  i 
n 1
(N – 43)
4/29/2021 N - 26 of 138 nilo t. aldon
Present Worth of Annuity A, and Geometric Gradient, g: P
A  1  i n  1  g  n 
P   (N – 44)
1  i n  ig 
When: g= i
nA
P (N – 45)
1 i
where: A = uniform periodic payment
i = periodic interest rate
G = uniform increase in periodic payment
g = geometric increase in periodic payment
P = present worth
Fn = future worth, the accumulated amount of annuity and geometric gradient
payments at the end of the nth period
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F. Interest Factors
1. Single-Payment Future-Worth Factor
 1  i n  F / P, i %, n 
F
(N – 46)
P
F  PF / P, i%, n (N – 47)
2. Single Payment Present-Worth Factor
 P / F , i %, n 
P 1
 (N – 48)
F 1  i n
P  F P / F , i%, n (N – 49)
3. Future Worth Annuity Factor

F 1  i   1
n
  F / A, i %, n  (N – 50)
A i
F  AF / A, i%, n (N – 51)
  A / F , i %, n 
A i
 (N – 52)
F 1  i n  1
A  F  A / F , i%, n (N – 53)
4. Present Worth Annuity Factor

P 1  i n  1 (N – 54)
  P / A, i %, n 
A 1  i n i
P  AP / A, i%, n (N – 55)
i1  i n
  A / P, i %, n 
A
 (N – 56)
P 1  i n  1
A  P A / P, i%, n (N – 57)
 A / P, i%, n   A / F , i%, n  i (N – 58)
4/29/2021 N - 28 of 138 nilo t. aldon

5. Present Worth Uniform Arithmetic Gradient Factor
P = PA + PG (N – 59)
 1  i n  1
PA  A n 
 AP / A, i%, n  (N – 60)
 i1  i  
G  1  i   1 
n
PG  n 
 n  GP / G, i %, n  (N – 61)
1  i   i 
6. Present Worth Geometric Gradient Factor
A  1  i   1  g  
n n
Pg    (N – 62)
1  i n  ig 
7. Continuous Compounding and Discrete Cash Flow
 e rn  1
F  A r  (N – 63)
 e 1
A  e rn  1
P  rn  r  (N – 64)
e  e 1 
8. Continuous Compounding, Continuous Uniform Cash Flow
 e rn  1
F  A  (N – 65)
 r 
A  e rn  1
P   (N – 66)
e rn  r 
9. Discounted Rate factor, id

 P/F,i%,1 i
i (N – 67)
id 
1  i 
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Example:
1. A loan of one million pesos is to be paid in 10 years at an interest rate of 8.5% pa. How much should the 10
annual payments be?
Solution:
   0.085 
A  P1  i n    1,000,0001.085 
i
  152,407.71
10
 1  i   1   1.085  1 
n 10
2. What will be the future equivalent amount at the end of five years of a uniform 5 yearly deposit of P5,000.
if the nominal annual interest rate is 12% compounded:
a. annually
b. monthly
c. continuously
Solution:
a. Compounded Annually
 1  i n  1   1.125  1 
F  A   5,000   31,764.24
 i   0.12 
b. Compounded monthly:
i  1  r / m   1  1  0.12 / 12   1  0.1268  12 .68 %
m 12
 1  i n  1  1.12685  1
F  A   5,000   32,196.17
 i   0.1268 
c. Compounded continuously: i  er 1
e  0.12  5
 e  1
nn
 1
F5  A  r   5, 000  0.12   P32, 241
 e 1   e 1 
d. What will be the equivalent future amount at the end of five years if the uniform deposit of P5,000 flows
continuously per year; compounding is also continuous.
 enn  1   e 0.12 5  1 
F5  A    5, 000    P34, 255
 r   0.12 
3. A uniform amount of P2,000 will be deposited monthly in the bank at the beginning of each period for the
next 2 years. The first of such deposits is to be made now. What is the accumulated amount after 2 years if
money is worth 12% pa compounded monthly?
Solution:
If deposits are made at the beginning of each period:
 1  i n 1  1   1  0.01241  1 
Fn  A   1 ; F24  2, 000   1  P54, 486
   
i 0.01
If deposits are made at the end of each period:
 1  i n  1   1  0.0124  1 
Fn  A   ; F24  2, 000    P53,947
 i   0.01 
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4. A machine costs P50,000 cash. The dealer agreed for a 10 uniform quarterly payments, the first due at the
end of the first year after purchase. If money is worth 12% per annum compounded quarterly, determine the
quarterly installment.
Solution:
If the first payment is made after a year (end of 4th quarter) then the last payment would be on the 13th
quarter. The amount of P50,000 must, therefore, be projected on that period which is equal to the accumulated
amount of 10 quarterly payments.
 1  0.0310  1 
 
F13  50, 000 1.0313  A   ; A  P 6, 405
 0.03 
5. What is the accumulated amount of a series of payments when the initial payment of P1000 increases by
P200 each period, until the third period if cost of money is 10% pa.
A A+G A+2G
0 1 2 3
P10000 P 1200 P1400
F3
Required: Fn
Solution: A= P1000 ,G =P200, and i =10%
Fn  FAn  FGn
 1  i n  1  G  1  i   1
n
  1  0.10 3  1  200  1  0.10 3  1 
Fn  A    FGn    n   1000     3  P3, 930
 i  i 

i 
 

0.10 

0.10 

0.10 
6. What is the accumulated amount after 3 years, if instead of P200 per period, the payment of P1,000
increases by 15% after the first year and the interest rate is still the same?
Solution:
 1  i   1  g    1.1  1.15 
n n 3 3
Fg 3  A   1000   3,797.50
 ig   0.1  0.15 
7. A debt is to be repaid by 24-monthly installments of P5,000, the first of which to be made one month from
now. If cost of money is 12% pa compounded monthly, how much is the equivalent amount of the debt now?
Solution:
 1  0.0124  1 
P  5, 000  
 0.011  0.01 
24
 106, 217
Using the preceding example solve for the debt now if interest is continuous,
 e rn  1 
P  A  rn r 
 e e  1  
Solution:  e 0.01 24  1 
 5, 000   0.01 24 0.01 
 e e 1   
 P106,153
4/29/2021 N - 31 of 138 nilo t. aldon

N.3.1-4 Prob ems: l
1. What is the simple annual rate of interest if P350 is earned in six months on an investment of P7000.
a. 10% b. 20% c. 15% d. 16.67% e
2. A man borrowed P12,000 and agreed to pay the loan in one year. The bank discounted the loan and gave him P10,000 in
cash. What was the rate of discount?
a. 10% b. 20% c. 15% d. 16.67%
3. What was the effective interest? (Refer to previous number) )
a. 10% b. 20% c. 15% d. 16.67%
4. A fund is to be donated by a wealthy man to provide annual scholarships to deserving students. The fund will grant P
5,000 each month for the first 5 years and P10,000 each month for another 5 years. If the fund earns a 12% interest p.a.
compounded monthly, what is the amount of donation now?
a. P350,560 b. P365,890 c. P345,660 d. P472,230
5. A nominal interest rate of 12% per annum compounded monthly is equal to what nominal interest compounded quarterly?
a. 12.49% b. 12.12% c. 12.68% d. 13.34%
6. What is the effective interest rate? (refer to the previous problem)
a. 12.68% b. 12.12% c. 12.58% d. 13.34%
7. An item presently costs P500. If inflation is at the rate of 5% per year, what will be the cost of the item in 2 years?
a. P453.51 b. P531. 15 c. P515.25 d. P551.25
8. An economy is experiencing inflation at an annual rate of 5%. If this continues, what will P500 be worth two years from
now in terms of today’s pesos?
a. P453.51 b. P531. 15 c. P515.25 d. P551.25
9. What is the worth of P100, five years from now if invested at 10% pa, and inflation is expected at 8% pa?
a. 16.5% b. 17.81% c. 17.55% d. 18.5%
10. What is the real interest rate?
a. 16.5% b. 1.75% c. 17.55% d. 1.85%
11. A company borrowed P100,000 today to be repaid after 3 years at a market interest rate of 11%..
What is the actual amount owed at the end of 3 years.
a. P136,763 b. P118,141 c. P136,410 d. P1180,400
12. What is the real interest earned by the lender if the general inflation rate is 5% per year
a. 16.5% b. 17.81% c. 17.55% d. 18.5% e. 18.71%
13. What is the real peso equivalent in purchasing power to the actual-peso amount at the end of the third year?
a. P136,763 b. P118,141 c. P136,410 d. P1180,400
14. The unit price of the goods is P100. The company plans to increase its selling price by 10% (ej’ ). What will its actual unit
selling price be if inflation projected for the year is 5%.
a. P115.50 b. P111.00 c. P141.00 d. P100.40
15. A credit card company charges an interest rate of 1.375% per month on the unpaid balance of all accounts. The annual
interest, they claim, is 12(1.375%) =16.5%. What is the effective interest rate per year being charged by the company?
a. 16.5% b. 17.81% c. 17.55% d. 18.5%
16. Determine the ordinary simple interest on P12,000 from the period Jan 15, 1997 to October 30, 1997 if the rate of
simple interest is 12%.
a. P1,140 b. P1,110 c. P1,410 d. P1,040
17. A vendor borrows P5,000 from a savings credit association. Instead of giving him the full amount, the interest was
deducted from his loan to cover the interest for one year, thus he only received P 4,500. What is the discounted rate of
interest?
a. 10% b. 11.11% c. 12% d. 12.5%
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18. A young engineer at the age of 25 contributes P 250 a month into the retirement fund and the company matches this
contribution. How much money will be in the fund when the engineer reaches 65 years old. The fund earns 12% pa
compounded monthly.
a. P 318,667 b. P400,500 c. P5,159,333 d. P 5,882,386
19. Your rich aunt is going to give you an end-of-year gift of P100,000 for each year of the next ten years. If the general
inflation is expected to average 6% per year during the next 10 years, what is the equivalent value of these gifts at the
present time. The real interest is 4% per year.
a. P 318,667 b. P400,500 c. P608,172 d. P 582,386
20. Choose the best retirement plan for the employee from among those presented below. Assume cost of money is 10% pa
compounded monthly.
a. P1.4M now b. P64,000/month for 2 years
c. P1.65M after the 2nd year d. P120,000/month for 1 year, 1 st payment 13 months from now
21. Suppose your aunt specified that the annual gifts of P100,000 are to be increased by 6% each year to keep pace with
inflation of 6%. With market interest rate of 4% per year, what is the current present worth of the gifts?
a. P 318,667 b. P400,500 c. P608,172 d. P811,090
22. It is desired to have a certain sum of money 12 years from now. When the present value is 0.5 times the compounded
value, what is the discreet value of interest to attain this value?
a. 5.95% b. 11.90% c. 12.00% d. 12.90%
23. What will be the future worth after 18 months if a sum of P1,000 is invested at a simple interest of 10% per year?
a. P 1,150 b. P 1,157.62 c. P 1,153.69 d. P1,510
24. Mr. Eden borrows from the bank P600,000 at 12% compounded annually, agreeing to pay the loan in 15 equal payments.
How much does Mr. Eden still owe to the bank after he has made the 8 th payment?
a. P452,040 b. P 402,042 c. P341,153.69 d. P211,510
25. What end of year expenditure for 10 years is equivalent to P100,000 at the end of the second year, P200,000 at the end
of the fifth year and P600,000 at the end of the eight year, if the interest is 8% per year?
a. P 81,372 b. P156,471 c. P 83,372 d. P 154,671
26. What is the equivalent amount if a single expenditure is to be made 10 years from now? (Refer to previous prob)
a. P1,178,799 b. P1,149,032 c. P 1,154,671 d. P1,781,098
27. What is the equivalent amount if a single expenditure is to be made now?(Refer to Prob 25)
a. P645,012 b. P 180,000 c. P108,000 d. P546,012
28. If P200,000 is invested at 12% per annum compounded quarterly, the annual interest for the investment is nearest to:
a. P24,504 b. P 26,223 c. P25,450 d. P25,102
29. In 2004, the system’s income was $575 billion, projected to increase at an average rate of $43 billion per year. In
which year will the system’s income be $ 1177 billion?
a. 2010 b. 2012 c. 2016 d. 2018
30. The ABD company is building a new plant, whose equipment maintenance costs are expected to be $500 the
first year, $150 the second year, $200 the third year, $250 the fourth year, etc, increasing by $50 per year
through the tenth year. The plant is expected to have a 10-year life. Assuming the interest rate is 8%
compounded annually, how much should the company plan to set aside now in order to pay for the
maintenance?
a. $2340 b. $3240 c. $4320 d. $2430
31. Mr Jones is planning a 20-year retirement; he wants to withdraw P6000 at the end of the first year and then to
increase the withdrawals by P800 each year to offset inflation. How much money should he have in his savings
account at the start of his retirement if the bank pays 9% per year, compounded annually on his savings?
a. P104,193 b. P103,104 c. P109,143 d. P193,104
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N.3.5. Bonds
A. Introduction
A bond is a certificate of indebtedness of a corporation usually for a period not less than ten years
and guaranteed by a mortgage on certain assets of the corporation or its subsidiaries. Bonds are issued when
there is a need for more capital such as for expansion of the plant or the services rendered by the corporation.
The face or par value of a bond is the amount stated on the bond. When the face value has been repaid, the
bond is said to have been retired or redeemed. The bond rate is the interest quoted on the bond.
Classification of Bonds
1. Registered Bonds _ The name of the owner of this bond is recorded on the record books
of the corporation and interest payments are sent to the owner periodically without any
action on his part.
2. Coupon Bonds _ Have a coupon attached to the bond for each interest payment that will
come due during the life of the bond. The owner of the bond can collect the interest due
by surrendering the coupon to the offices of the corporation or at specified banks.
B. Retirement of Bonds
1. The corporation may issue another set of bonds equal to the amount of bonds due for
redemption.
2. The corporation may set up a sinking fund into which periodic deposits of equal amount
are made. The accumulated amount in the sinking fund is equal to the amount needed to
retire the bonds at the time they are due.
If we let:
A = periodic deposit to the sinking fund
I = interest on the bonds per period
Then: A+I = total periodic expense (N – 68)
Also, if we let:
F = accumulated amount, (par value of the bond) _ the amount needed to retire
the bond
i = rate of interest in the sinking fund
r = bond rate per period
Then:
 i 
A  F  (N – 69)
 1  i   1
n
I  Fr
(N – 70)
Total Periodic Expense:
 i 
A  I  F   Fr (N – 71)
 1  i   1
n
4/29/2021 N - 34 of 138 nilo t. aldon

C. Bond Value, P
The value of the bond is the present worth of all future amounts that are expected to be received
through ownership of the bond.
C  1  i n  1
P  Fr  n  (N – 72)
1  i n  i 1  i  
where: P = value of the bond n periods before redemption

C = redemption price, usually equal to F
(also known as Principal, Face Value, Par Value)
r = bond rate per period
n = number of periods before redemption
i = investment rate or yield per period
Example:
1. A bond issue of P200,000, in 10-years, in P1,000 units paying 16% nominal interest in semi-annual
payments, must be retired by the use of sinking fund that earns 12% pa compounded semi-annually. What
is the total semi-annual expense?
Solution:
F = P200,000
r = 16%/2= 8% per semi-annual
i = 12%/2 = 6% per semi-annual
Total semi-annual expense = A + I
 i 
Total Semi  annual Expense  F    Fr
 1  i   1 
n
 0.06 
 200, 000    200, 000  0.08 
 1  0.06   1 
20
 P 21, 437
2. Find the current price of a 10-year bond paying 6% per year that is redeemable at par value, if bought by a
purchaser to yield 10% per year. The face value of the bond is P100,000
C  1  i n  1 100,000  1  0.110  1 
P  Fr    100,0000.06  10 
1  i n
 i1  i   1  0.1
n 10
 0.101  0.10 
P  38,554.33  38,867.40  75,421.73
3. A bond issue of P200,000 in 10-years, in P1,000 units paying 16% interest per annum payments, must be retired
by the use of sinking fund that earns 12% pa. What is the total annual expense?
 i 
Total annual expense = C   Fr
 1  i   1 
n
 0.12 
Total annual expense  200,000    200,0000.16 
 1  0.12  1 
10
= P 43,396.83
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N3.5 PROBLEMS
1. Find the current price of a 10-year bond paying 6% per year that is redeemable at par value, if bought by a purchaser to
yield 10% per year. The face value of the bond is P100,000
a. P76,120 b. P71,610 c. P70,600 d. P75,422
2. A bond issue of P200,000 in 10-years, in P1,000 units paying 16% interest per annum payments, must be retired by the
use of sinking fund that earns 12% pa. What is the total annual expense?
a. P43,397 b. P34,793 c. P24,147 d. P21,7340
3. A city will issue 9% bonds, redeemable at par in 15 years, with interest payable annually. The proceeds from the
bond issue will be used to finance part of the public works program of the city. To pay for both the deposit to the
sinking fund and the annual interest, it is estimated that P1M can be raised yearly through taxation. If the fund
earns 8% compounded annually, what is the maximum amount of bonds which the city can issue?
a. P8,026,940 b. P 7,884,598 c. P 7,126,825 d. P6,162,825
4. A bond with a par value of P1,000 redeemable in 10 years and with bond rate of 10% payable annually is sold
now for P1080. If the yield is to be 12%, how much should the redemption price be at the end of 8 years?
a. P1,444 b. P 1,569 c. P 1,825 d. P1,825
5. A bond, with a face value of P1000 redeemable at par in 10 years, pays dividends at the rate of 6% per annum.
Determine the purchase price of the bond now if the yield on the bond is 10%?
a. P754.22 b. P 1,569 c. P 1,825 d. P1,825
6. A corporation sold an issue of 20-year bonds having a total face value of P10,000 for 9,500. The bonds bear
interest at 16%, payable semi-annually. The company wishes to establish a sinking fund for retiring the bond
issue and will make semi-annual deposits that will earn 12%, compounded semi-annually. Compute the annual
cost for interest and redemption of these bonds.
a. P 1,126 b. P 1,131 c. P 1,825 d. P1,781.11
7. How much can be paid for P50,000, 10% bond, with interest paid semi-annually, if the bond matures 12 years hence?
Assume that the purchaser will be satisfied with 6% nominal interest compounded semi-annually.
a. P66,936 b. P 51,569 c. P7 1,825 d. P61,825
8. You bought a P10,000 bond at par value that paid nominal interest at a rate of 10%, payable semi-annually, and held it for
10 years. You then sold it at a price that resulted in a yield of 8% nominal interest compounded semi-annually on you
capital. What was the selling price?
a. P7,022 b. P 8,569 c. P 6,825 d. P7,825
9. Find the price of a 10-year bond paying 6% per year, redeemable at par value 2 years after it was bought, yielding 10%
per year. The face value of the bond is P100,000
a. P76,120 b. P71,610 c. P70,600 d. P52,650.74
10. A bond issue of P200,000 in 10-years, in P1,000 units paying 8% interest per annum payments, must be retired by the
use of sinking fund that earns 6% pa. What is the total annual expense?
a. P31,173.59 b. P34,793 c. P24,147 d. P21,7340
11. A bond with a par value of P1,000 and with bond rate of 10% payable annually is sold for P1080, four years
before its redemption. If the yield is to be 6%, how much should the redemption price be?
a. P754.22 b. P 1,700 c. P 1,500 d. P P926.01
12. A bond, with a face value of P1000 redeemable at par in 10 years, pays dividends at the rate of 6% per annum.
Determine the purchase price of the bond now if the yield on the bond is 10%?
a. P754.22 b. P 1,569 c. P 1,825 d. P1,825
4/29/2021 N - 36 of 138 nilo t. aldon

N.4. DEPRECIATION
N.4.1. Introduction
A. Types of Depreciation
The decrease in the value of equipment, building or other structures due to the passage of
time. The causes of depreciation may be physical (use related, or time related) or functional.
 Physical Depreciation
Examples of physical depreciation are, wear and tear, corrosion, accident,
deterioration due to age (time) or elements.
 Functional depreciation and one good example is obsolescence. This is caused by

technological advances or developments which make an existing property obsolete. Even
though the property has suffered no physical change, its economic serviceability is reduced
because it is inferior to improved types of similar assets that have been made available
through advancements in technology
Reasons for Depreciation

An asset starts to lose value as soon as it is purchased. For example, a car bought for P2,000,000
today may be worth P1,800,000 next week, P1,500,000 next year, and P100,000 in 10 years.
This loss in value, called depreciation, occurs for several reasons.

1. Use-related physical loss: As something is used, parts wear out. An automobile engine has a
limited life span because the metal parts within it wear out. This is one reason why a car
diminishes in value over time. Often, use-related physical loss is measured with respect to units
of production, such as thousands of kilometers for a car, hours of use for a light bulb, or
thousands of cycles for a punch press.
2. Time-related physical loss: Even if something is not used, there can be a physical loss over
time. This can be due to environmental factors affecting the asset or to endogenous physical
factors. For example, an unused car can rust and thus lose value over time. Time related physical
loss is expressed in units of time, such as a 10-year-old car or a 40-year-old sewage treatment
plant.
3. Functional loss: Losses can occur without any physical changes. For example, a car can lose
value over time because styles change so that it is no longer fashionable. Other examples of
causes of loss of value include legislative changes, such as for pollution control or safety
devices, and technical changes. Functional loss is usually expressed simply in terms of the
particular unsatisfied
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Other causes of functional depreciation could be:

a. Change in demand for the service rendered by the property, such as decrease in
the demand for the product involved because of saturation of the market,
b. Shift of population center
c. Changes in the requirements of public authority
d. Inadequacy or insufficient capacity for the service required
e. Termination of the need for the type of service rendered
f. Abandonment of the enterprise
Depletion_ Another kind of depreciation is material loss due to consumption or exploitation

particularly applicable to natural resources.
B. Purposes of Depreciation
To provide for the recovery of capital which has been invested in physical property
To enable the cost of depreciation to be charged to the cost of producing products or services that
results from the use of property.
For engineers, depreciation is included as cost of production of any product or the rendering of
any service where equipment is used to provide for the replacement either at the end of its physical
or economic life or at the time when its operation no longer results in satisfactory profit or to
provide for the maintenance of capital to replace the decrease in the value of equipment.
C. Definition of Terms
Maintenance conveys the idea of constantly keeping a property in good condition;
Repairs connotes replacing or mending broken or worn parts of a property.
Service life of the property is the period during which the use of property is economically feasible. Both
physical and functional depreciation are taken into consideration in determining service life. The term is
synonymous with economic or useful life. In estimating the probable service life, it is assumed that a
reasonable amount of maintenance and repairs will be carried out at the expense of the property owner.
Recovery Period_ The number of years over which the basis of the property is recovered through the
accounting process. For the classical methods of depreciation, this is normally the useful life. Under the
MACRS, this period is the property class for the the General Depreciation System (GDS), and it is the class
life for the Alternative Depreciation System (ADS)
Present Value _ The value of the asset in its condition at the time of valuation
Salvage Value is the net amount of money obtainable from the sale of the used property over and above
any charges involved in removal and sale.
If a property is capable of further service, its salvage value may be higher. This is not
necessarily true, however, because other factors, such as location of the property, existing price levels,
market supply and demand, and difficulty in dismantling, may have an effect. The term salvage value
implies that the asset can give some type of further service and is worth more than merely its scrap or junk
value.
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Scrap or junk value is the amount of money obtained when the property cannot be disposed as a useful
unit but rather dismantled and sold as junk to be used again as a manufacturing raw material.
Book value _ also known as depreciated value, is the worth of the property as recorded in the books of
account of the enterprise and is equal to the original cost less the amounts which have been charged to
depreciation. It is sometimes called the unamortized value.
Market value _ The price which could be obtained for an asset if it were placed on sale in the open market.
Is the amount which a willing buyer will pay to a willing seller for the property when neither one is under
compulsion to buy or sell.
Fair Value _ The value is usually determined by a disinterested third party in order to establish a price that
is fair to both the seller and the buyer
Replacement value _ The cost necessary to replace an existing property at any given time with one at least
equally capable of rendering the same service.
Adjusted Cost basis_ The original cost of the asset, adjusted by allowable increases or decrease , is used
to compute depreciation and depletion deductions. For example, the cost of any improvement to a capital
asset with a useful life greater than one year increases the original cost basis, an d a casualty or theft loss
decreases it. If the basis is altered , the depreciation deduction may need to be adjusted.
Basis, or cost basis_ The initial cost of acquiring an asset (purchase price plus tax) , including
transportation expenses and other normal costs of making an asset serviceable for its intended use. This
amount is also called the unadjusted cost basis.
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N.4.2. Estimated Life of Equipment:

(Plant Design and Economics, Peters/Timmerhaus 4th Ed)
A. General Business Assets Years
1. Office furniture, fixtures, machine, equipment 10
2. Transportation
a. Aircraft 6
b. Automobile 3
c. Buses 9
d. General-purpose truck 4-6
e. Railroad Cars (except for railroad companies) 15
f. Tractor units 4
g. Trailers 6
h. Water transportation equipment 18
3. Land & site Improvements (not otherwise covered) 20
4. Buildings (apartments, banks, factories, hotels, stores, warehouses) 40-60
B. Non-Manufacturing Activities (excluding transportation, communications, public utilities)

1. Agriculture
a. Machinery and equipment 10
b. Animals 3-10
c. Trees and vines variable
d. Farm buildings 25
2. Contract Construction
a. General 5
b. Machines 12
3. Fishing variable
4. Logging and saw milling 6-10
5. Mining (excluding petroleum refining & smelting & refining of minerals) 10
6. Recreation and amusement 10
7. Services to general public 10
8. Wholesale and retail trade 10
C. Manufacturing
1. Aerospace industry 8
2. Apparel and textile products 9
3. Cement (excluding cement products) 20
4. Chemicals and allied products 11
5. Electrical equipment
a. Electrical equipment in general 12
b. Electronic general 8
6. Fabricated metal products 12
7. Food products (except grains, sugar, and vegetable oil) 12
8. Glass Products 14
9. Grain and grain mill products 17
10. Knitwear and knitwear products 9
11. Leather products 11
12. Lumber, wood products, furniture 10
13. Machinery unless otherwise listed 12
14. Metalworking machinery 12
15. Motor vehicles and parts 12
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16. Paper and allied products

a. Pulp and paper 16
b. Paper conversion 12
17. Petroleum and natural gas
a. Contract drilling and field service 6
b. Company exploration, drilling and production 14
c. Petroleum refining 16
d. Marketing 16
18. Plastic products 11
19. Primary metals
a. Ferrous metals 18
b. Nonferrous metals 14
20. Printing and publishing 11
21. Scientific instruments, optical and clock manufacturing 12
22. Railroad transportation equipment 12
23. Rubber products 14
24. Ship and boat building 12
25. Stone and clay products 15
26. Sugar products 18
27. Textile mill products 12-14
28. Tobacco products 15
29. Vegetable oil products 18
30. Other manufacturing in general 12
D. Transportation, Communications, and Public Utilities

1. Air transport 6
2. Central steam production and distribution 28
3. Electric utilities
a. Hydraulic 50
b. Nuclear 20
c. Transmission and distribution 28
d. Trunk pipelines and storage 30
4. Gas utilities
a. Distribution 35
b. Manufacture 30
c. Natural gas production 14
d. Trunk pipeline storage 22
5. Motor transport (freight) 8
6. Motor transport (passenger) 8
7. Pipeline transportation 22
8. Radio and television broadcasting 6
9. Railroads
a. Machinery and equipment 14
b. Structures and similar improvements 30
c. Grading and other right of way improvement variable
10. Wharves and docks 20
11. Power plant equipment see item 3
12. Telephone and telegraph communications variable
13. Water transportation 20
14. Water utilities 50
4/29/2021 N - 41 of 138 nilo t. aldon
N.4.3. Methods of Depreciation
Non-Interest Depreciation Methods

Method Description
1. Straight-Line The book value of an asset diminishes by an equal amount
each year.
2. Declining Balance The book value of an asset diminishes by an equal
proportion each year.
3. Sum-of-the-years’-digits An accelerated method, like declining-balance, in which
the depreciation rate is calculated as the ratio of the
remaining years of life to the sum of the digits
corresponding to the years of life.
4. Double-declining-balance A declining-balance method in which the depreciation rate
is calculated as 2/N for an asset with a service life of N years.
5. 150%-declining-balance A declining-balance method in which the depreciation rate
is calculated as 1.5/N for an asset with a service life of N years.
6. Units of Production The depreciation rate is calculated per unit of production as
the ratio of the units produced in a particular year to the
total estimated units produced over the asset’s lifetime
7. Working Hours Method This method assumes that the total depreciation that has taken
place is directly proportional to the operating time of the
equipment. This method has the advantage of making the unit cost
of depreciation constant and giving low depreciation expense
during low operating or utilization period.
8. MACRS Modified Accelerated Cost Recovery System_, the salvage
value is defined to be zero, and the useful life estimates are
not used directly in calculating depreciation amounts.
9. Depletion This method is usually applicable to natural resources such as
petroleum deposits, natural gas, mines, timberlands, etc. A
depletion fund is provided for the recovery of the capital
invested in the said undertaking. The annual charge set aside for
the gradual extraction is called depletion cost.
4/29/2021 N - 42 of 138 nilo t. aldon

A. Uniform Depreciation
1. Straight Line Method

This is the simplest and most widely used method compared to any other method. It is based on uniform
annual charge. It doesn’t take into account the interest or profit earned on accumulated depreciation fund.
It is a standard accounting method acceptable by the Bureau of Internal Revenue.
FC  SV (N – 73)
d
L
d Tn  n d  (N – 74)
BVn  FC  nd  (N – 75)

where: d = periodic depreciation
dTn= total depreciation after nth period
FC = First cost
SV = Salvage Value
BVn = Book value after nth period
L = Service Life
n = nth period
2. Sinking Fund Method

It is based on uniform annual charge. It is assumed that a sinking fund is created to replace the
original cost of equipment. All amounts in the sinking fund (including interest) earn interest. The company
uses the amount accumulated in its operations, and therefore assumed to earn interest. It is generally used
for economy-study purposes.
 i 
d  FC  SV   (N – 76)
 1  i   1
L
 1  i n  1
d Tn  d   (N – 77)
 i 
BVn  FC  d Tn (N – 78)
where: d = periodic depreciation

dTn = total depreciation after nth period
BVn = Book value after nth period
4/29/2021 N - 43 of 138 nilo t. aldon

Example:
1. An asset for drilling was purchased and placed in service by a petroleum production company. Its cost basis
is P6M and has an estimated book value of P1.2 M at the end of an estimated useful life of 14 years.
Compute the book value at the end of the fifth year of life by the straight-line method
FC  SV 6  1.2
d3    P 0.3429M
L 14
BV5  6  0.34295  P 4.2855
2. The original cost of a certain piece of equipment is P500,000 and is depreciated by a 12% sinking fund method.
Determine the annual depreciation charge if the book value of the equipment after 10 years is the same as if
it had been depreciated at P40,000 each year by straight line formula.
Using straight line Method:
Total deprectiation  40,000(10)  400,000
Salvage Value  500,000  400,000  100,000
Using sinking fund Method:
 i   0.12 
d  FC  SV   400,000   22,793.67
 1  i   1   1  0.12 10
 1
3. In order to make it worthwhile to purchase a piece of equipment, the annual depreciation costs for the
equipment cannot exceed P295,000 at any time. The original cost of the equipment is P3M and a salvage value
of P50,000. Determine the length of service life necessary if the equipment is depreciated by
a. Sum-of-the-years-digit method
d1 
FC  SV L  1  n 
L  1L / 2
Maximum depreciation occurs on the 1st year:
295,000 
3,000,000  50,000L  1  1
L  1L / 2
L  19 years
b. Straight-line method
d
FC  SV
 295,000 
3,000,000  50,000
L L
L  10 years
B. Non-Uniform Depreciation
1. Declining-Balance-Method
Also known as Matheson formula. The annual depreciation cost is a constant percentage of the
salvage value at the beginning of the year. The annual depreciation cost differs every year, and decreases
in absolute value as time progresses. The salvage value of the property can never depreciate to zero.
d n  FC 1  f   f 
n 1
(N – 79)
BV n  FC 1  f n (N – 80)
BV n  SV 1  f  nL (N – 81)
4/29/2021 N - 44 of 138 nilo t. aldon

1
 SV  Ln
f  1   

 BVn 
f  1  SV / FC 
1/ L
(N – 82)
where: f = fractional depreciation

dn = depreciation at the nth period
BVn = Book value at the nth period
2. Double-Declining Balance Method

This method is similar to the declining balance method except that the f is replaced by 2/L.
3. Sum-of-the-Years Digit Method

The annual depreciation cost differs each year and decreases as time progresses. It provides for
a rapid depreciation during the early years of life of property, hence faster recovery of capital.
dn 
FC  SV L  1  n (N – 83)
L  1L / 2
d Tn 
FC  SV 2 L  1  nn (N – 84)
L  1L
BVn  FC  dTn (N – 85)

where: dn = annual depreciation after nth year
dTn = total annual depreciation after nth year
BVn = book value after period
FC = First Cost
SV = Salvage Value
L = service life, years
n = nth year
4. Service-Output Method
This method assumes that the total depreciation that has taken place is directly proportional to the
quantity of output of the property up to that time. This method has the advantage of making the unit cost
of depreciation constant and giving low depreciation expense during periods of low production.
Depreciation
d 
FC  SV  (N – 86)
unit output QT
dn 
FC  SV  Q (N – 87)
n
QT
4/29/2021 N - 45 of 138 nilo t. aldon

FC = first cost of equipment

SV = salvage value of equipment after its service life
QT = total units of output up to its service life
Qn = number of units of output during the nth year
dn = annual depreciation during the nth year
5. Working Hours Method

This method assumes that the total depreciation that has taken place is directly proportional to the
operating time of the equipment. This method has the advantage of making the unit cost of depreciation
constant and giving low depreciation expense during low operating or utilization period.
dn 
FC  SV  H (N – 88)
n
HT
Where: FC = first cost of equipment
SV = salvage value of equipment after its service life
HT = total hours of operation up to its service life
Hn = hours of operation during the nth year
dn = annual depreciation during the nth year
Example:
1. Solve, using the declining-balance- method, the depreciation cost of an equipment on the 8th year, if its book
value on the 7th year is P250,000. The Book value of the equipment is computed to be P460,512 on the 5 th
year..
Required: d8
Solution:
BV7 BV7 1  f   250,000 
7
BV5
FC   ;   
1  f  1  f 7 BV5 1  f 5  460,512 
5
1  f   250,000 ;1  f   250,000  ; f  0.2632

2
2
460,512  460,512 
d 8  BV7 f  250,0000.2632  65,800
2. An asset for drilling was purchased and placed in service by a petroleum production company.
Its cost basis is P6M and has an estimated book value of P1.2 M at the end of an estimated useful life of 14
years. Compute the depreciation amount in the third year and the book value at the end of the fifth year of
life by SYD method
L  1  n  14  1  3
Solution: d 3  FC  SV  L  1L /2  6  1.2  14  114 /2  P 0.5486 M
BV5  FC  d t5  6  6  1.2 
14  13  12  11  10   P 3.2571M
105
3. To develop an oil well containing an estimated 4M barrels of oil required an initial investment of P3B. in a
certain year, 400,000 barrels were produced from this well. Determine the depletion charge during that year.
Solution:
dn 
FC  SV  Q
d
3x10  400,000  300 M
9
n
QT 4x106
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4. Solve using the declining-balance- method, the depreciation cost of an equipment on the 8 th year, if its book
value on the 7th year is P250,000. The Book value of the equipment is computed to be P460,512 on the 5th
year..
Solution:
1
BV5 BV7 BV7  250,000  2
7 
; 1 f   0.7368; f  0.2632; d8  BV7  f   250,000  0.2632   P65,800
7 5
FC    
1  f 
5
1  f  BV5  460,512 
C. Depletion
This method is usually applicable to natural resources such as petroleum deposits, natural gas, mines,
timberlands, etc. A depletion fund is provided for the recovery of the capital invested in the said
undertaking. The annual charge set aside for the gradual extraction is called depletion cost.
1. Unit of Production Method

This method is similar to service output method of depreciation. The depletion Charge depends upon the
initial cost of the property and the number of units in the property.
dn 
Fc  SV  Q (N – 89)
n
QT
2. Percentage Method
This method allows a fixed percentage of the gross income received during the year to be the depletion
charge. Considering that the total depletion charge may exceed the initial cost of the property, it is
required that for any year the depletion charge should not exceed 50% of the net taxable income for that
year obtained by deducting all expenses excluding depletion from the gross income.
D. Modified Accelerated Cost Recovery System (MACRS)

The principal method for computing depreciation deductions for property in engineering projects in the
U.S.. Unlike the conventional method of computing depreciation which requires estimates of useful
life (L) and salvage value (SV) at the end of useful life, in MARCS, the SV is defined to be zero, and
the useful life estimates are not used directly in calculating depreciation amounts. MACRS consists of
two systems for computing depreciation deductions; The main system is called General Depreciation
System (GDS), and the second system is called the Alternative Depreciation System (ADS).
When an asset is depreciated under MACRS, the following information is needed before deductions
can be calculated:
1. The cost basis (B)
2. The date the property was placed in service
3. The property class and recovery period
4. The MACRS depreciation method to be used (GDS or ADS)
5. The time convention that applies (half-year)
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1. General Depreciation System (GDS)
Basic information about property classes and recovery period:
a. Most tangible personal property is assigned to one of six personal property classes
(3,5,7,10,15,20) in years. The personal property class is the same as the GDS recovery
period. Any depreciable personal property that does not fit into one of the defined
asset classes is depreciated as being in the seven-year property class.
b. Real property is assigned to two real property classes: Nonresidential real property
and residential rental property.
c. The GDS recovery period is 39 years for nonresidential real property and 27.5 years
for residential property.
2. Alternative Depreciation System (ADS)
Basic information about property classes and recovery period:

a. A table is provided for ADS recovery period of tangible personal property
b. Any tangible personal property that does not fit into one of the asset classes is
depreciated using a 12-year ADS recovery period.
c. The ADS recovery period for non-residential real property is 40 years.
3. Depreciation Methods, Time Convention, Recovery Rates

a. GDS 3,5,7 and 10-year personal property classes: The 200% DB method, which
switches to the SL method when that method provides a greater deduction.
b. GDS 15 and 20-year personal property classes: The 150% DB method, which
switches to the SL method when that method provides a greater deduction.
c. GDS nonresidential real and residential rental property classes: SL method over the
fixed GDS recovery periods.
d. ADS: The SL method for both personal and real property over the fixed ADS
recovery periods.
e. Half-year time convention is used in depreciation calculations for tangible personal
property. If asset is disposed of before the full recovery period is used, then only half
of the normal depreciation deduction can be taken for that year.
f. If the asset is disposed of in year n+1 the final BV of the asset will be zero.
4. Double Declining and 1.5 Declining with Switch-over to Straight Line

Rates are determined by applying the 200% Declining method and 150% Declining method (with
switchover to the SL method) to the recovery period with the half-year convention applied to the first
and last years. Rates of each period must sum 1.0000
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Table N – 1. MACRS Class Lives and Recovery Periodsa

Class Recovery Period
Asset Class Description of Assets Life GDSb ADS
00.11 Office Furniture and equipment 10 7 10
00.12 Information systems, including computers 6 5 5
00.22 Automobile, taxis 3 5 5
00.23 Buses 9 5 9
00.241 Light general purpose trucks 4 5 5
00.242 Heavy general purpose trucks 6 5 6
00.26 Tractor units for use over the road 4 3 4
10.0 Mining 10 7 10
13.2 Production of petroleum and natural gas 14 7 14
13.3 Petroleum refining 16 10 16
15.0 Construction 6 5 6
22.3 Manufacture of Carpets 9 5 9
24.4 Manufacture of products 10 7 10
28.0 Manufacture of chemicals & allied products 9.5 5 9.5
30.1 Manufacture of rubber Products 14 7 14
32.2 Manufacture of Cement 20 15 20
34.0 Manufacture of fabricated metal products 12 7 12
36.0 Manufacture of electronic components, products,& system 6 5 6
37.11 Manufacture of motor vehicles 12 7 12
37.2 Manufacture of aerospace products 10 7 10
48.12 Telephone central office equipment 18 10 18
49.13 Electric utility steam production 28 20 28
49.21 Gas utility distribution facilities 35 20 35
a
Partial listing abstracted from How to Depreciate Property, IRS Publication 946, Tables B - 1 and B - 2, 1998
b
Also the GDS property class
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Table N – 2. GDS Recovery Rates (rk) for the Six Personal Property Classes.
Recovery Period (and Property Class)
Year 3-yeara 5-yeara 7-yeara 10-yeara 15-yearb 20-yearb
1 0.3333 0.2000 0.1429 0.1000 0.0500 0.0375
2 0.4445 0.3200 0.2449 0.1800 0.0950 0.0722
3 0.1481 0.1920 0.1749 0.1440 0.0855 0.0668
4 0.0741 0.1152 0.1249 0.1152 0.0770 0.0618
5 0.1152 0.0893 0.0922 0.693 0.0571
6 0.0576 0.0892 0.0737 0.0623 0.0528
7 0.0893 0.0655 0.0590 0.0489
8 0.0446 0.0655 0.0590 0.0452
9 0.0656 0.0591 0.0446
10 0.0655 0.0590 0.0446
11 0.0328 0.0591 0.0446
12 0.0590 0.0446
13 0.0591 0.0446
14 0.0590 0.0446
15 0.0591 0.0446
16 0.0295 0.0446
17 0.0446
18 0.0446
19 0.0446
20 0.0446
21 0.0223
Depreciation. IRS Publication 534. Washington, D.C: U.S. Government Printing Office, for 1998 tax returns
a
These rates are determined by applying the 200% DB method (with switchover to the SL method) to the recovery
period with the half-year convention applied to the first and last years. Rates of each period must sum 1.0000
b
These rate are determined with the 150% DB method instead of the 200% DB method (with switchover to the SL
method) and rounded off to four decimal places.
Reference: Engineering Economy, 12th edition, Sullivan, Wicks, Luxhoj
2 1.5
dn  for 3,5,710 dn  for 15,20
L L
Example: 3-year
 2  1  2
d1      0.3333 50% only for the 1st year , d 2  1  0.3333   0.4445 ,
 3  2  3
2
d 3  1  0.3333  0.4445   0.1481; d 4  1  0.3333  0.4445  0.1481  0.0741 ,
3
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Flow Diagram for Computing

Depreciation Deductions
Under MACRS
MACRS Depreciation
GDS or ADS
GDS ADS
Ascertain Property Class; Ascertain recovery period:

Same as recovery period for Table N-2, personal property
personal property:
 Table N-1, based on
asset description
Obtain recovery rates: Compute Depreciation Amount;

 Table N-2, personal SL 
Asset ' s Cost Basis
property Recovery Period (years)
Compute Depreciation Compute depreciation

deduction in Year n (dn) by deduction in year n (dn);
multiplying the asset’s cost  d1= 0.5(SL amount)
basis by appropriate recovery  d2 thru dn =SL amount
rate  dn+1= 0.5(SL amount)
Basis(B)  Actual Cash Cost  Book Value of the Trade  in

rn recovery rate at the nth year
Depreciation at the end of the nth year
d n  rn .B ; 1 n  L  1 (N – 90)
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GDS Recovery Rate Table

Year 3 5 7 10 15 20
1 0.3333 0.2000 0.1429 0.1000 0.0500 0.0375
2 0.4444 0.3200 0.2449 0.1800 0.0950 0.0722
3 0.1481 0.1920 0.1749 0.1440 0.0855 0.0668
4 0.0741 0.1152 0.1249 0.1152 0.0770 0.0618
5 0.1152 0.0892 0.0922 0.0693 0.0571
6 0.0576 0.0892 0.0737 0.0623 0.0528
7 0.0892 0.0655 0.0590 0.0489
8 0.0446 0.0655 0.0590 0.0452
9 0.0655 0.0590 0.0446
10 0.0655 0.0590 0.0446
11 0.0328 0.0590 0.0446
12 0.0590 0.0446
13 0.0590 0.0446
14 0.0590 0.0446
15 0.0590 0.0446
16 0.0295 0.0446
17 0.0446
18 0.0446
19 0.0446
20 Shift to straight line 0.0446
21 0.0223
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A B C D E F G
DERIVATION OF GDS Recovery Rate Table (Using Excel)

Recovery Period Recovery Period Recovery Period
4 Year 3 Year 5 Year 7
5 1 0.3333 1 0.2000 1 0.1429
6 2 0.4444 2 0.3200 2 0.2449
7 3 0.1481 3 0.1920 3 0.1749
8 4 0.0741 4 0.1152 4 0.1249
9 5 0.1152 5 0.0893
10 6 0.0576 6 0.0893
11 7 0.0893
12 8 0.0445
13
14 Year Formula YEAR Formula YEAR Formula
15 1 2/(C5*2) 1 2/(E4*2) 1 2/(G4*2)
16 2 (1-C5)*2/C4 2 (1-E5)*2/E4 2 (1-G5)*2/G4
17 3 (1-C5-C6)*2/C4 3 (1-E5-E6)*2/D4 3 (1-G5-G6)*2/G4
18 4 1-C5-C6-C7 4 (1-E5-E6-E7)*2/E4 4 (1-G5-G6-G7)*2/G4
19 5 (1-SUM(E5:E8))*1/1.5 5 (1-SUM(G5:G8))*2/G4
20 6 1-SUM(E5:E9) 6 (1-SUM(G5:G9))*1/2.5
21 7 (1-SUM(G5:G10))*1/1.5
22 8 1-SUM(G5:G11)
23
Double-Declining Balance with switch-over to straight-line method
Example of Double-Declining Balance with Switch-over to Straight-Line

• For a 5-year recovery period
The DB recovery rate=2/L (except the first year, 1/L)
The SL recovery rate=1/L
DB SL
1st year 1/5 =0.2 1/5 = 0.2
2nd year (1-0.2)(2/5) =0.32 (1-0.2)/4.5 = 0.1778
3rd year (1-0.52)(2/5) =0.192 (1-0.52)/3.5 = 0.1371
4th year (1-0.712)(2/5) =0.1152 (1-0.712)/2.5 = 0.1152 Switch over
5th year (1-0.8272)/1.5 = 0.1152
6th year (1-0.9424) = 0.0576
Year Annual Depreciation Total Depreciation:

1 0.2 =0.2
2 0.32 =0.2+0.32 =0.52
3 0.192 =0.52+0.192 =0.712
4 0.115 =0.712+0.1152 =0.82724
5 0.115 = 0.8272+0.1152 =0.9424
6 0.0576 =0.9424+0.0576 =1.000
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H I J K L M N N
DERIVATION OF GDS Recovery Rate Table
Recovery Period Recovery Period Recovery Period

4 Year 10 Year 15 Year 20
5 1 0.1000 1 0.0500 1 0.0375
6 2 0.1800 2 0.0950 2 0.0722
7 3 0.1440 3 0.0855 3 0.0668
8 4 0.1152 4 0.0770 4 0.0618
9 5 0.0922 5 0.0693 5 0.0571
10 6 0.0737 6 0.0623 6 0.0528
11 7 0.0655 7 0.0590 7 0.0489
12 8 0.0655 8 0.0590 8 0.0452
13 9 0.0655 9 0.0590 9 0.0446
14 10 0.0655 10 0.0590 10 0.0446
15 11 0.0328 11 0.0590 11 0.0446
16 12 0.0590 12 0.0446
17 13 0.0590 13 0.0446
18 14 0.0590 14 0.0446
19 15 0.0590 15 0.0446
20 16 0.0295 16 0.0446
21 17 0.0446
22 18 0.0446
23 19 0.0446
24 20 0.0446
25 21 0.0223
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H I J K L M N
26 YEAR Formula YEAR Formula YEAR Formula
27 1 2/(J4*2) 1 1.5/(L4*2) 1 1.5/(N4*2)
28 2 (1-J5)*2/J4 2 (1-L5)*1.5/L4 2 (1-N5)*1.5/N4
29 3 (1-SUM(J5:J6))*2/J4 3 (1-SUM(L5:L6))*1.5/L4 3 (1-SUM(N5:N6))*1.5/N4
30 4 (1-SUM(J5:J7))*2/I4 4 (1-SUM(L5:L7))*1.5/L4 4 (1-SUM(N5:N7))*1.5/N4
31 5 (1-SUM(J5:J8))*2/I4 5 (1-SUM(L5:L8))*1.5/L4 5 (1-SUM(N5:N8))*1.5/N4
32 6 (1-SUM(J5:J9))*2/J4 6 (1-SUM(L5:L9))*1.5/L4 6 (1-SUM(N5:N9))*1.5/N4
33 7 (1-SUM(J5:J10))*1/4.5 7 (1-SUM(L5:L10))/9.5 7 (1-SUM(N5:N10))*1.5/N4
34 8 (1-SUM(J5:J11))/3.5 8 (1-SUM(L5:L11))/8.5 8 (1-SUM(N5:N11))*1.5/N4
35 9 (1-SUM(J5:J12))/2.5 9 (1-SUM(L5:L12))/7.5 9 (1-SUM(N5:N12))/12.5
36 10 (1-SUM(J5:J13))/1.5 10 (1-SUM(L5:L13))/6.5 10 (1-SUM(N5:N13))/11.5
37 11 1-SUM(J5:J14) 11 (1-SUM(L5:L14))/5.5 11 (1-SUM(N5:N14))/10.5
38 12 (1-SUM(L5:L15))/4.5 12 (1-SUM(N5:N15))/9.5
39 13 (1-SUM(5:L16))/3.5 13 (1-SUM(N5:N16))/8.5
40 14 (1-SUM(L5:L17))/2.5 14 (1-SUM(N5:N17))/7.5
41 15 (1-SUM(L5:L18))/1.5 15 (1-SUM(N5:N18))/6.5
42 16 (1-SUM(L5:L19)) 16 (1-SUM(N5:N19))/5.5
43 17 (1-SUM(N5:N20))/4.5
44 18 (1-SUM(N5:N21))/3.5
19 (1-SUM(N5:N22))/2.5
20 (1-SUM(N5:N23))/1.5
21 (1-SUM(N5:N24))
Tabulated Data of Switchover from DDB to SL Method: Recovery Period=10 years
BVn Begi nni ng Annual Depreciation

Year 200% DBM SLM 200% DBM SLM Selected
1 4,000 4,000 400.00 400.00 400.00
2 3,600 720.00 378.95 720.00
3 2,880 576.00 338.82 576.00
4 2,304 460.80 307.20 460.80
5 1,843 368.64 283.57 368.64
6 1,475 294.91 268.10 294.91
7 1,180 1,180 235.93 262.14 262.14
8 918 262.14 262.14
9 655 262.14 262.14
10 393 262.14 262.14
11 131 262.14 131.07
BVn-dn BVn* (2/10) BVn*(1/10+1.5-n) 4,000.00
4/29/2021 N - 55 of 138 nilo t. aldon
Sample Problem:
A firm purchased and placed in service a new piece of semiconductor manufacturing equipment. The cost basis
for the equipment is P100,000. Using MACRS Method, determine
(a) the depreciation charge permissible in the fourth year,
(b) the BV at the end of the fourth year,
(c) the cumulative depreciation through the third year, and
(d) the BV at the end of the fifth year if the equipment is disposed of at that time.
Solution:
From Table N-1, the semi-conductor (electronic manufacturing equipment has a class life of six years and a GDS
recovery period of five years (Asset Class 36). The recovery rates that apply are given in Table N-2.
(a) The depreciation deduction, or cost-recovery allowance , that is allowable in year four (d 4) is
d4  0.1152 (100,000)  P11,520
(b) The BV at the end of year four (BV4) is the cost basis less depreciation charges in years from one through
four:
BV4  100,000  100,000(0.20  0.32  0.192  0.1152) P17,280
(c) Accumulated depreciation through year three,d 3, is the sum of depreciation amounts in years one through
three:
dT3=d1+d2+d3
dT 3  100,000(0.20  0.32  0.192) P71,200
(d) The depreciation deduction in year five when the equipment is disposed of prior to year six.
d5=(0.5)(0.1152)(100,00)= P5,760
Thus, BV at the end of year five is, BV5= BV4-d5

= 17,280-5,760 = P11,520
Sample Problem (ADS)

A manufacturing equipment has cost basis is P6M and has an estimated book value of P1M at the
end of an estimated useful life of 7 years. Compute the depreciation amount in the third year and the
book value at the end of the fifth year of life using ADS.
1 1
SL    0.14286
L 7
r1  0.0.14286/2   0.071429
r2  d 5  0.14286
d 3  FC r3   6 0.14286   P 0.85714 ans
BV5  6 1  (0.0.071429  0.14286 4  )  P 2.14278 ans
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N.4 PROBLEMS
1. In order to make it worthwhile to purchase a piece of equipment, the annual depreciation costs for the equipment
cannot exceed P295,000 at any time. The original cost of the equipment is P3M and a salvage value of P50,000.
Determine the length of service life necessary if the equipment is depreciated by
Sum-of-the-years-digit method
a. 30 b. 19 c. 25 d. 23
2. Declining - balance method
a. 30 b. 40 c. 29 d. 31
3. Straight-line method
a. 8 b. 10 c. 14 d. 12
4. The original cost of a certain piece of equipment is P500,000 and is depreciated by a 12% sinking fund method.
Determine the annual depreciation charge if the book value of the equipment after 10 years is the same as if it had
been depreciated at P40,000 each year by straight line formula.
a. P22,793.67 b. P497,026 c. P683,113 d. P383,600
5. An asset for drilling was purchased and placed in service by a petroleum production company. Its cost basis is
P6M and has an estimated book value of P1.2 M at the end of an estimated useful life of 14 years. Compute the
book value at the end of the fifth year of life by each of these methods.
The straight-line method
a. P4.29M b. P2.78M c. P5.5M d. P6.5M
6. The SYD method
a. P4.29M b. P2.78M c. P1.34M d. P3.26M
7. The 200% DB method with switchover to straight line
a. P4.29M b. P2.78M c. P1.34M d. P6.5M
8. The GDS (For petroleum, recovery period is 7 years;)
a. P4.29M b. P2.78M c. P1.34M d. P6.5M
9. An optical scanning machine was purchased for P150,000 in the current tax year (year one) It is to be used for
reproducing blueprints of engineering drawings, and its MACRS class life is nine years. The estimated market
value of this machine at the end of 10 years is P30,000. What is the GDS recovery period of the machine?s
a. 4years b. 5 years c. 6 years d. 7 years
10. Based on your answer to the preceding question , what is the depreciation deduction in year four?
a. P 15, 500 b. P25, 920 c. P 16,500 d. P17, 280
11. What is the BV at the beginning of year 5?
a. P 15, 500 b. P25, 920 c. P 16,500 d. P17, 280
12. Your company has purchased a large new truck for over-the road use (asset class 00.26). It has a basic cost of P1.8M.
With additional option costing P150,000, the cost basis for depreciation purposes is P1.95M. Its market value at the
end of five years is estimated as P400,000. Assume it will be depreciated under GDS. The cumulative depreciation
through the end of year three is closest to: (Note: Recovery period is 3 years using GDS)
a. P1.950 M b. P1.878 M c. P 1.800M d. P1.806 M
13. The MACRS depreciation in year four is most nearly.
a. 0 b. P1.33,400 c. P 144,500 d. P311,500
14. The book value at the end of year 2 is most nearly
a. P330,000 b. P360,000 c. P 420,000 d. P433,000
15. The depreciation deduction in year 3 when the equipment is disposed of prior to year 4.
a. P330,000 b. P360,000 c. P 420,000 d. P433,000
16. An old pump costs P25,000 a year to maintain. What expenditure for a new pump is justified if no maintenance
will be required for the first 2 years, P5,000 a year for the next 8 years and P25,000 a year thereafter. Assume
cost of money is 10% pa and no other costs are to be considered.
a. P126,940 b. P 131,569 c. P 126,825.03 d. P162,825.03
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17. A firm purchased and placed in service a new piece of semi-conductor equipment The cost basis for the equipment is
P100,000. Determine the depreciation charge permissible in the fourth year. Use Modified Accelerated Cost Recovery
System (MACRS). Class life is six years
a. P 10,126 b. P 12,131 c. P11,825 d. P11,520
18. What is the book value at the end of the fourth year (BV 4)?
a. P 10,126 b. P 12,131 c. P11,825 d. P17,280
19. A company purchased a machine for P800,000, used it for 4 years and sold it for P300,000. If money is worth
10% determine the capital recovery cost of operating the equipment.
a. P187,735.40 b. P47,026 c. P33,113 d. P23,600 e. P35,600
20. A certain equipment costs P 250,000, lasts 10 years with a salvage value of P25,000. Money is worth 8%. If the
owner decides to sell it after using for 5 years, what should his price be so that he can recover his investment plus
interest?
a. P222,793.67 b. P247,026 c. P133,113 d. P276,214
21. A company purchased an equipment for P 110,000. It is estimated that it will have a useful life of 10 years, production of
100,000 units and working hours of 100,000. The scrap value of the equipment is P10,000,
The company uses the equipment for 7,000 hours and produces 8,000 units on its first year of operation and 8,000 hours
and 9,500 units on its second year of operation.
Compute the book value of the equipment at the beginning of the third year using.
a. Declining-balance method.
a. P 68,096 b. P70,400 c. P94,371 d. P 95,000
b. Double-declining-balance method
a. P 68,096 b. P70,400 c. P94,371 d. P 95,000
c. Sinking-fund method, i=6%
a. P 68,096 b. P70,400 c. P94,371 d. P 95,000
d. Working hours
a. P68,096 b. P70,400 c. P94,371 d. P 95,000
e. Output method
a. P 68,096 b. P70,400 c. P942,500 d. P 95,000
f. MACRS, assume recovery period of 5 years.
a. P52,500 b. P70,400 c. P75,455 d. P 95,000
g. SYDM
a. P52,500 b. P70,400 c. P P75,455 d. P 95,000
22. Mr Jones is planning a 20-year retirement; he wants to withdraw P6000 at the end of the first year and then to
increase the withdrawals by P800 each year to offset inflation. How much money should he have in his savings
account at the start of his retirement if the bank pays 9% per year, compounded annually on his savings?
a. P104,193 b. P270,00 c. P 101,193 d. P 105,000
23. A machine costs P900,000 and will have a salvage value of P450,000 when retired at the end of 5 years. Using
sum-of-the-years digit method, what is the sum of the depreciation cost in the first two years?
a. P104,193 b. P270,00 c. P 101,193 d. P 105,000
4/29/2021 N - 58 of 138 nilo t. aldon

N.5. CAPITAL INVESTMENTS

N.5.1. Introduction
Before an industrial plant can be put into operation, a large amount of money must be supplied to purchase
and install the necessary machinery and equipment. Land and service facilities must be obtained, and the plant must
be erected complete with all piping, controls and services. In addition, it is necessary to have money available for the
payment of expenses involved in the plant operation.
The capital needed to supply the necessary manufacturing and plant facilities is called the fixed-capital
investment, while that necessary for the operation of the plant is termed the working capital. The sum of the fixed-
capital investment and the working capital is known as the total capital investment. The fixed-capital portion may
be further subdivided into manufacturing fixed-capital investment and non-manufacturing fixed-capital investment.
N.5.2. Fixed-Capital Investment

Manufacturing fixed-capital investment represents the capital necessary for the installed process equipment
with all auxiliaries that are needed for complete process operation. Expenses for piping, instruments, insulation,
foundations, and site preparation are typical examples of costs included in the manufacturing fixed-capital investment.
Fixed capital required for construction overhead and for all plant components that are not directly related to
the process operation is designated as the non-manufacturing fixed-capital investment. These plant components
include the land, processing buildings, administrative and other offices, warehouse, laboratories, transportation,
shipping and receiving facilities, utility and waste-disposal facilities, shops, and other permanent part of the plant. The
construction overhead cost consists of field-office and supervision expenses, home-office expenses, engineering
expenses, miscellaneous construction costs, contractor’s fees, and contingencies. In some cases, construction overhead
is proportioned between manufacturing and non-manufacturing fixed-capital investment.
N.5.3. Working Capital

The working capital for an industrial plant consists of the total amount of money invested in (1) raw
materials and supplies carried in stocks, (2) finished products in stock and semi-finished products in the process of
being manufactured, (3) accounts receivable, (4) cash kept on hand for monthly payment of operating expenses,
such as salaries, wages, and raw-materials purchases, (5) accounts payable, and (6) taxes payable.
The raw materials inventory included in working capital usually amounts to a 1-month supply of the raw
materials valued at delivered prices. Finished products in stock and semi-finished products have a value approximately
equal to the total manufacturing cost for 1 month’s production. Because credit terms extended to customers are usually
based on an allowable 30-day payment period, the working capital required for account receivable ordinarily amounts
to the production cost for 1 month of operation.
The ratio of working capital to total capital investment varies with different companies, but most chemical
plants use an initial working capital amounting to 10 to 20 percent of the total capital investment. This percentage
may increase to as much as 50 percent or more for companies producing products of seasonal demands because of the
large inventories that must be maintained for appreciable periods of time.
N.5.4. Estimation of Capital Investment

Of the many factors that contribute to poor estimates of capital investments, the most significant one is usually
traceable to sizable omissions of equipment, services, or auxiliary facilities rather than to gross errors in costing. A
checklist of items covering a new facility is an invaluable aid in making a complete estimation of the fixed-capital
investment.
Types of capital cost estimates
An estimate of the capital investment for a process may vary from a pre-design estimate based on little information
except the size of the proposed project to a detailed estimate prepared from complete drawings and specifications.
Between these two extremes of capital-investment estimates, there can be numerous other estimates which vary in
accuracy depending upon the stage of develop.
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A. Fixed-Capital Investment (FCI)a;
1. Direct Costs (DI) (70-85% FCI)

a. Purchased equipment (20-40% FCI)
All equipment listed on a complete flow sheet
Spare parts and non installed equipment spares
Surplus equipment, supplies, and equipment allowance
Inflation cost allowance
Freight charges
Taxes, insurance, duties
Allowance for modification during start-up
b. Purchased-equipment installation (35-45% Equip Cost, EC)

Installation of all equipment listed on complete flow sheet
Structural supports, insulation, paint
c. Instrumentation and controls (6-30% EC)

Purchase, installation, calibration
d. Piping (10-80% EC)

Process piping-carbon steel, alloy, cast iron, lead lined, aluminum, copper, asbestos-cement, ceramic,
plastic, rubber, reinforced concrete, Pipe hangers, fittings, valves, Insulation-piping, equipment
e. Electrical equipment and materials (8-20% EC)
Electrical equipment_ switches, motors, conduit, wire, fittings, feeders, grounding, instrument and
control wiring, lighting, panels, Electrical materials and labor
f. Buildings (including services) (10-70% EC)

Process buildings_ substructures, superstructures, platforms, supports, stairways, ladders, access ways,
cranes, monorails, hoists, elevators
Auxiliary buildings_ administration and office, medical and dispensary, cafeteria, garage, product
warehouse, guard and safety, fire station, change house, personnel building, shipping office and
platform, research laboratory, control laboratory
Maintenance shops _ electric, piping, sheet metal, machine, welding, carpentry, instrument
Building services_ plumbing, ventilation, heating, duct collection, air conditioning, building lighting,
elevators, telephones, intercommunication systems, painting, sprinkler systems, fire alarm.
g. Yard Improvements (20-45% EC)

Site development_ site clearing, grading roads, walkways, railroads, fences, parking areas, wharves,
piers, recreational facilities, landscaping
h. Service facilities (20-45% EC)

Utilities_ steam, power, refrigeration, compressed air, fuel, waste disposal
Facilities_ boiler plant incinerator, wells, river intake, water treatment, cooling towers, water storage,
electric sub-station, refrigeration plant, air plant, fuel storage, waste disposal plant, fire protection
Non-process equipment_ office furniture and equipment, cafeteria equipment, safety and medical
equipment, shop equipment, yard material-handling equipment, laboratory equipment, locker-room
equipment, garage equipment, shelves, bins, pallets, hand trucks, housekeeping equipment, fire
extinguishers, hoses, fire engines, loading stations
Distribution and packaging_ raw material and product storage and handling equipment, product
packaging equipment, blending facilities, loading stations
i. Land (1-2% FCI or 4-8% EC)

Surveys and fees, Property cost
a
Source: Plant Design and Economics for Chemical Engineers, 4 th ed, Peters and Timmerhaus
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2. Indirect Costs (15-30% Direct Cost)
1. Engineering and supervision (5-15% DC)

Engineering costs_ administrative, process, design and general engineering, drafting, cost engineering,
procuring, expediting, reproduction, communications, scale models, consultant fees, travel,
Engineering supervision and inspection
2. Construction expenses (7-20% DC)

Construction, operation and maintenance of temporary facilities, offices, roads, parking lots, rail roads,
electrical piping, communications, fencing, Construction tools equipment, Construction supervision,
accounting, time keeping, purchasing, expediting, Warehouse personnel and expense, guards, Safety,
medical, fringe benefits, Permits, field tests, special licenses, Taxes, insurance, interests
3. Contractor’s fee (1.5-5% FCI)
4. Contingency (6-18% FCI)
B. Working capital (10-20% of total capital investment)
C. Total capital investment = fixed-capital investment + working capital
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N.6. OPERATIONAL COSTS

N.6.1. Introduction
Profits and earnings of the company are determined by the difference between what the customers pay for
the company’s product and what it costs the company to manufacture, package, store, and sell it to the customer. For
purpose of simplification all the costs will be considered to fall into either fixed costs or variable costs. The annual
costs that vary more or less with the annual production will be called VARIABLE COSTS, while annual costs
that remain constant regardless of the production rate will be called FIXED COSTS.
Please take note that variable costs refer to the plant costs that vary with the amount of production but they are
constant for each unit of production. Conversely, fixed costs per unit of production vary with production.
N.6.2. Typical distribution of product costs a:

A. Variable Costs (60% - 70%)
1. Raw materials used in the making of product
2. Direct Labor (operators, helpers), add 15% for social security, pensions, vacation)
3. Utilities or process services (steam, power, water, fuel, air, refrigeration)
4. Maintenance (labor and materials), about 4%-6% of fixed capital investment
5. Miscellaneous supplies and others, about 0.5% of FCI
6. Direct supervision (foremen), about 10% of direct labor
7. Laboratory charges (process control)
8. Royalty (charges for using some other company’s name or process)
9. Packaging and storage charges
10. Credit for by-products
11. Spoilage and other losses
(Items 9 to 11 can be estimated at 5% of total of raw materials plus labor plus services.)
B. Fixed Costs (40% - 30%)

1. Indirect plant costs, or plant burden 15%
a. Investment costs, 5%
i. Depreciation, 10% of fixed capital investment
ii. Taxes, 2% of FCI
iii. Insurance, 1% of FCI
iv. Interest on inventories, plant equipment, total capital when desired
v. Others (assessments)
b. Overhead, 10%
i. Technical (engineering)
ii. Non-technical (office force, plant protection, etc)
iii. Supplies (those that are not chargeable to direct costs)
iv. Rent (included where equipment, buildings, land, or a service is rented)
v. Others
2. Management expense, 5%
a. Executives
b. Legal
c. Research, (technical research and market research)
3. Selling expense, or distribution expense, 10% - 20%
a
Source: Plant Design and Economics for Chemical Engineers, 4th ed, Peters and Timmerhaus
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N.6.3. Detailed Distribution of Total Product Costs

(Classified into the general categories of manufacturing and general expenses)
A. Manufacturing costs
1. Direct production Costs
a. Raw materials
b. Operating labor
c. Operating supervision
d. Power and utilities
i. Steam
ii. Electricity
iii. Fuel
iv. Refrigeration
v. Water
e. Maintenance and repairs
f. Operating supplies
g. Laboratory charges
h. Royalties (if not on lump-sum basis)
i. Catalysts and solvents
2. Fixed Charges
a. Depreciation
b. Taxes (property)
c. Insurance
d. Rent
3. Plant Overhead Costs
a. Medical
b. Safety and protection
c. General plant overhead
d. Payroll overhead
i. Packaging
i. Restaurant
ii. Recreation
iii. Salvage
iv. Control laboratories
v. Plant superintendence
vi. Storage facilities
B. General expenses
1. Administrative expenses
a. Executive salaries
b. Clerical wages
c. Engineering and legal costs
d. Office maintenance
e. Communications
2. Distribution and marketing Expenses
a. Sales offices
b. Salesmen expense
c. Shipping
d. Advertising
e. Technical sales service
3. Research and development
4. Financing
5. Gross earnings expense
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N.6.4. Whole-Life Costs

_ refers to the total cost of ownership over the life of an asset. Also commonly referred to as "cradle to
grave" or "womb to tomb" costs. Typical areas of expenditure which are included in calculating the whole-life
cost are:
 Planning
 Design
 Construction/acquisition
 Operations
 Maintenance
 Renewal/rehabilitation
 Financial (e.g. depreciation and cost of finance)
 Replacement or disposal
Overview
Whole-life cost is most commonly used for:
 option evaluation when procuring new assets,
 decision-making to minimize whole-life costs throughout the life of an asset,
 comparison of actual costs for similar asset types,
 as feedback into future design and acquisition decisions.
The primary benefit of whole-life costing is that costs which occur after an asset has been constructed or acquired,
such as maintenance, operation, disposal, become an important consideration in decision-making. Previously, the
focus has been on the up-front capital costs of creation or acquisition, and organizations may have failed to take
account of the longer-term costs of an asset.
 It allows an analysis of business function interrelationships. Low development costs may lead to high
maintenance or customer service costs in the future.
Whole-life cost topics

Project Appraisal
Whole-life costing is a key component in the economic appraisal associated with evaluating asset acquisition
proposals. An economic appraisal is generally a broader based assessment, considering benefits and indirect or
intangible costs as well as direct costs.
In this way, the whole-life costs and benefits of each option are considered and usually converted using
discount rates into present-value costs and benefits. This results in a benefit cost ratio for each option, usually
compared to the "do-nothing" counterfactual. Typically the highest benefit-cost ratio option is chosen as the
preferred option.
Historically, asset investments have been based on expedient design and lowest cost construction. If such
investment has been made without proper analysis of the standard of service required and the maintenance and
intervention options available, the initial saving may result in increased expenditure throughout the asset's life.
By using whole-life costs, this avoids issues with decisions being made based on the short-term costs of design
and construction. Often the longer-term maintenance and operation costs can be a significant proportion of the
whole-life cost.
Asset Management
During the life of the asset, decisions about how to maintain and operate the asset need to be taken in context with
the effect these activities might have on the residual life of the asset. If by investing 10% more per annum in
maintenance costs the asset life can be doubled, this might be a worthwhile investment.
Other issues which influence the lifecycle costs of an asset include:

 site conditions,
 historic performance of assets or materials,
 effective monitoring techniques,
 appropriate intervention strategies.
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Although the general approach to determining whole-life costs is common to most types of asset, each asset will
have specific issues to be considered and the detail of the assessment needs to be tailored to the importance and value
of the asset. High cost assets (and asset systems) will likely have more detail, as will critical assets and asset systems.
Maintenance expenditure can account for many times the initial cost of the asset. Although an asset may be
constructed with a design life of 30 years, in reality it will possibly perform well beyond this design life. For assets
like these a balanced view between maintenance strategies and renewal/rehabilitation is required. The appropriateness
of the maintenance strategy must be questioned, the point of intervention for renewal must be challenged. The process
requires proactive assessment which must be based on the performance expected of the asset, the consequences and
probabilities of failures occurring, and the level of expenditure in maintenance to keep the service available and to
avert disaster.
IT industry usage
Whole-life cost is often referred to as "total cost of ownership (TCO)" when applied to IT hardware and
software acquisitions. Use of the term "TCO" appears to have been popularized by Gartner Group in 1987 but its roots
are considerably older, dating at least to the first quarter of the twentieth century.
It has since been developed as a concept with a number of different methodologies and software tools. A
TCO assessment ideally offers a final statement reflecting not only the cost of purchase but all aspects in the further
use and maintenance of the equipment, device, or system considered. This includes the costs of training support
personnel and the users of the system, costs associated with failure or outage (planned and unplanned), diminished
performance incidents (i.e. if users are kept waiting), costs of security breaches (in loss of reputation and recovery
costs), costs of disaster preparedness and recovery, floor space, electricity, development expenses, testing
infrastructure and expenses, quality assurance, boot image control, marginal incremental growth, decommissioning,
e-waste handling, and more. When incorporated in any financial benefit analysis (e.g., ROI, IRR) TCO provides a
cost basis for determining the economic value of that investment.
Total cost of ownership is also common in the automobile industry. In this context, the TCO denotes the cost
of owning a vehicle from the purchase, through its maintenance, and finally its sale as a used car. Comparative TCO
studies between various models help consumers choose a car to fit their needs and budget.
TCO can and often does vary dramatically against TCA (total cost of acquisition), although TCO is far more
relevant in determining the viability of any capital investment, especially with modern credit markets and financing.
TCO also directly relates to a business's total costs across all projects and processes and, thus, its profitability. Some
instances of "TCO" appear to refer to "total cost of operation", but this may be a subset of the total cost of ownership
if it excludes maintenance and support costs.
Understanding and familiarity with the term TCO has been somewhat facilitated as a result of various
comparisons between the TCO of open source and proprietary software. Because the software cost of open source
software is often zero, TCO has been used as a means to justify the up-front licensing costs of proprietary software.
Studies which attempt to establish the TCO and provide comparisons have as a result been the subject of many
discussions regarding the accuracy or perceived bias in the comparison.
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N.7 Accounting Fundamentals

N.7.1 Introduction
Accounting is often referred to as the language of business. Engineers make serious efforts to learn about a
firm’s accounting practice so that they can better communicate with top management. This section contains a
brief and simplified exposition of the elements of financial accounting inn recording and summarizing
transactions affecting the finances of the enterprise.
All accounting is based on the fundamental accounting equation, which is ;
Assets = liabilities + owner’s equity
Where assets are those things of monetary value that the firm possesses, liabilities are those things of monetary
value that the firm owes, and owner’s equity is the worth of what the firm owes to the stockholders (also referred
to as equities, net worth, etc.)
Basic Engineering Accounting Terms:

1. Revenue = total income (or total savings)
2. Net profits = Gross Profits - income tax
3. Gross profits = Net sales – Costs of Sales
4. Income tax = (Gross Profits) ( tax rate)
5. Cash flow = Net Profits + Depreciation
SHARE
The stock of a corporation is partitioned into shares, the total of which are stated at the time of business formation. Additional
shares may subsequently be authorized by the existing shareholders and issued by the company. In some jurisdictions, each
share of stock has a certain declared par value, which is a nominal accounting value used to represent the equity on the
balance sheet of the corporation. In other jurisdictions, however, shares of stock may be issued without associated par value.
Shares represent a fraction of ownership in a business. A business may declare different types (classes) of shares, each
having distinctive ownership rules, privileges, or share values. Ownership of shares may be documented by issuance of a
stock certificate. A stock certificate is a legal document that specifies the amount of shares owned by the shareholder, and
other specifics of the shares, such as the par value, if any, or the class of the shares.
Capital stock
_or stock of an incorporated business constitutes the equity stake of its owners. It represents the residual assets
of the company that would be due to stockholders after discharge of all senior claims such as secured and unsecured debt.
Stockholders' equity cannot be withdrawn from the company in a way that is intended to be detrimental to the company's
creditors.
Stock typically takes the form of shares of either common stock or preferred stock.
 Common stock typically carries voting rights that can be exercised in corporate decisions, As a unit of ownership,.
 Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to
receive a certain level of dividend payments before any dividends can be issued to other shareholders.
Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed
number of common shares, usually any time after a predetermined date.
Stock Derivative
A stock derivative is any financial instrument which has a value that is dependent on the price of the underlying stock.
Futures and options are the main types of derivatives on stocks. The underlying security may be a stock index or an
individual firm's stock, e.g. single-stock futures.
Stock futures are contracts where the buyer is long, i.e., takes on the obligation to buy on the contract maturity date,
and the seller is short, i.e., takes on the obligation to sell. Stock index futures are generally not delivered in the usual
manner, but by cash settlement.
Stock Option
A stock option is a class of option. Specifically, a call option is the right (not obligation) to buy stock in the future at a
fixed price and a put option is the right (not obligation) to sell stock in the future at a fixed price. Thus, the value of a stock
option changes in reaction to the underlying stock of which it is a derivative. The most popular method of valuing stock
options is the Black Scholes model. Apart from call options granted to employees, most stock options are transferable.
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Share Holders
_shareholder (or stockholder) is an individual or company (including a corporation) that legally owns one or more
shares of stock in a joint stock company. Both private and public traded companies have shareholders. Companies listed at
the stock market are expected to strive to enhance shareholder value.
Shareholders are granted special privileges depending on the class of stock, including the right to vote on matters such
as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new
shares issued by the company, and the right to a company's assets during a liquidation of the company. However,
shareholder's rights to a company's assets are subordinate to the rights of the company's creditors.
Shareholders are considered by some to be a partial subset of stakeholders, which may include anyone who has a direct or
indirect equity interest in the business entity or someone with even a non-pecuniary interest in a non-profit organization. Thus
it might be common to call volunteer contributors to an association stakeholders, even though they are not shareholders.
Typical accounts:
Assets = Liabilities + Owner’s equity
Cash Short-term debt
Receivables Payables Capital stock
Inventories Long-term debt
Equipment Retained earnings (income retained in the firm)
Buildings
Land
These following financial statements are basic requirements for project feasibility presentation:
N.7.2 Income Statement

The income statement is a computation of the project’s total revenue and total costs for one period of fiscal year, thereby
arriving at the concern’s net income or deficit within the period, together with its performance in terms of profitability and cost
control. It differs from the “cash budget” in the sense that it follows the “actual concept” in accounting, by which revenues
should be associated with the costs involved in realizing the former within the period of occurrence. A model format for income
statement preparation is presented. An analysis of each account in the presentation follows:
Profit (loss) = revenues – expenses

Gross Profit = net Sales – cost of Sales
a. Production of units _ is a function of sales forecasts and inventory policy, the latter serving as a “buffer” to meet customer
convenience in the face of fluctuations in sales. As a consequence, three forms of inventory levels should be specified in
the study – the moving inventory, the minimum inventory, and the maximum inventory levels.
Moving inventories refer to the amount, which moves from one production process to the next. It is arrived at by
the Formula I  S T  , where I is the moving inventory, S the rate of movement from one state to the next per period of
time, and T the transit time. This formula is usually applied in the determination of ending raw materials and goods-in-
process inventories.
b. Net sales_ in pesos are arrived at by subtracting sales returns, allowances, and discounts from gross sales. Sales returns
represent goods sold which could not meet customer requirements and thus have been returned. Allowance refer to goods
which cannot be sold due to spoilage, wrong specification, and similar cause; sales discount are price reduction
occasionally given in favor of customer. The latter items are to be considered as different from sales discount favoring
the project, which are entered in the ”other income” account of the statement.
c. Cost of sales_ is a function of raw materials used, direct labor expenses, and factory overhead accounts. The latter are
itemized as follows: materials and labor expenses indirectly related with production; heat, light, and power required for
manufacturing; maintenance costs associated with productive fixed assets supplies needed to produce fixed assets; taxes
associated with the manufacturing fixed assets; and insurance expenses related to the productive operation.
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Pro-forma Income Statements

Years ending: 31 December
1st year 2nd year 3rd year
Production (in Units) 308,000 300,000 300,000

Add: Inventory, beginning (8,000) (8,000)
Units available for sale 308,000 308,000 308,000
Less: Inventory investments (8,000) (8,000) (8,000)
Sales, gross 300,000 300,000 300,000
Sales, gross (in P) 750,000 789,000 828,000
Less: sales returns and allowances (60,000) (63,120) (66,240)
sales discounts (15,000) (15,780) (16,560)
Sales, net 675,000 710,100 745,200
Cost of sales:
Raw materials:
Purchases 57,500 56,160 58,890
Add: freight in 420 441 463
Total purchases 57,920 56,601 59,353
Add:inventory beginning 5,000 6,000
Cost of raw materials available for use 57,920 61,601 65,353
Less: Inventory, ending (5,000) (6,000) (7,000)
Cost of raw materials 52,920 55,601 58,353
Add: direct labor 17,280 18,144 19,051
Overhead:
Indirect materials 113,009 118,659 124,632
Indirect labor 13,200 13,860 14,553
Heat, light and power 50,640 25,162 26,764
Maintenance 7,126 7,126 7,126
Supplies 10,499 11,010 11,471
Depreciation 43,010 43,010 43,010
Taxes 2,600 2,600 2,600
Insurance, etc. 4,751 3,819 2,887
Manufacturing costs 315,035 298,991 310,447
Add: Goods-in process inventory, begnng 9,000 10,000
Less:Goods- inprocess inventory, ending (9,000) (10,000) (11,000)
Costs of goods available for sale 306,035 297,991 309,447
Add: finished-goods inventory, beginning 20,000 21,000

Costs of goods available for sale 306,035 317,991 330,447
Less: finished-goods inventory, ending (20,000) (21,000) (22,000)
Costs of sales 286,035 296,991 308,447
Gross profit 388,965 413,109 436,753
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Gross profit 388,965 413,109 436,753

Operating expenses: 1st year 2nd year 3rd year
General and administrative salaries:
General and administrative salaries 36,480 38,304 40,220
Fringe benefits 6,511 6,794 7,051
Research and development 180 189 198
Engineering costs 36,387
Depreciation 3,600 3,600 3,600
Taxes
Insurance
Office supplies 5,520 6,012 6,550
Heat, light and power 114 120 126
Telephone 768 806 846
Water supply
Miscellaneous: Amortization 700 700 700
Total 90,260 56,525 59,291
Selling expenses:
Salaries 7,439 7,794 8,168
Storage of goods 16,620 17,451 18,324
Billing
Transportation
Public relations
Advertisment, sales taxes 43,188 45,435 47,681
Miscellaneous: bad debts 13,500 14,202 14,904
Total 80,747 84,882 89,077
Operating expenses 171,007 141,407 148,368
Operating profit 217,958 271,702 288,385
Financial expenses (net of other income):

Interest 28,506 27,714 24,546
Borrowing costs
Total 28,506 27,714 24,546
Profit before income tax 189,452 243,988 263,839
Provision for income tax (56,308) (75,396) (82,344)
Net income (net lost) 133,144 168,592 181,495
Add: Retained earnings, beginning 35,106 105,660
Less: Cash dividends, declared (98,038) (98,038) (98,038)

Retainend earnings, ending 35,106 105,660 189,117
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N.7.3 Cash-Flow Statement

The cash-flow statement or the” cash budget” is a systematic presentation of cash receipts and disbursements for a given
operating period or fiscal year, taking for granted the” accrual concept “ in account illustrates a cash budget model ,
showing the inflow and presenting a large-scale schedule for the determination of ending cash balance sheet. The budget
is used to estimate future loans or financing needs, optimize the timing of project financing, and maximize profitability
by efficient cash utilization.
a. Cash receipts are subdivided into those which flow from financing the project and those coming from sales revenues.
Cash flow from financing may take the form of stocks issued including stock premium or discount being closed, the
net of the latter two accounts being closed to the “paid-in surplus” account; bond issues: and long-terms loans.
In computing for cash in-flows from sales revenues; the “profit – before-income tax” account is entered in the
budget, and this is increased to the period such as depreciation and amortization.
Other account which increase the entries are increases in account payable, accrued expenses, and deferred income.
b. Under cash disbursement, out-of-pocket expenses on intangible assets acquisition are entered. Other account
included here are decreases in account payable, notes payable, bank-drafts payable, accrued expenses, mortgage
bonds payable and long-terms notes receivable, inventories, and investment. Cash dividends issued and income tax
payments also comprise cash disbursements.
The beginning cash balance for the period is then added to the net cash flow to arrive at ending cash balance
in the balance sheet. It should be noted that all accounts entered in the cash budget should tally with the same account
in the income statement and balance sheet.
Pro-formal cash-flow statements

Years ending 31 December
(in pesos)
CASH RECEIPTS: 1st year 2nd year 3rd year
Common stocks issued 400,000
Preffered stocks issued 90,192
Paid-in surplus
Mortgage bonds payable-increases 11,151
Long-term notes payable-increases 200,000
Total receipts from financing 701,343
Profit before income tax 189,452 243,988 263,839
Add: Depreciation of fixed assest 46,610 46,610 46,610
Amortization of pre-paid expenses
Amortization of deferred charges
Amortization of intangible assets 700 700 700
Other non-out-of-pocket expenses
Accounts payable 6,394
Notes payable-increases 20,000
Bank drafts payable-increases
Accrued expenses-increases
Deferred income-increases
Total inflow from production,
operations and financial accounts 263,156 291,298 311,149
TOTAL ASSUMED CASH RECEIPTS 964,499 291,298 311,149
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TOTAL ASSUMED CASH RECEIPTS 964,499 291,298 311,149
CASH DISBURSEMENTS: 1st year 2nd year 3rd year

Expenses on intangible assets (Out of Pocket)
Good will
Patents 500
Copyrights
Leases
Licenses 500
Franchises 500
Organization and pre-operating expenses 2,000
Acquisitions of fixed assets (out-of-pocket):
Land 200,000
Buildings 60,000
Equipment 77,545
Machinery 100,000
Accounts payable-decreases
Notes payable-decreases
Bank drafts payable-decreases
Accrued expenses-decreases
Treasury stocks-increases
Mortgage bonds payable-decreases 1,394 1,394
Long-term notes payable-decreases 25,000 25,000
Cash dividends issued 98,038 98,038
Marketable securities-increases 85,507 78,196 89,297
Accounts receivable-increases 317,520 16,511 16,511
Notes receivable-increases
Inventories-increases:
Raw materials 5,000 1,000 1,000
Supplies 2,000 1,000 1,000
Goods in process 9,000 1,000 1,000
Finished goods 20,000 1,000 1,000
Income tax payments 56,308 75,396
Investment-increases (pre-paid and deferred charges) 2,000 2,000 2,000
TOTAL CASH DISBURSEMENTS 882,072 281,447 311,636
NET CASH FLOW (Net cash deficit) = receipts - disbursements 82,427 9,851 (487)
Add: balance, beginning 82,427 92,278
CASH BALANCE, ENDING 82,427 92,278 91,791
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N.7.4 Balance Sheet

The balance sheet shows the assets derived by the project from corresponding liabilities and equities (net
worth).It is an overall picture of a film’s financial condition as of a certain time. Furthermore, it shows the major changes
brought about by the project’s operation within the fiscal period. The assets are entered under the debit portion of the balance
sheet while the liability and equity claims on these assets are found under the credit portion. Exhibit F-3 present a model balance
sheet.
Comprising the asset portion of the statement are current asset, fixed asset, and intangible assets.
Current assets refer to those type with are either cash account or other account expected to be converted into cash
with one year. The item listed in this division are of course cash, marketable securities, receivables, inventories, prepaid
expense, and deferred change. The latter two accounts signify cash expenditures for the services of a creditor not yet received
in full by the project in question, such as prepaid insurance.
On the other hand, fixed assets era the tangible assets of an enterprise of an enterprise, the service life of which
usually extends to over one year. Land, building, machinery, and equipment are typical example of fixed assets. The balance
sheets or book value of these assets are derived by subtracting their accumulated depreciation from their cost of acquisition,
depreciation being the portion of cost allocated to one fiscal period.
Finally, other assets mean intangible assets whose service life, like fixed will, patents, copyrights, leases, licenses,
franchises, and organization and pre-operation expenses fall under other assets. When an intangible asset is amortized, the
accumulated amortization account is not entered in the balance sheet, which contains only the net book value of assets in this
category.
Assets = liabilities + (beginning owner’s equity + revenue - expenses)
(in pesos)
ASSETS: 1st year 2nd year 3rd year

Current assets
Cash 82,427 92,278 91,791
Marketable securities 85,507 163,703 253,000
Account receivable, net 317,520 334,031 350,542
Notes receivable
Inventories
Raw materials 5,000 6,000 7,000
Supplies 2,000 3,000 4,000
Goods-in-process 9,000 10,000 11,000
Finished goods 20,000 21,000 22,000
Pre- paid expenses 1,000 2,000 3,000
Deferred charges 1,000 2,000 3,000
Tota current assets 523,454 634,012 745,333
Fixed assets:
Land 200,000 200,000 200,000
Building 60,000 60,000 60,000
Equipment 77,545 77,545 77,545
Machinery 100,000 100,000 100,000
Total fixed assets, 437,545 437,545 437,545
Less:accumulated depreciation (46,610) (93,220) (139,830)
Total fixed assets, net 390,935 344,325 297,715
4/29/2021 N - 72 of 138 nilo t. aldon

1st year 2nd year 3rd year

Other assets:
Investments
Intangible assets, net of amortization:
Goodwill
Patents 400 300 200
Copyrights
Lease
Licenses 400 300 200
Franchises 400 300 200
Organization and pre-operating expenses 1,600 1,200 800
Total other assets 2,800 2,100 1,400
TOTAL ASSETS (current, fixed, other) 917,189 980,437 1,044,448
LIABILITIES AND EQUITY:

Current liabilities
Accounts payable 6,394 6,394 6,394
Notes payable 20,000 20,000 20,000
Bank-drafts payable
Estimated tax liability 56,308 75,396 82,344
Accrued expenses:
Dividends payable 98,038 98,038 98,038
Deferred income
Total current liabilities 180,740 199,828 206,776
Other liabilities:
Mortgage bonds payable 11,151 9,757 8,363
Long-term notes payable 200,000 175,000 150,000
Total other liabilities 211,151 184,757 158,363
TOTAL LIABILITIES 391,891 384,585 365,139
OWNER'S EQUITY:
Common stocks 400,000 400,000 400,000
Preferred stocks 90,192 90,192 90,192
Less: treasury stocks
Paid-in surplus
Retained earnings 35,106 105,660 189,117
TOTAL EQUITIES 525,298 595,852 679,309
TOTAL LIABILITIES AND EQUITY 917,189 980,437 1,044,448
4/29/2021 N - 73 of 138 nilo t. aldon

Accounting Principles:
1. Generally Accepted Accounting Principles (GAAP)

GAAP is a codification of how CPA firms and corporations prepare and present their business income and
expense, assets and liabilities on their financial statements. GAAP is not a single accounting rule, but rather the
aggregate of many rules on how to account for various transactions. The basic principles underlying GAAP
accounting are set forth below.
The Basic (GAAP) Principles

 Principle of regularity: Regularity can be defined as conformity to enforced rules and laws.
 Principle of consistency: This principle states that when a business has once fixed a method for the
accounting treatment of an item, it will enter all similar items that follow in exactly the same way.
 Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the
reality of the company's financial status.
 Principle of the permanence of methods: This principle aims at allowing the coherence and comparison
of the financial information published by the company.
 Principle of non-compensation: One should show the full details of the financial information and not seek
to compensate a debt with an asset, revenue with an expense, etc.
 Principle of prudence: This principle aims at showing the reality "as is": one should not try to make things
look prettier than they are. Typically, revenue should be recorded only when it is certain and a provision
should be entered for an expense which is probable.
 Principle of continuity: When stating financial information, one should assume that the business will not
be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at
their disposable value, but it is accepted that they are at their historical value
 Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly
if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be
split to the entire time-span and not counted for entirely on the date of the transaction.
 Principle of Full Disclosure/Materiality: All information and values pertaining to the financial position of
a business must be disclosed in the records.
 Principle of Utmost Good Faith: All the information regarding to the firm should be disclosed to the
insurer before the insurance policy is taken
2. Accrual accounting _is considered to be the standard accounting practice for most companies, with the
exception of very small operations. This method provides a more accurate picture of the company's current
condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash
accounting, which recognizes transactions only when there is an exchange of cash.
The need for this method arose out of the increasing complexity of business transactions and a desire for
more accurate financial information. Selling on credit and projects that provide revenue streams over a long
period of time affect the company's financial condition at the point of the transaction. Therefore, it makes
sense that such events should also be reflected on the financial statements during the same reporting period
that these transactions occur.
For example, when a company sells a TV to a customer who uses a credit card, cash and accrual
methods will view the event differently. The revenue generated by the sale of the TV will only be
recognized by the cash method when the money is received by the company. If the TV is purchased on
credit, this revenue might not be recognized until next month or next year.
Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain,
that the company will receive the cash at some point in the future because the sale has been made.
Therefore, the accrual accounting method instead recognizes the TV sale at the point at which the customer
takes ownership of the TV. Even though cash isn't yet in the bank, the sale is booked to an account known
in accounting lingo as "accounts receivable," increasing the seller's revenue
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N.8. BASIC METHODS OF PROFITABILITY ANALYSIS

N.8.1. Return on Investment, ROI
Profit or savings (before income tax) divided by investment required.
Whereas, interest refers to the compensation paid for the use of capital, which is usually fixed, ROI
refers to the profit obtained through the use of capital.
Profit cannot be guaranteed, unlike interest on money which must be paid to the owner of the capital
whether the business succeeds or fails.
The methods for determining rate of return, give “point values”, which are either applicable for one
particular year or for some sort of “average” year. They do not consider the time value of money,
and they do not account for the fact that profits and costs may vary significantly over the life of the
project.
Profit x 100% (N – 91)

ROI 
Investment
Incremental Profit x 100% (N – 92)

ROI 
Incremental Investment
Minimum Acceptable Rate of Return (MARR)

Also known as Minimum Attractive Rate of Return or known as hurdle rate, the interest rate used in
the valuation of profitability of a project in Present Worth, Future Worth and Annual Worth Methods. It is
usually a policy issue by the top management of an organization in view of the following considerations:
1. The amount of money available for investment,
2. Number of good projects available for investment,
3. The amount of perceived risk associated with investment opportunities available and
4. Type of organization involved.
In business and engineering, the minimum acceptable rate of return, often abbreviated MARR, or
hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting
a project, given its risk and the opportunity cost of forgoing other projects.
For example, suppose a manager knows that investing in a conservative project, such as a bond investment
or another project with no risk, yields a known rate of return. When analyzing a new project, the manager may
use the conservative project's rate of return as the MARR. The manager will only implement the new project if
its anticipated return exceeds the MARR by at least the risk premium of the new project.
The hurdle rate is usually determined by evaluating existing opportunities in operations expansion, rate
of return for investments, and other factors deemed relevant by management. A risk premium can also be
attached to the hurdle rate if management feels that specific opportunities inherently contain more risk than
others that could be pursued with the same resources. A common method for evaluating a hurdle rate is to apply
the discounted cash flow method to the project, which is used in net present value models. The hurdle rate
determines how rapidly the value of the dollar decreases out in time, which, parenthetically, is a significant factor
in determining the payback period for the capital project when discounting forecast savings and spending back
to present-day terms. Most companies use a 12% hurdle rate, which is based on the fact that the S&P 500
typically yields returns somewhere between 8% and 11% (annualized). Companies operating in industries with
more volatile markets might use a slightly higher rate in order to offset risk and attract investors.
The hurdle rate is frequently used as synonym of cutoff rate, benchmark and cost of capital.
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Project Analysis
When a project has been proposed, it must first go through a preliminary analysis in order to determine
whether or not it has a positive net present value using the MARR as the discount rate. The MARR is the target rate
for evaluation of the project investment. This is accomplished by creating a cash flow diagram for the project, and
moving all of the transactions on that diagram to the same point, using the MARR as the interest rate. If the resulting
value at that point is zero or higher, then the project will move on to the next stage of analysis. Otherwise, it is
discarded. The MARR generally increases with increased risk.
Example:
1. Given:
Investment Total Investment Net profit
1 P 100,000 P 23,000
2 P 150,000 P 28,000
3 P 180,000 P 37,000
Required: Select the best alternative if minimum acceptable return on investment required is 10%
Solution:
ROI based on initial total investment:
ROI1 
 23, 000  100  23%  10%, ok
100, 000
28, 000
ROI 2  100  18.67%  10%, ok
150, 000
37, 000
ROI 3  100  19.05%  10%, ok
180, 000
ROI based on incremental investment:

Comparing 1 and 2 (Additional investment of P50,000 will yield additional net profit of P5,000)
ROI12 
 28, 000  23, 000  100  10%, ok
150, 000  100, 000 
Comparing 2 and 3 (Additional investment of P30,000 will yield additional net profit of P9,000)
ROI 23 
 37, 000  28, 000  100  30%  10%, ok
180, 000  150, 000 
Therefore, select Investment 3.
2. A company is considering two types of equipment for its new plant. The following data are given:
Equipment A Equipment B
First Cost P 2.0 M P 3.0 M
Annual Operating Cost/yr P 350,000 P 250,000
Annual Labor Cost/yr P 500,000 P 350,000
Insurance and Taxes/yr 3.5% of First Cost 3.5% of First Cost
Other Cost/yr 8% of first Cost 8% of First Cost
Salvage Value P200,000 P300,000
Estimated life 10 years 10 years
If the minimum return on investment is 15%, which equipment should be selected using
a. Annual Cost Method?
b. ROI
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Solution:
a. Annual Cost Method
Annual Costs Equipment A, Pesos Equipment B, Pesos
Depreciation Cost (Sinking fund) 88,654 132,981
Annual Operating Cost 350,000 250,000
Annual Labor Cost 500,000 350,000
Insurance and Taxes,3.5% FC 70,000 105,000
Other Cost, 8% FC 160,000 240,000
Return on Investment,15% FC 300,000 450,000
Total Annual Costs 1,468,654 1,527,981
Since total annual cost of equipment A is less than equipment B, therefore chose A
b. ROI Method (Minimum ROI required is 15%) :

Annual Costs Equipment A, Pesos Equipment B, Pesos
Depreciation Cost (Sinking fund) 88,654 132,981
Insurance and Taxes,3.5% FC 70,000 105,000
Other Cost, 8% FC 160,000 240,000
Total Annual Costs 1,168,654 1,077,981
Savings Annual Cost A  Annual Cost B
ROI on Addtional Investment  
Additional Investment First Cost A  First Cost B
 1,168,654  1,077,981 
ROI on Additional Investment   100  9.07%  15% thereforechose A
 3,000,000  2,000,000 
N.7.2. Annual Cost Method

The annual cost of the alternatives including the minimum return on investment is
determined. The alternative with the least annual cost is chosen. This method, like the rate of return
on investment method, applies only to alternatives which have a uniform cost data for each year and
a single investment of capital at the beginning of the project life.
Typical Cost Factors:
a. Depreciation Cost (usually as sinking fund)
b. Annual Operating Cost
c. Annual Labor Cost
d. Insurance and Taxes
e. Other Cost
f. Return on Investment or Cost of Money
Total Annual Costs
FC1  i   SV
L
NOTE: a  f  capital re cov ery  CR 
1  i L  1
i
4/29/2021 N - 77 of 138 nilo t. aldon

N.8.3. Discounted Cash Flow, (Internal Rate of Return)

The method of approach for discounted cash flow takes into account the time value of money and is based
on the amount of the investment that is unreturned at the end of each year during the estimated life of the equipment.
A trial-and-error method is used to establish a rate of return which can be applied to yearly cash flow so
that the original investment is reduced to zero (or to salvage and land value plus working capital investment) during
the project life.
Thus, the rate of return by this method is equivalent to the maximum interest rate (normally after taxes) at
which money could be borrowed to finance the project over its life would just be sufficient to pay all principal and
interest accumulated on the outstanding principal.
The discount rate reflects two things:

1. The time value of money - investors would rather have cash immediately than having to wait and must therefore
be compensated by paying for the delay.
2. A risk premium - reflects the extra return investors demand because they want to be compensated for the risk that
the cash flow might not materialize after all.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial
management.
CF1 CF2 CFn (N – 93)

Total Capital Investment    ... 
1  i  1  i 
1 2
1  i n
Internal Rate of Return (IRR)

Internal Rate of Return is the most widely used rate of return method for performing engineering economic
analyses. It is sometimes called by several names, such as the investor’s method, the discounted cash flow method,
and the profitability index. Also means that the value of this measure depends only on the cash flows from an
investment and not on any assumptions about reinvestment rates.
The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability
of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR).
In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact
that its calculation does not incorporate environmental factors (e.g. the interest rate).
The internal rate of return is the rate of return promised by an investment project over its useful life. It is some time
referred to simply as yield on project. The internal rate of return is computed by finding the discount rate that equates
the present value of a project's cash out flow with the present value of its cash inflow In other words, the internal rate
of return is that discount rate that will cause the net present value of a project to be equal to zero.
Showing the position of the IRR on the graph of NPV(r) (r is labeled 'i' in the graph)
The internal rate of return on an investment or potential investment is the annualized effective compounded
return rate that can be earned on the invested capital.
4/29/2021 N - 78 of 138 nilo t. aldon

In more familiar terms, the IRR of an investment is the interest rate at which the costs of the investment lead
to the benefits of the investment. This means that all gains from the investment are inherent to the time value of money
and that the investment has a zero net present value at this interest rate.
Uses
Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an
investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an
investment.
An investment is considered acceptable if its internal rate of return is greater than an established minimum
acceptable rate of return. In a scenario where an investment is considered by a firm that has equity holders, this
minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of
alternative investments). This ensures that the investment is supported by equity holders since, in general, an
investment whose IRR exceeds its cost of capital adds value for the company (i.e. it is profitable).
Calculation
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from
the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal
rate of return.
Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of periods N, and
the net present value NPV, the internal rate of return is given by r in:
Note that the period is usually given in years, but the calculation may be made simpler if r is calculated using
the period in which the majority of the problem is defined (e.g. using months if most of the cash flows occur at
monthly intervals) and converted to a yearly period thereafter.
Note that any fixed time can be used in place of the present (e.g. the end of one interval of an annuity); the
value obtained is zero if and only if the NPV is zero.
In the case that the cash flows are random variables, such as in the case of a life annuity, the expected values
are put into the above formula.
Often, the value of r cannot be found analytically. In this case, numerical methods or graphical methods must
be used.
Example
If an investment may be given by the sequence of cash flows
A B C
1 year, n Cash Flow, Cn
2 0 -100
3 1 40
4 2 59
5 3 55
6 4 20
7
8 IRR 29%
9 =IRR(B2:B6) (Using Excel)
then the IRR r is given by
.
In this case, the answer is 29%.
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Problems using internal rate of return (IRR)

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only
to decide whether a single project is worth investing in.
NPV vs. discount rate comparison for two mutually exclusive projects. Project 'A' has a higher NPV (for
certain discount rates), even though its IRR (= x-axis intercept) is lower than for project 'B' (click to enlarge)
In cases where one project has a higher initial investment than a second mutually exclusive project, the first project
may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be
accepted over the second project (assuming no capital constraints).
IRR assumes consumption of positive cash flows during the project. If positive cash flows can be
reinvested back into the project, then a suitable reinvestment rate is required in order to calculate the reinvestment
cash flow and hence the IRR with cash flows reinvested.
When the calculated IRR is different from the true reinvestment rate for interim cash flows, the measure will
accurately reflect the annual equivalent return from the project. The company may have additional projects, with
equally attractive prospects, in which to invest the interim cash flows. This makes IRR a suitable (and popular) choice
for analyzing venture capital and other private equity investments, as these strategies usually require several cash
investments throughout the project, but only see one cash outflow at the end of the project (e.g. via IPO or M&A).
Since IRR does not consider cost of capital, it should not be used to compare projects of different duration.
Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a better indication of a project's
efficiency in contributing to the firm's discounted cash flow.
In the case of positive cash flows followed by negative ones (+ + - - -) the IRR may have multiple values. In
this case a discount rate may be used for the borrowing cash flow and the IRR calculated for the investment cash flow.
This applies for example when a customer makes a deposit before a specific machine is built.
In a series of cash flows like (-10, 21, -11), one initially invests money, so a high rate of return is best, but then receives
more than one possesses, so then one owes money, so now a low rate of return is best. In this case it is not even clear
whether a high or a low IRR is better. There may even be multiple IRRs for a single project, like in the example 0%
as well as 10%. Examples of this type of project are strip mines and nuclear power plants, where there is usually a
large cash outflow at the end of the project.
In general, the IRR can be calculated by solving a polynomial equation. Sturm's theorem can be used to
determine if that equation has a unique real solution. In general the IRR equation cannot be solved analytically but
only iteratively.
When a project has multiple IRRs it may be more convenient to compute the IRR of the project with the
benefits reinvested. Accordingly, MIRR is used, which has an assumed reinvestment rate, usually equal to the project's
cost of capital.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV.
Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return
than by dollars of NPV. However, NPV remains the "more accurate" reflection of value to the business. IRR, as a
measure of investment efficiency may give better insights in capital constrained situations. However, when
comparing mutually exclusive projects, NPV is the appropriate measure.
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Modified Internal Rate of Return: (MIRR)

Returns the internal rate of return for a series of periodic cash flows, considering both the cost of
investment and interest on reinvestment of cash. Also known as External Rate of Return.
Example:
1. Given:
Reinvestment rate,rR= 10% pa
Required: MIRR
Solution;
1001  i 4  401.13  591.12  551.11  20
i  19.68%
Using Excel:
n Cash Flow
0 -100
1 40
2 59
3 55
4 20
iF 8.00%
iR 10.00%
MIRR 19.68%
=MIRR (B2:B6,B8,B9)
2. Given:
Initial Fixed-Capital Investment = P100,000
Working capital Investment = P10,000
Service life = 5 years
Salvage value @ the end of service life = P10,000
YEAR CASH FLOW

0 P (110,000)
1 P 30,000
2 P 31,000
3 P 36,000
4 P 40,000
5 P 43,000
Required: Internal Rate of Return (IRR)
Solution:
30,000 31,000 36,000 40,000 43,000 10,000  10,000 By Trial-and-Error: i = 0.207 or 20.7%
110,000      
1  i 1 1  i 2 1  i 3 1  i 4 1  i 5 1  i 5
3. The Fly-by-Night finance company advertises a “bargain 6% plan” for financing the purchase of automobiles.
To the amount of the loan being financed, 6% is added for each year money is owed. This total is then divided
by the number of months over which the payments are to be made, and the result is the amount of the monthly
payments. For example if a person purchases a P1M automobile under this plan and makes an initial cash
payment of P250,000 the P750,000 balance is paid in 24 monthly payments.
What effective annual interest does the person actually pays?
Solution:
Total amount to be paid  750,000  0.062750,000  840,000
840,000
Monthly payments   35,000; effective interest rate :
24
35,000  1  i   1
24
750,000  24  
1  i   i 
By Trial-and-Error, i = 0.93%/month or 11.16% pa
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N.8.4. Pay-out Period, N

This method determines the number of years within which the invested capital can be recovered
out of the expected cash flow. It does not consider the possible earnings of the reinvested capital
during the pay-put period.
A. Without Interest
Depreciable Fixed Capital Investment (N – 94)

N
AverageCashFlow / yr
Fixed Capital Investment  SalvageValue (N – 95)

N
AverageNetProfit/yr  AverageDepreciation/yr
B. With Interest
Depreciable Fixed Capital Investment  Interest On Total Investment (N – 96)

N
Average CashFlow / yr
N

DFCI  TCI 1  i   1
n
 (N – 97)
AverageNetProfit/yr  AverageDepreciation/yr as annuity
Note: 1. Depreciable Fixed Capital Investment= Fixed Capital Investment- Salvage Value
2. TCI=Total capital Investment=Fixed Capital Investment +Working Capital
Example
A. Without Interest:
1. Given:
Total fixed Working Salvage Value Service Life, Net Profit
capital capital years
P 100,000 P 11,000 P 10,000 6 P21,000
Required: Pay-out Period, N, without interest
Solution:
Where:
100,000  10,000
Depreciable Fixed Capital Investment Ave Dep   15,000
N= 6
 Net Profit+ Depreciation avee
year
N
100,000  10,000  2.5 years
21,000 15,000
B. With Interest
2. Given:
Total fixed Working Salvage Value Service Life, Net Profit
capital capital years
P 100,000 P 11,000 P 10,000 6 P21,000
Required: Pay-out Period, N with interest, i =10% pa
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Solution:
DFCI  Interest on Capital Investment
N
Ave Cash Flow as annuity
Annual Depreciation as annuity:

 
d  FC  SV 
i

 1  i L
 1 
 0.10 
 100,000  10,000   11,664.66
 1.10  1
6
Pay-out Period:
100,000  10,000   100,000  11,000  1.10   1
6
N   5.4 years
21,000  11,664.66
3. Given:
Total Fixed Working Salvage Value Service Annual
Capital capital life, years Cash flow
P 100,000 P 11,000 P10,000 6 P 36,000
Cost of money = 12 pa.

Required: Pay-out Period, N, with interest
N
100,000  10,000  100,000  11,0001.126  1 
 5.48 years

36,000
N.8.5. Present Worth (Net Present Worth)

The difference between the present value of the annual cash flows (CF) and the total
initial investment (TCI). If the present worth of the net cash flow is equal to or greater than
zero, the project is justified economically.
CF1 CF2 CFn

NPW    ..   TCI (N – 98)
1  i  1  i 2
1  i n
1. Given:
Total Fixed Working capital Salvage Value Service life, Annual
Capital years Cash flow
P 100,000 P 11,000 P10,000 6 P 36,000
Cost of money = 12% pa.

Required:
a. Net Present Worth
Solution:
CF1 CF2 CFn
Net Pr esent Worth    ..   FC
  1  i 
1  i 2
1  i 
n
 1  0.12 6  1  11, 000  10, 000 

 36, 000    100, 000  11, 000   47, 650
  0.12 1  0.12   1  0.12 
6 6
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N.8.6. Future Worth Method, F

This method is comparable to the present worth method except that all cash inflows and
outflows are compounded forward to a reference point in time called the future. If the future
worth of the net cash flow is equal or greater than zero, the project is justified economically.
F  CF1 1  i   CF2 1  i   ..  CFn  TCI 1  i 

n 1 n2 n
(N – 99)
N.8.7. Capitalized Cost, K

The total amount of money that must be available initially to purchase the equipment and
simultaneously provide funds for interest accumulation to permit perpetual replacement of
the equipment.
In perpetuity, the amount required for replacement must be earned as compounded interest
over a given length of time. Let P be the amount of present principal or present worth which
can accumulate to an amount F during the interest periods at periodic interest i. Then,
F = P(1+i)n (N – 100)
If perpetuation is to occur, the amount F accumulated after n periods minus cost for the
replacement must equal the present worth P. If we let CR represent the replacement cost,
P = F-CR (N – 101)
P = P(1+i)n - CR (N –102)
CR
P (N – 103)
1  i n  1
K = FC + P (N – 104)
CR
K  FC  (N – 105)
1  i n  1
where: FC = First Cost of the equipment
CR = Replacement/Maintenance Cost of the equipment
K = Capitalized Costs
Capitalized Cost, K
Given:
The initial cost of the equipment is P100,000, a salvage vale of P20,000 after 5 years and a maintenance cost
of P10,000 per year, and cost of money of 10% pa..
Required: Capitalized Cost
Solution:
K  100, 000 
100, 000  20, 000   10, 000  P 331, 038
1  0.10   1 1  0.10   1
5 1
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N.8.8. Capital Recovery, CR

The minimum income that must be earned by the investor in order to recover the cost of depreciation of
the equipment plus the interest earned by the initial investment made.
FC1  i   SV
L
CR   FC A/P,i%, n   SV  A/F,i%, n  (N – 106)
1  i L  1
i
where: FC = First cost of the equipment
SV = salvage value at the end of service life
L = service life,
i = periodic interest
Example:
1. Given: Installed cost of Equipment = P400,000
Service life = 5 years
Salvage value = P40,000
Cost of money = 10% p.a.
Required: Capital Recovery, CR
Solution:
FC1  i   SV 400,0001  0.1  40,000
L 5
CR    98,967
1  i   1
L
1  0.1  1
5
i 0.1
 0.1 
CR  400,000  40,000   400,000(0.1)  98,967
 1.1  1
5
2. A company requires an initial fixed capital investment of P100,000 and a working capital of P10,000. The
fixed capital investment has a salvage value of P10,000 after 5 years, The projected annual cash flow is P36,000
and annual expenses is P44,000. Assume a minimum yield on investment of 15% pa. Determine the ff.
a. ROI
b. Minimum pay-out period, w/o and w/ interest
c. Present worth
d. Capitalized costs
Solution:
a. ROI  Profit
Total Investment
Profit = Cash flow – Annual depreciation
Total Investment = FCI + working capital
Annual depreciation = (100,000 – 10,000)/ 5 = P18,000
Total investment = 100,000 + 10,000 = P110,000
Profit = 36,000 – 18,000 = 18,000
Profit 18, 000
ROI   100%  16.36%
Investment 110, 000
b. Minimum pay-out period, without interest

Depreciable Fixed Capital Investment
N
Cash Flow
100,000  10,000
  2.5 years
36,000
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c. Minimum pay-out period, with interest

90, 000  110, 000 1  0.15   1
5
Depreciable Fixed Capital Investment  Interest on Total Investment    5.6 years
N 
Cash Flow 36, 000
d. Net Present Worth

CF1 CF2 CFn
NPW    ..   FC
  1  i 
1  i 2
1  i 
n
 1  0.155  1  10,000  10,000 

 36,000    110,000  P20,622
 1  0.15  0.15  1  0.15
5 5
e. Capitalized Costs
K  FC 
CR 44, 000 100, 000  10, 000 
 110, 000    P 492,322
1  i n  1 0.15 1  0.15  1
5
3. A company is considering two types of equipment for its manufacturing plant. Pertinent data are as follows:
Type A Type B
A. First Cost P 200,000 P 300,000
B. Annual Operating Cost 32,000 24,000
C. Annual Labor Cost 50,000 32,000
D. Insurance and Property Taxes 3% 3%
E. Payroll Taxes 4% 4%
F. Estimated Life 10 years 10 years
If the minimum required rate of return is 15%, which equipment should be selected? Using:
a. ROI on additional investment
b. Annual Cost
c. Present Worth
Solution:
a. ROI on additional investment::
Type A Type B
Depreciation P 9,850 P 14,776
Insurance and Property Taxes (A x D) 6,000 9,000
Payroll Taxes (A x E) 2,000 1,280
Total Annual Cost P 99,850 P 81,056
 i 
d  FC  SV   
 1  i  L
 1 
Savings 99,850  81,056

ROI on addtional investment    18.79%  15%
Additonal investment 300,000  200,000
Therefore, select Type B
b. Annual Cost
Type A Type B
Depreciation P 9,850 P 14,776
Insurance and Property Taxes (A x D) 6,000 9,000
Payroll Taxes (A x E) 2,000 1,280
Interest on Capital (A x 15%) 30,000 45,000
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Since Total annual Cost B is less than A, select Type B
c. Present Worth (Summation of all Expenses and projecting them at present worth)
Type A Type B
Insurance and Property Taxes (Dx3%) 6,000 9,000
Payroll Taxes (E x 4%) 2,000 1,280
Pr esent Worth A  200,000  90,000

1  0.15 1
10

 P651,692
0.151  0.15
10
Pr esent Worth B  300,000  66,280

1  0.15
10
1 
 P632,646
0.151  0.15
10
Since, Present Worth Expenses B < Present Worth Expenses A, Therefore, select B
N.8.9. Break Even Analysis

_means of identifying the value of a particular project variable that causes the project to exactly
break even (income is equal to expenses).
Break-even point _ level of production where the total income is equal to the total expenses
Basic Production Assumptions:
1. That the variable costs are substantially directly proportional to production rate over the range
from 0 to 100% capacity.
2. That the fixed charges are constant regardless of the annual production.
3. That there are no financial costs.
4. That there is no income other than from operations.
5. That all units produced are sold at a constant price per unit.
Gross Profit = net Sales – cost of Sales (N – 107)

= net Sales - (Variable costs + Fixed Costs) (N – 108)
Z  nS  nV  F  (N – 109)
 nS  V   F (N – 110)
At Break-even point; Z = 0
F
n (N – 111)
S V
where: Z = gross profit in pesos
n = number of units sold per year
S = nets sales, pesos/unit
V = variable cost, pesos/unit
F = annual fixed cost, pesos
Note: If S and V are in terms of total sales pesos and total variable cost pesos, respectively, at 100%
capacity, then n is terms of fractional capacity.
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Example:
1. A company has the capacity to produce one million units of product per year. At present it can only produce and
sell 800 thousand units annually at a total sales of P800 million. Variable costs per unit is P500 with an annual
fixed costs of P50 million.
a. Calculate the company's annual profit or loss for this present production.
b. What is its break-even point?
Use analytical and graphical method
Solution:
a. Profit  Sales  Cost of Sales
Z  S - (F  V)
  500 
 800,000,000  50,000,000  800,000 units    P350M
  unit 
P 800,000,000 P1,000
selling price/unit  S   ;
800,000 unit
P 500
variable cost/unit  V 
unit
F 50,000,000
b. BEP  n  100,000 units
S -V 1,000  500
2. The annual fixed costs of for a plant are P100,000, and the variable costs are P140,000 at 70% capacity with net
sales of P280,000. What is the break-even point in units of production if the selling price per unit is P40?
Solution: The variable costs and net sales are based on 70% capacity, therefore we express them based on 100%
capacity:
V = P140,000/0.7 = P200,000 ; S = P280,000/0.7 = P400,000
F 100, 000
n  100%  50%
S  V 400, 000  200, 000
P 400, 000
  0.50   5, 000 units
P 40 / unit
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N.8. Problems:
1. Given:
Total Fixed Capital Working Capital Salvage value Service Life Annual Cash Flow
P 100,000 P11,000 P 10,000 6 years P 36,000
Cost of money=12 % pa.
Solve for the net present worth of the investment.
a. P 47,650 b. P 12,131 c. P11,825 d. P11,520
2. The initial cost of the equipment is P100,000, a salvage value of P12,000 after 5 years and annual repair and maintenance
cost of P10,000. If cost of money is 10% pa, the capitalized cost is:
a. P 344,142 b. P 112,131 c. P131,825 d. P121,520
3. An investment requires an initial fixed capital of P100,000 and a working capital of P20,000. The fixed capital investment
has salvage value of P10,000 after 5 years. The projected annual cash flow is P36,000 and annual expenses is P44,000.
Assume a minimum yield on investment of 15% pa.
Determine the pay-out period in years with interest.
a. 2 b. 3 c. 4 d.6
4. Determine the net present worth *refer to previous problem)
a. P 18,560 b. P 12,131 c. P22,980 d. P15,593
5. Determine the capitalized costs
a. P 318,560 b. P 412,131 c. P522,980 d. P502,323
6. The annual fixed costs of a plant is P100,000 and the variable costs is P140,000 at 70% operating capacity with net sales of
P280,000. What is the break-even point in units of production if the selling price per unit is P40?
a.3500 b. 3450 c. 4450 d. 5,000
7. A company produces 100,000 units of electric fans annually at P900 per unit. A unit is sold at P 1,400. The fixed costs of
production is P5.0M. The company has 1000 shares of stocks at P50,000 per stock paying an annual dividend of 10%.
What is the break-even-point?
a.3,500 b. 9,450 c. 14,450 d. 20,0000
8. What is the capitalized cost of the of the equipment which has an initial cost of P200,000, salvage value of
P20,000 after a service life of 5 years and a maintenance cost of P25,000 every 2 years. Cost of money is 10%
pa.
a. P613,883 b. P497,026 c. P683,113 d. P383,600
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9. What is the capital recovery cost of the of the equipment which has an initial cost of P500,000; salvage value of
P20,000 after a service life of 5 years. Cost of money is 10% pa.
a. P 100,921 b. P 119,230` c. P 128,623 d. P 177,644
10. A proposed plant will require a fixed capital investment of P100M. It is estimated that the working capital will
amount to 20% of the total capital investment, and annual depreciation costs are estimated to be 10% of the fixed-
capital investment. If the annual net profit will be P30 M, determine the minimum pay-out period.
a. 5 years b. 3.3 years c. 5.5 years d. 2.5 years
11. Find the return on total investment of the preceding problem.
a. 24% b. 10.8% c. 11% d. 11.5%
a. P 30M b. P 700M c. P 600M d. P 300M
13. A proposed petroleum refining facility has an estimated total investment of P50 M of which P5M is for land and
P45 M is for fixed and other physical property subject to depreciation. What is the minimum income that must
be earned by the company in order to recover the cost of depreciation of the equipment plus a profit of 15% on
their total investment. Assume a service life of the equipment equal to 10 years without salvage value.
a. P 9.72M b. P 9.96M c. P 8.72M d. P 8.97M
14. The capitalized cost for a piece of equipment has been found to be P550,000. This cost is based on the original
cost plus the present value of an indefinite number of renewals. An annual interest rate of 12% was used in
determining the capitalized cost. The salvage value of the equipment at the end of the service life was taken to be
10% of the first cost of the equipment and the service life was estimated to be 10 years. Under these conditions,
what would be the original cost of the equipment?
a. P 385,321 b. P 258,000 c. P 310,00 d. P450,000
15. An investigation of a proposed investment has been made. The following result has been presented to
management. The minimum pay-out period based on the capital recovery using a minimum annual return of
10% as a fictitious expense is 10 years; Annual depreciation costs amount to 8% of the total investment. Using
this information, Determine the standard rate of return on the total investment.
a. 6.27% b. 10% ` c. 8.27 % d. 16.27%
16. Calculate the theoretical pay-out time for an oil field gas compressor station that costs P48,000,000 for a 20 m3
hourly capacity if operating and other production costs are P300,000 per year except for depreciation. The
selling price of the gas is P100 per/m3 with interest at 8% and equipment life of 12 years.
a. 12 years b. 7 years c. 9 years d. 10 years
17. Two electric motors (A and B) are being considered to drive a centrifugal pump. Each motor is capable of delivering 50
HP (output) to the pumping operation. It is expected that the motors will be in use 1,000 hours per year. If electricity costs
P6.00/kwh and minimum rate of return on investment is 8%what would be the expected savings in annual cost if motor A
is chosen instead of motor B? Pls refer to the following data:
Motor A Motor B
Initial Cost P48,000 P40,000
Electrical Eff 82% 77%
Annual Maintenance P6,000 P10,000
Service Life 4 years 5 years
a. P17,248 b. P 18,569 c. P 10,339 d. P42,708
18. In the food industry the variable costs for canning whole corn may be considered as made up as follows: raw materials
49%, packaging 24%, direct labor 17%, and others 10%. If the fixed costs are P1M and are equivalent to one-half the direct
costs at full production, what is the profit on operation if sales are P4M
a. P1M b. P2M c. P1.5M d. P0.5M
19. What would be the increase in profit if packaging costs are reduced by 25%?
a. P1M b. P2M c. P1.5M d. P0.06M
20. A company having annual fixed costs of P3.1M with variable costs of 0.38 of net sales does an annual business of P8M per
year at 100% capacity. What is the percent capacity at breakeven point.
a. 35% b. 42.25% c. 62.5% d. 75%
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N.9. OTHER METHODS OF FINANCIAL ANALYSIS

This portion of financial study gauges the project’s profitability, liquidity, cash solvency, and growth
overtime. It should be noted that the functions elaborated are meaningful only when compared with
other functions of the same type computed in one-year intervals.
N.9.1. Test of Liquidity

These measures are used to determine a firm’s ability to meet short-term obligations, and to
remain solvent in the event of adversities.
Liquidity ratios are used to measure your enterprise's ability to pay its bills on time.
They can be overall measures of liquidity or measures of specific assets.
Liquidity is the availability of liquid assets to an enterprise.
Liquid assets are those assets held in or easily converted into cash.
A. Current Ratio 
Current Assets (N – 112)
Current Liabilities
The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt
and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more
capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to
pay off its obligations if they came due at that point. While this shows the company is not in good financial health,
it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is
definitely not a good sign.
The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its
product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover
can run into liquidity problems because they are unable to alleviate their obligations. Because business operations
differ in each industry, it is always more useful to compare companies within the same industry.
This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory and pre-
paid as assets that can be liquidated. The components of current ratio (current assets and current liabilities) can
be used to derive working capital (difference between current assets and current liabilities). Working capital is
frequently used to derive the working capital ratio, which is working capital as a ratio of sales.
Current Assets  Inventories (N – 113)

B. Quick or Acid Test Ratio 
Current Liabilities
A stringent indicator that determines whether a firm has enough short-term assets to cover its immediate
liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio,
primarily because the working capital ratio allows for the inclusion of inventory assets.
Companies with ratios of less than 1 cannot pay their current liabilities and should be looked at with extreme
caution. Furthermore, if the acid-test ratio is much lower than the working capital ratio, it means current assets
are highly dependent on inventory. Retail stores are examples of this type of business.
The term comes from the way gold miners would test whether their findings were real gold nuggets. Unlike
other metals, gold does not corrode in acid; if the nugget didn't dissolve when submerged in acid, it was said to
have passed the acid test. If a company's financial statements pass the figurative acid test, this indicates its
financialintegrity.
C. Inventory Turn - Over Ratio 

Cost of Goods (N – 114)
Average Inventory
The liquidity of a firm's inventories is reflected in the number of time the firm's average inventory is turned
over during the year. The inventory ratio requires confirmation by other measures and a more thorough examination
of contents because rapid turnover on a few items or a slow turnover on others could skew the results.
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Example:
Cost of Goods Sold = P 1,520,891
Inventory Beginning = P 139,725
Inventory Ending = P 141,410
Formula
Inventory turnover ratio = cost of goods sold / average inventory
= 1,520,891 / ((139,725 + 141,410) / 2)
= 1,520,891 / 140,568
= 10.82 times
The company turns its inventory almost eleven times a year or almost every month. It's a good strategy to
mention in your plan the false assumptions associated with this conclusion.
Average inventory is the average of the beginning and ending inventories. Sales are sometimes used in the
numerator of the inventory ratio rather than the cost of goods sold. This would include markup, a variable which
fluctuates across different situations.
D. Cash Ratio 
Cash  Short Term or Marketable Securities (N – 115)
Current Liabilities
The cash ratio is an indicator of a company’s liquidity that further defines both the current ratio and the quick
ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current
liabilities.
The cash ratio is the most stringent and conservative liquidity ratio of all (current, quick and cash). It only
measures the ability of a firm's cash, along with investments that are easily converted into cash, to pay its short-term
obligations. It ignores the inventory and receivables, as there are no assurances that two accounts can be converted to
cash in a timely manner to meet current liabilities.
Along with the quick ratio, a higher cash ratio generally means the company is in better financial shape.
It is seldom used in financial reporting or by analysts in the fundamental analysis of a company.
Cash Reserve Ratio (CRR) on the other hand is a specified minimum fraction of the total deposits of customers,
which commercial banks have to hold either in cash or as deposits with the Central Bank. CRR is set according to the
guidelines of the central bank of a country.
N.9.2. Tests of Debt-Service (Leverage Ratios)

These tests are employed to present the project’s ability to meet long-term obligations.
Total Liabilities
A. Debt to  Net Worth Ratio  (N – 116)
Total Equities
Measure used in the analysis of financial statements to show the amount of protection available to creditors.
The ratio equals total liabilities divided by total stockholders' equity; also called debt to net worth ratio. A high ratio
usually indicates that the business has a lot of risk because it must meet principal and interest on its obligations.
Potential creditors are reluctant to give financing to a company with a high debt position. However, the magnitude of
debt depends on the type of business. For example, a bank has a high debt ratio but its assets are generally liquid. A
utility can afford a higher ratio than a manufacturer because its earnings can be controlled by rate adjustments.
Usually, book value is used to measure a firm's debt and equity securities in calculating the ratio. Market value may be
a more realistic measure, however, because it takes into account current market conditions.
Long term Liabilites (N – 117)

B. Total Capitalization Ratio 
Long term Liabilities  Equities
The capitalization ratio measures the debt component of a company's capital structure, or capitalization
(i.e., the sum of long-term debt liabilities and shareholders' equity) to support a company's operations and growth.
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Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to
be one of the more meaningful of the "debt" ratios - it delivers the key insight into a company's use of leverage.
There is no right amount of debt. Leverage varies according to industries, a company's line of business and
its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the
capitalization ratio indicate investment quality.
A company's capitalization (not to be confused with its market capitalization) is the term used to describe
the makeup of a company's permanent or long-term capital, which consists of both long-term debt and shareholders'
equity. A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of
financial fitness.
Market capitalization on the other hand is factored by the current share price and number of shares
outstanding.
Prudent use of leverage (debt) increases the financial resources available to a company for growth and
expansion. It assumes that management can earn more on borrowed funds than it pays in interest expense and fees
on these funds. However successful this formula may seem, it does require a company to maintain a solid record of
complying with its various borrowing commitments.
A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its
creditors and/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having
trouble meeting operating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company
in a highly competitive business, if hobbled by high debt, will find its competitors taking advantage of its problems
to grab more market share.
As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses
on the relationship of debt liabilities as a component of a company's total capital base, which is the capital raised by
shareholders and lenders.
C. Debt Service Ratio 

Earnings before Interest and Taxes (N – 118)
Interest
The ratio measures debts servicing capacity of a business so far as interest on long-term loans is concerned.
This ratio shows how many times the interest charges are covered by the earnings. Debt service ratios is also known
as interest coverage ratio.
The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding
debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's
interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When
a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. The
ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While
the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational
difficulties can stay alive for quite some time as long as it is able to service its interest expenses.
In a more positive sense, prudent borrowing makes sense for most companies, but the operative word here is
"prudent." Interest expenses affect a company's profitability, so the cost-benefit analysis dictates that borrowing
money to fund a company's assets has to have a positive effect. An ample interest coverage ratio would be an indicator
of this circumstance, as well as indicating substantial additional debt capacity.
D. Fixed Charge Coverage Ratio
(N – 119)
Earnings before Interest & Taxes  Lease Payments

Interest Charges  Lease Payments
Equation that indicates whether the company is able to meet its fixed commitments (i.e., interest) from its profits. A
high ratio reflects favorably upon the firm's ability to refinance obligations as they mature. The ratio equals earnings
available to meet fixed charges divided by fixed charges. Fixed charges include rent and interest.
The fixed charge coverage ratio includes lease payments as well as interest payments. Lease payments, like
interest payments, must be met on an annual basis. The fixed charge coverage ratio is especially important for firms
that extensively lease equipment, for example.
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EBIT, Taxes, and Interest Expense are taken from the company's income statement. Lease Payments are taken
from the balance sheet and are usually shown as a footnote on the balance sheet. The result of the fixed charge
coverage ratio is the number of times the company can cover its fixed charges per year. The higher the number, the
better the debt position of the firm, similar to the times interest earned ratio.
Like all ratios, you can only make a determination if the result of this ratio is good or bad if you use either
historical data from the company or if you use comparable data from the industry.
The above formula can be explained with the help of an example:
For example, a company has P13,000 as EBIT and P2,000 as lease payments and P1,000 as interest payments
the fixed charge coverage ratio is measured as:
Fixed charge coverage ratio = (13,000+2,000)/(1,000+2,000) = 15,000/3000 = 5

This means that the company has earned five times its fixed charges, the company is able to pay the fixed
charges of the company.
Therefore this means that by calculating the fixed charge coverage ratio, it helps in ascertaining the company’s
ability to pay the various fixed costs of the company in case the business tends to fall. Every business would have its
own share of risks involved and every company must be well prepared to handle all the expenses and losses that can
occur to the company. This is why it is important to calculate the fixed charge coverage ratio and it enables a
business to understand the loss or expense taking capacity of the business in case some misfortune strikes the
company. This ratio like all other ratios can provide a basic idea of the standing of the company’s finances based on
the historical data provided to you. Therefore it is important that you determine fixed charge coverage ratio to
ascertain the standing of the company.
E. Debt ServiceCoverage Ratio : DSCR

Net Income  Amortization (N – 120)

Depreciation  Interest Expense  Lease Payments
DSCR = (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash and discretionary
items (such as non-contractual management bonuses)) / (Principal Repayment + Interest payments + Lease payments )
The debt service coverage ratio (DSCR), also known as "debt coverage ratio," (DCR) is the ratio of cash
available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the
measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease)
payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and
may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition. Breaching a DSCR
covenant can, in some circumstances, be an act of default.
In corporate finance, DSCR refers to the amount of cash flow available to meet annual interest and
principal payments on debt, including sinking fund payments.
In personal finance, DSCR refers to a ratio used by bank loan officers in determining debt servicing ability.
In commercial real estate finance, DSCR is the primary measure to determine if a property will be able to
sustain its debt based on cash flow. In the late 1990s and early 2000s banks typically required a DSCR of at least 1.2
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N.9.3. Tests of Profitability

These show the operational performance and efficiency of the project
A. Net Profit Margin 

Net Income After Tax (N – 121)
Sales
Net profit margin (or profit margin, net margin, return on revenue) is a ratio of profitability
calculated as after-tax net income (net profits) divided by sales (revenue). Net profit margin is displayed as a
percentage. It shows the amount of each sales dollar left over after all expenses have been paid.
Net profit margin is a key ratio of profitability. It is very useful when comparing companies in
similar industries. A higher net profit margin means that a company is more efficient at converting sales into
actual profit.
B. Operating Profit Margin 

Profit Before Interest and Taxes (N – 122)
Sales
EBIT
Return on Sales(operating margin) 
Revenue
Return on sales (ROS) is a ratio widely used to evaluate an entity's operating performance. It is also
known as "operating profit margin" or "operating margin". ROS indicates how much profit an entity makes
after paying for variable costs of production such as wages, raw materials, etc. (but before interest and tax). It
is the return achieved from standard operations and does not include unique or one off transactions. ROS is
usually expressed as a percentage of sales (revenue).
Return on sales (operating margin) can be used both as a tool to analyze a single company's performance
against its past performance, and to compare similar companies' performances against one another. The ratio
varies widely by industry but is useful for comparing different companies in the same business. As with many
ratios, it is best to compare a company's ROS over time to look for trends, and compare it to other companies
in the industry. An increasing ROS indicates the company is becoming more efficient, while a decreasing ratio
could signal looming financial troubles. Though, in some instances, a low return on sales can be offset by
increased sales.
C. Gross Profit Margin 

Gross Profit (N – 123)
Sales
Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of sales) to sales revenue.
It is the percentage by which gross profits exceed production costs. Gross margins reveal how much a company
earns taking into consideration the costs that it incurs for producing its products or services. Gross margin is a
good indication of how profitable a company is at the most fundamental level, how efficiently a company uses its
resources, materials, and labour. It is usually expressed as a percentage, and indicates the profitability of a
business before overhead costs; it is a measure of how well a company controls its costs.
Gross margin measures a company's manufacturing and distribution efficiency during the production process.
The higher the percentage, the more the company retains on each dollar of sales to service its other costs and
obligations, the better the company is thought to control costs. Investors use the gross profit margin to compare
companies in the same industry and also in different industries to determine what are the most profitable. A
company that boasts a higher gross margin than its competitors and industry is more efficient.
Net Incomeaftertax
D. Return on Invested Capital  (N – 124)
Invested Capital
Invested capital = Book value of debt + Book value of equity – Cash

= Fixed assets + Current assets – Current non-financial liabilities – Cash
= Fixed assets + Non-cash working capital
= Total assets – Cash - noninterest bearing current liabilities
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A calculation used to assess a company's efficiency at allocating the capital under its control to profitable
investments. The return on invested capital measure gives a sense of how well a company is using its money to
generate returns. Comparing a company's return on capital (ROIC) with its cost of capital (WACC) reveals whether
invested capital was used effectively.
Total capital includes long-term debt, and common and preferred shares. Because some companies receive
income from other sources or have other conflicting items in their net income, net operating profit after tax
(NOPAT) may be used instead.
ROIC is always calculated as a percentage. Invested capital can be in buildings, projects, machinery, other
companies etc. One downside of return on capital is that it tells nothing about where the return is being generated.
For example, it does not specify whether it is from continuing operations or from a one-time event, such as a gain
from foreign currency transactions.
Fundamentally, ROIC mends on Return on Assets and Return on Equity because it places the liability and
equity financing at a comparable footing. It gets rid of the debt related to aberration that can make extremely leveraged
organizations look very productive when they using return On Equity. It also applies distinct definitions of Profits
than Return on Equity and Return on Assets; both of these apply Net Profits. However, ROIC (returned on invested
capital) applies Operating Profits subsequently deduction of taxes but earlier than interest expenses.
So why would be this percentage so significant? If calculated correctly, this value is very important as
well as return on equity because it shows what value can be created by company compared to its cost of capital. If
company’s return on capital is lower than its cost of capital, that would mean that such business is not worth to be
expanded. But if return on invested capital is much higher than cost of capital, then huge profits (and value) can be
created by expansion. Of course, this works theoretically, but in practice everything is more difficult, because the
business model should create the same return on new investments as was in the calculations which is not very probable
under real market conditions. Basically, ROIC is valuable when the profitability of new projects sustains the same
level as on previous activity of the company.
E. Return on Equity 
Net Income aftertax (N – 125)
Ave. Shareholders Equity
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It
reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the
balance sheet.
ROE is one of the most important financial ratios and profitability metrics. It is often said to be the ultimate
ratio or the ‘mother of all ratios’ that can be obtained from a company’s financial statement. It measures how
profitable a company is for the owner of the investment, and how profitably a company employs its equity.
F. Return on Common Stock Equity

Net Income  Preferred Stock Dividends Earnings Available for Common Stock (N –
 
Net Worth  Par Value of Preferred Stock Common Stock Equity
12
A publicly-traded company's earnings (less dividends on preferred shares) divided by the amount of money invested
in common stock, expressed as a percentage. This is a measure of how well the company is investing the money 6)
invested in it. A high return on common equity indicates that the company is spending wisely and is
likely profitable; a low return on common equity indicates the opposite. As a result, high returns on common equity
lead to higher stock prices. Some analysts believe that return on common equity is an extremely important indicator
in publicly-traded companies' health.
For firms with no preferred stock, return on common stock equity is identical to return on equity
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Example:
PERIOD ENDING 31-Dec-08 31-Dec-07
Net Income 4,008,000 14,982,000
Preferred Stock And Other Adjustments (1,452,000) (182,000)
Net Income Applicable To Common Shares 2,556,000 14,800,000
Stockholders' Equity
Preferred Stock 37,701,000 4,409,000
Common Stock 76,766,000 60,328,000
Retained Earnings 73,823,000 81,393,000
Other Stockholder Equity (11,238,000) 673,000
Total Stockholder Equity 177,052,000 146,803,000
Return on Common Stock Equity =
2,556,000 + 1,452,000 14,800,000 + 182,000

177,052,000 - 37,701,000 146,803,000 - 4,409,000
= 2.88% =10.52%
Profit before Interest and Taxes

G. Return on Operating Profit  (N – 127)
Total Tangible Assets
H. Asset Turnover 
Sales (N – 128)
Tangible Assets
Asset turnover measures a firm's efficiency at using its assets in generating sales or revenue - the higher the number
the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while
those with high profit margins have low asset turnover
Net Income
I. Return on Asset or Earning Power  (N – 129)
Total Tangible Assets
Return on Assets
Where asset turnover tells an investor the total sales for each P1 of assets, return on assets, or ROA for
short, tells an investor how much profit a company generated for each P1 in assets. The return on assets figure is
also a sure-fire way to gauge the asset intensity of a business. Companies such as telecommunication providers, car
manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment
to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light
(in the case of a software companies, once a program has been developed, employees simply copy it to a five-cent
disk, throw an instruction manual in the box, and mail it out to stores).
Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal (the
shareholders’ capital plus short and long-term borrowed funds). Thus, it is the most stringent and excessive test of
return to shareholders. If a company has no debt, the return on assets and return on equity figures will be the same.
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Return on Assets as a Measure of Asset Intensity (or How "Good" a Business Is)
The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per
dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the
more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA
of 20%, it means that the company earned P0.20 for each P1 in assets. As a general rule, anything below 5% is very
asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies).
The first option requires that we calculate net profit margin and asset turnover. In most of your analyses, you will have
already calculated these figures by the time you get around to return on assets. For illustrative purposes, we’ll go
through the entire process using Johnson Controls as our sample business.
Our first step is to calculate the net profit margin. We divide P469,500,000 (the net income) by the total
revenue of P18,427,200,000. We come up with 0.025 (or 2.5%).
We now need to calculate asset turnover. We average the P9,911,500,000 total assets from 2001 and P9,428,000,000
total assets from 2000 together and come up with P9,669,750,000 average assets for the one-year period we are
studying. Divide the total revenue of P18,427,200,000 by the average assets of P9,660,750,000. The answer, 1.90, is
the total number of asset turns. We have both of the components of the equation to calculate return on assets:
.025 (net profit margin) x 1.90 (asset turn) = 0.0475, or 4.75% return on assets
The second option for calculating ROA is much shorter. Simply take the net income of P469,500,000 divided
by the average assets for the period of P9,660,750,000. You should come out with 0.04859, or 4.85%.
[Note: You may wonder why the ROA is different depending on which of the two equations you used. The first,
longer option came out to 4.75%, while the second was 4.85%. The difference is due to the imprecision of our
calculation; we truncated the decimal places. For example, we came up with asset turns of 1.90 when in reality, the
asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as
possible.
Is a 4.75% ROA good for Johnson Controls? A little research shows that the average ROA for Johnson’s
industry is 1.5%. It appears Johnson’s management is doing a much better job than the competitors. This should be
welcome news to investors.
N.9.4. Funds-Flow Analysis

This technique is employed to determine the major uses and sources of funds within one year in
a project’s life.
 Cash-flow analysis
 Working-capital flow analysis
N.98.5. Tests of Operating Leverage

These functions indicate how the project employs assets for which it pays a fixed cost. Before
these tests are applied, a clarification should be made on what “variable” and “fixed “costs are.
Fixed Costs
A. Break  Even Volume Analysis  (N – 130)
Selling Price / unit  Variable Cost/unit
Cash Fixed Costs

B. Break  Even Cash Analysis  (N – 131)
Selling Price  Cash Variable Cost /unit
Variable Costs  Fixed Costs (N – 132)

C. Break  Even Selling Pr ice Analysis 
Unit Volume
Fixed Costs (N – 133)

D Break  Even Sales Analysis 
1  Variable Cost/Net Sales
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N.9.6. Asset Management Ratios

A set of ratios which measures how effectively a firm is managing its assets
Sales (N – 134)
A. Inventory Turnover Ratio 
Inventories
B. Days Sales Outstanding 

Receivables (N – 135)
Average Sales/day
Sales (N – 136)
C. Fixed Assets Turnover 
Net Fixed Assests
Sales (N – 137)
D. Total Assets Turnover 
Total Assets
N.9.7. Market Value Ratios

Relates the firm’s stock price to its earnings and book value per share; an indication of what
investors think of the company’s past performance and future prospect.
A. Price Earning Ratio 

Pr ice per Share (N – 138)
Earnings per Share
B. Market Book Ratio 

MarketPrice per Share (N – 139)
Book Value per Share
N.9.8. Benefit-Cost (B-C) Ratio

The primary goal of a private project is to make profit for the project owners and investors. In these projects,
a unified purpose is usually agreed on and the projects’ evaluation is only based on monetary values. On the other
hand, “public projects" do not aim to generate profit, but instead have the (social) goal of providing service and benefit
to the general public.
Difficulties:
- Quantifying service in monetary terms
- Multiple purposes and conflicting interests
Their evaluation requires different methods. One such method is called Benefit-Cost (B-C) ratio method.
B-C ratio method calculates the ratio of project’s benefits to its costs. The components are:
Benefits : Positive consequences to the public.

Costs : Monetary expenditures required for the project (financed by government often through taxation).
Disbenefits : Negative consequences to a segment of the public.
As in the private projects, time value of money is important for the public projects, so an interest rate needs to be
determined.
Several factors are considered in selecting an appropriate interest rate, such as interest rate on borrowed capital and
the opportunity cost of capital both to the taxpayers and the governmental agency.
Prof. Ozgun Caliskan Demirag, SEG2440A/B (2008-2009) Chapter 11 - Public projects and benefit-cost ratio
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Notation:
B = benefits of the project
FC = initial investment
O&M = operating and maintenance cost of the project
CR = capital recovery amount
D = disbenefits of the project
MV = market value of investment.
Conventional B/C Ratio

B B

C CR  O & M 
B BD

C CR  O & M 
Modified B-C ratio:

B AW B   AW O & M 

C CR
or
B PW B   PW O & M 

C FC
A project is acceptable if B-C ≥ 1, otherwise not.

Conventional and modified B-C methods give identical acceptability results (not necessarily the
same numerical results!).
Example : The project is to extend the runways of an airport and it is considered by the city. The following costs
have been identified:
Land: P3,500,000
Construction: P6,000,000
Annual maintenance: P225,000
Terminal construction: P2,500,000
Annual operating and maintenance for the terminal: P750,000
Addition of air traffic controllers per year: P1,000,000
The project is estimated to bring the following benefits:

Rental receipts: P3,250,000
Tax to passengers: P650,000
Convenience: P500,000
Tourism: P500,000.
Apply the B-C ratio method with a study period of 20 years and a MARR of 10% per year, and determine
whether this is an acceptable project or not.
Prof. SEG2440A/B (2008-2009) Chapter 11 - Public projects and benefit-cost ratio
Solution:
Annual Benefits, B=3,250,000+650,000+500,000+500,000 = 4,900,000
Capital Investment, FC =3,500,000+6,000,000+2,500,000=12,000,000
Annual Operating Costs & Maintenance, O&M = 225,000+750,000 =975,000
Additional air traffic controllers=1,000,000
assume SV equal to the Cost of Land) FC1  i  12,000,0001.10  3,500,000
n 20
CR    1,348,407
1  i n  1 1.1020  1
i 0.10
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Conventional B-C ratio:

B
B/C 
CR  O & M
4,900,000
B/C   1.474  1
1,348,407  975,000  1,000,000
Modified B-C ratio:

B  O & M  4,900,000  975,000  1,000,000
B/C    2.169  1
CR 1,348,407
Suppose the increased noise level caused by the project will bring a disbenefit of P1,000,000/yr to the
neighborhood.
Conventional net B/C ratio : (with disbenefits)
BD 4,900,000  1,000,000
B/C    1.173  1
CR  O & M 1,348,407  975,000  1,000,000
B 4,900,000
B/C    1.1333  1
CR  O & M  D 1,348,407  975,000  1,000,000  1,000,000
Recommendation: Extend the runways!ag,
benefit-cost ratio meth

N.9.9. Life-Cycle Cost
This term refers to a summation of all costs, both recurring and nonrecurring, related to a product, structure,
system, or service during its life span. The life cycle begins with identification of the economic need or want ( the
requirement) and ends with retirement and disposal activities. It is a time horizon that must be defined in the context
of the specific situation-whether it is a highway bridge, a jet engine or a cell-phone. The end of the life-cycle may be
projected on a functional or economic basis. For example, the amount of time that a structure or piece of equipment
is able to perform economically may be shorter than that permitted by its physical capability. Changes in the design
efficiency of a boiler illustrate this situation. The old boiler may be able to produce the steam required, but not
economically enough for the intended use.
The life cycle may be divided into two general periods: the acquisition phase and the operation phase. Each
of these phases is further subdivided into interrelated but different activity periods.
The acquisition phase begins with an analysis of the economic need or want-the analysis necessary to make
explicit the requirement of the product, structure, system or service. Then, with the requirement explicitly defined, the
other activities in the acquisition phase can proceed in a logical sequence. The conceptual design activities translate
the defined technical and operational requirements into a preferred preliminary design. Included in these activities are
development of the feasible alternatives and engineering and economic analyses to assist in selection of the preferred
preliminary design. Also, advanced development and prototype-testing activities to support the preliminary design
work occur during this period.
The next group of activities in the acquisition of phase involves detailed design and planning for the
production or construction. This step is followed by the activities necessary to prepare, acquire, and make ready for
operation of the facilities and other resources needed. Again, engineering economy studies are an essential part of the
design process to analyze and compare alternatives and to assist in the determining the final detailed design.
In the operation phase, the production, delivery, or construction of the end item(s) or service and their
operation or customer use occur. This phase end with retirement from active operation or use, often, disposal of the
physical assets involved. The priorities for engineering economy studies during operation phase are:
1. Achieving efficient and effective support to operations
2. Determining whether (and when) replacement of assets should occur, and
3. Projecting the timing of retirement and disposal activities
The greatest potential for achieving life-cycle cost savings is early in the acquisition phase . How much of
the life-cycle costs for a product for example can be saved is dependent on many factors. However, effective
engineering design and economic analysis during this phase are critical in maximizing potential savings.
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One aspect of cost-effective engineering design is the minimizing of the impact of design changes during the
steps in the life cycle. In general, the cost of a design change increases by a multiple of 10 with each step. Thus there
is a large savings incentive to have an excellent conceptual design on which to base the detailed design and to prevent
any changes during the production or construction and operation stages of the life cycle.
Thus one purpose of the life-cycle concept is to make explicit the interrelated effects of the costs over the life
span of the product. An objective of the design process is to minimize the life-cycle cost-while meeting other
performance requirements-by making the right trade-offs between prospective costs during the acquisition phase and
during the operation phase.
The cost element of the life cycle that need to be considered will vary with the situation. Because of their
common use, however, several basic life-cycle cost categories will now be defined.
Investment cost _is the capital required the most of the activities in the acquisition phase. In simple cases,
such as acquiring specific equipment, investment cost may be incurred as a single expenditure. This cost is also called
capital investment.
Working Capital_ refers to the funds required for current assets (i.e., other than fixed assets such as
equipment, facilities, etc.) that are needed for the start-up . For example, products cannot be made or services delivered
without having materials available in inventory. Functions such as maintenance cannot be supported without spare
parts, tools, trained personnel and other resources. Also, cash must be available to pay employees, salaries and other
expenses of operation. The amount of working capital needed will vary with the project involved, and some or all of
the investment in working capital is usually recovered at the end of a project’s life.
Operation and Maintenance cost_ includes many of the recurring annual expense items associated with the
operation phase of the life cycle. The direct and indirect costs of operation associated with the five primary resource
areas-people, machines, energy, and information-are a major part of the costs in this category.
Disposal Cost_ includes those nonrecurring costs of shutting down the operation and the retirement and
disposal of assets at the end of the life cycle. Normally, costs associated with personnel, materials, transportation, and
one-time special activities can be expected. These costs will be offset in some instances by receipts from the sale of
assets with remaining market value. A classic example of a disposal cost is that associated with cleaning up a site
where a chemical processing plant had been located.
Sample Problem:
Given:
Purchase cost = P 1M
Salvage Value= P50,000
Installation Cost = P250,000
Operating and Maintenance Cost= P150,000
Service Life= 10 years
Interest = 8% pa
Disposal Cost = P 5,000
Calculate the life-cycle cost of the Equipment
Solution:
LCC  1,000,000  250,000 
150,000  1.10  1   5,000 - 50,000  2,154,336
100
1.1  0.10 
10
1.1
100
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N.10. OPTIMIZATION
An optimum design is based on the best or most favorable conditions. In almost every case, these optimum
conditions can ultimately be reduced to a consideration of cost or profits. Thus, an optimum economic design could
be based on conditions giving the least cost per unit of time or the maximum profit per unit production. When one
design variable is changed, it is often found that some costs increase and others decrease. Under these conditions, the
total costs may go through a minimum at one value of the particular design variable, and this value would be
considered as an optimum.
The optimum conditions could be expressed in terms of mathematical equations which could represent the theoretical
basis for the design recommendation. However, factors that cannot easily be quantified or practical considerations
may change the final recommendation, to other than the theoretically correct optimum condition.
N.10.1. Optimum Production Rates in Plant Operation

It is convenient to consider operating costs on the basis of one unit of production. When this is done, the
operating costs can be divided into two types of expenses as follows: (1) minimum expenses for raw materials, labor,
power, etc., that remain constant and must be paid for each unit of production as long as any amount of material is
produced; (2) extra expenses due to increasing the rate of production. These extra expenses are known as super
production costs. They become particularly important at high rates of production. Examples of superproduction costs
are extra expenses caused by overload on power facilities, additional labor requirements, or decreased efficiency of
conversion.
Super production costs can be represented as follows:

CT  mP n (N – 140)
Where: P = rate of production as total units of production per unit time
m = a constant
n = a constant
Designating h as the operating costs which remain constant per unit of production and Oc as the organization
costs per unit time, the total product cost CT per unit of production is
Oc
cT  h  mP n  (N – 141)
P
 O  (N – 142)
CT  cT P   h  mP n  c  P
 P
Oc
r  s  cT  s  h  mP n  (N – 143)
P
 O 
(N – 144)
R'  rP   s  h  mP n  c  P
 P
Where: CT = total production cost per unit of time
r = profit per unit of production
R’ = profit per unit time
s = selling price per unit of production
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N.10.2. Optimum Production Rate for Minimum Cost Per Unit of Production in Plant
Operation
It is often necessary to know the rate of production which will give the least cost on the basis of one unit of
material produced. This information shows the selling price at which the company would be forced to cease operation
or else operate at a loss. At this particular optimum rate, a plot of the total product cost per unit of production versus
the production rate shows a minimum product cost; therefore, the optimum production rate must occur where
dcT
 0 . An analytical solution for this case may be obtained from Equation (140) and the optimum rate P o giving
dP
the minimum cost per unit of production is found as follows:
dcT O
 0  nmPon 1  c2 (N – 145)
dP Po
1
 O   n 1
Po   c  (N – 146)
 nm 
The optimum rate shown in equation (146) would, give the maximum profit per unit of production if the
selling price remains constant.
N.10.3. Optimum Production Rate for Maximum Total Profit Per Unit of Time
In most business concerns, the amount of money earned over a given time period is much more important
than the amount of money earned for each unit of product sold. Therefore, it is necessary to recognize that the
production rate for maximum profit per unit time may differ considerably from the production rate for minimum cost
per unit production.
From equation (144), when the selling price remains constant, the optimum rate giving the maximum profit per unit
time is:
1
 sh  n
Po    (N – 147)
 n  1m 
N.10.4. Optimum Conditions in Cyclic Operations

Many processes are carried out by the use of cyclic operations which involve periodic shutdowns
for discharging, cleanout, or activation. This type of operation occurs when the product is produced by a batch
process or when the rate of production decreases with time, as in the operation of filtration unit. In a true batch
operation, no product is obtained unit the unit is shut down for discharging. In semi-continuous cyclic operations,
product is delivered continuously while the unit is in operation, but the rate of delivery decreases with time. Thus,
in batch or semi-continuous cyclic operations, the variable total time required per cycle must be considered when
determining optimum conditions
 operating and shutdown cos ts  cycles 
Total annual cos t      annual fixed cos ts (N – 148)
 cycle  year 
 production  cycles 
Annual Production     (N – 149)
 cycle  year 
Cycles  operating  shutdown time  cycle  (N – 150)

   
year  year  operating  shutdown time 
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Sample Problem:
A plant produces a type of product at a rate of P units per day. The variable costs per unit have been to be 4,773
+ 10P1.2. The total daily fixed charges are 175,000, and all other expenses are constant at 732,000 per day.
If the selling price per unit of product is 17,300; determine:
a. The daily profit at a production schedule giving the minimum cost per unit of product
b. The daily profit at a production schedule giving the maximum daily profit
c. The production schedule at the break-even
Solution;
a. Production at minimum total cost per unit of product :
175, 000  732, 000
C  4, 773  10 P1.2 
P
dC 907,000
 12 P 
0.2
0
dP P2
P 165 units
Daily profit at production schedule for minimum cost per unit of product:
  175, 000  732, 000  
Z  17,300   4, 773  10 P1.2    165
  165 
 P 404, 085 / day
b. Production schedule for maximum daily profit:

  175,000  732,000  
Z  17,300   4,773  10 P1.2   P
  P 
dZ
 0  17,300  4773  22 p 1.2 ; P  197
dP
Maximum daily profit:
  175,000  732,000 
Z  17,300   4,773  10197  197
1.2
  197 
 3,408,100  1,051,923  907,000  1,449,177
c. Production per day at break-even:
  175,000  732,000  
Z  17,300   4,773  10 P1.2   P
  P 
  175,000  732,000  
Z  0  17,300   4,773  10 P1.2   P
  P 
P = 87 units/day
N.10.5. Economic Order Quantity, EOQ

The order quantity which minimizes the inventory cost unit time. It is one of the oldest classical production
scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model,
Wilson Formula or Andler Formula. The model was developed by Ford W. Harris in 1913 but R. H. Wilson,
a consultant who applied it extensively, and K. Andler are given credit for their in-depth analysis
2aK
EOQ  Q 
h
where: EOQ = Optimal order quantity
Q = ordering quantity
a = total annual requirements, unit
K= the fixed cost per order (peso/order)
h= the inventory storage cost (peso/unit item per unit time)
p = cost per unit
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DERIVATION OF FORMULA:
Total Cost = Purchase (Item) Cost + Ordering Cost + Inventory Cost

 a  Q
CT   p a   K    h  
Q  2 
dCT  a  h
 0   K  2  
dQ Q  2
2aK
Q  EOQ 
h
Relevant Costs
When calculating EOQ, it is important to include only those ordering and holding costs that are relevant. Any costs
that are not incremental should be ignored while calculating EOQ. Following examples illustrate the application of
relevant costing in the calculation of EOQ.
Order Costs Relevance to EOQ calculation
Salary paid to clerk who processes orders. If increase in number of orders would not result in overtime
or hiring an additional clerk, the cost will not be relevant to
EOQ.
Supplier charges $5 delivery cost for each unit of inventory The total delivery expense will be the same irrespective of
supplied. the number of order deliveries so it should be ignored in
EOQ calculation.
Supplier charges $500 fixed delivery charge for each Delivery expense will increase with an increase in number
delivery. of orders so it should be included in EOQ calculation.
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The annual insurance cost is fixed irrespective of how

Auto dealer transports cars from the car factory to its
many cars are transported in one go and should therefore be
showroom using its own trucks. Insurance premium is paid
ignored.
to cover for any accidents during the transportation. $100
premium is paid for each vehicle that is transported.
Holding Costs Relevance to EOQ calculation
Company earns a return of 15% on its projects. One unit of The opportunity cost of holding one more unit of inventory
inventory costs $100. for one year is $15(15%x$100) which should be included
in EOQ calculation because more the number of units of
inventory that are held, higher the opportunity cost of
capital tied in inventory purchase.
Company pays lease rentals of $20,000 for its warehouse. Warehouse rent is fixed and hence irrelevant to EOQ
calculation as the cost does not vary to changes in the
number of units of inventory held.
Insurance premium of $10 per day is paid for each unit of The insurance cost rises with an increase in number of units
inventory stored in the warehouse to cover the risk of fire held and is therefore relevant to EOQ.
and theft.
0.2% of the average number of inventory units stored in the The cost of damage and shrinkage (theft) of inventory
warehouse get damaged or stolen. increases as more units of inventory are held at the
warehouse. The cost should therefore be factored into EOQ
calculation.
1. Example
 Annual requirement quantity, a = 10,000 units
 Cost per order, K = P 200
 Cost per unit, p= P 8/unit
 Carrying cost percentage (h/p)(fraction of p) = 0.02
 Annual carrying cost per unit, h =(8)(0.020= P 0.16
Economic order quantity = Q  2aK  210,000200 10,000

 5000 units ; n  2
h 0.16 5000
Total Cost = Purchase (Item) Cost + Ordering Cost + Inventory Cost

a Q  10,000   5000 
Total Cost   p a   K    h    810,000  200   0.16   P 80,80
Q 2  5000   2 
If we check the total cost for any order quantity other than 500(=EOQ), we will see that the cost is higher. For
instance, supposing 6000 units per order, then
 10,000   6000 
Total Cost  810,000  200   0.16   P 80,813.33
 6000   2 
Similarly, if we choose 3000 for the order quantity then
 10,000   3000 
Total Cost  810,000  200   0.16   P 81,006.67
 3000   2 
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2. Example
ABC Ltd. uses EOQ logic to determine the order quantity for its various components and is planning its orders.
The Annual consumption is 80,000 units, Cost to place one order is P1,200, Cost per unit is P50 and carrying cost
is 6% of Unit cost.
Find
a) EOQ
b) No. of order per year
c) Annual Ordering Cost
d) Annual Carrying Cost
e) Total Annual Cost of Inventory
2aK 280,0001,200
a.Q    8000
h 0.0650
80,000
b. n   10
8000
c. Annual OrderingCosts  Ka / Q  1,20080,000 / 8000  12,000
d . Annua l CarryingCosts  hQ / 2  0.065080001 / 2  12,000
e.Total Annual Cost of Inventory  12,000  12,000  24,000
N.10 Problems:
1. Demand for the Child BiCycle at Aldoni is 500 units per month. Best Buy incurs a fixed order placement,
transportation, and receiving cost of P 4,000 each time an order is placed. Each bicycle costs P500 and the retailer
has a holding cost of 20 percent.
a. Evaluate the number bicycles the store manager should order in each replenishment lot? P693
b. What is the number of orders to be made each year? 9
c. What is the total cost of the purchase and inventory of the items/yr? P3,070,600
2. A local TV repairs shop uses 36,000 units of a part each year (A maximum consumption of 100 units per working
day). It costs P20 to place and receive an order. The shop orders in lots of 400 units. It cost P 4 to carry one unit
per year of inventory.
Required:
a. Calculate total annual ordering cost, P1800
b. Calculate total annual carrying cost, P 800
c. Calculate total annual inventory cost, P 2600
d. Calculate the Economic Order Quantity, 6000 UNITS
e. Calculate the total annual cost inventory cost using EOQ inventory Policy,P2400
f. How much is saved using EOQ?, P200
3. A plant is being designed in which 450,000 kg per 24-h day of a water-caustic soda liquor containing 5% by
weight caustic must be concentrated to 40% by weight. A single-effect or multiple-effect evaporator will be used,
and a single effect evaporator of the required capacity requires an initial investment of P12M. This same
investment is required for each additional effect. The service life is estimated to be 10 years, and the service life
is estimated to be 10 years, and the salvage value of each effect at the end of the service life is estimated to be
P6M. Fixed charges minus depreciation amount to 20% yearly, based on initial investment. Steam Cost P0.60/kg,
and administration, labor, and miscellaneous costs are P40,000 per day, no matter how many evaporator effects
are used.
Where X is the number of evaporator effects, 0.9X equals the number of kg of water evaporated per kg of
steam. There are 300 operating days per year. If the minimum acceptable return on investment is 15%, how
many effects should be used? Use straight line method of depreciation.
b. 1 b. 2 c. 3 d. 4
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4. The cost of operating a large ship (Co) varies as the square of its velocity (v); specifically, Co=kLv2, where L is the
trip length in kilometers and k is a constant of proportionality. It is known that at 12 kilometers per hour the average
cost of operation is P10,000 per kilometer. The owner of the ship wants to minimize the cost of operation, but it
must be balanced against the cost of perishable cargo (Cc), which the customer has set at P150,000 per hour. A t
what velocity (km/h) should the trip be planned to minimize the total cost (CT), which is the sum of the cost of
operating the ship and the cost of perishable cargo?
b. 10.26 b. 11.5 c. 15.25 d. 20.65
5. In a certain design of a steel bridge the weight of one span is W where W=3L2 + 2,700L-14,000, W is in kg and
L, the span length in meters. Steel costs P100 per kg and the bridge will span a river 600 meters wide. The piers
and abutments are each estimated to cost C= P3,200,000 + 2,400L. Find the number of span to give the minimum
first cost.
a. 1 b. 2 c4 d. 8
6. A company produces circuit boards used to update outdated computer equipment The fixed cost is P2.0 M per
month, and the variable cost is P2,700 per circuit board. The selling price is S=7500-2n. Where n is the number
of units produced. Maximum plant capacity is 4,000 units a month. Determine the optimum demand for this
product.
a. 1200 b. 1863 c. 1100 d.1900
7. What is the maximum profit per month
a. P880,00 b. P863,000 c. P1,000,100 d.P900,000
8. At what volume does breakeven occurs
a. 1200 b. 1863 c. 1100 d.1900
9. A continuous evaporator is operated with a given feed material under conditions in which the concentration of the
product remains constant. The feed rate at the start of a cycle after the tubes have been cleaned had been found to
be 10,000 kg/hr. After 48 hr of continuous operation, tests have shown that the feed rate decreases to 5,000 kg/hr.
The reduction in capacity is due to true scale formation. The rate of scale formation is assumed to be constant
regardless of time. If the down time per cycle for emptying, cleaning, and recharging is 6 hr, how long should the
evaporator be operated between cleaning in order to produce the maximum amount of product per 30 days?
a. 9 hr b. 12.26 hr c. 18.74 hr d. 14 hr
10. What is the maximum production in 30 days? Pls refer to the preceding problem
a. 4,388,965 kg b. 4,387,468 kg c. 4,389,171 kg d. 2,457,890 kg
11. A company has determined that the price and the monthly demand of one of its products are related by the equation
D  400  p where p is the price per unit in pesos and D is the monthly demand. The associated fixed cost are
P1,125 and the variable costs are P100 per unit. How much should be produced and sold each month to maximize
profits?
a. 10 units b. 100 c. 30 units d. 300
12. A plant produces a type of product at a rate of P units per day. The variable costs per unit have been to be P4,773 +
10P1.2. The total daily fixed charges are P 175,000, and all other expenses are constant at P732,000 per day. If the selling
price per unit of product is P17,300, determine the daily profit at a production schedule giving the minimum cost per unit
of product
a. P404,054 b. P444,416 c. P485,670 d. P454,520
13. Determine the daily profit at a production schedule giving the maximum daily profit
a. P404,054 b. P444,425 c. P185,670 d. P454,520
14. Determine the production schedule at the break-even
a. 87 units b. 120 units c. 89 units d. 65 units
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15. The project is to extend the runways of an airport and it is considered by the city municipality.
The following costs have been identified: Determine the net benefit cost ratio. Assume
MARR=10% pa; Service Life = 20 years
Data:
Land: P3,500,000
Construction: P26,000,000
Annual maintenance: P2,250,000
Terminal construction: P52,500,000
Annual operating cost for the terminal: P5,750,000
Addition of air traffic controllers per year: P5,000,000
Inconvenience to the community due to noise: P1,000,000/yr
Loss of income of the farmers deprived of land to farm: P10,000,000/yr
The project is estimated to bring the following benefits:
Rental receipts: P20,250,000
Tax to passengers: P5,650,000
Convenience: P2,500,000
Tourism: P15,000,000.
Solve for the benefit-cost ratio, (B)/(CR+OM+D)
a. 1.293 b. 2.340 c. 1.103 d. 1.205
16. A diesel engine SUV costs P2.1 M. A similar but gasoline engine driven costs P1.8 M. Annual
maintenance costs for each type of SUV is 5% of its first cost. Gasoline costs P55/liter while
diesel cost P40/liter. Salvage value of each type of engine after service life of 10 years is equal
to 10% of its first cost. Fuel consumption for diesel engine driven is 1liter/12 km while that
of gasoline is 1 liter/8 km. If the average monthly distance covered by the vehicle is 1500
kilometers, which of the two vehicles is the better option using Life Cycle Cost Analysis
method and by how much lower?. Cost of money is 8.5% pa.
a. P33,200 b. P32.340 c. P11,000 d. P 42,205
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N. 12. Glossary
Accounting _ is the process of recording all the transactions of the company which affect any investment of capital,
so that at any time the results of the investment may be known.
Accrual-basis accounting_ when the business performs a service, makes a sale or incurs an expense, the accountant
enters the transaction into the books, whether or not cash has been received or paid.
_an accounting method that measures the performance and position of a company by recognizing economic
events regardless of when cash transactions occur. The general idea is that economic events are recognized
by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather
than when payment is made (or received). This method allows the current cash inflows/outflows to be
combined with future expected cash inflows/outflows to give a more accurate picture of a company's current
financial condition
Amortization _ method of repaying a debt, the principal and interest included, usually by a series of equal
payments at periodic interval of time.
Analytical quality control_ commonly shortened to AQC refers to all those processes and procedures designed
to ensure that the results of laboratory analysis are consistent, comparable, accurate and within
specified limits of precision Constituents submitted to the analytical laboratory must be accurately
described to avoid faulty interpretations, approximations, or incorrect results. The qualitative and
quantitative data generated from the laboratory can then be used for decision making. In the
chemical sense, quantitative analysis refers to the measurement of the amount or concentration of
an element or chemical compound in a matrix that differs from the element or compound. Fields
such as industry, medicine, and law enforcement can make use of AQC.
Annuity _ a series of equal payments made at equal interval of time.
Annuity due _ is one where the payments are made at the start of each period, beginning from the first period.
Assets _ anything of value possessed by a enterprise, classified as current, fixed and other assets (goodwill,
copyrights, franchises, etc. )
Authorized capital_ The authorized capital of a company (sometimes referred to as the authorized share capital,
registered capital or nominal capital, is the maximum amount of share capital that the company is
authorized by its constitutional documents to issue (allocate) to shareholders. Part of the authorized
capital can (and frequently does) remain unissued. This number can be changed by shareholders'
approval
Average cost method _ all materials in the store room are mixed and no attempt is made to determine which
materials came in first or last, and therefore all materials issued are to be priced at the average price of
the all the materials in the store room at that time.
A3 Problem Solving _ A3 is a structured problem solving and continuous improvement approach, first
employed at Toyota and typically used by lean manufacturing practitioners. It provides a simple and
strict approach systematically leading towards problem solving over structured approaches.
A3 leads towards problem solving over the structure, placed on an ISO - ISO A3 single sheet paper.
This is where the process got its name. A3 is also known as SPS, which stands for "Systematic Problem
Solving". The process is based on the principles of Edward Deming's PDCA (Plan-Do-Check-Act).
The A3 approach is divided into a number of steps which can vary. Most often, eight (8) problem-
solving steps are used. Some examples of A3 Problem Solving Steps are:
1. Problem description, Initial Perception (PLAN)
2. Breakdown of the Problem, Problem Clarification (PLAN)
o Mapping out for this step can be driven by a set of questions. For example, the "5 W's
(what, where, when, why, who) and 2H's" (how, how many).
3. Point of Cause, Setting Target (PLAN)
4. Containment (PLAN)
5. Cause and Effect, Ishikawa (PLAN)
6. Follow Up Action, Corrective Actions (DO)
7. Effect Confirmation (CHECK)
8. Share the successfully implemented actions (ACT)
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Balance sheet _ is a financial summary showing the relationship in the enterprise on a given date. Basically, it
enumerates the nature and amount of the assets, liabilities, and ownership (equity) in the company. The
most important financial statement of any enterprise. It shows the financial position of the company at
the end of the reporting period. Also known as statement of financial position.
Benefit-Cost (B-C) Ratio The primary goal of a private project is to make profit for the project owners and
investors. In these projects, a unified purpose is usually agreed on and the projects’ evaluation is only
based on monetary values. On the other hand, “public projects" do not aim to generate profit, but instead
have the (social) goal of providing service and benefit to the general public.
Bilateral Monopoly_ a market situation where there is one seller and one buyer.
Black–Scholes / or Black–Scholes–Merton model_ is a mathematical model of a financial market containing
certain derivative investment instruments. From the model, one can deduce the Black–Scholes
formula, which gives a theoretical estimate of the price of European-style options. The formula led to
a boom in options trading and legitimized scientifically the activities of the Chicago Board Options
Exchange and other options markets around the world.[2] lt is widely used, although often with
adjustments and corrections, by options market participants. [3]:751 Many empirical tests have shown
that the Black–Scholes price is "fairly close" to the observed prices, although there are well-known
discrepancies such as the "option smile"1 The Black–Scholes was first published by Fischer Black and
Myron Scholes in their 1973 paper, "The Pricing of Options and Corporate Liabilities", published in
the Journal of Political Economy. They derived a stochastic partial differential equation, now called
the Black–Scholes equation, which estimates the price of the option over time. The key idea behind
the model is to hedge the option by buying and selling the underlying asset in just the right way, and
consequently "eliminate risk". This hedge is called delta hedging and is the basis of more complicated
hedging strategies such as those engaged in by investment banks and hedge funds. The hedge implies
that there is a unique price for the option and this is given by the Black–Scholes formula.
Bond _ is a certificate of indebtedness of a corporation usually for a period not less than 10 years, and guaranteed
by a mortgage on certain assets of the corporation or its subsidiaries.
Coupon bonds _ bonds which are attached coupons indicating the interest due and the date which such interest
is to be paid. The owner of the bond can collect the interest due by surrendering the same to the
officers of the corporation or the same may be cashed at specified banks.
Collateral bonds _ the corporation pledges securities which it owns, such as stocks or bonds of one of its
subsidiaries
Equipment obligation bonds _ refer primarily to bonds whose guarantee is a lien on equipment.
Registered bonds _ the owner's name is recorded in the books of the corporation, and the interest is paid
periodically to the owner without their asking for it.
Joint bonds _ bonds which are issued by two or more corporations
Par value of the bond or face value_ is the amount stated on the bond.
Bond rate _ is the rate of interest quoted on the bond.
Redemption or disposal price—usually equal to par value.
Mortgage bonds _ bonds whose security is mortgaged on certain specified assets of the corporation.
Debenture bonds _ bonds without security behind them except a promise to pay by the issuing corporation
Callable bond _entitles the issuer to pay off the principal prior to the stated maturity date. Similarly, the
owner of a potable bond _can force the issuer to pay off the principal before the maturity date.
Convertible bond _gives the bondholder the right to exchange the bond for shares of the issuer's common
stock at a specified date.
Municipal bonds _are issued by state and local governments and other public entities, such as colleges and
universities, hospitals, power authorities, resource recovery projects, toll roads, and gas and water
utilities. Municipal bonds are often attractive to investors because the interest is exempt from
federal income taxes and some local taxes. There are two types of municipal bonds: general
obligation bonds and revenue bonds.
Leveraged _ company that raises funds by issuing bonds.
Book costs_ are those that do not involve cash payments, but rather represent the recovery of past expenditures
over a fixed period of time. The most common of which is the depreciation charge for the use of assets
such as plant and equipment.
Book value _ also known as depreciated value, is the worth of the property as recorded in the books of account of
the enterprise and is equal to the original cost less the amounts which have been charged to depreciation.
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Bookkeeping _ is the systematic recording of all business transactions in financial terms.

Borrowed capital_ are those supplied by others on which a fixed rate of interest must be paid and the debt must be
repaid at a specified time.
Break-even point _ level of production where the total income is equal to the total expenses
Break-even analysis_ a means of identifying the value of a particular project variable that causes the project to
exactly break even.
Capacity or plant factor _ the ratio between the average load and the total available capacity.
Capitalized cost _ is the sum of the first cost and the additional investment necessary in order to take care of the
replacement and operating costs of the equipment etc. to perpetually operate it. Only the interest of the
additional investment will take care all the replacement and operating expenses.
Capital_ refers to wealth in the form of money or property that can be used to produce more wealth. Two forms
of capital, debt and equity.
1. Equity capital_ capital owned by individuals who have invested their money or property in a business
project or venture in the hope of receiving profit.
2. Debt capital _ also known as borrowed capital. Capital obtained from lenders (e.g. obtained from sale of
bonds) for investment. In return, the lenders receive interest from the borrowers.
Capital_ collective term for a body of goods and monies from which future income can be derived. Land,
buildings, equipment, inventory, and raw materials, as well as stocks, bonds, and bank balances
available are considered as capital. Generally, consumer goods and monies spent for present needs
and personal enjoyment are not included in the definition or economic theory of capital. Homes,
furnishings, cars, and other goods that are consumed for personal enjoyment (or the money set aside
for purchasing such goods) are not considered capital in the traditional sense.
Paid-in-capital_ amount of money received from the sale of stock more than the par value of the stock.
Outstanding stock is the number of shares issued that is actually held by the public. If the corporation
buys back part of its own issued stock, it is listed as Treasury Stock on balance sheet.
Subscribed capital_ also known as issued share capital_ the total of a company’s shares that are held by
shareholders. A company can, at any time, issue new shares up to the full amount of authorized share
capital.
Capital gains tax_ tax on sale of assets; a tax on profit above a fixed level made from the sale of financial assets
Capital Recovery_ The minimum income that must be earned by the investor in order to recover the cost of
depreciation of the equipment plus the interest earned by the initial investment made.
Cartel_ a group of businesses controlling market: an alliance of companies formed to control production,
competition and prices. A formal organization of producers within industry forming perfect collusion
purposely formed to increase profit and block new comers from the industry.
Cash Costs_ are those that involves payment of cash (and results in cash flow). It is distinguished from non-cash
costs or book costs like depreciation.
Cash Flow _ is a systematic presentation of cash receipts and disbursements for a given operating period or fiscal
year, taking for granted the accrual concept in accounting. It details how the company generated the
cash and how the company used the cash during the reported period.
Collateral bonds _ the corporation pledges securities which it owns, such as stocks or bonds of one of its
subsidiaries.
Commodity_ usually produced and/or sold by many different companies. Ii is uniform in quality between
companies that produce/sell it. You cannot tell the difference between one firm's product and another.
Lumber, oil, and electricity could all be considered commodities, while Levi's jeans would not be, as
consumers consider them to be distinct from jeans sold by other firms. Economists call this
distinctness "product differentiation".
Common stock _ represents the ownership of stockholders who have residual claim on the assets of the
corporation after all other claims have been settled. No return is guaranteed on the investment of
common stockholders. They have the right to call meetings, to vote, to elect members of the board of
directors, amend charter and constitution and by-laws, inspect books of the corporation, receive
dividends, share remaining assets if corporation is dissolved.
Compound interest _ both the principal and the interest from the principal earn interest.
Consumer goods and services_ are those products or services that are directly used by people to satisfy their wants.
Food, clothing, homes, cars, television sets, haircuts, cinema, and medical services are examples.
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Consumer price index (CPI) _measures changes in the price level of consumer goods and services purchased by
households. The CPI is a statistical estimate constructed using the prices of a sample of representative
items whose prices are collected periodically. Sub-indexes and sub-sub-indexes are computed for
different categories and sub-categories of goods and services, being combined to produce the overall
index with weights reflecting their shares in the total of the consumer expenditures covered by the index.
It is one of several price indices calculated by most national statistical agencies. The annual percentage
change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust for the effect
of inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary
magnitudes to show changes in real values.
Copyright _ is an exclusive right granted by the government to protect the production and sale of literary or artistic
works for a period of 50years.
Corporation _ is a distinct legal entity, separate from the individuals who own it, and which can engage in
practically any business transaction which a real person could do. It may sue, or be sued in its own
name. It is separate from its owners and managers. This separation gives the corporation four major
advantages: 1) It can raise capital from large investors by issuing stocks and bonds; 2) it permits easy
transfer of ownership interest by trading shares of stock; 3) it allows limited liability-personal liability
is limited to the amount of the individual’s investment in the business; 4) it is taxed differently than the
proprietorships and partnerships, and under certain conditions, the tax laws favor corporations. On the
negative side, it is expensive to establish a corporation. Furthermore, a corporation is subject to
numerous governmental requirements and regulations.
Corrective and preventive action (CAPA, also called corrective action / preventive action, or simply corrective
action) are improvements to an organization's processes taken to eliminate causes of non-conformities
or other undesirable situations. It is usually a set of actions which are required to be taken and
implemented in an organization at levels of manufacturing, documentation, procedures or systems in
order to rectify and eliminate the recurrence of nonperformance. Nonperformance is identified after
systematic evaluation and analysis of the root cause of the nonperformance. Non-conformance may be
a market complaint or customer complaint or a failure of a machinery or a quality management
system, or misinterpretation of written instructions to carryout a work. The corrective and preventive
action is designed by a team including quality assurance personnel and the personnel involved in the
actual observation point of nonconfirmance, and is required to be systematically implemented and
observed for its ability to eliminate further recurrence of such non-conformation in future.
In certain markets and industries, CAPA may be required as part of the quality management system,
such as the Medical Devices and Pharmaceutical industries in the United States. In this case, failure to
adhere to proper CAPA handling is considered a violation of US Federal regulations on good
manufacturing practices. As a consequence, a medicine or medical device can be termed as
adulterated or substandard if the company has failed to investigate, record and analyse the root-cause
of a non-conformance, and failed to design and implement an effective CAPA.
Cost accounting _ is the process of determining the actual cost of manufacturing a product or of rendering a
service. Methods used are, post-mortem cost accounting, method of predicted cost, and method of
standard cost. Elements of cost are materials, direct labor and overhead.
Coupon bonds _ bonds which are attached coupons indicating the interest due and the date which such interest is
to be paid. The owner of the bond can collect the interest due by surrendering the same to the officers
of the corporation or the same may be cashed at specified banks.
Current liabilities _ these are liabilities which mature within a short time, usually a year.
Current or liquid assets - include cash, accounts receivables within a short period of time or at least within the
present accounting period and inventories (Examples are, raw materials, goods in the process of
production, and finished goods ready for sale).
Types of current assets
1. Cash_ represents actual money. Cash equivalent like marketable securities and short term investments.
2. Accounts receivable_ money which is owed to the firm but has yet to be received.
3. Inventories_ money invested in raw materials, work-in-process, finished goods available.
Debenture bonds _ bonds without security behind them except a promise to pay by the issuing corporation.
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Deferred annuity _ is also an ordinary annuity but the first payment is deferred a certain number of periods after
the first period.
Deflation_ reduction in the level of national income and output usually accompanied by a fall in general price
level. Deflation involves a decrease in the average price of goods and services resulting to the increase
in the purchasing power of money. It is usually associated with a prolonged erosion of economic activity
and high unemployment.
Demand _ is the quantity of a certain commodity bought at a certain price at a given place and time.
Demand factor _ the ratio between the maximum power demand and the sum of the connected loads of the system
Depreciation _ decrease in the value of a property such as machinery, equipment building, etc.
Depression _ in economics, a period in an industrial nation characterized by low production and sales and a high
rate of business failures and unemployment.
Derivative instrument_ is a contract between two parties that specifies conditions (especially the dates, resulting
values of the underlying variables, and notional amounts) under which payments are to be made
between the parties
Devaluation_ is a reduction in the value of a currency with respect to those goods, services or other monetary units
with which that currency can be exchanged. ‘Devaluation’ means official lowering of the value of a country's
currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with
respect to a foreign reference currency. In contrast, depreciation is used for the unofficial decrease in the exchange
rate in a floating exchange rate system. Under the second system central banks maintain the rates up or down by
buying or selling foreign currency, usually USD.
In common modern usage, it specifically implies an official lowering of the value of a country's currency within
a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a
foreign reference currency. In contrast, depreciation is used for the unofficial increase in the exchange rate in a
floating exchange rate system. The opposite of devaluation is called revaluation.
Depreciation and devaluation are sometimes incorrectly used interchangeably, but they always refer to values in terms of
other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to
its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination,
not a devaluation or revaluation.
Direct Costs_ are costs that can be reasonably measured and allocated to a specific output or work activity. The
labor and material costs directly associated with a product, service, or construction activity are direct
costs.
Direct materials _ are materials which are used in the finished product itself.
Discount _ the difference between the value of a negotiable paper between now and the future.
Discounted interest_ The interest for the money borrowed (discount) is deducted from the principal in advance
Disposal costs_ includes those nonrecurring costs of shutting down the operation and the retirement and disposal
of assets at the end of the life cycle.
Discounting_ is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a
defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the
present purchases the right to delay the payment until some future date. The discount, or charge, is
simply the difference between the original amount owed in the present and the amount that has to be
paid in the future to settle the debt
Duopoly_ concentration of power in two forces: an economic situation in which two powerful groups or
organizations dominate commerce in one business market or commodity.
Duopsony_ two rival buyers’ control over sellers: a situation in which two competing buyers exert controlling
influence over many sellers.
EBITDA_ an initialism for earnings before interest, taxes, depreciation, and amortization. It is a non-GAAP
(generally accepted accounting principles) metric that is measured exactly as stated. All interest, tax,
depreciation and amortization entries in the income statement are reversed out from the bottom-line net
income. It purports to measure cash earnings without accrual accounting, canceling tax-jurisdiction
effects, and canceling the effects of different capital structures. EBITDA differs from the operating cash
flow in a cash flow statement primarily by excluding payments for taxes or interest as well as changes
in working capital. EBITDA also differs from free cash flow because it excludes cash requirements for
replacing capital assets (capex).
EBITDA is widely used in loan covenants. The theory is that it measures the cash earnings that can be
used to pay interest and repay the principal. Since interest is paid before income tax is calculated, the
debtholder can ignore taxes. They are not interested in whether the business can replace its assets when
they wear out, therefore can ignore capital amortization and depreciation.
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EBITDA margin refers to EBITDA divided by total revenue. EBITDA margin measures the extent to which cash
operating expenses use up revenue. Used by debt holders
Economics_ is the study of scarcity. Resources are limited, and every society wants to figure out how to allocate
its resources for maximum benefit
Economic life_ is the length of time during which an equipment or property will operate at a satisfactory profit.
Effective interest _ is the actual rate of interest on the principal for one year.
Efficiency _ output divided by input
Eight dimensions of product quality management can be used at a strategic level to analyze quality
characteristics. The concept was defined by David A. Garvin. Some of the dimensions are mutually
reinforcing, whereas others are not—improvement in one may be at the expense of others.
Understanding the trade-offs desired by customers among these dimensions can help build a
competitive advantage. Garvin's eight dimensions can be summarized as follows: [1]
1. Performance: Performance refers to a product's primary operating characteristics. This dimension
of quality involves measurable attributes; brands can usually be ranked objectively on individual
aspects of performance.
2. Features: Features are additional characteristics that enhance the appeal of the product or service
to the user.
3. Reliability: Reliability is the likelihood that a product will not fail within a specific time period.
This is a key element for users who need the product to work without fail.
4. Conformance: Conformance is the precision with which the product or service meets the specified
standards.
5. Durability: Durability measures the length of a product’s life. When the product can be repaired,
estimating durability is more complicated. The item will be used until it is no longer economical to
operate it. This happens when the repair rate and the associated costs increase significantly.
6. Serviceability: Serviceability is the speed with which the product can be put into service when it
breaks down, as well as the competence and the behavior of the serviceperson.
7. Aesthetics: Aesthetics is the subjective dimension indicating the kind of response a user has to a
product. It represents the individual’s personal preference.
8. Perceived Quality: Perceived Quality is the quality attributed to a good or service based on
indirect measures.
Elastic demand _ occurs when a decrease in selling price will cause greater than proportionate increase in sales.
Usually applicable to luxury goods.
Engineering Economy _ study of economic theories and their applications to engineering problems with the
concept of obtaining maximum benefit at the least cost.
EOQ _Economic Order Quantity. The order quantity which minimizes the inventory cost unit time
Equipment obligation bonds _ refer primarily to bonds whose guarantee is a lien on equipment.
Equities _ are the claims of anyone against the asset of the enterprise. It includes the liabilities to the creditors as
well as the claims of the owners.
Equity capital_ or ownership funds_ are those supplied and used by the owners of an enterprise in the expectation
that a profit will be earned.
Exact simple interest _ is simple interest paid based on exact number of days of 365 days per common year and
366 days for leap year.
Expense _ the cost of producing income or revenue, or the value of commodities and services needed in the
operation of the business. Also classified as operating and non-operating expenses.
Extended Internal Rate of Return: The Internal rate of return calculates the rate at which the investment made will
generate cash flows. This method is convenient if the project has a short duration, but for projects which
has an outlay of many years this method is not practical as IRR ignores the Time Value of Money. To
take into consideration the Time Value of Money Extended Internal Rate of Return was introduced
where all the future cash flows are first discounted at a discount rate and then the IRR is calculated. This
method of calculation of IRR is called Extended Internal Rate of Return or XIRR.
Fair value _ is the value which a disinterested third party, different from the buyer or the seller, will determine
in order to establish a price that is fair and acceptable to both the buyer and the seller.
FIFO _ first-in, first out method. The principle behind this method is that the materials issued at any time are taken
from the oldest stock and should be priced at the cost when they are purchased. Ex food manufacturing.
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First Article Inspection (FAI_) is a design verification and design history file and a formal method of providing
a reported measurement for a given manufacturing process. Both the supplier and purchaser perform
the First Article on the ordered product. The evaluation method consists of comparing supplier and
purchasers results from measuring the properties and geometry of an initial sample item against given
specifications, for example a drawing. Items to be checked by the supplier and purchaser FAI are wide
and varied and may include distances between edges, positions of holes, diameters and shapes of holes,
weight, density, stiffness, color or surface finish. Despite the name, the inspected article may not
necessarily be the 'first' produced, but a random sample of 3 parts from the first lot provided to the
purchaser. First article inspection is typically called for in a Purchase Order contract between the
producer and buyer of some manufactured article, both perform the First Article inspection to ensure
that the production process reliably produces what is intended, design verification of the print, and is
part of the purchasing, and design control requirements.
First cost of property _ includes original purchase price, freight and transportation, installation, taxes, permits
and all other expenses to put it into operation.
Fixed assets _ properties that will take time to be converted into cash or transformed into saleable form. Examples
are, buildings, land , machinery, equipment, furniture and fixtures. With exception of land, most fixed
assets have limited useful life.
Fixed liabilities _ liabilities which are not due for payment until sometime in the future, usually after a period
exceeding one year.
Fixed Costs _ are those unaffected by the changes in activity level over a feasible range of operations for the
capacity or capability available.
Franchise_ the right and privilege granted to an individual or corporation to do business in a certain region.
Franchise value _ is an intangible item of value arising from the exclusive right of a company to provide a specific
product or service in a stated region of the country.
Futures trading _are essentially self-defining – they are standard contracts giving rise to a future trade based on
today’s price point of a given underlying asset. The essential ingredients for any futures contract are a
specific date on which the position will mature, a price point, and a defined asset, e.g. wheat, steel, US
government bonds. Futures can be traded on commodities, stocks and even other instruments, and are
traded in liquid markets worldwide by both private investors and large-scale investment houses alike.
They work by tying in traders to execute a particular trade (or to reverse their futures position) before
a specific date, allowing them to profit on the difference between the quoted future price and the
actual future price.
Going concern value_ The value of a company as an ongoing entity. This value differs from the value of a liquidated
company's assets, because an ongoing operation has the ability to continue to earn profit, while a liquidated company
does not.
The value of a proven property operation. It includes the incremental value associated with the business
concern, which is distinct from the value of the real estate only. Going-concern value includes an intangible
enhancement of the value of an operating business enterprise which is produced by the assemblage of the land,
building, labor, equipment, and marketing operation
Goodwill_ an intangible value_ is that element of value which a business has earned through the favorable
consideration and patronage of its customers arising from its well-known and well conducted policies and
operation.
Gratuitous_ an obligation with no condition attached.
Gross Domestic Product (GDP)_ measures the value of all goods and services produced within a nation’s borders
regardless of the nationality of the producer. GDP measures a country’s economic activity regardless of
who owns the productive assets in that country. For example, the output United States-owned companies
based in the Philippines is considered part of Philippine’s GDP rather than part of the U.S. GDP may
be calculated in three ways: (1) by adding up all the value of all goods and services produced (2) by
adding up the expenditures on goods and services at the time of sale, or (3) by adding up producers’
incomes from the sale of goods or services.
GDP is usually divided by its population to arrive at GDP per head. The figure is then converted to
dollars to allow for its comparison between countries. If GDP grows at a higher rate than the population,
standards of living are said to be rising. If the population is growing higher than GDP, living of standards
are said to be falling. GDP per head does not take the cost of living into account.
Gross National Product (GNP)_ used to describe in monetary value the total annual flow of goods and services
in the economy of a nation. It is measured by totaling all personal spending, all government spending,
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and all investment spending by a nation’s industry both domestically and all over the world. In other
words, the income earned by a U.S.-owned business based in the Philippines would be considered part
of the U.S.
Gross Margin_ net sales less the cost of goods sold.
Hedge funds_ risk-taking investment company: an investment company that is organized as a limited partnership
and uses high-risk techniques in the hope of making large profits. Hedge funds may leverage their
assets by financing a portion of their portfolios with the cash proceeds from the short sale of other
positions.
Income _ the value of personal and professional services rendered or of goods sold in the operation of the business.
Usually classified as operating and non-operating income.
Income statement _ or a profit and loss statement, is a summary of the incomes and expenses of an individual or
enterprise for a given period. The next in importance to the balance sheet.
Incremental Costs _ are additional costs that result from increasing the output of a system by one (or more) units.
Indirect Costs_ are costs that are difficult to attribute or allocate to a specific output or work activity. For example,
the costs of common tools, general supplies, and equipment maintenance in plant are treated as indirect
costs.
Indirect materials _ are materials not directly part of the product being produced
Inelastic demand _ occurs when a decrease in the selling price will cause a little a less than proportionate increase
in sales.
Inflation_ is the increase in the prices of goods and services from one year to another, thus decreasing the
purchasing power of money.
Intangible assets _ have not physical substance. Examples are, goodwill, leaseholds, copyrights, patents,
franchises, licenses, and trademarks. Accounting for an intangible asset is rendered somewhat difficult
because the lack of physical substance makes evidence of its existence more elusive, may make its value
debatable and its useful life may be questionable.
Interest _ is the amount of money paid for the use of borrowed capital.
Internal Rate of return (IRR) _ the rate of return by this method is equivalent to the maximum interest rate
(normally after taxes) at which money could be borrowed to finance the project over its life would just
be sufficient to pay all principal and interest accumulated on the outstanding principal.
_the most widely used rate of return method for performing engineering economic analyses. It is
sometimes called by several names, such as the investor’s method, the discounted cash flow method,
and the profitability index. Also means that the value of this measure depends only on the cash flows
from an investment and not on any assumptions about reinvestment rates.
Inventory_ stock of goods; the merchandise or stock a store or company has on hand
Investment Cost_ is the capital required for most of the activities in the acquisition phase. This cost is often called
a capital investment.
Ishikawa diagrams (also called fishbone diagrams, herringbone diagrams, cause-and-effect diagrams, or
Fishikawa) are causal diagrams created by Kaoru Ishikawa (1968) that show the causes of a specific
event. Common uses of the Ishikawa diagram are product design and quality defect prevention to
identify potential factors causing an overall effect. Each cause or reason for imperfection is a source of
variation. Causes are usually grouped into major categories to identify these sources of variation. The
categories typically include
 People: Anyone involved with the process
 Methods: How the process is performed and the specific requirements for doing it, such as policies,
procedures, rules, regulations and laws
 Machines: Any equipment, computers, tools, etc. required to accomplish the job
 Materials: Raw materials, parts, pens, paper, etc. used to produce the final product
 Measurements: Data generated from the process that are used to evaluate its quality
 Environment: The conditions, such as location, time, temperature, and culture in which the process
operates
Joint bonds _ bonds which are issued by two or more corporations.
Journal _ is an accounting book where the original record of all transaction is ordinarily recorded. It is the book of
original entry
Kelvin's Law _ the most economical cross sectional area for a conductor is that one for which the investment
cost just equals the annual cost of lost energy.
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Law of Diminishing returns _ when one of the factors of production is fixed in quantity or is difficult to increase,
increasing the other factors of production will result in a less than proportionate increase in output.
Law of diminishing utility _ an increase in the quantity of any good consumed or acquired by an individual will
decrease the amount of satisfaction derived from that good.
Ledger _ serves as a secondary record of business transactions. The ledger sheets are used as intermediates,
between journal records, balance sheets, income statements, and general records. Examples are, cash,
equipment, accounts receivables, inventory, accounts payable and manufacturing expense.
Leverage_ (gearing in UK) any technique to multiply gains and losses. Most often it involves buying more of an
asset by using borrowed funds, with the belief that the income from the asset or asset price appreciation
will be more than the cost of borrowing. Almost always this involves the risk that borrowing costs will
be larger than the income from the asset, or the value of the asset will fall, leading to incurred losses.
Liabilities _ are debts or claims anyone other than the owners of the property upon the assets of the company.
Life-cycle cost_ refers to a summation of all costs, both recurring and non-recurring, related to a product, structure,
system, or service during its life plan.
Life cycle_ refers to the notion that a fair, holistic assessment requires the assessment of raw material production,
manufacture, distribution, use and disposal including all intervening transportation steps necessary or
caused by the product's existence. The sum of all those steps - or phases - is the life cycle of the product.
The concept also can be used to optimize the environmental performance of a single product (ecodesign)
or to optimize the environmental performance of a company.
LIFO _ last-in. last out method. The materials last to obtained are the first to be issued. Ex sand and gravel industry
Load factor _ the ratio between the average demand and the maximum demand.
Luxuries_ are those products or services that are desired by humans and will be purchased if money is available
after the required necessities have been obtained.
Marginal cost _ is the additional cost of producing one more unit.
Marginal revenue _ is the amount received from the sale of an additional unit of a product.
Marginal utility _ is the utility of the last unit of the same commodity which is consumed or acquired. If a man has
three shirts of the same kind of brand, the marginal utility of the 2 nd unit is greater than the marginal
utility of the fourth unit.
Market - is a place where sellers and buyers come together
Market value _ is the amount which a willing buyer will pay to a willing seller for the property when neither one
is under compulsion to buy or sell.
Minimum Attractive Rate of Return (MARR) _ also known as hurdle rate, the interest rate used in the valuation
of profitability of a project in Present Worth, Future Worth and Annual Worth Methods. It is
usually a policy issue by the top management of an organization in view of the following considerations:
The amount of money available for investment, number of good projects available for investment, the
amount of perceived risk associated with investment opportunities available and type of organization
involved..
Monopoly _ a unique product or service is available only from a single supplier and entry of all other possible
suppliers are prevented.
Monopsony_ single-customer market: a situation in which a product or service is only bought and used by one
customer
Mortgage bonds _ bonds whose security is mortgaged on certain specified assets of the corporation.
Mutual Fund_ form of management-investment company that combines the money of its shareholders and
invests those funds in a wide variety of stocks, bonds, and so-called money market instruments. The
latter include short-term investments such as United States Treasury bills and other federal securities,
commercial paper, and bank certificates of deposit. Mutual funds provide the investor with
professional management of funds and diversification of investment among the securities offered by
leading corporations, federal and state governments, and other entities.
Most mutual funds are classed as open-end funds, meaning that the fund will redeem outstanding shares
immediately upon request. Thus, the number of shares of a given mutual fund is not fixed, but fluctuates
as new shares are sold to investors and outstanding shares are redeemed. The offering price and
redemption price of an open-end fund are based on the market value of the securities in its portfolio. In
addition, varying charges, called loads, may be applied. The offering price may include a front-end load,
generally to cover the commission to the broker or other sales representative. A back-end load may be
subtracted from the redemption price, often at a rate that progressively decreases the longer the shares
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are held. Closed-end funds generally have a fixed number of shares outstanding and are traded on the
over-the-counter market or, in some instances, on stock exchanges. Shares are purchased and sold at the
market price plus a commission. They may sell at a premium, that is, above the value of their assets, or
at a discount, below the value of their assets.
Classification of mutual funds based on investment objectives are:
1. Money market,_ Money-market funds, which many investors look upon as an alternative to a bank
account, seek complete safety of capital in short-term investments. Yields vary, being loosely linked
with the interest rate paid on U.S. Treasury bills. There is a rapid flow of cash into and out of
money-market funds.
2. Growth funds_ seek high returns by investing in promising but speculative securities. These funds
entail greater risk than standard growth funds, which tend to invest in larger, more financially secure
companies with records of steadily increasing earnings.
3. Growth and Income Funds_ attempt to achieve a balance between money-market funds and growth
funds. Among funds that seek stability and safety, some may invest in high-quality bonds, others in
blue-chip stocks, and still others in federal securities, which are backed by the full faith and credit of
the U.S. government. Funds that aim for current income may be speculative, investing in high-yield,
high-risk securities such as junk bonds, or conservative in outlook, investing in low-risk securities
with a good record of paying dividends. Between the extremes are funds that are willing to take
some risk for higher returns but are mindful of the need to conserve capital. In general, younger
investors, with most of their earning power ahead of them, can tolerate more risk than investors who
are close to retirement.
4. Other Funds (Balanced, Sector, International Stock , Bonds, Gold and Precious Metals, Municipal)
Balanced funds, seeking both growth and income, may invest in stocks, bonds, and other financial
instruments. Sector funds put all their funds in corporations in one area of business, such as the
automobile industry, or in one country or region of the world. International stock funds and bond
funds, gold and precious metals funds, and municipal bond funds are among the dozens of other
categories and subcategories. In contrast to the extreme specialization offered by some funds, there
are fully managed mutual funds, which are free by company policy to alter the composition of the
portfolio according to the management's evaluation of the current market. Another approach is
offered by index funds, which do not attempt to outguess the markets but simply structure their
portfolios to duplicate one of the major stock market indexes, such as the Standard and Poor's index
of 500 leading stocks.
Necessities _ are those products or services that are required to support human life activities that will be purchased
in somewhat the same quantity even though the price varies considerably.
Net profit _ gross profit less income tax
Net Sales_ represent the gross sales less any sales return and allowances.
Nominal interest _ the rate of interest usually quoted which specifies the rate of interest and the number of interest
periods per year. Ex 12% per annum compounded annually.
Non-recurring costs_ are those which arte non-repetitive, even though the total expenditure may be cumulative
over a relatively short period of time.. For example, the purchase of a real estate upon which the plant
will be constructed is a non-recurring cost, as the cost of constructing the plant itself.
Obsolescence - refers to the changes external to the equipment such as, decrease or disappearance of demand,
invention of more efficient equipment or style of products may have changed considerably.
Organization cost_ an intangible value_ is the amount of money spent in organizing a business and arranging for
its financing and building.
Oligopoly _ occurs when there are few suppliers and any action taken by one of them will definitely affect the
course of action of the others.
Operation and maintenance cost_ includes many of the recurring annual expenses associated with the operation
phase of life cycle. The direct and indirect costs of operation associated with the five primary resource
areas- people, machines, materials, energy, and information- are a major part of the costs in this category.
Opportunity Cost_ is incurred because of the use of limited resources, such as the opportunity to use those
resources to monetary advantage in an alternative use is foregone.
Ordinary annuity _ is one where the equal payments are made at the end of each payment period starting at the
first period.
Ordinary simple interest _is simple interest paid based on a banker's year of 12 months or 120 days.
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Overhead expenses _ consist of those expenses which cannot be readily included under direct materials and direct
labor. Also known as indirect costs or burden.
Ownership or proprietorship _ it represents the investment of a person or several persons in the enterprise.
Partnership _ is an association of two or more persons for the purpose of engaging in a business profit. Usually
formed by the voluntary agreement of the partners either verbally or in writing. The agreement among the
partners usually states the relations between partners on matters relating to the proportion in which profits
or losses are to be shared, their investments , rights and duties of each partner, and provisions for the
withdrawal of any partner or the dissolution of the partnership.
A partnership has many advantages, among which are its low cost and ease of formation. Because
more than one person makes contributions, a partnership typically has larger amount of capital available
for business use. Since the personal assets of all partners stand behind the business, a partnership can
borrow money more easily from a bank. Each partner pays only personal income tax on his or her share
of a partnership’s taxable income.
Patent _ is an exclusive right granted by the government for the manufacture, use, and sale of a specific product.
When a company acquires a patent or copyright by purchase of from the owner, the purchase price is
classified as an intangible asset.
Payout period _ the minimum period needed to recover an investment. Depreciable fixed capital/ net cash flow
Perfect competition_ a situation where a commodity or service is supplied by a number of vendors and there is
nothing to prevent additional vendors entering the market.
Perpetual Inventory _ consists of the preparation of inventory cards, and their being kept up-to-date for each type
of equipment or materials used or issued, and for the products completed or in the process of manufacture.
Perpetuity _ is an annuity where the payments periods extend or in which the periodic payments continue
indefinitely.
Physical inventory _ consists of the actual counting or determination of the actual of quantity of materials on
hand as of a given date.
Physical Life of an equipment _ is the length of time during which it is capable of performing the function for
which was designed and manufactured.
Power factor _ ratio of the power output in watts and the product of volts and amperes
Preferred stock _ also represent ownership. And it possesses the same rights as common stock, but in addition, it
enjoys certain preferences, not possessed by common stock. It has priority over common stock in receipt
of dividends, and it is usually guaranteed a fixed annual dividend, regardless of the amount of the earnings
of the corporation. In case the corporation is dissolved, the owner of the preferred stock, has priority over
the common stockholders. They may have right to vote in meetings.
Prepaid expense _ assets in the form of money paid for certain materials not yet delivered or services not yet
rendered to the company.
Prepaid income _ these are liabilities representing income which have been paid to the enterprise but for which
the goods have not been delivered or any service rendered to the payer.
Present economy _ involves the analysis of problems for manufacturing a product or rendering a service upon
basis of present or immediate costs.
Present value _ is the amount which if invested now will give a value of F after n interest periods. It is also
defined as projected cash inflows and outflows expressed or discounted to the present time.
Price _ is defined as the amount of money or its equivalent which is given in exchange of the goods being sold.
Principal _ is the amount of money borrowed inn which interest is charged.
Producer goods and services_ are used to produce consumer goods and services or other producer goods.
Machine tools, factory buildings, buses, and farm machinery are examples.
Profit _ is the excess of income over expenses
Project Risk_ the possibility that an investment project will not meet the minimum requirements for
acceptability and success.
Producer Price Index (PPI)_ is a family of indexes that measure the average change over time in the prices received
by domestic producers of goods and services. PPIs measure price change from the perspective of the
seller. The headline PPI (for finished goods) is a measure of the average price level for a fixed basket of
capital and consumer goods for prices received by producers. The producer price index for finished goods
is a major indicator of commodity prices in the manufacturing sector. These prices are more sensitive to
supply and demand pressures than the more comprehensive consumer price index. Changes in the
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producer price index are considered a leading indicator for consumer price changes, although only a small
portion of the PPI is directly connected to less than half of the CPI.
Proprietorship_ the simplest form of business organization wherein the business is owned entirely by one person.
Pyramid scheme_ a fraudulent scheme in which the perpetrators recruit people to pay money to those above them
in a hierarchy on the expectation that they will get payments from those below. When the number of
newly recruited people eventually dwindles, the payment structure collapses. Also known as Ponzi
scheme.
Quality assurance (QA) is a way of preventing mistakes or defects in manufactured products and avoiding
problems when delivering solutions or services to customers; which ISO 9000 defines as "part of quality
management focused on providing confidence that quality requirements will be fulfilled".This defect
prevention in quality assurance differs subtly from defect detection and rejection in quality control, and
has been referred to as a shift left as it focuses on quality earlier in the process.
The terms "quality assurance" and "quality control" are often used interchangeably to refer to ways of
ensuring the quality of a service or product. For instance, the term "assurance" is often used as follows:
Implementation of inspection and structured testing as a measure of quality assurance in a television set
software project at Philips Semiconductors is described. The term "control", however, is used to
describe the fifth phase of the DMAIC model. DMAIC is a data-driven quality strategy used to improve
processes.
Quality assurance comprises administrative and procedural activities implemented in a quality system
so that requirements and goals for a product, service or activity will be fulfilled. It is the systematic
measurement, comparison with a standard, monitoring of processes and an associated feedback loop
that confers error prevention. This can be contrasted with quality control, which is focused on process
output.
Rate of interest _ is the amount earned by one unit of principal during a unit of time.
Rate of return _ annual profit/capital invested
Registered bonds _ the owner's name is recorded in the books of the corporation, and the interest is paid
periodically to the owner without their asking for it.
Recession _the time when business activity has reached its peak and starts to fall until the time when business
activity (employment, industrial production, real income and wholesale-retail sales) bottoms out. When
the business activity starts to rise again it is called an expansionary period. By this definition, the average
recession lasts about a year.
Recurring Costs _are those that are repetitive and occur when an organization produces similar goods or services
on a continuing basis. Variable costs are also recurring costs because they repeat with each unit of output.
A fixed cost that is paid on a repeatable basis is also a recurring cost.
REER (Real effective exchange rate)_ measures the competitiveness of a currency in terms of making exports
more or less expensive. It takes into account the movement of one currency against several others, and
the inflation rates in other countries. Inflation is taken into account to measure currency competitiveness
in real terms because affordability of export goods is determined not just by the movement of an exchange
rate, but also by movement of prices of raw materials.
Replacement value _ The cost necessary to replace an existing property at any given time with one at least equally
capable of rendering the same service.
Retained earnings_ the cumulative net income of the firm since its beginning, less the total dividends that have
been paid to stockholders. It indicates the amount of assets that have been financed by plowing profits
back into the business. Therefore, these retained earnings belong to the stockholders.
Revenue_ the price of goods sold and services rendered during a given accounting period.
Root cause analysis (RCA) is a method of problem solving used for identifying the root causes of faults or
problems. A factor is considered a root cause if removal thereof from the problem-fault-sequence
prevents the final undesirable event from recurring; whereas a causal factor is one that affects an
event's outcome, but is not a root cause. Though removing a causal factor can benefit an outcome,
it does not prevent its recurrence with certainty.
Salvage value _ the amount to which the equipment or machine can be sold as second hand. It implies that the
machine can still perform the function.
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Scenario analysis_ a means of comparing a “base-case” or expected project measurement (such as NPW) to one
or more additional scenarios, such as best and worst case, to identify the extreme and most likely project
outcomes.
Scrap value _ the amount the equipment can be disposed off as junk.
Simple interest _ interest paid is directly proportional to the length of time the amount or the principal is borrowed.
Six-tenths-factor rule_ If a cost of given unit at one capacity is known, the cost of a similar unit with X times the
capacity of the first is approximately (X)0.6 times the cost of the initial unit.
0.6
 CapA 
 CapB 
Sole proprietorship _ or individual ownership, is the simplest of business organization, wherein the business is
owned entirely by one person who is responsible for the operation, firm’s policies, and is personally
liable for its debts. The proprietorship has two major advantages. First, it can be formed easily and
inexpensively. No legal and organizational requirements are associated with setting up a proprietorship,
and organizational costs are therefore, virtually nil. Second, the earnings of a proprietorship are taxed at
the owner’s personal tax rate, which may be lower than the rate at which corporate income is taxed. Apart
from personal liability considerations, the disadvantage of a proprietorship is that it cannot issue stocks
and bonds, making it difficult to raise capital for any business expansion.
Standard Costs _ are representative costs per unit of output that are established in advance of actual production or
service delivery. The are developed from anticipated direct labor hours, materials, and overhead
categories (with their established cost per unit).
Stock _ in business and finance, a share of ownership in a corporation. Shares in a corporation can be bought and
sold, usually on a public stock exchange. Consequently, the owner of shares can realize a profit or
capital gain if the stock is sold at a price above what the owner originally paid for it.
Stock Exchange_ organized market for buying and selling financial instruments known as securities, which
include stocks, bonds, options, and futures. Most stock exchanges have specific locations where the
trades are completed. For the stock of a company to be traded at these exchanges, it must be listed, and
to be listed, the company must satisfy certain requirements. But not all stocks are bought and sold at a
specific site. Such stocks are referred to as unlisted. Many of these stocks are traded over the counter—
that is, by telephone or by computer.
Stock Holder_ shareholder, owner of company stock,
Stockholder’s Equity_ the amount available to the owners after all other debts have been paid
Sunk cost _ money which has been spent or capital which has been invested and which cannot be recovered due
to certain reasons. They are non-refundable cash outlay, such as earnest money on a house, capital that
has been invested and cannot be retrieved or money spent on passport.
Supply _ is the quantity of a certain commodity that is offered for sale at a certain price at a given place and time.
Taxes;
Income taxes_ expressed as a function of gross revenues minus allowable deductions.
Property taxes_ are assessed as a function of the value of property owned, such as land, buildings, equipment,
and so on, and the applicable tax rates. They are independent of the income or profit of the company.
Sales taxes_ are assessed on the basis of purchases of goods or services and are thus independent of gross
income or profits.
Excise Taxes_ assessed as a function of the sale of certain goods or services often considered non-necessities
(alcohol, tobacco), and are hence independent of the income or profit of a business.
The Law of Demand _ the demand for a commodity varies inversely as the price of commodity, though not
proportionately.
The Law of Supply _ the supply of commodity varies directly as the price of the commodity, though not
proportionately.
The Law of Supply and Demand _ when free competition exists, the price of a product will be that value where
supply is equal to the demand.
Time value of money_ is the value of money figuring in a given amount of interest earned over a given amount
of time. The time value of money is the central concept in finance theory.
For example, P100 of today's money invested for one year and earning 5% interest will be worth $105 after
one year. Therefore, P100 paid now or P105 paid exactly one year from now both have the same value to
the recipient who assumes 5% interest; using time value of money terminology, P100 invested for one
year at 5% interest has a future value of P105.
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Tort_ a wrongful act that causes injury to a person or property and for which the law allows a claim by the injured
party to recover damages.
Unitary elasticity of demand _ occurs when the mathematical product of price and volume of sales remain constant
regardless of any change in price. PV=C
Utility _ is the capacity of a commodity to satisfy human wants and needs.
Utility or use value _ is what it is worth to the owner of a property when in actual operation.
Value_ the price that must be paid in order to obtain a particular item
Valuation_ or appraisal_ is the process of determining the value of certain property for specific reasons.
Variable Costs_ are those associated with an operation that vary in total with the quantity of output or other
measures of activity level.
Working capital_ refers to the funds required for current assets (other than fixed assets) that are needed for the
start-up and support of operational activities. Also known as the circulating capital, includes all funds
which are required to make the enterprise a going concern.
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N.111 More SAMPLE PROBLEMS:

1. Determine the ordinary simple interest on P1,000 for 10 months if the rate of interest is 12% per annum.
Solution:
I  Pin 
1,0000.12`030  P 100 or 1,0000.1210  P 100
I  Pin 
360 12
2. Determine the exact simple interest on P1,000 for the period from January 01 to October 31, 2003 if the rate of
interest is 12% per annum.
Solution:
Month Days
Jan 30
Feb 28
Mar 31
Apr 30
May 31
Jun 30
Jul 31
Aug 31
Sep 30
Oct 31
Total 303
I  Pin 
1,0000.12303  P 99.62
365
3. A man borrowed P1,000 from the bank and agreed to pay the loan in 10 months. The bank discounted the loan
and gave him P800 in cash. What is:
a. discounted interest rate
b. effective interest rate
Solution:
a. id 
Id

1,000  800  0.20  20% per 10 months
P 1,000
I
or id  d 
1,000  800  0.24  24% per annum
Pn 1,00010 / 12
I
b. i  d' 
1,000  800  0.25  25% per 10 months
P 800
I
or i  d ' 
1,000  800  0.30% per 30% per annum
Pn 80010 / 12
4. A person wishes to accumulate P100,000 in the bank after 5 years. How much is he going to deposit now
assuming that his money earns 6% per annum compounded annually?
F 100, 000
P   P 74, 726
1  i  1  0.06 
n 5
If interest is compounded monthly:

F 100, 000
P   P 74,137
1  i  1  0.005
n 60
If interest is compounded continuously:

100, 000
P   0.06 5  P74, 082
e
5. What will be the future equivalent amount at the end of five years of a uniform 5 yearly deposit of P5,000. if the
nominal annual interest rate is 12% compounded:
b. annually; b. monthly; c. continuously
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Solution:
b. Compounded Annually
 1  i n  1   1  0.12 5  1 
F5  A    5,000    P31,764
 i   0.12 
c. Compounded monthly:
i  1  r / m  1  1  0.12 / 12  1  0.1268  12.68%
m 12
 1  i n  1   1  .12685  1 
F5  A    5,000    P32,198
 i   0.1268 

c. Compounded continuously:
i  er 1
 e nn  1   e 0.12 5  1 
F5  A  r   5, 000  0.12   P32, 241
 e  1   e 1 
d. What will be the equivalent future amount at the end of five years if the uniform deposit of P5,000
flows continuously per year; compounding is also continuous.
 enn  1   e 0.12 5  1 
F5  A    5, 000    P34, 255
 r   0.12 
6. A uniform amount of P2,000 will be deposited monthly in the bank at the beginning of each period for the next
2 years. The first of such deposits is to be made now. What is the accumulated amount after 2 years if money
is worth 12% pa compounded monthly?
Solution: If deposits are made at the beginning of each period:
 1  i n 1  1 
Fn  A   1
 i 
 1  0.01  1 
24 1
F24  2, 000   1
 
0.01
 P54, 486
If deposits are made at the end of each period:

 1  i n  1 
Fn  A  
 i 
 1  0.0124  1 
F24  2, 000  
 0.01 
 P53,947
7. A machine costs P50,000 cash. The dealer agreed for a 10 uniform quarterly payments, the first due at the end of
the first year after purchase. If money is worth 12% per annum compounded quarterly, determine the quarterly
installment.
Soln: If the first payment is made after a year (end of 4th quarter) then the last payment would be on the 13 th
quarter. The amount of P50,000 must, therefore, be projected on that period which is equal to the
accumulated amount of 10 quarterly payments.
 1  0.0310  1 
 
F13  50, 000 1.0313  A  
 
0.03
A  P 6, 405
4/29/2021 N - 126 of 138 nilo t. aldon

8. What is the accumulated amount of a series of payments when the initial payment of P1000 increases by P200
each period, until the third period if cost of money is 10% pa.
A A+G A+2G A+(n-1)G
0 1 2 3 N
Required: Fn
Solution: A= P1000 ,G =P200, and i =10%
Fn  FAn  FGn
 1  i n  1  G  1  i   1 
n
Fn  A    FGn    n
 i  i 

i 
 1  0.10   1  200  1  0.10   1 
3 3
Fn  1000     3
 0.10  0.10  0.10 
 P3,930
9. What is the accumulated amount after 3 years, if instead of P200 per period, the payment of P1,000 increases by
15% after the first year and the interest rate is still the same?
Solution:
 1  i n  1  g  n 
Fng  A  
 ig 
 
 3
 1  0.10   1  0.15  
3
F  1, 000  
g3 0.10  0.15
 
 
 P3, 798
10. A debt is to be repaid by 24-monthly installments of P5,000, the first of which to be made one month from now.
If cost of money is 12% pa compounded monthly, how much is the equivalent amount of the debt now?
Solution:
 1  0.0124  1 
P  5, 000  
 0.011  0.01 
24
 106, 217
11. Using the preceding example solve for the debt now if interest is continuous,
Solution:
 e rn  1 
P  A  rn r 

 e e  1  
 e 0.01 24  1 
 5, 000   0.01 24 0.01 
 e 
e 1  
 P106,153
12. Given: Loan = P100,000, Interest =10% pa, payable in 5 years
Beginning Payment, Payment, Total

balance Principal Interest Payment
100,000 20,000 10,000 30,000
80,000 20,000 8,000 28,000
60,000 20,000 6,000 26,000
40,000 20,000 4,000 24,000
20,000 20,000 2,000 22,000
Total 100,000 30,000 130,000
REQUIRED: Average interest payments
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SOLUTION:
30,000
Average Interest Payments   6,000 / year
5
6,000
i ave   0.06  6%
100,00
r n  1 105  1
i ave    6%
2n 25
Thus, rather than paying a maximum interest on the first year of P10,000 and minimum interest of P2,000 on
the fifth year, the equivalent uniform annual payment would be 6% of the original loan or P6,000 annually.
13. A company borrowed P100,000 today to be repaid after 3 years at a market interest rate of 11%. a.
What is the actual amount owed at the end of 3 years.
b. What is the real interest earned by the lender if the general inflation rate is 5% per year
c. What is the real peso equivalent in purchasing power to the actual-peso amount at the end of
the third year?
SOLUTION:
a. F  P1  i   100,0001  0.11  P136,763
n
5
i  f 0.11  0.05
b. i '    0.0571428  5.71428% per year
1 f 1  0.05
c. F  P 1  i '   100, 000 1  0.0571428   P 118,141

n
3
n
 1 i   1  0.11 
3
 P   100, 000    P 118,141

 1 f   1  0.05 
14. What is the worth of P100, five years from now if invested at 10% pa, and inflation is
expected at 8% pa? What is the real interest rate?
Solution:
The P100 invested at 10% pa is equivalent to F5 =100(1+0.10)5
Due to inflation, the same P100 will be worth only, F5 = 100/(1.+0.08)5
Considering time value of money and inflation, 5 years from now, P100 is equivalent to:
n
 1 i  1  0.10 
n
Fn  P  F5  100   P 109.61

1  f   1  0.08 
F  P1  i ' = 109.61  1001  i'

n 5
i'  5 1.0961  1  0.0185  1.85%
Real interest rate, i '  i  f  0.10  0.08  0.0185  1.85%

1 f 1  0.08
15. A bond issue of P200,000, in 10-years, in P1,000 units paying 16% nominal interest in semi-annual
payments, must be retired by the use of sinking fund that earns 12% pa compounded semi-annually.
What is the total semi-annual expense?
Solution:
F = P200,000
i = 12%/2 = 6% per semi-annual
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Total semi-annual expense = A + I

 i 
Total Semi  annual Expense  F    Fr
    
n
1 i  1
 0.06 
 200, 000    200, 000  0.08 
 1  0.06   1 
20
 P 21, 437
16. The cost of an item now is P100. What will be its cost 2 years from now if inflation rate
is 5%?
SOLUTION:
F  P 1  f   1001  0.05  P 110.25
n 2
It means that the purchasing power of money after 2 years is equivalent to only 90.7% of the
money now (100/110.25) or your P100 two years from now could only buy P90.70 worth of goods or
services now.
17. A man wants to make 14% nominal interest compounded semi-annually on a bond
investment. How much should the man be willing to pay now for a 12% pa P10,000-bond
that will mature in 10 years and pay interest semi-annually?
Solution:
F = P10,000
i = 14%/2 =7% per semi-annual
 1   1  i n  1
PW  F    Fr  n 
 1  i    i1  i  
n
 1   1  0.07 20  1 
PW  10,000    10,000  0.06     P 8,941
 1  0.07    0.07 1  0.07  
20 20
18. Find the current price of a 10-year bond paying 6% per year (payable semi-annually) that is redeemable at
par value, if bought by a purchaser to yield 10% per year. The face value of the bond is P100,000 .
Solution:
F=P100,000; n  2 10  20  
r  6 / 2  3% per semi  annual period
i  `1.10 2  1  0.0488  4.88% per semi  annual period
1
 1   1  i n  1
PW  F  n 
 Fr  n 
 1  i    i1  i  
   1  0.048820  1 
 100,0000.03
1
PW  100,000 20  20 
 1  0.0488   0.04881  0.0488 
 P76,120
Alternative Solution:
F=P100,000; n  10
2
 0.06 
r  6% per annum paid semi  annually  1    1  0.0609  6.09% pa
 2 
 1   1  i n  1
PW  F  n 
 Fr  
 1  i    i1  i  
n
4/29/2021 N - 129 of 138 nilo t. aldon

 1   1  0.10 10  1 
PW  100, 000    100, 000  0.0609   
 1  0.10    0.10 1  0.10  
10 10
 P 75,975
Solution:
d 
 FC  SV  Q
n n
QT
9
3 x10
  400, 000 
4 x106
 P300 M
20. An equipment was purchased at a cost of P1,000,000 with an expected service life of 10 years and a salvage
value P100,000. Solve for the annual depreciation cost and book value during the 8 th year using
a. Straight-line method
b. Sinking fund method, i=10% pa
c. Declining balance method
d. Sum-of-the-years-digit method
Solution:
a. Straight line method
BVn  FC  d n 
FC  SV
d
L
d 
1,000,000  100,000  P 90,000 / year
10
BVn  FC  dTn  FC  d (n)  1,000,000  90,0008

 P 280,000
b. Sinking fund method
 
d  FC  SV 
i

 1  i   1
L
 
d  1,000000  100,000
0.1
  P56,471
 1  0.10  1
10
BV8  FC  dTn
 1  i n  1
 FC  d  
 i 
 1  0.108  1
 1,000,000  56,471 
 0.10 
 P534,204
c. Declining Balance Method

d n  FC 1  f   f 
n 1
BVn  FC 1  f  d n  FC 1  f  f
n n 1
 SV 1  f  d8  1, 000, 000 1  0.2057   0.2057 

nL 81
1  P 41, 032
 SV  L
f 1    BVn  FC 1  f 
n
 FC 
1, 000, 00 1  0.2057 
8
1 BVn
 100,000 10  P158, 444
 1  
 1,000,000 
 0.2057
4/29/2021 N - 130 of 138 nilo t. aldon

d. Sum-of-the-years digit method
dn 
FC  SV L  1  n 2 ; d  FC  SV 2 L  1  n n ; BVn  FC  dTn
L  1L Tn
L  1L
d8 
1,000,000  100,00010  1  82
10  110
 P 49,091
BV8  1,000,000 
1,000,000  100,000 210  1  88
10  110
 P149,090
21. A firm purchased and placed in service a new piece of semiconductor manufacturing equipment. The cost
basis for the equipment is P100,000. Using MACRS Method, determine (a) the depreciation charge
permissible in the fourth year, (b) the BV at the end of the fourth year, (c) the cumulative depreciation through
the third year, and (d) the BV at the end of the fifth year if the equipment is disposed of at that time.
Solution:
From Table N-1, the semi-conductor (electronic manufacturing equipment has a class life of six years and a GDS
recovery period of five years (Asset Class 36). The recovery rates that apply are given in Table N-2.
(a) The depreciation deduction, or cost-recovery allowance , that is allowable in year four (d 4) is
d 4  0.1152 (100,00)  P11,520
(b) The BV at the end of year four (BV4) is the cost basis less depreciation charges in years one
through four:
BV4  100,000  100,000(0.20  0.32  0.192  0.1152)  P17,280
(c) Accumulated depreciation through year three,d 3, is the sum of depreciation amounts in years
one through three:
dT3=d1+d2+d3
dT 3  100,000(0.20  0.32  0.192)
 P71,200
(d) The depreciation deduction in year five when the equipment is disposed of prior to year six.
d5=(0.5)(0.1152)(100,00)= P5,760
Thus, BV at the end of year five is

BV5= BV4-d5 = 17,280-5,760 = P11,520
22. A company has three alternative investments which are being considered. Because all three investments are
for the same type of unit and yield the same service, only one of the investments can be accepted. The risk
factors are the same for all three cases. Company policies, based on the current economic situation, dictate
that a minimum annual return on the original investment of 15% after taxes must be predicted for any
unnecessary investment with interest on investment not included as a cost. (This may be assumed to mean
that other equally sound investment yielding a 15% return after taxes are available). Company policies dictate
that, where applicable, straight-line method depreciation is used, and, for time-value of money interpretation,
end-of-year cost and profit analysis is used. Land value and prestart-up costs can be ignored.
Given the following data, determine which investment, if any, should be made by alternative-analysis
profitability-evaluation methods of
a. Rate of return on initial investment
b. Minimum pay-out period with no interest charge
c. Minimum pay-out period with interest charge
d. Discounted cash flow
e. Net present worth
f. Capitalized costs
g. Capital recovery
4/29/2021 N - 131 of 138 nilo t. aldon

Data:
Investment Fixed Capital Working Salvage Service Ө Annual Ω Annual Cash
Number Investment, P Capital, P Value, P Life, Year Cashflow, P Expenses, P
1 100,000,000 10,000,000 10,000,000 5 ¤ see table 44,000,000
2 170,000,000 10,000,000 15,000,000 7 52,000,000 28,000,000
3 210,000,000 15,000,000 20,000,000 8 59,000,000 21,000,000
Ө =annual income minus all costs except depreciation and interest cost for investment
¤ 1st yr= P30M; 2nd yr=P31M; 3rd yr=P36M; 4th yr=P40M; 5th yr=P43M
Ω this is annual cost for operation, maintenance, taxes & insurance. Equals total annual income
minus annual cash flow
Solution:
Net Pr ofit Cashflow  Depreciation
ROI  
Total Investment Total Investment
For Investment #1, average annual cash flow  30  31  36  40  43  P 36M
5
Annual Depreciation#1  100  10  P18M
5
Annual Depreciation#2  170  15  P 22.14M
7
Annual Depreciation#3  210  20  P 23.75M
5
Net Pr ofit Cashflow  Depreciation 36  18
ROI #1     16.36%
Total Investment Total Investment 100  10
Net Pr ofit Cashflow  Depreciation 52  22.14
ROI #2     16.59%
Net Pr ofit Cashflow  Depreciation 59  23.75
ROI #3     11.67%
Depreciable Fixed Capital Investment 100  10

N #1    2.5 yr
Cashflow 36

N #2    2.98 yr
Cashflow 52
N #3    3.22 yr
Cashflow 59
Discounted Cash flow:

DCF #1
30 31 36 40 43  10  10
110      ;i 
1  i  1  i  1  i  1  i  1  i 
DCF #2
52  1  i 7  1 10  15
180    ;i 
1  i 7  i  1  i 
7
4/29/2021 N - 132 of 138 nilo t. aldon

DCF #3
59  1  i 8  1 15  20
225    ;i 
1  i 8  i  1  i 
8
Net Present Worth

30 31 36 40 43  10  10
NPW1       110 
1  0.15 1  0.152 1  0.153 1  0.154 1  0.155
52  1  0.157  1 10  15
NPW2  7    180 
1  0.15  015  1  0.157
59  1  0.158  1 15  20
NPW3     225 
1  0.158  0.15  1  0.158
Capitalized Cost:
K1  FC 
CR
 110 
100  10  44 
1  i   1
L
1.155 0.15
K 2  FC 
CR
 180 
170  15  28 
1  i   1
L
1.155 0.15
K1  FC 
CR
 225 
210  20  21 
1  i   1
L
1.158 0.15
Capital Recovery

CR1  TCI 1  i   SV  WC
L
1  ii L
1

 1101.15  10  10
5
1.15
0.15
5
 1


CR 2  1801.15  10  15
7
 0.15

1.15  1
7

CR1  2251.15  15  20
8 0.15
1.158  1


23. Six years ago, an 80-kw diesel electric generator costs P800,000,. The cost index for this class of equipment six
years ago was 187 and is now 194. The cost capacity factor is 0.6 Determine the cost of a 120 kw unit now?
a. P537,452 b. P 488,569 c. P 520,339 d. P842,708 e. P464,171
X
 I  S 
0.6
 197  120 
C B  C A  n  A   400,000  
 I K  S B   187  80 
 P 537,451.61
4/29/2021 N - 133 of 138 nilo t. aldon

N.112 Derivation of equations:

a. Ordinary Annuity
F3  A1  i   A1  i   A
2
P
0 1 2 3 n
F3
 1  2i  i 2  1  i  1  3  3i  3i 2 A A A
A F3 Fn
F3
i  3i  3i 2  3i 3
A
F3
i  1  1  3i  3i 2  3i 3
A
 1  i 3  1
F3  A 
 i 
 1  i   1
n
Fn  A  N-27
 i 
b. Annuity Due
F2  A  1  i   A 1  i 
2
P
F2
0 1 2 n
 1  2i  i 2  1  i  2  3i  i 3 A A F3
A
F2i Fn
 2i  3i 2  i3
A
F2i
  1  i   1  3i  3i 2  i 3  1  i 
3
A
  1  i 3   1  i  
F2  A  
 i 
  1  i  n 1  1 
Fn  A   1 N-29
 i 
c. Uniform Arithmetic Gradient

0 1 2 3 . n
A A+G A+2G A+(n-1)G
FG3  G  1  i   2G
FG3
 3i
G
FG3 2
i  3i 2  i 3
G
FG3 2
i   1  3i   1  3i  3i 2  i 3  1  i 
3
G
  1  i 3   1  3i   G   1  i 3  1 
FG3  G  2    3
 i  i  i 
G  1  i   1 
n
FGn    n N-40
i  i 

4/29/2021 N - 134 of 138 nilo t. aldon
d. Geometric Gradient
0 1 2 3 . n
A A(1+g) A(1+g)2 A(1+g)n-1
F3
 3  3i  i 2  3g  gi  g 2
A
F3
A

i  g   i  g  3  3i  i 2  3g  gi  g 2 
 3i  3i 2  i 3  3gi  gi 2  g 2 i  3g  3gi  gi 2  3g 2  g 2 i  g 3
 1  3i  3i 2  i 3  1  3g  3g 2  g 3
 1  i   1  g 
3 3
 1  i 3  1  g 3 
F3  A 
 i  g  
  1  i n   1  g n 
Fn  A   N-42
 ig 
When: g=i
F3
 3  3i  i 2  3g  gi  g 2
A
F3  3 A 1  i 
31
Fn  nA 1  i 
n 1 N-43
e. Continuous Compounding and Discrete Cash Flow

Cash flow occur at discrete intervals (e.g. once per year) but that compounding is continuous
throughout the interval. If we let m the number of interest periods per year, then :
r

m
At the end of the year, one unit of principal will amount to:
m
 r
 1  
 m
At the end of the nth year, one unit of principal will amount to:
n  r  n 
= 1  r   = 1  r  
m m/r
     
 m   m 
For the equation:
m/r
 r
As m approaches infinity, 1   e
 m
The equation then becomes:
 r  n 
 r   e r n   1  i  er  1  i
m/r
n
where:
1   
 m  
4/29/2021 N - 135 of 138 nilo t. aldon

i  er  1
Substituting the value of ieff in equation N-50 and N-54
F 1  i   1
n
   P / A, i%, n  (N-50)
A i
P 1  i   1
n
   P / A, i%, n  (N-54)
A i 1  i n
 e rn  1
F  A r  (N-63)
 e 1
A  e rn  1
P  r  (N-64)
e rn  e 1 
6. Continuous Compounding, Continuous Uniform Cash Flow

Continuous cash flow of funds means a series of cash flows occurring at infinitesimally short periods;
this corresponds to annuity having a definite number of short periods.
The change in the value of F per unit period is:
dF
 A  Fr
dn
dF
0 A  Fr  0 dn
F n
1 A  Fr
Ln n
r A
A  Fr
 e rn
A
 ern  1 (N – 65)
FA 
 r 
A  e rn  1 (N – 66)
P  
e rn  r 
7. Annual Depreciation , Sum-of-the-years Digit Method

Year 1 2 3 4 5
Numerator 5 4 3 2 1
4 4
d2  
1  2  3  4  5 15
n
The sum of consecutive numbers S  (a  l)
2
Where: n = number of integers;
a = 1st number = 1
l = the last number = L (service life)
L
Denominator, S 
(1  L )
2
Numerator, nth year  L  1  n
4/29/2021 N - 136 of 138 nilo t. aldon

FC  SV L  1  n  (N – 83)

dn 
L( L  1)
2
8. Total Depreciation, Sum-of-the-years Digit Method

5 ;
54 9
d1 
5 d  
1 2  3  4  5
2
1 2  3  4  5 15 15
Numerator = sum of consecutive numbers

n n n
S  (a  l)  L  L  1  n   2L  1  n 
2 2 2
d Tn 
FC  SV  n2L  1  n
 FC  SV    2L  1  n 
n
2   d   FC  SV   n  2 L  1  n  LL  1
dTn 
L( L  1) Tn
L  L  1 (N – 84)
2
9. Declining- Balance method
Period BV begin dep BVend

1 FC f(FC) FC-f(FC)= FC(1-f)
2
2 FC(1-f) FC(1-f)f FC(1-f)-FC(1-f)f= FC(1-F)
n-1
n FC(1-f) FC(1-f)n-1 (f) FC(1-f)n
d n  FC 1  f n 1  f  (N – 79)
BV n  FC 1  f n (N – 80)
BV n  FC 1  f n ; SVL  FC1  f L
BVn  FC1  f  BVn  1  f 
n n

SVL  FC1  f L SVL  1  f L
BVn  FC 1  f 
n L FC (N – 81)

1  f Ln
1 1
 SV  Ln
  1  
SV  L
f  1    (N – 82)
 BVn   FC 
N.113 References ;
Plant Design and Economics for Chemical Engineers, Max S. Peters and Klaus D. Timmerhaus, 4th Ed 2001
Process Engineering Economics, Schweyer
Engineering Economy, de Garmo, Sullivan, Canada, 7th Ed
Engineering Economy, Arreola, 2nd Ed
Engineering Economy Sta. Maria, 3rd Ed
Engineering Economy, Sullivan, Bentadilli and Wichs, 12th Ed 2003
Contemporary Engineering Economics, Chan S. Park, 3rd Ed 2002
Engineering Economy by L.T. Blank and A.J. Tarquin, 6th ed., McGraw Hill, 2005.
Engineering Economy by W.G. Sullivan, E.M. Wicks, and J.T. Luxhoj, 13th ed., Prentice Hall, 2006.
Contemporary Engineering Economics by Chan S. Park, 4th ed., Prentice Hall, 2007.
4/29/2021 N - 137 of 138 nilo t. aldon
Excel for Engineering Economics by R.W. Larsen and Chan S. Park, Prentice Hall, 2003.
Engineering Economy and the Decision Making Process by J.C. Hartman, Prentice Hall, 2007.
Engineering Economic Analysis by D. G. Newman, T. G. Eschenbach, and J. P. Larelle, 9th ed., Oxford University Press, 2004.
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Colegio San Agustin-Bacolod Engineering Economy

College of Engineering by Nilo T. Aldon

by : Eng’r Nilo T. Aldon ChE

N.2 Selection and Equivalence in Present Economy 8

N.3. Money-Time Relationship

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N.6. Operational Costs 60

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Economists study topics such as:

 How prices and quantities of items are determined in market economies

Understanding what economists do and don’t study is important, since sometimes

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1.1 Principles of Engineering Economy

Uses of Engineering Economy

1.2 Engineering Economic Decisions

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1.3 Engineering Economy and Design Process

Engineering Economic Analysis Procedure Engineering Design Process

2. Development of feasible alternatives 3. Synthesis of possible solutions (alternatives)

4. Selection of criterion (or criteria)

The design process

Approaches to Design Problems

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1.4 Cost Concepts for Decision Making

Following are some of the basic uses of cost estimation

 Combination of Price Cost Index and Sixteenth Rule:

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N.2 SELECTION AND EQUIVALENCE IN PRESENT ECONOMY

Present economy studies occur in the following situations:

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Total Costs P 36,500,000 P 33,300,000

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For Soap containing 5% water, the Cost per kg FOB = X

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N.3. MONEY-TIME Relationship

Interest __ the time value of money

3. Time, n = the period of time during which interest is charged, measured in

N.3.2. Types of Interest

1. Ordinary Simple Interest

2. Exact Simple Interest

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Effective interest rate, i

b. Rate of interest (9 months)

c. Effective interest rate? (1 year)

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or (total amount due at the end of nth period)

1. Nominal Interest Rates, r

2. Effective Interest Rates, i

Conversion of Nominal Interest rate to Effective Interest Rate:

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Integrating and substituting the limit of F from P to F, and that of n, from 0 to n,

To convert nominal continuous interest rate to effective interest rate:

Equating (N –10) and (N-15) Pi 1n  Pe rn (N – 16)

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If interest is compounded monthly:

If interest is compounded continuously:

3. What is the effective interest rate? (refer to the previous problem)

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C. Average Interest, iave

100,000 20,000 10,000 30,000

REQUIRED: Average interest payments