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This chapter introduces some topics that are related to the economic evaluation of
alternatives such as the depreciation, breakeven analysis and the sensitivity analysis.
These topics are very important for the economic evaluation of projects. Also, the use of
investment laws and economic evaluation are presented and applied for the construction
projects such as: calculation of the renting cost of equipment, equipment replacement
analysis and the evaluation of bids.
4.1 Depreciation
The depreciation in defined as “the decrease in market value of an asset over time”
through wear, deterioration or obsolescence. A machine may depreciate (decline in value)
because it is wearing out and no longer performing its function as well as when it was
new. Many kinds of machinery require increased maintenance as they age, reflecting a
slow but continuing failure of individual parts. Also, the quality of outputs may decline
due to wear in components. Another aspect of depreciation is that caused by
obsolescence. Obsolescence occurs when the asset is no longer technologically superior
to available alternatives. A machine is described as obsolete when the function it
performs can be done in some better manner. A machine may be in excellent working
condition, yet may still be obsolete. For example, electronic machines, computers, etc.
As asset always has different values: initial value (P), book value (BV), salvage value (F)
and market value (MV). The initial value represents the purchase price of an asset.
Salvage value represents the expected price for selling the asset at the end of its useful
life. The book value represents the current value in the accounting systems. The book
value equals the initial value of the asset minus all the depreciation costs till given time.
Depreciation is an accounting charge that allows for the recuperation of capital that was
used to procure equipment or other physical assets. There are three common methods for
calculating depreciation expense for financial accounting purposes: straight-line, sum-of-
years digits and the sinking fund method. Each method involves the spreading of the
amount to be depreciated over the recovery life of an asset in a systematic manner.
Where:
Dn = Annual depreciation
P = Initial value of the asset (include purchase price, delivery cost,
installation cost and other equipment related costs).
P = Salvage value of the asset (the net value after dismantling or removal
costs have been subtracted from the actual monetary value).
N = Expected depreciable life of the asset.
Example 4.1: If an asset has a initial value of LE50,000 with LE10,000 salvage value
after five years. Calculate the annual depreciation and calculate the book
value of the asset after each year.
Solution:
Annual depreciation:
Dn = (P - F) / N = 50,000 - 10,000 / 8 = LE8,000 per year
Example 4.2: If the purchase price of an equipment is LE60,000 and its salvage value
after 8 years is LE6,000, calculate the annual depreciation and the book
value of the equipment each year.
Solution:
P = 60,000; F = 6,000; N = 8;
Total depreciation = 60000 – 6000 = LE54,000
Annual depreciation = 54000 / 8 = LE6,750
Notice that the book value of the equipment equals its salvage value at the
end of its useful life as shown in Table 4.1.
For an asset with useful life N, to obtain the annual depreciation charge, Dn, at any year
n, can be calculated as follows:
Ν - n 1
Dn (P F ) (4.3)
N ( N 1)/2
Example 4.3: Resolve Example 4.2 using the straight-line depreciation method.
Solution:
P = 60,000; F = 6,000; N=8
Sum-of-years digits = 8 (8 + 1) / 2 = 36 years
The calculations are shown in the following table (Table 4.2).
Example 4.4: Calculate the depreciation charge for the first three years and the book
value for year three for an asset which had a first cost of LE25,000, and a
salvage value of LE4,000 and a life of eight years.
Solution:
The sum of years digits must be calculated first:
Sum of Years Digits = 8 (8 + 1) / 2 = 36
D1 = [(8 – 1 + 1) / 36] (25,000 – 4,000) = LE4667
i
A (P F ) (4.4)
(1 i) 1
n
Then the depreciation value, Dn, at any year n is calculated using the following equation.
Example 4.5: Resolve Example 4.2 using the sinking fund depreciation method,
assuming that the interest rate is 10%.
Solution:
P = 60,000; F = 6,000; N = 8; i =10%
8
A = (60000 – 6000) × [(0.1) / (1.1 – 1)] = LE4,722
Accordingly, the annual depreciation could be calculated as follows:
At the first year: D1 = LE4,722
At the second year: D2 = 4722 × (1.1) = LE5,194
At the third year: D3 = 4722 × (1.1)2 = LE5,714
……………..
At the eighth year: D8 = 4722 × (1.1)7 = LE9,202
The results of the depreciation calculations are summarized in Table 4.3.
After studying depreciation calculations from the previous listed three methods,
Figure 4.1 illustrates the difference between the three methods. The figure shows that
the sum-of-year digits method gives an accelerated depreciation compared to the
straight-line method. On the other hand, the sinking fund is a decelerated method
compared with the straight-line method. However, the straight-line method is the
commonly used for calculating asset depreciation.
Initial
value
Sinking
fund
Book value
Straight-
line
Sum-of
years
Salvage
value
Age
Figure 4.1: Comparison among the three depreciation methods
The cost per unit of time of owning an item of equipment has to be determined. Costs
associated with owing equipment called the ownership costs. Estimating equipment cost
involves identifying the ownership and operating costs. Ownership costs include: initial
cost, financing (investment) costs, depreciation costs and taxes and insurance costs. The
operating costs include: maintenance and repair costs, storage costs and fuel and
lubrication costs.
The initial cost is the total cost required to purchase a piece of equipment. This initial
cost is the basis for determining other costs related to ownership as well as operating
costs. Generally, initial cost is made up of: price at the factory or used equipment price,
extra options and accessories, sales tax, freight and assembly or setup charges. The initial
cost is very straight forward, whereas the other costs require more analysis and
computation. Te annual depreciated cost of the equipment should be calculated as
described in the previous section.
In order to calculate the cost of finance (or investment cost) of an equipment, both the
purchase price, P, and the salvage value, F, should be converted into uniform annual
values. In this situation, the purchase price is considered as a present value invested for n
yeas as a series of uniform payments (equipment useful life) and the salvage value is
considered as a future sum of money to be discounted for n years as a series of uniform
payments.
Example 4.6: An excavator purchase price is LE460,000 and its salvage value is
LE40,000 after 10 years of useful life. Find the annual cost of finance of
this excavator if the annual interest rate is 15%.
Solution:
P = 460,000; F = 40,000; n = 10; i = 15%
Annual cost of finance =
= LE47,684/year
Operating cost accrue only when the unit of equipment is used, whereas ownership costs
accrue whether or not the equipment is used. Operating costs include maintenance and
repairs, fuel, oil and lubricants. The amounts consumed by a piece of equipment vary
with the type and size of equipment, the conditions under which it is operated. An
equipment is seldom used its total horse power and also it is seldom to work for 60
minute/hour. Thus, the fuel consumed should be based on the actual operating conditions.
Perhaps the average demand on an engine might be 50 percent of its maximum power for
an average 45 minutes/hour.
Maintenance and repair costs: The cost for maintenance and repairs include the
expenditures for replacement parts and the labor required to keep the equipment in
good working condition. Historical cost records of maintaining and servicing
equipment are the most reliable guide in estimating maintenance and repair cost.
The manufacturers of construction equipment provide information showing
recommended costs for maintenance and repairs for the equipment they
Cost of rubber tires: Many types of construction equipment use rubber tires,
whose life usually will not be the same as the equipment on which they are used.
For example, a unit of equipment may have an expected useful life of six years,
but the tires on the equipment may last only for two years. Therefore, a new set of
tires must be placed on the equipment every two years, which would require three
sets of tires during the six years the equipment will be used. Thus, the cost of
depreciation and repairs for tires should be estimated separately from the
equipment.
Example 4.7: Calculate the ownership cost per hour for an excavator powered by a
250-hp engine based on the following data:
- Purchase price (P) = LE420,000
- Salvage value (F) = LE250,000
- Operation factor = 50%
- Useful life (N) = 6 years
- Working hours per year = 2000
- Maintenance and repair costs = 110% of annual depreciation
- Diesel fuel price = 3.8/gallon
Solution:
Depreciation (assume straight-line) = (420000 – 250000) / 6
= LE28333.33/year
Investment annual cost is calculated as follows:
Example 4.7: Calculate the hourly rate of equipment based on the following data:
- Purchase price (P) = LE460,000
- Salvage value (F) = LE40,000
- Useful life (N) = 10 years
- Working hours per year = 2000 years
- Annual maintenance costs = 10% of purchase price
- Annual operating costs = LE47,000
- Interest rate (i) = 15%
In this method, the cash flow for both the costs and the revenues are calculated and the
net present worth is calculated so that the net present worth equal zero taking into
account the time value of money.
Example 4.8: Resolve example 4.7 using the cash flows method.
Solution:
Let’s assume that the annual return from renting the equipment is x,
accordingly, the cash flows could be summarized as given in Table 4.4.
Annual costs = annual maintenance + operating cost
= 0.1 × 460000 + 47000 =
= 46000 + 47000 = LE93,000
By equating the PV for both the costs and revenues (i.e., NPV =0), as
follows:
0 = -460000 + (x – 93000) (P/A, 15%, 10) + 40000 (P/F, 15%, 10)
= -460000 + (x – 93000) (5.0188) + 40000 (0.2472)
x – 93000 = 89685
Then, x = LE182,685 / year
The hourly rent = 182685 / 2000 = LE91.34/hr
All the previous analysis assumes that the data used for an economic decision is
deterministic and certain. Also, since many data gathered in solving a problem represents
projections of future consequences, there may be considerable uncertainty regarding the
accuracy of that data. As the desired results of the analysis is decision making, as
appropriate question is, “to what extent do variations in the data affect my decision?”
What variations in a particular estimate would change selection of the alternative? In
such case, the decision is said to be sensitive to the estimate.
Example 4.9: The purchasing cost of a given equipment is LE90,000 and its return
for the first year is LE30,000 decreasing annually by LE3,000. If the
investment rate changes between 10% and 25% and the equipment age
ranges from 8 to 12 years. It is required to study the sensitivity of the
decision considering the effect of the change of the investment rate and the
age using the EUAW method. Neglect the equipment salvage value.
Solution:
The cash flow could be represented as follows:
G = 3,000
LE30,000
LE90,000
The previous results show that all the values of the EUAW remain positive
for all values of n (in the specified range). Accordingly, the decision does
not affected with the change of the equipment life.
On the other hand, the change of the investment rate changes the values of
the EUAW from being positive to negative. Accordingly, the decision
changes with the change of the i values.
Example 4.10: A test vehicle has a cost of LE100,000 with a life of 10 years.
Additional revenues of LE17,500 per year are expected and the required
MARR is 15%. If the additional revenues are only estimates and might
fluctuate 15%. Evaluate the sensitivity of the analysis.
Revenue EUAW
14,875 -5,050
15,750 -4,175
16,625 -3,300
17,500 -2,425
18,375 -1,550
19,250 -675
20,125 200
Example 4.11: A company wants to purchase a new core driller for information
gathering. It is expected that the machine can be purchased for LE275,000
it will last 8 years, expenses will total LE50,000 per year and that the
revenues will be LE100,000 per year. The company requires a MARR of
10%.
A fundamental of accounting is that all revenues and costs must be accounted for and the
difference between the revenues and costs is the profit, or loss, of the business. Costs can
be classified as either a fixed cost or a variable cost. A fixed cost is one that is
independent of the level of sales; rather, it is related to the passage of time. Examples of
fixed costs include rent, salaries and insurance. A variable cost is one that is directly
related to the level of sales, such as cost of goods sold and commissions. In planning and
managing your business it is important to know what level of sales must be achieved in
order to meet total costs. Every LE of sales above this will contribute to profits.
Example 4.12: A factory produces concrete blocks units. Each unit sells for LE15
and costs LE5. The annual maintenance and operation costs are LE75,000.
Calculate the number of blocks that should be produced to justify keep this
business running.
Solution:
Let’s assume that number of units produced is x. Accordingly, the cost of
blocks equal 5x and the annual revenue is 15x.
The annual cost = 75000 + 5x
Cost
Revenue
Total cost
Fixed cost
Units
Example 4.13: There are two proposals to buy a new production line for brick
manufacturing. The information related to both alternatives is shown in the
following table. If the interest rate is 10%, find:
a. The volume of production that justifies the purchase of Alternative A.
b. If the demand on the production of this factory is 2000 ton annually,
which alternative do you recommend for purchasing?
Alternative A B
Initial cost LE230,000 LE80,000
Annual costs LE35,000 LE15,000
Salvage value LE40,000 -
Labor cost (EL/ton) 15 40
Age (years) 10 5
Solution:
First, let’s calculate the EUAW for both alternatives:
EUAWA = 230000(A/P, 10%, 10) + 35000 – 40000(A/F, 10%, 10)
= LE69,922
EUAWB = 80000(A/P, 10%, 5) + 15000
By equating the total cost for both alternatives, then, the breakeven point
equals; x = 1353 ton/year
a. Thus means that, if the annual production is more than 1353 ton, then
alternative A is better.
b. In case of the required production is 2000, then alternative A is better.
As shown in the figure below, if the production is less than 1353 ton
annually then it is better to use alternative B. While alternative A is
better in case of production is more that 1353 ton annually.
Solution:
First, calculate the breakeven point for each alternative (the point at which
the total costs and the revenue are equal).
Alternative A:
30000 + 17x = 27x; then x = 3000 units
Alternative B:
50000 + 12 x = 35x; then x = 2174 units
Alternative C:
60000 + 10 x = 40z; then x = 2000 units
Second, draw the relation between the total cost and the number of units
produced.
4.5 Exercises
1. A company purchased a piece of equipment 3 years ago with an initial value of
LE15,000, salvage value of LE3,000, annual operating cost of LE2,000, and
estimated life of 10 years. Calculate the book value of the machine now using the
straight-line, sum-of years digits and sinking fund depreciation method. Assume
interest rate 10%.
3. Calculate the ownership cost per hour for a dump truck powered by a 120-hp
gasoline engine based on the following data:
4. When studying the different alternative air conditioning systems for a building,
there were two available systems with their information as shown in the table
below. It is required to calculate the decision of selecting any of the two systems
to if the interest rate ranges from 8% to 15%. Use the EUAW method.
Alternative A B
Initial cost LE100,000 LE150,000
Annual costs LE2,000 LE1,500
Salvage value LE5,000 LE10,000
Maintenance at mid-age LE20,000 -
Age (years) 8 12
5. Find the breakeven point for the following two alternatives. Assume that the
investment rate is 10%. Which one do you select if the expected production is
2000 m3/year?
Newman, D.G., and Lavelle, J.P., Engineering Economic Analysis, 7th edition,
Engineering Press, Austin, Texas, 1998.
Ammar, M., Principles of Engineering Economy, Lecture Notes, Tanta University, 2008.
Griffis, F.H., Farr, J.V., and Morris, M.D., Construction Planning for Engineers,
McGraw-Hill, Inc., New York, 2000.