IM in ENSC-20093-ENGINEERING-ECONOMICS-TAPAT #Cea

Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

OFFICE OF THE VICE PRESIDENT FOR BRANCHES AND CAMPUSES
MARAGONDON BRANCH
INSTRUCTIONAL MATERIALS
FOR
ENSC 20093
ENGINEERING ECONOMICS
Compiled by: Checked by:
Engr. John Richard T. Tapat Assoc. Prof. Cherry E. Angeles

Faculty Member
Committee on Writing Instructional Materials
Date: _________________ Date: ___________________
Approved by:
Dr. Agnes Y. Gonzaga Assoc. Prof. Denise A. Abril

Head, Academic Programs Director
Date: _________________ Date: __________________

INTRODUCTION
Welcome to the Polytechnic University of the Philippines. These instructional materials will help
you become an effective learner and successfully meet the requirements of the course. You will
discover that you can learn in a very challenging way at your own pace.
THE POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

VISION
PUP: The National Polytechnic University
MISSION
Ensuring inclusive and equitable quality education and promoting lifelong learning
opportunities through a re-engineered polytechnic university by committing to:
provide democratized access to educational opportunities for the holistic development of
individuals with global perspective
• offer industry-oriented curricula that produce highly-skilled professionals with managerial
and technical capabilities and a strong sense of public service for nation building
• embed a culture of research and innovation
• continuously develop faculty and employees with the highest level of professionalism
• engage public and private institutions and other stakeholders for the attainment of social
development goal
• establish a strong presence and impact in the international academic community
PHILOSOPHY
As a state university, the Polytechnic University of the Philippines believes that:
• Education is an instrument for the development of the citizenry and for the
enhancement of nation building;
• That meaningful growth and transmission of the country are best achieved in an
atmosphere of brotherhood, peace, freedom, justice and nationalist-oriented education
imbued with the spirit of humanist internationalism.
TEN PILLARS
Pillar 1: Dynamic, Transformational, and Responsible Leadership

Pillar 2: Responsive and Innovative Curricula and Instruction
Pillar 3: Enabling and Productive Learning Environment
Pillar 4: Holistic Student Development and Engagement
Pillar 5: Empowered Faculty Members and Employees
Pillar 6: Vigorous Research Production and Utilization
Pillar 7: Global Academic Standards and Excellence
Pillar 8: Synergistic, Productive, Strategic Networks and Partnerships
Pillar 9: Active and Sustained Stakeholders’ Engagement
Pillar 10: Sustainable Social Development Programs and Projects
ii
SUBJECT: ENSC 20093 – ENGINEERING ECONOMICS
COMPILED BY: JOHN RICHARD T. TAPAT, REE
SHARED VALUES
• Integrity and Accountability

• Nationalism
• Spirituality
• Passion for Learning and Innovation
• Inclusivity
• Respect for Human Rights and The Environment
• Excellence
• Democracy
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

MARAGONDON BRANCH
GOALS
• Quality and excellent graduates

• Empowered faculty members
• Relevant curricula
• Efficient administration
• Development – oriented researches
• State-of-the-art physical facilities and laboratories
• Profitable income – generating programs
• Innovative instruction
• ICT – driven library
• Strong local and international linkages
PROGRAM OBJECTIVES
The College of Engineering aims to:

1. Strengthen the Engineering program consistent with global trends;
2. Develop faculty as competent mentors and quality researchers, through advanced study
and other facets of continuing professional education;
3. Develop critical thinking and communication skills of students, giving emphasis to
research and extension services;
4. Equip graduates with appropriate knowledge and technical skills, imbued with desirable
work attitude and moral values through enhanced teaching/learning process by using
multi-media facilities on top of traditional methods;
5. Create a conducive teaching and learning atmosphere with emphasis to faculty and
students’ growth and academic freedom;
6. Establish network with educational institution industry, GO’s and NGO’s, local and
international which could serve as:
a. funding sources and/or partners of researches;
b. sources of new techniques
c. centers for faculty and student exchange program and On the Job Training, and;
d. grantees of scholarship/additional facilities, and;
7. Continuously conduct action researches on the needs of laboratory and other facilities that
could be locally produce or innovated using local materials and adapted technology.
iii
ENSC 20093
ENGINEERING ECONOMICS
COURSE DESCRIPTION
COURSE TITLE : ENGINEERING ECONOMICS

COURSE CODE : ENSC 20093
COURSE CREDIT : 3 UNITS ( 3 hrs. lab )
PRE-REQUISITE : N/A
The course can be designed as a 3 -credit course (1 semester) or a sequence of 2-3 credits per
semester (2 semester) course. At the minimum, Engineering Economics is a 3-credit required
course for ALL Engineering Majors. Topics covered in this course include time value of money,
analysis of alternatives using net present value and internal rate of return, depreciation, taxes,
and inflation. Monte Carlo simulation is used throughout the course to study variability in
engineering designs and the resulting economic impact. Engineering ethics case studies are
presented and analyzed.
COURSE OBJECTIVES
After this course, the student should be able to:
1. Apply knowledge of mathematics, economics, and engineering principles to solve

engineering problems.
2. Understand the major capabilities and limitations of cash flow analysis for evaluating
proposed capital investments.
3. Recognize, formulate, analyses and solve cash flow models in practical situations.
Understand the assumptions underlying these models, and the effects on the modelling
process when these assumptions do not hold.
4. Develop the ability to account for time value of money using engineering economy
factors and formulas, as well as the implications and importance of considering taxes,
depreciation, and inflation.
5. Apply engineering economic techniques on solving engineering problems by using
computer tools such as spreadsheets.
COURSE REQUIREMENTS
The course requirements are as follows:
1. Students are encouraged to attend the class sessions (online students) and complete all
the requirements (online and offline students).
2. The course is expected to have a minimum of four (4) quizzes and two (2) major
examination (Midterm and Final Examination).
3. Other requirements such as written outputs, exercises, assignments and the likes will be
given throughout the sessions. These shall be submitted on the due dates set by the
teacher.
Note: Some activities will be rated using the Rubrics.
iv
GRADING SYSTEM
The grading system will determine if the student passed or failed the course. There will be two
grading periods: Midterm and Final Period. Each period has components of: 70% Class Standing
+ 30% Major Examination. Final Grade will be the average of the two periodical grades.
Midterm Finals
Class Standing 70% Class Standing 70%
• Quizzes • Quizzes
• Activities • Activities
Mid-term Examination 30% • Project
Final Examination 30%
FINAL GRADE = (Midterm + Finals) /2
RUBRICS:
Unsatisfactory Satisfactory Work Very Good Work Excellent Work
Work
1.0 1.5 - 2.5 3.0 - 4.0 4.5 - 5.0
Participation Student did not Student Student Student
participate in this participated in participated in most participated in all
electrical circuit some aspects of aspects of this aspects of this
activity. this electrical circuit electrical circuit electrical circuit
activity. activity. activity.
Materials Student did not Student gathered Student gathered Student gathered
gather any of the some of the most of the needed all needed
needed materials needed materials materials for this materials for this
for this project. for this project. project. Project was project. Project was
Project was almost completed completed as
completed partially as instructed. instructed.
as instructed.
Instructions/Procedures Students did not Students did not Students follow Students follow
attempt to perform follow instructions must instructions to instructions to
the task. to connect series connect series and connect series and
and parallel parallel circuits as parallel circuits as
circuits. Students well as open and well as open and
were not able to short circuit short circuit
connect open and following safety following safety
short circuit. Did rules and rules and
not follow safety guidelines to guidelines to
rules and handle equipment handle equipment
guidelines to properly. properly.
handle equipment
properly.
Performance Student did not Student Student was able to Student was able to
attempt to construct constructed basic construct a partially construct a fully
a circuit board. circuit board, working board, working board,
however neither however either one both lights and
bulb provided switch or one light switches worked as
would light. would not operate instructed.
as directed.
v
COURSE GUIDE
Week Topic Learning Methodology Resource Assessme

Outcomes s nt
1 Orientation of Discussion of the mission, Orientation and PUP Student None
University’s vision, vision, goals and Discussion. Handbook
mission, goals and objectives of the Course
objectives. University; course Syllabus
overview and
Course Overview requirements.
Classroom policies
Lesson 1 - The Students will Lecture See Discussion/Int
Introduction to understand terms that is Interactive Discussion reference eraction.
Engineering use in Engineering lists
Economic Economics, its history
and its importance.
2-3 Lesson 2 - The students will Lecture See Quiz on
Interest and Time understand the Giving the Student reference previous
Value of Money importance of the Interest Idea for a meaningful lists lesson.
and Economic Innovation. Discussion/Int
Equivalence in the study. eraction
Lesson 3 - The students will know Lecture See Quiz on

4-5 Basic the rate of return, Giving the Student reference previous
Methodologies of Payback and Equivalent knowledge the lists lesson.
Engineering Method. importance of Discussion/Int
Economic Analysis Economic Analysis. eraction
6-8 Lesson 4 The students will Lecture See Quiz on

Replacement understand the Giving the Student reference previous
Analysis importance of Comparing knowledge the lists lesson.
Defender and Challenger, importance of the Discussion/Int
Decision Framework. Replacement Analysis eraction
and Planning Horizon.
9 MIDTERM EXAMINATION
Lesson 5 The students will Individual See Assignment
10 Risk Analysis understand the Lecture, Discussion reference
Sensitivity, Breakeven lists Participation,
and Scenario Analysis. Discussion
11-12 Lesson 6 The students will learn the Lecture See Quiz on
Depreciation and Concept of Depreciation, Giving the Student reference previous
Corporate Income Method of Depreciation knowledge the lists lesson.
Taxes and Cash Flow Estimate. importance of the Discussion/Int
sales and marketing eraction
plan
Lesson 7 The students will learn the Individual See Quiz on
13-14 Concept of Inflation, Lecture, Discussion reference previous
lists lesson.
vi
Inflation and Its Measuring Inflation and Discussion/Int
Impact on Project Impact of Inflation eraction
Cashflows
15-17 Lesson 8 Students will know the Lecture See Participation,

Financing, and margin of safety, break- Giving the Student reference Discussion
Break-Even even point and knowledge the lists
Analysis Contribution Margin importance of Assignment
competitors and
strategic partner.
18 FINAL EXAMINATION
Reference:
• https://en.wikipedia.org/wiki/Engineering_economics
• https://mysite.du.edu/~jcalvert/econ/enecon.htm#:~:text=Engineering%20economy%2C
%20the%20analysis%20of,Railway%20Location%2C%20published%20in%201887.
• http://engineeringandeconomicanalysis.blogspot.com/2013/12/engineering-economics-
description-
and.html#:~:text=Engineers%20play%20a%20vital%20role,deals%20with%20the%20ec
onomic%20factors.
• http://www.frickcpa.com/tvom/TVOM_CashFlowDiagram.asp
• http://www.csun.edu/~ghe59995/docs/Glossary%20of%20Concepts%20&%20Terms%2
0in%20Engineering%20Economy.pdf
• https://www.investopedia.com/terms/t/timevalueofmoney.asp
• http://engineeringandeconomicanalysis.blogspot.com/2013/12/economic-
equivalence.html#:~:text=Economic%20equivalence%20is%20a%20fundamental,engine
ering%20economy%20computations%20are%20based.&text=Economic%20equivalenc
e%20is%20a%20combination,are%20equal%20in%20economic%20value.
• https://www.investopedia.com/articles/investing/020614/learn-simple-and-compound-
interest.asp#:~:text=Simple%20interest%20is%20calculated%20on,as%20%22interest%
20on%20interest.%22
• https://www.gristprojectmanagement.us/economics/cash-flow-series-with-a-special-
pattern.html
• http://engineeringandeconomicanalysis.blogspot.com/2013/12/minimum-attractive-rate-
of-return.html
• https://financeformulas.net/Real_Rate_of_Return.html
• https://www.investopedia.com/terms/p/paybackperiod.asp
• https://link.springer.com/chapter/10.1007/978-3-540-70810-
0_4#:~:text=Equivalent%20annual%20worth%20analysis%20is,of%20the%20problem%
20into%20account.
• https://www.investopedia.com/terms/r/rateofreturn.asp
• https://www.investopedia.com/terms/b/bcr.asp
• https://www.openlca.org/wp-content/uploads/2015/11/How-to-perform-Life-Cycle-
Costing-in-openLCA.pdf
• http://www.fao.org/investment-learning-platform/themes-and-tasks/financial-economic-
analysis/en/
vii
• http://docshare01.docshare.tips/files/25225/252252098.pdf
• http://www.eng.utoledo.edu/~nkissoff/lessons/Lesson14.html
• https://www.investopedia.com/terms/r/risk-
analysis.asp#:~:text=Risk%20analysis%20is%20the%20study,and%20possible%20futur
e%20economic%20states.
• https://www.investopedia.com/terms/m/montecarlosimulation.asp
• https://www.investopedia.com/terms/s/sensitivityanalysis.asp
• https://corporatefinanceinstitute.com/resources/knowledge/modeling/break-even-
analysis/
• https://www.investopedia.com/terms/d/depreciation.asp#:~:text=Depreciation%20is%20a
n%20accounting%20method,value%20has%20been%20used%20up.
• https://corporatefinanceinstitute.com/resources/knowledge/finance/corporate-vs-
personal-income-tax/
• https://www.investopedia.com/terms/c/cfat.asp
• https://www.investopedia.com/ask/answers/012615/are-taxes-calculated-operating-cash-
flow.asp
• https://www.investopedia.com/articles/investing/062713/capital-losses-and-tax.asp
• https://www.investopedia.com/terms/i/inflation.asp#the-formula-for-measuring-inflation
• https://www.investopedia.com/articles/insights/122016/9-common-effects-inflation.asp
• https://www.investopedia.com/terms/f/financial-
analysis.asp#:~:text=Financial%20analysis%20is%20the%20process,to%20warrant%20
a%20monetary%20investment.
• https://www.investopedia.com/terms/b/breakevenanalysis.asp
viii
TABLE OF CONTENTS
Topic Page
Introduction ii
Lesson 1 Introduction to Engineering Economics 1

Unit 1: Basic of Economics 1
Unit 2. Definition of terms 3
Lesson 2 Interest and Time Value of Money 8

Unit 1: Introduction to Time Value of Money 8
Unit 2: Interest 10
2.1 Simple Interest
2.2 Compound Interest
2.3 Type of Cash flow.
Lesson 3 Basic Methodologies of Engineering Economic Analysis 15

Unit 1: Rate of Return (MARR) and Methods. 15
Unit 2: Introduction to Financial and Economic Analysis 21
Lesson 4 Replacement Analysis 26

Unit 1: Analysis, Planning and Decision. 26
Lesson 5 Risk Analysis 30

Unit 1: Concept of Economic Analysis 30
Lesson 6 Depreciation and Corporate Income Taxes 38

Unit 1: Concept of Depreciation 38
Unit 2: Corporate Income Tax 41
Lesson 7 Inflation and Its Impact on Project Cashflows 49

Unit 1: Inflation 49
1.1 Concept of Inflation
1.2 Measuring Inflation
1.3 Impact of Inflation
Lesson 8 Financing, and Break-Even Analysis 60

Unit 1: Definitions, Calculation and Importance. 60
ix
Lesson 1 – Introduction to Engineering Economy
Unit 1-Basic Economics
Overview:
This lesson will help the Students to understand terms that is use in Engineering Economics, its
history and its importance.
Learning Objectives:
After successful completion of this lesson, you should be able to:
1. Discuss what is the definition of Engineering Economy.

2. Learn its importance to the society especially we are dealing to the new normal in this
modern day.
Course Materials:
Engineering Economy
Engineering economics, previously known as engineering economy, is a subset of economics
concerned with the use and application of economic principles in the analysis of engineering
decisions. As a discipline, it is focused on the branch of economics known as microeconomics in
that it studies the behavior of individuals and firms in making decisions regarding the allocation of
limited resources. Thus, it focuses on the decision-making process, its context and environment.
It is pragmatic by nature, integrating economic theory with engineering practice. But it is also a
simplified application of microeconomic theory in that it avoids a number of microeconomic
concepts such as price determination, competition and demand/supply. As a discipline though, it
is closely related to others such as statistics, mathematics and cost accounting. It draws upon the
logical framework of economics but adds to that the analytical power of mathematics and
statistics.
History of Engineering Economy
Engineering economy, the analysis of the economic consequences of engineering decisions, was
originated by A. M. Wellington in his The Economic Theory of Railway Location, published in
1887. For more information on Wellington, see A. M. Wellington. Engineering economy is now
considered a part of the education of every engineer.
There are many bad ways to make decisions. Because of the uncertainties of the future, even a
rational method of decision-making can sometimes result in bad choices. However, a bad result
is almost guaranteed by a poor decision-making process. A fundamental principle is that choices
can be made only among alternatives, and that only the differences between these alternatives
are material. A course of action cannot usefully be compared only with itself. We hear every day
enthusiasts for one course of action or another recommending their hobby on the basis of its
peculiar beauty, with alternatives deprecated if considered at all. In any engineering decision, all
reasonable alternatives should be discovered and fairly considered.
Roles of Engineer in Decision Making
1
PREPARED BY: JOHN RICHARD T. TAPAT, REE
Decisions are made routinely to choose one alternative over another by individuals in everyday
life; by engineers on the job; by managers who supervise the activities of others; by corporate
presidents who operate a business; and by government officials who work for the public good.
Most decisions involve money, called capital or capital funds , which is usually limited in
amount. The decision of where and how to invest this limited capital is motivated by a primary
goal of adding value as future, anticipated results of the selected alternative are realized.
Engineers play a vital role in capital investment decisions based upon their ability and experience
to design, analyze, and synthesize. The factors upon which a decision is based are commonly a
combination of economic and noneconomic elements. Engineering economy deals with the
economic factors. By defi nition,
Engineering economy involves formulating, estimating, and evaluating the expected economic
outcomes of alternatives designed to accomplish a defi ned purpose. Mathematical techniques
simplify the economic evaluation of alternatives.
Because the formulas and techniques used in engineering economics are applicable to all types
of money matters, they are equally useful in business and government, as well as for individuals.
Therefore, besides applications to projects in your future jobs, what you learn from this book and
in this course may well offer you an economic analysis tool for making personal decisions such
as car purchases, house purchases, major purchases on credit, e.g., furniture, appliances, and
electronics.
Cash Flow Diagram: The Basic Concept
A cash flow diagram allows you to graphically depict the timing of the cash flows as well as their
nature as either inflows or outflows.
Activities/Assessments:
Answer the following questions briefly:

1. What is the Importance of the Engineering Economy in the new setup of our society?
2. What is Cash Flow Diagram?
Assignment:
2
Who is the pioneer of Economics?
Reference:
• https://en.wikipedia.org/wiki/Engineering_economics
• https://mysite.du.edu/~jcalvert/econ/enecon.htm#:~:text=Engineering%20economy%2C
%20the%20analysis%20of,Railway%20Location%2C%20published%20in%201887.
• http://engineeringandeconomicanalysis.blogspot.com/2013/12/engineering-economics-
description-
and.html#:~:text=Engineers%20play%20a%20vital%20role,deals%20with%20the%20ec
onomic%20factors.
• http://www.frickcpa.com/tvom/TVOM_CashFlowDiagram.asp
Unit 2 – Definition of Terms
Overview:
This lesson will help the student to familiarize in certain terminology used in Engineering
Economy.
1. Familiarize and learn different terminology in Engineering Economy
Course Materials:
Important Concepts and Guidelines

The following elements of engineering economy are identify throughout the text in the margin
by this checkmark and a title below it. The numbers in parentheses indicate chapters where the
concept or guideline is introduced or essential to obtaining a correct solution.
Time Value of Money It is a fact that money makes money. This concept explains the change in
the amount of money over time for both owned and borrowed funds.
Economic Equivalence A combination of time value of money and interest rate that makes
different sums of money at different times have equal economic value .
Cash Flow The flow of money into and out of a company, project, or activity. Revenues are cash
inflows and carry a positive (+) sign; expenses are outflows and carry a negative (−) sign. If only
costs are involved, the − sign may be omitted, e.g., benefit/cost (B/C) analysis.
End-of-Period Convention To simplify calculations, cash flows (revenues and costs) are
assumed to occur at the end of a time period. An interest period or fiscal period is commonly 1
year. A half-year convention is often used in depreciation calculations.
3
Cost of Capital The interest rate incurred to obtain capital investment funds. COC is usually
a weighted average that involves the cost of debt capital (loans, bonds, and mortgages) and
equity capital (stocks and retained earnings).
Minimum Attractive Rate of Return (MARR) A reasonable rate of return established for the
evaluation of an economic alternative. Also called the hurdle rate, MARR is based on cost of
capital, market trend, risk, etc. The inequality ROR ≥ MARR > COC is correct for an economically
viable project.
Opportunity Cost A forgone opportunity caused by the inability to pursue a project. Numerically,
it is the largest rate of return of all the projects not funded due to the lack of capital funds. Stated
differently, it is the ROR of the first project rejected because of unavailability of funds.
Nominal or Effective Interest Rate ( r or i ) A nominal interest rate does not include any
compounding; for example, 1% per month is the same as nominal 12% per year. Effective interest
rate is the actual rate over a period of time because compounding is imputed; for example, 1%
per month, compounded monthly, is an effective 12.683% per year. Inflation or deflation is not
considered.
Placement of Present Worth ( P ; PW) In applying the ( P/A , i%, n ) factor, P or PW is always
located one interest period (year) prior to the first amount. The A or AW is a series of equal, end-
of-period cash flows for n consecutive periods, expressed as money per time (say, $/year; /year).
Placement of Future Worth (F; FW) In applying the (F/A , i %, n ) factor, F or FW is always
located at the end of the last interest period (year) of the A series.
Placement of Gradient Present Worth (P G ; P g) The ( P / G , i %, n ) factor for an arithmetic

gradient finds the P G of only the gradient series 2 years prior to the fi rst appearance of the
constant gradient G. The base amount A is treated separately from the gradient series. The ( P /
A , g , i , n ) factor for a geometric gradient determines P g for the gradient and initial amount A1
two years prior to the appearance of the first gradient amount. The initial amount A1 is included
in the value of P g.
Equal-Service Requirement Identical capacity of all alternatives operating over the same
amount of time is mandated by the equal-service requirement. Estimated costs and revenues for
equal service must be evaluated. PW analysis requires evaluation over the same number of years
(periods) using the LCM (least common multiple) of lives; AW analysis is performed over one life
cycle. Further, equal service assumes that all costs and revenues rise and fall in accordance with
the overall rate of inflation or deflation over the total time period of the evaluation.
LCM or Study Period To select from mutually exclusive alternatives under the equal-service
requirement for PW computations, use the LCM of lives with repurchase(s) as necessary. For a
stated study period (planning horizon), evaluate cash flows only over this period , neglecting any
beyond this time; estimated market values at termination of the study period are the salvage
values.
Salvage/Market Value Expected trade-in, market, or scrap value at the end of the estimated life
or the study period. In a replacement study, the defender’s estimated market value at the end of
4
a year is considered its “first cost” at the beginning of the next year. MACRS depreciation always
reduces the book value to a salvage of zero.
Do Nothing the DN alternative is always an option, unless one of the defined alternatives must
be selected. DN is status quo; it generates no new costs, revenues, or savings.
Revenue or Cost Alternative Revenue alternatives have costs and revenues estimated; savings
are considered negative costs and carry a + sign. Incremental evaluation requires comparison
with DN for revenue alternatives. Cost (or service) alternatives have only costs estimated;
revenues and savings are assumed equal between alternatives.
Rate of Return An interest rate that equates a PW or AW relation to zero. Also, defined as the
rate on the unpaid balance of borrowed money, or rate earned on the unrecovered balance of an
investment such that the last cash flow brings the balance exactly to zero.
Project Evaluation For a specified MARR, determine a measure of worth for net cash flow series
over the life or study period. Guidelines for a single project to be economically justified at the
MARR (or discount rate) follow.
• Present worth: If PW ≥ 0 Annual worth: If AW ≥ 0

• Future worth: If FW ≥ 0 Rate of return: If i * ≥ MARR
• Benefit/cost: If B/C ≥ 1.0 Profitability index: If PI ≥ 1.0
ME Alternative Selection For mutually exclusive (select only one) alternatives, compare two
alternatives at a time by determining a measure of worth for the incremental (∆) cash flow series
over the life or study period, adhering to the equal-service requirement.
• Present worth or annual worth: Find PW or AW values at MARR; select numerically largest
(least negative or most positive).
• Rate of return: Order by initial cost, perform pairwise ∆i * comparison; if ∆i * ≥ MARR,
select larger cost alternative; continue until one remains.
• Benefit/cost: Order by total equivalent cost, perform pairwise ∆B/C comparison; if ∆B/C ≥
1.0, select larger cost alternative; continue until one remains.
• Cost-effectiveness ratio: For service sector alternatives; order by effectiveness measure;
perform pairwise ∆C/E comparison using dominance; select from nondominated
alternatives without exceeding budget.
Independent Project Selection No comparison between projects; only against DN. Calculate a
measure of worth and select using the guidelines below.
• Present worth or annual worth: Find PW or AW at MARR; select all projects with PW or
AW ≥ 0.
• Rate of return: No incremental comparison; select all projects with overall i * ≥ MARR.
• Benefit/cost: No incremental comparison; select all projects with overall B/C ≥ 1.0.
• Cost-effectiveness ratio: For service sector projects; no incremental comparison; order by
CER and select projects to not exceed budget.
When a capital budget limit is defined, independent projects are selected using the capital
budgeting process based on PW values. The Solver spreadsheet tool is useful here.
5
Capital Recovery CR is the equivalent annual amount an asset or system must earn to recover
the initial investment plus a stated rate of return. Numerically, it is the AW value of the initial
investment at a stated rate of return. The salvage value is considered in CR calculations.
Economic Service Life the ESL is the number of years n at which the total AW of costs, including
salvage and AOC, is at its minimum, considering all the years the asset may provide service.
Sunk Cost Capital (money) that is lost and cannot be recovered. Sunk costs are not included
when making decisions about the future. They should be handled using tax laws and write-off
allowances, not the economic study.
Inflation Expressed as a percentage per time (% per year), it is an increase in the amount of
money required to purchase the same amount of goods or services over time. Inflation occurs
when the value of a currency decreases. Economic evaluations are performed using either a
market (inflation-adjusted) interest rate or an inflation-free rate (constant-value terms).
Breakeven For a single project, the value of a parameter that makes two elements equal, e.g.,
sales necessary to equate revenues and costs. For two alternatives, breakeven is the value of a
common variable at which the two are equally acceptable. Breakeven analysis is fundamental to
make-buy decisions, replacement studies, payback analysis, sensitivity analysis, breakeven ROR
analysis, and many others. The Goal Seek spreadsheet tool is useful in breakeven analysis.
Payback Period Amount of time n before recovery of the initial capital investment is expected.
Payback with i > 0 or simple payback at i = 0 is useful for preliminary or screening analysis to
determine if a full PW, AW, or ROR analysis is needed. (13)
Direct / Indirect Costs Direct costs are primarily human labor, machines, and materials
associated with a product, process, system, or service. Indirect costs, which include support
functions, utilities, management, legal, taxes, and the like, are more difficult to associate with a
specific product or process.
Value Added Activities have added worth to a product or service from the perspective of a
consumer, owner, or investor who is willing to pay more for an enhanced value.
Sensitivity Analysis Determination of how a measure of worth is affected by changes in

estimated values of a parameter over a stated range. Parameters may be any cost factor,
revenue, life, salvage value, inflation rate, etc.

1. Familiarize yourself to terminology used for an easier understand of engineering economy.
2. Discuss the basic importance of clear understanding of what you are doing.
Quiz of this lesson will be given before the next lesson begin.
Assignment:
6
Research the definition and Importance of Interest and Time Value Money
Reference:
• http://www.csun.edu/~ghe59995/docs/Glossary%20of%20Concepts%20&%20Terms%2
0in%20Engineering%20Economy.pdf
7
Lesson 2 – Interest and Time Value of Money
Unit 1 – Introduction to Time Value of Money
Overview:
This lesson will help the students to understand the importance of the Interest and Economic
Equivalence in the study.
1. Understand the concept of Time Value of money and Economic Equivalence

2. Discuss the formula of computing Time value of money.
Course Materials:
What Is the Time Value of Money (TVM)?
The time value of money (TVM) is the concept that money you have now is worth more than the
identical sum in the future due to its potential earning capacity. This core principle of finance holds
that provided money can earn interest, any amount of money is worth more the sooner it is
received. TVM is also sometimes referred to as present discounted value.
Understanding Time Value of Money (TVM)
The time value of money draws from the idea that rational investors prefer to receive money today
rather than the same amount of money in the future because of money's potential to grow in value
over a given period of time. For example, money deposited into a savings account earns a certain
interest rate and is therefore said to be compounding in value.
KEY TAKEAWAYS
• Time value of money is based on the idea that people would rather have money today
than in the future.
• Given that money can earn compound interest, it is more valuable in the present rather
than the future.
• The formula for computing time value of money considers the payment now, the future
value, the interest rate, and the time frame.
• The number of compounding periods during each time frame is an important determinant
in the time value of money formula as well.
Further illustrating the rational investor's preference, assume you have the option to choose
between receiving $10,000 now versus $10,000 in two years. It's reasonable to assume most
people would choose the first option. Despite the equal value at the time of disbursement,
receiving the $10,000 today has more value and utility to the beneficiary than receiving it in the
future due to the opportunity costs associated with the wait. Such opportunity costs could include
the potential gain on interest were that money received today and held in a savings account for
two years.
8
Time Value of Money Formula
Depending on the exact situation in question, the time value of money formula may change
slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has
additional or less factors. But in general, the most fundamental TVM formula takes into account
the following variables:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of compounding periods per year
t = number of years
Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (i / n)] (n x t)
Time Value of Money Examples

Assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money
is:
FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000
The formula can also be rearranged to find the value of the future sum in present day dollars. For
example, the value of $5,000 one year from today, compounded at 7% interest, is:
PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673
Effect of Compounding Periods on Future Value
The number of compounding periods can have a drastic effect on the TVM calculations. Taking
the $10,000 example above, if the number of compounding periods is increased to quarterly,
monthly, or daily, the ending future value calculations are:
Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038
Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047
Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052
This shows TVM depends not only on interest rate and time horizon, but also on how many times
the compounding calculations are computed each year. process of technological innovation (of
which R&D is the first phase) is complex and risky.
Economic Equivalence
Economic equivalence is a combination of interest rate and time value of money to determine
the different amounts of money at different points in time that are equal in economic value.
As an illustration, if the interest rate is 6% per year, $100 today (present time) is equivalent to
$106 one year from today.
Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106
9
If someone offered you a gift of $100 today or $106 one year from today, it would make no
difference which offer you accepted from an economic perspective. In either case you have $106
one year from today. However, the two sums of money are equivalent to each other only when
the interest rate is 6% per year. At a higher or lower interest rate, $100 today is not equivalent to
$106 one year from today.

1. Learn the relationship between research and development in entrepreneurship.
2. Discuss the basic importance of clear understanding of Innovation.
Assignment:
How Innovation will help technopreneur in the future and why research is important for the people
who take this course.
Reference:
• https://www.investopedia.com/terms/t/timevalueofmoney.asp
• http://engineeringandeconomicanalysis.blogspot.com/2013/12/economic-
equivalence.html#:~:text=Economic%20equivalence%20is%20a%20fundamental,engine
ering%20economy%20computations%20are%20based.&text=Economic%20equivalenc
e%20is%20a%20combination,are%20equal%20in%20economic%20value.
Unit 2 - Interest
Overview:
This lesson will help the student to clearly understand the importance of a good idea in an
Innovation of a certain services or product in the development of the company or organization.
1. Understand the market needs or provide a solution to a key problem,

2. Explore the feasibility and creation of a business enterprise,
Course Materials:
Interest
Interest is defined as the cost of borrowing money as in the case of interest charged on a loan
balance. Conversely, interest can also be the rate paid for money on deposit as in the case of a
certificate of deposit. Interest can be calculated in two ways, simple interest or compound interest.
10
Simple interest is calculated on the principal, or original, amount of a loan.
Compound interest is calculated on the principal amount and also on the accumulated interest
of previous periods, and can thus be regarded as "interest on interest."
There can be a big difference in the amount of interest payable on a loan if interest is calculated
on a compound rather than simple basis. On the positive side, the magic of compounding can
work to your advantage when it comes to your investments and can be a potent factor in wealth
creation.
While simple interest and compound interest are basic financial concepts, becoming thoroughly
familiar with them may help you make more informed decisions when taking out a loan or
investing.
Simple Interest Formula

The formula for calculating simple interest is:
Simple interest=P×i×n
where:
P=Principle
i=interest rate
n=term of the loan
Thus, if simple interest is charged at 5% on a $10,000 loan that is taken out for three years, the
total amount of interest payable by the borrower is calculated as $10,000 x 0.05 x 3 = $1,500.
Interest on this loan is payable at $500 annually, or $1,500 over the three-year loan term.
Compound Interest Formula
The formula for calculating compound interest in a year is:
Compound interest=[P(1+i) n]−P
Compound interest=P[(1+i) n −1]
where:
P=Principle
i=interest rate in percentage terms
n=number of compounding periods for a year
Compound Interest = Total amount of Principal and Interest in future (or Future Value) less the
Principal amount at present called Present Value (PV). PV is the current worth of a future sum of
money or stream of cash flows given a specified rate of return.
Continuing with the simple interest example, what would be the amount of interest if it is charged
on a compound basis? In this case, it would be:
$10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25.
While the total interest payable over the three-year period of this loan is $1,576.25, unlike simple
interest, the interest amount is not the same for all three years because compound interest also
takes into consideration accumulated interest of previous periods.
Compounding Periods
11
When calculating compound interest, the number of compounding periods makes a significant
difference. Generally, the higher the number of compounding periods, the greater the amount of
compound interest. So for every $100 of a loan over a certain period, the amount of interest
accrued at 10% annually will be lower than the interest accrued at 5% semi-annually, which will,
in turn, be lower than the interest accrued at 2.5% quarterly.
In the formula for calculating compound interest, the variables "i" and "n" have to be adjusted if
the number of compounding periods is more than once a year.
That is, within the parentheses, "i" or interest rate has to be divided by "n," the number of
compounding periods per year. Outside of the parentheses, "n" has to be multiplied by "t," the
total length of the investment.
Therefore, for a 10-year loan at 10%, where interest is compounded semi-annually (number of
compounding periods = 2), i = 5% (i.e., 10% / 2) and n = 20 (i.e., 10 x 2).
To calculate total value with compound interest, you would use this equation:
Total value with compound interest=[P( n1+i ) nt ]−P
Compound interest=P[( n1+i ) nt −1]
where:
P=Principle
i=interest rate in percentage terms
n=number of compounding periods per year
t=total number of years for the investment or loan
Types of Cash Flow
Whenever one can identify patterns in cash flow transactions, one may use them in developing
concise expressions for computing either the present or future worth of the series. For this
purpose, we will classify cash flow transactions into three categories: (1) equal cash flow series,
(2) linear gradient series, and (3) geometric gradient series. To simplify the description of various
interest formulas, we will use the following notation:
1. Uniform Series: Probably the most familiar category includes transactions arranged as a
series of equal cash flows at regular intervals, known as an equal-payment series (or uniform
series) (Figure 17.2.3a). This describes the cash flows, for example, of the common installment
loan contract, which arranges for the repayment of a loan in equal periodic installments. The equal
cash flow formulas deal with the equivalence relations of P, F, and A, the constant amount of the
cash flows in the series.
2. Linear Gradient Series: While many transactions involve series of cash flows, the amounts
are not always uniform: yet they may vary in some regular way. One common pattern of variation
12
occurs when each cash flow in a series increases (or decreases) by a fixed amount (Figure
17.2.3b). A 5-year loan repayment plan might specify, for example, a series of annual payments
that
Geometric Series Annual Percent Rate
FIGURE 17.2.2 Decomposition of uneven cash flow series into three single-payment transactions.
This decomposition allows us to use the single-payment present worth factor.
increased by $50 each year. We call such a cash flow pattern a linear gradient series because its
cash flow diagram produces an ascending (or descending) straight line. In addition to P, F, and
A, the formulas used in such problems involve the constant amount, G, of the change in each
cash flow.
3. Geometric Gradient Series: Another kind of gradient series is formed when the series in cash
flow is determined, not by some fixed amount like $50, but by some fixed rate, expressed as a
percentage. For example, in a 5-year financial plan for a project, the cost of a particular raw
material might be budgeted to increase at a rate of 4% per year. The curving gradient in the
diagram of such a series suggests its name: a geometric gradient series (Figure 17.2.3c). In the
formulas dealing with such series, the rate of change is represented by a lowercase g.
Table 17.2.1 summarizes the interest formulas and the cash flow situations in which they should
be used. For example, the factor notation (F/A, i, N) represents the situation where you want to
calculate the equivalent lump-sum future worth (F) for a given uniform payment series (A) over N
period at interest rate i. Note that these interest formulas are applicable only when the interest
(compounding) period is the same as the payment period. Also in this table we present some
useful interest factor relationships. The next two examples illustrate how one might use these
interest factors to determine the equivalent cash flow.
(a) Equal (uniform) payment series at regular Intervals

13
(b) Linear gradient series where each cash flow In a series increases or decreases by a fixed
amount.
(c) Geometric gradient series where each cash flow in a series increases or decreases by a fixed
rate (percentage),

1. What is the Three different types of cash flow?
2. What is the two types of Interest?
Assignment:
Give the Difference between Simple and Compound Interest and give their importance.
Reference:
• https://www.investopedia.com/articles/investing/020614/learn-simple-and-compound-
interest.asp#:~:text=Simple%20interest%20is%20calculated%20on,as%20%22interest%
20on%20interest.%22
• https://www.gristprojectmanagement.us/economics/cash-flow-series-with-a-special-
pattern.html
14
Lesson 3 – Basic Methodologies of Engineering Economic Analysis
Unit 1-Rate of Return(MARR) and Methods
Overview:
This lesson will help the students to know the definition and importance of the rate of return,
Payback and Equivalent Method.
1. Understand the difference between payback period and Equivalent Worth method..
2. Discuss how rate of return works.
Course Materials:
Minimum Attractive Rate of Return (MARR)
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return established for the
evaluation and selection of alternatives. A project is not economically viable unless it is expected
to return at least the MARR. MARR is also referred to as the hurdle rate, cutoff rate, benchmark
rate, and minimum acceptable rate of return.
To develop a foundation-level understanding of how a MARR value is established and used to

make investment decisions. Although the MARR is used as a criterion to decide on investing in
a project, the size of MARR is fundamentally connected to how much it costs to obtain the needed
capital funds. It always costs money in the form of interest to raise capital. The interest,
expressed as a percentage rate per year, is called the cost of capital. As an example, on a
personal level, if you want to purchase a new widescreen HDTV, but do not have sufficient money
(capital), you could obtain a bank loan for, say, a cost of capital of 9% per year and pay for the
TV in cash now. Alternatively, you might choose to use your credit card and pay off the balance
on a monthly basis. This approach will probably cost you at least 15% per year. Or, you could use
funds from your savings account that earns 5% per year and pay cash. This approach means that
you also forgo future returns from these funds. The 9%, 15%, and 5% rates are your cost of capital
estimates to raise the capital for the system by different methods of capital financing. In analogous
ways, corporations estimate the cost of capital from different sources to raise funds for
engineering projects and other types of projects.`
Rate of Return Formula
The real rate of return formula is the sum of one plus the nominal rate divided by the sum of one
plus the inflation rate which then is subtracted by one. The formula for the real rate of return can
be used to determine the effective return on an investment after adjusting for inflation.
The nominal rate is the stated rate or normal return that is not adjusted for inflation.
15
The rate of inflation is calculated based on the changes in price indices which are the price on a
group of goods. One of the most commonly used price indices is the consumer price index(CPI).
Although the consumer price index is widely used, a company or investor may want to consider
using another price index or even their own group of goods that relates more to their business
when calculating the real rate of return.
For quick calculation, an individual may choose to approximate the real rate of return by using the
simple formula of nominal rate - inflation rate.
Example of Real Rate of Return Formula
An example of the real rate of return formula would be an individual who wants to determine how
much goods they can buy at the end of one year after leaving their money in a money market
account that earns interest.
For this example of the real rate of return formula, we must assume that the individual wants to
purchase the exact same goods and same proportion of goods that the consumer price index
uses considering that it is used often to measure inflation.
For this example of the real rate of return formula, the money market yield is 5%, inflation is 3%,
and the starting balance is $1000. Using the real rate of return formula, this example would show
Real Rate of Return Example
which would return a real rate of 1.942%. With a $1000 starting balance, the individual could
purchase $1,019.42 of goods based on today's cost. This example of the real rate of return
formula can be checked by multiplying the $1019.42 by (1.03), the inflation rate plus one, which
results in a $1050 balance which would be the normal return on a 5% yield.
What Is the Payback Period?
The payback period refers to the amount of time it takes to recover the cost of an investment.
Simply put, the payback period is the length of time an investment reaches a break-even point.
The desirability of an investment is directly related to its payback period. Shorter paybacks mean
more attractive investments.
Although calculating the payback period is useful in financial and capital budgeting, this metric
has applications in other industries. It can be used by homeowners and businesses to calculate
the return on energy-efficient technologies such as solar panels and insulation, including
maintenance and upgrades.
KEY TAKEAWAYS
16
• The payback period refers to the amount of time it takes to recover the cost of an
investment or how long it takes for an investor to reach breakeven.
• Account and fund managers use the payback period to determine whether to go through
with an investment.
• Shorter paybacks mean more attractive investments, while longer payback periods are
less desirable.
• The payback period is calculated by dividing the amount of the investment by the annual
cash flow.
Understanding the Payback Period
Corporate finance is all about capital budgeting. One of the most important concepts every
corporate financial analyst must learn is how to value different investments or operational projects
to determine the most profitable project or investment to undertake. One way corporate financial
analysts do this is with the payback period.
The payback period is the cost of the investment divided by the annual cash flow. The shorter the
payback, the more desirable the investment.
Conversely, the longer the payback, the less desirable it is. For example, if solar panels cost
$5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the
payback period.
Capital Budgeting and the Payback Period
But there is one problem with the payback period calculation: Unlike other methods of capital
budgeting, the payback period ignores the time value of money (TVM)—the idea that money today
is worth more than the same amount in the future because of the present money's earning
potential.
Most capital budgeting formulas—such as net present value (NPV), internal rate of return (IRR),
and discounted cash flow—consider the TVM. So if you pay an investor tomorrow, it must include
an opportunity cost. The TVM is a concept that assigns a value to this opportunity cost.
The payback period disregards the time value of money. It is determined by counting the number
of years it takes to recover the funds invested. For example, if it takes five years to recover the
cost of an investment, the payback period is five years. Some analysts favor the payback method
for its simplicity. Others like to use it as an additional point of reference in a capital budgeting
decision framework.
The payback period does not account for what happens after payback, ignoring the overall
profitability of an investment. Many managers and investors thus prefer to use NPV as a tool for
making investment decisions. The NPV is the difference between the present value of cash
coming in and the current value of cash going out over a period of time.
Example of Payback Period
Assume Company A invests $1 million in a project that is expected to save the company $250,000
each year. The payback period for this investment is four years—dividing $1 million by $250,000.
17
Consider another project that costs $200,000 with no associated cash savings will make the
company an incremental $100,000 each year for the next 20 years at $2 million.
Clearly, the second project can make the company twice as much money, but how long will it take
to pay the investment back?
The answer is found by dividing $200,000 by $100,000, which is two years. The second project
will take less time to pay back and the company's earnings potential is greater. Based solely on
the payback period method, the second project is a better investment.
Equivalent Worth Method
Equivalent annual worth analysis is one of the most used analysis techniques for the evaluation
of investments. The main process is to convert any cash flow to an equivalent uniform cash flow.
Later, the decision is given taking the economic category of the problem into account. If it is a
fixed input problem, you should maximize equivalent uniform annual benefit. If it is a fixed output
problem, minimize equivalent uniform annual cost, and if it is neither output nor input fixed
problem, maximize equivalent uniform annual profit. In this chapter, it is shown that how you can
apply this technique when the parameters are all fuzzy. Numerical examples are given for different
analysis periods.
What Is a Rate of Return (RoR)?
A rate of return (RoR) is the net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment’s initial cost. When calculating the rate of return,
you are determining the percentage change from the beginning of the period until the end.
KEY TAKEAWAYS
• The rate of return (RoR) is used to measure the profit or loss of an investment over time.
• The metric of RoR can be used on a variety of assets, from stocks to bonds, real estate,
and art.
• The effects of inflation are not taken into consideration in the simple rate of return
calculation but are in the real rate of return calculation.
• The internal rate of return (IRR) takes into consideration the time value of money.
Understanding a Rate of Return (RoR)
A rate of return (RoR) can be applied to any investment vehicle, from real estate to bonds, stocks,
and fine art. RoR works with any asset provided the asset is purchased at one point in time and
produces cash flow at some point in the future. Investments are assessed based, in part, on past
rates of return, which can be compared against assets of the same type to determine which
investments are the most attractive. Many investors like to pick a required rate of return before
making an investment choice.
The formula to calculate the rate of return (RoR) is:
Rate of return=[ (Current value−Initial value) /Initial value]×100
18
This simple rate of return is sometimes called the basic growth rate, or alternatively, return on
investment (ROI). If you also consider the effect of the time value of money and inflation, the real
rate of return can also be defined as the net amount of discounted cash flows (DCF) received on
an investment after adjusting for inflation.
Rate of Return (RoR) on Stocks and Bonds
The rate of return calculations for stocks and bonds is slightly different. Assume an investor buys
a stock for $60 a share, owns the stock for five years, and earns a total amount of $10 in dividends.
If the investor sells the stock for $80, his per share gain is $80 - $60 = $20. In addition, he has
earned $10 in dividend income for a total gain of $20 + $10 = $30. The rate of return for the stock
is thus a $30 gain per share, divided by the $60 cost per share, or 50%.
On the other hand, consider an investor that pays $1,000 for a $1,000 par value 5% coupon bond.
The investment earns $50 in interest income per year. If the investor sells the bond for $1,100 in
premium value and earns $100 in total interest, the investor’s rate of return is the $100 gain on
the sale, plus $100 interest income divided by the $1,000 initial cost, or 20%.
Real Rate of Return (RoR) vs. Nominal Rate of Return (RoR)
The simple rate of return is considered a nominal rate of return since it does not account for the
effect of inflation over time. Inflation reduces the purchasing power of money, and so $335,000
six years from now is not the same as $335,000 today.
Discounting is one way to account for the time value of money. Once the effect of inflation is taken
into account, we call that the real rate of return (or the inflation-adjusted rate of return).
Real Rate of Return (RoR) vs. Compound Annual Growth Rate (CAGR)
A closely related concept to the simple rate of return is the compound annual growth rate (CAGR).
The CAGR is the mean annual rate of return of an investment over a specified period of time
longer than one year, which means the calculation must factor in growth over multiple periods.
To calculate compound annual growth rate, we divide the value of an investment at the end of the
period in question by its value at the beginning of that period, raise the result to the power of one,
divide by the number of holding periods, such as years, and subtract one from the subsequent
result.
Example of a Rate of Return (RoR)
The rate of return can be calculated for any investment, dealing with any kind of asset. Let's take
the example of purchasing a home as a basic example for understanding how to calculate the
RoR. Say that you buy a house for $250,000 (for simplicity let's assume you pay 100% cash).
Six years later, you decide to sell the house—maybe your family is growing and you need to move
into a larger place. You are able to sell the house for $335,000, after deducting any realtor's fees
and taxes. The simple rate of return on the purchase and sale of the house is as follows:
{(335,000-250,000)/250,000} x 100 = 34%

19
Now, what if, instead, you sold the house for less than you paid for it—say, for $187,500? The
same equation can be used to calculate your loss, or the negative rate of return, on the
transaction:
(187,500−250,000)/ 250,000) ×100=−25%
Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)
The next step in understanding RoR over time is to account for the time value of money (TVM),
which the CAGR ignores. Discounted cash flows take the earnings of an investment and discount
each of the cash flows based on a discount rate. The discount rate represents a minimum rate of
return acceptable to the investor, or an assumed rate of inflation. In addition to investors,
businesses use discounted cash flows to assess the profitability of their investments.
Assume, for example, a company is considering the purchase of a new piece of equipment for
$10,000, and the firm uses a discount rate of 5%. After a $10,000 cash outflow, the equipment is
used in the operations of the business and increases cash inflows by $2,000 a year for five years.
The business applies present value table factors to the $10,000 outflow and to the $2,000 inflow
each year for five years.
The $2,000 inflow in year five would be discounted using the discount rate at 5% for five years. If
the sum of all the adjusted cash inflows and outflows is greater than zero, the investment is
profitable. A positive net cash inflow also means that the rate of return is higher than the 5%
discount rate.
The rate of return using discounted cash flows is also known as the internal rate of return (IRR).
The internal rate of return is a discount rate that makes the net present value (NPV) of all cash
flows from a particular project or investment equal to zero. IRR calculations rely on the same
formula as NPV does and utilizes the time value of money (using interest rates). The formula for
IRR is as follows:

1. How would you define the rate of return?
2. Karen bought her house in 1974 for $85,000. In 2016, it was worth $750,000. What's the
rate of return on Karen's investment?
Assignment:
What is Benefit Cost Ratio Method?
Reference:
• http://engineeringandeconomicanalysis.blogspot.com/2013/12/minimum-attractive-rate-
of-return.html
• https://financeformulas.net/Real_Rate_of_Return.html
• https://www.investopedia.com/terms/p/paybackperiod.asp
20
• https://link.springer.com/chapter/10.1007/978-3-540-70810-
0_4#:~:text=Equivalent%20annual%20worth%20analysis%20is,of%20the%20problem%
20into%20account.
• https://www.investopedia.com/terms/r/rateofreturn.asp
Unit 2 – Introduction to Financial and Economic Analysis
Overview:
This lesson will help the students to know the definition and importance of the Lifecycle costing,
Economic Analysis, and Benefit Cost Ratio Method.
1. Understand the Financial and Economic Analysis.

2. Discuss how Benefit Cost Ratio Method works in Engineering Economics.
Course Materials:
What Is a Benefit-Cost Ratio (BRC)?
A benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis to summarize the overall
relationship between the relative costs and benefits of a proposed project. BCR can be expressed
in monetary or qualitative terms. If a project has a BCR greater than 1.0, the project is expected
to deliver a positive net present value to a firm and its investors.
KEY TAKEAWAYS
A benefit-cost ratio (BCR) is an indicator showing the relationship between the relative costs and
benefits of a proposed project, expressed in monetary or qualitative terms.
If a project has a BCR greater than 1.0, the project is expected to deliver a positive net present
value to a firm and its investors.
If a project's BCR is less than 1.0, the project's costs outweigh the benefits, and it should not be
considered.
How Benefit-Cost Ratio Works
Benefit-cost ratios (BCRs) are most often used in capital budgeting to analyze the overall value
for money of undertaking a new project. However, the cost-benefit analyses for large projects can
be hard to get right, because there are so many assumptions and uncertainties that are hard to
quantify. This is why there is usually a wide range of potential BCR outcomes.
The BCR also does not provide any sense of how much economic value will be created, and so
the BCR is usually used to get a rough idea about the viability of a project and how much the
21
internal rate of return (IRR) exceeds the discount rate, which is the company’s weighted-average
cost of capital (WACC) – the opportunity cost of that capital.
The BCR is calculated by dividing the proposed total cash benefit of a project by the proposed
total cash cost of the project. Prior to dividing the numbers, the net present value of the respective
cash flows over the proposed lifetime of the project – taking into account the terminal values,
including salvage/remediation costs – are calculated.
What Does the BCR Tell You?
If a project has a BCR that is greater than 1.0, the project is expected to deliver a positive net
present value (NPV) and will have an internal rate of return (IRR) above the discount rate used in
the DCF calculations. This suggests that the NPV of the project’s cash flows outweighs the NPV
of the costs, and the project should be considered.
If the BCR is equal to 1.0, the ratio indicates that the NPV of expected profits equals the costs. If
a project's BCR is less than 1.0, the project's costs outweigh the benefits, and it should not be
considered.
Example of How to Use BCR
As an example, assume company ABC wishes to assess the profitability of a project that involves
renovating an apartment building over the next year. The company decides to lease the
equipment needed for the project for $50,000 rather than purchasing it. The inflation rate is 2%,
and the renovations are expected to increase the company's annual profit by $100,000 for the
next three years.
The NPV of the total cost of the lease does not need to be discounted, because the initial cost of
$50,000 is paid up front. The NPV of the projected benefits is $288,388, or ($100,000 / (1 +
0.02)^1) + ($100,000 / (1 + 0.02)^2) + ($100,00 / (1 + 0.02)^3). Consequently, the BCR is 5.77,
or $288,388 divided by $50,000.
In this example, our company has a BCR of 5.77, which indicates that the project's estimated
benefits significantly outweigh its costs. Moreover, company ABC could expect $5.77 in benefits
for each $1 of costs.
Limitations of BCR
The primary limitation of the BCR is that it reduces a project to a simple number when the success
or failure of an investment or expansion relies on many factors and can be undermined by
unforeseen events. Simply following a rule that above 1.0 means success and below 1.0 spells
failure is misleading and can provide a false sense of comfort with a project. The BCR must be
used as a tool in conjunction with other types of analysis to make a well-informed decision
Introduction: What is Life Cycle Costing?
Life Cycle Costing (LCC) is a method of economic analysis for all costs related to product and
services throughout the entire life cycle. Traditionally it takes into account mainly investment,
operation, maintenance and end of life disposal costs. Including the environmental impacts
22
expressed in monetary terms that may come from Life Cycle Assessment (LCA), LCC can be
convenient to address the economic dimension of sustainability (e.g. Klöpffer Renner 2008). A
methodology for LCC had developed by SETAC Working Group which is applied in parallel to an
LCA called “Environmental LCC”. The aim was to provide methodology to merge traditional LCC
with LCA efficiently and consistently. As Environmental LCC and LCA have similar structure,
conducting both analysis in one software makes sense. The aim of this paper is to investigate
how this is possible with open LCA
Financial and Economic Analysis
Sound financial and economic analysis (FEA) during project design, appraisal and implementation
plays a key role in achieving the desired economic outcomes and increasing the likelihood of
sustained economic benefits of a project.
The main goal of financial analysis (FA) is to examine the financial returns to project participants
(beneficiaries, project entity, institutions and governments) in order to demonstrate that all actors
have enough financial incentive to participate. EA is carried out to assess the projects efficiency
in terms of its net contribution to the national economic and social welfare.
FEA of investment projects is an appraisal requirement of most governments and International

Financing Institutions (IFIs). It provides the grounds for making decisions on investment financing
a proposed project based on its financial and economic viability. While IFIs and governments
require FEA to be conducted at the project appraisal stage, it is also increasingly considered to
be an important instrument for identification, design, implementation and ex-post evaluation of
investment programmes and projects [see box for country example].
The Government of Sierra Leone has recently revised its Medium-Term Expenditure Framework
(MTEF) guidelines, including regulations for the Public Investment Programme (PIP). The PIP
outlines the schedule for project appraisal, evaluation and submission of proposed public
investment projects with the aim to improve the efficiency and impact of public investments and
thereby achieve the government’s objective of inclusive economic growth and wide-scale poverty
reduction as stated in its “Agenda for Prosperity”. Under the PIP, it is expected that EA will be
significantly scaled up to improve ex-ante planning and ex-post evaluation and consequently
ensure that public investment programmes and projects have the highest possible economic and
social returns. The “Agenda for Prosperity” states that all Ministry of Agriculture, Forestry and
Food Security policy and programme/project options should be developed on the basis of a
participatory planning process and an EA, as part of a broader impact assessment which would
also include social and environmental aspects.
Who needs to understand FEA and why?
While FEA is usually carried out by economists (e.g. . staff from government, IFIs FAO, and
consultants), their close cooperation with the technical experts involved in project design,
implementation and evaluation is key to meaningful FEA. Most importantly, decision-makers at
various levels have to understand the implications of FEA outcomes to make informed decisions
about project design and resource allocations.
What are the main elements of FEA?
23
FEA starts with analysis of the proposed project’s main objectives and targets that need to be
reflected in the project’s logical framework. This is followed by the monetization of the relevant
project benefits and of their associated costs (see Costing). FEA basically consists of two main
steps: firstly, an assessment of the project’s financial profitability and sustainability in order to
determine whether the farmers or other stakeholders will have sufficient incentive to participate in
the project; and secondly, an assessment of its economic viability from the point of view of the
national economy. FEA should also examine a project’s expected impact on the government
budget to ensure its fiscal sustainability. Furthermore, FEA usually includes an assessment of a
project’s impact on employment and poverty, as well as an analysis of the distribution of benefits.
What are the differences between FA and EA?
The basic principles for carrying out FA and EA are the same and both are required for project
screening and selection. However, there is a difference in approach; FA deals with the cost and
benefit flows from the point of view of the individual, firm or institution, while EA deals with the
costs and benefits to society. EA takes a broader view of costs and benefits, and the methods of
analysis differ in a number of important respects. An enterprise is interested in financial
profitability and the sustainability of that profit, while society is concerned with wider objectives,
such as food security, poverty alleviation, and net benefits to society as a whole. The main
differences between FA and EA are that EA: (i) attempts to quantify “externalities” (i.e. negative
or positive effects on specific groups in society without the project entity incurring a corresponding
monetary cost or enjoying a monetary benefit. This includes both environmental and social
impacts resulting from the project); (ii) removes transfer payments (i.e. subsidies and taxes); and
(iii) makes use of “shadow prices” that might differ from the “market prices”, in order to eliminate
market distortions and reflect the effective opportunity costs for the economy, thus achieving a
proper valuation of economic costs and benefits from the perspective of the economy as a whole.
What are the main categories of FEA?
FEA usually belongs to one of two general categories: cost-benefit or cost-effectiveness. Cost-
benefit analysis (CBA) monetizes all major benefits and all costs generated by the project and
presents their streams over a given number of years (cash flow). Costs and benefits can then be
directly compared with each other as well as with reasonable alternatives to the proposed project.
A CBA is generally considered to be the most comprehensive approach and is the standard for
FEA. In general, CBA provides two main indicators, the Net Present Value (NPV) and the Internal
Rate of Return (IRR). Comparing the NPV of several possible investments allows for identifying
the alternative which yields the highest result – for cases in which the alternatives are mutually
exclusive. The IRR allows for ranking investment alternatives based on their return on the
investment – when a number of projects can be financed – up to a certain maximum investment
amount. As such, these indicators are important decision-making tools for national governments,
as well as for IFIs and other donors. Cost-effectiveness analysis evaluates which project design
options provide the desired results at the lowest cost. While it is similar to CBA in many important
respects, it does not attempt to monetize all anticipated benefits deriving from a project or the
alternatives considered.

1. What are the limitations of Benefit-cost Ratio?
2. What are the difference between Financial Analysis and Economic Analysis?
24
Assignment:
What is the Fundamental of Replacement Analysis and Economic Service life of Challenger and
Defender?
Reference:
• https://www.investopedia.com/terms/b/bcr.asp
• https://www.openlca.org/wp-content/uploads/2015/11/How-to-perform-Life-Cycle-
Costing-in-openLCA.pdf
• http://www.fao.org/investment-learning-platform/themes-and-tasks/financial-economic-
analysis/en/
25
Lesson 4 – Replacement Analysis
Unit 1-Analysis. Planning, and Decision
Overview:
This lesson will help the students to understand the importance of Comparing Defender and
Challenger, Decision Framework
1. Understand the difference Finite and Infinite Planning Horizon.

2. Discuss the definition defender and challenger.
Course Materials:
Replacement Analysis
Replacement projects are decision problems involving the replacement of existing obsolete or
worn-out assets. The continuation of operations is dependent on these assets.
• Defender: is an existing asset

• Challenger: is the best available replacement candidate
• Current market value: is the value to use in preparing a defender’s economic analysis
• Sunk cost: past costs that cannot be changed by any future investment decision and
should not be considered in a defender’s economic analysis
Example 11.1: Information Relevant to Replacement Analysis
Macintosh Printing Inc. purchased a $20,000 printing machine two years ago. The company
expected this machine to have a five-year life and a salvage value of $5,000. The company spent
$5,000 last year on repairs, and current operating costs are running at the rate of $8,000 per year.
The anticipated salvage value of the machine has been reduced to $2,500 at the end of the
machine’s remaining useful life. In addition, the company has found that the current machine has
a market value of $10,000 today. The equipment vendor will allow the company this full amount
as a trade-in on a new machine.
What values for the defender are relevant to our analysis?

Example 11.1: Solution
Original cost: The printing machine was purchased for $20,000.
Current market value: The company estimates the old machine’s current market value at $10,000.
Trade-in allowance: This is the same as the market value.
Repair cost: $5,000 was spent last year to repair the machine. Operating costs: If kept, the
machine costs $8,000 per year to operate. Future salvage value: The machine has a salvage
value of $2,500 three years from today.
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Economic service life
How long should an asset be kept in service? The longer an asset is kept, the less the annual
cost of capital recovery, but the higher the operation and maintenance cost.
27
The economic service life occurs at the minimum total EAC (The sum of CR and O&M).
Thus, the EAC of ownership at any year j can be found by :
EACj = -P(A/P, i, j) - SV(A/F, i, j) + [(Sum from j =1 to N of O&Mj)(P/F, i, j)](A/P, i, N)
Example: Determine economic service life for i = 8%, equipment purchase price = $24,000,
decline in salvage value = 20% / year, O&M cost = $3,000 for the first year, O&M increase =
$1,000 /year.
Life Salvage Value Capital recovery EAC Total

j, years SVj O&Mj Cost O&M EAC
1 $19,200 $3,000 $6720 $3000 $9720
2 $15,360 $4,000 $6074 $3481 $9555
3 $12,288 $5,000 $5528 $3949 $9477
4 $9,830 $6,000 $5065 $4404 $9469 Least Cost
5 $7,864 $7,000 $4671 $4847 $9518
6 $6,291 $8,000 $4334 $5276 $9610
The minimum total EAC is in year 4. Thus, the equipment should be sold after year 4 yielding
a four year economic service life.
As an example, let's see how the year 4 EAC is calculated.
Capital Recovery cost = $24,000(A/P,8,4) - $9,830(A/F,8,4)

= $24,000(0.30192) - $9,830(0.22192)
= $5,065
EAC O&M (4) = [3000(P/F,8,1) + 4000(P/F,8,2) + 5000(P/F,8,3) + 6000(P/F,8,4)] (A/P,8,4)

= [3000(0.9259) + 4000(0.8573) + 5000(0.7938) + 6000(0.7350)] (0.30192)
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= $4,404
or in this case, since we have an arithmetic gradient
EAC O&M (4) = 3000 + 1000(A/G,10,4)

= 3000 + 1000(1.4090)
= $4,404
Required Assumptions and Decision Frameworks
1. Planning Horizon: the service period required by the defender and a sequence of future
challengers
• Infinite planning horizon is used when we are simply unable to predict when the activity
under consideration will be terminated.
• Finite planning horizon is used when the project will have a definite and predictable
duration.
2. Technology: No technology improvement is anticipated over the planning horizon. However,

technology improvement cannot be ruled out.
3. Revenue and Cost Patterns Over the Life of an Asset
4. Decision Frameworks
To illustrate how a decision framework is developed, we indicate a replacement sequence of

assets by the notation
(j0 ,n0 ), (j1 ,n1 ), (j2 ,n2 ), ..., (jK ,nK )
• Each pair of numbers ( j, n) indicates a type of asset and the lifetime over which that asset
will be retained. The defender, asset 0 is listed first; if the defender is replaced now, n0 =
0.
• The sequence (j0,2), (j1,5), (j2,3) indicates retaining the defender for two years, then
replacing the defender with an asset of type j1 and using it for five years, and then
replacing j1 with an asset of type j2 and using it for three years.
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5. Decision Criterion
The AE or AEC method provides a more direct solution when the planning horizon is infinite.
When the planning horizon is finite, the PW or PEC method is more convenient to use.
Replacement Strategies Under the Infinite Planning Horizon
An annual cash flow analysis with unequal service life alternatives are not valid in the usual
defender– challenger situation. The unequal-life problem is resolved because we really are
comparing the following two options in replacement analysis:
1. Replace the defender now: The cash flows of the challenger estimated today will be used. An
identical challenger will be used thereafter if replacement becomes necessary in the future. This
stream of cash flows is equivalent to a cash flow of AECC* each year for an infinite number of
years.
2. Replace the defender, say, x years later: The cash flows of the defender will be used in the first
x years. Starting in year x+1,the cash flows of the challenger will be used indefinitely thereafter
Replacement Analysis Under the Finite Planning Horizon (PW Approach)
Consider again the defender and the challenger in Example. Suppose that the firm has a contract
to perform a given service, using the current defender or the challenger for the next eight years.
After the contract work, neither the defender nor the challenger will be retained. What is the best
replacement strategy?
Example 11.4:
Defender:
30
Current salvage value = $5,000, decreasing at an annual rate of 1000$ from the previous year’s
value
Required overhaul = $1,200
O&M = $2,000 in year 1, increasing by $1,500 per year
Challenger:
I = $10,000
Salvage value = $6,000 after one year, will decline 15% each year
O&M = $2,000 in the first year, increasing 800$ per year after.

1. What is the required Assumptions and Decision Frameworks?
2. What is Current market value?
Assignment:
Find the definition of Risk Analysis and Decision Tree and how it works.
Study Lesson 1- 4 for the Preparation in the Midterm Examination.
Reference:
• http://docshare01.docshare.tips/files/25225/252252098.pdf
• http://www.eng.utoledo.edu/~nkissoff/lessons/Lesson14.html
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Lesson 5 – Risk Analysis
Unit 1-Concept of Economic Analsis
Overview:
This lesson will help the students to understand the importance of the students to understand the
Sensitivity, Breakeven and Scenario Analysis.
1. Understand the difference between Qualitative and Quantitative Risk.

2. Discuss the how Monte Carlo Simulation Works.
Course Materials:
What Is Risk Analysis?
Risk analysis is the process of assessing the likelihood of an adverse event occurring within the
corporate, government, or environmental sector. Risk analysis is the study of the underlying
uncertainty of a given course of action and refers to the uncertainty of forecasted cash flow
streams, the variance of portfolio or stock returns, the probability of a project's success or failure,
and possible future economic states. Risk analysts often work in tandem with forecasting
professionals to minimize future negative unforeseen effects.
KEY TAKEAWAYS
• Risk analysis is the process of assessing the likelihood of an adverse event occurring
within the corporate, government, or environmental sector.
• Risk can be analyzed using several approaches including those that fall under the
categories of quantitative and qualitative.
• Risk analysis is still more of an art than a science.
Understanding Risk Analysis
A risk analyst starts by identifying what could go wrong. The negative events that could occur are
then weighed against a probability metric to measure the likelihood of the event occurring. Finally,
risk analysis attempts to estimate the extent of the impact that will be made if the event happens.
Quantitative Risk Analysis
Risk analysis can be quantitative or qualitative. Under quantitative risk analysis, a risk model is
built using simulation or deterministic statistics to assign numerical values to risk. Inputs that are
mostly assumptions and random variables are fed into a risk model.
32
For any given range of input, the model generates a range of output or outcome. The model is
analyzed using graphs, scenario analysis, and/or sensitivity analysis by risk managers to make
decisions to mitigate and deal with the risks.
A Monte Carlo simulation can be used to generate a range of possible outcomes of a decision
made or action taken. The simulation is a quantitative technique that calculates results for the
random input variables repeatedly, using a different set of input values each time. The resulting
outcome from each input is recorded, and the final result of the model is a probability distribution
of all possible outcomes. The outcomes can be summarized on a distribution graph showing some
measures of central tendency such as the mean and median, and assessing the variability of the
data through standard deviation and variance.
The outcomes can also be assessed using risk management tools such as scenario analysis and
sensitivity tables. A scenario analysis shows the best, middle, and worst outcome of any event.
Separating the different outcomes from best to worst provides a reasonable spread of insight for
a risk manager.
For example, an American Company that operates on a global scale might want to know how its
bottom line would fare if the exchange rate of select countries strengthens. A sensitivity table
shows how outcomes vary when one or more random variables or assumptions are changed. A
portfolio manager might use a sensitivity table to assess how changes to the different values of
each security in a portfolio will impact the variance of the portfolio. Other types of risk management
tools include decision trees and break-even analysis.
What is a Monte Carlo Simulation?
Monte Carlo simulations are used to model the probability of different outcomes in a process that
cannot easily be predicted due to the intervention of random variables. It is a technique used to
understand the impact of risk and uncertainty in prediction and forecasting models.
Monte Carlo simulation can be used to tackle a range of problems in virtually every field such as
finance, engineering, supply chain, and science.
Monte Carlo simulation is also referred to as multiple probability simulation.
Explaining Monte Carlo Simulations

When faced with significant uncertainty in the process of making a forecast or estimation, rather
than just replacing the uncertain variable with a single average number, the Monte Carlo
Simulation might prove to be a better solution. Since business and finance are plagued by random
variables, Monte Carlo simulations have a vast array of potential applications in these fields. They
are used to estimate the probability of cost overruns in large projects and the likelihood that an
asset price will move in a certain way. Telecoms use them to assess network performance in
different scenarios, helping them to optimize the network. Analysts use them to assess the risk
that an entity will default and to analyze derivatives such as options. Insurers and oil well drillers
also use them. Monte Carlo simulations have countless applications outside of business and
finance, such as in meteorology, astronomy and particle physics.
Monte Carlo simulations are named after the gambling hot spot in Monaco, since chance and
random outcomes are central to the modeling technique, much as they are to games like roulette,
33
dice, and slot machines. The technique was first developed by Stanislaw Ulam, a mathematician
who worked on the Manhattan Project. After the war, while recovering from brain surgery, Ulam
entertained himself by playing countless games of solitaire. He became interested in plotting the
outcome of each of these games in order to observe their distribution and determine the
probability of winning. After he shared his idea with John Von Neumann, the two collaborated to
develop the Monte Carlo simulation.
Qualitative Risk Analysis
Qualitative risk analysis is an analytical method that does not identify and evaluate risks with
numerical and quantitative ratings. Qualitative analysis involves a written definition of the
uncertainties, an evaluation of the extent of the impact (if the risk ensues), and countermeasure
plans in the case of a negative event occurring.
Examples of qualitative risk tools include SWOT Analysis, Cause and Effect diagrams, Decision
Matrix, Game Theory, etc. A firm that wants to measure the impact of a security breach on its
servers may use a qualitative risk technique to help prepare it for any lost income that may occur
from a data breach.
While most investors are concerned about downside risk, mathematically, the risk is the variance
both to the downside and the upside.
Almost all sorts of large businesses require a minimum sort of risk analysis. For example,
commercial banks need to properly hedge foreign exchange exposure of overseas loans while
large department stores must factor in the possibility of reduced revenues due to a global
recession. It is important to know that risk analysis allows professionals to identify and mitigate
risks, but not avoid them completely.
Example of Risk Analysis: Value at Risk (VaR)
Value at risk (VaR) is a statistic that measures and quantifies the level of financial risk within a
firm, portfolio, or position over a specific time frame. This metric is most commonly used by
investment and commercial banks to determine the extent and occurrence ratio of potential losses
in their institutional portfolios. Risk managers use VaR to measure and control the level of risk
exposure. One can apply VaR calculations to specific positions or whole portfolios or to measure
firm-wide risk exposure.
VaR is calculated by shifting historical returns from worst to best with the assumption that returns
will be repeated, especially where it concerns risk. As a historical example, let's look at the Nasdaq
100 ETF, which trades under the symbol QQQ (sometimes called the "cubes") and which started
trading in March of 1999. If we calculate each daily return, we produce a rich data set of more
than 1,400 points. The worst are generally visualized on the left, while the best returns are placed
on the right.
For more than 250 days, the daily return for the ETF was calculated between 0% and 1%. In
January 2000, the ETF returned 12.4%. But there are points at which the ETF resulted in losses
as well. At its worst, the ETF ran daily losses of 4% to 8%. This period is referred to as the ETF's
worst 5%. Based on these historic returns, we can assume with 95% certainty that the ETF's
34
largest losses won't go beyond 4%. So if we invest $100, we can say with 95% certainty that our
losses won't go beyond $4.
One important thing to keep in mind. VaR doesn't provide analysts with absolute certainty.
Instead, it's an estimate based on probabilities. The probability gets higher if you consider the
higher returns, and only consider the worst 1% of the returns. The Nasdaq 100 ETF's losses of
7% to 8% represent the worst 1% of its performance. We can thus assume with 99% certainty
that our worst return won't lose us $7 on our investment. We can also say with 99% certainty that
a $100 investment will only lose us a maximum of $7.
Limitations of Risk Analysis
Risk is a probabilistic measure and so can never tell you for sure what your precise risk exposure
is at a given time, only what the distribution of possible losses are likely to be if and when they
occur. There are also no standard methods for calculating and analyzing risk, and even VaR can
have several different ways of approaching the task. Risk is often assumed to occur using normal
distribution probabilities, which in reality rarely occur and cannot account for extreme or "black
swan" events.
The financial crisis of 2008 that exposed these problems as relatively benign VaR calculations
understated the potential occurrence of risk events posed by portfolios of subprime mortgages.
Risk magnitude was also underestimated, which resulted in extreme leverage ratios within
subprime portfolios. As a result, the underestimations of occurrence and risk magnitude left
institutions unable to cover billions of dollars in losses as subprime mortgage values collapsed.
What Is Sensitivity Analysis?
A sensitivity analysis determines how different values of an independent variable affect a

particular dependent variable under a given set of assumptions. In other words, sensitivity
analyses study how various sources of uncertainty in a mathematical model contribute to the
model's overall uncertainty. This technique is used within specific boundaries that depend on one
or more input variables.
Sensitivity analysis is used in the business world and in the field of economics. It is commonly
used by financial analysts and economists, and is also known as a what-if analysis.
KEY TAKEAWAYS
• A sensitivity analysis determines how different values of an independent variable affect a

particular dependent variable under a given set of assumptions.
• This model is also referred to as a what-if or simulation analysis.
• Sensitivity analysis can be used to help make predictions in the share prices of publicly-
traded companies or how interest rates affect bond prices.
• Sensitivity analysis allows for forecasting using historical, true data.
How Sensitivity Analysis Works
Sensitivity analysis is a financial model that determines how target variables are affected based
on changes in other variables known as input variables. This model is also referred to as what-if
35
or simulation analysis. It is a way to predict the outcome of a decision given a certain range of
variables. By creating a given set of variables, an analyst can determine how changes in one
variable affect the outcome.
Both the target and input—or independent and dependent—variables are fully analyzed when
sensitivity analysis is conducted. The person doing the analysis looks at how the variables move
as well as how the target is affected by the input variable.
Sensitivity analysis can be used to help make predictions in the share prices of public companies.
Some of the variables that affect stock prices include company earnings, the number of shares
outstanding, the debt-to-equity ratios (D/E), and the number of competitors in the industry. The
analysis can be refined about future stock prices by making different assumptions or adding
different variables. This model can also be used to determine the effect that changes in interest
rates have on bond prices. In this case, the interest rates are the independent variable, while bond
prices are the dependent variable.
Sensitivity analysis allows for forecasting using historical, true data. By studying all the variables
and the possible outcomes, important decisions can be made about businesses, the economy,
and about making investments.
What is Break Even Analysis?
Break Even Analysis in economics, business, and cost accounting refers to the point in which
total cost and total revenue are equal. A break even point analysis is used to determine the
number of units or dollars of revenue needed to cover total costs (fixed and variable costs).
Formula for Break Even Analysis
The formula for break even analysis is as follows:
Break even quantity = Fixed costs / (Sales price per unit – Variable cost per unit)
Where:
• Fixed costs are costs that do not change with varying output (e.g., salary, rent, building
machinery).
• Sales price per unit is the selling price (unit selling price) per unit.
• Variable cost per unit is the variable costs incurred to create a unit.
It is also helpful to note that sales price per unit minus variable cost per unit is the contribution
margin per unit. For example, if a book’s selling price is $100 and its variable costs are $5 to make
the book, $95 is the contribution margin per unit and contributes to offsetting the fixed costs.

1. What is the formula of break-even analysis?
2. How sensitivity analysis works?
36
Assignment:
Find the Method and Concept of Depreciation
Reference:
• https://www.investopedia.com/terms/r/risk-
analysis.asp#:~:text=Risk%20analysis%20is%20the%20study,and%20possible%20futur
e%20economic%20states.
• https://www.investopedia.com/terms/m/montecarlosimulation.asp
• https://www.investopedia.com/terms/s/sensitivityanalysis.asp
• https://corporatefinanceinstitute.com/resources/knowledge/modeling/break-even-
analysis/
37
Lesson 6 – Depreciation and Corporate Income Taxes
Unit 1-Concept of Depreciation
Overview:
This lesson will help the students to learn the Concept of Depreciation, Method of Depreciation
and Cash Flow Estimate.
1. Understand the difference between Qualitative and Quantitative Risk.

2. Discuss the how Monte Carlo Simulation Works.
Course Materials:
What Is Depreciation?
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over
its useful life or life expectancy. Depreciation represents how much of an asset's value has been
used up. Depreciating assets helps companies earn revenue from an asset while expensing a
portion of its cost each year the asset is in use. If not taken into account, it can greatly affect
profits.
Businesses can depreciate long-term assets for both tax and accounting purposes. For example,
companies can take a tax deduction for the cost of the asset, meaning it reduces taxable income.
However, the Internal Revenue Service (IRS) states that when depreciating assets, companies
must spread the cost out over time. The IRS also has rules for when companies can take a
deduction.
KEY TAKEAWAYS
• Per the matching principle of accounting, depreciation ties the cost of using a tangible
asset with the benefit gained over its useful life.
• There are many types of depreciation, including straight-line and various forms of
accelerated depreciation.
• Accumulated depreciation refers to the sum of all depreciation recorded on an asset to a
specific date.
• The carrying value of an asset on the balance sheet is its historical cost minus all
accumulated depreciation.
• The carrying value of an asset after all depreciation has been taken is referred to as its
salvage value.
Understanding Depreciation
Depreciation is an accounting convention that allows a company to write off an asset's value over
a period of time, commonly the asset's useful life. Assets such as machinery and equipment are
38
expensive. Instead of realizing the entire cost of the asset in year one, depreciating the asset
allows companies to spread out that cost and generate revenue from it.
Depreciation is used to account for declines in the carrying value over time. Carrying value
represents the difference between the original cost and the accumulated depreciation of the
years.
Each company might set its own threshold amounts for when to begin depreciating a fixed asset–
or property, plant, and equipment. For example, a small company may set a $500 threshold, over
which it depreciates an asset. On the other hand, a larger company may set a $10,000 threshold,
under which all purchases are expensed immediately.
For tax purposes, the IRS publishes depreciation schedules detailing the number of years an
asset can be depreciated, based on various asset classes.
The entire cash outlay might be paid initially when an asset is purchased, but the expense is
recorded incrementally for financial reporting purposes because assets provide a benefit to the
company over a lengthy period of time. Therefore, depreciation is considered a non-cash charge
since it doesn't represent an actual cash outflow. However, the depreciation charges still reduce
a company's earnings, which is helpful for tax purposes.
The matching principle under generally accepted accounting principles (GAAP) is an accrual
accounting concept that dictates that expenses must be matched to the same period in which the
related revenue is generated. Depreciation helps to tie the cost of an asset with the benefit of its
use over time. In other words, each year, the asset is put to use and generates revenue, the
incremental expense associated with using up the asset is also recorded.
The total amount that's depreciated each year, represented as a percentage, is called the
depreciation rate. For example, if a company had $100,000 in total depreciation over the asset's
expected life, and the annual depreciation was $15,000; the rate would 15% per year.
Recording Depreciation
When an asset is purchased, it is recorded as a debit to increase an asset account, which then
appears on the balance sheet, and a credit to reduce cash or increase accounts payable, which
also appears on the balance sheet. Neither side of this journal entry affects the income statement,
where revenues and expenses are reported. In order to move the cost of the asset from the
balance sheet to the income statement, depreciation is taken on a regular basis.
At the end of an accounting period, an accountant will book depreciation for all capitalized assets
that are not fully depreciated. The journal entry for this depreciation consists of a debit to
depreciation expense, which flows through to the income statement, and a credit to accumulated
depreciation, which is reported on the balance sheet. Accumulated depreciation is a contra asset
account, meaning its natural balance is a credit which reduces the net asset value. Accumulated
depreciation on any given asset is its cumulative depreciation up to a single point in its life.
As stated earlier, carrying value is the net of the asset account and accumulated depreciation.
The salvage value is the carrying value that remains on the balance sheet after all depreciation
has been taken until the asset is sold or otherwise disposed. It is based on what a company
39
expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s
estimated salvage value is an important component in the calculation of depreciation.
Example of Depreciation
If a company buys a piece of equipment for $50,000, it could expense the entire cost of the asset
in year one or write the value of the asset off over the asset's 10-year useful life. This is why
business owners like depreciation. Most business owners prefer to expense only a portion of the
cost, which boosts net income.
In addition, the company can scrap the equipment for $10,000 at the end of its useful life, which
means it has a salvage value of $10,000. Using these variables, the accountant calculates
depreciation expense as the difference between the cost of the asset and its salvage value,
divided by the useful life of the asset. The calculation in this example is ($50,000 - $10,000) / 10,
which is $4,000 of depreciation expense per year.
This means the company's accountant does not have to expense the entire $50,000 in year one,
even though the company paid out that amount in cash. Instead, the company only has to expense
$4,000 against net income. The company expenses another $4,000 next year and another $4,000
the year after that, and so on until the asset reaches its $10,000 salvage value in ten years.
Types of Depreciation
Straight-Line
Depreciating assets using the straight-line method is typically the most basic way to record
depreciation. It reports equal depreciation expense each year throughout the entire useful life until
the entire asset is depreciated to its salvage value. The example above used straight-line
depreciation.
Assume, for another example, that a company buys a machine at a cost of $5,000. The company
decides on a salvage value of $1,000 and a useful life of five years. Based on these assumptions,
the depreciable amount is $4,000 ($5,000 cost - $1,000 salvage value) and the annual
depreciation using the straight-line method is: $4,000 depreciable amount / 5 years, or $800 per
year. As a result, the depreciation rate is 20% ($800/$4,000). The depreciation rate is used in
both the declining balance and double-declining balance calculations.
Declining Balance
The declining balance method is an accelerated depreciation method. This method depreciates
the machine at its straight-line depreciation percentage times its remaining depreciable amount
each year. Because an asset's carrying value is higher in earlier years, the same percentage
causes a larger depreciation expense amount in earlier years, declining each year.
Using the straight-line example above, the machine costs $5,000, has a salvage value of $1,000,
a 5-year life, and is depreciated at 20% each year, so the expense is $800 in the first year ($4,000
depreciable amount * 20%), $640 in the second year (($4,000 - $800) * 20%), and so on.
Double Declining Balance (DDB)

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The double-declining balance (DDB) method is another accelerated depreciation method. After
taking the reciprocal of the useful life of the asset and doubling it, this rate is applied to the
depreciable base, book value, for the remainder of the asset’s expected life. For example, an
asset with a useful life of five years would have a reciprocal value of 1/5 or 20%. Double the rate,
or 40%, is applied to the asset's current book value for depreciation. Although the rate remains
constant, the dollar value will decrease over time because the rate is multiplied by a smaller
depreciable base each period.
Sum-of-the-Year's-Digits (SYD)
The sum-of-the-year’s-digits (SYD) method also allows for accelerated depreciation. To start,
combine all the digits of the expected life of the asset. For example, an asset with a five-year life
would have a base of the sum of the digits one through five, or 1+ 2 + 3 + 4 + 5 = 15. In the first
depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only
4/15 of the depreciable base would be depreciated. This continues until year five depreciates the
remaining 1/15 of the base.
Units of Production
This method requires an estimate for the total units an asset will produce over its useful life.
Depreciation expense is then calculated per year based on the number of units produced. This
method also calculates depreciation expenses based on the depreciable amount.

1. What is Depreciation?
2. Types of Depreciation
Assignment:
Definition of Income Tax and How does it works.
Reference:
• https://www.investopedia.com/terms/d/depreciation.asp#:~:text=Depreciation%20is%20a
n%20accounting%20method,value%20has%20been%20used%20up.
Unit 2-Corporate Income Taxes
Overview:
This lesson will help the students to learn the Corporate Income Tax, Tax Cash Flow Estimate
And Tax Economic Analysis.
41
1. Understand the difference between Capital Gain and Capital Loss
2. Discuss the Corporate and Personal Income Tax.
Course Materials:
What is Corporate Tax?
Corporate tax, also called company tax or corporation tax, is a direct tax levied on a company’s
income or capital by the government.
Corporate taxation is a difficult aspect in a country’s jurisdiction, and rules around it vary a lot from
country to country. Some countries are considered to be tax havens, such as Curacao, Fiji,
Cyprus, etc., and are very valued by corporations due to soft tax policies in such areas.
Corporate taxes are subtracted from the earnings before tax figure in a company’s income
statement to arrive at net income (net profit) generated for a particular period.
The maximum corporate tax rate is equal to 35%.
What Does Corporate Tax Apply To?

Corporate taxes apply to the following institutions:
All corporations originated in the country (small, medium, and large)
Corporations running a business inside the country
Foreign enterprises with a permanent establishment in the country
Corporations that are residents for tax purposes inside the country
What is Personal Income Tax?
Personal income tax is a tax imposed by a government on an individual’s income. In other words,
the income tax is payable on an employee’s wages and salaries.
Most individuals do not pay the individual income tax on the full amount of income due to tax
exemptions, deductions, and credits. A series of deductions is offered by the U.S. Internal
Revenue Service, e.g., deductions for healthcare and education expenses, which taxpayers
benefit from to reduce their taxable income.
Imagine an individual who earns $200,000 in income and is qualified for $30,000 of tax
deductions. In such a case, the taxable income will be reduced to $170,000 ($200,000 – $30,000).
Regarding tax credits, they are used in the reduction of a taxpayer’s tax obligation or owed
amount. For example, someone needs to pay $30,000 in income taxes, and they only qualify for
$5,000 in tax credits. So, their tax obligation will be reduced to $25,000 ($30,000 – $5,000).
Personal income tax rates vary from country to country because of different laws and government
systems. Although, the majority of the countries employ a so-called progressive income tax
system, which means those who earn more are subject to a higher tax rate compared to the lower-
income earners.
What Does Personal Income Tax Apply To?

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Personal income tax applies to the following entities:
• Self-employed individuals
• Full-time employees
What Is a Tax Return?
A tax return is a special document filed with the tax authority that contains information needed to
calculate taxes for an entity. The document specifies reported income, expenses, and other
financial information. It consists of three sections:
• Income (mentions all sources of income of an entity)

• Deductions
• Tax credits
After accounting for tax benefits (deductions and tax credits, etc.), taxpayers arrive at their tax
return, which is the amount owed to the government in taxes.
What Is Cash Flow After Taxes? (CFAT)
Cash flow after taxes (CFAT) is a measure of financial performance that shows a company's
ability to generate cash flow through its operations. It is calculated by adding back non-cash
charges such as amortization, depreciation, restructuring costs, and impairment to net income.
CFAT is also known as after-tax cash flow.
KEY TAKEAWAYS:
• Cash flow after taxes (CFAT) examines a company's ability to generate cash flow through
its operations.
• To calculate CFAT, non-cash charges such as amortization, depreciation, restructuring
costs, and impairment are added back to net income.
• CFAT can determine the cash flow of an investment or project undertaken by a
corporation.
• CFAT measures a company's financial health and performance over time and can be
compared to the CFAT of competitors within the same industry.
Understanding Cash Flow After Taxes (CFAT)
CFAT after taxes is a measure of cash flow that takes into account the impact of taxes on profits.
This measure is used to determine the cash flow of an investment or project undertaken by a
corporation. To calculate the after-tax cash flow, depreciation must be added back to net income.
Depreciation is a non-cash expense that represents the declining economic value of an asset but
is not an actual cash outflow. (Remember that depreciation is subtracted as an expense to
calculate profits. In calculating CFAT, it is added back in.). Here is the formula for calculating
CFAT.
CFAT = Net Income + Depreciation + Amortization + Other Non-Cash Charges
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For example, let’s assume a project with an operating income of $2 million has a depreciation
value of $180,000. The company pays a tax rate of 35%. The net income generated by the project
can be calculated as:
Earnings Before Tax (EBT) = $2 million - $180,000
EBT = $1,820,000
Net Income = $1,820,000 - (35% x $1,820,000)
Net Income = $1,820,000 - $637,000
Net Income = $1,183,000
CFAT = $1,183,000 + $180,000
CFAT = $1,363,000
Depreciation is an expense that acts as a tax shield. However, as it is not an actual cash flow, it
must be added back to the after-tax income.
Calculating Taxes from Cash Flow
Being able to assess a company's operating cash flow (OCF)--and how that is impacted by taxes-
-is an important skill in evaluating a company's overall health.
The operating cash flow indicates the cash a company brings in from ongoing, regular business
activities. The operating cash flow can be found on a company's cash flow statement in the
financial reporting done annually and quarterly. Simply, it is Total Revenue - Operating Expenses
= Operating Cash Flow.
Taxes are included in the calculations for the operating cash flow. Cash flow from operating
activities is calculated by adding depreciation to the earnings before income and taxes and then
subtracting the taxes.
A company's EBIT--also known as its earnings before interest and taxes--consists of its net
income before income tax and interest expenses are deducted. Once a company's EBIT is known,
multiply that by the tax rate to calculate the total tax paid. Finally, to calculate operating cash flow,
use the following equation: EBIT - tax paid + depreciation.
In terms of how to calculate OCF with tax rate already known, the equation above can be simply
reverse-engineered, solving for the unknown variables.
Impact of Taxes on Cash Flows
The operating cash flow is important when considering whether the company can generate
enough positive funds to maintain and grow its operations. If not, the company may require
external financing. Shorter turnover rates in inventory and shorter times for receiving funds
increase the operational cash flow. Items such as depreciation and taxes are included to adjust
44
the net income, rendering a more accurate financial picture. Higher taxes and lower depreciation
methods adversely impact the operational cash flow.
Implications of Operating Cash Flow
Investors find it important to look at the cash flow after taxes, which indicates a corporation's
ability to pay dividends. The higher the cash flow, the better the company is financially, and the
better positioned it is to make distributions. Income the company has from outside of its operations
is not included in the operating cash flow. Any dividends paid and infrequent long-term expenses
are often excluded from this calculation as well.
One-time asset sales are also noted, as they inflate the cash flow numbers during the relevant
time period. Investors look at the balance and income statements to gain a better knowledge of
the overall health of a company.
Capital Losses and Tax
It's never fun to lose money on an investment, but declaring a capital loss on your tax return can
be an effective consolation prize in many cases. Capital losses have limited impact on earned
income in subsequent tax years, but they can be fully applied against future capital gains.
Investors who understand the rules of capital losses can often generate useful deductions with a
few simple strategies.
KEY TAKEAWAYS
• A capital loss—when a security is sold for less than the purchase price—can be used to
reduce the tax burden of future capital gains.
• There are three types of capital losses—realized losses, unrealized losses, and
recognizable gains.
• Capital losses make it possible for investors to recoup at least part of their losses on their
tax returns by offsetting capital gains and other forms of income.
The Basics
Capital losses are, of course, the opposite of capital gains. When a security or investment is sold
for less than its original purchase price, then the dollar amount of difference is considered a capital
loss.
For tax purposes, capital losses are only reported on items that are intended to increase in value.
They do not apply to items used for personal use such as automobiles (although the sale of a car
at a profit is still considered taxable income).
Tax Rules
Capital losses can be used as deductions on the investor’s tax return, just as capital gains must
be reported as income. Unlike capital gains, capital losses can be divided into three categories:
1. Realized losses occur on the actual sale of the asset or investment.

2. Unrealized losses are not reported.
45
3. Recognizable losses are the amount of a loss that can be declared in a given year.
Any loss can be netted against any capital gain realized in the same tax year, but only $3,000 of
capital loss can be deducted against earned or other types of income in the year. Remaining
capital losses can then be deducted in future years up to $3,000 a year, or a capital gain can be
used to offset the remaining carry-forward amount.
For example, an investor buys a stock at $50 a share in May. By August, the share price has
dropped to $30. The investor has an unrealized loss of $20 per share. They hold the stock until
the following year, and the price climbs to $45 per share. The investor sells the stock at that point
and realizes a loss of $5 per share. They can only report that loss in the year of sale; they cannot
report the unrealized loss from the previous year.
Another category is recognizable gains. Although all capital gains realized in a given year must
be reported for that year, there are some limits on the amount of capital losses that may be
declared in a given year in some cases. While any loss can ultimately be netted against any
capital gain realized in the same tax year, only $3,000 of capital loss can be deducted against
earned or other types of income in a given year.1
For example, Frank realized a capital gain of $10,000 in 2013. He also realized a loss of $30,000.
He will be able to net $10,000 of his loss against his gain, but can only deduct an additional $3,000
of loss against his other income for that year. He can deduct the remaining $17,000 of loss in
$3,000 increments every year from then on until the entire amount has been deducted. However,
if he realizes a capital gain in a future year before he has exhausted this amount, then he can
deduct the remaining loss against the gain. So if he deducts $3,000 of loss for the next two years
and then realizes a $20,000 gain, he can deduct the remaining $11,000 of loss against that gain,
leaving a taxable gain of only $9,000.
The Long and Short of It

Capital losses do mirror capital gains in their holding periods. An asset or investment that is held
for a year to the day or less, and sold at a loss, will generate a short-term capital loss.
A sale of any asset held for more than a year to the day, and sold at a loss, will generate a long-
term loss. When capital gains and losses are reported on the tax return, the taxpayer must first
categorize all gains and losses between long and short term, and then aggregate the total
amounts for each of the four categories.
Then the long-term gains and losses are netted against each other, and the same is done for
short-term gains and losses. Then the net long-term gain or loss is netted against the net short-
term gain or loss.2 This final net number is then reported on Form 1040.
For example, Frank has the following gains and losses from his stock trading for the year:
Short-term gains: $6,000
Long-term gains: $4,000
Short-term losses: $2,000
Long-term losses: $5,000
Net short-term gain/loss: $4,000 ST gain ($6,000 ST gain - $2,000 ST loss)
Net long-term gain/loss: $1,000 LT loss ($4,000 LT gain - $5,000 LT loss)
Final net gain/loss: $3,000 short-term gain ($4,000 ST gain - $1,000 LT loss)
Tax Reporting
46
A new tax form was recently introduced. This form provides more detailed information to the
Internal Revenue Service (IRS) so that it can compare gain and loss information with that reported
by brokerage firms and investment companies. Form 8949 is now used to report net gains and
losses, and the final net number from that form is then transposed to the newly revised Schedule
D and then to the 1040.3
Capital Loss Strategies
Although novice investors often panic when their holdings decline substantially in value,
experienced investors who understand the tax rules are quick to liquidate their losers, at least for
a short time, to generate capital losses. Smart investors also know that capital losses can save
them more money in some situations than others. Capital losses that are used to offset long-term
capital gains will not save taxpayers as much money as losses that offset short-term gains or
other ordinary income.
Wash Sale Rules
Investors who liquidate their losing positions must wait at least 31 days after the sale date before
buying the same security back if they want to deduct the loss on their tax returns.
If they buy back in before that time, the loss will be disallowed under the IRS wash sale rule.4 This
rule may make it impractical for holders of volatile securities to attempt this strategy, because the
price of the security may rise again substantially before the time period has been satisfied.
But there are ways to circumvent the wash sale rule in some cases. Savvy investors will often
replace losing securities with either very similar or more promising alternatives that still meet their
investment objectives.
For example, an investor who holds a biotech stock that has tanked could liquidate this holding
and purchase an ETF that invests in this sector as a replacement. The fund provides
diversification in the biotech sector with the same degree of liquidity as the stock.
Furthermore, the investor can purchase the fund immediately, because it is a different security
than the stock and has a different ticker symbol. This strategy is thus exempt from the wash sale
rule, as it only applies to sales and purchases of identical securities.

1. What is the difference between Capital Loss and Capital Gain?
2. What does it means by CFBT and CFAT and their definitions?
Assignment:
Describe the Positive and Negative effects of Inflation to the Economy..
Reference:
• https://corporatefinanceinstitute.com/resources/knowledge/finance/corporate-vs-
personal-income-tax/
47
• https://www.investopedia.com/terms/c/cfat.asp
• https://www.investopedia.com/ask/answers/012615/are-taxes-calculated-operating-cash-
flow.asp
• https://www.investopedia.com/articles/investing/062713/capital-losses-and-tax.asp
48
Lesson 7 – Inflation and Its Impact on Project Cashflows
Unit 1-Inflation
Overview:
This lesson will help the students to learn the Concept of Inflation, Measuring Inflation and Impact
of Inflation
1. Understand how inflation works, the cause and effect of inflation in the economy.
2. Discuss the different types of inflation and how it works.
Course Materials:
What Is Inflation?
Inflation is a quantitative measure of the rate at which the average price level of a basket of
selected goods and services in an economy increases over some period of time. It is the rise in
the general level of prices where a unit of currency effectively buys less than it did in prior periods.
Often expressed as a percentage, inflation thus indicates a decrease in the purchasing power of
a nation’s currency.
Inflation can be contrasted with deflation, which occurs when prices instead decline.
KEY TAKEAWAYS
• Inflation is the rate at which the general level of prices for goods and services is rising and,
consequently, the purchasing power of currency is falling.
• Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-
In inflation.
• Most commonly used inflation indexes are the Consumer Price Index (CPI) and the
Wholesale Price Index (WPI).
• Inflation can be viewed positively or negatively depending on the individual viewpoint and
rate of change.
• Those with tangible assets, like property or stocked commodities, may like to see some
inflation as that raises the value of their assets.
• People holding cash may not like inflation, as it erodes the value of their cash holdings.
• Ideally, an optimum level of inflation is required to promote spending to a certain extent
instead of saving, thereby nurturing economic growth.
Understanding Inflation
As prices rise, a single unit of currency loses value as it buys fewer goods and services. This loss
of purchasing power impacts the general cost of living for the common public which ultimately
49
leads to a deceleration in economic growth. The consensus view among economists is that
sustained inflation occurs when a nation's money supply growth outpaces economic growth.
To combat this, a country's appropriate monetary authority, like the central bank, then takes the
necessary measures to keep inflation within permissible limits and keep the economy running
smoothly.
Inflation is measured in a variety of ways depending upon the types of goods and services
considered and is the opposite of deflation which indicates a general decline occurring in prices
for goods and services when the inflation rate falls below 0%.
Causes of Inflation
Rising prices are the root of inflation, though this can be attributed to different factors. In the
context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push
inflation, and Built-In inflation.
Demand-Pull Effect
Demand-pull inflation occurs when the overall demand for goods and services in an economy
increases more rapidly than the economy's production capacity. It creates a demand-supply gap
with higher demand and lower supply, which results in higher prices. For instance, when the oil
producing nations decide to cut down on oil production, the supply diminishes. This lower supply
for existing demand leads to a rise in price and contributes to inflation.
How Does Inflation Work?
Additionally, an increase in money supply in an economy also leads to inflation. With more money
available to individuals, positive consumer sentiment leads to higher spending. This increases
demand and leads to price rises. Money supply can be increased by the monetary authorities
either by printing and giving away more money to the individuals, or by devaluing (reducing the
value of) the currency. In all such cases of demand increase, the money loses its purchasing
power.
Cost-Push Effect
Cost-push inflation is a result of the increase in the prices of production process inputs. Examples
include an increase in labor costs to manufacture a good or offer a service or increase in the cost
of raw material. These developments lead to higher cost for the finished product or service and
contribute to inflation.
Built-In Inflation
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and
services rises, labor expects and demands more costs/wages to maintain their cost of living. Their
increased wages result in higher cost of goods and services, and this wage-price spiral continues
as one factor induces the other and vice-versa.
Theoretically, monetarism establishes the relation between inflation and money supply of an
economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive
50
amounts of gold and especially silver flowed into the Spanish and other European economies.
Since the money supply had rapidly increased, prices spiked and the value of money fell,
contributing to economic collapse.
Types of Inflation Indexes
Depending upon the selected set of goods and services used, multiple types of inflation values
are calculated and tracked as inflation indexes. Most commonly used inflation indexes are the
Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
The Consumer Price Index
The CPI is a measure that examines the weighted average of prices of a basket of goods and
services which are of primary consumer needs. They include transportation, food, and medical
care. CPI is calculated by taking price changes for each item in the predetermined basket of goods
and averaging them based on their relative weight in the whole basket. The prices in consideration
are the retail prices of each item, as available for purchase by the individual citizens. Changes in
the CPI are used to assess price changes associated with the cost of living, making it one of the
most frequently used statistics for identifying periods of inflation or deflation. The U.S. Bureau of
Labor Statistics reports the CPI on a monthly basis and has calculated it as far back as 1913.1
The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in the
price of goods in the stages before the retail level. While WPI items vary from one country to
other, they mostly include items at the producer or wholesale level. For example, it includes cotton
prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many
countries and organizations use WPI, many other countries, including the U.S., use a similar
variant called the producer price index (PPI).
The Producer Price Index
The producer price index is a family of indexes that measures the average change in selling prices
received by domestic producers of goods and services over time. The PPI measures price
changes from the perspective of the seller and differs from the CPI which measures price changes
from the perspective of the buyer.2
In all such variants, it is possible that the rise in the price of one component (say oil) cancels out
the price decline in another (say wheat) to a certain extent. Overall, each index represents the
average weighted cost of inflation for the given constituents which may apply at the overall
economy, sector or commodity level.
The Formula for Measuring Inflation
The above-mentioned variants of inflation indexes can be used to calculate the value of inflation
between two particular months (or years). While a lot of ready-made inflation calculators are
already available on various financial portal and websites, it is always better to be aware of the
underlying methodology to ensure accuracy with a clear understanding of the calculations.
Mathematically,
51
Change in Inflation = (Final CPI Index Value/Initial CPI Value)
Say you wish to know how the purchasing power of $10,000 changed between Sept. 1975 and
Sept. 2018. One can find inflation index data on various portals in a tabular form. From that table,
pick up the corresponding CPI figures for of the given two months. For Sept. 1975, it was 54.6
(Initial CPI value) and for Sept. 2018, it was 252.439 (Final CPI value).3 Plugging in the formula
yields:
Rise in Inflation = (252.439/54.6) = 4.6234 = 462.34%
Since you wish to know how much $10,000 of Sept. 1975 would be in Sept. 2018, multiply the
rise in inflation factor with the amount to get the changed dollar value:
Change in dollar value = 4.6234 * $10,000 = $46,234.25
To get the final dollar value of the end period, add the original dollar amount ($10,000) to the
change in dollar value:
Final dollar value = $10,000 + $46,234.25 = $56,234.25
This means that $10,000 in Sept. 1975 will be worth $56,234.25. Essentially, if you purchased a
basket of goods and services (as included in the CPI definition) worth $10,000 in 1975, the same
basket would cost you $56,234.25 in Sept. 2018.
Pros and Cons of Inflation
Inflation can be construed as either a good or a bad thing, depending upon which side one takes,
and how rapidly the change occurs.
For example, individuals with tangible assets, like property or stocked commodities, may like to
see some inflation as that raises the value of their assets which they can sell at a higher rate.
However, the buyers of such assets may not be happy with inflation, as they will be required to
shell out more money. Inflation-indexed bonds are another popular option for investors to profit
from inflation.
People holding cash may also not like inflation, as it erodes the value of their cash holdings.
Investors looking to protect their portfolios from inflation should consider inflation-hedged asset
classes, such as gold, commodities, and Real Estate Investment Trusts (REITs).
Inflation promotes investments, both by businesses in projects and by individuals in stocks of

companies, as they expect better returns than inflation. An optimum level of inflation is also
required to promote spending to a certain extent instead of saving. If the purchasing power of
money remains the same over the years, there may be no difference in saving and spending. It
may limit spending, which may negatively impact the overall economy as decreased money
circulation will slow overall economic activities in a country. A balanced approach is required to
keep the inflation value in an optimum and desirable range.
High, negative, or uncertain value of inflation negatively impacts an economy. It leads to

uncertainties in the market, prevents businesses from making big investment decisions, may lead
52
to unemployment, promotes hoarding as people flock to stock necessary goods at the earliest
amid fears of price rise and the practice leads to more price increase, may result in imbalance in
international trade as prices remain uncertain, and also impacts foreign exchange rates.
Controlling Inflation
A country’s financial regulator shoulders the important responsibility of keeping inflation in check.
It is done by implementing measures through monetary policy, which refers to the actions of a
central bank or other committees that determine the size and rate of growth of the money supply.
In the U.S., the Fed's monetary policy goals include moderate long-term interest rates, price
stability and maximum employment, and each of these goals is intended to promote a stable
financial environment. The Federal Reserve clearly communicates long-term inflation goals in
order to keep a steady long-term rate of inflation, which in turn, maintains price stability.
Price stability—or a relatively constant level of inflation—allows businesses to plan for the future
since they know what to expect. It also allows the Fed to promote maximum employment, which
is determined by non-monetary factors that fluctuate over time and are therefore subject to
change. For this reason, the Fed doesn't set a specific goal for maximum employment, and it is
largely determined by members' assessments. Maximum employment does not mean zero
unemployment, as at any given time there is a certain level of volatility as people vacate and start
new jobs.
Monetary authorities also take exceptional measures in extreme conditions of the economy. For
instance, following the 2008 financial crisis, the U.S. Fed has kept the interest rates near zero
and pursued a bond-buying program—now discontinued—called quantitative easing.4 Some
critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation
peaked in 2007 and declined steadily over the next eight years. There are many complex reasons
why QE didn't lead to inflation or hyperinflation, though the simplest explanation is that the
recession itself was a very prominent deflationary environment, and quantitative easing supported
its effects.
Consequently, the U.S. policymakers have attempted to keep inflation steady at around 2% per
year.5 The European Central Bank has also pursued aggressive quantitative easing to counter
deflation in the eurozone, and some places have experienced negative interest rates, due to fears
that deflation could take hold in the euro zone and lead to economic stagnation.6 Moreover,
countries that are experiencing higher rates of growth can absorb higher rates of inflation.
Hyperinflation is often described as a period of inflation of 50% or more per month.
Hedging Against Inflation

Stocks are considered to be the best hedge against inflation, as the rise in stock prices are
inclusive of the effects of inflation. Since any increase in the cost of raw materials, labor, transport
and other facets of operation leads to an increase in the price of the finished product a company
produces, the inflationary effect gets reflected in stock prices.
Additionally, special financial instruments exist which one can use to safeguard investments
against inflation. They include Treasury Inflation Protected Securities (TIPS), low-risk treasury
security that is indexed to inflation where the principal amount invested is increased by the
53
percentage of inflation. One can also opt for a TIPS mutual fund or TIPS-based exchange traded
fund (ETFs). To get access to stocks, ETFs and other funds that can help to avoid the dangers of
inflation, you'll likely need a brokerage account. Choosing a stockbroker can be a tedious process
due to the variety among them.
Gold is also considered to be a hedge against inflation, although this doesn't always appear to be
the case looking backwards.
Example of Inflation
Imagine your grandma stuffed a $10 bill in her old wallet in the year 1975 and then forgot about
it. The cost of gasoline during that year was around $0.50 per gallon, which means she could
have then bought 20 gallons of gasoline with that $10 note. Twenty-five years later in the year
2000, the cost of gasoline was around $1.60 per gallon. If she finds the forgotten note in the year
2000 and then goes on to purchase gasoline, she would have bought only 6.25 gallons. Although
the $10 note remained the same for its value, it lost its purchasing power by around 69 percent
over the 25-year period. This simple example explains how money loses its value over time when
prices rise. This phenomenon is called inflation.
However, it is not necessary that prices always rise with the passage of time. They may remain
steady or even decline. For instance, the cost of wheat in the U.S. hit a record high of $11.05 per
bushel during March 2008. By August 2016, it came down to $3.99 per bushel which may be
attributed to a variety of factors like good weather condition leading to higher production of wheat.
This means that a particular currency note, say $100, would have gotten a lesser quantity of
wheat in 2008 and a greater quantity in 2016. In this case, the purchasing power of the same
$100 note increased over the period as the price of the commodity declined. This phenomenon
is called deflation and is the opposite of inflation.
While it is easy to measure the price changes of individual products over time, human needs
extend much beyond one or two such products. Individuals need a big and diversified set of
products as well as a host of services for living a comfortable life. They include commodities like
food grains, metal and fuel, utilities like electricity and transportation, and services like healthcare,
entertainment, and labor. Inflation aims to measure the overall impact of price changes for a
diversified set of products and services, and allows for a single value representation of the
increase in the price level of goods and services in an economy over a period of time.
Extreme Examples of Inflation
A handful of currencies are fully backed by gold or silver. Since most world currencies are fiat
money, the money supply could increase rapidly for political reasons, resulting in inflation. The
most famous example is the hyperinflation that struck the German Weimar Republic in the early
1920s. The nations that had been victorious in World War I demanded reparations from Germany,
which could not be paid in German paper currency, as this was of suspect value due to
government borrowing. Germany attempted to print paper notes, buy foreign currency with them,
and use that to pay their debts.
This policy led to the rapid devaluation of the German mark, and hyperinflation accompanied the
development. German consumers exacerbated the cycle by trying to spend their money as fast
as possible, expecting that it would be worthless and less the longer they waited. More and more
money flooded the economy, and its value plummeted to the point where people would paper
54
their walls with the practically worthless bills. Similar situations have occurred in Peru in 1990 and
Zimbabwe in 2007–2008.
9 Common Effects of Inflation to the Economy
1. Erodes Purchasing Power
This first effect of inflation is really just a different way of stating what it is. Inflation is a decrease
in the purchasing power of currency due to a rise in prices across the economy. Within living
memory, the average price of a cup of coffee was a dime. Today the price is closer to two dollars.
Such a price change could conceivably have resulted from a surge in the popularity of coffee, or
price pooling by a cartel of coffee producers, or years of devastating drought/flooding/conflict in a
key coffee-growing region. In those scenarios, the price of coffee products would rise, but the rest
of the economy would carry on largely unaffected. That example would not qualify as inflation
since only the most caffeine-addled consumers would experience significant depreciation in their
overall purchasing power.
Inflation requires prices to rise across a "basket" of goods and services, such as the one that
comprises the most common measure of price changes, the consumer price index (CPI). When
the prices of goods that are non-discretionary and impossible to substitute—food and fuel—rise,
they can affect inflation all by themselves. For this reason, economists often strip out food and
fuel to look at "core" inflation, a less volatile measure of price changes.
2. Encourages Spending, Investing
A predictable response to declining purchasing power is to buy now, rather than later. Cash will
only lose value, so it is better to get your shopping out of the way and stock up on things that
probably won't lose value.
For consumers, that means filling up gas tanks, stuffing the freezer, buying shoes in the next size
up for the kids, and so on. For businesses, it means making capital investments that, under
different circumstances, might be put off until later. Many investors buy gold and other precious
metals when inflation takes hold, but these assets' volatility can cancel out the benefits of their
insulation from price rises, especially in the short term.
Over the long term, equities have been among the best hedges against inflation. At close on Dec.
12, 1980, a share of Apple Inc. (AAPL) cost $29 in current (not inflation-adjusted) dollars.
According to Yahoo Finance, that share would be worth $7,035.01 at close on Feb. 13, 2018,
after adjusting for dividends and stock splits. The Bureau of Labor Statistics' (BLS) CPI calculator
gives that figure as $2,449.38 in 1980 dollars, implying a real (inflation-adjusted) gain of 8,346%.
Say you had buried that $29 in the backyard instead. The nominal value wouldn't have changed
when you dug it up, but the purchasing power would have fallen to $10.10 in 1980 terms; that's
about a 65% depreciation. Of course not every stock would have performed as well as Apple: you
would have been better off burying your cash in 1980 than buying and holding a share of Houston
Natural Gas, which would merge to become Enron.
3. Causes More Inflation
55
Unfortunately, the urge to spend and invest in the face of inflation tends to boost inflation in turn,
creating a potentially catastrophic feedback loop. As people and businesses spend more quickly
in an effort to reduce the time they hold their depreciating currency, the economy finds itself awash
in cash no one particularly wants. In other words, the supply of money outstrips the demand, and
the price of money—the purchasing power of currency—falls at an ever-faster rate.
When things get really bad, a sensible tendency to keep business and household supplies
stocked rather than sitting on cash devolves into hoarding, leading to empty grocery store shelves.
People become desperate to offload currency so that every payday turns into a frenzy of spending
on just about anything so long as it's not ever-more-worthless money.
The result is hyperinflation, which has seen Germans papering their walls with the Weimar
Republic's worthless marks (the 1920s), Peruvian cafes raising their prices multiple times a day
(the 1980s), Zimbabwean consumers hauling around wheelbarrow-loads of million- and billion-
Zim dollar notes (the 2000s) and Venezuelan thieves refusing even to steal bolívares (2010s).
4. Raises the Cost of Borrowing
As these examples of hyperinflation show, states have a powerful incentive to keep price rises in
check. For the past century in the U.S., the approach has been to manage inflation using monetary
policy. To do so, the Federal Reserve (the U.S. central bank) relies on the relationship between
inflation and interest rates. If interest rates are low, companies and individuals can borrow cheaply
to start a business, earn a degree, hire new workers, or buy a shiny new boat. In other words, low
rates encourage spending and investing, which generally stoke inflation in turn.
By raising interest rates, central banks can put a damper on these rampaging animal spirits.
Suddenly the monthly payments on that boat, or that corporate bond issue, seem a bit high. Better
to put some money in the bank, where it can earn interest. When there is not so much cash
sloshing around, money becomes more scarce. That scarcity increases its value, although as a
rule, central banks don't want money literally to become more valuable: they fear outright deflation
nearly as much as they do hyperinflation. Rather, they tug on interest rates in either direction in
order to maintain inflation close to a target rate (generally 2% in developed economies and 3% to
4% in emerging ones).
Another way of looking at central banks' role in controlling inflation is through the money supply.
If the amount of money is growing faster than the economy, the money will be worthless and
inflation will ensue. That's what happened when Weimar Germany fired up the printing presses
to pay its World War I reparations, and when Aztec and Inca bullion flooded Habsburg Spain in
the 16th century. When central banks want to raise rates, they generally cannot do so by simple
fiat; rather they sell government securities and remove the proceeds from the money supply. As
the money supply decreases, so does the rate of inflation.
5. Lowers the Cost of Borrowing
When there is no central bank, or when central bankers are beholden to elected politicians,
inflation will generally lower borrowing costs.
Say you borrow $1,000 at a 5% annual rate of interest. If inflation is 10%, the real value of your
debt is decreasing faster than the combined interest and principle you're paying off. When levels
of household debt are high, politicians find it electorally profitable to print money, stoking inflation
56
and whisking away voters' obligations. If the government itself is heavily indebted, politicians have
an even more obvious incentive to print money and use it to pay down debt. If inflation is the
result, so be it (once again, Weimar Germany is the most infamous example of this phenomenon).
Politicians' occasionally detrimental fondness for inflation has convinced several countries that
fiscal and monetary policymaking should be carried out by independent central banks. While the
Fed has a statutory mandate to seek maximum employment and steady prices, it does not need
a congressional or presidential go-ahead to make its rate-setting decisions. That does not mean
the Fed has always had a totally free hand in policy-making, however. Former Minneapolis Fed
president Narayana Kocherlakota wrote in 2016 that the Fed's independence is "a post-1979
development that rests largely on the restraint of the president."
6. Reduces Unemployment
There is some evidence that inflation can push down unemployment. Wages tend to be sticky,
meaning that they change slowly in response to economic shifts. John Maynard Keynes theorized
that the Great Depression resulted in part from wages' downward stickiness. Unemployment
surged because workers resisted pay cuts and were fired instead (the ultimate pay cut).
The same phenomenon may also work in reverse: wages' upward stickiness means that once
inflation hits a certain rate, employers' real payroll costs fall, and they're able to hire more workers.
That hypothesis appears to explain the inverse correlation between unemployment and inflation—
a relationship known as the Phillips curve—but a more common explanation puts the onus on
unemployment. As unemployment falls, the theory goes, employers are forced to pay more for
workers with the skills they need. As wages rise, so does consumers' spending power, leading
the economy to heat up and spur inflation; this model is known as cost-push inflation.
7. Increases Growth
Unless there is an attentive central bank on hand to push up interest rates, inflation discourages
saving, since the purchasing power of deposits erodes over time. That prospect gives consumers
and businesses an incentive to spend or invest. At least in the short term, the boost to spending
and investment leads to economic growth. By the same token, inflation's negative correlation with
unemployment implies a tendency to put more people to work, spurring growth.
This effect is most conspicuous in its absence. In 2016, central banks across the developed world
found themselves vexingly unable to coax inflation or growth up to healthy levels. Cutting interest
rates to zero and below did not seem to be working. Neither did the buying of trillions of dollars'
worth of bonds in a money-creation exercise known as quantitative easing. This conundrum
recalled Keynes's liquidity trap, in which central banks' ability to spur growth by increasing the
money supply (liquidity) is rendered ineffective by cash hoarding, itself the result of economic
actors' risk aversion in the wake of a financial crisis. Liquidity traps cause disinflation, if not
deflation.
In this environment, moderate inflation was seen as a desirable growth-driver, and markets
welcomed the increase in inflation expectations due to Donald Trump's election. In February 2018,
however, markets sold off steeply due to worries that inflation would lead to a rapid increase in
interest rates.
57
8. Reduces Employment, Growth
Wistful talk about inflation's benefits is likely to sound strange to those who remember the
economic woes of the 1970s. In today's context of low growth, high unemployment (in Europe)
and menacing deflation, there are reasons think a healthy rise in prices – 2% or even 3% per year
– would do more good than harm. On the other hand, when growth is slow, unemployment is high
and inflation is in the double digits, you have what a British Tory MP in 1965 dubbed "stagflation."
Economists have struggled to explain stagflation. Early on, Keynesians did not accept that it could
happen, since it appeared to defy the inverse correlation between unemployment and inflation
described by the Phillips curve. After reconciling themselves to the reality of the situation, they
attributed the most acute phase to the supply shock caused by the 1973 oil embargo: as
transportation costs spiked, the theory went, the economy ground to a halt. In other words, it was
a case of cost-push inflation. Evidence for this idea can be found in five consecutive quarters of
productivity decline, ending with a healthy expansion in the fourth quarter of 1974. But the 3.8%
drop in productivity in the third quarter of 1973 occurred before Arab members of OPEC shut off
the taps in October of that year.
The kink in the timeline points to another, earlier contributor to the 1970s' malaise, the so-called
Nixon shock. Following other countries' departures, the U.S. pulled out of the Bretton Woods
Agreement in August 1971, ending the dollar's convertibility to gold. The greenback plunged
against other currencies: for example, a dollar bought 3.48 Deutsche marks in July 1971, but just
1.75 in July 1980. Inflation is a typical result of depreciating currencies.
And yet even dollar devaluation does not fully explain stagflation since inflation began to take off
in the mid-to-late 1960s (unemployment lagged by a few years). As monetarists see it, the Fed
was ultimately to blame. M2 money stock rose by 97.7% in the decade to 1970, nearly twice as
fast as the gross domestic product (GDP), leading to what economists commonly describe as "too
much money chasing too few goods," or demand-pull inflation.
Supply-side economists, who emerged in the 1970s as a foil to Keynesian hegemony, won the
argument at the polls when Reagan swept the popular vote and electoral college. They blamed
high taxes, burdensome regulation and a generous welfare state for the malaise; their policies,
combined with aggressive, monetarist-inspired tightening by the Fed, put an end to stagflation.
9. Weakens or Strengthens Currency
High inflation is usually associated with a slumping exchange rate, though this is generally a case
of the weaker currency leading to inflation, not the other way around. Economies that import
significant amounts of goods and services – which, for now, is just about every economy – must
pay more for these imports in local-currency terms when their currencies fall against those of their
trading partners. Say that Country X's currency falls 10% against Country Y's. The latter doesn't
have to raise the price of the products it exports to Country X for them to cost Country X 10%
more; the weaker exchange rate alone has that effect. Multiply cost increases across enough
trading partners selling enough products, and the result is economy-wide inflation in Country X.
But once again, inflation can do one thing, or the polar opposite, depending on the context. When
you strip away most of the global economy's moving parts it seems perfectly reasonable that
rising prices lead to a weaker currency. In the wake of Trump's election victory, however, rising
inflation expectations drove the dollar higher for several months. The reason is that interest rates
58
around the globe were dismally low – almost certainly the lowest they've been in human history –
making markets likely to jump on any opportunity to earn a bit of money for lending, rather than
paying for the privilege (as the holders of $11.7 trillion in sovereign bonds were doing in June
2016, according to Fitch).

1. What is the pros and cons of inflation?
2. Give the nine(9) common types of Inflation.
Assignment:
Give at least two countries that experiencing hyperinflation and what is the best solution to fix it.
Reference:
• https://www.investopedia.com/terms/i/inflation.asp#the-formula-for-measuring-inflation
• https://www.investopedia.com/articles/insights/122016/9-common-effects-inflation.asp
59
Lesson 8 – Financing, and Break-Even Analysis
Unit 1-Definition, Calculation and Importance
Overview:
This lesson will help the Students to know the margin of safety, break-even point and Contribution
Margin
1. Understand the importance of Fundamental and Technical Analysis

2. Discuss the calculation of break-even analysis.
Course Materials:
What Is Financial Analysis?
Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-
related transactions to determine their performance and suitability. Typically, financial analysis is
used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a
monetary investment.
KEY TAKEAWAYS
• If conducted internally, financial analysis can help managers make future business
decisions or review historical trends for past successes.
• If conducted externally, financial analysis can help investors choose the best possible
investment opportunities.
• There are two main types of financial analysis: fundamental analysis and technical
analysis.
• Fundamental analysis uses ratios and financial statement data to determine the intrinsic
value of a security.
• Technical analysis assumes a security's value is already determined by its price, and it
focuses instead on trends in value over time.
Understanding Financial Analysis

Financial analysis is used to evaluate economic trends, set financial policy, build long-term plans
for business activity, and identify projects or companies for investment. This is done through the
synthesis of financial numbers and data. A financial analyst will thoroughly examine a company's
financial statements—the income statement, balance sheet, and cash flow statement. Financial
analysis can be conducted in both corporate finance and investment finance settings.
One of the most common ways to analyze financial data is to calculate ratios from the data in the
financial statements to compare against those of other companies or against the company's own
historical performance.
60
For example, return on assets (ROA) is a common ratio used to determine how efficient a
company is at using its assets and as a measure of profitability. This ratio could be calculated for
several companies in the same industry and compared to one another as part of a larger analysis.
How Financial Analysis is Used
Corporate Financial Analysis
In corporate finance, the analysis is conducted internally by the accounting department and
shared with management in order to improve business decision making. This type of internal
analysis may include ratios such as net present value (NPV) and internal rate of return (IRR) to
find projects worth executing.
Many companies extend credit to their customers. As a result, the cash receipt from sales may
be delayed for a period of time. For companies with large receivable balances, it is useful to track
days sales outstanding (DSO), which helps the company identify the length of time it takes to turn
a credit sale into cash. The average collection period is an important aspect in a company's overall
cash conversion cycle.
A key area of corporate financial analysis involves extrapolating a company's past performance,
such as net earnings or profit margin, into an estimate of the company's future performance. This
type of historical trend analysis is beneficial to identify seasonal trends.
For example, retailers may see a drastic upswing in sales in the few months leading up to
Christmas. This allows the business to forecast budgets and make decisions, such as necessary
minimum inventory levels, based on past trends.
Investment Financial Analysis
In investment finance, an analyst external to the company conducts an analysis for investment
purposes. Analysts can either conduct a top-down or bottom-up investment approach. A top-down
approach first looks for macroeconomic opportunities, such as high-performing sectors, and then
drills down to find the best companies within that sector. From this point, they further analyze the
stocks of specific companies to choose potentially successful ones as investments by looking last
at a particular company's fundamentals.
A bottom-up approach, on the other hand, looks at a specific company and conducts similar ratio
analysis to the ones used in corporate financial analysis, looking at past performance and
expected future performance as investment indicators. Bottom-up investing forces investors to
consider microeconomic factors first and foremost. These factors include a company's overall
financial health, analysis of financial statements, the products and services offered, supply and
demand, and other individual indicators of corporate performance over time.
Types of Financial Analysis
There are two types of financial analysis: fundamental analysis and technical analysis.
Fundamental Analysis
61
Fundamental analysis uses ratios gathered from data within the financial statements, such as a
company's earnings per share (EPS), in order to determine the business's value. Using ratio
analysis in addition to a thorough review of economic and financial situations surrounding the
company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive
at a number that an investor can compare with a security's current price in order to see whether
the security is undervalued or overvalued.
Technical Analysis
Technical analysis uses statistical trends gathered from trading activity, such as moving averages
(MA). Essentially, technical analysis assumes that a security’s price already reflects all publicly-
available information and instead focuses on the statistical analysis of price movements.
Technical analysis attempts to understand the market sentiment behind price trends by looking
for patterns and trends rather than analyzing a security’s fundamental attributes.
Examples of Financial Analysis
As an example of fundamental analysis, Discover Financial Services reported its quarter two 2019
earnings per share (EPS) at $2.32. That was up from a quarter one 2019 reported EPS of $2.15.
A financial analyst using fundamental analysis would take this as a positive sign of increasing
intrinsic value of the security.
Therefore, future EPS projections are also estimated higher. For example, according to
Nasdaq.com, estimated third quarter 2019 EPS is up to $2.29 from an estimated second quarter
2019 EPS of $2.11 and estimated first quarter 2019 EPS of $2.00. Notice also, the reported EPS
for the first two quarters of 2019 exceeded the estimated EPS for the same quarters.
On the other hand, technical analysis was conducted on the British Pound (GBP)/ US Dollar
(USD) exchange rate after the results of the Brexit vote in June 2016. Looking at the exchange
rate chart, it was apparent that the GBP's value dropped significantly, to a 31 year low, in
comparison to the dollar after the vote to leave the European Union on June 23, 2016.
What Is a Break-Even Analysis?
Break-even analysis entails the calculation and examination of the margin of safety for an entity
based on the revenues collected and associated costs. Analyzing different price levels relating to
various levels of demand a business uses break-even analysis to determine what level of sales
are necessary to cover the company's total fixed costs. A demand-side analysis would give a
seller significant insight regarding selling capabilities.
KEY TAKEAWAYS
• Break-even analysis tells you at what level an investment must reach to recover your initial
outlay.
• It is considered a margin of safety measure.
• Break-even analysis is used broadly, from stock and options trading to corporate
budgeting for various projects.
How Break-Even Analysis Works

62
Break-even analysis is useful in the determination of the level of production or a targeted desired
sales mix. The study is for management’s use only, as the metric and calculations are not
necessary for external sources such as investors, regulators or financial institutions. This type of
analysis depends on a calculation of the break-even point (BEP). The break-even point is
calculated by dividing the total fixed costs of production by the price of a product per individual
unit less the variable costs of production. Fixed costs are those which remain the same regardless
of how many units are sold.
Break-even analysis looks at the level of fixed costs relative to the profit earned by each additional
unit produced and sold. In general, a company with lower fixed costs will have a lower break-even
point of sale. For example, a company with $0 of fixed costs will automatically have broken even
upon the sale of the first product assuming variable costs do not exceed sales revenue. However,
the accumulation of variable costs will limit the leverage of the company as these expenses come
from each item sold.
Special Considerations
Break-even analysis is also used by investors to determine at what price they will break even on
a trade or investment. The calculation is useful when trading in or creating a strategy to buy
options or a fixed-income security product.
Contribution Margin
The concept of break-even analysis deals with the contribution margin of a product. The
contribution margin is the excess between the selling price of the product and total variable costs.
For example, if an item sells for $100, the total fixed costs are $25 per unit, and the total variable
costs are $60 per unit, the contribution margin of the product is $40 ($100 - $60). This $40 reflects
the amount of revenue collected to cover the remaining fixed costs, excluded when figuring the
contribution margin.
Calculations For Break-Even Analysis
The calculation of break-even analysis may use two equations. In the first calculation, divide the
total fixed costs by the unit contribution margin. In the example above, assume the value of the
entire fixed costs is $20,000. With a contribution margin of $40, the break-even point is 500 units
($20,000 divided by $40). Upon the sale of 500 units, the payment of all fixed costs are complete,
and the company will report a net profit or loss of $0.
Alternatively, the calculation for a break-even point in sales dollars happens by dividing the total
fixed costs by the contribution margin ratio. The contribution margin ratio is the contribution margin
per unit divided by the sale price. Returning to the example above the contribution margin ratio is
40% ($40 contribution margin per item divided by $100 sale price per item). Therefore, the break-
even point in sales dollars is $50,000 ($20,000 total fixed costs divided by 40%). Confirm this
figured by multiplying the break-even in units (500) by the sale price ($100) which equals $50,000.
63
1. What is contribution margin?
2. How investment financial analysis works?
Assignment:
Prepare for the upcoming Final Examination, review Lesson 5 – Lesson 8.
Reference:
• https://www.investopedia.com/terms/f/financial-
analysis.asp#:~:text=Financial%20analysis%20is%20the%20process,to%20warrant%20
a%20monetary%20investment.
• https://www.investopedia.com/terms/b/breakevenanalysis.asp
64

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Republic of the Philippines

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Compiled by: Checked by:

Engr. John Richard T. Tapat Assoc. Prof. Cherry E. Angeles

Date: _________________ Date: ___________________

Dr. Agnes Y. Gonzaga Assoc. Prof. Denise A. Abril

Date: _________________ Date: __________________

THE POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

PUP: The National Polytechnic University

As a state university, the Polytechnic University of the Philippines believes that:

Pillar 1: Dynamic, Transformational, and Responsible Leadership

• Integrity and Accountability

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

• Quality and excellent graduates

The College of Engineering aims to:

COURSE TITLE : ENGINEERING ECONOMICS

After this course, the student should be able to:

1. Apply knowledge of mathematics, economics, and engineering principles to solve

The course requirements are as follows:

Note: Some activities will be rated using the Rubrics.

Week Topic Learning Methodology Resource Assessme

Lesson 3 - The students will know Lecture See Quiz on

6-8 Lesson 4 The students will Lecture See Quiz on

15-17 Lesson 8 Students will know the Lecture See Participation,

Lesson 1 Introduction to Engineering Economics 1

Lesson 2 Interest and Time Value of Money 8

Lesson 3 Basic Methodologies of Engineering Economic Analysis 15

Lesson 4 Replacement Analysis 26

Lesson 5 Risk Analysis 30

Lesson 6 Depreciation and Corporate Income Taxes 38

Lesson 7 Inflation and Its Impact on Project Cashflows 49

Lesson 8 Financing, and Break-Even Analysis 60

Unit 1-Basic Economics

After successful completion of this lesson, you should be able to:

1. Discuss what is the definition of Engineering Economy.

History of Engineering Economy

Roles of Engineer in Decision Making

Cash Flow Diagram: The Basic Concept

Answer the following questions briefly:

Unit 2 – Definition of Terms

After successful completion of this lesson, you should be able to:

1. Familiarize and learn different terminology in Engineering Economy

Important Concepts and Guidelines

Placement of Gradient Present Worth (P G ; P g) The ( P / G , i %, n ) factor for an arithmetic

• Present worth: If PW ≥ 0 Annual worth: If AW ≥ 0

Sensitivity Analysis Determination of how a measure of worth is affected by changes in

After successful completion of this lesson, you should be able to:

Unit 1 – Introduction to Time Value of Money

After successful completion of this lesson, you should be able to:

1. Understand the concept of Time Value of money and Economic Equivalence

What Is the Time Value of Money (TVM)?

Understanding Time Value of Money (TVM)

Based on these variables, the formula for TVM is:

Time Value of Money Examples

Effect of Compounding Periods on Future Value

Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038

Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047

Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052

Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106

After successful completion of this lesson, you should be able to:

After successful completion of this lesson, you should be able to:

1. Understand the market needs or provide a solution to a key problem,

Date: _ Date: ___

Date: _ Date: __