Ekotek Minggu 3

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ENGINEERING
Newnan, Lavelle, and Eschenbach
ECONOMIC
ANALYSIS, 12/e Copyright © 2014 by Oxford University Press
Chapter 8
Choosing the Best Alternative
Copyright Oxford University Press 2014

Chapter Outline
• Incremental Analysis
• Graphical Technique in solving problems
with mutually exclusive alternatives
• Using Spreadsheets in Incremental
Analysis

Learning Objectives
• Define incremental analysis

• Apply Graphical Technique in solving
problems with mutually exclusive
alternatives
• Use Spreadsheets in Incremental Analysis

Mutually Exclusive Alternatives
• Only one alternative may be implemented

• All alternatives serve the same purpose
• Objective of incremental analysis is to
select the best of these mutually exclusive
alternatives

Incremental Analysis
• Could be applied to rate of return (IRR), present worth (PW),

equivalent uniform annual cost (EUAC), or equivalent
uniform annual worth (EUAW) approaches.
• [Higher-cost Alternative] = [Lower-cost Alternative] +
[Increment between them]
• The “defender” is the best alternative identified so far in the
process, and “challenger” is the next higher-cost alternative
to be evaluated.
• For a set of N mutually exclusive alternatives, (𝑁 − 1)
“challenger/defender” comparisons must be made from
[𝑁(𝑁 − 1)/2] possibilities.

Example 8-7 Incremental Analysis
using Pair-wise Comparisons
A B C D E
Initial Cost $4000 $2000 $6000 $1000 $9000
Uniform Annual Benefit 639 410 761 117 785
1. Rearrange the alternatives in order of increasing cost

D B A C E
Initial Cost $1000 $2000 $4000 $6000 $9000
Uniform Annual Benefit 117 410 639 761 785
2. Calculate IRR of the least expensive alternative to see if it

is better than “Do Nothing” at MARR of 10%
PWD = 0 = -$1000 + $117 (P/A, IRRD, 20)
IRRD = 9.94% < 10%
“Do Nothing” is preferred, and is still the “Defender.”
3. Calculate IRR of the next alternative, B, to see if it is better
than “Do Nothing” at MARR of 10%
PWB = 0 = -$2000 + $410 (P/A, IRRB, 20)
IRRB = 19.96% > 10%
“Alternative B” is preferred, and is the new “Defender.”
4. Compare Defender B with the next alternative, A. This

comparison must be made incrementally.
PWA-B = 0 = -($4000-$2000)+(639-410)(P/A, IRRA-B,20)
IRRA-B = 9.63% < 10%
“Alternative B” is preferred, and is still the “Defender.”

5. Compare Defender B with the next alternative, C. This
PWC-B = 0 = -($6000-$2000)+(761-410)(P/A, IRRC-B,20)
IRRC-B = 6.08% < 10%
“Alternative B” is preferred, and is still the “Defender.”
6. Compare Defender B with the next alternative, E. This

PWE-B = 0 = -($9000-$2000)+(785-410)(P/A, IRRE-B,20)
IRRE-B = 0.67% < 10%
“Alternative B” is preferred, and is the final selection.

Elements in Comparing
Mutually Exclusive Alternatives
1. Identify all alternatives.
2. Construct an NPW or EUAW graph showing all
alternatives on the same axes.
3. Examine the line of maximum values and
determine which alternative create it, and over
what range.
4. Determine the changeover point.
5. Create a choice table to summarize the
information.

Choosing an Analysis Method
• All analysis methods provide consistent solutions.

• Rate of Return Analysis
• Easier to explain
• Most frequently used
• More difficult to calculate (without spreadsheet)
• Does not require a Minimum Attractive Rate of
Return in calculation
• Present Worth or Annual Cash Flow Analysis
• Require a known Minimum Attractive Rate of Return
in calculation
• Easier to calculate (without spreadsheet)

Incremental Rate of Return
Analysis
Example 8 - 7
•PWB = A (P/A, 6%, 20) = A (11.47)
•MARR = 6% (given)
•All projects are initially acceptable because IRR MARR
A B C D E
Cost 4000 2000 6000 1000 9000
EUAB (A) 639 410 761 117 785
PWB 7330 4700 8730 1340 9000
IRR 15% 20% 11% 10% 6%
P/A 6.26 4.88 7.88 8.55 11.47
12
1. Rank from lowest cost to highest cost
2. Start with two lowest cost alternatives
3. Compare increments using MARR criteria
4. Repeat until a “winner” is determined
D B A C E
Cost 1000 2000 4000 6000 9000
EUAB (A) 117 410 639 761 785
Increment B-D A-B C-A E-A

incr. Cost 1000 2000 2000 5000
incr. UAB 293 229 122 146
incr. ROR 29% 10% 2% < 0%
Keep B A A A
P/A 3.413 8.73 16.393 34.236
13
Graphical Solutions
PWB vs. PWC at MARR
Above the 45 degree line projects are acceptable (NPW>0)
Benefit-cost Graph
MARR 6.00 % Alternatives
30
POSITIVE NPW
25
Present Worth of Benefit
0.06
20
15
0 $26.42
0 $26.42
10
NEGATIVE NPW
0
0 5 10 15 20 25 30
Present Worth of Cost
14
Graphical Solution
• Projects B, A, C and E shown.
• Incremental analysis looks at adjacent points on the Benefit-Cost Graph
15
Graphical Incremental Analysis
If line between two alternatives is > 45 degrees, accept
higher cost alternative. Alternative A wins.
16
Graphical Incremental Analysis
• Graphical solution has a logical connection to NPW
•Incremental analysis seeks out the alternative with highest NPW.
Alternative A maximizes NPW.
17
Choosing an Analysis Method
Method MARR Computations* Explanation
PW Required for Less Depends

calculation
AW Required for Less Depends

calculation
ROR For comparison More Depends
*Not an issue when using a spreadsheet.
Do what the Organization requires. Occasionally augment

with alternate methods where the method adds beneficial
information.
18
Spreadsheet and
Excel Functions Purpose
Rate (n, A, -P, [F], [Type], [guess]) To find rate of return or incremental
rate of return given n, P, and A
IRR (range, [guess]) To find internal rate of return (or
incremental rate of return) of a series
of cash flow (or incremental cash flow)
Excel Tools Purpose

Goal Seek It varies the value in one specific cell until a formula that's
dependent on that cell returns the wanted result.
Solver Solver adjusts the values in the changing cells to produce
the result from the target cell formula. Constraints are
applied to restrict the values Solver can use in the model.

Appendix 7A
Difficulties in Solving for

an Interest Rate

Chapter Outline
• Why Multiple Solutions can Occur?

• Modified Internal Rate of Return (MIRR)
Calculation
• Solving MIRR using Spreadsheets

Learning Objectives
• Understand why multiple solutions can

occur
• Identify when multiple roots can occur
• Develop and use spreadsheet in solving
MIRR

Example 7A-1
Cash Flow with Multiple Solutions
A piece of land may be purchased for $610,000 to be strip-
mined for the underlying coal. Annual net income will be
$200,000 for 10 years. At the end of 10 years, the surface of
the land will be restored as required by a federal law on strip
mining. The reclamation will cost $1.5 million more than the
land’s resale value after it is restored. Is this a desirable
project, if the minimum attractive rate of return is 10%?
200k 200k
0 1 2 3 4 5 6 7 8 9 10
1500k
610k

Example 7A-1
Yr Cash Flow NPV
0 −$610k $60,00
1 +200k $40,00
2 +200k
$20,00
3 +200k
4 +200k $-
5 +200k $(20,00) 0% 5% 10% 15% 20% 25% 30%
6 +200k $(40,00)
7 +200k $(60,00)
8 +200k
$(80,00)
9 +200k
+200k − $(100,00)
10 1500K $(120,00)

Example 7A-1
• Example 7A–1 demonstrates that cash flows can have
multiple solutions to the IRR equation (PW=0).
• The example also demonstrates a common feature of
such a problem—the cash flows fit neither the pattern
of an investment nor the pattern of a loan.
• Example 7A–1 has two sign changes in its series of
cash flows. Two or more sign changes in the series of
cash flows are the distinguishing feature of instances
where multiple roots can, but may not, arise when
solving for the rate of return for a set of cash flows.

Multiple IRR
Occurs when a cash flow produces more than one point at
which NPW = 0. This happens when there is more than
one sign change in the cash flow series
Example 7A-1
Cash Flow
Year Cash Flow
80
0 19
60
1 10 40
2 -50 20
3 -50 0
4 20 -20 1 2 3 4 5 6
-40
5 60 -60
7
EGR 403 - Cal Poly Pomona - SA10
Example 7A-1
This series of cash flows produces two

solutions for IRR: 10.2% and 47.3%.
8
EGR 403 - Cal Poly Pomona - SA10
Cash Flow Rule of Signs
• May be converted to a polynomial

• Then, by Descartes’ rule
Number of sign Number of positive values
changes, m of X
0 0
1 1
2 2 or 0
3 3 or 1
4 4, 2 or 0
Engineering
9
Economic
Expands on This Notion
• There may be as many positive values of
“i” as there are sign changes in the cash
flow.
• Sign changes are counted when:
– + to -
– - to +
• A zero cash flow is ignored
Engineering
10
Economic
- Possibilities -
Number of sign changes, m Number of positive values of “i”
0
0
1
1 or 0
2
2, 1 or 0
3
3, 2, 1 or 0
4
4, 3, 2, 1 or 0
Engineering
11
Economic
Zero Sign Changes
• Receiving a gift
• Giving your friend a loan and not being
paid back
In either case, no “i” can be computed.
Engineering
12
Economic
What to do if cash flow has two or
more sign changes?
• Traditional approach tends to focus attention on
hypothetical possibilities.
• A simpler approach is to graph present worth values over
an appropriate range of negative and positive interest rates.
• In general, the range (−100%, 100%] includes the interest
rates and present worth values that are useful for decision
making.
• When multiple roots occur, there is usually a negative root
that can be ignored and a positive root that can be used.
• If there is only one root and it is negative, then it is a valid
IRR.

Projects with
Multiple Sign Changes
• The most common case of two or more sign changes
in cash flows is projects with a salvage cost which
typically have two sign changes.
• This salvage cost can be large for environmental
restoration at termination.

Example 7A-2
This project is representative of ones with a salvage cost.
How many roots for the PW equation exist?
50k
0 1 2 3 4 5 6 7
70k
180k

Example 7A-2
Yr Cash Flow NPV
$250,00
0 −$180k
$200,00
1 +50k
$150,00
2 +50k
3 +50k $100,00
4 +50k $50,00
5 +50k $-
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%
6 +50k $(50,00)
7 −$70k
$(100,00)
$(150,00)
• In this case, there is one positive root of 10.45%. The value can be
used as an IRR.
• There is also a negative root of −38.29%. This root is not useful.
Example 7A-3
Adding an oil well to an existing field costs $4M. It will increase
recovered oil by $3.5M, and it shifts $4.5M worth of production
from Years 5, 6, and 7 to earlier years. Thus, the cash flows
for Years 1 through 4 total $8M and Years 5 through 7 total
−$4.5M. If the well is justified, one reason is that the oil is
recovered sooner. How many roots for the PW equation exist?
Is one useful as an IRR, and should the project be funded?
3.5M
2.5M
1.5M 0.5M
0 1 2 3 4 5 6 7
-0.5M
-1.5M
4M
-2.5M

Example 7A-3
Yr Cash Flow NPV
0 −$4M $0,50
$0,40
1 +3.5M $0,30
2 +2.5M $0,20
3 +1.5M $0,10
4 +0.5M $-
0% 10% 20% 30% 40% 50% 60%
5 −0.5M $(0,10)
$(0,20)
6 −1.5M
$(0,30)
7 −2.5M $(0,40)
$(0,50)
$(0,60)
• In this case, there are positive roots at 4.73 and 37.20%. These
roots are not useful.

Modified Internal Rate of Return
(MIRR)
• The MIRR is a measure of the attractiveness of the
cash flows, but it is also a function of the two external
rates of return.
– External rates for investing, 𝑒𝑖𝑛𝑣
– External rate for financing, 𝑒fi𝑛
• The rate for investing is generally higher than the rate
for financing.

Modified Internal Rate of Return
(MIRR)
1. Combine cash flows in each period (𝑡) into a single net
receipt, 𝑅𝑡, or net expense, 𝐸𝑡.
2. Find the present worth of the expenses with the
financing rate.
3. Find the future worth of the receipts with the investing
rate.
4. Find the MIRR which makes the present worth and
future worth equivalent.
𝐹 Τ𝑃 , 𝑀𝐼𝑅𝑅, 𝑛 ෍ 𝐸𝑡 𝑃Τ𝐹 , 𝑒𝑓𝑖𝑛 , 𝑡 = ෍ 𝑅𝑡 𝐹 Τ𝑃 , 𝑒𝑖𝑛𝑣 , 𝑛 − 𝑡

𝑡 𝑡

Example 7A-5 MIRR
(7A-3 Revisited)
3.5M
2.5M
1.5M 0.5M
0 1 2 3 4 5 6 7
-0.5M
-1.5M
4M
-2.5M
F
0 1 2 3 4 5 6 7

Example 7A-5 MIRR
0.5M(F/P, 15%,3)+
1.5M(F/P, 15%,4)+
3.5M
2.5M 2.5M(F/P,15%,5)+
1.5M 3.5M(F/P,15%,6)
0.5M =FW(Rt)
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7
0.5M
1.5M 4M +
2.5M
0.5M(P/F, 8%, 5) +
4M 1.5M(P/F, 8%, 6) +
2.5M(P/F, 8%, 7)=PW(Et)
PW(Et)=6.744M; FW(Rt)=16.507M; MIRR=13.64%

Spreadsheet and MIRR

MIRR(values, finance_rate, reinvest_rate) To find Modified internal
rate of return (MIRR) of a
series of cash flow (period
0 to n) using finance_rate
for negative cash flows, and
reinvest_rate for positive
cash flows.

ENGINEERING
ECONOMIC
Chapter 9
Other Analysis Techniques

Chapter Outline
• Future Worth Analysis

• Benefit-Cost Ratio or Present Worth Index
Analysis
• Payback Period
• Sensitivity, Breakeven, and What-if
Analysis

Learning Objectives
• Apply future worth analysis, and benefit-

cost ratio analysis (present worth Index
analysis)
• Understand the meaning of “payback
period”
• Conduct sensitivity, breakeven, or what-if
analysis for Engineering Economy
problems

Future Worth Analysis
• Alternatives are compared in terms of

future worth at a given point of time in the
future.

Example 9-1
Future Worth Calculation
How much could one accumulate by age 65 if $35 is saved
each week from age 20? The saving account pays 5%
interest, compounded semiannually?
𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔 = $35 × 26 = $910

𝐹𝑊 = $910 𝐹 Τ𝐴 , 2.5%, 90 = $910 329.2 = $299,572

Example 9-2
Future Worth Analysis
0 1 2 3 0 1 2 3
Year New Plant Remodel
0 $85,000 $850,000 85K 200K 200K 250K 250K 250K
1 200,000 250,000 850K
2 1,200,000 250,000 1,200K
3 200,000 250,000 FWNew Plant FWRemodel
𝐹𝑊𝑁𝑒𝑤 𝑃𝑙𝑎𝑛𝑡
= 85,000 𝐹 Τ𝑃 , 8%, 3 + 200,000 𝐹 Τ𝐴 , 8%, 3
+ 1,000,000(𝐹 Τ𝑃, 8%, 1)
= $1,836,000
𝐹𝑊𝑅𝑒𝑚𝑜𝑑𝑒𝑙 = 850,000 𝐹 Τ𝑃 , 8%, 3 + 250,000 𝐹 Τ𝐴 , 8%, 3
= $1,882,000
Benefit-Cost Ratio Analysis
At a given minimum attractive rate of return

(MARR), an alternative is acceptable, provided
𝑁𝑃𝑊 = 𝑃𝑊 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊(𝐶𝑜𝑠𝑡𝑠) ≥ 0
𝐸𝑈𝐴𝑊 = 𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 ≥ 0
These criteria could also be stated as a ratio:

𝐵 𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) 𝐸𝑈𝐴𝐵
= = ≥1
𝐶 𝑃𝑊(𝐶𝑜𝑠𝑡𝑠) 𝐸𝑈𝐴𝐶

Situation Criterion
Neither input nor output Incremental B/C Ratio Analysis:
fixed: Typical situation • Compute incremental B/C ratio
• If ΔB/ΔC≥1, choose higher-cost
alternative
• If ΔB/ΔC<1, choose lower-cost
alternative
Fixed input: amount of Maximize B/C
money or other input
resources are fixed
Fixed output: fixed task, Maximize B/C
benefit, or other outputs

Example 9-3
Device A Device B Incremental (B-A)
400 450 500 200
A=300 300 350 150
100
50
0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5
P=350
P=1000
P=1350
𝐵 𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠)𝐴 300(𝑃Τ𝐴 , 7%, 5) 1230
= = = = 1.23
𝐶 𝐴
𝑃𝑊(𝐶𝑜𝑠𝑡𝑠)𝐴 1000 1000
𝐵 𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠)𝐵−𝐴 50(𝑃Τ𝐺 , 7%, 5) 382
= = = = 1.09
𝐶 𝐵−𝐴
𝑃𝑊(𝐶𝑜𝑠𝑡𝑠)𝐵−𝐴 350 350

Example 9-4
Machine X Machine Y
Initial Cost $200 $700
Uniform annual benefit 95 120
End-of-useful-life salvage value 50 150
Useful life, in years 6 12
𝐵 𝐸𝑈𝐴𝐵𝑋 95 95
= = = = 2.38
𝐶 𝑋
𝐸𝑈𝐴𝐶𝑋 200 𝐴Τ𝑃 , 10%, 6 − 50(𝐴Τ𝐹 , 10%, 6) 40
𝐵 𝐸𝑈𝐴𝐵𝑌−𝑋 𝐸𝑈𝐴𝐵𝑌 − 𝐸𝑈𝐴𝐵𝑋

= =
𝐶 𝑌−𝑋
𝐸𝑈𝐴𝐶𝑌−𝑋 𝐸𝑈𝐴𝐶𝑌 − 𝐸𝑈𝐴𝐶𝑋
120 − 95 25 25
= = = = 0.45
700 𝐴Τ𝑃 , 10%, 12 − 150 𝐴Τ𝐹 , 10%, 12 − 40 96 − 40 56

Example 9-5
A B C D E F
Initial Cost $4000 $2000 $6000 $1000 $9000 $10000
PW of Benefit 7330 4700 8730 1340 9000 9500
B/C 1.83 2.35 1.46 1.34 1.00 0.95
1. Rearrange the alternatives in order of increasing cost
D B A C E
Initial Cost $1000 $2000 $4000 $6000 $9000
PW of Benefit 1340 4700 7330 8730 9000
B/C 1.34 2.35 1.83 1.46 1.00
2. Calculate ΔB/ΔC of the incremental investments, if

ΔB/ΔC≥1, choose the higher-cost alternative
B-D A-B C-A E-A
Initial Cost $2000-1000 $4000-2000 $6000-4000 $9000-4000
PW of Benefit 4700-1340 7330-4700 8730-7330 9000-7330
ΔB/ ΔC 3.36 1.32 0.70 0.33

Graphical Representation of
B/C=2.0 B/C=1.5 B/C=1.0
PW of Benefits
B/C=0.5
PW of Costs

Graphical Representation of
B/C=2.0 B/C=1.5 B/C=1.0
10000
9000 C F
A
8000 E
7000
PW of Benefits
6000
5000 B B/C=0.5
4000
3000
2000
1000
D
0
$0 $2,000 $4,000 $6,000 $8,000 $10,000
PW of Costs

Variations on Benefit-Cost Ratio
• Government B/C ratio in Public Sector:

𝐵 𝐴𝑙𝑙 𝑐𝑜𝑛𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒𝑠 𝑡𝑜 𝑡ℎ𝑒 𝑢𝑠𝑒𝑟𝑠 𝑜𝑟 𝑡ℎ𝑒 𝑝𝑢𝑏𝑙𝑖𝑐
=
𝐶 𝐴𝑙𝑙 𝑐𝑜𝑛𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒𝑠 𝑡𝑜 𝑡ℎ𝑒 𝑠𝑝𝑜𝑛𝑠𝑜𝑟𝑠 𝑜𝑟 𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡
• Present Worth Index in Private Sector:
𝐵 𝐴𝑙𝑙 𝑐𝑜𝑛𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒𝑠 𝑒𝑥𝑐𝑒𝑝𝑡 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡
=
𝐶 𝑃𝑟𝑜𝑗𝑒𝑐𝑡 ′ 𝑠 𝑓𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡
• All B/C ratios use same criterion: B/C ≥ 1
• Various B/C ratios may differ in value, but they
provide consistent recommendations

Example 9-6
Government B/C Ratio Analysis
Right turn Left turn
lanes lanes Incremental
Initial cost $8.9M $3M
Uniform annual benefit 1.6M $2.2M
Annual maintenance $150K 75K
Disbenefit $900K 2.1M
𝐵 𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡) 1.6𝑀 𝑃Τ𝐴 , 10%, 15 − 900𝐾 11.27𝑀
= = = = 1.122
𝐶 𝑅
𝑃𝑊(𝐶𝑜𝑠𝑡) 8.9𝑀 + 150𝐾 𝑃Τ𝐴 , 10%, 15 10.04𝑀
𝐵 ∆𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡) 0.6𝑀 𝑃Τ𝐴 , 10%, 15 − 1.2𝑀 3.364𝑀

= = = = 0.942
𝐶 𝐿−𝑅
∆𝑃𝑊(𝐶𝑜𝑠𝑡) 3𝑀 + 75𝐾 𝑃Τ𝐴 , 10%, 15 3.570𝑀

Example 9-7
Present Worth Index Analysis
Minimal Total Incremental
Initial cost $8.9M $3M
Uniform annual benefit 1.6M $2.2M
Annual maintenance $150K 75K
Disbenefit $900K 2.1M
𝐵 𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡) (1.6𝑀 − 0.15𝑀) 𝑃Τ𝐴 , 10%, 15 11.03𝑀

= = = = 1.125
𝐶 𝑀𝑖𝑛.
𝑃𝑊(𝐶𝑜𝑠𝑡) 8.9𝑀 + 0.9𝑀 9.8𝑀
𝐵 ∆𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡) (0.6𝑀 − 75𝐾) 𝑃Τ𝐴 , 10%, 15 3.993𝑀

= = = = 0.951
𝐶 𝑇𝑜𝑡𝑎𝑙−𝑀𝑖𝑛.
∆𝑃𝑊(𝐶𝑜𝑠𝑡) 3𝑀 + 1.2𝑀 4.2𝑀

Payback Period
• It is the period of time required for the project’s

profit or other benefits to equal the project’s
cost
• It is an approximate economic analysis method
• The effect of timing is ignored
• All economic consequences after payback are
ignored
• May not consistent with equivalent worth and
rate of return methods

Example 9-8 Payback Period
Year 0 1 2 3 4 5
A -$1000 +200 +200 +1200 +1200 +1200
B -$2783 +1200 +1200 +1200 +1200 +1200
$3,000 $3,000
$2,500 $2,500
Accumulative Benefits
$2,000 $2,000
$1,500 $1,500
$1,000 $1,000
Payback Period
$500 Payback Period =2.33 years
$500
=2.5 years
$0 $0
0 1 2 3 4 5 0 1 2 3 4 5
Year Year
Alternative A Alternative B

Alternatives Cost Uniform Annual Benefit Salvage Value
Atlas $2000 $450 $100
Tom Thumb $3000 $600 $700
$4,000 $4,000
$3,500 $3,500
$3,000 $3,000
$2,500 $2,500
$2,000 $2,000
$1,500 $1,500
$1,000 $1,000
Payback Period Payback Period
$500 = 4.4 years $500 = 5 years
$0 $0
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Atlas Year Year

Tom Thumb

Alternatives Cost Annual Benefit Useful Life
Tempo $30000 $12000, 9000, 6000,… 4
Dura $35000 $1000, 4000, 7000,… 8
$40,000 $40,000
$35,000 $35,000
$30,000 $30,000
$25,000 $25,000
$20,000 $20,000
$15,000 $15,000
$10,000 Payback Period $10,000
= 4 years Payback Period
$5,000 $5,000 = 5 years
$0 $0
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Tempo Year Year
Dura

What is wrong here?
Payback
Payback and IRR analysis do
not agree.
Analysis
Alternative
With alternative A we get our Year A B
money back in 4 years but 0 ($30,000.00) $ (35,000.00)
1 $12,000.00 $ 1,000.00
never make a return on the
2 $9,000.00 $ 4,000.00
investment. 3 $6,000.00 $ 7,000.00
With alternative B we get our 4 $3,000.00 $ 10,000.00
money back in 5 years and 5 $0.00 $ 13,000.00
make a return on the 6 $0.00 $ 16,000.00
7 $0.00 $ 19,000.00
investment of 19%. 8 $0.00 $ 22,000.00
Salvage $0.00 $ -
How should we make a decision? Payback: 4.00 5.00
1. Liquidity vs. profitability. Select: A
2. Life of project.
IRR = 0% 19%
Select: B
22
Contoh 5.8
What is the payback period for the $500,000 SMP

investment, given an annual savings of $92,500?
PBP = $500,000/$92,500
= 5.4054 years
=NPER(0%,92500,-500000)
= 5.4054
Payback Period(3)
Four points to be understood about payback period
calculations :
1. This is an approximate, rather than an exact,
economic analysis calculation
2. All cost and all profits, or savings of the
investment, prior to payback are included
without considering differences in their timing.
3. All the economic consequences beyond the
payback are completely ignored.
4. Being an approximate calculation, payback
period may or may not select the correct
alternative. That is, the payback period
calculation may select a different alternative
from that found by exact economic analysis
techniques.
Metoda Discounted Payback
Period
Cari jangka waktu dimana investasi telah
kembali secara keseluruhan sambil
memperhitungkan time value of money
Tingkatkan popularitas
Cari nilai terkecil m sehingga
m
 A
t =0
(1 +
t i )  0−t
(cari titik waktu dimana kumulatip discounted cash flow > $0)
Contoh 5.6
Based on a 10% MARR, how long does it take for the

$500,000 investment in a surface mount placement
machine to be recovered, based on an annual savings
of $92,500 and a negligible salvage value, regardless
of how long the machine is used?
# years =NPER(10%,92500,-500000)
= 8.16 years
Sensitivity and Breakeven Analysis
• Sensitivity Analysis:
– Projections of expenditures and returns ultimately affect
economic decisions
– To what extend do variations in the data affect the
decision?
• Breakeven Analysis
– It is a form of sensitivity analysis
– In what conditions, two alternatives are viewed as
“indifferent”?
– One application is “staged construction”

Example 9-11 Breakeven Analysis
Construction Cost
Full- $250,000
$140,000
capacity
$100,000 now +
$200,000
Two-stage 120,000 n years Two-stage
from now
PW(Costs)
$150,000
Full capacity
$100,000
𝑃𝑊(𝑐𝑜𝑠𝑡𝑠)𝐹𝑢𝑙𝑙 = 140000
𝑃𝑊(𝑐𝑜𝑠𝑡𝑠)2 𝑆𝑡𝑎𝑔𝑒
$50,000 Breakeven
= 100000 + 120000(𝑃Τ𝐹 , 8%, 𝑛) point
$0
0 5 10 15 20 25 30
Year

A B C
Initial Cost $2000 X $5000
Uniform Annual Benefit 410 639 700
$7,000
𝑁𝑃𝑊𝐴 = 410 𝑃Τ𝐴 , 6%, 20 − 2000
$6,000
= 2703
𝑁𝑃𝑊𝐵 = 639 𝑃Τ𝐴 , 6%, 20 − 𝑋 $5,000
= 7329 − 𝑋 $4,000
NPW
𝑁𝑃𝑊𝐶 = 700 𝑃Τ𝐴 , 6%, 20 − 5000
$3,000
= 3029
$2,000
For Alternative B to be selected, $1,000

𝑁𝑃𝑊𝐵 ≥ 𝑁𝑃𝑊𝐶
$0
7329 – 𝑋 ≥ 3029 0 1000 2000 3000 4000 5000 6000
𝑋 ≤ 4300 X

Right turn lanes Left turn lanes
Initial cost $8.9M $11.9M
Uniform annual benefit 1.6M 2.2M
Annual maintenance 0.15M 0.225M
Disbenefit 0.9M 2.1M
$3,000
$2,500 Breakeven for Right turn lanes
𝑁𝑃𝑊𝑅 = −8.9𝑀 − 0.9𝑀 +
$2,000
(1.6𝑀 − 0.15𝑀)(𝑃Τ𝐴, 10%, 𝑛) Breakeven for
NPW (in $1000s)

$1,500 Left turn lanes
Breakeven for
$1,000
Incremental
𝑁𝑃𝑊𝐿 = −11.9𝑀 − 2.1𝑀 + $500 Investment
(2.2𝑀 − 0.225𝑀)(𝑃Τ𝐴, 10%, 𝑛) $0

10 12 14 16 18 20
($500)
($1,000)
Life of project, n (years)

Consider Problem 6-21
• Diesel engine is preferred based on values assumed.
• How much would changes in assumptions have to be in order to change the
preferred alternative?
Prob 6-21
Diesel Gas
Vehicle Cost 13000 12000
Fuel 685.71 910.71
Repairs 300 200
Resale 2000 3000
Insurance 500 500
EUAC $4,780.22 $5,157.70
n 4 3
31
How much would price of diesel fuel need to
go up before Gas would be the preferred
alternative?
Diesel Cost EUAC

$0.48 $4,780.22
$0.50 $4,808.79
$0.55 $4,880.22
$0.60 $4,951.65 Price of Diesel
$0.65 $5,023.08 would have to go
up to $.75 to
$0.70 $5,094.51 change decision.
$0.75 $5,165.93
32
What is the impact of the variability of resale
value on the analysis?
By varying the resale value, we find that at about $4200 resale value for the
gasoline powered vehicle the EUAC is almost equal
Resale (Gas) EUAC

$2,000 5,471.81
$3,000 5,157.70
$4,000 4,843.59
$5,000 4,529.48
$4,200 4,780.77
33
Example 9-15 What-if Analysis

ENGINEERING
ECONOMIC
Chapter 11
Depreciation

Chapter Outline
• Basic Aspects of Depreciation

• Historical Depreciation Methods
• Modified Accelerated Cost Recovery
System (MACRS)
• Depreciation and Asset Disposal
• Unit-of-Production Depreciation
• Depletion
• Spreadsheets and Depreciation

Learning Objectives
• Understand the concepts of depreciation,

deterioration, and obsolescence
• Use historical and MACRS to calculate annual
depreciation charge and book value over the asset’s
life
• Account for capital gains/losses, ordinary losses,
and depreciation recapture due to the disposal of a
depreciated asset
• Use unit-of-production and depletion depreciation
methods in economic analysis
• Use spreadsheets to calculate depreciation

Income, Depreciation,
and Cash Flow
• Sales of products
Revenue • Charges for services
• Cost of Goods Sold
• Labor wages, Materials, Utilities,
Machines (depreciation), Factory
buildings (depreciation)
• Selling Costs
Costs • Advertising, Sale commissions
• Administration Costs
• Administrative salaries, Office rental
• Financial Costs
• Interest paid on debt
Basic Aspects of Depreciation
• An important component in computing
income taxes.
• For tax purposes:
Depreciation is the systematic

allocation of the cost of an asset
spread over its depreciable life.
6
Basic Aspects of Depreciation
DEFINITION: A DECREASE IN VALUE

In Economic Context:
• Decline in market value of an asset due to
deterioration or obsolescence
• Decline in value of an asset to its owner
In Accounting Context:
• Systematic allocation of an asset’s cost over its
useful or depreciable life. Depreciable life is
related to
– Deterioration
– Obsolescence
Depreciation and Expenses
Expenses:
• Part of regular business operations
• “Consumed” over short period of time
• Sometimes recurring
• Do not lose value gradually over time
• Subtracted from business revenues as they
occur
• Reduce income taxes as they can be written off
when they occur
• Examples: labor, utilities, materials, insurance,…

Depreciation and Expenses
Depreciation:
• Business costs due to capital assets are not fully
written off when they occur
• Capital assets lose value gradually over time
• Capital cost must be written off or depreciated
over its depreciable life or recovery period
• Reduce the taxable income, and thus reduce
income taxes as they were written off
• It is a non-cash cost
• Examples: building, plants, machines,…

Basic Requirements for
Depreciation
A Property is Depreciable If:
• The property must be used for business purposes
to produce income.
• The property must have a useful life that can be
determined, and the useful life must be longer than
one year.
• The property must be an asset that decays, gets
used up, wears out, becomes obsolete, or loses
value to the owner from natural causes.
Only the owner of property may claim depreciation
expenses

Types of Property
Tangible property: can be seen, touched, and felt.

• Real property: land, buildings, and things growing
on, built upon, constructed on, or attached to the land
• Personal property: equipment, furnishings, vehicles,
office machinery, and anything that is tangible
excluding real property
Intangible property: has value but cannot be
directly seen or touched, examples include
patents, copyrights, and trademarks, trade
names, and franchises.

Property and Depreciation
• Almost all tangible property can be depreciated

except land, factory inventory, containers
considered as inventory, and leased property.
• Tangible property used in both business and
personal activities can be depreciated, but only in
proportion to the use for business purposes.
• Intangible property can generally be depreciated.
In general buildings and
equipment are depreciable;
land is not.
Example 12-1 Taxable Income
Actual cash flows:
Year 1 Year 2 Year 3
Gross income $200 $200 $200
Purchase of special tooling -60 0 0
All other expenditures -140 -140 -140
Cash flows for the year $0 $60 $60
Taxable Income:
Year 1 Year 2 Year 3
Gross income $200 $200 $200
All other expenditures -140 -140 -140
Depreciation charges -20 -20 -20
Cash flows for the year $40 $40 $40

Depreciation Calculation
Fundamentals
Book value = Cost basis − Depreciation charges made to date
𝑡
𝐵𝑉𝑡 = 𝐶𝑜𝑠𝑡 𝑏𝑎𝑠𝑖𝑠 − ෍ 𝑑𝑗 (11-1)
B
𝑗=1
𝐵𝑉𝑡 = Book value at the end of time t Total
Book Value
Depreciation
Cost basis = 𝐵 = Dollar amount being Charges
depreciated including the asset’s Curve values depend
purchase price and any other On depreciation method
costs necessary to make the asset
“ready to use” Salvage value
S
𝐷𝑗 = Depreciation deduction in year 𝑗
Depreciable Life
 𝐷𝑗 = Accumulated depreciation
charges from time 1 to 𝑗

Time-based Depreciation Methods
Pre-1981 classic methods:

• Straight-line (SL)
• Sum-of-the-years’-digits (SOYD)
• Declining balance (DB)
• required estimates of useful life and salvage value
1981-1986 method:
• Accelerated Cost Recovery System (ACRS)
• Property class lives were created
• Salvage value was ignored
• Shorter recovery periods were used
1986-present:
• Modified Accelerated Cost Recovery System (MACRS)
• Number of property classes was expanded
• Half-year convention for the first and final years

Classic Depreciation Methods
Straight-line (SL)
𝐵−𝑆 (11-2)
𝑑𝑡 = where
𝑁 𝑑𝑡 = Depreciation charge in
Sum-of-the-years’-digits (SOYD) year 𝑡
𝑁−𝑡+1 𝐵 = Cost of the asset made
𝑑𝑡 = (B – S) (11-3)
𝑆𝑂𝑌𝐷 ready for use
𝑆 = Estimated salvage value
Double declining balance (DDB) after depreciable life
2 𝑁 = Number of years in
𝑑𝑡 = 𝐵𝑉𝑡−1 (11-4) depreciable life
𝑁 𝑆𝑂𝑌𝐷 = Sum of years’ digits
2 𝑡−1
= (𝐵 − ෍ 𝑑𝑗 ) = 𝑁(𝑁 + 1)/2
𝑁 𝑗=1

Example 11-2 SL Depreciation
Cost of the asset, 𝐵 $900

Depreciable life, in years, 𝑁 5
Salvage value, 𝑆 $70
900
800 166
𝑑𝑡 𝑑𝑡 𝐵𝑉 700
Year 166
($1,000) ($1000) ($1000) 600
Book Value
500 166
0 900
400
1 166 166 734 166
300
2 166 332 568 200
3 166 498 402 100 Salvage value
166
4 166 664 236 0
5 166 830 70 0 1 2 3 4 5
Year

Accelerated Depreciation
• The rest of the methods discussed are called
“Accelerated Depreciation” methods.
• These methods deduct larger depreciation
expenses in the early years and less at the end.
• The large early deductions result in tax savings
that are realized sooner.
• A basic principle of the time value of money:
“Money now is better than money later”
18
Sum-of-Years-Digits (SOYD)
19
Example 11-3 SOYD Depreciation
900.00
𝑑𝑡 𝑑𝑡 𝐵𝑉 800.00
Year 277
($1,000) ($1000) ($1000) 700.00
0 $900.00 600.00
Book Value
500.00 221
1 $276.67 $276.67 623.33
400.00
2 221.33 498.00 402.00 166
300.00
3 166.00 664.00 236.00
200.00 111
4 110.67 774.67 125.33 Salvage value 55
100.00
5 55.33 830.00 70.00 0.00
0 1 2 3 4 5
Year

Double Declining Balance (DDB)
21
Example 11-4 DDB Depreciation
900.00
800.00
𝑑𝑡 𝑑𝑡 𝐵𝑉 700.00
360
Year
($1,000) ($1000) ($1000) 600.00
Book Value
500.00 216
0 900.00
400.00
1 360.00 360.00 540.00
300.00 130
2 216.00 576.00 324.00
200.00 78
3 129.60 705.60 194.40 100.00 Salvage value 47
4 77.76 783.36 116.64 0.00
5 46.66 830.02 69.98 0 1 2 3 4 5
Year

DDB With Conversion to SL
at the Most Desirable Time
• Since DDB does not use a value for Salvage, we
have three possible scenarios at time of disposal:
– Over depreciation: Book Value < Salvage Value. Tax
savings realized early. Small gain upon sale of the
asset and taxes on the gain.
– Exact depreciation: Book value = Salvage value.
There are no tax consequences upon sale of the asset.
– Under depreciation: Book Value > Salvage Value.
Did not deduct as much as you could have and lost tax
savings.
• To allow companies the advantage of all the depreciation
charges they are entitled to, they can switch from DDB to
straight line at the most favorable time.
23
DDB Is the Preferred Approach
• Using the DDB approach provides the
greatest PW (tax savings).
• The DDB approach does not fully
depreciate an item unless a switch to
straight line is accomplished in the latter
years.
• The question is which is the most
advantageous year to switch to SL.
24
Example of DDB with Conversion to
SL
• Same example, except that the Salvage Value is $ 30
instead of $ 70
• Year Depreciation Book value at the
end of year
1 $ 360 $ 540
2 $ 216 $ 324
3 $ 129,6 $ 194,4
4 $ 77,76 $ 116,64
5 $ 46,656 $ 69,984
25
Declining Balance depreciation with conversion
to Straight-Line depreciation
• If we convert to the straight line at year :

Straight line Declining Balance Decision
540 − 30
2 = $127,5 < $216 Do not convert
4
to straight line
324 − 30
3 = $98 < $129,6 Do not convert
3 to straight line
194,4 − 30 > $ 77,76 Convert to straight

4 = $82,2
2 line for year
4
Declining Balance depreciation with conversion
to Straight-Line depreciation
• Conclusion :
The depreciation charge with declining
balance depreciation with conversion to
straight line depreciation are :
Year Depreciation charge
1 $ 360
2 $ 216
3 $ 129,6
4 $ 82,2
5 $ 82,2
Advantages of Modified Accelerated
Cost Recovery System
• “Property class lives” are less than the “actual
useful lives”
• Definition of MACRS classes of depreciable property is
based on the guideline of the asset depreciable range
(ADR)
• With ADR, each class of property has a lower limit, a
midpoint, and a upper limit of useful life
• The ADR midpoint lives were somewhat shorter than the
actual average useful lives
• MACRS property class lives are shorter than the ADR
midpoint lives
• Salvage value was assumed to be 0
• Tables of annual percentages simplify computations

Modified Accelerated Cost
Recovery System (MACRS)
• General Depreciation System (GDS)
• Based on declining balance with switch to straight-line
depreciation
• Alternative Depreciation System (ADS)
• ADS provides a longer recovery period and uses straight-
line depreciation
• ADS must be used for
• Tangible property used primarily outside the United States
• Property that is tax exempt or financed by tax-exempt bonds
• Farming property placed in service when uniform capitalization
rules are not applied
• ADS may be elected for an asset, it is not possible to
switch back to the GDS.
Procedures in Applying
MACRS-GDS Depreciation
1. Determine if a property is eligible for depreciation
2. Determine the asset’s cost basis (𝐵)
• Cost to obtain and place the asset in service fit for use
• For real property, the basis may include certain fees and
charges, such as legal and recording fees, abstract fees,
survey charges, transfer taxes, title insurance, …
3. Determine the property class and recovery period
• Use property class given in problem
• Match asset name with MACRS-GDS property classes
definition (Table 11-2)
• Use IRS publication, such as Table 11-1
• Use ADR class life to determine property class
Applying
MACRS-GDS Depreciation
𝑑𝑡 = 𝐵 × 𝑟𝑡 (11-5)
where
𝑑𝑡 = Depreciation charge in year 𝑡
𝐵 = Cost basis
𝑟𝑡 = Appropriate MACRS percentage rate

Table 11-1 Example Class Lives
and MACRS Property Classes
IRS Class Life MACRS Property
Asset Asset Description (Years) Class (years)
Class ADR GDS ADS
00.11 Office furniture, fixtures, and equipment 10 7 10
00.12 Information Systems: computer/peripheral 6 5 6
00.22 Automobiles, taxis 3 5 5
00.241 Light general-purpose trucks 4 5 5
00.25 Railroad cars and locomotives 15 7 15
00.40 Industrial steam and electric distribution 22 15 22
01.11 Cotton gin assets 12 7 12
01.21 Cattle, breeding or dairy 7 5 7
13.00 Offshore drilling assets 7.5 5 7.5
13.30 Petroleum refining assets 16 10 16
15.00 Construction assets 6 5 6

Table 11-1 Example Class Lives
and MACRS Property Classes
IRS Class Life MACRS Property
Asset Asset Description (Years) Class (years)
Class ADR GDS ADS
21.10 Manufacture of grain and grain mill products 17 10 17
22.2 Manufacture of yarn, thread, and woven fabric 11 7 11
24.10 Cutting of timber 6 5 6
32.20 Manufacture of cement 20 15 20
37.11 Manufacture of motor vehicles 12 7 12
48.11 Telephone Communications assets and 24 15 24
buildings
48.2 Radio and television broadcasting equipment 6 5 6
49.12 Electric utility nuclear production plant 20 15 20
49.13 Electric utility steam production plant 28 20 28
49.23 Natural gas production plant 14 7 14
50.00 Municipal wastewater treatment plant 24 15 24
80.00 Theme and amusement park assets 12.5 7 12.5
Table 11-2
MACRS GDS Property Classes
Property Class Personal Property (all property except real estate)
3-Year Property • Special handling devices for food and beverage manufacture
• Special tools for the manufacture of finished plastic products,
fabricated metal products, and motor vehicles
• Property with ADR class life of 4 years or less
5-Year Property • Automobiles and trucks (The depreciation for automobiles is limited
to $2960 the first tax year, $4700 the second year, $2850 the third year,
and 1675 per year in subsequent years.)
• Aircraft (of non-air-transport companies)
• Equipment used in research and experimentation
• Computers
• Petroleum drilling equipment
• Property with ADR class life of more than 4 years and less than 10
years
7-Year Property • All other property not assigned to another class
• Office furniture, fixtures, and equipment
• Property with ADR class life of 10 years or more and less than 16
years
Table 11-2
MACRS GDS Property Classes
Property Class Personal Property (all property except real estate)
10-Year • Assets used in petroleum refining and certain food products
Property • Vessels and water transportation equipment
years
15-Year • Telephone distribution plants
Property • Municipal sewage treatment plants
years
20-Year • Municipal sewers
Property • Property with ADR class life of 25 years or more
Property Class Real Property (real estate)
27.5 Year Residential rental property (does not include hotels and motels)
39 Years Nonresidential real property

Table 11-3
MACRS GDS Percentage Rate
Recovery 3-year 5-year 7-year 10-year 15-year 20-year
Year class class class class class class
1 33.33 20.00 14.29 10.00 5.00 3.750
2 44.45 32.00 24.49 18.00 9.50 7.219
3 14.81* 19.20 17.49 14.40 8.55 6.677
4 7.41 11.52* 12.49 11.52 7.70 6.177
5 11.52 8.93* 9.22 6.93 5.713
6 5.76 8.92 7.37 6.23 5.285
7 8.93 6.55* 5.90* 4.888
8 4.46 6.55 5.90 4.522
9 6.56 5.91 4.462*
10 6.55 5.90 4.461
11 3.28 5.91 4.462
12-15 5.90 4.461
16 2.95 4.461
17-20 4.462
21 2.231

Calculation of
MACRS GDS Percentages
1. The 3-, 5-, 7-, and 10-year classes use 200% and the 15-
and 20-year classes use 150% declining balance
depreciation.
2. All classes convert to straight-line depreciation in the
optimal year, shown with the asterisk (*).
3. A half-year of depreciation is allowed in the first and last
recovery years.
4. Salvage value are assumed to be zero for all assets.

Table 11-4
MACRS GDS Percentage Rate
Residential Rental Property
Recovery
Year Month placed in service
1 2 3 4 5 6 7 8 9 10 11 12
1 3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152
2-27 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636
28 1.970 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636
29 0.152 0.455 0.758 1.061 1.364 1.667
Nonresidential Real Property
Recovery
Year Month placed in service
1 2 3 4 5 6 7 8 9 10 11 12
1 2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107
2-39 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564
40 0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461

Example 11-5 Calculation of
MACRS GDS Percentages
The 5-year class uses 200% declining balance depreciation
with conversion to straight-line depreciation. B=100%, S=0,
half-year for the 1st and last of recovery period
MACRS Book
Year DDB Calculation SL Calculation Rates Value
0 100.00%
1 (½)(2/5)(100%)=20.00% (½)(100%/5)=10.00% 20.00% 80.00%
2 (2/5)(80.00%)=32.00% (80.00%/4.5)=17.78% 32.00% 48.00%
3 (2/5)(48.00%)=19.20% (48.00%/3.5)=13.71% 19.20% 28.80%
4 (2/5)(28.80%)=11.52% (28.80%/2.5)=11.52% 11.52% 17.28%
5 11.52% 11.52% 5.76%
6 (½)11.52%=5.76% 5.76% 0.00%

MACRS GDS Depreciation
7-year property class, B=$150000, S=$30000
MACRS
Year MACRS, 𝑟t MACRS Calculation Depreciation, 𝑑 t Book Value
0 $150,000
1 14.29% ($150000)(14.29%) $21,435 128,565
2 24.49% (150000)(24.49%) 36,735 91,830
3 17.49% (150000)(17.49%) 26,235 65,595
4 12.49% (150000)(12.49%) 18,735 46,860
5 8.93% (150000)(8.93%) 13,395 33,465
6 8.92% (150000)(8.92%) 13,380 20,085
7 8.93% (150000)(8.93%) 13,395 6,690
8 4.46% (150000)(4.46%) 6,690 0

MACRS GDS Depreciation
39-year property class, B=$20,000,000, purchased in April,
disposed 5 years later in August.
MACRS, MACRS
Year 𝑟𝑡 MACRS Calculation Depreciation, 𝑑𝑡 Book Value
0 $20,000,000
1 1.819% ($20000000)(1.819%) $363,800 19,636,200
2 2.564% (20000000)(2.564%) 512,800 19,123,400
3 2.564% (20000000)(2.564 %) 512,800 18,610,600
4 2.564% (20000000)(2.564 %) 512,800 18,097,800
5 2.564% (20000000)(2.564 %) 512,800 17,585,000
6 2.564% (7.5/12)(20000000)(2.564 %) 321,000 17,264,000
2,736,000

Example 11-8 Comparison of
Depreciation Methods
150000
125000
Book Value
100000
SL
75000
SOYD
50000
MACRS
25000 DDB
0
0 1 2 3 4 5 6 7 8 9 10
Year

Depreciation and Asset Disposal
When a depreciable asset is disposed of, and the market

value is different than the book value, the difference must
be treated as:
• Depreciation recapture (ordinary gains): Depreciation
recapture occurs when an asset is sold for more than its
current book value, but less than the original cost basis.
• Losses: A loss occurs when an asset is sold for less than
its current book value.
• Capital gains: Capital gain occur when an asset is sold for
more than its original cost basis. Capital gains may be
taxed at lower rate than ordinary gains.

14000 14000 14000
$4000
12000 12000 12000 Capital
Gain
10000 $2000 10000 10000
Depreciation
8000 Recapture 8000 8000 $5000
$3000 Depreciation
6000 6000 Loss 6000 Recapture
4000 4000 4000
2000 2000 2000
0 0 0
Cost Market Book Cost Market Book Cost Market Book
Basis Value Value Basis Value Value Basis Value Value

Item is sold for more than Book Value -
Ordinary Gain
45
Item is sold for below Book
Value - Ordinary Loss
46
Item sold for more that what was
paid for it-Ordinary & Capital Gain
47
Example 11-9
3-year property class, B=$10000
MACRS
Year MACRS, 𝑟𝑡 Depreciation, 𝑑𝑡 Book Value Market Value
0 $10,000
1 33.33% $3,333 6,667
2 44.45% 4,445 2,222
3 14.81% 1,481 741
4 7.41% 741 0
5 0 0 0 X
a) If market value = $7000, the recaptured depreciation = $7000

b) If market value = $0, no recaptured depreciation or loss
c) If market value = -$2000, there is a loss of $2000
Example 11-10
1) MACRS
0 $10,000
1 33.33% $3,333 6,667
2 44.45% (1/2)4,445=2,222.5 4,444.5 $5000
Market Value – Book Value = $5000 – 4444.5 = 555.5 (recaptured depreciation)
Total deduction from taxable income = 𝑑2 − 𝑅𝑒𝑐. 𝑑𝑒𝑝. = 2222.5 − 555.5 = $1667
2)
MACRS
0 $10,000
1 33.33% $3,333 6,667
2 44.45% (0)4,445=0 6,667 $5000
Market Value – Book Value = $5000 – 6667 = -1667 (Loss)

Total deduction from taxable income = $1667

Example 11-10
3) MACRS
0 $10,000
1 33.33% $3,333 6,667
2 44.45% (1)4,445=4445 2,222 $5000
Market Value – Book Value = $5000 – 2222 = 2778 (recaptured depreciation)
Total deduction from taxable income = 𝑑2 − 𝑅𝑒𝑐. 𝑑𝑒𝑝. = 4445 − 2778 = $1667

Unit-of-Production Depreciation
• Useful when the recovery of depreciation on an asset is

more closely related to use than time
• Not considered an acceptable method for general use
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛𝑡
𝑑𝑡 = (𝐵 − 𝑆) (11-6)
σ𝑗=1 𝑡𝑜 𝑁 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛𝑗
where
𝑑𝑡 = Depreciation charge in year 𝑡
𝐵 = Cost basis
𝑆 = Estimated salvage value after depreciable life
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛𝑡 = Production for year 𝑡
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 = Total lifetime production for asset

Example 11-11
Unit-of-Production Depreciation
5-year depreciable life, B=$900, S=$70
Annual UOP Depreciation UOP Book
Year Production Calculation Depreciation, 𝑑𝑡 Value
0 $900
1 4,000 (4,000/40,000)(830) $83 817
2 8,000 (8,000/40,000)(830) 166 651
3 16,000 (16,000/40,000)(830) 332 319
4 8,000 (8,000/40,000)(830) 166 153
5 4,000 (4,000/40,000)(830) 83 70
40,000

Depletion
• Depletion is the exhaustion of natural resources as a result
of their removal.
• Except for standing timber and most oil and gas wells,
depletion allowance is the larger of the two methods.
• Cost Depletion:
• Similar to the unit-of-production depreciation method
• Permissible for standing timber and most oil and gas wells
• Cost of land must be excluded from the property cost
• Percentage Depletion:
• Depletion allowance is a certain percentage of the property’s
gross income during the year
• Cannot exceed 50% of the property’s taxable income
computed without the depletion deduction

Table 11-6
Percentage Depletion Allowance
Type of Deposits Rate
Sulfur, uranium, and, if from deposits in the United States, asbestos, 22%
lead ore, zinc ore, nickel ore, and mica
Gold, silver, copper, iron ore, and certain oil shale, if from deposits in 15%
the United States
Borax, granite, limestone, marble, mollusk shells, potash, slate, 14%
soapstone, and carbon dioxide produced from a well
Coal, lignite, and sodium chloride 10%
Clay and shale used or sold for use in making sewer pipe or bricks or 7½%
used or sold for use as sintered or burned lightweight aggregates
Clay used or sold for making drainage and roofing tile, flower pots, and 5%
kindred products, and gravel, sand, and stone (other than stone
used or sold for use by a mine owner or operator as dimension or
ornamental stone)

Cost Depletion (1)
• The elements of the Depletion calculation:
– Cost of the property
– Estimation of the number of recoverable units (tons of
ore, cubic meters of gravel, barrels of oil, and so forth
– Salvage value of the property
Cost Depletion (2)
• Example :
A small lumber company bought a tract of
timber for $ 35.000 of which $5.000 was the
value of the land and $ 30.000 was the value
of the estimated 1,5 million board-feet of
standing timber. The first year, the company
cut 100.000 boar-feet of standing timber on
the tract. What was the depletion allowance
for the year?
Cost Depletion (3)
• Depletion allowance per 1000 board-feet

of timber
$35000 − $5000
= = $20 per 1000board − feet
1500000board − feet
• The depletion allowance for the year

would be
= 100000 board-ft x $20 per 1000 board-
ft = $2000
Example 11-12 Cost Depletion
Cost of property (timber) = $35,000

Cost of land = $5000 (included in the cost of property)
Estimated timber production = 1.5 million board-feet
First year’s production = 100,000 board-feet
100,000
𝑑1 = $35,000 − 5,000 = $2,000
1,500,000

Percentage Depletion (1)
• Percentage depletion is an annual allowance of a percentage of

the gross income from the property.
• Allowable percentage depletion on a property in any year
cannot exceed 50% of the property taxable income computed
without the depletion deduction
• Percentage depletion allowance for selected items:
• Example:
A coal mine has a gross income of $250.000 for the
year. Mining expenses equal $ 210.000. Compute the
allowable percentage depletion deduction !
• Compute percentage depletion :
Gross income from mine
$250000
Percentage depletion x 10%
Computed percentage depletion $ 25000
• Taxable income limitation:
Gross income from mine $250000
less: expenses other than depletion - 210000
Taxable income from mine 40000
Deduction limitation x 50%
Taxable income limitation $ 20000
Since the taxable income limitation ($20.000) is less

than the computed percentage depletion ($ 25.000),
the allowable percentage depletion deduction is $
20.000
Example 11-13
Percentage Depletion
Gross income = $250,000
Mining expenses = $210,000
Percentage depletion = (10%)($250,000) = $25,000

Taxable Income = $250,000 - $210,000 = $40,000
Taxable Income Limitation = $40,000 (50%) = $20,000

Spreadsheet and Depreciation

SLN(cost, salvage, Returns the straight-line depreciation of an asset for
life) one period.
DDB(cost, salvage, Returns the depreciation of an asset for a specified
life, period, [factor])
period using the double-declining balance method
or some other method specified.
SYD(cost, salvage, Returns the sum-of-years' digits depreciation of an
life, period) asset for a specified period.
VDB(cost, salvage, Returns the depreciation of an asset for any period
life, start_period, specified, including partial periods, using the
end_period, [factor], double-declining balance method or some other
[no_switch]) method specified. VDB stands for variable declining
balance.

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Choosing the Best Alternative

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• Define incremental analysis

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• Only one alternative may be implemented

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• Could be applied to rate of return (IRR), present worth (PW),

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1. Rearrange the alternatives in order of increasing cost

2. Calculate IRR of the least expensive alternative to see if it

4. Compare Defender B with the next alternative, A. This

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6. Compare Defender B with the next alternative, E. This

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• All analysis methods provide consistent solutions.

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Increment B-D A-B C-A E-A

PW Required for Less Depends

AW Required for Less Depends

ROR For comparison More Depends

*Not an issue when using a spreadsheet.

Do what the Organization requires. Occasionally augment

Excel Tools Purpose

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Difficulties in Solving for

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• Why Multiple Solutions can Occur?

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• Understand why multiple solutions can

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This series of cash flows produces two

• May be converted to a polynomial

Number of sign changes, m Number of positive values of “i”

In either case, no “i” can be computed.

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𝐹 Τ𝑃 , 𝑀𝐼𝑅𝑅, 𝑛 ෍ 𝐸𝑡 𝑃Τ𝐹 , 𝑒𝑓𝑖𝑛 , 𝑡 = ෍ 𝑅𝑡 𝐹 Τ𝑃 , 𝑒𝑖𝑛𝑣 , 𝑛 − 𝑡

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PW(Et)=6.744M; FW(Rt)=16.507M; MIRR=13.64%

Excel Functions Purpose

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Other Analysis Techniques

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• Future Worth Analysis

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• Apply future worth analysis, and benefit-

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• Alternatives are compared in terms of

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𝑆𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔 = $35 × 26 = $910

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At a given minimum attractive rate of return