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Module 4

Decisions Under Certainty

I. Effects of Inflation

Inflation is the increase in the prices for goods and services from one year to
another, thus decreasing the purchasing power of money.

��′ = �� + �� + ��(��)

Where,

��′ = ������������������ �������� ����


����������������

�� = �������� ���� ����������������

�� = �������� ���� ������������������

�� = ��(1 + ��′)��

Sample Problem:

A machine costs P20,000 today. If inflation is 6% per year and interest is 10% per year,
what will be the appropriate future value of the machine adjusted for inflation in 5 years?

Solution:

We must first solve the corrected rate of interest including the inflation

rate. ��′ = �� + �� + ��(��)

��′ = 10% + 6% + 10%(6% )

��′ = 0.166
Then solve for the future value of the machine,
�� = ��(1 + ��′)��

�� = 20,000(1 + 0.166)5

�� = ��43,104.51

II. Depreciation

Depreciation is the decrease in value of property such as machinery, cars


equipment, building or other structures, due to the passage of time.

Purposes of Depreciation

1 To provide for the recovery of capital which has been invested in physical property.

2. To enable the cost of depreciation to be charge to the cost of producing products or


services that results from the use of property.

Depreciation Methods

We shall use the following symbols for the different depreciation

methods: �� = ������������ �������� ����

��ℎ�� ���������������� ����

����������

��. ��. = ���������� �������� ���� ��ℎ��


���������������� ��������

��. ��. = ���������� ���������� ����


�������������� ��������

���� = ��ℎ�� ������������ �������� ����


������������������������

������ = �������� ���������� ���� ��ℎ�� ������


���� �� ����������

���� = ������������������������ ���� ����


������ ���� �� ����������

Methods of Determining Depreciation Cost


1. Straight-line Method 🡪 This method assumes that the loss in value is directly

proportional to the age of the property.


Annual Depreciation,

���� =���� − ����


��

Total Depreciation after “m” years,

���� = ���� �� ��

Book value,

������ = ��. �� − ����

Sample Problem:

A machine cost P1,800,000. It has a salvage value of P300,000 at the end of 5 years. If
money is worth 6% annually; using the 5 types of depreciation, determine the
depreciation at 3rd year.

��3 =���� − ����


��

��3 =��1,800,000 − ��300,000


5

��3 = ��300,000

��3 = ��3 �� 3

���� = ��300,000�� 3

���� = ��900,000

����3 = ��. �� − ����


����3 = ��1,800,000 − 900,000

����3 = 900,000
2. Sinking Fund Method 🡪 This method assumes that a sinking fund is established in

which funds will accumulate for replacement. The total depreciation that has taken place
up to any given time is assumed to be equal to the accumulated amount in the sinking
fund at that time.

From the formula of Annuity,

��
�� =��[(1 + ��) − 1]
��

(���� − ����) =��[(1 + ��)�� − 1]


��

�� =(���� − ����)��
(1 + ��)�� − 1

Total Depreciation of “m” years,

���� =��[(1 + ��)�� − 1]


��

Book value,

������ = ��. �� − ����

Annual depreciation,

���� = ������−1 − ������

Sample Problem:

A machine cost P1,800,000. It has a salvage value of P300,000 at the end of 5 years. If
money is worth 6% annually; using the 5 types of depreciation, determine the
depreciation at 3rd year.

�� =(���� − ����)��
(1 + ��)�� − 1

�� =(��1,800,000 − 300,000)(6%)
(1 + (6%))5 − 1

�� = ��266,094.60
���� =��[(1 + ��)�� − 1]
��

��2 =��266,094.60[(1 + 6%)2


− 1] 6%

��2 = ��548,154.876

������ = ��. �� − ����

����2 = ��1,800,000 −

��548,154.876 ����2 =

��1,251,845.124

��3 =��266,094.60[(1 + 6%)3


− 1] 6%

��2 = ��847,138.7686

������ = ��. �� − ��3

����3 = ��1,800,000 −

��847,138.7686 ����3 =

��952,861.2314

���� = ������−1 − ������


��3 = ����2 − ����3

��3 = ��1,251,845.124 −

��952,861.2314 ���� =

������, ������. ����

3. Declining Balance Method 🡪 In this method, sometimes called the Matheson’s

Formula or Constant Ratio Method. It is assumed that the annual cost of depreciation is
fixed percentage of the salvage value at the beginning of the year. The ratio of the
depreciation in any year to the book value at the beginning of that year is constant
throughout the life of the property and is designated by k, the rate of depreciation.

Annual rate of depreciation, k,

�� = 1 − √����
��

����

Book value after “x” years,

������′ = ����(1 − ��)��−��

������ = ����(1 − ��)��

Annual Depreciation,

���� = ������′ − ������

Sample Problem:

A machine cost P1,800,000. It has a salvage value of P300,000 at the end of 5 years. If
money is worth 6% annually; using the 5 types of depreciation, determine the
depreciation at 3rd year.

�� = 1 − √����
��

����
�� = 1 − √��300,000
5

��1,800,000

�� = 0.3012
������′ = ����(1 − ��)��−��

����3′ = ��1,800,000(1 − 0.3012)5−3

����3′ = ��878,978.592

������ = ����(1 − ��)��

����3 = ��1,800,000(1 − 0.3012)3

����3 = ��614,230.24

���� = ������′ − ������

��3 = ��878,978.592 − ��614,230.24

��3 = 264,748.35

4. Double Declining Balance Method 🡪 it is very similar to the declining balance

method except that the rate of depreciation k is replaced by 2/n.

Annual rate of depreciation, k,

2
�� = ��

Book value after “x” years,

2
������−1 = ���� (1 − ��)��−1
2
������ = ���� (1 − ��)��

Annual Depreciation,
���� = ������−1 − ������

Sample Problem:

A machine cost P1,800,000. It has a salvage value of P300,000 at the end of 5 years. If
money is worth 6% annually; using the 5 types of depreciation, determine the
depreciation at 3rd year.

2
�� = ��
2
�� = 5

�� = 0.4

2
������−1 = ���� (1 − ��)��−1

����3−1 = ��1,800,000(1 − 0.4)3−1

����3−1 = ��648,000

����3 = ����(1 − ��)��

����3 = ��1,800,000(1 − 0.4)3

����3 = ��388,800

��3 = ������−1 − ������

��3 = ��648,000 − ��388,800


��3 = ��259,200
5. Sum of the Years’ Digit Method

������ ���� ��ℎ�� ���������� =��(�� + 1)


2

Annual Depreciation,

���� = [(�� − �� + 1)

������ ���� ��ℎ�� ����������] (���� −


����)

Total Depreciation of “m” years,

���� = [��(2�� − �� + 1)
2(������ ���� ��ℎ�� ����������)] (����
− ����)

Book Value,

������ = ���� − ����

Sample Problem:

A machine cost P1,800,000. It has a salvage value of P300,000 at the end of 5 years. If
money is worth 6% annually; using the 5 types of depreciation, determine the
depreciation at 3rd year.

������ ���� ��ℎ�� ���������� =��(�� + 1)


2

������ ���� ��ℎ�� ���������� =5(5 + 1)


2

������ ���� ��ℎ�� ���������� = 15


���� = [(�� − �� + 1)

������ ���� ��ℎ�� ����������] (���� −


����)

��3 = [(5 − 3 + 1)

15 ] (��1,800,000 − ��300,000)
��3 = 300,000

���� = [��(2�� − �� + 1)
2(������ ���� ��ℎ�� ����������)] (����
− ����)

��3 = [3(2(5) − 3 + 1)
2(15)] (��1,800,000 − ��300,000)

��3 = ��1,200,000

������ = ���� − ����

����3 = ��1,800,000 − ��1,200,000

����3 = ��600,000

6. Service Output Method

������������������������ ������ ��������

=���� − ����
���������� ���������� ���� ������������
������������ �������� ����
����������������

Sample Problem:

A television company purchased machinery for P100,000 on July 1, 1979. It is estimated


that it will have a useful life of 10 years, scrap value of P4,000, production of 400,000
units and working hours of 120,000 hours in 1979, and 18,000 hours in 1980. The
machinery produces 36,000 units in 1979 and 44,000 units in 1980. Compute the
depreciation for 1980 using the working hours method.

Solution:

������������������������ ������ ��������

=���� − ����
���������� ���������� ���� ������������
������������ �������� ����
����������������

������������������������ ������ �������� =100,000 −


4,000
400,000

������������������������ ������ �������� = ��0.24


������������������������ ������ 1980 = ��0.24 (44,000)

������������������������ ������ �������� =


������, ������. ����

7. Working Hours or Machine Hour Method

������������������������ ������

ℎ������ =���� − ����


���������� ������������ ����
ℎ��������

Sample Problem:

A television company purchased machinery for P100,000 on July 1, 1979. It is estimated


that it will have a useful life of 10 years, scrap value of P4,000, production of 400,000
units and working hours of 120,000 hours in 1979, and 18,000 hours in 1980. The
machinery produces 36,000 units in 1979 and 44,000 units in 1980. Compute the
depreciation for 1980 using the working hours method.
Solution:

������������������������ ������

ℎ������ =���� − ����


���������� ������������ ����
ℎ��������

������������������������ ������ ℎ������ =100,000 −


4,000
120,000

������������������������ ������ ℎ������ = ��0.80

������������������������ ���� 1980 = ��0.80 (18,000)

������������������������ ���� �������� = ������,


������. ����
III. Bond and Stock Valuation

Valuation or appraisal is the process of determining the value of certain property


for specific reasons. The person engaged in the task of valuation is called an appraiser.

The Corporation. A corporation is a distinct legal entity, separate from the


individuals who own it, and which can engage in almost any type of business transaction
in which a real person could occupy himself or herself.

Advantages of Corporation

• It enjoys perpetual life without regard to any change in the person of its owners,

the stockholders.

• The stockholders of the corporation are not liable for the debt of the corporation. • It

is relatively easier to obtain large amounts of money for expansion, due to its
perpetual life.

• The ownership in the corporation is readily transferred.


• Authority is easily delegated by the hiring of managers.

Disadvantages of Corporation

• The activities of a corporation are limited to those stated in its charter. •

It is relatively complicated in formation and administration.

• There is a greater degree of governmental control as compared to other types of

business organization.

Capitalization of a Corporation

• The capital of a corporation is acquired through the sale of stock. There are two

principal types of capital stock: common stock and preferred stock.

Common Stock

• Common Stock represents ordinary ownership without special guarantee of return.

Common stakeholders have certain legal rights, among which are the following: o
Vote at stockholders’ meeting.
o Elect directors and delegates to them power to conduct the affairs the
business.
o Sell or dissolve the corporation.
o Make and amend by the laws of the corporation.
o Subject to government approval, amend, or change the charter or capital
structure.
o Participate in the profits.
o Inspect the books of the corporation.

Preferred Stock

• Preferred stockholders are guaranteed a definite dividend on their stocks. In case

the corporation is dissolved, the assets must be used to satisfy the claims of the
preferred stockholders before those of the holders of the common stock.
Preferred stockholders usually have the right to vote in meetings, but not always.

Financing with Bonds

• A bond is a certificate of indebtedness of a corporation usually for a period not less

than ten years and guaranteed by a mortgage on certain assets of the corporation
or its subsidiaries. Bonds are issued when there is need for more capital such as
for expansion of the plant or the services rendered by the corporation.

• The face or par value of a bond is the amount stated on the bond. • When the face

value has been repaid, the bond is said to have been retired or redeemed. The bond
rate is the interest rate quoted on the bond.

Classification of Bonds

• Registered bonds. The name of the owner of this bond is recorded on the record

books of the corporation and interest payments are sent to the owner periodically
without any action on his part.

• Coupon bonds. Coupon bond have coupon attached to the bond for each interest

payment that will come due during the life of the bond. The owner of the bond can
collect the interest due by surrendering the coupon to the offices of the
corporation or at specified banks.
Methods of Bond Retirement

• The corporation may issue another set of bonds equal to the amount of bonds due

for redemption.

• The corporation may set up a sinking fund which periodic deposits of equal amount

are made. The accumulated amount in the sinking fund is equal to the amount
needed to retire the bonds at the time they are due.

Bonds

• A bond is an interest-bearing security that obligates the issuer to pay the


bondholder a specified sum of money, usually at specific intervals (known as a
coupon or dividend), and to repay the principal amount of the loan at maturity.

Formula to be used in Bonds,

��
�� =��[(1 + ��) − 1]
��
��(1 + ��) +��
(1 + ��)��

Elements:

�� = �������� ����������

�� = ������������������, �� = ����

�� = ���������������� ��������

�� = ���������������� ������������

�� = �������������������� ����������

Sample Problem:

A 9% coupon bond has a P200,000 face value and matures in 6 years. What is the price
of this bond if yield to maturity is 8.2%?
Solution:

Given from the problem,

�� = 9%

�� = ��200,000

�� = 6 ����������

�� = 8.2 %

�� = �� = 200,000

Note: If Redemption Value is not given, redemption value and face value are equal.
First to solve is the dividends or coupon,

�� = ����

�� = (9%)(��200,000)

�� = ��18,000 ������ ��������

Use the formula.

��
�� =��[(1 + ��) − 1]
��
��(1 + ��) +��
(1 + ��)��

�� = ��������, ������. ����

Activity:

A bond issue of P200,000 in 10-year bonds, in P1,000 units, paying 16% nominal
interest in semi-annual payments, must be retired by the use of a sinking fund that
earns 12% compounded semi-annually. What is the total semi-annual expense?
IV. Break-even Analysis

Break-even Analysis

• This involves investments of capital wherein at a certain level of production, the

total income of the company would just be equal to the total expenses, thus
resulting in no loss nor profit.

• To illustrate the principles of this analysis clearly, it more conveniently is presented

on a chart called the break-even chart which shows the fixed costs, variable
costs, the expected profit or loss at any production levels.

• The intersection of the income and the variable costs indicates the break-even

point of the point where there is no loss nor profit.


Formula to be used in Break-even Analysis:
������������ = �������������� − ��������

Note: + ������������ = ��������

− ������������ = ��������

0 ������������ = ������������������
����������
�������� = ���������������� �������� + ����������
��������

Where,

Variable Cost 🡪 the costs of producing a product that varies proportionally


to the quantity of production.

Fixed Cost 🡪 the costs that must be paid regardless of the quantity

produced.

Sample Problem:

A photocopying business determined that for every page of paper, an equivalent


of 10 cents of ink is used. In addition, they also found out that for every page of paper,
the machine incurs an electrical cost of 5 cents. If the cost of one paper is 40 cents, and
they need to pay monthly and permit of P7,500 and salary of P5,000, how many pages
must be print in order to break-even if they charge 1 peso per page?

Solution:

Let p = no. of pages

Identify first the Cost,

��������:

���������� �������� = ��7,500 + ��5,000 = ��12,500 ������


��������ℎ

���������������� �������� = 0.10 + 0.05 + 0.40 = 0.55 ������


��������

�������� = 12,500 + 0.55��

Then identify the Revenue,

��������������:

�������������� = ��1 ������ ��������

�������������� = 1��
Then, use the breakeven formula (Profit = 0)

������������ = �������������� − ��������

0 = 1�� − (12,500 + 0.55��)

�� = 27,777.77

�� ≈ ����, ������ ���������� ������ ����������

References

• Engineering Economy 3rd Edition by Hipolito B. Sta. Maria •

Engineering Mathematics Volume 2 by Gillesania •

Engineering Economics by Besavilla


• Bonds and Stocks

https://www.youtube.com/watch?

v=sKDjMFKrKRc • Break-even Analysis

https://www.youtube.com/watch?v=sKDjMFKrKRc

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