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ENGINEERING ECONOMICS

CHEMICAL ENGINEERING ECONOMICS
I.

INTRODUCTION

II.

PLANT DESIGN PROCESS

III.

GENERAL CONSIDERATIONS

IV.

CAPITAL INVESTMENT

V.

PRODUCT COST – ECONOMIC PRODUCTION

VI.

TIME VALUE OF MONEY

VII.

PROFITABILITY

VIII. ANALYSIS OF ALTERNATIVES
IX.

ANALYSIS OF REPLACEMENTS

X.

INFLATION

XI.

OPTIMIZATION

XII.

PROJECT MANAGEMENT

XIII. BASIC ACCOUNTING
XIV. COST CONTROL

I. INTRODUCTION

ENGINEERING ECONOMICS
RATIONAL DECISION MAKING PROCESS





STEP1: RECOGNIZE A DECISION PROBLEM
STEP2: DEFINE THE GOAL / OBJECTIVES
STEP3: COLLECT INFORMATION
STEP4: IDENTIFY FEASIBLE DECISION ALTERNATIVES
STEP5: DETERMINE THE DECISION CRITERIA
STEP6: SELECT THE BEST ALTERNATIVE

ENGINEERING ECONOMICS
PURCHASING A COMPUTER
•STEP1: DECISION PROBLEM – NEED A COMPUTER
•STEP2: GOALS – DURABILITY, LOW COST, POWERFUL
PROCESSING, OPERATION SYSTEM
•STEP3: INFORMATION – TECHNICAL & FINANCIAL DATA
•STEP4: FEASIBLE DECISION ALTERNATIVES – APPLE,
LENOVO, HP
•STEP5: DECISION CRITERIA – MINIMUM COST, MAXIMUM
DURABILITY, MAXIMUM PROCESSOR SPEED
•STEP6: BEST ALTERNATIVE - ?

ENGINEERING ECONOMICS .

THERE IS NO INVESTMENT OR PRODUCTION .ENGINEERING ECONOMICS • THE FINAL AIM OF ALL ACTIVITIES IN INDUSTRY IS TO HAVE REASONABLE PROFIT • WHEN THERE IS NO PROFIT.

ENGINEERING ECONOMICS * ANY PRODUCT DEVELOPED OR PRODUCED WHICH CANNOT BE MARKETED (SOLD) AT A PRICE ABOVE ITS COST IS A FAILURE * ENGINEERS SHOULD NEVER FORGET THAT ECONOMICS IS THE ONLY GUIDE IN INDUSTRY BECAUSE ALL ENGINEERING PRACTICES REQUIRE THE USE OF LARGE AMOUNT OF CAPITAL. PROCESS AND EQUIPMENT * RUNNING THE PLANT SHOULD BE QUIDED BY ECONOMIC PRINCIPLES IN INDUSTRY SO ENGINEERS SHOULD KNOW ENGINEERING ECONOMY . AND CAPITAL OWNERS EXPECT MAXIMUM RETURN ON THEIR CAPITAL INVESTED THEREFORE * SELECTION OF ALTERNATIVES TO ALLOCATE CAPITAL * DETERMINATION OF CAPACITY.

ENGINEERING ECONOMICS EFFICIENCY THE OBJECTIVE OF ENGINEERING IS TO GET THE GREATEST END RESULT PER UNIT OF RESOURCE EXPENDITUTE. . ECONOMIC EFFICIENCY = WORTH / COST ECONOMIC EFFICIENCIES CAN EXCEED UNITY AND MUST DO SO FOR ECONOMIC PROJECTS TO BE SUCCESSFUL. KILOWATTS OR KG. THESE ARE EXPRESSED IN TERMS OF ECONOMIC UNITS SUCH AS MONEY. ON THE FIRST LEVEL IS PHYSICAL EFFICIENCY EXPRESSED AS OUTPUT DIVIDED BY INPUTS OF SUCH PHYSICAL UNITS AS BTU’S. ON THE SECOND LEVEL ARE ECONOMIC EFFICIENCIES. PHYSICAL EFFICIENCY = OUTPUT / INPUT THIS KIND OF EFFICIENCY IS ALWAYS LESS THAN UNITY. ENGINEER MUST BE CONCERNED WITH TWO LEVELS OF EFFICIENCY.

‘ENGINEERING ECONOMICS’ IN 1930 : E.‘FINANCIAL PLANNING’ FISH .GRANT (USUALLY CALLED THE FATHER OF ENGINEERING ECONOMY) PUBLISHED ‘PRINCIPLES OF ENGINEERING ECONOMY’ .ENGINEERING ECONOMICS THE LITERATURE ON ENGINEERING ECONOMY STARTED BY WELLINGTON’S ‘THE ECONOMIC THEORY OF LOCATION OF RAILWAYS’ IN 1887 IN 1920 : GOLDMAN .L.

WHICH INVESTMENT ALTERNATIVE SHOULD BE SELECTED? * WHICH ONE OF SEVERAL COMPETING ENGINEERING DESIGNS SHOULD BE SELECTED? * SHOULD THE MACHINE (OR PROCESS) NOW IN USE BE REPLACED WITH A NEW ONE? .ENGINEERING ECONOMICS IN INDUSTRY AN ENGINEER MAY ENCOUNTER QUESTIONS LIKE: * HOW MUCH MONEY YOU NEED TO MAKE AN INVESTMENT? * IS THIS INVESTMENT OR PROJECT PROFITABLE OR NOT? * WITH LIMITED CAPITAL AVAILABLE.

OR SHOULD THE PLANT SUBCONTRACT (MAKE OR BUY) ? ENGINEERS SHOULD BE ABLE FIND THE CORRECT ANSWERS TO THESE QUESTIONS . KNOWING THAT INVESTMENT WILL BE NEEDED.ENGINEERING ECONOMICS * WOULD IT BE PREFERABLE TO PURSUE A SAFER COURSE OF ACTION OR TO FOLLOW A RISKIER ONE THAT OFFERS HIGHER POTENTIAL RETURNS? * HOW MANY UNITS OF PRODUCT HAVE TO BE SOLD BEFORE A PROFIT CAN BE MADE? * SHOULD A PLANT PRODUCE A PART IN ITS OWN FACILITY.

ENGINEERING ECONOMICS THE CORE OF ENGINEERING ECONOMICS IS DECISION MAKING BASED ON COMPARISONS OF THE WORTH OF ALTERNATIVE COURSES OF ACTION WITH RECPECT TO THEIR COSTS IN THIS COURSE WE WILL STUDY THE ECONOMIC PRINCIPLES THAT IS USED FOR DESIGNING PLANTS OR PROCESSES IN INDUSTRY AND GUIDE THE ENGINEERS IN THEIR DECISIONS. .

PLANT DESIGN PROCESS .II.

A PLANT DESIGN PROJECT MOVES TO COMPLETION THROUGH A SERIES OF STAGES: 1.PLANT DESIGN PROCESS DETERMINATION OF THE PROCESS AND CAPACITIES. PROCESS DEVELOPMENT (MAY INCLUDE LAB EXPERIMENT OR PILOT PLANT) 4. INSPECTION OF THE BASIC IDEA AND INITIAL ANALYSIS 2. MARKET SURVEY AND PRELIMINARY EVALUATION 3. SIZES AND KINDS OF PROCESS EQUIPMENT TO BE USED BEFORE THE CONSTRUCTION AND OPERATION OF A PLANT IS CALLED PROCESS DESIGN DEVELOPMENT OF A NEW PLANT OR PROCESS FROM CONCEPT EVALUATION TO PROFITABLE REALITY IS OFTEN AN ENORMOUSLY COMPLEX PROBLEM. FEASIBILITY STUDY AND ECONOMIC EVALUATION . PRELIMINARY DESIGN (INCLUDING THE NECESSARY INFORMATION TO ESTIMATE THE INVESTMENT AND PRODUCTION COST WITH A NARROW ERROR MARGIN) 5.

7. DECISION DETAILED ENGINEERING DESIGN PROCUREMENT ERECTION START-UP AND TRIAL RUNS PRODUCTION AFTER EACH PHASE OF THE DESIGN. 10. 9. . AN EVALUATION SHOULD BE MADE AND ENGINEERS SHOULD BE REALISTIC AND PRACTICAL.PLANT DESIGN PROCESS 6. COST ESTIMATES SHOULD BE MADE THROUGHOUT ALL THE EARLY STAGES USING VARIOUS COST ESTIMATION METHODS COVERING BOTH INVESTMENT COSTS AND PRODUCTION COSTS. DESIGN ENGINEERS SHOULD KEEP IN MIND THAT THE AIM OF INVESTING MONEY IS TO HAVE A RETURN COVERING THE TIME VALUE OF MONEY AND REASONABLE AFTER-TAX PROFIT. SHOULD ELIMINATE UNPROFITABLE VENTURES BEFORE THE DESIGN PROJECT APPROACHES ITS FINAL STAGES. 11. 8.

PLANT LOCATION AND LAYOUT 5. CONSUMER CHARACTERISTICS) 2. THE PREFERRED METHOD SHOULD BE THE ONE INVOLVING THE LEAST TOTAL COSTS. PRICE RANGE OF PRODUCTS.PROCESSES AND PRICES OF COMPETITORS) 3. AN IMPORTANT STAGE IN THE DESIGN PROCESS IS THE FEASIBILITY STUDY WHICH LEADS TO FINAL DECISION. PRODUCTION METHOD (PRELIMINARY DESIGN) 4. FEASIBILITY STUDY SHOULD CONTAIN: 1. MARKET SURVEY (PRESENT AND FUTURE DEMAND AND SUPPLY. THIS IS CALLED OPTIMUM DESIGN.PLANT DESIGN PROCESS WHEN THERE ARE SEVERAL ALTERNATIVE METHODS WHICH CAN BE USED FOR OBTAINING THE SAME RESULTS. COMPETITION (PRODUCTS. TECHNOLOGY AND PATENT SITUATIONS . NEW USES.

UTILITIES. 9. 16. 15. PACKAGING. 14. 10. PRODUCTION AND TEST EQUIPMENT) SALES METHODS AND REQUIREMENTS INVESTMENT COST PRODUCTION COST FINANCIAL ANALYSIS PROFIT AND RETURN ON INVESTMENT IMPLEMENTATION PLAN EXECUTIVE SUMMARY . 12. BUILDINGS. 7. 17. 11.PLANT DESIGN PROCESS 6. ORGANIZATION AND LABOR REQUIREMENTS RAW MATERIALS (COST AND AVAILABILITY) WASTE DISPOSAL AND SAFETY/SECURITY CONSIDERATIONS STORING. ADMINISTRATIVE FACILITIES. SERVICES. 8. SHIPPING REQUIREMENTS FACILITIES AND EQUIPMENT THAT SHOULD BE BUILT OR PURCHASED ( INCLUDING LAND. 13.

GENERAL CONSIDERATIONS .III.

YOU SHOULD CONSIDER: * RAW MATERIALS ( AVAILABILITY. TRANSPORTATION EXPENSE) * MARKET ANALYSIS * POWER AND FUEL (AVAILIBILITY. WATER SUPPLY * TRANSPORTATION FACILITIES * WASTE DISPOSAL SITUATION * LABOR (AVAILABILITY. NATURAL EVENTS (FLOOD. PLANT LOCATION THE PLANT SHOULD BE LOCATED WHERE THE MINIMUM TOTAL COST OF PRODUCTION AND DISTRIBUTION CAN BE OBTAINED. COST.EARTQUAKE). PRICE. COMPETITION) * TAX BENEFITS * COMMUNITY FACTOR (LIVING CONDITIONS. SOCIAL FACILITIES) . PRICE) * LAND PRICE. PURITY. EXPANSION FACTOR * CLIMATE. FIRST GENARAL LOCATION THEN EXACT SITE SHOULD BE DETERMINED.GENERAL CONSIDERATIONS 1. SOIL STRUCTURE.

SAFETY. PLANT LAYOUT BESIDES THE BASIC PROCESS. FIRE PROTECTION * WASTE DISPOSAL * STORAGE * TRANSPORTATION * SECURITY . SERVICES. YOU SHOULD CONSIDER: * MINIMUM MATERIAL FLOW * OPERATIONAL CONVENIENCE * UTILITIES. ADMINISTRATIVE FACILITIES * HEALTH.GENERAL CONSIDERATIONS 2.

APPLYING QUALITY ASSURANCE. INSTRUMENTATION A ‘QUALITY PLAN’ SHOULD BE MADE. MINIMIZING THE CONTROLS. THE LABORATORIES AND KIND OF EQUIPMENT TO BE USED FOR QUALITY ASSURANCE SHOULD BE DECIDED BEFORE FINAL DESIGN USE BUILT-IN-TESTERS WHERE POSSIBLE 4. MAINTENANCE MAINTENANCE REQUIREMENTS AND PLANS SHOULD BE CONSIDERED BEFORE LAYOUT AND COST CALCULATION TOTAL PRODUCTIVE MAINTENANCE (TPM) SHOULD BE APPLIED .GENERAL CONSIDERATIONS 3.

GENERATORS) SHOULD BE CONSIDERED DURING DESIGN 6. FLOORS SHOULD BE DESIGNED TO BE RESISTANT TO CHEMICALS. FUEL AND WATER ARE MAJOR COST ITEMS IN MOST CHEMICAL INDUSTRIES.GENERAL CONSIDERATIONS 5. UTILITIES ELECTRICITY. STORAGE TANKS. ALTERNATIVES AND NECESSARY FACILITIES (PIPING. STRUCTURAL DESIGN FOUNDATION DESIGN IS ESPECIALLY IMPORTANT FOR HEAVY AND VIBRATING EQUIPMENT. CORROSIVE EFFECTS SHOULD BE CONSIDERED WHEN CHOOSING CONSTRUCTION MATERIAL 7. STORAGE STORAGE SPACE. EASY TO CLEAN AND SAFE. PROPER EQUIPMENT FOR GASES AND LIQUIDS AND SAFETY IS IMPORTANT . THE SUPPLY METHODS.

ELEVATORS. PUMPS. WASTE DISPOSAL . TRUCKS AND PNEUMATIC SYSTEMS ARE USED FOR SOLIDS. DUCTS ARE USED FOR LIQUIDS AND GASES. HEALTH AND SAFETY CAREFULL ANALYSIS SHOULD BE MADE DURING THE DESIGN TO PREVENT HAZARDOUS ENVIRONMENT OR FIRE AND ACCIDENT POTENTIALS 11. PROPER EQUIPMENT SHOULD BE CHOSEN CONSIDERING PROPERTIES OF MATERIALS. MATERIALS HANDLING IMPORTANT COST IN CHEMICAL INDUSTRY. PIPES.AIR POLLUTION IMPORTANT COST IN CHEMICAL INDUSTRY. BLOWERS. TRY TO ELIMINATE AT SOURCE OR RECOVER BEFORE WASTE TREATMENT 10. PATENTS A NEW DESIGN SHOULD BE EXAMINED TO MAKE CERTAIN NO PATENT INFRINGEMENTS ARE INVOLVED .GENERAL CONSIDERATIONS 8. TYPE AND DISTANCE OF MOVEMENT AND COST 9.

IV. CAPITAL INVESTMENT .

CASH FLOW TAX GROSS SALES NET PROFIT + DEPRECIATION PROFIT OPERATIONS WORKING EXPENSES CAPITAL FIXED CAPITAL TOTAL CAPITAL INVESTMENT REPAYMENTS DISTIBUTED PROFIT CAPITAL SOURCE AND SINK OTHERS CAPITAL BONDS LOANS .

INPUT IS WORKING CAPITAL AND SALES. BONDS SOLD. TAX IS PAID FROM THE GROSS PROFIT AND THE REST (NET PROFIT + DEPRECIATION) GOES TO THE TREASURY.CASH FLOW THE BOX “CAPITAL SOURCE…” IS THE COMPANY TREASURY SERVING AS RESERVOIR AND SOURCE OF NECESSARY FUNDS. NET PROFIT + DEPRECIATION COMING FROM OPERATIONS AND OTHERS ( SALES OF ASSETS. THE BOX “OPERATIONS” IS THE PRODUCTION. THE OUT GOING MONEY IS THE TOTAL INVESTMENT. THE INPUTS OF THIS BOX ARE CAPITAL PAID BY THE STOCKHOLDERS. OUT GOING MONEY IS THE EXPENSES (ALL COSTS EXCEPT DEPRECIATION) AND GROSS PROFIT. BACK PAYMENTS OF BORROWED MONEY AND PROFIT DISTRIBUTED. . PROFIT OF OTHER OPERATIONS…). ENGINEERING. MARKETING … ACTIVITIES OF THE COMPANY. LOANS FROM BANKS.

salvage.working capital recovery Cumulative cash position Construction period -2 -1 0 1 2 3 4 5 6 7 8 9 10 FC Investment Book value of investment WC Investment Years . $ Land.CASH POSITION Cumulative cash position.

THE DEPRECIATION IS 10 YEAR STRAIGHT.LINE DEPRECIATION. AT TIME ZERO WE HAVE THE WORKING CAPITAL AS A NEGATIVE VALUE. AFTER TIME ZERO. LAND. .CASH POSITION ASSUMING THAT THE CONSTRUCTION STARTS TWO YEARS BEFORE THE PRODUCTION. DEPENDING ON THE PROFIT. CUMULATIVE CASH POSITION = NET PROFIT AFTER TAX + DEPRECIATION – TOTAL CAPITAL INVESTMENT. THE CASH POSITION STARTS GOING UP. CASH POSITION GOES DOWN TO NEGATIVE VALUES AS WE SPEND FOR THE FIXED INVESTMENT. CUMULATIVE CASH POSITION GOES TO POSITIVE VALUES AFTER SEVERAL YEARS. SALVAGE VALUE OF THE PLANT AND THE WORKING CAPITAL ARE RECOVERED AT THE END OF THE PROJECT.

IN AN ANALYSIS OF COSTS IN INDUSTRIAL PROCESSES. ENGINEERS SHOULD BE AWARE OF ALL TYPES OF COSTS INVOLVED IN THE INDUSTRY.COST A PLANT DESIGN MUST PRESENT A PROCESS THAT IS CAPABLE OF OPERATING UNDER CONDITIONS WHICH YIELD A PROFIT. SINCE PROFIT EQUALS INCOME MINUS COSTS. * CAPITAL INVESTMENT COST AND * PRODUCTION COST MUST BE TAKEN INTO CONSIDERATION .

CAPITAL INVESTMENT BEFORE AN INDUSTRIAL PLANT CAN BE PUT INTO OPERATION. EQUIPMENT AND BUILDINGS. THE SUM OF ALL THESE AMOUNTS IS CALLED TOTAL CAPITAL INVESTMENT. AN ADDITIONAL AMOUNT OF MONEY IS REQUIRED TO START THE PRODUCTION. BUILDINGS. UTILITIES. A LARGE AMOUNT OF MONEY MUST BE SUPPLIED TO PURCHASE AND INSTALL THE NECESSARY MACHINERY. PROCESS AND CONTROL EQUIPMENT AND INSTALLATION * WORKING CAPITAL COVERS THE EXPENSES NECESSARY FOR THE OPERATION OF THE PLANT . TOTAL CAPITAL INVESTMENT HAS TWO COMPONENTS: * FIXED CAPITAL INVESTMENT COVERS LAND.

CAPITAL INVESTMENT BREAKDOWN OF FIXED CAPITAL INVESTMENT DIRECT COSTS 1. INSULATION 6. YARD IMPROVEMENTS 9. R& D. LAND INDIRECT COSTS 12. ENGINEERING AND SUPERVISION 13. DISTRIBUTION. ELECTRICAL 7. CONTRACTOR’S FEE 14. OTHER COSTS (START . LICENSE) . PURCHASED EQUIPMENT INSTALLATION 3. SERVICE FACILITIES 11. PIPING 5.UP. PURCHASED EQUIPMENT 2. UTILITIES 10. CONTINGENCY 15. BUILDINGS 8. INSTRUMENTATION AND CONTROLS 4.

30%) TO A DETAILED ESTIMATE PREPARED FROM COMPLETE DRAWINGS AND SPECIFICATIONS (+/.CAPITAL INVESTMENT AN ESTIMATE OF THE CAPITAL INVESTMENT FOR A PROCESS MAY VARY FROM A PREDESIGN ESTIMATE BASED ON LITTLE INFORMATION (+/. . PREDESIGN COST ESTIMATES ARE EXTREMELY IMPORTANT FOR DETERMINING IF A PROPOSED PROJECT SHOULD BE GIVEN FURTHER CONSIDERATION AND TO COMPARE ALTERNATIVE DESIGNS.5%). ONCE THE EQUIPMENT COST IS DETERMINED. THE OTHER COST ITEMS OF THE PLANT CAN BE ESTIMATED USING PERCENTAGES AND PREVIOUS DATA. EQUIPMENT COST ESTIMATES ARE USUALLY THE FIRST STEP FOR MORE DETAILED PLANT COST ESTIMATES.

LITERATURE .CAPITAL INVESTMENT PLANT COST ESTIMATION ITEMS: 1.ESTIMATING CHARTS * PRICE CHARTS FOR DIFFERENT PROCESS EQUIPMENT IS AVAILABLE IN LITERATURE AS PRICE vs CAPACITY. BESIDES PRICE. MANUFACTURERS’ QUOTATIONS ACCURATE AND PREFERABLE METHOD. THESE ARE ROUGH COST ESTIMATES . USEFULL TECHNICAL INFORMATION CAN BE OBTAINED BUT NEEDS TIME AND AUTHORIZATION AND DESIGN DETAILES MAY BE REQUIRED BY EQUIPMENT MANUFACTURERS. B. PURCHASED EQUIPMENT COST (PEC) ESTIMATION EQUIPMENT COST IS USUALLY 20-30% OF THE TOTAL PLANT COST IN CHEMICAL INDUSTRIES AND IS EITHER FOUND BY QUOTATIONS OR BY USING CHARTS. A.

6 0R 0.CAPITAL INVESTMENT EQUIPMENT COST DATA ARE CORRELATED ON LOG-LOG PLOTS AS FUNCTIONS OF EQUIPMENT SIZE PARAMETER (HEAT TRANSFER AREA FOR HEAT EXCHANGERS. WHICH IS EQUIVALENT TO THE EQUATION C2 / C1 = (S2 / S1)n WHERE C IS COST. . WORKING CAPACITY FOR MIXERS…).7 FOR MANY TYPES OF EQUIPMENT. S IS SIZE AND n IS SLOPE ON THE LOG-LOG PLOT. OVER A LIMITED RANGE OF SIZES THE LOG-LOG CURVE CAN BE APPROXIMATED BY A STRAIGHT LINE. THE VALUE OF n IS FREQUENTLY AROUND 0.

.6  C2 = C1 (S2 / S1)0. THE SIX-TENTH-RULE MAY BE USED MORE RELIABLY FOR A TOTAL PROCESS. THE LOWER THE COST OF EQUIPMENT PER UNIT OF CAPACITY.52 C1 THIS SIMPLE EXAMPLE SHOWS THAT WHEN YOU DOUBLE THE CAPACITY.CAPITAL INVESTMENT IF WE ASSUME THAT n = 0.6 WHICH IS REFERRED AS SIX-TENTHS-RULE.6 C2 = C1 (2 / 1)0. EXAMPLE: USE THE SIX-TENTHS-RULE TO ESTIMATE THE % INCREASE IN PURCHASED COST WHEN THE CAPACITY OF A PIECE OF EQUIPMENT IS DOUBLED.6 THAN THE RELATION BECOMES: C2 / C1 = (S2 / S1)0. WHEN ESTIMATING THE COST OF A SINGLE EQUIPMENT IT IS SAFER TO USE SPECIFIC COST EXPONENTS. C2 = C1 (S2 / S1)0. THE COSTS OF EQUIPMENT INCREASES ONLY 52%.6 C2 = 1. SO WE CAN STATE : THE LARGER THE EQUIPMENT.

. ENGINEERING AS WELL AS COMPOSITE PLANT COST INDEX (CEPCI). CONSTRUCTION LABOR. PROCESS MACHINERY. THIS IS ACCOMPLISHED WITH COST INDICES USING THE RELATION Cost in year m Cost in year n = Index value for year m Index value for year n EQUIPMENT COST INDEX IS PUBLISHED MONTHLY IN Chemical Engineering. SINCE COSTS CHANGE WITH TIME. PUBLISHED COST DATA MUST BE CORRECTED TO THE PRESENT YEAR. PIPES …). INDEX VALUES ARE GIVEN FOR VARIOUS CATEGORIES OF EQUIPMENT (HEAT EXCHANGERS.CAPITAL INVESTMENT ANY COST DATA REFER TO A PARTICULAR YEAR AND IT IS NECESSARY TO KNOW THIS YEAR BEFORE THE DATA ARE USED. BUILDINGS.

223.000 TONS/YEAR IN 2004.61 COST INDEX NOW : 580 COST INDEX 8 YEARS AGO: 520 COST OF THE NEW PUMP = (1000)(580/520) (6/4)0.000 EXAMPLE :ASSUME A PUMP (4 hp) WAS BOUGHT FOR $1000 EIGHT YEARS AGO AND YOU WILL BUY A NEW PUMP (6 hp) NOW. COST IN 2004 = (COST IN 1986) (CAPACITY COR.000 TONS/YEAR ISOPROPONAL PLANT IN 1986 WAS ESTIMATED TO BE $7 MILLION. ESTIMATE THE CAPITAL COST OF A NEW PLANT WITH A PRODUCTION RATE OF 50. EXPONENT FOR SIZE OF PUMPS = 0.) (INFLATION COR.61 = $1428 .CAPITAL INVESTMENT EXAMPLE: THE CAPITAL COST OF A 30.) THE CEPCI IS 318 FOR YEAR 1986 AND 442 FOR YEAR 2004 COST IN 2004 = $7.000.000 ( 50/30)0.6 (442/318) = $13.

FOB OR EX-WORKS PRICE FREIGHT CHARGES (DEPENDS ON DISTANCE – VEHICLE) INSURANCE ANY OTHER CHARGES ( SPECIAL PACKING. DOCUMENT. THE EFFECT OF BETTER MATERIAL AND HIGHER PRESSURES ON THE COST OF THE EQUIPMENT SHOULD BE FOUND AND NECESSARY CORRECTIONS SHOULD BE MADE. THE COSTS FOUND THROUGH QUOTATIONS OR LITERATURE ARE USUALLY THE PRICE OF THE EQUIPMENT. ALL ADDITIONAL COSTS NECESSARY TO BRING THE EQUIPMENT TO THE FACTORY SITE SHOULD BE ADDED. TRAINING…) TOTAL CIF(ANKARA) PRICE .CAPITAL INVESTMENT THE DATA IN LITERATURE IS USUALLY FOR EQUIPMENT MADE FROM MOST COMMON MATERIAL AND USED IN AMBIENT PRESSURE.

5 17575 .CAPITAL INVESTMENT PROFORMA INVOICE 100000 92500 6937.

CAPITAL INVESTMENT 7500 7500 .

CAPITAL INVESTMENT 2. INSTALLATION COST OF EQUIPMENT THE INSTALLATION OF EQUIPMENT INVOLVES COSTS FOR LABOR.SUPPORTS. INSTRUMENTATION AND CONTROL TOTAL INSTRUMENTATION COST DEPENDS ON THE AMOUNT OF CONTROL REQUIRED (QUALITY PLAN OF THE COMPANY) AND MAY AMOUNT TO 6-30 % OF THE PEC . PLATFORMS. CONSTRUCTION EXPENSES AND OTHER FACTORS DIRECTLY RELATED TO THE ERECTION OF PURCHASED EQUIPMENT. IT IS ESTIMATED TO VARY FROM 30 TO 45% OF THE PEC 3. FOUNDATIONS.

PIPES. ELECTRICAL INSTALLATIONS POWER WIRING. 5. INSTRUMENTCONTROL WIRING ARE THE MAIN COSTS. STEAM. WAREHOUSES. INSULATION COST WHEN HIGH OR LOW TEMPERATURES ARE INVOLVED. 6. IT COVERS VALVES. PIPING ONE OF THE IMPORTANT COSTS IN CHEMICAL INDUSTRIES. FITTINGS. SOCIAL BUILDINGS. BUILDINGS 40 –70% OF PEC INCLUDING ADMINISTRATIVE SERVICES. INTERMEDIATE PRODUCTS. LABS. TRANSFORMATION. INCREASING ENERGY COSTS MAKE INSULATION MORE IMPORTANT. MAINTENANCE FACILITIES . IT IS 15 – 70 % OF PEC. ADDING UP TO 10 – 15%OF PEC 7. SUPPORTS AND LABOR OF PIPING USED FOR RAW MATERIALS. INSULATION COST IS IMPORTANT. AIR. LIGHTING.CAPITAL INVESTMENT 4. WASTE. PRODUCTS. IT IS 2 – 8% OF PEC.

DRAFTING. ENGINEERING AND SUPERVISION. 20 – 40% OF PEC 11. TELEPHONE AND WASTE DISPOSAL. ABOUT 35% OF PEC . FENCING. COMPRESSED AIR. ENGINEERING AND SUPERVISION COSTS FOR CONSTRUCTION DESIGN. MATERIAL HANDLING AND PACKAGING EQUIPMENT. SAFETY AND MEDICAL EQUIPMENT. 30 – 60% OF PEC 10. FUEL. UTILITIES INCLUDE GENERAL SERVICES REQUIRED TO OPERATE THE PLANT SUCH AS WATER. PURCHASING. FIRE PROTECTION. EMERGENCY GENERATOR. STEAM. HOUSE KEEPING EQUIPMENT.CAPITAL INVESTMENT 8. LAND 4 – 8% OF PEC 12. CAFETERIA EQUIPMENT. SERVICE FACILITIES OFFICE FURNITURE. YARD IMPROVEMENTS LANDSCAPING. ABOUT 10 – 15% OF PEC 9. SIDEWALKS. ROADS. PARKING. ELECTRICITY.

CONTRACTORS FEE VARIES BETWEEN 2 – 6% OF FIXED CAPITAL INVESTMENT 15. 5 – 10% OF FIXED CAPITAL INVESTMENT 16. OFFICES USED DURING CONSTRUCTION. LICENSE FEES ARE THE OTHER COSTS THAT SHOULD BE CONSIDERED . CONSTRUCTION TOOLS. OFF-SITE FACILITIES LIKE DISTRIBUTION CENTERS AND OFFICES. ROADS. RESEARCH AND DEVELOPMENT DEPARTMENTS. CHANGES). OTHER COSTS COSTS FOR PLANT START-UP (TRIALS. CONTINGENCY UNPREDICTABLE COSTS. CONSTRUCTION EXPENCES THE COST OF TEMPORARY FACILITIES.CAPITAL INVESTMENT 13. UP TO 30% OF PEC 14. SECURITY EXPENCES.

CAPITAL INVESTMENT
METHODS FOR ESTIMATING FIXED CAPITAL INVESTMENT
THERE ARE DIFFERENT METHODS THAT CAN BE USED.
IN DECREASING DETAIL, PREPARATION TIME AND ACCURACY
THEY CAN BE SUMMARIZED AS:
METHOD A – DETAILED ITEM ESTIMATE
ALL ITEMS ARE DESIGNED AND DETERMINED ACCURATELY; SITE
SURVEYS ARE MADE, QUOTATIONS FOR EQUIPMENT AND
SERVICES ARE OBTAINED, ALL ITEMS ARE SPECIFIED FOR
PRICING INCLUDING LABOR.
VERY TIME CONSUMING AND EXPENSIVE WORK.
USUALLY DONE AT THE FINAL STAGE OR BY THE CONTRACTORS
FOR QUOTING. +/- 5% ACCURACY CAN BE OBTAINED

CAPITAL INVESTMENT
METHOD B: MODULE COSTING TECHNIQUE
FIND THE BASE CASE COST (C0P) OF EACH EQUIPMENT FROM
LITERATURE. BASE CASE MEANS, EQUIPMENT MADE OF THE
MOST COMMON MATERIAL (USUALLY CARBON STEEL) AND
OPERATING AT NEAR AMBIENT PRESSURE.
FIND THE BARE MODULE FACTOR (F0BM) WHICH IS THE
MULTIPLICATION FACTOR TO ACCOUNT FOR OTHER ASSOCIATED
COSTS (PIPING, INSULATION, FOUNDATIONS, SUPPORTS,
INSTRUMENTATION AND ELECTRICAL, LABOR FOR INSTALLATION,
TRANSPORTATION, ENGINEERING AND PROJECT MANAGEMENT).
NOW YOU CAN CALCULATE BARE MODULE COST AT BASE
CONDITIONS FOR EACH EQUIPMENT:
C0BM = C0P F0BM

CAPITAL INVESTMENT
FOR EQUIPMENT MADE FROM OTHER MATERIALS OF
COSTRUCTION ( STAINLESS STEEL, ALUMINUM, TITANIUM …)
AND/ OR OPERATING AT NONAMBIENT PRESSURE, YOU SHOULD
MAKE THE NECESSARY CORRECTIONS.
FIND FBM WHICH IS THE MULTIPLICATION FACTOR TO ACCOUNT
FOR ASSOCIATED COSTS PLUS THE SPECIFIC MATERIALS OF
CONSTRUCTION AND OPERATING PRESSURE. THIS IS FOUND
FROM LITERATURE. THE BARE MODULE EQUIPMENT COST CAN
NOW BE CALCULATED:
CBM = C0P FBM

CAPITAL INVESTMENT
EXAMPLE: FIND THE BARE MODULE COST OF A FLOATING-HEAD
SHELL-AND-TUBE HEAT EXCHANGER WITH A HEAT TRANSFER
AREA OF 100 m2. THE OPERATING PRESSURE IS 100 barg AND
MATERIAL OF CONTRUCTION IS STAINLESS STEEL.
C0P = 250 $/ m2 x 100 m2 = $ 25,000 ; YEAR 2001 (Turton, Appendix A)
FBM = B1 + B2FMFP = 1.63 + 1.66 (2.73) (1.383) = 7.9
ALL THE CONSTANTS ARE FOUND FROM Turton, Appendix A
CBM = C0P x FBM = 25,000 x 7.9 = $197,500
197,500 x 468 / 397 = $232,821 AT YEAR 2005, FEBRUARY

CAPITAL INVESTMENT
WHEN FINDING THE TOTAL COST OF AN ALTERATION OR A NEW
PLANT YOU SHOULD CONSIDER THE ADDITIONAL COSTS.
TOTAL MODULE COST(CTM) : THE COST OF MAKING EXPANSIONS OR
ALTERATIONS TO AN EXISTING PLANT. YOU SHOULD ADD
CONTRACTORS FEE AND CONTINCENCY (18%):
CTM = 1.18  CBM, i
WHERE CBM IS THE BARE MODULE COST OF EACH EQUIPMENT USED
IN THE ALTERATION AND i = 1 TO n.
GRASS ROOTS COST(CGR) : THE COST OF MAKING A NEW FACILITY.
YOU SHOULD ADD LAND, YARD IMPROVEMENT, UTULITIES,
ADMINISTRATIVE AND SERVICE FACILITIES AND BUILDINGS. THESE
ARE GENERALLY UNEFFECTED BY MATERIAL OR PRESSURE AND IS
TAKEN AS 50% OF C0BM
CGR = CTM + 0.50  C0BM, i
WHERE C0BM IS THE BARE MODULE COST OF EACH EQUIPMENT AT
BASE CONDITIONS USED IN THE NEW PLANT AND i = 1 TO n.

FCI = (PEC) (LANG FACTOR). Cn = C (R)X R: CAPACITY RATIO. C: CAPITAL INVESTMENT FOR X THERE IS DATA FOR DIFFERENT INDUSTRIES. GREATER ACCURACY IS OBTAINED BY USING MORE THAN ONE FACTOR. 3.0.8 n n . DIFFERENT FACTORS FOR DIFFERENT KINDS OF EQUIPMENT (4 FOR PUMPS.6. ALL OTHER ITEMS ARE THEN ESTIMATED AS PERCENTAGE OF PEC. IN AVARAGE IT IS 0.5 FOR HEAT EXCHANGERS) METHOD E – POWER FACTOR THE CAPITAL INVESTMENT OF A NEW PLANT CAN BE FOUND BY GETTING THE EXPONENTIAL POWER OF A SIMILAR PREVIOUS PLANT INVESTMENT. THERE IS DATA AVAILABLE FOR AVERAGE PERCENTAGE VALUES FOR DIFFERENT TYPES OF INDUSTRIES METHOD D – ‘LANG’ FACTORS FOR APPROXIMATION MULTIPLY PEC BY A FACTOR TO OBTAIN FIX CAPITAL INVESTMENT COST (USUALLY 4 – 6).CAPITAL INVESTMENT METHOD C – PERCENTAGE OF PURCHASED EQUIPMENT COST DETERMINE THE PURCHASED EQUIPMENT COST.

FOR CHEMICAL INDUSTRIES IT IS ABOUT 0.CAPITAL INVESTMENT METHOD F – COST PER UNIT OF CAPACITY THERE IS DATA GIVING THE FIXED CAPITAL INVESTMENT REQUIRED PER ANNUAL TON OF A PRODUCT METHOD G – TURNOVER RATIO FIXED CAPITAL INVESTMENT = ANNUAL SALES / TURNOVER RATIO TURNOVER RATIO IS BETWEEN 0.4 – 3 IN GENERAL.5 .

TAXES AND ALL OTHER EXPENSES . WORKING CAPITAL CONSISTS OF * RAW MATERIALS AND SUPPLIES CARRIED IN STOCK * SEMIFINISHED PRODUCTS IN THE PROCESS * FINISHED PRODUCTS NOT SOLD YET * ACCOUNTS RECEIVABLE * CASH REQUIRED FOR WAGES.CAPITAL INVESTMENT WORKING CAPITAL (WC) EVERY PLANT HAS A REQUIREMENT FOR A CERTAIN AMOUNT OF CAPITAL TO BE AVAILABLE TO PAY THE BILLS AND SUSTAIN THE OPERATION BEFORE THE PRODUCT IS SOLD AND PAYMENT IS RECEIVED.

WC = (ANNUAL PRODUCTION COST / 12) (TOTAL LEAD TIME IN MONTHS) .CAPITAL INVESTMENT FOR MOST CHEMICAL PLANTS WORKING CAPITAL IS ABOUT 10 – 20% OF TOTAL CAPITAL INVESTMENT. A MUCH MORE RELEVANT METHOD OF ESTIMATING WORKING CAPITAL IS TAKING A FRACTION OF THE YEARLY PRODUCTION COST AND IT MAY TYPICALLY BE 20 – 35% OF THE YEARLY OPERATING COSTS.

NO INCREASE OF CAPACITY AND NO PROBLEM IN SELLING WHAT WE PRODUCE IN INDUSTRY IT IS IMPORTANT TO DECREASE THE WORKING CAPITAL REQUIREMENT SINCE FINANCIAL COSTS INCREAE WITH INCREASING WORKING CAPITAL ‘JUST IN TIME’ OPERATING METHODS AND GOOD PLANNING MAY BE EFFECTIVE IN DECREASING THE WORKING CAPITAL .CAPITAL INVESTMENT WE NEED THE WORKING CAPITAL ONLY IN THE BEGINNING OF PRODUCTION SINCE WE ASSUME NO INFLATION.

PRODUCT COST – ECONOMIC PRODUCTION .V.

DURING THE PRODUCTION PHASE. MAINTENANCE AND REPAIR 5. LABORATORY CHARGES 6.PRODUCT COST CONSISTS OF MANUFACTURING COSTS AND GENERAL EXPENSES. PRODUCT COST SHOULD BE CALCULATED AND CONTROLLED CONTINUOUSLY SINCE COST IS ONE OF THE MAIN FACTORS DETERMINING THE SUCCESS OF AN INDUSTRY. PRODUCT COST MANUFACTURING COST 1. OPERATION AND SUPERVISION LABOR 3. OPERATING SUPPLIES. RAW MATERIALS 2. PATENTS AND ROYALTIES . UTILITIES 4. PRODUCT COST SHOULD BE ESTIMATED DURING DESIGN PHASE IN ORDER TO CALCULATE RETURN ON INVESTMENT AND PROFITABILITY AND DECIDE ON ALTERNATIVES.

FINANCING COSTS OTHER 16. 8. ADMINISTRATIVE EXPENSES 13. 10. 9. PLANT OVERHEAD COSTS RENT INSURANCE PROPERTY TAXES AND OTHER DUTIES DEPRECIATION GENERAL EXPENSES 12. CONTINGENCIES . 11. RESEARCH AND DEVELOPMENT COSTS 15. DISTRIBUTION AND MARKETING COSTS 14.PRODUCT COST 7.

TREATING AGENTS.PRODUCT COST PRODUCT COST ITEMS 1.SF. TRANSPORTATION AND OTHER COSTS. BESIDES THE MAIN MATERIALS. LOSES AND INEFFICIENCIES. WHICH IS ‘DAYS OF OPERATION / 365’ AND IS MOSTLY LESS THEN 0.9). IT IS IMPORTANT TO FIND CORRECT MATERIAL COSTS IN ORDER TO MAKE REALISTIC EVALUATIONS. SINCE THE LARGEST OPERATING COST IS NEARLY ALWAYS THE COST OF RAW MATERIALS IN CHEMICAL PLANTS. WHEN CONVERTING HOURLY RATES TO YEARLY CONSUMPTION. PRICE FOR MATERIALS CAN BE FOUND FROM LITERATURE OR QUOTATIONS. YOU SHOULD ALSO CONSIDER SCRAPS. . THE FRACTION OF TIME THAT THE PLANT IS OPERATING IN A YEAR MUST BE KNOWN (CALLED STREAM FACTOR. YOU SHOULD ADD ALL EXPENSES TO THE FACTORY: INSURANCE. RAW MATERIALS: AMOUNT OF MATERIALS USED IN THE PLANT SHOULD BE FOUND FROM PROCESS FLOW DIAGRAMS. CATALYSTS AND FILTER AIDS SHOULD BE CALCULATED.

56 OPERATORS SHOULD BE HIRED FOR EACH OPERATOR NEEDED. MOST CHEMICAL PLANTS WORK 24 HOURS A DAY AND 365 DAYS A YEAR. LABOR REQUIREMENT FOR DIFFERENT PROCESSES CAN BE FOUND FROM LITERATURE.PRODUCT COST 2. OPERATION AND SUPERVISION LABOR NUMBER OF PEOPLE (SKILLED AND UNSKILLED) REQUIRED FOR MANUFACTURING SHOULD BE CALCULATED. . ONE WORKER: 48 WEEKS/YEAR x 5 DAYS/WEEK x 8 HOURS/DAY : 1920 HOURS/ YEAR 365 DAYS/YEAR x 24 HOURS/DAY = 8760 HOURS/YEAR 8760 / 1920 = 4. WHEN CALCULATING TOTAL NUMBER OF OPERATORS YOU SHOULD KNOW NUMBER OF SHIFTS AND WORKING HOURS.56 THAT MEANS FOR SUCH A PLANT 4.

40 + 0. AVERAGE WAGE RATES ARE REQUIRED.70) . THE AMOUNT OF SUCH PEOPLE FOR EACH SHIFT SHOULD BE FOUND FROM LITERATURE OR PREVIOUS EXPERIENCES. THE AVERAGE NET WAGES MAY SHOW SIGNIFICANT VARIATIONS DEPENDING ON PLANT LOCATION AND TYPE OF WORK. COST TO COMPANY = (NET WAGE)+(TAX)+(SOCIAL SECURITY)+(OTHERS) IN AVERAGE YOU CAN USE THE FOLLOWING FIGURES: COST TO COMPANY = (NET WAGE)(1+ 0. TO ESTIMATE THE COST FOR LABOR.PRODUCT COST BESIDES THE OPERATING LABOR YOU NEED SUPPORT AND SUPERVISORY STAFF (TECHNICIANS.20 + 0. BUT WHEN CALCULATING THE COSTS YOU SHOULD ALWAYS CONSIDER ADDITIONAL EXPENSES ON THE NET WAGE. ENGINEERS) IN THE MANUFACTURING PROCESS.10) COST TO COMPANY = (NET WAGE)(1.

COMPRESSED AIR AND WASTE TREATMENT IN CHEMICAL INDUSTRIES IS A CONSIDERABLE PERCENTAGE OF THE PRODUCT COST. COMPRESSED AIR. ELECTRICITY AND WATER WHICH CAN BE FOUND FROM RELATED ORGANIZATIONS.UTILITIES: THE COST OF ELECTRICITY. WATER. LPG AND FUEL OIL ARE THE OTHER (MORE EXPENSIVE) ALTERNATIVES. THERE ARE LOCAL RATES FOR FUEL. STEAM. MOST OF THE UTILITIES COST IS INFLUENCED BY THE COST OF FUEL. IN TURKEY. COOLING WATER AND WASTE TREATMENT CAN BE CALCULATED OR FOUND FROM LITERATURE.PRODUCT COST 3. . THE COSTS FOR STEAM. FUEL. COAL AND NATURAL GAS ARE THE CHEAPEST. BUT COAL HAS HANDLING AND ENVIRONMENTAL PROBLEMS AND NATURAL GAS MAY NOT BE AVALIABLE.

CAFETERIA. LABORATORY CHARGES: MATERIAL WHICH IS NOT LISTED SEPARATELY BUT NEEDED FOR PRODUCTION (LUBRICANTS. PACKAGING ETC. MAINTENANCE AND REPAIRS: DEPENDS ON THE QUALITY OF EQUIPMENT INVESTED AT THE BEGINNING AND INCREASES AS THE PLANT GETS OLDER. SAFETY. SHOULD BE CALCULATED CASE BY CASE. LABORATORY CHARGES INCLUDE QUALITY CONTROL FUNCTIONS FOR INCOMING INSPECTION. TEST CHEMICALS…) ARE OPERATING SUPPLIES. PLANT OVERHEAD COSTS: INCLUDE COSTS FOR MEDICAL CARE. SECURITY.PRODUCT COST 4. OPERATING SUPPLIES. PATENTS AND ROYALTIES: EITHER TO PAY A SET AMOUNT OF PATENT RIGHTS OR A ROYALTY ON THE QUANTITY PRODUCED OR SOLD MAY BE REQUIRED. 2 – 10% OF FIXED CAPITAL COST 5. CLEANING. 7. GENERAL ENGINEERING. CAN BE CALCULATED ITEM BY ITEM IF DATA IS AVAILABLE OR ESTIMATED AS 10 – 15% OF TOTAL PRODUCT COST . PRODUCTION CONTROL AND FINAL PRODUCT CONTROL. CAN BE ESTIMATED AS 10 – 20% OF OPERATING LABOR 6. STORAGE.

YOU CAN DEPRECIATE ALL FIXED INVESTMENT EXCEPT LAND . AVARAGE %1 ANNUALY OF INSURED VALUE 10. GOVERNMENT ALLOWS A DEDUCTION FOR A FRACTION OF THE INITIAL COST OF THE PLANT AS A ‘HYPOTHETICAL EXPENSE’ TO BE SUBTRACTED FROM THE GROSS PROFIT. THIS DEDUCTION. MAY BE CONSIDERED AS A FUND TO ALLOW EVENTUAL REPLACEMENT OF THE PLANT. CALLED DEPRECIATION.PRODUCT COST 8. RENT: IF THERE IS RENTED LAND OR BUILDINGS 9. IN COMPUTING INCOME TAX ON THE PROFIT. DEPRECIATION: MEANS OF DISTRIBUTING THE ORIGINAL EXPENSE FOR A PHYSICAL ASSET OVER THE PERIOD DURING WHICH THE ASSET IS IN USE. PROPERTY TAXES AND OTHER DUTIES: SHOULD BE CALCULATED LOCALLY 11. INSURANCE: THE FACILITIES AND ALL MATERIAL AND PRODUCTS IN THE INVENTORY SHOULD BE INSURED.

DEPRECIATION CREDIT STOPS WHEN THE TOTAL GOVERNMENT. FILTERS. 10-20 YEARS FOR UTILITIES. DEPRECIATION PERIODS ARE 40-50 YEARS FOR BUILDINGS. IN TURKEY. .PRODUCT COST GOVERNMENTS PUBLISH LISTS OF ALLOWABLE DEPRECIATION RATES FOR DIFFERENT EQUIPMENT AND OTHER ITEMS. EQUIPMENT AND FURNITURE.ALLOWED USEFULL LIFE PERIOD HAS BEEN USED UP. LESS THAN 5 YEARS FOR COMPUTERS AND SPECIAL PUMPS. SALVAGE VALUE IS USUALLY 0. 5-10 YEARS FOR MACHINERY. EVEN IF THE EQUIPMENT IS STILL IN SERVICE. ACCOUNTING DEPARTMENTS KEEP SEPARATE DEPRECIATION RECORDS ON EACH ITEM. METHODS OF DEPRECIATION: * STRAIGHT LINE DEPRECIATION ORIGINAL COST – SALVAGE VALUE YEARLY DEPRECIATION = EQUIPMENT LIFE SAME PERCENTAGE EVERY YEAR.

– SALVAGE VALUE) EQUIPMENT LIFE * SUM – OF – YEARS DIGIT DEPRECIATION THE NUMBERS FOR EACH YEAR OF THE PLANT LIFE ARE ADDED (FOR 5 YEAR LIFE: 1+2+3+4+5 = 15) AND DEPRECIATION FOR THE FIRST YEAR IS 5/15 OF THE ORIGINAL COST. SALVAGE 0 YEARS STR.PRODUCT COST * DOUBLE DECLINING BALANCE DEPRECIATION 2 X (ORIGINAL COST – PREVIOUS DEPRE.00 4 200 108 133.67 $1000 $1000 $1000 .33 2 200 240 266.32 5 200 108 66.67 3 200 144 200. LINE DOUBLE-DEC SUM OF DIGITS 1 $200 $400 $333. SECOND YEAR 4/15 … EXAMPLE: MACHINE PRICE $1000. LIFE 5 YEARS.

STRAIGHT LINE IS EASY TO APPLY. IF YOU DO SO. YOU CANNOT DEPRECIATE COMPLETELY IF YOU CONTINUE WITH THE METHOD TO THE END. (YOU CANNOT CHANGE THE METHOD IF YOU START WITH STRAIGHT LINE) IN TURKEY EITHER STRAIGHT LINE (NORMAL AMORTİSMAN) OR DOUBLE DECLINING BALANCE (AZALAN BAKİYELER) CAN BE USED. THEY CAUSE THE ANNUAL TAX OBLIGATION TO VARY.PRODUCT COST IN DECLINING BALANCE METHOD. DIFFERENT DEPRECIATION METHODS DO NOT CHANGE THE COMPANY’S OVERALL TAX OBLIGATION. . DECLINING BALANCE HAS FINANCIAL ADVANTAGES DUE TO HIGHER DEPRECIATIONS IN THE EARLY-LIFE YEARS. BALANCE WILL BE DIVIDED TO REMAINING YEARS. THEREFORE IT IS ALLOWABLE TO DEPRECIATE AN ASSET OVER THE EARLY PORTION OF ITS LIFE USING DECLINING BALANCE AND THEN SWITCHING TO STRAIGHT LINE DEPRECIATION.

CONTINGENCIES: 1 – 5% CONTINGENCY FACTOR SHOULD BE ADDED. SHIPPING EXPENSES. ADVERTIZING EXPENSES. TRAVELLING EXPENSES. 13. SUPPLIES AND OTHER EXPENSES OF SALES OFFICES. MAY BE UP TO 20% OF PRODUCT COST. INDUSTRY AVERAGE IS 5 – 10% OF PRODUCT COST. OFFICE PERSONNEL. SECRETARIES. COMMUNICATIONS. ADMINISTRATIVE EXPENSES: WAGES FOR MANAGERS. COMPUTER OPERATORS AND EXPENSES FOR OFFICE SUPPLIES. RESEARCH AND DEVELOPMENT COSTS: ALL EXPENSES RELATED TO DEVELOPING NEW METHODS AND PRODUCTS. DEPENDS ON THE COMPANY CAPITAL AND THE REQUIREMENT FOR THE WORKING CAPITAL. DISTRIBUTION AND MARKETING COSTS: WAGES. 16. CAN BE ESTIMATED USING LOCAL RATES. ACCOUNTANTS. COMMISSIONS. 14.PRODUCT COST 12. FINANCING COSTS: THE INTERESTS PAID FOR THE BARROWED MONEY. 15. . ADMINISTRATORS.

FROM THE PRELIMINARY DESIGN. CALCULATE THE YEARLY PRODUCTION COST 2. FIND THE LIST OF EQUIPMENT 2.PRODUCT COST SUMMARY FOR FINDING TCI: A. 1. USUALLY 20 – 35 %) C. TOTAL CAPITAL INVESTMENT = FCI + WC . FIND PEC (MAKE THE NECESSARY CORRECTIONS) 3. 1. FIND THE WORKING CAPITAL (FRACTION OF YEARLY PRODUCTION COST. CALCULATE FIX CAPITAL INVESTMENT (USE LANG’S FACTOR OR % METHOD) B.

AS A CERTAIN PERCENTAGE (t) OF IT: INCOME TAX (T) = GROSS PROFIT x t / 100 NET PROFIT IS GROSS PROFIT MINUS THE INCOME TAX: NET PROFIT = GROSS PROFIT – T = GROSS PROFIT (1 – t /100) CASH FLOW IS NET PROFIT PLUS DEPRECIATION: CASH FLOW = NET PROFIT + DEPRECIATION .PRODUCT COST THE PRODUCT SALES REVENUE (INCOME) MINUS THE TOTAL PRODUCT COST GIVES THE GROSS PROFIT: SALES REVENUE – TOTAL PRODUCT COST = GROSS PROFIT THE INCOME TAX IS CALCULATED ON THE GROSS PROFIT.

00 FACTORY BUILDING ERECTED. THIS COMPANY BOUGHT LAND FOR $220.000). EXCLUDING THE DEPRECIATION.600 CASH FLOW = 158.000 + 27. WERE $100.000 – 316.000 – 100.02 + (700.PRODUCT COST EXAMPLE : A COMPANY WAS FORMED TO PRODUCE HOUSEHOLD CLEANING CHEMICALS.000) .000.000) .2 = 158.800) = 27. THE SALES INCOME FOR THE FIRST YEAR WAS $450.000) .000) .2 = 316.200 .000 TAX: (450.600 = 311. 50 YEARS FOR BUILDINGS.000 WORTH OF CHEMICAL AND PACKAGING EQUIPMENT.400) = 153.000 TAX : (450.200 = 343. NET PROFIT AND CASH FLOW FOR THE FIRST YEAR IF TAX RATE IS %20.800 NET PROFIT = (450.USING a) STRAIGHT LINE b) DOUBLE DECLINING BALANCE DEPRECIATION a) DEP: (900.000 + 153. AND INSTALLED $700.600 b) DEP: 2 x (900.000 – 100.000 – 158.000).000 – 100.400 NET PROFIT = (450.20 = 6.000 – 6.200 CASH FLOW = 316.20 = 38. ALLOWABLE DEPRECIATION PERIODS ARE 5 YEARS FOR EQUIPMENT.000. HAD A $900.000 – 38. SUPPLIES AND ALL OPERATING EXPENSES.000 – 316. FIND THE TAX.000 – 158.000.02 + 2 x (700.000 – 100.

PRODUCT COST DEPLETION A WASTING OR DEPLETING ASSET IS A NATURAL RESOURCE IN WHICH NATURE IS INCAPABLE OF REPLACING THE MINERAL THAT IS EXTRACTED (LIKE COAL MINE OR OIL WELL). . SINCE THE CAPITAL INVESTED IN A DEPLETING ASSET IS CONSUMED AS THE MINERAL IS EXTRACTED. SO FOUND DEPLETION ALLOWANCE CANNOT EXCEED %50 OF THE PROPERTY’S TAXABLE INCOME COMPUTED WITHOUT THE DEPLETION DEDUCTION. THE DEPLETION ALLOWANCE FOR A GIVEN YEAR IS DETERMINED BY MULTIPLYING THE GROSS INCOME FROM OPERATIONS OF THAT YEAR BY A SPECIFIED PERCENTAGE SET BY GOVERMENTAL REGULATIONS. IT IS NECESSARY TO ADJUST THE ACCOUNTING RECORDS OF THE FIRM TO REFLECT THE LOSS.

000 – 62.000.000.22) = 66.500 GROSS PROFIT = 125. (300.500 = 62.500 .500 SO DEPLETION IS $62.000 UPPER LIMIT : (125. THE DEDUCTION OF ALL BUSINESS EXPENSES EXCEPT DEPLETION REDUCED THIS AMOUNT TO $125.000)(. FIND THE DEPLETION AMOUNT IF DEPLETION RATE ON GROSS INCOME IS %22 AND RESTRICTED TO %50 OF THE INCOME AS COMPUTED PRIOR TO DEPLETION.PRODUCT COST EXAMPLE: AN OIL WELL YIELDED A GROSS ANNUAL INCOME OF $300.50) = 62.000)(.

000 = 60.10 = 25. IF COAL MINES HAVE %10 DEPLETION ALLOWANCE AND RESTRICTED TO %50 OF THE INCOME AS COMPUTED PRIOR TO DEPLETION. CALCULATE THE DEPLETION.000) .000 FOR THE YEAR. MINING EXPENSES EQUAL $190.000. (250.000 .000 GROSS PROFIT = 60.50 = 30.000 = 35.PRODUCT COST EXAMPLE : A COAL MINE HAS A GROSS INCOME OF $250.000 UPPER LIMIT: 250.000 (60.000 ALLOWABLE DEPLETION REDUCTION IS 25.000 – 190.000 – 25.000) .

THAT IS. LABOR . THEY DO NOT VARY WITH THE LEVEL OF OUTPUT. COSTS LIKE PROPERTY TAX.) ARE CALLED VARIABLE COSTS (VC).. SOME OF THE PLANT OVERHEAD COSTS AND ADMINISTRATIVE COSTS ARE ALSO FIXED. MARGINAL COST CAN BE EITHER ABOVE OR BELOW AVERAGE COST . OTHER COSTS THAT CHANGE WITH THE LEVEL OF OUTPUT (RAW MATERIALS. PLANT INSURANCE.) ARE THE COSTS DIVIDED BY THE OUTPUT. TOTAL COST C = F + VC MARGINAL COST (MC) IS THE INCREMENT OR ADDITION TO COST THAT RESULTS FROM PRODUCING ONE MORE UNIT OF OUTPUT.PRODUCT COST SOME COST ITEMS ARE FIXED.. AVARAGE COSTS (AVERAGE TOTAL COST. AVERAGE VC. DEPRECIATION AND RENT ARE FIXED COSTS (F).

. 15 ……..PRODUCT COST OUTPUT 0 1 2 3 4 5 6 7 8 9 10 ……… ………. ……. ………. 6 ……. 9 ……. 13 …….6 20.9 21... 10 ……. ……. 108 ……. 60 ……. 73 ……. ……… ……… ……… 100 110 119 125 132 140 149 160 173 188 208 ………. 88 …….. 7 ……. 20 . ………. 0 …….. 8 ……. 49 ……. 9 …….. 25 …….8 MARGINAL COST …… …… 10 ……. ……. 40 ……. ……… ……… ……… ……… ……… ……… ……….7 33 28 24.5 41. ……. …….. 11 …….. 32 ……..... …….8 22.9 20. …….. ……… ……… ……… 110 59. ……… ……… ……… ……… ……… ……… ………. 19 ……. FIXED COST 100 100 100 100 100 100 100 100 100 100 100 VARIABLE TOTAL COST AVERAGE COST COST …….

THE FIRM HAS CONSTANT RETURNS TO SCALE IF AVERAGE COST RISES WITH OUTPUT. THE FIRM IS SAID TO HAVE ECONOMIES OF SCALE (OR INCREASING RETURNS TO SCALE) IF AVERAGE COST DOES NOT VARY WITH OUTPUT. THE FIRM IS SAID TO HAVE DISECONOMIES OF SCALE (OR DECREASING RETURNS TO SCALE) .PRODUCT COST ECONOMIES OF SCALE IF AVERAGE COST FALLS AS OUTPUT INCREASES.

. ECONOMIES OF SCALE EXIST. ECONOMIES OF SCALE EXIST IF S>1.PRODUCT COST REASONS OF AVERAGE COST DECREASE : * FIXED COSTS ARE FIXED * SPECIALIZATION SO MORE EFFICIENT USE OF LABOR * CHEAPER RAW MATERIAL (QUANTITY DISCOUNTS) AS LONG AS MARGINAL COST IS BELOW AVERAGE COST. CONSTANT RETURN OF SCALES EXIST IF S=1. DISECONOMIES OF SCALE EXIST IF S<1. IF WE DEFINE AC/MC = S. IF MARGINAL COST EXCEEDS AVERAGE COST THERE ARE DISECONOMIES OF SCALE.

OPPURTUNITY COST AN ACTION’S OPPURTUNITY COST IS THE VALUE OF THE BEST FORGONE ALTERNATIVE USE OF THE RESOURCES EMPLOYED IN THAT ACTION. HAVING TWO PLANTS WITH LOWER CAPACITIES MAY BE MORE PROFITABLE DUE TO TRANSPORTATION COSTS. BUT NOT THE ONLY ONE. .PRODUCT COST NUMBER OF PRODUCTION PLANTS WHEN DECIDING ON THE NUMBER OF PLANTS. PRODUCTION COST IS AN IMPORTANT FACTOR. IF A FIRM OWNS THE BUILDING IT OCCUPIES AND IF THE BUILDING COULD BE RENTED FOR $1000 / MONTH. SO COST OF RAW MATERIAL TRANSPORTATION AND PRODUCTS TRANSPORTATION SHOULD ALSO BE CONSIDERED AND THE DECISION SHOULD BE ACCORDING TO THE TOTAL COST. THAN THE FIRM SHOULD COUNT THAT AMOUNT (OPPURTUNITY COST) AS ITS COST OF OCCUPYING THE BUILDING. EVEN IF YOU HAVE ECONOMIES OF SCALE IN PRODUCTION.

IF SC IS POSITIVE. FIRMS OFTEN PRODUCE MANY PRODUCTS TO GAIN ECONOMIES OF SCOPE IN MARKETING AND DISTRIBUTION. CONSIDER THE PRODUCTION OF q1 UNITS OF PRODUCT 1 AND q2 UNITS OF PRODUCT 2. q2) SC MEASURES THE RELATIVE INCREASE IN COST THAT WOULD RESULT IF THE PRODUCTS WERE PRODUCED SEPARATELY. IT IS CHEAPER TO PRODUCE THE PRODUCTS TOGETHER. 0) + C (0 . q2) – C (q1 . q2). THERE IS AN ECONOMY OF SCOPE.PRODUCT COST ECONOMIES OF SCOPE WHEN IT IS CHEAPER TO PRODUCE TWO PRODUCTS TOGETHER RATHER THAN SEPARATELY. q2) SC = C (q1 . 0) + C (0 . THE COST OF PRODUCING THEM TOGETHER IS C (q1 . . q2). ECONOMIES OF SCOPE (SC) IS MEASURED AS: C (q1 . THE COST OF PRODUCING EACH SEPARATELY IS C (q1 .

LABOUR. ETC) d 100-a-b c ENERGY.b. . FACTORY PRICE IS ABOUT 50-70 YTL. SO FOR A PRODUCT SOLD TO 100 YTL.ECONOMIC PRODUCTION BREAKDOWN OF RETAIL PRICE: RETAILERS SELLING PRICE TO CUSTOMER 100 NET PROFIT OF RETAILER a RETAILER’S EXPENSES (RENT. LABOUR. TELEPHONE.ENERGY.c.d MAY CHANGE BUT NORMALLY IT IS IN THE RANGE OF 30-50. TAXES. ETC.) b WHOLESALER’S PRICE TO RETAILER NET PROFIT OF WHOLESALER WHOLESALER’S EXPENSES (RENT. TAXES. FACTORY PRICE TO WHOLESALER 100-a-b-c-d THE TOTAL OF a. TELEPHONE. DELIVERY.

BAD PLANNING OR QUALITY PROBLEMS YIELD MAY DECREASE THE FIXED COSTS WILL NOT DECREASE AS THE RATE OF PRODUCTION DECREASE OR AS THE PLANT STAYS IDLE.DUE TO BAD MANAGEMENT.DUE TO POOR MAINTENANCE LONG IDLE PERIODS MAY OCCUR . SO THE . THE UNIT COST OF THE PRODUCT WILL INCREASE AND PROFIT WILL DECREASE.DUE TO POOR DESIGN OR BAD/OLD EQUIPMENT THE RATE MAY DECREASE .ECONOMIC PRODUCTION RATE OF PRODUCTION IS A VERY IMPORTANT FACTOR FROM ECONOMY POINT OF VIEW. THE DESIGN CAPACITY MAY NOT BE ACHIEVED BECAUSE OF SEVERAL REASONS: .SALES DEMAND MAY BE LOW .

VARIABLE COSTS ARE DIRECTLY PROPORTIONAL TO PRODUCTION RATE .THERE IS NO INCOME OTHER THAN THE SALES  Z = nS – (nV + F) = n (S – V) – F Z : GROSS PROFIT. COSTS AND PROFIT CAN BE EXPRESSED MATHEMATICALLY IF FOLLOWING ASSUMPTIONS ARE MADE : .FIXED COSTS ARE CONSTANT .ECONOMIC PRODUCTION THE RELATION BETWEEN SALES. S : NET SALES PRICE / UNIT n : NUMBER OF UNITS PRODUCED / YEAR V : VARIABLE COST / UNIT.THERE ARE NO FINANCIAL COSTS .UNIT SELLING PRICE IS CONSTANT . F : FIXED ANNUAL COST IF PROFIT TAX IS CONSIDERED : NET PROFIT Y = Z ( 1 – t) .

THAT IS AT A LOSS. THE SHUT DOWN POINT OCCURS WHEN THE ANNUAL LOSS IS EQUALS OR EXCEEDS THE VALUE OF THE FIXED COSTS. BREAK – EVEN POINT IS SAME REGARDLESS OF WHETHER OR NOT PROFIT TAX IS INCLUDED. THE PROFIT IS ZERO : Z = 0 = nbS – (nbV + F) = nb (S – V) – F  nbS = nbV + F AND nb = F / (S – V) THIS CAPACITY (nb ) IS CALLED ‘BREAK – EVEN POINT’. ABOVE THIS POINT A PROFIT RESULTS.ECONOMIC PRODUCTION WHEN THE GROSS INCOME (SALES) EQUALS THE TOTAL COST OF THE SALES. WHEN A PLANT OPERATES BELOW THE BREAK – EVEN POINT. IT DOES NOT MEAN THE PLANT SHOULD BE SHUT DOWN. . BECAUSE THE FIXED COSTS WOULD HAVE TO BE PAID IN ANY EVENT.

000 UNITS SOLD AT 70% CAPACITY 140. AND THE TOTAL VARIABLE COSTS ARE $140.ECONOMIC PRODUCTION EXAMPLE: THE ANNUAL FIXED COSTS FOR A PLANT ARE $100.000.000.000 PER YEAR AT 70% CAPACITY WITH SALES INCOME OF $280.000 / 40 = 7.000 / 20 = 5.000 / 7.000 UNITS AT BREAK-EVEN . WHAT IS THE BREAK-EVEN POINT IN UNITS OF PRODUCTION IF THE SELLING PRICE PER UNIT IS $40? 280.000 = $20 / UNIT VARIABLE COST nb = F / (S-V) = 100.

000 } / 5.ECONOMIC PRODUCTION EXAMPLE: IF THE RATIO OF VARIABLE COSTS TO SALES PRICE IS 0.000 FOR A PRODUCT SELLING AT $40 PER TON.000 TON = $ 30 / TON b) $200. WHAT IS THE COST FOR UNIT OF PRODUCT a) AT MAXIMUM CAPACITY OF 10.000 } / 10.5 x 40 = $20 CTOTAL ={ ( 10.5 V = 0.000 TONS x $20 / TON ) + $100.000 TONS x $20 / TON ) + $100.000 TON = $ 40 / TON .000 / $40 /TON = 5.000 TONS SOLD CTOTAL ={ ( 5.5 AND THE FIXED COSTS ARE $100.000 TOTAL SALES? a) V / S = 0.000 TONS AND b) AT $200.

HE OBTAINS GREATER TOTAL PROFIT BY RUNNING HIS PLANT AT HIGHER CAPACITY TO OBTAIIN LOWER UNIT COSTS THAN WOULD RESULT FROM PRODUCING AT A LESSER CAPACITY. AND n2 AT PRICE S2.000 / (40 – 20) = 5.ECONOMIC PRODUCTION EXAMPLE: ANNUAL FIXED COSTS ARE $100. DESIGN CAPACITY IS 10. IF n1 IS THE NUMBER OF UNITS SOLD AT PRICE S1. VARIABLE COSTS ARE $20 PER TON. SELLING PRICE IS $40 PER TON.000 TONS ‘ DUMPING’ OCCURS WHEN A COMPANY SELLS A PORTION OF HIS PRODUCTION AT ONE SALE PRICE S1 AND THE REMAINING AT A LOWER PRICE S2. WHAT IS THE BREAK – EVEN POINT CAPACITY? nb = F / (S – V) = 100. THE GROSS PROFIT IS: Z = n1S1 + n2S2 – (n1V + n2V + F) .000 TONS/YEAR.000.

nS 300 Total Cost Break-even Point 200 Variable Costs 100 Fixed Costs 0 2 4 6 8 10 TONS / YEAR. x1000 . x1000 400 Net Sales.ECONOMIC PRODUCTION chart $.

000 WE.000 FIXED COST PER YEAR IS $2.000)(.000 – 55.000 / 95.600.000)(.000 WE. SELLING PRICE – WEIGHTED AVE.000)(. $/ton 100.000 100.SELLING PRICE = (200. $/ton 200.000 = 65 ton/year .50)= 95.000)(. VARIABLE COST) EXAMPLE: A COMPANY IS PRODUCING 3 PRODUCTS IN THE FOLLOWING AMOUNTS: A B C AMOUNT.20) + (75.000 nb = 2.30) + (50.000 VARIABLE COST.000)(.000 25.50) = 55.600.000 50.30) + (25.AVE.000)(. tons/year 40 60 100 SALES PRICE.000 75.20) + (100.VARIABLE COST= (100.AVE.ECONOMIC PRODUCTION IN A MULTI-PRODUCT COMPANY BREAK EVEN CAN BE CALCULATED BY: nb = F / (WEIGHTED AVE.

BREAK – EVEN POINT IS AN IMPORTANT INFORMATION TO JUDGE ON THE RISK OF A NEW PLANT OR A NEW PRODUCT. EXISTING PLANTS OR NEW PRODUCTS. IF WE DEFINE ‘RATE OF RETURN’ (ROI) AS THE RATIO OF YEARLY NET PROFIT TO TOTAL INVESTMENT : ROI = NET ANNUAL PROFIT / TOTAL INVESTMENT = n [ S – (V + F / n)] (1 – t) / P FROM THIS RELATION WE CAN CALCULATE THE NUMBER OF UNITS THAT SHOULD BE SOLD YEARLY FOR A CERTAIN TOTAL INVESTMENT (P) TO ACHIEVE THE REQUIRED ROI .ECONOMIC PRODUCTION THE RELATION BETWEEN PRODUCTION RATE – COST – SALES CAN BE USED FOR EVALUATION OF NEW PLANTS.

000/n) ] 0.000 = (10n – 4n – 2.857. THE INCOME TAX RATE IS 30% AND DESIRED ROI IS 0.857.000.000) 0.70 / 10.70 4.000 = (12n – 4n – 2.20 = n [12 – (4 + 2.ECONOMIC PRODUCTION EXAMPLE: A PLANT IS DESIGNED TO PRODUCE 1.000 2.000.143 kg/year . b) $12/kg ROI = n [ S – (V + F/n)] (1 – t) / P a) 0.200 TONS/YEAR OF CHEMICAL X WITH A TOTAL INVESTMENT OF $10.000 2.142 = 8n  n = 607.20 = n [10 – (4 + 2.000.000. WHAT SHOULD BE THE YEARLY SALES IF SELLING PRICE IS a) $10/kg.000/n) ] 0.142 = 6n  n = 809.524 kg/year b) 0.000.000.70 4.000.000.000.70 / 10.000.000.000 AND VARIABLE COSTS ARE $4/kg.000) 0.20. THE FIXED COSTS PER YEAR ARE $2.

WE CAN INCREASE SALES. MANAGEMENT MAY DECIDE ON THE OPTIMUM SELLING PRICE MAXIMIZING THE PROFIT revenue at low price $ TC revenue at high price FC a b QUANTITY .ECONOMIC PRODUCTION BY LOWERING OUR UNIT SELLING PRICE.EVEN CURVE. HERE WE HAVE TWO POSSIBLE REVENUE LINES. IN THAT CASE WE HAVE A NEW BREAK. BY DISCUSSING ON THESE CURVES. THE TOTAL PROFIT AT POINT B MAY BE LARGER OR SMALLER THAN THE PROFIT AT POINT A.

HOW MUCH THE PRODUCT SHOULD BE SOLD BEFORE THE REDUCED SELLING PRICE INCREASES PROFIT? TCA = 2.000 B > 4000 KG . IF THE SELLING PRICE IS REDUCED TO $11 PER KG.000 + 20.000 – 10B > 2.000 PA = 2.000 TCB = 2. THE PRODUCT IS SOLD FOR $12 PER KG AND 2000 KG IS SOLD.ECONOMIC PRODUCTION EXAMPLE: THE FIXED COSTS OF MAKING A PRODUCT ARE $2000 AND THE VARIABLE COSTS ARE $10 PER KG.000 = 24.000 = 22.000 RA = 12 x 2.000 + 10B RB = 11B PB = 11B – 2.

LOWER THE VARIABLE COSTS. $ revenue TC for low FC TC for high FC high FC low FC a b c QUANTITY . AUTOMATIC) TO MAXIMIZE THE PROFIT. MANAGEMENT DECIDES ON THE INVESTMENT TYPE (MANUAL VS. HIGHER INVESTMENT COSTS (FC).EVEN CURVES MAY ALSO BE USED TO DECIDE ON THE LEVEL OF INVESTMENT.ECONOMIC PRODUCTION BREAK. IN MOST OF THE CASES. SO DEPENDING ON THE SALES VOLUME.

2000 OF A PRODUCT ARE SOLD.000 = 22.000 PA = 2. IF THE SELLING PRICE IS REDUCED TO $10. VARIABLE COSTS OF $10 A UNIT AND A SELLING PRICE OF $12 A UNIT.ECONOMIC PRODUCTION EXAMPLE: WITH FIXED COSTS OF $2.000 B > 3000 .000. TO WHAT FIGURE THE SALES BE INCREASED TO JUSTIFY THE EXTRA INVESTMENT ON TOOLING? TCA = 2.000 – 8B > 2. THIS WILL RAISE FIXED COSTS TO $4.000 RA = 12 x 2. THE COMPANY IS CONSIDERING IMPROVING ITS MACHINERY.000 TCB = 4.000 = 24.000 + 20.000 BUT REDUCE VARIABLE COSTS TO $8 A UNIT.000 + 8B RB = 10B PB = 10B – 4.

IN THESE CASES WE HAVE THE MAXIMUM PROFIT AT A OPTIMUM POINT. TO INCREASE SALES QUANTITY. COSTS AND SALES REVENUES MAY BE NONLINEAR.ECONOMIC PRODUCTION NON LINEAR BREAKEVEN IN SOME CASES. THE REVENUE MAY ALSO BE NONLINEAR DUE TO LOWER SELLING PRICE REQUIREMENT FOR INCREASING THE SALES QUANTITY. IN NONLINEAR CASES WE HAVE TWO BREAKEVEN POINTS AND BETWEEN THESE POINTS WE HAVE THE PROFIT AREA. SECOND OR THIRD SHIFTS OR OVERTIME PAYMENTS MAY HAVE INCREASING EFFECT ON THE UNIT VARIABLE COSTS. . MORE ADVERTISING OR PROMOTIONS MAY BE REQUIRED WHICH WILL ALSO INCREASE THE UNIT COSTS.

ECONOMIC PRODUCTION be2 sales $ max. profit tc be1 vc fc output .

THEY HAVE HIGH FIXED COSTS AND RELATIVELY LOW VARIABLE COSTS THE TOTAL-COST LINE HAS A LOW SLOPE SO WHEN SALES ARE LOW IT IS HARD TO LOWER THE TOTAL COST.ECONOMIC PRODUCTION ASSET – INTENSIVE INDUSTRIES AUTOMATED PRODUCTION PLANTS ARE LIKE THIS. PROFIT – LOSS IS MORE SENSITIVE TO QUANTITY TR $ TC FC VC Q . IN THESE INDUSTRIES.

WHERE MOST OPERATIONS ARE MANUAL.LOSS IS LESS SENSITIVE TO QUANTITY TC $ TR VC FC Q .ECONOMIC PRODUCTION LABOR – INTENSIVE INDUSTRIES THESE ARE LESS AUTOMATED PLANTS. TOTAL COST CAN BE MORE EASILY CONTROLLED SO THE PROFIT . THEY HAVE RELATIVELY HIGH VARIABLE COSTS AND LESS FIXED COSTS IN THESE PLANTS.

0? (ASSUME ALL PRODUCTION IS SOLD) FIXED CAPITAL INVESTMENT = 1.000 x 1.0 GROSS ANNUAL SALES = SELLING PRICE x ANNUAL PRODUCTION  $900.PROBLEM • THE TOTAL CAPITAL INVESTMENT FOR A CHEMICAL PLANT IS $1 MILLION AND THE WORKING CAPITAL IS $100. IF THE PLANT CAN PRODUCE AN AVERAGE OF 8000 KG OF FINAL PRODUCT PER DAY DURING A 365-DAY YEAR.  GROSS ANNUAL SALES = 900.000 = SELLING PRICE x (8000 KG/DAY)(365 DAYS/YEAR) SELLING PRICE = $0.CAPITAL INVESTMENT .308 .000 = $900.000.000 – 100.000.000 TURNOVER RATIO = GROSS ANNUAL SALES / FIXED CAPITAL INV. WHAT SELLING PRICE IN DOLLARS PER KG OF PRODUCT WOULD BE NECESSARY TO GIVE A TURNOVER RATIO OF 1.

PROBLEM • A PIECE OF EQUIPMENT ORIGINALLY COSTING $40. AT THE TIME THE EQUIPMENT WAS PUT INTO USE. HOW MUCH NEW CAPITAL MUST BE SUPPLIED TO MAKE THE PURCHASE? YEARLY DEPRECIATION = 40.000 REQUIRED .000.000 – 24.000 = $21.000 AND A MORE ADVANCED MODEL CAN BE INSTALLED FOR $55.000 WAS PUT INTO USE 12 YEARS AGO. THE SERVICE LIFE WAS ESTIMATED TO BE 20 YEARS AND THE SALVAGE VALUE WAS ASSUMED TO BE ZERO.000 = $24.000 55. ON THIS BASES.PRODUCT COST . ASSUMING THE DEPRECIATION FUND IS AVAILABLE FOR USE.000 – 10.000 TOTAL DEPRECIATION FOR 12 YEARS = 12 x 2. A STRAIGHT-LINE DEPRECIATION FUND WAS SET UP.000 / 20 = 2. THE EQUIPMENT CAN NOW BE SOLD FOR $10.

PROBLEM • A COMPANY HAS A TOTAL INCOME OF $1 MILLION/YEAR AND ALL EXPENSES EXCEPT DEPRECIATION ARE $600.000 = $14.000.000/YR DOUBLE DECLINING: d = 2 (850.000 – 40.PRODUCT COST . WHAT WOULD BE THE REDUCTION IN INCOME TAX CHARGES FOR THE FIRST YEAR OF OPERATION IF DOUBLE DECLINING BALANCE METHOD WERE USED FOR DEPRECIATION INSTEAD OF STRAIGHT-LINE METHOD? STARIGHT-LINE: d = (850.000 – 600.000 .000.000 – 600.000/ FIRST YR TAX : T = (1.000) / 20 = $80.35) = $112.000/YEAR.35) = $126.000)(0.000 – 80.000/YR TAX : T = (1.000)(0.000 – 50. THE COMPOSITE AMOUNT OF ALL DEPRECIABLE ITEMS HAS A VALUE OF $850. THE INCOME TAX RATE IS 35%.000. OVERALL SERVICE LIFE OF 20 YEARS AND SALVAGE VALUE OF $50.000 – 50.000.000/ FIRST YR REDUCTION IN TAX FOR FIRST YEAR = 126.000 – 112.000) / 20 = $40.

62 = $86.62 = $49.800 c) Y* = [400.000 – 120.000) – 120.ECONOMIC PRODUCTION .000 – 0.000 b) Y* = [1.3)(400.5(400.3(400.000)] 0.000 – 0.000 – 0. THE PROFIT TAX RATE IS 38%.000 Z* = Z = 100.5S*  S* = $440.5 (1.000 WITH VARIABLE COSTS EQUAL TO 50% OF NET SALES AND IS PLANNING TO INCREASE ITS PRESENT CAPACITY OF $400.000) = $100.000 SALES BY 30% WITH A 20% INCREASE IN FIXED COSTS.000 = S* – 120.000)] 0.PROBLEM *A COMPANY HAS FIXED COSTS OF $100. a) WHAT NEW SALES DOLLARS ARE REQUIRED TO OBTAIN THE SAME GROSS PROFIT AS THE PRESENT PLANT OPERATION? b) WHAT WOULD BE THE NET PROFIT IF THE ENLARGED PLANT IS OPERATED AT FULL CAPACITY? c) WHAT WOULD BE THE NET PROFIT FOR THE ENLARGED PLANT IF SALES REMAINED THE SAME AS AT PRESENT? a) Z = 400.000 – 0.600 .5(400.000 – 100.

THE WORKING CAPITAL REQUIREMENT IS 15% OF THE TOTAL CAPITAL INVESTMENT.000 PER TON.ECONOMIC PRODUCTION .000 PER TON AND ANNUAL FIXED COSTS OTHER THAN DEPRECIATION IS $200.000.000 PER TON. WHAT IS THE BREAK – EVEN POINT PRODUCTION RATE AS PERCENT OF THE DESIGN CAPACITY OF THE PLANT? . THE EXPECTED SERVICE LIFE IS 10 YEARS AND STRAIGHT LINE DEPRECIATION IS USED. DURING THE TESTING PERIOD THE PLANT WAS PUT INTO TRIAL RUNS OF OPERATION AT 60% OF ITS DESIGN CAPACITY AND IT WAS FOUND OUT THAT VARIABLE COSTS ARE $15. THE TOTAL CAPITAL INVESTMENT REQUIRED FOR THE PLANT IS $800.PROBLEM * A COMPANY DESIGNED A PLANT TO PRODUCE A CHEMICAL TO BE SOLD AT $50. THE EXPECTED PROFIT AT DESIGN CAPACITY IS $10.000.

72 = .15 x TCI = $120.000A – ( 68.000 + 15.PROBLEM TCI : $800. A : PROFIT = CAPACITY x PROFIT PER TON = A x 10.715 .000A = 50.72 TONS PER YEAR LET B = BREAK – EVEN CAPACITY WHERE SALES = COSTS 50.000A) A = 10.000 = A x PRICE – [ DEPRECIATION + FC + (A x VC) ]  10.000 + 200.000 + 200.000 WCI = .000 THE TOTAL PROFIT AT DESIGN CAPACITY.000 / 10 = 68.66 / 10.000  FIXED CAPITAL INVESTMENT (FCI) = $680.ECONOMIC PRODUCTION .66 TONS PER YEAR B / A = 7.000 + 15.000B = 68.000 DEPRECIATION PER YEAR = 680.000B B = 7.

000 = $0.8)(4.333 = $0.PROBLEM A PLANT MAKING 4.700.000 TONS PER YEAR OF PRODUCT AND SELLING AT $0.80) = $400.000.000 – 400.000) – 2.1)(4.000](0.000) – 2.8)(1.333.5 PER kg AT BREAK – EVEN : n = 700.000 / 2.000.000 / 4.000.000](0.000 / (0.000 = $256.5) = 2.700.000 NEW NET PROFIT = [(0.ECONOMIC PRODUCTION .80) = $656.000. WHAT IS THE FIXED COSTS PER kg AT THE BREAK – EVEN POINT ? IF THE SELLING PRICE IS INCREASED BY 10%.333.000 . WHAT IS THE DOLLAR INCREASE IN NET PROFIT AT FULL CAPACITY IF THE INCOME TAX RATE IS 20% OF GROSS PROFIT? V = 2.000.8 – 0.000 INCREASE IN NET PROFIT = 656.8 PER kg HAS ANNUAL VARIABLE COSTS OF $2.000 AT 100% CAPACITY AND ANNUAL FIXED COSTS OF $700.30 PER kg ORIGINAL NET PROFIT = [(0.000.333   FC PER kg = 700.

000. AT FULL CAPACITY YEARLY GROSS PROFIT IS 2.000.000 TL AND ANNUAL FIXED COST IS AGAIN 30% OF THE NEW FIXED CAPITAL INVESTMENT.000 NEW PROFIT = 35.1 – 4.000.000 TL/YEAR. WHAT IS THE NEW GROSS PROFIT AT THE NEW CAPACITY? TR = SALES/FCI SALES = 0.000 – 0. AND ANNUAL FIXED COST IS 30% OF THE FIXED CAPITAL INVESTMENT.400.250.000 TL. COMPANY MAKES A NEW INVESTMENT INCREASING THE FIXED CAPITAL INVESTMENT 20% RESULTING WITH 10% INCREASE IN CAPACITY AND SALES.000 x 0.400.5 x 1.2 = 2.3FCI FCI = 35.000 .5.000 kg/YEAR CAPACITY HAS A TURNOVER RATIO OF 0. TOTAL VARIABLE COST OF THE COMPANY AT FULL CAPACITY 5.3 x 1. F = 0.000.000.5FCI.000.000 – 35.ECONOMIC PRODUCTION-PROBLEM A COMPANY WITH 50.000 = 0. THE YEARLY VARIABLE COST AT THE NEW FULL CAPACITY IS 4.000 x 0.3FCI PROFIT = 2. V = 100 TL.5FCI – 100 x 50.

TIME VALUE OF MONEY .VI.

THE AMOUNT OF INTEREST DEPENDS UPON THE SCARCITY OF MONEY AT THE TIME OF THE LOAN AND WHAT ALTERNATIVE INVESTMENTS MIGHT HAVE YIELDED. THE ECONOMIC GAIN THROUGH THE USE OF MONEY IS WHAT GIVES MONEY ITS TIME VALUE. IT IS THE PREMIUM PAID TO COMPENSATE A LENDER FOR THE LOSS OF USE OF THE LOANED MONEY. . A DOLLAR RECEIVED AT SOME FUTURE DATE IS NOT WORTH AS MUCH AS A DOLLAR IN HAND AT PRESENT. ON THE OTHER HAND A BORROWER PAYS INTEREST CHARGES FOR THE OPPURTUNITY TO DO SOMETHING NOW THAT OTHERWISE WOULD HAVE TO BE DELAYED OR WOULD NEVER BE DONE.TIME VALUE OF MONEY INTEREST REPRESENTS THE EARNING POWER OF MONEY. THIS LEADS TO THE CONCEPT OF TIME VALUE OF MONEY. THE RISK OF NONREPAYMENT AND THE ADMINISTRATIVE COST OF MAKING A LOAN. BECAUSE MONEY CAN EARN AT AN INTEREST RATE THROUGH ITS INVESTMENT FOR A PERIOD OF TIME. IT ALSO DEPENDS UPON THE RISK THE LENDER FEELS THAT HE IS TAKING THAT THE MONEY MIGHT NOT BE REPAID OR WHAT SECURITY MAY BE PLEDGED TO THE LENDER THAT HAS AN EQUAL OR SOMEWHAT GREATER VALUE.

THIS OPPURTUNITY WILL EARN A RETURN SO THAT AFTER n YEARS THE ORIGINAL DOLLAR PLUS ITS INTEREST WILL BE A LARGER AMOUNT THAN THE ONE DOLLAR RECEIVED AT THAT TIME. THE TIME VALUE OF MONEY IS LIMITED TO THE FACT THAT MONEY HAS AN EARNING POWER. . IT IS IMPORTANT THAT THE TIME VALUE OF THE MONEY USED BE PROPERLY REFLECTED IN THE EVALUATION OF THE PROJECTS. SINCE ENGINEERING PROJECTS REQUIRE THE INVESTMENT OF MONEY.TIME VALUE OF MONEY A DOLLAR IN HAND NOW IS WORTH MORE THAN A DOLLAR RECEIVED n YEARS FROM NOW SINCE HAVING A DOLLAR NOW PROVIDES THE OPPURTUNITY FOR INVESTING THAT DOLLAR FOR n YEARS MORE THAN THE DOLLAR TO BE RECEIVED n YEARS HENCE. THE EFFECT OF INFLATION IS SEPARATE.

TIME VALUE OF MONEY THE AMOUNT OF CAPITAL ON WHICH INTEREST IS PAID IS DESIGNATED AS THE PRINCIPAL (P). THE PRINCIPAL WOULD BE $1000 AND THE RATE OF INTEREST WOULD BE 100 / 1000 = 0. SIMPLE INTEREST THE SIMPLEST FORM OF INTEREST REQUIRES COMPENSATION PAYMENT AT A CONSTANT INTEREST RATE BASED ONLY ON THE ORIGINAL PRINCIPAL. FOR EXAMPLE. THE AMOUNT OF SIMPLE INTEREST I DURING n INTEREST PERIOD IS: I = (P)(i)(n) .1 OR 10% / YEAR. TYPES OF INTEREST: 1. IF $100 WERE THE COMPENSATION DEMANDED FOR GIVING SOMEONE THE USE OF $1000 FOR A PERIOD OF ONE YEAR. THE TIME UNIT IS USUALLY TAKEN AS ONE YEAR. AND THE AMOUNT OF INTEREST EARNED BY A UNIT OF PRINCIPAL IN A UNIT OF TIME AS THE RATE OF INTEREST (i).

TIME VALUE OF MONEY THE PRINCIPLE MUST BE REPAID EVENTUALLY. THEREFORE THE ENTIRE AMOUNT S OF PRINCIPLE + INTEREST DUE AFTER n INTEREST PERIOD IS: S = P + I = P + (P)(i)(n) = P(1 + in) IF THE INTEREST RATE IS EXPRESSED ON THE REGULAR YEARLY BASIS AND d REPRESENTS THE NUMBER OF DAYS IN AN INTEREST PERIOD: ORDINARY SIMPLE INTEREST = P(i)(d/360) EXACT SIMPLE INTEREST = P(i)(d/365) .

THIS IS CALLED ‘COMPOUND INTEREST’ WHICH ASSUMES THAT THE INTEREST RECEIVED IS NOT WITHDRAWN BUT ADDED TO THE PRINCIPLE AND INTEREST IS RECEIVED UPON THIS ENLARGED PRINCIPLE DURING THE FOLLOWING PERIOD.TIME VALUE OF MONEY 2. THE COMPOUND AMOUNT (S) DUE AFTER DISCREET NUMBER OF INTEREST PERIODS CAN BE DETERMINED AS FOLLOWS: YEAR P AT THE START INTEREST EARNED S AT THE END 1 P P(i) P + P(i) = P(1 + i) 2 P(1+i) P(1+i)(i) P(1+i)+P(1+i)(i) = P(1+i) 2 3 P(1+i)2 P(1+i)2(i) P(1+i)2+P(1+i)2(i) = P(1+i)3 n P(1+i)n-1 P(1+i)n-1(i) P(1+i)n . COMPOUND INTEREST INTEREST HAS AN IMPORTANT TIME VALUE AND WHENEVER THE INTEREST IS PAID THE RECEIVER CAN IMMEDIATELY PUT THE INTEREST TO WORK AND EARN ADDITIONAL INTEREST.

1)3 = 1331 .1) = 1100 2 S2 = 1000(1+0.2) = 1200 3 S3 = 1000(1+0.1) = 1100 .TIME VALUE OF MONEY SO IN COMPOUND INTEREST : S = P(1+i)n EXAMPLE: IF P = $1000 AND i = 10% n 1 COMPOUND S1 = 1000(1+0.3) = 1300 7 S7 = 1000(1+0. = 1000(1+0. SIMPLE = 1000(1+0.7) = 1700 COMPOUND INTEREST IS THE MOST USED TYPE OF INTEREST AND IF NOTHING ELSE IS INDICATED WE SHALL UNDERSTAND COMPOUND INTEREST COMPOUNDED YEARLY .1)2 = 1210 . = 1000(1+0. = 1000(1+0.1)7 = 1949 .

NOMINAL INTEREST RATE 6% COMPOUNDED YEARLY: S1 = $106 P= $100. INTEREST RATES STATED IN THIS FORM ARE KNOWN AS ‘NOMINAL INTEREST RATES’. P = $100.03)(1.09 . WE WILL ASSUME ONE YEAR). THE ACTUAL ANNUAL RETURN ON THE PRINCIPAL WOULD NOT BE EXACTLY 6% BUT WOULD BE SOMEWHAT LARGER BECAUSE OF THE COMPOUNDING EFFECT AT THE END OF THE SEMIANNUAL PERIOD. NOMINAL INTEREST RATES SHOULD ALWAYS INCLUDE A QUALIFYING STATEMENT INDICATING THE COMPOUNDING PERIOD (IF NO STATEMENT.NOMINAL INTEREST RATE 6% COMPOUNDED SEMIANNUALLY S1 = $100(1. CONSIDER AN EXAMPLE IN WHICH THE INTEREST RATE IS 3% PER PERIOD AND INTEREST IS COMPOUNDED AT HALF-YEAR PERIODS.03) = $106.TIME VALUE OF MONEY NOMINAL AND EFFECTIVE INTEREST RATES: THERE ARE CASES WHERE TIME UNITS OTHER THAN ONE YEAR ARE USED. A RATE OF THIS TYPE WOULD BE REFERRED TO AS ‘6% COMPOUNDED SEMIANNUALLY’.

09% IN THE ABOVE CASE). THEN THE INTEREST RATE BASED ON THE LENGTH OF ONE INTEREST PERIOD IS r / m. SINCE S = P (1+i)n Safter 1 year = P (1+r/m)m IF WE DESIGNATE EFFECTIVE INTEREST RATE AS i eff  S1 = P (1+ieff) = P (1+r/m)m ieff = (1+r/m)m .TIME VALUE OF MONEY SOMETIMES IT IS DESIRABLE TO EXPRESS THE EXACT INTEREST RATE BASED ON THE ORIGINAL PRINCIPAL AND THE TIME UNIT OF ONE YEAR.1 . THE ONLY TIME THAT THE NOMINAL AND EFFECTIVE INTEREST RATES ARE EQUAL IS WHEN THE INTEREST IS COMPOUNDED ANNUALLY. LET r BE THE NOMINAL INTEREST RATE UNDER CONDITIONS WHERE THERE ARE m CONVERSIONS OR INTEREST PERIODS PER YEAR. A RATE OF THIS TYPE IS KNOWN AS THE ‘EFFECTIVE INTEREST RATE’ (6.

06168.06168) = 106. COMPOUNDED QUARTERLY ieff = (1+r/m)m – 1 = 1. COMPOUNDED MONTHLY ieff = (1+r/m)m – 1 = 1. S = 100 (1.06 .06136.0609.168 . 015 4 – 1 = 0. 03 2 – 1 = 0. n = 1. S = 100 (1. AND a) INTEREST IS 6 % ieff = i = 0. 005 12 – 1 = 0.TIME VALUE OF MONEY EXAMPLE FIND S AND ieff FOR P = 100 TL.0609) = 106.09 c) INTEREST IS NOMINAL 6%. S = 100 (1.06136) = 106. S = 100 (1.136 d) INTEREST IS NOMINAL 6%. COMPOUNDED SEMIANNUALLY ieff = (1+r/m)m – 1 = 1.06) = 106 b) INTEREST IS NOMINAL 6%.

MONTHLY INTEREST RATE OF 2% * TOTAL AMOUNT PRINCIPAL + SIMPLE INTEREST DUE AFTER 2 YEARS IF NO INTERMEDIATE PAYMENTS ARE MADE S = P(1+in) = $1000 ( 1+ 0.8% .02 X 24) = $1480 a) TOTAL AMOUNT PRINCIPAL + COMPOUNDED INTEREST AFTER 2 YEARS IF NO INTERMEDIATE PAYMENTS ARE MADE S = P (1+I)n = $1000 (1.24/12)12 – 1 = 0.02 X 12 = 0.24 OR 24% COMPOUNDED MONTHLY c) EFFECTIVE INTEREST RATE WHEN THE INTEREST IS COMPOUNDED MONTHLY ieff = (1+r/m)m – 1 = (1+0.268 OR 26.TIME VALUE OF MONEY EXAMPLE : P = $1000.02)24 = $1608 b) NOMINAL INTEREST RATE WHEN THE INTEREST IS COMPOUNDED MONTHLY r = 0.

m : INTEREST PERIODS / YEAR Sn = Plim m →∞ (1+r/m)mn = Plimm→∞ (1+r/m)m/r x rn SINCE limm→∞(1+r/m)m/r = e  Sn = Pern TO USE ieff WHICH IS (1+r/m)m – 1 = (1+r/m)m/r x r.1 SO ieff = er – 1 AND Sn = P(ieff +1)n .TIME VALUE OF MONEY 3. CONTINUOUS INTEREST FOR INTEREST ACCUMULATION YOU CAN TAKE SHORTER TIME INTERVALS THAN ONE YEAR LIKE ONE MONTH. r : NOMINAL INTEREST RATE . ONE HOUR OR EVEN SHORTER. AND THE EXTREME CASE IS WHEN THE TIME INTERVAL BECOMES INFINITESIMALLY SMALL SO THAT THE INTEREST IS COMPOUNDED CONTINUOUSLY. ONE DAY.

2214 – 1 = 0.TIME VALUE OF MONEY EXAMPLE : IF r = 0.2 (NOMINAL INTEREST RATE OF 20%) a) TOTAL AMOUNT TO WHICH $1 OF INITIAL PRINCIPAL WOULD ACCUMULATE AFTER ONE YEAR IF COMPOUNDED DAILY S = P (1+r/m)m = 1(1 + 0.2214 c) ieff FOR CONTINUOUS COMPOUNDING ieff = er – 1 = 1.2214 OR 22.2213 b) TOTAL AMOUNT TO WHICH $1 OF INITIAL PRINCIPAL WOULD ACCUMULATE AFTER ONE YEAR WITH CONTINUOUS COMPOUNDING S = Pern = 1 (e)0.14% .2/365)365 = $ 1.2 = $ 1.

TIME VALUE OF MONEY PRESENT WORTH AND DISCOUNT THE PRESENT WORTH (OR PRESENT VALUE) OF A FUTURE AMOUNT IS THE PRESENT PRINCIPLE WHICH MUST BE DEPOSITED AT A GIVEN INTEREST RATE TO YIELD THE DESIRED AMOUNT AT SOME FUTURE DATE. SINCE S = P (1 + i)n P = S / (1 + i)n FOR COMPOUND INTEREST AND SINCE S = Pern P = S / ern FOR CONTINUOUS INTEREST THE DISCOUNT = FUTURE VALUE – PRESENT VALUE =S–P .

03)x4 = $887 .03)4 = $888 b) DISCOUNT DISCOUNT = 1000 – 888 = $112 c) DISCRETE COMPOUND RATE OF EFFECTIVE INTEREST WHICH WILL BE RECEIVED BY A PURCHASER IF THE BOND WAS OBTAINED FOR $700 P = S / (1+i)n . DETERMINE THE FOLLOWING AT A TIME 4 YEARS BEFORE THE BOND REACHES MATURITY VALUE: a) PRESENT WORTH P = S/ (1 + i)n = 1000 / (1 + 0.TIME VALUE OF MONEY EXAMPLE : A BOND HAS A MATURITY VALUE OF $1000 AND IS PAYING DISCRETE COMPOUND INTEREST AT AN EFFECTIVE ANNUAL RATE OF 3%.0933 d) REPEAT (a) FOR THE CASE WHERE THE NOMINAL BOND INTEREST IS 3% COMPOUNDED CONTINUOUSLY P = S / ern = 1000 / e(0. 700 = 1000 / (1+i)4  i = (1000/700)1/4 – 1 = 0.

TIME VALUE OF MONEY ANNUITIES : AN ANNUITY IS A SERIES OF EQUAL PAYMENTS OCCURING AT EQUAL TIME INTERVALS. AND S IS THE AMOUNT OF ANNUITY. THIS FIRST PAYMENT WILL HAVE ACCUMULATED TO AN AMOUNT OF R(1 + i)n-1. LET R REPRESENT THE UNIFORM PERIODIC PAYMENTS MADE DURING n DISCRETE PERIODS IN AN ORDINARY ANNUITY. S = R(1+i)n-1+ R(1+i)n-2 + …. THE FIRST PAYMENT R IS MADE AT THE END OF THE FIRST PERIOD AND WILL BEAR INTEREST FOR n – 1 PERIODS. THUS AT THE END OF THE ANNUITY TERM. THE SECOND PAYMENT WILL BE R(1 + i)n-2 AND SO ON. THE ‘AMOUNT OF AN ANNUITY’ IS THE SUM OF ALL THE PAYMENTS PLUS INTEREST. THE INTEREST RATE BASED ON THE PAYMENT PERIOD IS i. + R(1+i) + R MULTIPLY BOTH SIDES BY (1+i)  S + Si = R(1+i)n + R(1+i)n-1…+R(1+i) SUBTRACT THE FIRST EQUATION FROM THIS ONE Si = R (1+i)n – R  S = R { (1+i)n . AN ‘ANNUITY TERM’ IS THE TIME FROM THE BEGINNING OF THE FIRST PAYMENT PERIOD TO THE END OF THE LAST PAYMENT PERIOD.1} / i .

+ Rer + R MULTIPLY BOTH SIDES BY er Ser = Rern + Rern-1 + ….TIME VALUE OF MONEY FOR DISCRETE CASH FLOW AND CONTINUOUS COMPOUNDING: SINCE S = Rern . SECOND WILL BE Rer(n-2) AND SO ON.  S = Rer(n-1) + Rer(n-2) + …. THE FIRST PAYMENT WILL BE Rer(n-1) AT THE END. + Rer SUBTRACT THE FIRST EQUATION FROM THIS Ser – S = Rern – R S (er – 1) = R (ern – 1) S = R { ( ern – 1) / ( er – 1) } .

Ř MEANS THAT THE PAYMENTS ARE MADE CONTINUOUSLY THROUGHOUT THE TIME PERIOD.) .TIME VALUE OF MONEY FOR CONTINUOUS CASH FLOW AND INTEREST COMPOUNDING. LET Ř REPRESENT THE TOTAL OF ALL ORDINARY ANNUITY PAYMENTS OCCURING UNIFORMLY THROUGHOUT THE YEAR SO THAT Ř / m IS THE UNIFORM ANNUITY PAYMENT AT THE END OF EACH PERIOD: S = Ř / m [ { (1 + r/m)mrn/r – 1 } / r/m ] = Ř { (ern – 1) /r } (THE SYMBOLS S. LET r REPRESENT NOMINAL INTEREST RATE WITH m INTEREST PERIODS PER YEAR SO THAT i = r / m AND THE TOTAL NUMBER OF INTEREST PERIODS IN n YEARS IS mn. R REPRESENT DISCRETE LUMPSUM PAYMENTS. A BAR ABOVE THE SYMBOL. SUCH AS Š.

06 / { (1.6 – 1) } = $730 / YEAR . DETERMINE THE YEARLY INSTALMENTS a) IF i = 0.06)10 .000 { 0.000 [ 0.06 / (e0.000 IN 10 YEARS BY MAKING EQUAL INSTALMENTS EACH YEAR.TIME VALUE OF MONEY PRESENT WORTH OF ANNUITY: SINCE P = S / (1 + i)n .06 ANNUALLY R = S [ i / { (1 + i)n – 1 } ] = $10. BEGINNING AT THE END OF THE FIRST YEAR .1} ] = $759 / YEAR b) IF ANNUAL INTEREST OF 0. P = R [ { (1 + i)n – 1 } / i(1 + i)n ] FOR CONTINUOUS CASH FLOW AND INTEREST COMPOUNDING : P = Ř { (ern – 1) / rern } ANNUITY DUE : IF PAYMENTS ARE MADE AT THE BEGINNING OF EACH PERIOD INSTEAD OF END OF THE PERIODS DEFERRED ANNUITY : IF THE FIRST PAYMENT IS DUE AFTER A DEFINITE NUMBER OF YEARS EXAMPLE : YOU WANT TO ACCUMULATE $10.06 COMPOUNDED CONTINUOUSLY WITH CONTINUOUS CASH FLOW Ř = S { r / (ern – 1) } = $10.

TIME VALUE OF MONEY SUMMARY OF BASIC INTEREST RELATIONS • SIMPLE INTEREST : S = P (1 + in) n: NUMBER OF PERIODS i : INTEREST PER PERIOD • COMPOUND INTEREST: S = P (1 + i)n • CONTINUOUS COMPOUNDING: S = Pern = P (ieff + 1)n • ANNUITIES WITH DISCRETE PAYMENTS.R. AND CONTINUOUS COMPOUNDING: S = Ř { (ern – 1) / r Ř: TOTAL ANNUITY PAYMENT P = Ř { (ern – 1) / rern PER YEAR . Ř. R : S = R [ {(1 + i)n – 1} / i ] P = R [ {(1 + i)n – 1} / i (1 + i)n ] • • r:NOMINAL INTEREST RATE R:UNIFORM PERIODIC PAYMENTS MADE AT EACH n DISCRETE PERIOD ANNUITIES WITH DISCRETE PAYMENTS. CONTINUOUS COMPOUNDING: S = R { (ern – 1) / (er – 1) } P = R { (ern – 1) / ern(er – 1) } ANNUITIES WITH CONTINUOUS CASH FLOW.

TIME VALUE OF MONEY WHAT HAPPENS WHEN THE INVESTMENT IS CONSIDERED TO BE PERMENANT. (1 + i)n =  SINCE S = P (1 + i)n  S =  FOR ANY P P = S / (1 + i)n  P = 0 FOR ANY S SINCE R = P [{i (1 + i)n} / { (1 + i)n – 1 }] {i (1 + i)n} / { (1 + i)n – 1 } = [ i / { (1 + i)n – 1} ] + i WHEN n   = 0 +i  R = Pi . THAT IS n   ? WHEN n   .

 S = P + CR SINCE S = P(1 + i)n = P + CR  (1 + i)n = 1 + CR / P  P = CR / {(1 + i)n – 1 } . SUCH THAT WHEN YOU SPEND C R. IF REPLACEMENT AT THE END OF n YEARS COSTS C R . THEN WE SHOULD HAVE A PRINCIPAL (P) IN THE BEGINNING WHICH WILL ACCUMULATE TO S IN n YEARS.TIME VALUE OF MONEY CAPITALIZED COST WE MAY DESIRE TO DETERMINE A TOTAL COST FOR A PIECE OF EQUIPMENT UNDER CONDITIONS WHICH PERMIT THE EQUIPMENT TO BE REPLACED PERPATUALLY WITHOUT CONSIDERING INFLATION OR PRICE CHANGES. YOU STILL HAVE P IN HAND TO ACCUMULATE AGAIN TO S IN n YEARS AND SO ON.

000 + 10.1 ) = $24. OUT OF WHICH $10. WHAT IS THE CAPITALIZED COST IF INTEREST IS 0.650 IN 10 YEARS. REMAINING $12.000 / (1.000 WILL BE USED TOGETHER WITH THE SCRAP VALUE TO RENEW THE EQUIPMENT.650 WILL ACCUMULATE TO $22. AND THIS WILL GO ON.000 WILL BE USED FOR BUYING THE EQUIPMENT IN THE BEGINNING.650 THAT MEANS OUT OF THIS AMOUNT $12.06 ? K = CV + CR /{ (1 + i)n – 1} = 12. .0610 .TIME VALUE OF MONEY THE CAPITALIZED COST (K) IS DEFINED AS THE ORIGINAL COST OF THE EQUIPMENT (CV) PLUS P K = CV + CR /{ (1 + i)n – 1 } IF CV = CR K = CV [ 1 + 1/{ (1 +i)n – 1 }] ENGINEERS USE CAPITALIZED COST PRINCIPALLY FOR COMPARING ALTERNATIVES EXAMPLE : A NEW EQUIPMENT COSTS $12.000 AND WILL HAVE A SCRAP VALUE OF $2000 AT THE END OF ITS USEFULL LIFE OF 10 YEARS.

WHAT SHOULD BE THE USEFULL LIFE PERIOD OF THE STAINLESS STEEL REACTOR TO HAVE EQUAL CAPITALIZED COST IF SCRAP VALUES ARE ZERO AND MONEY IS WORTH 6% COMPOUNDED ANNUALLY ? FOR THE MILD STEEL REACTOR : K = CV + CR /{ (1 + i)n – 1} = 5000 + 5000 / (1.3 YEARS.TIME VALUE OF MONEY EXAMPLE : IF A REACTOR IS MADE FROM MILD STEEL IT COSTS $5000 AND ITS USEFULL LIFE IS 3 YEARS.176 FOR THE STAINLESS STEEL TO HAVE EQUAL K 31.000 + 15.06n = 1.176 = 15. IF THE LIFE IS > 11.9273 n = 11.3 THAT MEANS.06n – 1) 1. CHOOSE STAINLESS STEEL FOR MAKING THE REACTOR .000. IF IT IS MADE FROM STAINLESS STEEL IT COSTS $15.000 / (1.063 – 1) = $31.

TIME VALUE OF MONEY WHEN THERE IS A PAYMENT AT THE END OF EACH YEAR (LIKE MAINTANENCE COST). WE SHOULD ADD IT TO THE ‘CAPITILIZED COST’ FORMULA: P = R [ (1 + i )n – 1 / i (1 + i )n ] DIVIDE BY (1 + i )n P = R [ 1 – 1/ (1 + i )n / i ] WHEN n GOES TO ∞ P=R/i CAPITALIZED COST FORMULA BECOMES: K = R / i + CV + CR / (1 + i )n – 1 WHERE R IS THE YEARLY EXPENSE .

12/12)69 = $1986.9 .07 (1 + i x 3. HOW MUCH INTEREST IS EARNED? S = 1000(1 + 0.07 YIELD $8.82 = 65. I = $986.5)  i = 3. S = P(1 + i)n = 100(1.9 .75 IN SIMPLE INTEREST IN 3 YEARS 6 MONTHS? S = P(1 + in) 73.84% • FIND THE COMPOUND AMOUNT OF $100 FOR 4 YEARS AT 6% COMPOUNDED ANNUALLY.06)4 = $126.TIME VALUE .25 • ACCUMULATE A PRINCIPLE OF $1000 FOR 5 YEARS 9 MONTHS AT A NOMINAL RATE OF 12% COMPOUNDED MONTHLY.PROBLEM • AT WHAT RATE WILL $65.

n = 9 S = P(1 + i)n 2000 / 1000 = (1 + i)9  21/9 = 1 + i  i = 0.08/4)4 – 1 = 0.08 .0824)n ln 1.TIME VALUE .25 .PROBLEM • AT WHAT ANNUAL INTEREST RATE WILL $1000 INVESTED TODAY BE WORTH $2000 IN 9 YEARS ? P = 1000 .4 = nln1.0824)n 1. WHEN SHOULD THE $1400 BE RECEIVED IF THE LOAN IS TO EARN INTEREST AT A RATE OF NOMINAL YEARLY 8% COMPOUNDED QUARTERLY? P = 1000 .0824  n = 4.0824 S = P(1 + ieff)n  1400 = 1000(1.08 • A LOAN OF $1000 IS MADE TODAY UNDER AN AGREEMENT THAT $1400 WILL BE RECEIVED IN PAYMENT SOMETIME IN FUTURE. m = 4 ieff = (1 + r/m)m – 1 = (1 + 0.4 = (1. S = 1400 . r = 0. S = 2000 .

015 ieff = (1 + r/m)m – 1 = (1 + 0. 2006  $500 .4 .07)2 } = $1978. ARE TO BE RECEIVED EVERY 2 YEARS FROM NOW AND DEPOSITED IN A BANK WHERE THEY WILL EARN INTEREST AT 7% PER YEAR.07)4 + (1.015)18 = $1307. 2008  $500 S = P (1 + i)n = 500 { (1.4 .5% PER MONTH ON THE UNPAID BALANCE. DETERMINE a) THE EFFECTIVE ANNUAL INTEREST RATE b) THE TOTAL AMOUNT OF INTEREST PAID a) SINCE r/m = 0. I = $307. 3 PAYMENTS.015)12 – 1 = .07)6 + (1.1956 b) S = P (1 + i)n = 1000 ( 1 + 0. HOW LARGE WILL THE BANK ACCOUNT BE ON JUNE 30.TIME VALUE – PROBLEM • NOW IS JUNE 30. EACH OF $500. 2002. IF THE ENTIRE AMOUNT IS PAID AS A LUMP SUM AT THE END OF 18 MONTHS. 2010? 2004  $500 .3 • A PERSONAL LOAN OF $1000 IS MADE FOR A PERIOD OF 18 MONTHS AT A INTEREST RATE OF 1.

12 = $631.67 • A CREDIT PLAN CHARGES INTEREST AT A RATE OF NOMINAL YEARLY 18% COMPOUNDED MONTHLY.8.92 . 8.10(1 + 1/12) } = $221. WHAT FUTURE AMOUNT IS DUE AT THE END OF THE LOAN PERIOD? S = P(1 + in) = 200 { 1 + 0.12 COMPOUNDED MONTHLY ? S = P(1 + r/m)m  2500 = P (1 + 0.56% • HOW MUCH WOULD A PERSON HAVE HAD TO INVEST 1 YEAR AGO TO HAVE $2500 AVAILABLE TODAY WHEN NOMINAL YEARLY INTEREST r = 0.6 .06)4.PROBLEM • FIND THE COMPOUND AMOUNT OF $500 AT 6% FOR 4. $796.18/12)12 – 1 = 0.10 • A LOAN OF $200 IS MADE FOR A PERIOD OF 13 MONTHS AT A SIMPLE INTEREST RATE OF 10%. $1006.1956 OR 19. S = P (1 + i)n = 500 (1.24 .TIME VALUE . WHAT IS THE EFFECTIVE INTEREST RATE ? ieff = (1 + r/m)m – 1 = (1 + 0. 12 YEARS.12/12)12  P = $2218.

000 AND HAS RECENTLY BEEN SOLD FOR $120.000.08 COMPOUNDED ANNUALLY? S = P(1 + i)n 2P = P(1. DETERMINE THE RATE OF INTEREST OBTAINED ON THE INITIAL INVESTMENT.138 OR 13.8% • A BUILDING WAS PURCHASED 10 YEARS AGO FOR $50.000 = 50.08)n  n = 9 YEARS b) r = 0. DISREGARDING ANY TAXES.15% .0915 OR 9.TIME VALUE .66 YEARS • AT WHAT NOMINAL INTEREST RATE WILL A MONEY DOUBLE USING CONTINUOUS COMPOUNDING IN 5 YEARS? S = Pern 2P = Pe5r  r = 0. S = P(1 + i)n 120.08n  n = 8.08 WITH CONTINUOUS INTEREST? S = Pern 2P = Pe0.000 (1 + i)10  i = 0.PROBLEM • HOW MANY YEARS DOES IT TAKE FOR A MONEY TO DOUBLE IF a) r = 0.

630 PM = 5000 / (1.573  2nd ALT. WITH MAINTENANCE INCLUDED.TIME VALUE . WHICH ALTERNATIVE IS GOOD IF i = 0.10 THAN PS = $75.000 SECOND ALTERNATIVE : P2 = $240.07) + 5000 / (1.060  1st ALT.000 PAYABLE NOW.000.203 P2 = 240.203 = $175.000 THE THIRD YEAR (PAYABLE AT THE END OF EACH YEAR). IS BETTER . THE ALTERNATIVE IS TO BUY A CRANE FOR $240.000 / (1.07)3 = $81.07)2 + 10. PM = $16.131 + 16.131 .000 / (1.PROBLEM • A CONSTRUCTION FIRM CAN LEASE A CRANE REQUIRED IN A PROJECT FOR 3 YEARS FOR $180.07? FIRST ALTERNATIVE : P1 = $180.000 AND SELL IT AT THE END OF 3 YEARS FOR $100.000 – 81.07)3 = $17. ANNUAL MAINTENANCE COSTS FOR THIS ALTERNATIVE IS $5000 THE FIRST 2 YEARS AND $10. IS BETTER IF i = 0.000 – PS + PM PS = S / (1 + i)n = 100.630 + 17.000 – 75.191 = $181.191 P2 = 240.

2105 = 4 ln (1+i) .06 ln 1. COMPARE THE NOMINAL INTEREST RATE RECEIVED FROM YOUR PROPERTY PURCHASE. S = P(1 + i)n  2421 = 2000 (1 + i)4   i = 0.TIME VALUE .PROBLEM • ASSUME THAT YOU SOLD A PROPERTY TODAY FOR $2421 WHICH YOU HAD PURCHASED 4 YEARS AGO WITH $2000 WITHDRAWN FROM YOUR SAVING ACCOUNT.0489 < 0. DURING THE FOUR YEAR PERIOD YOUR SAVINGS WOULD HAVE EARNED 6% PER YEAR.

025)16 – 1} / 0.06]  R = $3. THE NOMINAL INTEREST RATE IS 6% COMPOUNDED MONTHLY.005 (1.548 • IF YOU DEPOSIT $10.005)30 – 1} / 0.PROBLEM • WHAT ANNUAL YEAR.000 = R [{ (1.06 / 12 = 0.5 x 12 = 30 i = .5 YEARS.06)5 – 1} / 0.025)16]  R = $765.END PAYMENT MUST BE MADE EACH YEAR TO HAVE $20.10 / 4 = 0. i = .TIME VALUE .89 .000 TODAY WHAT EQUAL AMOUNTS CAN YOU WITHDRAW AT THE END OF EACH QUARTER FOR THE NEXT 4 YEARS WHEN THE NOMINAL INTEREST RATE IS 10%. HOW LARGE IS EACH PAYMENT ? n = 2.005 P = R [{(1 + i) n – 1} / i (1 + i)n ] 5000 = R [{(1.1} / i (1 + i)n ] 10.025 (1.74 • A LOAN OF $5000 IS SCHEDULED TO BE PAID IN EQUAL MONTHLY INSTALLMENTS OVER 2.025 P = R [{(1 + i)n . COMPOUNDED QUARTERLY ? n = 4 x 4 = 16 .005)30]  R = 179.000 AVAILABLE 5 YEARS FROM NOW IF THE COMPOUND ANNUAL INTEREST RATE IS 6% ? S = R [{(1 + i)n – 1} / i ]  20.000 = R [{(1.

000. P = R[{(1 + i) n – 1} / i(1 + i)n ] 10. PAYING $2000 DOWN AND THE DEALER WILL FINANCE THE REMAINDER AT A NOMINAL ANNUAL RATE OF 6%.005 .06 ? ANNUAL SAVING = 7000 – 4000 = 3000 P = R [{1 + i)n – 1} / i(1 + i)n ] P = 3000 [{1.000 IN THE BEGINNING AND $4000 PER YEAR.005(1. COMPOUNDED MONTHLY FOR 5 YEARS.000 = R[{(1. START . SHOULD WE START THE PROGRAM IF i = 0. IT IS ESTIMATED TO PRODUCE SAVINGS OF $7000 EACH YEAR FOR 5 YEARS.06 / 12 = 0.636 SINCE PRESENT WORTH OF SAVINGS IS > $12. DETERMINE THE AMOUNT OF YOUR MONTHLY PAYMENTS n = 5 x 12 = 60 .06 (1. i = 0.06)5 ] = $12.PROBLEM • THERE IS A TRAINING PROGRAM WHICH WILL COST $12.TIME VALUE . • YOU CAN BUY A NEW CAR FOR $12.06)5 – 1} / 0.33 .000 .005)60]  R = $193.005)60 – 1} / 0.

DETERMINE THE TOTAL AMOUNT THAT THE ACCOUNT WILL CONTAIN AT THE END OF THE FIFTH YEAR UNDER THE FOLLOWING CONDITIONS : a) DEPOSITS MADE AT THE BEGINNING OF EACH YEAR WITH SIMPLE INTEREST S = P(1 + ni) = 1200{ (1+5x.12)+(1+2x.1268)5 – 1} / .TIME VALUE .12) } = $8160 b) DEPOSITS MADE AT THE END OF EACH YEAR WITH INTEREST COMPOUNDED ANNUALLY S = R [{ (1+i)n – 1} / i ] = 1200 [{ (1.12)+(1+.08 .1268 S = R [{ (1+i)n – 1} / i ] = 1200 [{ (1.42 c) DEPOSITS MADE AT THE END OF EACH MONTH ($100) WITH INTEREST COMPOUNDED MONTHLY S = R [{ (1+i)n – 1} / i ] = 100 [{ (1+.12)+(1+3x.12/12) ] = $8166.12)+(1+4x.1268] = $7727.97 d) DEPOSITS MADE AT THE END OF EACH YEAR WITH INTEREST COMPOUNDED MONTHLY ieff = (1 + r/m)m – 1 = (1 + .1} / (. USING A NOMINAL INTEREST RATE OF 12% PER YEAR.PROBLEM • THE AMOUNT OF $1200 PER YEAR IS TO BE PAID INTO AN ACCOUNT OVER EACH OF THE NEXT 5 YEARS.12/12)60 .12)5 – 1} / .12/12)12 – 1 = 0.12] = $7623.

15]  R = $25.000 = R [{(1. IF THE PAYMENTS ARE LEFT IN THE FOREIGN COUNTRY.15)5 – 1} / 0.15] = $168.000 BE ACCUMULATED BY THE END OF 5 YEARS ? 175. INTEREST ON THE RETAINED FUNDS WILL BE PAID AT AN ANNUAL RATE OF 15%.000 IN ROYALTIES AT THE END OF EACH YEAR FOR THE NEXT 5 YEARS.560 b) HOW LARGE WOULD THE UNIFORM ANNUAL PAYMENTS HAVE TO BE IF THE PATENT OWNERS INSISTED THAT A MINIMUM $175.PROBLEM • A MANUFACTURING FIRM IN A FOREIGN COUNTRY HAS AGREED TO PAY $25.955 .000 [{ (1.TIME VALUE .15)5 – 1} / 0. a) WHAT TOTAL AMOUNT WILL BE AVAILABLE IN 5 YEARS? S = R [{(1 + i)n – 1} / i ] = 25.

01)100 – 1} / 0.126825 S = P (1 + ieff)n = 40.88 (today value of what was paid) ieff = (1 + r/m)m – 1 = (1 + 0.230.892.000) 57. HOW MUCH WOULD THIS PAYMENT BE? i = 0.337.88 = $29. AGREEING TO REPAY THE LOAN IN 100 MONTHLY PAYMENTS AT AN ANNUAL NOMINAL INTEREST RATE OF 12% COMPOUNDED MONTHLY.75 (today value of 40.126825)3 = $57.01)36 – 1} / 0.63 [{(1.000 (1.1} / i(1 + i)n] 40.12 / 12)12 = 0.01(1.87 SHOULD BE PAID .75 – 27.12 / 12 = 0. THE COMPANY NOW WANTS TO PAY OFF THE LOAN.PROBLEM • A COMPANY 3 YEARS AGO BORROWED $40.000 = R [{(1.63 n (up to now) = 3 x 12 = 36 S = R [{(1 + i)n – 1} / i ] = 634.000 TO PAY FOR A NEW MACHINE TOOL.337.01 MONTHLY .01] = $27.230.TIME VALUE . n (total) = 100 P = R [{(1 + i)n .01)100]  R = $634.

67 [{(1.12) = $3360 when paid as single payment 3200 – 3360 = .12/12(1+.$160 b) AS S AMOUNT S = R [{(1 + i)n – 1} / i] = 266.01)12 = 0.67 = $3200 when paid in installments S = 3000 (1 + i)n = 3000 (1.12/12)12 – 1} / .TIME VALUE .1268 which is > 0.1} / 0.01)12 .12 .PROBLEM • COMPARE THE COST TO PAY OFF A $3000 LOAN IN 1 YEAR WITH 12 EQUAL PAYMENTS WHEN INTEREST IS 12% COMPOUNDED MONTHLY AS OPPOSED TO MAKING A SINGLE PAYMENT WHEN THE EFFECTIVE INTEREST RATE IS 12% a) AS OUT OF POCKET AMOUNT P = R [{ (1 + i)n – 1} / i(1 + i)n]  3000 = R [{(1+.01] = $3382 3382 – 3360 = $22 c) WHICH IS ADVANTAGEOUS AND WHY? single payment is advantageous because : ieff = (1 + r/m)m – 1 = (1 + 0.67  12 x 266.12/12)12]  R = 266.

130 .06 – 1)} = $9992 • THE EXPECTED LIFE OF A NEW MACHINE IS 5 YEARS.1398} = $97.06 – 1) / (e0. ieff = er – 1  0.15 = er – 1  r = 0.TIME VALUE . ANNUAL CASH FLOW DUE TO THIS MACHINE IS $27. ASSUMING CONTINUOUS CASH FLOW AND CONTINUOUS COMPOUNDING. WHAT IS THE AMOUNT THAT CAN INITIALLY BE PAID TO THIS MACHINE IF WE WANT TO EARN 15% ON THE INVESTMENT ? Ř = 27.1398e5x0.1398 P = Ř {(ern – 1) / rern} = 27.000 .000.1398 – 1) / 0.000 {(e5x0. WHAT IS THE AMOUNT IN THE ACCOUNT AFTER 5 YEARS? S = R {(ern – 1) / (er – 1)} = 1766 {(e5x0.PROBLEM • AT THE END OF EACH YEAR A SINGLE PAYMENT OF $1766 IS DEPOSITED IN AN ACCOUNT THAT EARNS 6% COMPOUNDED CONTINUOUSLY.

NEEDS REPLACEMENT EVERY 5 YEARS AND REQUIRES $300 / YEAR AS MAINTENANCE EXPENSE WITH ANOTHER ONE THAT COSTS $4000 BUT WOULD HAVE A 10 YEAR LIFE AND ONLY NEEDS $100 / YEAR FOR MAINTENANCE.PROBLEM • USING THE CAPITALIZED COST PROCEDURE COMPARE THE MERITS OF BUYING A PUMP THAT COSTS $2000.1 + 2000 + 2000 / {(1.276 K2 = R / i + CV + CR / {(1 + i)n – 1} = 100 / .1)5 – 1} = $8.1)10 – 1} = $7.1 + 4000 + 4000 / {(1. K1 = R / i + CV + CR / {(1 + i)n – 1} = 300 / .TIME VALUE . ASSUME 10% INTEREST RATE PER YEAR.510 SECOND ALTERNATIVE IS BETTER .

VII. PROFITABILITY .

PROFITABILITY
BEFORE CAPITAL IS INVESTED IN A PROJECT, IT IS NECESSARY TO
KNOW HOW MUCH PROFIT CAN BE OBTAINED AND WHETHER OR
NOT IT MIGHT BE MORE ADVANTAGEOUS TO INVEST THE CAPITAL
IN ANOTHER FORM OF ENTERPRICE. THUS, DETERMINATION OF
PROFIT IS A MAJOR GOAL OF AN ECONOMIC ANALYSIS.
PROFIT CAN BE CALCULATED WITH SOME ASSUMPTIONS ABOUT
FUTURE (DEMAND, PRICE, AMOUNT OF PRODUCTION), SO IT IS
NOT AN UNFAILING VALUE AND CAN ONLY SERVE AS A GUIDE.
PROFIT ALONE CANNOT BE USED FOR DETERMINING IF AN
INVESTMENT SHOULD BE MADE. SUPPOSE TWO INVESTMENTS
ARE UNDER CONSIDERATION : ONE REQUIRES $100,000 OF
CAPITAL AND WILL YIELD A PROFIT OF $10,000/ YEAR;
THE OTHER REQUIRES $1 MILLION OF CAPITAL AND WILL YIELD
$50,000/ YEAR. THE SECOND GIVES A GREATER YEARLY PROFIT,
BUT THE RATE OF RETURN IS ONLY 5% WHILE THE RATE OF
RETURN OF THE FIRST IS 10%.

PROFITABILITY
THE MOST COMMONLY USED METHODS FOR PROFITABILITY
EVALUATION ARE:
1. RATE OF RETURN
2. PAYOUT PERIOD
3. NET RETURN
4. DISCOUNTED CASH FLOW
5. NET PRESENT WORTH
6. EQUIVALENT ANNUAL COST – ANNUAL WORTH
EACH OF THESE METHODS HAVE ITS ADVANTAGES AND
DISADVANTAGES AND SINCE NO SINGLE METHOD IS BEST FOR
ALL SITUATIONS THE ENGINEER SHOULD KNOW THEM ALL AND
CHOOSE THE BEST SUITING ONE.

PROFITABILITY
1. RATE OF RETURN ON INVESTMENT
THE YEARLY PROFIT DIVIDED BY THE TOTAL INITIAL INVESTMENT
(FIXED + WORKING CAPITAL) REPRESENTS THE RETURN ON
INVESTMENT.
PROFITS AND THEREFORE RATE OF RETURNS MAY BE
EXPRESSED ON THE BEFORE-TAX OR AFTER-TAX BASIS AND THIS
SHOULD BE INDICATED.
ROI = NET PROFIT PER YEAR / TOTAL INVESTMENT
RATE OF RETURN MAY BE COMPARED FOR ALTERNATIVE
INVESTMENTS, INCLUDING PUTTING THE MONEY IN THE BANK,
AND GIVES A FIRST APPROXIMATION OF HOW ATTRACTIVE THE
NEW PROJECT MAY BE. IF THE PROFIT VARIES FROM YEAR TO
YEAR, AN AVERAGE MAY BE ASSUMED.
IN RATE OF RETURN CALCULATION, WE DO NOT CONSIDER THE
TIME VALUE OF MONEY.

PROFITABILITY
EXAMPLE : A PROPOSED MANUFACTURING PLANT REQUIRES AN
INITIAL FIXED CAPITAL OF $900,000 AND A WORKING CAPITAL OF
$100,000. IT IS ESTIMATED THAT ANNUAL INCOME WILL BE
$800,000 AND ANNUAL EXPENSES (INCLUDING DEPRECIATION)
WILL BE $520,000 BEFORE INCOME TAX. INCOME TAX IS 20%.
FIND % RETURN ON INVESTMENT BEFORE AND AFTER TAX.
800,000 – 520,000 = $280,000 / YEAR PROFIT BEFORE TAX
280,000 / 1,000,000 = 0.28

28% ROI BEFORE TAX
(280,000)(0.80) / 1,000,000 = .224  22.4% ROI AFTER TAX

THE ‘MINIMUM ACCEPTABLE RATE OF RETURN’ (MARR) IS THE RATE
SET BY AN ORGANIZATION TO DESIGNATE THE LOWEST LEVEL OF
RETURN THAT MAKES AN INVESTMENT ACCEPTABLE. IT IS A
DEVICE DESIGNED TO MAKE THE BEST POSSIBLE USE OF MONEY
AND APPLIED FOR EVALUATING NEW PROJECTS, COST
REDUCTION PROPOSALS, RESEARCH AND DEVELOPMENT
PROGRAMS.

PROFITABILITY
MARR IS THE KEY FOR DECIDING ON THE PROFITABILITY OF A NEW
INVESTMENT.
HAVING PROFIT DOES NOT MAKE A PROJECT FEASIBLE OR
PROFITABLE . YOU WOULD NOT CONSIDER A NEW INVESTMENT
PROFITABLE IF YOU INVEST 1,000,000$ AND HAVE A PROFIT OF
1,000 $ / YEAR.
TO HAVE PROFITABLE INVESTMENT, YOU SHOULD EARN MORE THAN
MARR.

. TO HAVE PROFITABLE INVESTMENTS BECOMES EASIER AND CAPITAL OWNERS PREFER TO MAKE NEW INVESTMENTS.PROFITABILITY THE VALUE OF MARR DEPENDS MAINLY ON * THE REAL INTEREST RATE IN THE COUNTRY * THE RISK OF THE INVESTMENT * THE POLITICAL AND ECONOMIC STABILITY AS THE MARR VALUE DECREASE.

THAN WE HAVE ‘PAYOUT PERIOD INCLUDING INTEREST’. IF TIME VALUE OF MONEY IS ALSO CONSIDERED. IN THIS CASE THE ANNUAL CASH FLOWS ARE DISCOUNTED. DEPRECIATION/YEAR INTEREST IS NEGLECTED AND ONLY DEPRECIABLE FIXED INVESTMENT IS CONSIDERED. PAYOUT PERIOD (PAYBACK METHOD) PAYOUT PERIOD OR TIME IS THE MINIMUM LENGTH OF TIME THEORETICALLY NECESSARY TO RECOVER THE ORIGINAL FIXED CAPITAL INVESTMENT IN THE FORM OF CASH FLOW TO THE PROJECT (NET PROFIT + DEPRECIATION). DEPRECIABLE FIXED CAPITAL INVESTMENT PAYOUT PERIOD = AV.PROFITABILITY 2. PROFIT/YEAR + AV. .

LINE DEPRECIATION WILL BE USED.000 = 75.08 (1.000 TO MANUFACTURE A NEW PRODUCT.08)n 4 x 0.PROFITABILITY EXAMPLE: A COMPANY PLANS AN INVESTMENT OF $300.08 PAYOUT PERIOD n = 5 YEARS .08)n = 1  n = log 1. STRAIGHT.000 = 4 YEARS b) P = R [ {(1 + i)n – 1} / i (1 + i)n 300.000 a) PAYOUT PERIOD = 300.000 {(1.000 / 75.47 / log 1. WHAT IS THE PAYOUT PERIOD a) IF TIME VALUE OF MONEY IS NOT CONSIDERED? b) IF TIME VALUE IS CONSIDERED AND i IS 8%? ANNUAL CASH FLOW = NET PROFIT + DEPRECIATION = 45.68(1.000.000 + 30.08)n – 1  0.08 (1. ALLOWABLE DEPRECIATION IS 10 YEARS. ANNUAL NET PROFIT IS $45.08)n – 1} / 0.000 = 75.08)n = (1.

PROFITABILITY THE PAYOUT PERIOD METHOD IS USED WIDELY TO RATE RELATIVELY SMALL INVESTMENT PROPOSALS IN PRODUCTION DEPARTMENTS. FOR EXAMPLE AN INVESTMENT OF $1000 WITH LIFE OF 1 YEAR AND HAS A NET RETURN OF $1000 WILL YIELD A PAYOUT PERIOD OF 1 YEAR. . IF YOU CONSIDER ONLY PAYOUT PERIODS. IT MAY LEAD TO INCORRECT CONCLUSIONS SINCE IT DOES NOT RECOGNIZE THE CASH FLOW OCCURING AFTER THE PAYOUT PERIOD. ANOTHER INVESTMENT OF $1000 PROMISES TO RETURN $250/YEAR DURING ITS ECONOMIC LIFE TEN YEARS. THIS WILL YIELD A PAYOUT PERIOD OF 4 YEARS. YOU SHALL CHOOSE THE FIRST ALTERNATIVE WHICH ACCUALLY EARNS NOTHING.

THIS IS CALCULATED BY SUBTRACTING THE TOTAL AMOUNT EARNED AT THE MINIMUM RATE OF RETURN AND THE TOTAL CAPITAL INVESTMENT FROM THE TOTAL CASH FLOW. NET RETURN NET RETURN IS THE AMOUNT OF CASH FLOW OVER AND ABOVE THAT REQUIRED TO MEET THE MINIMUM ACCEPTABLE RATE OF RETURN AND RECOVER THE TOTAL CAPITAL INVESTMENT. TOTAL CASH FLOW: TOTAL NET PROFIT + TOTAL DEPRECIATION +SALVAGE VALUE + RECOVERED WORKING CAPITAL INVESTMENT + EARNING OF INVESTMENT: TOTAL CAPITAL INVESTMENT (FIXED + WORKING) + MARR MULTIPLIED BY TOTAL CAPITAL INVESTMENT FOR ALL YEARS .PROFITABILITY 3. IN THIS CALCULATION WE NEGLECT THE TIME VALUE OF MONEY.

(MARR)(N)(TC) j 1 IF WE HAVE AN AVERAGE PROFIT (PAVE).j + dj) + S + WC – TC – (MARR)(N)(TC) j 1 WHERE NP.PROFITABILITY N Rn =  (NP. dj IS DEPRECIATION FOR YEAR j. THEN Rn.j IS NET PROFIT. S IS THE SALVAGE VALUE IN CASES WHERE N dj + S + WC = TC Rn =  NP.j .AVE = PAVE – (MARR)(TC) .

18 . INCOME TAX IS 35%. IN THE FIRST YEAR CAPACITY IS USED 50%. MARR IS 30%. DEPRECIATION IS BY DOUBLE-DECLINING IN 5 YEARS. VARIABLE COSTS AT FULL CAPACITY IS $5 MILLION/YEAR. USING THE TABLE : PAVE = 1/10 (18.222p) 106 – (5.8p – 81)(1 .222p – 5.PROFITABILITY EXAMPLE: A COMPANY PLANS TO START A NEW PRODUCT WHICH REQUIRES $24 MILLION OF NEW MACHINERY AND $4 MILLION WORKING CAPITAL. IN THE SECOND YEAR 90% AND AFTER THE SECOND YEAR 100%. CALCULATE THE SALES PRICE (p) REQUIRED TO ACHIEVE MARR IN TEN YEARS BY NET RETURN METHOD. ALL FIXED COSTS EXCEPT DEPRECIATION IS $1 MILLION/YEAR.265) 106 – (0.0.30)(28) 106  p = $11.265) 106 Rn = 0 = (1. THE PRODUCTION RATE AT 100% CAPACITY IS 2 x 106 kg/YEAR.35) 106 = (1.

456 8.26 9.8 2 2 2 2 2 2 2 2 18.592 8. $ 106/yr F. PERCENT OF OPERATING TIME B.76 3.) $ 106/yr E.592 0 0 0 0 0 24 13.592 6 6 6 6 6 81 1 . DEPRECIATION. ALL VARIABLE COSTS.PROFITABILITY YEAR 1 2 3 4 5 6 7 8 9 10 SUM ----------------------------------------------------------------------------------A. TOTAL PRODUCT COST(C+D+E) $ 106/yr 50 1 90 100 100 100 100 100 100 100 100 1.1 11.6 5. ALL FIXED COSTS (EXCEPT DEP. 106 kg/yr C.592 2.8 2.5 4.456 2. $ 106/yr D. PRODUCT RATE.5 5 5 5 5 5 5 5 5 47 1 1 1 1 1 1 1 1 1 10 9.

PROFITABILITY 4. IF P < 0. NET PRESENT WORTH THE NET PRESENT WORTH OF A PROJECT IS THE DIFFERENCE BETWEEN THE PRESENT VALUE OF THE ANNUAL CASH FLOWS AND THE INITIAL REQUIRED INVESTMENT . YOUR PROJECT IS EQUAL OR BETTER THAN MARR. OR MORE GENERALLY: P = PRESENT WORTH OF BENEFITS – PRESENT WORTH OF COSTS YOU CAN USE PRESENT WORTH TO A. COMPARE ALTERNATIVES (ALLWAYS USING SAME NUMBER OF YEARS AND CONSTANT i). DECIDE IF A PROJECT IS FEASIBLE OR NOT (TAKING i = MARR). IF P ≥ 0. LESS THAN MARR . LARGER P IS BETTER B.

000 8.500 4.500. A COSTS $9000.YEAR 3.08)3 – 14.1} / 0.YEAR MACHINE A : $ 4.500 = $2550 MACHINE A IS BETTER .1} / 0.08)2 .08 (1+0.500 MACHINE B : $ 6.08)3 .500 4.PROFITABILITY EXAMPLE : THERE ARE TWO ALTERNATIVE MACHINES YOU CAN BUY TO YOUR FACTORY.08)2] + 8000 / (1+0.000 6.000 FIND PRESENT WORTH IF i = 0. B COSTS $14.08 (1+0. THE NET CASH FLOWS ARE: 1.8 AND SALVAGE VALUE IS ZERO PW(A) = (4500) [{(1+0.YEAR 2. A AND B.08)3] – 9000 = $2594 PW(B) = (6000) [{(1+0.

327 – 110.000 PWINCOME = 30.000 / (1.000 / (1.000 AND WORKING CAPITAL INVESTMENT IS $10.000 / (1.000 43.000.000+10.327 .000 AT THE END OF 5 YEAR LIFE.000 40.000 = $17.15)5 = $127.000 36.327 NET PRESENT WORTH IS 127.000 31.15)5 + (10.15)3 + 40. SALVAGE IS $10.PROFITABILITY EXAMPLE : FIXED CAPITAL INVESTMENT IS $100.15 AND AFTER TAX CASH FLOW AT THE END OF EACH YEAR IS AS FOLLOWS: YEAR 1 2 3 4 5 $ 30.15)4 + 43.15)2 + 36.000 / (1.15) + 31.000) / (1. FIND PW IF i = 0.000 / (1.

WHEREAS REACTOR B WILL REQUIRE $100 MAINTENANCE DURING THE THIRD YEAR AND $300 DURING THE FIFTH YEAR.000 INSTALLED AND HAS A LIFE OF 6 YEARS WITH A SALVAGE VALUE OF $800 FOR FITTINGS. MADE OF STEEL BUT GLASS LINED. WHICH INSTALLATION SHOWS THE LOWER EQUIVALENT CAPITAL REQUIREMENT AT THE PRESENT TIME? PA = –12.15 + 1400 / 1. COSTS $28.14 – 200 / 1. TWO ALTERNATIVES ARE SUGGESTED: REACTOR A MADE OF ORDINARY STEEL COSTS $12.12 – 12.16 = – 30.PROFITABILITY EXAMPLE: A REACTOR TO BE USED FOR OXIDATION OF PARAFFIN VAX TO MAKE FATTY ACIDS IS REQUIRED.529 PB = –28. WHEREAS REACTOR B.000 –12.000 + 400 / 1.13 + 400 / 1. THE VALUE OF THESE IMPROVEMENTS IS ESTIMATED AT $400 PER YEAR.12 + 300 / 1.1 + 400 / 1.000 INSTALLED AND HAS A LIFE OF TWO YEARS WITH A JUNK VALUE OF $200. IT IS EXPECTED THAT REACTOR B WILL GIVE A SLIGHTLY BETTER YIELD AND A BETTER QUALITY PRODUCT.200 / 1.14 + 100 / 1. BUT REACTOR A IS EXPECTED TO REQUIRE ABOUT $400 FOR MAINTENANCE DURING THE SECOND YEAR. IF MONEY IS WORTH 10%.015 REACTOR B HAS LOWER REQUIREMENT . LABOR AND OTHER OPERATING COSTS FOR BOTH REACTORS ARE THE SAME.200 / 1.16 = – 26.

000.215)] + 4. THE YEARLY EXPECTED CASH FLOW IS 2.000 / 1.12.000.PROFITABILITY • A COMPANY IS CONSIDERING A NEW INVESTMENT WHICH COSTS 12.000 – 10.000 = 2. IF MARR IS 20% AND LIFE OF THE PLANT IS 15 YEARS.000 [ (1.000 TL AND REST OF THE FCI COST IS 8.000.215 – 1) / . THE LAND COST IS 2.500.000. IS THIS INVESTMENT FEASIBLE? WC = 12.000.20 (1.000 P = 2.000.000.696 TL NOT FEASIBLE .500.000 TL AS TCI.000 TL.215 .000 TL.51.000 P = .000.

THE ESTIMATED LIFE OF THIS PROJECT IS 8 YEARS.000 TL? WC = (1.068 ) CF (CASH FLOW) = 120.25 TL . NECESSARY INVESTMENT IS 800.000p – 1. IF TAX RATE IS 20%.000 TL EXCEPT DEPRECIATION AND WORKING CAPITAL IS 20% OF THE TOTAL YEARLY PRODUCTION COST. YEARLY PRODUCTION COST IS ESTIMATED TO BE 1.300. WHAT SHOULD BE THE SELLING PRICE OF THE CHEMICAL IF MANAGEMENT REQUIRES A PRESENT WORTH OF MINIMUM 1.000)0.068 -1)/. AND i = 6%.000 p = 13.000.245 = NET PROFIT + DEPRECIATION 120.000) .000 + 260.06(1.000 = -800.LINE IN 8 YEARS.000.068 +(CF) (1.000 -260.200.000/1.20 = 260.245 = (100.000kg/YEAR.200.000 P=1.000 + 100.80 + 100.000 TL WORTH MACHINERY WHICH WILL BE DEPRECIATED BY STRAIGHT.PROFITABILITY EXAMPLE: IN AN EXISTING PLANT A NEW CHEMICAL WILL BE PRODUCED WITH A RATE OF 100.

PROFITABILITY
WORK SHEET FOR NET PRESENT WORTH
YEARS
0
1. FIXED CAPITAL INVESTMENT
2. WORKING CAPITAL
3. TOTAL CAPITAL INVESTMENT (1+2)
4.OPERATING RATE (% OF CAPACITY)
5. ANNUAL INCOME (SALES)
6. ANNUAL MANUFACTURING COST
7. DEPRECIATION
8. ANNUAL GENERAL EXPENSES
9. TOTAL PRODUCT COST (6 + 7 + 8)
10. ANNUAL GROSS PROFIT (5 - 9)
11. INCOME TAX
12. ANNUAL NET PROFIT (10 – 11)
13.ANNUAL OPERATING CASH FLOW (12 + 7)
14.TOTAL ANNUAL CASH FLOW (13 + 3)

1 st

2nd

3rd

4th

5th

PROFITABILITY
15.NET PRESENT WORTH
ENTER EXPENDITURES AS NEGATIVE, INCOMES AS POSITIVE
ASSUME ALL INVESTMENT IS MADE IN YEAR 0 AND PRODUCTION STARTS IN
THE BEGINNING OF YEAR 1; WORKING CAPITAL AND SALVAGE VALUE IS
RECOVERED AT THE END AND SINCE THEY ARE LUMP-SUM, FINITE CASH
FLOW SHOULD BE APPLIED IN ALL CASES.
NET PRESENT WORTH (LINE 15) IS CALCULATED BY DECIDING ON r OR i AND
USING THE BASIC FORMULAS:
a) P = S / ern
b) P = S / (1 + i)n

PROFITABILITY
5. DISCOUNTED CASH FLOW
RATE OF RETURN BASED ON DISDOUNTED CASH FLOW IS ALSO CALLED
PROFITABILITY INDEX, TRUE RATE OF RETURN OR INTERNAL RATE OF
RETURN. THIS METHOD TAKES INTO ACCOUNT THE TIME VALUE OF
MONEY. A TRIAL AND ERROR PROCEDURE IS USED TO ESTABLISH A RATE
OF RETURN WHICH CAN BE APPLIED TO YEARLY CASH FLOW SO THAT
THE ORIGINAL INVESTMENT IS REDUCED TO ZERO (OR TO SALVAGE AND
LAND VALUE PLUS WORKING CAPITAL INVESTMENT) DURING THE
PROJECT LIFE.
EXAMPLE : FIXED CAPITAL INVESTMENT IS $100,000 AND WORKING CAPITAL
INVESTMENT IS $10,000, SALVAGE IS $10,000 AT THE END OF 5 YEAR LIFE;
WHAT IS THE INTERNAL RATE OF RETURN IF PREDICTED AFTER-TAX CASH
FLOW AT THE END OF EACH YEAR IS AS FOLLOWS:
YEAR
1
2
3
4
5
$
30,000
31,000 36,000 40,000
43,000
S = (30,000)(1+i)4 + (31,000)(1+i)3 + (36,000)(1+i)2 + (40,000)(1+i) + 43,000
(110,000)(1+i)5 – 10,000 – 10,000 = 0
BY TRIAL AND ERROR i = 0.207

PROFITABILITY
USE OF CONTINUOUS INTEREST COMPOUNDING :
WHEN CONTINUOUS INTEREST IS USED WE SHOULD REPLACE
(1 + i)n WITH ern (r IS NOMINAL INTEREST)

EXAMPLE : DETERMINE THE INTERNAL RATE OF RETURN (i.e.
PROFITABILITY INDEX) FOR THE FOLLOWING PROJECT:
ONE YEAR PRIOR TO START - UP, LAND IS PURCHASED FOR
$200,000. FIXED CAPITAL INVESTMENT IS $600,000 AND A
WORKING CAPITAL OF $200,000 IS NEEDED. ESTIMATED LIFE IS 10
YEARS, SALVAGE VALUE IS $100,000. ANNUAL CASH FLOW (NET
PROFIT + DEPRECIATION) WILL BE $310,000 AND IS CONTINUOUS
CASH FLOW . INTEREST IS CONTINUOUS COMPOUNDING .

PROFITABILITY
LAND VALUE AT TIME 0  S = Pern = 200,000 er
FIXED INVESTMENT AT TIME 0  600,000
TOTAL CASH POSITION AT TIME 0 :
CP0 = 200,000 er + 600,000 + 200,000
AT THE END OF THE PROJECT WE HAVE SALVAGE + WORKING
CAPITAL + LAND WHICH IS $500,000
PWS = 500,000 / e10r
PRESENT WORTH OF CASH FLOW :
PWC = Ř {(ern – 1) / rern} = 310,000 {(e10r – 1) / re10r}
WE SHOULD FIND THE r WHICH DECREASES THE NET CASH
POSITION TO 0 AT THE END OF 10 YEARS : CP0 = PWS + PWC
200,000 er + 600,000 + 200,000 =
500,000 / e10r + 310,000 { (e10r – 1) / re10r}
BY TRIAL AND ERROR  r = 0.28 ; SO PROFITABILITY INDEX IS 28%

ANNUAL OPERATING COSTS IS $500 PER YEAR AND i = 0.08 /( 1. b) IF SALVAGE VALUE IS $300 ? a) R = P [ i (1 + i)n / {(1 + i)n – 1}] = 1.08. HAS 5 YEARS LIFE. EQUIVALENT ANNUAL COST – ANNUAL WORTH EQUIVALENT ANNUAL COST (EAC) IS CONVERTING ALL COSTS TO AN EQUIVALENT SERIES OF UNIFORM END-OF-YEAR PAYMENTS.600 [0. WHAT IS EAC a) IF SALVAGE VALUE IS 0 . IF WE ARE COMPARING INCOMES.PROFITABILITY 6.085 / (1.085 – 1)] = 51 EAC = 400 – 51 + 500 = $849 . EXAMPLE: A MACHINE COSTS $1.085 – 1)] = 400 EAC = 400 + 500 = $900 b) R = S [ i / {(1 + i)n – 1}] = 300 [0. WE CONVERT INCOMES SIMILARLY TO OBTAIN EQUIVALENT ANNUAL WORTH (EAW).08 x 1.600.

12 (1. OR IT CAN BE LEASED FOR 2.000 [.12)N / (1. WHAT IS THE MINIMUM N TO JUSTIFY PURCHASING? a) PRESENT WORTH METHOD P = R [ (1 + i)n – 1 / i (1 + i)n ] 10.2 N ln 1.12 (1.12)N – 1 / .200 [ (1.545 = (1. IF INTEREST IS 12% PER YEAR.200 A YEAR.000 AND LAST FOR N YEARS (WITH NO SALVAGE VALUE).PROFITABILITY EXAMPLE: EQUIPMENT CAN BE PURCHASED FOR $10.2 N=7 b) EAC METHOD R = P [ i (1 + i)n / (1 + i)n – 1] 2.12)N (1.000 = 2.12 = ln 2.12)N – 1 / (1.12)N – 1] N=7 .200 = 10.12)N ] .12)N = 2.

PROFITABILITY
EXAMPLE: A PACKAGING MACHINE WITH ECONOMIC LIFE OF 10
YEARS COSTS $20,000 WITH 0 SALVAGE VALUE. THIS MACHINE
HAS OPERATING AND MAINTENANCE COSTS OF $10 PER HOUR. IT
CAN PACKAGE 100 UNITS PER HOUR. THE CURRENT METHOD IS
BY HAND LABOR COSTING $12 PER HOUR TO PACKAGE AN
AVARAGE OF 100 UNITS IN 1.5 HOURS. HOW MANY PACKAGES
SHOULD BE MADE PER YEAR TO JUSTIFY THE PURCHASE OF THIS
MACHINE IF i = 6%?
R = P { i (1 + i)n / (1 + i)n – 1} = 20,000 { 0.06 (1.06)10 / (1.06)10 – 1} = 2,719
YEARLY COST WITH MACHINE =
$2,719 + ($10/HR)(1/100 HR/PACK)(X PACK/YEAR) = 2719 + 0.1X
YEARLY COST WITH CURRENT METHOD =
($12/HR)(1.5/100 HR/PACK)(X PACK/YEAR) = 0.18X
2719 + 0.1X = 0.18X
X = 33,988 PACKS / YEAR

PROFITABILITY
EXAMPLE: A FURNACE INSTALLATION COSTING $12,000 WITH OPERATING
COSTS OF $4,800 PER YEAR AND A 10-YEAR LIFE IS OFFERED BY ONE
SUPPLIER; A SECOND ALTERNATIVE GUARANTEES TO PROVIDE THE SAME
SERVICE WITH $1,000 A YEAR LOWER OPERATING COSTS AT A COST OF
$25,000. SALVAGE VALUE ON BOTH FURNACES IS ESTIMATED AT $1,000.
WHAT INCREASE IN SERVICE LIFE WOULD BE REQUIRED FOR THE
SECOND PROPOSAL TO WARRANT ITS SELECTION IF i = 8%?
R = P { i (1 + i)n / (1 + i)n – 1} AND R = S { i / (1 + i)n – 1 }
R = 12,000 { 0.08 (1.08)10 / (1.08)10 – 1} - 1,000 { 0.08 / (1.08)10 – 1 } = 1,719
1,719 + 4,800 = 25,000 { 0.08 (1.08)n / (1.08)n – 1} –
1,000 { 0.08 / (1.08) n – 1 } + 3800
2719 { (1.08)n – 1 } = 25,000 (0.08) (1.08)n – 1000 (0.08)
(1.08)n = 3.67
n = 16.88

PROFITABILITY
TO MAKE A DECISION ON THE PROFITABILTY OF A PROJECT:
- DECIDE ON A MARR VALUE,
- CALCULATE ROI; IF ROI ≥ MARR
OR
CALCULATE NET RETURN; IF Rn ≥ 0
OR
CALCULATE PRESENT WORTH USING i = MARR; IF P ≥ 0
OR
CALCULATE IRR; IF IRR ≥ MARR
THAN THE PROJECT IS PROFITABLE.
PAYBACK PERIOD METHOD IS APPLIED ONLY FOR SMALL PROJECTS
EQUIVALENT ANNUAL COST METHOD IS USUALLY APPLIED FOR COMPARING
ALTERNATIVES

PROFITABILITY
RISK ANALYSIS AND ACCEPTABLE RETURNS:
IN INDUSTRIAL OPERATIONS THERE IS ALWAYS A DEGREE OF
UNCERTANITY AND CALCULATED RETURN DEPENDS ON SOME
ASSUMPTIONS ABOUT THE FUTURE. SO THERE IS ALWAYS A RISK
FACTOR. A SIMPLE METHOD IS TO MAKE THE CALCULATIONS FOR
WORST, AVERAGE AND BEST CASES. A BETTER METHOD IS TO
MAKE RISK ANALYSIS USING PROPER SOFTWARES. YOU SHOULD
FIRST DECIDE ON THE RANGE OF VALUES FOR EACH FACTOR
(TOTAL INVESTMENT, PLANT LIFE, ANNUAL CASH FLOW…) AND THE
LIKELIHOOD OF OCCURANCE OF EACH VALUE. COMPUTER THAN
CALCULATES THE PROBABILITY OF ALL RETURNS.
DUE TO THE UNCERTANITIES, IN AVERAGE 20 – 30% RETURN
BEFORE TAX (NOT CONSIDERING THE EFFECT OF INFLATION)
WHICH MEANS 14 – 20% RETURN AFTER TAX IS REQUIRED FOR
INVESTING IN INDUSTRY.

VIII. ANALYSIS OF ALTERNATIVES

THE CAPITAL REQUIRED AND THE EXPENSES INVOLVED CAN VARY CONSIDERABLY DEPENDING ON THE METHOD CHOSEN. IN INDUSTRIAL OPERATIONS.ALTERNATIVES AN ‘ALTERNATIVE’ IN ENGINEERING ECONOMICS IS AN INVESTMENT POSSIBILITY. SIMILARLY. IT MAY BE NECESSARY. IT IS OFTEN POSSIBLE TO PRODUCE EQUIVALENT PRODUCTS IN DIFFERENT WAYS. THEREFORE. IT IS A SINGLE UNDERTAKING WITH A DISTINGUISHABLE CASH FLOW. NOT ONLY TO DECIDE IF A GIVEN BUSINESS VENTURE WOULD BE PROFITABLE. BUT ALSO TO DECIDE WHICH OF SEVERAL POSSIBLE METHODS WOULD BE THE MOST DESIRABLE. ALTHOUGH THE PHYSICAL RESULTS MAY BE APPROXIMATELY THE SAME. . DECISION USUALLY HAS LONG-TERM CONSEQUENCES SO IT IS IMPORTANT FOR THE ENGINEERS TO BE COMPETENT ECONOMIC ANALYSTS. ALTERNATIVE METHODS INVOLVING VARYING CAPITAL AND EXPENSES CAN OFTEN BE USED TO CARRY OUT OTHER TYPES OF BUSINESS VENTURES.

AIM SHOULD BE TO DEVELOP A SET OF ALTERNATIVES LARGE ENOUGH TO INCLUDE THE BEST POSSIBLE SOLUTION.BETTER OPTION. HOW MANY ALTERNATIVES SHOULD WE HAVE? YOU CAN NEVER DECIDE IF YOU CONTINUE SEARCHING FOR A STILL. COMPARISON IS MADE. EACH PROPOSAL IS EVALUATED ON ITS MERIT AND IS APPROVED IF IT MEETS THE CRETERIA OF ACCEPTABILITY. AFTER PREPARING ENOUGH DATA FOR EACH ALTERNATIVE. COMPARISONS OF INDEPENDENT INVESTMENT PROPOSALS ARE DESIGNED TO DETERMINE WHICH PROPOSALS SATISFY A MINIMUM LEVEL OF ECONOMIC VALUE. WE CAN CLASSIFY ALTERNATIVES INTO DEPENDENT AND INDEPENDENT CATEGORIES.ALTERNATIVES ANALYSIS START WITH THE IDENTIFICATION OF ALTERNATIVES. AN INDEPENDENT ALTERNATIVE IS NOT AFFECTED BY THE SELECTION OF ANOTHER ALTERNATIVE. . ON THE OTHER SIDE. ACTING ON THE FIRST OPTION THAT COMES TO MIND MAY RESULT WITH A WRONG DECISION. ALL THOSE THAT SURPASS THE MINIMUM LEVEL MAY BE IMPLEMENTED AS LONG AS SUFFICIENT CAPITAL IS AVAILABLE.

PROBLEM. BECAUSE A SINGLE COURSE OF ACTION IS SOUGHT TO SOLVE A PARTICULAR.ALTERNATIVES DEPENDENT ALTERNATIVES ARISE WHEN ALTERNATIVES ARE RELATED IN A WAY THAT INFLUENCES THE SELECTION PROCESS. THERE ARE TWO CLASSIFICATIONS FOR DEPENDENT ALTERNATIVES : MUTUALLY EXCLUSIVE DEPENDENT AND CONTINGENCY DEPENDENT. THE CONTINGENCY DEPENDENT ALTERNATIVES ARISE WHEN INDIVIDUAL INVESTMENT OPPURTUNITIES ARE LINKED TO OTHER ALTERNATIVES. ALTERNATIVES ARE MUTUALLY EXCLUSIVE WHEN THE SELECTION OF ONE ELIMINATES THE OPPURTUNITY TO ACCEPT ANY OF THE OTHERS. OFTEN URGENT. OPERATIONAL PROBLEMS NORMALLY FIT INTO THIS CATEGORY. THE PURCHASE OF NEW COMPUTER TERMINALS IS CONTINGENT ON THE PURCHASE OF HARDWARE INCREASING THE CAPACITY OF THE MAIN COMPUTER. THEN THE ACCEPTANCE OF ONE ALTERNATIVE DEPENDS ON THE SIMULTANEOUS ACCEPTANCE OF ONE OR MORE RELATED ALTERNATIVES. .

EASY MAY BE USEFULL WHEN ECONOMIC LIFES OF ALTERNATIVES ARE DIFFERENT . EASY YOU CAN USE IT IN ALL CASES WHEN ECONOMIC LIFE OF EQUIPMENT IS DIFFERENT. EQUIVALENT ANNUAL COST (WORTH) METHOD RELIABLE. B. YOU HAVE TO FIND THE COMMON NUMBER OF YEARS. PRESENT WORTH METHOD RELIABLE.ALTERNATIVES 1. AND IN SOME CASES IT CAN BE A LONG CALCULATION. ANALYSIS OF MUTUALLY EXCLUSIVE ALTERNATIVES WE CAN USE DIFFERENT METHODS FOR EVALUATION: A.

INTERNAL RATE OF RETURN (IRR) METHOD MAYBE MISLEADING.ALTERNATIVES C. SO YOU HAVE TO USE ‘INCREMENTAL IRR’ METHOD NOT EASY . CAPITALIZED COST METHOD EASY MAYBE USEFULL WHEN ECONOMIC LIFES OF ALTERNATIVES ARE DIFFERENT YOU CAN USE THIS METHOD WHEN YOU ARE COMPARING ONLY COST DATA (INCOMES SAME) D.

ALTERNATIVES EXAMPLE: TWO TYPES OF EQUIPMENT ARE AVAILABLE FOR PERFORMING A MANUFACTURING OPERATION AND THE COST DATA ARE RECORDED AS: TYPE A FIRST COST. $ 4.$ 88.000 SALVAGE.200 6 DETERMINE THE MORE ECONOMIC TYPE IF i = %8 .300 LIFE.000 5.000 4. $ 7.500 ANNUAL MAINTENANCE. YEARS 12 TYPE B 45.

9 TYPE B IS BETTER .0812 – 1) ] + 4.08 (1.08 (1.300 .200 [ (1.000 + 41.0812 – 1) ] = 15.08 (1.7.582.0812 = $ 117.0812 )] .086 ) / (1.4 EACB = 45. EAC METHOD EACA = 88.086 – 1) ] = 14.08 / (1.300 [ (1.08 (1.200 – 4.000 + 4.0812 )] .0812 = $ 108.432 TYPE B IS BETTER b.YEAR ANALYSIS PERIOD: PA = 88.ALTERNATIVES a.000 [.000 / 1.08 / (1.0812 – 1) / .415 PB = 45.500 [.000 [. PRESENT WORTH METHOD WE SELECT A 12.0812 ) / (1.086 – 1) ] + 5.7.4.000 / 1.500 / 1.387.0812 – 1) / .086 + 5.000 [.

200 [ (1.700 3.135 ) = $122.15 + 34.000 0 ANNUAL MAINTENANCE.000 / 1.000 / 1. YEARS 7 5 SINCE THE LOWEST COMMON MULTIPLE OF 7 AND 5 IS 35.000 / 1.000 / 1.378 TYPE B IS BETTER AND PA / PB = 122.000 / 1.125 + 34.135 ) = $117.000 / 1.046 .000 34.128 – 4.1(1.1(1.121 + 42.000 / 1.110 + 34.120 + 34.135 + 3.ALTERNATIVES EXAMPLE: COMPARE THE INVESTMENTS HAVING THE FOLLOWING COST DATA ON THE BASIS OF PRESENT WORTH OF COSTS USING i = %10: TYPE A TYPE B FIRST COST.130 + 3.000 + 34.000 / 1.000 + 42.135 – 1) / .000 / 1. WE SELECT AN ANALYSIS PERIOD OF 35 YEARS: PA = 46.000 / 1.720 PB = 34.114 + 42.700 [ (1.115 + 34.17 + 42.$ 3.720 / 117.000 / 1.$ 4.378 = 1.$ 46.135 – 1) / .000 SALVAGE.200 LIFE.

000 / (1.17 – 1) = 127.000 / (1.046 WE HAVE THE SAME RESULT BOTH METHODS AND CAPITALIZED COST CALCULATION IS SIMPLER .270 KB = 3.000 + 42.691 TYPE B IS BETTER AND KA / KB = 127.691 = 1.15 – 1) = 121.1 + 34.200 / .ALTERNATIVES SOLVE THE SAME PROBLEM USING CAPITALIZED COST METHOD: K = R / i + CV + CR / [(1 + i)n – 1] KA = 3.1 + 46.000 + 34.700 / .270 / 121.

IF NOT ELIMINATE. IF IRR > MARR. THE BIGGEST INVESTMENT THAT SATISFIES THE MARR IS THE BEST ALTERNATIVE . COMPARE WITH MARR. YOU START WITH THE LOWEST INVESTMENT ALTERNATIVE.ALTERNATIVES IN IRR INCREMANTAL APPROACH. IF THIS SATISFIES MARR IT IS ACCEPTABLE. NOW CALCULATE IRR FOR THE INCREMENT OF THE NEXT ALTERNATIVE. CALCULATE IRR. CONTINUE LIKE THIS TILL YOU EVALUATE ALL ALTERNATIVES. THAT IS AN ACCEPTABLE ALTERNATIVE.

CONSIDER THE NEXT HIGHER INVESTMENT STEP 3B: FOR AN ACCEPTABLE ALTERNATIVE. ASSUME THE LOWEST COST OPTION IS ACCEPTABLE STEP 2: COMPARE THE IRR WITH THE MARR TO DETERMINE WHETHER THE ALTERNATIVE IS ACCEPTABLE STEP 3A: IF IRR < MARR . GO TO STEP 6.ALTERNATIVES STEP 1A: CALCULATE THE IRR FOR THE ALTERNATIVE REQUIRING THE LEAST INVESTMENT STEP 1B: IF THE ALTERNATIVES ARE BASED ONLY ON RELATIVE COST. IRR < MARR. DETERMINE THE NEXT INCREMENT OF INVESTMENT STEP 4: COMPARE THE IRR FOR THE INCREMENT OF INVESTMENT WITH THE MARR. WE HAVE FOUND THE ACCEPTABLE ALTERNATIVE WITH THE GREATEST INVESTMENT ASSUMING AVAILABILITY OF CAPPITAL . ELIMINATE THE ALTERNATIVE. ELIMINATE THE ALTERNATIVE. OTHERWISE CALCULATE IRR FOR THE TOTAL INCREMENT OF INVESTMENT BETWEEN THE LAST ACCEPTABLE ALTERNATIVE AND NEXT HIGHER LEVEL OF INVESTMENT.GO TO ST4 STEP 6: DECISION. OTHERWISE ALTERNATIVE IS ACCEPTABLE IF STEP 5: IF NO HIGHER LEVEL OF INVESTMENT.

000 = 20.ALTERNATIVES EXAMPLE : INITIAL INVESTMENT ANNUAL CASH FLOW: MARR = 10% A : 170.000 = 5.000 = 90.000 = (66.000 inc.000 B 260.000 – 170. ALT B NOT ACCEPTABLE IRR FOR INCREMENT OF C TO A : 300.000 66. for 10 years SINCE INC.000 44. INVEST. investment 68.000 – 44. ALTERNATIVE A IS ACCEPTABLE INCREMENT OF ALT.000 = 50.000 [{ (1+i)10 – 1} / i(1+i)10]  i = 0.000 = 30.000 – 170. 10 x 5. for 10 years SINCE INC. INVEST.000 C 300.000 – 44.000 inc. 10 x 2. annual return .000 inc.000 – 300..000 – 66. ALT D NOT ACCEPTABLE CHOOSE ALTERNATIVE C .225 by trial and error > MARR.000 = 44.000 inc. annual return . B : 260. D : 330.000 D 330. ALTERNATIVE C IS ACCEPTABLE INCREMENT OF ALT. investment 49.000) [{ (1 + i) 10 – 1} / i(1 + i)10] i = 0. RETURN FOR 10 YEARS < INC.000 49.000 68.000 inc.109 by trial error > MAAR .000 IRR FOR A : P = R [{ (1 + i)n – 1} / i(1 + i)n]  170..000 = 2. RETURN FOR 10 YEARS < INC.000 inc.

000 49. WE MAY MAKE MISTAKES.7 D 330.000 66. IF WE CHOOSE ALTERNATIVE D (GREATEST INVESTMENT WITH IRR > MARR) WE WILL AGAIN LOOSE MONEY BY INVESTING AN EXTRA 30.9 IF WE DO NOT USE THE INCREMENTAL METHOD.000 15. IF WE CHOOSE ALTERNATIVE A (SINCE IT HAS THE GREATEST IRR) WE WILL LOOSE MONEY COMPARED WITH CHOOSING ALTERNATIVE C.000 68.000 ANNUAL CASH FLOW 44.5 17.000 300.000 260.ALTERNATIVES WHEN WE DIRECTLY COMPARE ALTERNATIVES : A B C INVESTMENT : 170.5 13.000 IRR (%) : 22.000 WITH LOWER RETURN. .

D : PW = .14475 = 100.170. A : PW = .000 + 44.000 x 6.000 + 49. B : PW = .000 x 6. i = 0.14475 ALT.330.300.369 = 41.ALTERNATIVES IF WE USE PRESENT WORTH FOR COMPARISON.14475) ALT.553 = 87.14475 ALT.1(1.110 – 1) / 0.843 ALTERNATIVE C GIVES THE BIGGEST PRESENT WORTH SO IT SHOULD BE CHOOSEN .1)10} = R (6. WE WILL GET THE SAME (CORRECT) RESULT (MUCH EASIER) P = R [{ (1 + i)n – 1} / i(1 + i)n] .000 + 66. C : PW = .14475 ALT.000 x 6.000 + 68.092 = 105.10 P = R{ (1.000 x 6.260.

10) 1 2 3 1 $300 $130 130 130 14. THE BEST ALTERNATIVE OR ALTERNATIVES MAY BE CHOSEN AFTER FINDING PW OR IRR VALUES FOR EACH ALTERNTIVE. ONE USEFULL METHOD TO HANDLE INDEPENDENT ALTERNATIVES IS TO CONVERT THEM TO MUTUALLY EXCLUSIVE GROUPS. EXAMPLE: YOU HAVE THE FOLLOWING 4 INDEPENDENT PROPOSALS PROPOSAL INVESTMENT END OF EACH YEAR IRR% PW CASH FLOW (i = 0. WE CAN CHOOSE MORE THAN ONE.5 22.74 YOU CAN CONVERT THIS TO 16 MUTUALLY EXCLUSIVE ALTERNATIVES .3 61.4 23. WITH THIS LIMIT IN MIND. SINCE THEY ARE NOT EXCLUSIVE.71 4 1500 628 628 628 12.0 21.ALTERNATIVES 2.24 3 600 250 250 250 12.29 2 500 210 210 210 12. ANALYSIS OF INDEPENDENT ALTERNATIVES FOR INDEPENDENT ALTERNATIVES THE CAPITAL AVAILABLE MAY BE THE LIMITING FACTOR.

71 45.74 105.03 83.45 106.98 .ALTERNATIVES GROUP 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 PROPOSALS 1 2 3 4 0 0 0 0 1 0 0 0 0 1 0 0 1 1 0 0 0 0 1 0 1 0 1 0 0 1 1 0 1 1 1 0 0 0 0 1 1 0 0 1 0 1 0 1 1 1 0 1 0 0 1 1 1 0 1 1 0 1 1 1 1 1 1 1 INVESTMENT 0 $300 500 800 600 900 1100 1400 1500 1800 2000 2300 2100 2400 2600 2900 ANNUAL RECEIPT FOR 3 YEARS 0 $130 210 340 250 380 460 590 628 758 838 968 878 1008 1088 1218 PW 0 $23.74 85.00 43.29 22.24 61.69 128.53 21.95 67.27 83.98 107.24 43.

THIS ALTERNATIVE SHOULD BE CHOSEN (IF THE INVESTMENT IS NOT A MUST). .13 – 1) / 0. WE SHOULD CHOOSE GROUP 16 COVERING ALL PROPOSALS SINCE IT HAS THE BIGGEST PW.1)3} – PINV IF THERE IS NO CAPITAL LIMITATION. IF THERE IS A LIMIT OF $1000 WE SHOULD CHOOSE GROUP 6. IF THERE IS A LIMIT OF $2400 WE SHOULD CHOOSE GROUP 12. THEN THE INVESTOR OR THE COMPANY WILL ‘DO NOTHING’ ABOUT THE PROJECTS BEING CONSIDERED AND THE AVAILABLE FUNDS WILL BE USED IN OTHER PROJECTS OR INVESTMENT TOOLS.1(1. IN ANY ANAYLSIS ‘DO NOTHING’ ALTERNATIVE SHOULD BE CONSIDERED.ALTERNATIVES PRESENT WORTHS CAN BE CALCULATED BY ADDING THE PRESENT WORTHS OF THE GROUP MEMBERS OR BY R {(1. WHEN ALL IRR’S ARE < MARR OR PW’S ARE NEGATIVE.

PROPOSALS A1 AND A2 ARE MUTUALLY EXCLUSIVE AND B1 AND B2 ARE ALSO MUTUALLY EXCLUSIVE BUT A’S AND B’S ARE INDEPENDENT (TWO KINDS OF COMPUTERS AND TWO KINDS OF FORKLIFTS).ALTERNATIVES WE MAY HAVE TWO INDEPENDENT SETS OF MUTUALLY EXCLUSIVE PROPOSALS. THAN WE HAVE : GROUP 1 2 3 4 5 6 7 8 9 A1 0 1 0 0 0 1 1 0 0 A2 0 0 1 0 0 0 0 1 1 B1 0 0 0 1 0 1 0 1 0 B2 0 0 0 0 1 0 1 0 1 . THAT IS.

. IF THERE IS ANY QUESTION AS TO WHICH METHOD SHOULD BE USED FOR A FINAL DETERMINATION. NET PRESENT WORTH SHOULD BE CHOSEN.ALTERNATIVES IT IS QUITE POSSIBLE TO COMPARE A SERIES OF ALTERNATIVE INVESTMENTS BY EACH OF THE DIFFERENT PROFITABILITY METHODS AND FIND DIFFERENT RESULTS DEPENDING ON THE EVALUATION TECHNIQUE USED.

BUT PAYBACK METHOD MAY MISLEAD .000 150.000 25.000 = 30.000 80.000 10.15 + 10.000 B $ 25. PAYBACK FOR B: 4 YEARS b) PWA : 100. ALT 1 2 3 4 5 6 YEARS A $100.742 PWB : 25.000 / 1.000 / 1.000 / 1.000/ 1.000 / 1.14 + 150.000 = 118.000 100.000) HAVE THE CASH FLOWS SHOWN BELOW.000/ 1. b) THE PRESENT WORTH.000/ 1.000 / 1.14 + 10.000/ 1.16 – 150.000 25.000) AND B ($150.15 + 80.000 80.000 10.000/ 1.13 + 100.000 10.1 + 80.ALTERNATIVES EXAMPLE: INVESTMENTS A ($160.000 20.12 + 25.16 – 160.13 + 10.000 a) PAYBACK FOR A: 2 YEARS. DETERMINE WHICH INVESTMENT SHOULD BE UNDERTAKEN IF THE SOLE CRITERION IS a) THE PAYBACK PERIOD.12 + 20.838 ALTERNATIVE B IS MUCH BETTER.000 / 1.1 + 25.000/ 1.

ALTERNATIVES REVENUE : TOTAL INCOME (OR TOTAL SAVINGS) NET PROFITS : REVENUE – ALL EXPENSES – INCOME TAX ALL EXPENSES : CASH EXPENSES + DEPRECIATION INCOME TAX : (REVENUE – ALL EXPENSES) (TAX RATE) CASH FLOW : NET PROFIT + DEPRECIATION .

IX. ANALYSIS OF REPLACEMENTS .

DUE TO TECHNOLOGICAL IMPROVEMENTS. BETTER OR MORE ECONOMICAL EQUIPMENT IS AVAILABLE . AN EXISTING PROPERTY MUST BE REPLACED TO CONTINUE A SATISFACTORY OPERATION BECAUSE a) PROPERTY IS WORN OUT b) CAPACITY IS NOT SUFFICIENT 2.REPLACEMENTS REPLACEMENT : AN ALTERNATIVE CASE IN WHICH FACILITIES ARE CURRENTLY IN EXISTENCE AND IT MAY BE DESIRABLE TO REPLACE THESE FACILITIES WITH DIFFERENT ONES THE REASONS FOR REPLACEMENTS CAN BE DIVIDED INTO TWO GENERAL CLASSES: 1.

ALTHOUGH THIS MAY BE LESS THAN THE ACTUAL VALUE OF THE PROPERTY AS FAR AS THE OWNER IS CONCERNED OR LESS THAN THE BOOK VALUE (UNAMORTIZED VALUE).REPLACEMENTS FOR THE FIRST CLASS OF REASONS. FOR THE SECOND CLASS OF REASONS. SO ECONOMIC ANALYSIS IS MADE BETWEEN THE NEW ALTERNATIVES. THE DIFFERENCE BETWEEN THE TOTAL COST OF THE NEW PROPERTY AND THE NET RELIZABLE VALUE OF THE EXISTING PROPERTY EQUALS THE NECESSARY INVESTMENT FOR THE REPLACEMENT. IT STILL REPRESENTS THE AMOUNT OF CAPITAL WHICH CAN BE OBTAINED FROM THE OLD EQUIPMENT. REPLACEMENTANALYSIS IS MADE BETWEEN THE EXISTING FACILITY AND NEW ALTERNATIVE. . YOU SHOULD EITHER MAKE THE REPLACEMENT OR GO OUT OF BUSINESS. THE NET RELIZABLE VALUE OF AN EXISTING PROPERTY SHOULD BE ASSUMED TO BE THE MARKET VALUE. IN THIS CALCULATION. ANY ATTEMP TO ASSIGN A VALUE GREATER THAN THIS TENDS TO FAVOR REPLACEMENTS WHICH ARE UNECONOMICAL.

DURING REPLACEMENT.000 WITH 10 YEARS ECONOMIC LIFE AND DEPRECIATE IT WITH STRAIGHT LINE METHOD.REPLACEMENTS SUPPOSE YOU BOUGHT AN EQUIPMENT FOR $100. ADDITIONAL EXPENSES OCCUR SUCH AS FREIGHT. NEW CONNECTIONS OF WIRING OR PIPING. TEST AND ADJUSTMENT EXPENSES.DOWN TIME DURING THE REPLACEMENT. . SO FOR REPLACEMENT ANALYSIS YOU SHOULD FORGET $20.000 DEPENDING ON MANY FACTORS. THESE COSTS WHICH MAY BE AS BIG AS THE PRICE OF THE NEW EQUIPMENT OR EVEN BIGGER SHOULD ALLWAYS BE CONSIDERED WHEN ANALYSING THE REPLACEMENT.000. CONSTRUCTION OF FOUNDATIONS. REPLACING OF FLOORS OR OTHER STRUCTURAL ELEMENTS AND THE SHUT. REMOVAL OF OLD EQUIPMENT. AFTER 8 YEARS IT HAS A BOOK VALUE OF $20. ITS VALUE MAY BE LOWER OR HIGHER THAN $20.000 AND TRY TO FIND OUT THE MARKET VALUE. BUT IF YOU TRY TO SELL IT.

OR SHALL WE KEEP IT FOR ONE OR MORE ADDITIONALYEARS. THE ECONOMIC EVALUATION MADE FOR THE ABOVE DECISION IS CALLED ‘REPLACEMENT ANALYSIS’. THE OLD CONCEPT WAS TO USE THE EXISTING EQUIPMENT AS LONG AS IT WORKS. MODERN CONCEPT IS TO MAKE REPLACEMENT ANALYSIS EVERY YEAR FOR ALL EQUIPMENT AND REPLACE THEM WHEN IT IS MORE ECONOMIC. BUT WHEN IT WILL BE REPLACED. THIS LEADS US TO THE DECISION: SHALL WE REPLACE THE EXISTING EQUIPMENT NOW. .REPLACEMENT REPLACEMENT ANALYSIS: ALL KINDS OF EQUIPMENT USED IN PLANTS GETS OLD AND SHOULD BE REPLACED ONE DAY. SO THE QUESTION IS NOT IF THE EXISTING EQUIPMENT WILL BE REPLACED.

AND THE BEST AVAILABLE REPLACEMENT EQUIPMENT ‘CHALLENGER’. MAINTAIN THE DEFENDER AS LONG AS THE MARGINAL COST OF OWNERSHIP FOR ONE MORE YEAR IS LESS THAN THE MINIMUM EAC OF THE CHALLENGER.REPLACEMENT WE CALL THE EXISTING EQUIPMENT ‘DEFENDER’. FIND THE EAC (EQUIVALENT ANNUAL COST) OF THE CHALLENGER 3. FIND THE MARGINAL COST DATA OF THE DEFENDER 2. 1. WHEN THE MARGINAL COST OF THE DEFENDER BECOMES GREATER THAN THE MINIMUM EAC OF THE CHALLENGER. THAN REPLACE THE DEFENDER WITH THE CHALLENGER MARGINAL COST OF AN ASSET FOR ANY YEAR IS THE COST OF KEEPING THE ASSET AND INCLUDE LOSS IN MARKET VALUE AND YEARLY OPERATING AND MAINTENANCE EXPENSES .

000 INCLUDING ALL KIND OF REPLACEMENT COSTS. IF AT ALL. IF MARR = %15.000.500 PER YEAR EACH YEAR. A NEW PIECE OF EQUIPMENT THAT MAY REPLACE THE EXISTING ONE.000 THE FIRST YEAR AND INCREASING AT $1.REPLACEMENT EXAMPLE: AN ASSET PURCHASED 5 YEARS AGO CAN BE SOLD TODAY FOR $15. DETERMINE WHEN. USEFUL LIFE OF THIS EQUIPMENT IS 5 YEARS ANDTHE SALVAGE VALUE IS $4. A REPLACEMENT DECISION SHOULD BE MADE . OPERATING AND MAINTENANCE EXPENSES FOR THE FIRST YEAR IS $10. ANNUAL OPERATING AND MAINTENANCE COSTS OF THIS NEW MACHINE IS $7. WILL COST $25. IT IS ESTIMATED THAT THE MARKET VALUE OF THE ASSET WILL DECREASE BY $1.000.000 PER YEAR THEREAFTER.000 BUT THESE ARE ESTIMATED TO INCREASE IN THE FUTURE BY $1.000 PER YEAR.

500 + [(12.000)] = 13.15 / (1.000 + 11.15 – (14.REPLACEMENT MARGINAL COST OF THE DEFENDER 1.155 – 4.606 .000)1.000)1.15 – (10.000)] = 17.000)] = 18.000)1.153 + (7.000)1.000)1.000)1.000 + (10.000 + [(15.950 4. YEAR: 11.500 + [(14.000)1.000)] = 14.250 2.155 – 1) = 15.15 – (11.000)] = 15.000)1.15 – (13.950 > 15.000 + [(11.606 AT THE BEGINNING OF THE THIRD YEAR YOU SHOULD REPLACE YOUR EQUIPMENT SINCE MARGINAL COST IS BIGGER THAN THE EAC OF THE NEW EQUIPMENT: 15.154] . YEAR: 13. YEAR: 14.000 + [(13.152 + (8.000)1.600 3.000)1. YEAR: 10.650 EAC OF THE CHALLENGER [(25.300 5. YEAR: 16.15 + (9.15 – (12.

600 Y 12.96 a) ALTERNATIVE Y IS BEST b) ALTERNATIVE Y + X IS BEST .60 PWZ = R[{(1+i)n – 1} / i(1+i)n ] – PINV = – 578.000 $0 6 YR $2.16 = 581.000 = 323.1)6 – 1} / 0.500 Z 18.1(1. WHICH ALTERNATIVE(S) SHOULD BE SELECTED ? a) WHEN ALTERNATIVES ARE MUTUALLY EXCLUSIVE b) WHEN ALTERNATIVES ARE INDEPENDENT PWX = R[{(1+i)n – 1} / i(1+i)n ] – PINV = 2600[{ (1.000 0 6 4.000 IF MARR = 0.ALTERNATIVES .PROBLEMS *ALTER INVESTMENT SALVAGE VALUE LIFE ANNUAL NET CASH FLOW X $11.1.68 PWY = R[{(1+i)n – 1} / i(1+i)n ] – PINV + 3000 / 1.000 3000 6 2.1)6] – 11.

13610 – 1)] – 2000[.000 SALVAGE.1366 – 1)] + 5.000 46.$ 4.000[ .13610 – 1)] + 4.136)6 / (1.800 + 5X = 10.$ 2. WHAT ANNUAL PRODUCTION IS REQUIRED TO JUSTIFY PURCHASE OF MACHINE B? MACHINE A MACHINE B FIRST COST.136 / (1.136)10 / (1.ALTERNATIVE PROBLEMS A MANUFACTURING FIRM HAS A CHOICE BETWEEN TWO MACHINES TO PRODUCE A STANDART COMMODITY.800 5. YEARS 10 6 LET X BE THE NUMBER OF UNITS PRODUCED ANNUALLY.356 + 5X EACB = 46.700 + 2X EACA = EACB 10.000[ .136 (1.6.700 + 2X X = 2115 UNITS / YEAR MACHINE B IS ECONOMIC WHEN YEARLY PRODUCTION IS > 2115 UNITS . $ / UNIT 5 2 LIFE.$ 30.000 0 FIXED ANNUAL PRODUCTION COST. EACA = 30.136 (1.000 + 2X = 16. IF i = %13.000 VARIABLE PRODUCTION COST.356 + 5X = 16.

FIND THE BETTER ALTERNATIVE USING EQUIVALENT ANNUAL COSTS IF i = 0.000 – 25.553 + 15.000 AND YEARLY OPERATING COST OF $15. FIRST ALTERNATIVE IS A $50.1.13/ (1.13/ (1.553 RB = (30.1x1.000/1.000 – 10.13) { .ALTERNATIVES – PROBLEMS • A SPECIAL EQUIPMENT IS REQUIRED FOR A R&D PROJECT THAT WILL LAST FOR 3 YEARS.000 EQUIPMENT WITH A SALVAGE VALUE OF $25.000. A SIMPLER EQUIPMENT WILL COST $30.13 – 1)} = 9.000 = $ 27.042 + 20. RA = P[ i(1 + i)n / {(1 + i)n – 1}] = (50.042 ALTERNATIVE A IS BETTER .000 AND YEARLY OPERATING COST OF $20.13) { .000/1.553  EACA = 12.000 WHICH WILL HAVE A SALVAGE VALUE OF $10.13 – 1)} = 12.000.1x1.042  EACA = 9.000 = $ 29.

156) {.156/(1.15x1.000 AT THE END OF THE 6th YEAR AND YEARLY OPERATING DISBURSEMENTS OF $3.000 WITH A SALVAGE VALUE OF $4.000 – 4000/1.PROBLEM • A COMPANY MAY BUY A MACHINE THAT COSTS $10.156-1)} = $4599  EACB = 4599 + 3000 = $7599 ALTERNATIVE A IS BETTER . $1.000 FOR THE LAST 3 YEARS WILL BE CONSIDERED RA =(10.000 A YEAR FOR THE FIRST 3 YEARS AND $6.000 IS SPEND EVERY YEAR.000 – 6000/1.15x1.156){.000 AT THE END OF 6 YEARS LIFE.154 +1000/1.000 A YEAR FOR THE LAST 3 YEARS. THERE IS AN AUTOMATIC VERSION WHICH COSTS $20.000 WITH A SALVAGE VALUE OF $6.000 A YEAR.155 +1000/1.156/(1.15.ALTERNATIVES . RA = P [ i(1 + i)n / {(1 + i)n – 1}] SINCE $5.156-1)} RA = $2582  EACA = 2582 + 5000 = $7582 RB = (20. THE ANNUAL OPERATING DISBURSEMENTS ARE $5.156 +1000/1. FIND THE BETTER ALTERNATIVE USING EQUIVALENT ANNUAL COSTS IF i = 0.

500 MARR = 9% a) WHICH PROPOSAL IS PREFERRED IF ONLY ONE CAN BE SELECTED? b) HOW MUCH SHOULD BE INVESTED IF THE PROPOSALS ARE INDEPENDENT AND UNLIMITED CAPITAL IS AVAILABLE? PWA=R[{(1+i)n – 1)} / i(1+i)n] – PINV =7500{(1.000 5.000 30.000 0 10.095} +(10.095) – 40.500{(1.000 / 1.000 = 2.000 7.000{(1.095) – 30.095} – 20.000 SALVAGE VALUE $ 0 10.421.9x1.000 = – 552 PWD = 10.095} +(10.9x1.PROBLEMS * 5 INVESTMENT PROPOSALS WITH 5 YEARS LIFE ARE AS FOLLOWS : A B C D E INVESTMENT $ 30.095 – 1) / 0.9x1.000 = 5.000{(1.31 PWE = 7.095) – 60.9x1.395.9x1.095 – 1) / 0.000 10.000 / 1.66 a) b) ALTERNATIVE D IS SELECTED SINCE IT HAS THE BIGGEST PW ALT B + ALT D + ALT E = $130.66 PWB = 13.000 .ALTERNATIVES .095 – 1) / 0.000 40.095} +( 5.000 = 0 PWC = 5.000 60.000 = – 827.095 – 1) / 0.755 5.000 NET ANNUAL CASH FLOW $ 7.095 – 1) / 0.000 / 1.095} – 30.755 {(1.000 20.500 13.

SO CHOOSE SITE 3 .15x1. THE LOCATION OF THE BUILDING EFFECTS THE COSTS.1510 – 1)/0.000/1.1510} + 175.000 CASH FLOW : $ 24.000 190.349 PW2 = 31.000{(1.896 PW3 = 41.000/1.000{(1.000 175.15x1.ALTERNATIVES .000 = 29.000 = 11.000 = 3.000 31.15x1.1510 – 190.1510 – 140.1510 – 1)/0.1510} + 155.1510 – 1)/0.000 41.000 RESALE VALUE : $125.000 PW1 = 24.000 155. SO DIFFERENT CASH FLOWS OCCUR.027 HIGHEST PW IS SITE 3. IF MARR = 15%.000{(1. WHICH BUILDING IS BEST ? SITE 1 SITE 2 SITE 3 PURCHASE PRICE : $140.000/1.1510 – 220.000 220.PROBLEMS * A COMPANY PLANS TO BUY A FACTORY BUILDING FOR A TEN YEAR PROJECT AND SELL IT AT THE END.1510} + 125.

000 + 7. AC HAS 10 YEARS LIFE WITH 0 SALVAGE VALUE.500 INSULATION HAS 20 YEARS.15 x 1.1520} = $133.100 3.000 + 38. WHICH ALT.056 PW4 = 80.000 + 32.000 45.15 x 1.15 x 1.000 + 12.124 + 5.000 38.1520 – 1) / 0.000 + 9.1520} PW1 = 35.045 PW3 = 60.1520} =$141.15 x 1.000 FIRST COST OF AC $ 52.100 {(1.000 ANNUAL POWER COST $ 6.538 PW2 = 45.500 {(1.ALTERNATIVES . INVESTMENT FOR AIRCONDITIONING GETS SMALLER : ALTERNATIVES 1 2 3 4 FIRST COST OF INS.100 {(1. AND REPLACEMENT COST IS CONSTANT ? CR (AC) = C / 1. IS BEST IF i = 15%.1520} = $140.910 + 3.1520} =$133.000 60.15 x 1.000 45.2472 x C PW = C(INS) + C(AC) + CR(AC) + R {(1.854 + 6.1520 – 1) / 0.000 + 11.000 + 45.1510 = 0.500 {(1.1520 – 1) / 0.394 + 4.100 4. $ 35.1520 – 1) / 0.000 + 52.000 80.817 CHOOSE THE MINIMUM PW : ALTERNATIVE 2 .000 32.1520 – 1) / 0.PROBLEMS * A FIRM FINDS THAT AIRCONDITIONING IS NECESSARY FOR A ROOM AND AS MONEY SPEND ON INSULATING THE WALLS GETS LARGER.500 5.

000 = 33.PROBLEM * TWO MUTUALLY EXCLUSIVE PROPOSALS HAVE THE FOLLOWING CASH FLOW : INVESTMENT 1 2 3 4 5YEARS A $ 100.000 0 B 100.000 30.000=51. THE REINVESTMENT RATES ARE EXPECTED TO CONTINUE THROUGHOUT THE 5-YEAR COMPARISON PERIOD.22 + 30.253 + 60.000/1.000/1.000/1.15 + 50.000 0 ALL RECEIPTS FROM PROPOSALS A AND B CAN BE REINVESTED AT 20% FOR A AND 25% FOR B.000 40.000 = 25.152 + 60.155.000 =58864 58. MARR = 15% a) WHICH IS BETTER WHEN REINVESTMENT OPPURTUNITY IS IGNORED? PW = S/(1+i)n PWA = 60.000/1.254 + 15.154 – 100.23 + 40.15 + 15.000 15.837  ALT.348 PWB =(60.000x1.864  ALT B IS BETTER .000 50.155.000 60.000x1. A IS BETTER b) WHICH IS BETTER WHEN RECEIPTS ARE INVESTED AT GIVEN RATES ? S = P (1+i)N PW = P(1+i)N / (1+i)n WHERE N : RECEIPT INVESTING TIME PWA =(60.100.000x1.000 60.000x1.000x1.152 + 40.2)/1.000x1.000/1.000x1.000 40.153 + 40.ALTERNATIVES .252 + 40.000/1.25)/1.24 + 50.434 PWB = 60.000/1.000 60.154– 100.000/1.000x1.153 + 30.100.

500 4.155 – 1) / 0.500/1.15+4.152-2.15x1.500 {(1.000 =3.500 B 25.500 4.000 =-1.154+10.15) ALT INVESTMENT 1 2 3 4 5 A $15.10.500 7.000 10.000/1.500/1.000 =.000/1.500 4.154+7.000 C 20.155.000 8.974 ALT B IS THE BEST b) IF INVESTMENT CAPITAL IS LIMITED WITH $30.000 2.500 -2.15+4.103 PWE =4.000 D 30. WHICH PROPOSALS SHOULD BE EXPECTED ? ALT B WILL BE EXPECTED .154+4.000 4.000/1.000/1.000 6.30.4.153+15.000/1.500 a) IF ALTERNATIVES ARE MUTUALLY EXCLUSIVE .ALTERNATIVES .500 4.754 PWD =15.500/1.000/1.20.500/1.500 4.000 15.15+10.000 12.000 4.000/1.PROBLEMS * CASH FLOWS FOR 5 ALTERNATIVES ARE BELOW : (i = 0.000 AND THE PROPOSALS ARE INDEPENDENT.000/1.152+8.675 PWC =2.000/1.000/1.153+8.000 4.154+15.000 = 84 PWB =12.153+6.000 4.000 8.000 E 10.155.000 =1.000 0 0 15. WHICH IS THE BEST ? PWA = R[ {(1+i)n – 1} / i(1+i)n] – PINV = 4.500 4.000 10.000/1.500/1.155.000 6.152+6.000/1.000/1.155} – 15.153+4.155.25.000 15.

THE MARR IS 20%.000 [(1.220)] = $21. PROPOSAL B REQUIRES $175. THE LIFE OF THE PROJECT IS EXPECTED TO BE 20 YEARS WITH $75.220)] = $44.2 x 1.000.220 – 1)/ (. ALTERNATIVE A SHOULD BE CHOOSEN .000/1.220 – 1)/ (.000 + 60. PWA = – 250.220 + 40. AT THE END OF 20 YEARS ITS SALVAGE WILL BE $60. THE PROPOSALS ARE MUTUALLY EXCLUSIVE ALTHOUGH THE COMPANY MAY TURN DOWN BOTH IF NEITHER IS ACCEPTABLE.220 + 60.000.000 [(1.000.000 SALVAGE AT THAT DATE.000/1.131 PWB = – 175.348 BOTH ALTERNATIVES ARE ACCEPTABLE.000 WHICH WILL BRING AN ANNUAL CASH FLOW OF $60.2 x 1.ALTERNATIVES .000 INVESTMENT WITH ANNUAL CASH FLOW OF $40. BUT SINCE THEY ARE EXCLUSIVE.PROBLEMS * PROPOSAL A REQUIRES AN INVESTMENT OF $250.000 + 75.

THE MINIMUM REQUIRED RATE OF RETURN IS 5%.000 TO CONSTRUCT WILL COST $15.05n – 1) / 0.05 x 1.000 + 10.000 + 15.5 x 1. BOTH INSTALLATIONS ARE FELT TO BE PERMENANT.000 A YEAR TO OPERATE AND MAINTAIN.05n] = 150.000 ALTERNATIVE B IS BETTER b) 100.000 [ (1.05n – 1) / 0.000 [ (1.05n]  1. a) WHICH ALTERNATIVE IS BETTER ? b) AT WHAT TIME THEY ARE EQUAL ? a) WHEN n   P = R / i PWA = 100.000 PWB = 150.05 x 1.05n = 2 n = 14.05 = $350.PROBLEMS * A DAM COSTING $100.000 + 10.000 / 0.ALTERNATIVES .2 YEARS .000 TO BUILD WILL COST $10. ANOTHER DESIGN COSTING $150.000 A YEAR TO OPERATE AND MAINTAIN.000 + 15.05n – 1 = 0.05n  1.000 / 0.05 = $400.

000 {(1.000 + 10 x 2. A SEMIAUTOMATIC MACHINE WHICH COSTS $10.000 + 10 x 900 = $29.288 SEMIAUTOMATIC COSTS LESS .000 + 2.529 PWS = 10.000 CS = 10.PROBLEM * AN AUTOMATIC MACHINE COSTS $20.110} = $25.1x1.10 ? a) CA = 20.000 = $30.000 + 900 {(1.000 AND IS EXPECTED TO HAVE AN ANNUAL OPERATING COST OF $900 AT THE END OF EACH YEAR OF ITS 10-YEAR LIFE.1x1. WHICH ONE COSTS LESS a) WHEN i = 0 AND b) WHEN i = 0.110} = $22. IF SALVAGE VALUES ARE 0.000 OVER ITS 10-YEAR LIFE.110 – 1) / 0.000 WILL HAVE ANNUAL OPERATING COSTS OF $2.ALTERNATIVES .000  AUTOMATIC COSTS LESS b) PW = PINV + R [{(1+i)n – 1} / i(1+i)n] PWA = 20.110 – 1) / 0.

0956 X X = $25.1O511 + 6.985 + .000 FOR THE REMAINING LIFE. IF MONEY IS WORTH %10.105 (1. AFTER THE FACILITY HAD BEEN IN OPERATION FOR 5 YEARS AN IMPROVEMENT WAS PROPOSED TO INCREASE ITS LIFE TO 11 YEARS.500 / 1.000 + X / 1.607 X EAC2 = (115. YEARLY MAINTENANCE COST IS $6.1O55 ) = 115.240 .681 FIND THE IMPROVED EAC ( LET X BE THE EXPENSE OF IMPROVEMENT): P = 80.105 / (1.5.0956 X EAC1 = EAC2 20.500.800 = 20.105 (1.105 (1.000[.1O59 – 1)] – 4.000 [.1O5)11 / (1.1O56 – 1) / .800.681 = 18.985 + .1O55 – 7.000.607 X) [.1O55 – 1) / . WHICH HAS A LIFE OF 9 YEARS AND A SALVAGE VALUE OF $4.268 + .1O511 – 1)] = 18.1O5)5 ] + 5.1O5)9 / (1. AND INCREASE THE SALVAGE VALUE TO $7.1O59 – 1)] + 6.000.000 [ (1.105 (1. REDUCE YEARLY MAINTENANCE TO $5.268 + .800 [ (1.1O5)6 ] ( 1 / 1. WHAT IS THE MAXIMIM AMOUNT THE FIRM SHOULD EXPEND FOR THIS IMPROVEMENT? FIND THE ORIGINAL EAC: EAC1 = 80.ALTERNATIVE PROBLEMS A FIRM INSTALLED A FACILITY WITH A FIRST COST OF $80.

X. INFLATION .

IT IS ARGUED THAT ALL PROPOSALS ARE AFFECTED SIMILARLY BY PRICE CHANGES AND THAT THERE IS TOO LITTLE DIFFERENCE BETWEEN CURRENT AND FUTURE COSTS TO INFLUENCE THE ORDER OF PREFERENCE. INFLATION RATES ARE USUALLY MEASURED BY WHOLESALE PRICE INDEX AND CONSUMER PRICE INDEX. 2 TO 4 PERCENT PER YEAR.INFLATION INFLATION CAUSES PRICES TO RISE AND DECREASES THE PURCHASING POWER OF MONEY. . IT IS GENERALLY IGNORED IN ECONOMIC EVALUATIONS OF PROPOSALS. THESE ARGUMENTS LOSE SUBSTANCE WHEN INFLATION IS HIGH AND SOME GOODS ESCALATE MORE RAPIDLY THAN OTHERS. WHEN INFLATION IS MODEST.

. CONVERT ALL CASH FLOWS TO CONSTANT. THEN USE THE REGULAR INTEREST RATES. MARKET INTEREST RATE (if) SHOULD BE USED. MARKET INTEREST RATES ARE ALSO REFERRED TO AS ‘COMPOSITE’ OR INFLATION ADJUSTED INTEREST RATES.CURRENT OR ACTUAL DOLLARS AND USE AN INTEREST RATE THAT INCLUDES INFLATION. 2.INFLATION THERE ARE TWO ALTERNATIVE METHODS OF TREATING INFLATION IN FINANCIAL ANALYSIS : 1. IN ANALYSIS THAT CONSIDERS INFLATION. THIS IS APPROPRIATE WHEN ALL COMPONENTS INFLATE AT UNIFORM RATE. if INCLUDES THE COMBINED EFFECT OF THE EARNING VALUE OF CAPITAL AND EXPECTED INFLATION. EXPRESS THE FUTURE CASH FLOWS IN THEN.WORTH (REAL OR TODAY’S DOLLAR) AMOUNTS TO ELIMINATE THE EFFECT OF INFLATION.

(1 + fN) ..12)(1.12 AND f = 0.232 CONSTANT (REAL) DOLLARS IN ANY FUTURE YEAR N CAN BE INFLATED TO CURRENT DOLLARS BY: CURRENT DOLLARS = (CONSTANT DOLLARS)(1 + f)N WHEN f IS DIFFERENT FOR EACH YEAR : (1+ f)N  (1 + f1)(1 + f2) ….1 THEN if = (1.INFLATION THE INTEREST RATE if IS DEFINED AS if = (1 + i)(1 + f) – 1 WHERE f IS THE AVERAGE INFLATION RATE.1) – 1 = 0. IF i = 0.

INFLATION EXAMPLE : AN INVESTMENT IS MADE FOR $4000.12(1.18722) + (1787 / 1.1872 PW = – 4000 + (1590 / 1.12)4 – 1} / 0.06) – 1 = 0.06)4 = 1894 if = (1. IF i = 0.06)3 = 1787 N4 : R = 1500 (1.1872) + (1685 / 1.12)4] = $556 b) WHEN WE FIND CURRENT DOLLARS N1 : R = 1500 (1.06 (CONSTANT FOR 4 YEARS). IT WILL BRING $1500 (REAL DOLLARS) EVERY YEAR FOR 4 YEARS.12 AND f = 0.06) = 1590 N2 : R = 1500 (1.12)(1.18723) + (1894 / 1.18724) = $556 . WHAT IS THE PW ? a) IN REAL DOLLARS WE DO NOT CONSIDER INFLATION PW = – 4000 + 1500 [{ (1.06)2 = 1685 N3 : R = 1500 (1.

DOLLARS : 40. EVALUATE THE PROPOSAL ACCORDING TO REAL.094 N5 : R = 41.659 N3 : R = 35. WHILE IT PROVIDES A REVENUE OF $40.1(1.000 TO CURRENT DOLLARS FOR f = 0. IT WILL NO SALVAGE VALUE AT THE END OF 5 YEAR USEFULL LIFE.000 x 1.1)5] = $6142 b) CONVERT $28. ESTIMATES ARE BASED ON CURRENT ECONOMIC CONDITIONS WITHOUT CONSIDERATION OF INFLATION.188 + 32.1885 = $6142 .141 if = (1.15 – 1) / 0.272/1.141/1.240/1.094/1.1882 + 35.000 [(1.000 – 12.000 / YEAR PW = – 100.272 N4 : R = 38.DOLLAR CASH FLOW WHEN INFLATION RATE IS 8%.000 ANNUALLY.000 PER YEAR. THE MARR IS 10% WITHOUT ANY ADJUSTMENT FOR INFLATION.000.000 = 28.DOLLAR DATA AND ACTUAL.INFLATION EXAMPLE : A MACHINE CAN BE PURCHASED FOR $100.240 N2 : R = 32.1884 + 41.08 = 30. OPERATING COSTS WILL BE $12. a) REAL.000 + 28.1 x 1.08 N1 : R = 28.659/1.08) – 1 = 0.1883 + 38.188 PW = – 100.000 + 30.

051 17.103/1.632 33.INFLATION OFTEN ONE OR MORE COMPONENTS IN A CASH FLOW STREAM HAVE ESCALATION RATES DIFFERENT FROM THE GENERAL INFLATION RATE.100 13.103 N3 46.305 15.040 N2 44.1885 = – $5.326 32.620 16.189 N4 48.040/1.294 N5 51.1883 + 32.960 $29.000 + 29.419/1.189/1.116 31.1882 + 31.000) WILL ESCALATE AT 5% WHILE INFLATION IS 8% AND EXPENSES INCREASE AT 8% REVENUE EXPENSES NET RECEIPT N1 $42.188 + 30.294/1.997 30.000 $12.289 .419 PW = – 100.1884 + 33. EXAMPLE : PREVIOUS PROBLEM BUT REVENUE ($40.

OPTIMIZATION .XI.

pressure. profit.OPTIMIZATION THE OPTIMUM FOR A PROCESS DESIGN IS THE MOST COST-EFFECTIVE SELECTION. ARRANGEMENT. HOW OPTIMIZATION IS MADE: 1. PROBLEM IS DEFINED: EXAMINATION OF PROCESS TO DETERMINE VARIABLES AND CONSTRAINTS THAT EFFECT THE OBJECTIVE FUNCTION AND ESTABLISHMENT OF MATHEMATICAL RELATIONS (temperature. equipment specifications…) 3. flow rate. production rate…) 2. SEQUENCING OF PROCESSING EQUIPMENT AND OPERATING CONDITIONS FOR THE DESIGN. OPTIMIZATION CRITERIA IS ESTABLISHED: SELECTION OF AN ECONOMIC CRITERION THAT IS TO BE THE OBJECTIVE FUNCTION (total cost. PROBLEM IS SOLVED FOR THE OPTIMAL VALUES .

OFTEN SOME COSTS INCREASE AND OTHERS DECREASE. $ total cost (fixed+heat loss) fixed costs cost of heat loss optimum insulation thickness Insulation thickness. EXAMPLE: Optimum Insulation Thickness for a steam pipe Cost per Year. THE TOTAL COST MAY GO THROUGH A MINIMUM AT ONE VALUE OF THAT VARIABLE AND THIS VALUE IS THE OPTIMUM VALUE OF THAT VARIABLE.cm .OPTIMIZATION WHEN A DESIGN VARIABLE IS CHANGED.

ARRANGEMENT AND SEQUENCING OF EQUIPMENT PARAMETRIC OPTIMIZATION: TO FIND THE BEST CONDITIONS. ONE OR MORE OF THESE IS THEN SUBJECTED TO PARAMETRIC OPTIMIZATION. AND THE MOST ECONOMICALLY ATTRACTIVE ONE IS SELECTED. YOU SHOULD CONSIDER SELECTING EQUIPMENT.OPTIMIZATION IN PROCESS DESIGN YOU SHOULD OPTIMIZE IN TWO FIELDS: STRUCTURAL OPTIMIZATION: TO FIND THE BEST FLOWHEET. YOU SHOULD CONSIDER YOU EQUIPMENT DESIGN PARAMETERS AND OPERATING VARIABLES TYPICALLY. . A FEW NEAR OPTIMAL FLOWSHEETS ARE OBTAINED BY ESTABLISHING SEVERAL FEASIBLE FLOWSHEETS AND THEN COMPARING THEIR NET PRESENT WORTHS OR ANNULAIZED COSTS.

THE VALUE IS MINIMUM). . c. x IS THE VARIABLE AND C IS THE OBJECTIVE FUNCTION TO BE MINIMIZED. IS AN ANALYTICAL FUNCTION OF A SINGLE VARIABLE.OPTIMIZATION WHEN THE FACTOR TO BE OPTIMIZED (MINIMIZED OR MAXIMIZED). WE SET THE DERIVATIVE OF C WITH RESPECT TO X EQUAL TO 0: dC / dx = a – c / x2 = 0 x = (c / a)1/2 TO CHECK IF THE VALUE IS MINIMUM OR MAXIMUM YOU CAN TAKE THE SECOND DERIVATIVE (IF IT IS POSITIVE. b. d ARE CONSTANTS. OR CALCULATE C FOR A SLIGHTLY DIFFERENT VALUE OF x. EXAMPLE: SUPPOSE WE HAVE A COST FOR AN OPERATION BEING A FUNCTION OF ONE VARIABLE: C = ax + b + c / x + d WHERE a. SOLVING THE PROBLEM IS SIMPLE.

8 KG / BATCH .8 + 60(50.8 WHERE Q IS THE KG OF PRODUCTION FOR BATCH.000 / Q2 = 0 Q1.OPTIMIZATION EXAMPLE: A BATCH OPERATION IN A PRODUCTION PLANT HAS ANNUAL OPERATION COST EQUAL TO $2. THE PREPARATION COST FOR BATCH IS $60.000 KG.000 Q0.000 Q0.8(2. WHAT IS THE OPTIMUM BATCH SIZE IF THE YEARLY PRODUCTION IS 50.000.000/Q) dC / dQ = 0.000 Q-0. TOTAL COST C = 2.2 ) – 3.8 = 1875 Q = 65.

. WE CAN FIND THE CORRECT VALUES OF BOTH VARIABLES OPTIMIZING THE COST.OPTIMIZATION WHEN TWO OR MORE INDEPENDENT VARIABLES AFFECT THE OBJECTIVE FUNCTION. WE USE A SIMILAR PROCEDURE EXAMPLE: SUPPOSE YOU HAVE A TOTAL COST TO BE MINIMIZED WHICH IS A FUNCTION OF TWO VARIABLES x AND y C = ax + b / xy + cy + d ∂C / ∂x = a – b / x2y ∂C / ∂y = c – b / xy2 IF WE SET BOTH EQUATIONS EQUAL TO ZERO AND SOLVE FOR x AND y.

33x2)2 = 11.900 / xy2 = 0  2.8y + 10 FIND THE x AND y VALUES GIVING THE MINIMUM TOTAL COST.900 1.900 / 2. THE TOTAL COST IS FOUND TO BE: C = 2.900 / x2y = 0 ∂C / ∂y = 1.33 – 11.86 xy2 = 11.OPTIMIZATION EXAMPLE: FOR AN OPERATION.900  x = 16.33x + 11. y = 20.7 . C = 121.900 / xy + 1.86 – 11.900  x ( 11. ∂C / ∂x = 2.33 x2y = 11.

XII. PROJECT MANAGEMENT .

PROJECT ACTIVITIES HAVE PRECEDENCE RELATIONSHIPS.PROJECT MANAGEMENT PROJECT : A MAJOR UNDERTAKING THAT IS UNLIKELY TO BE REPEATED IN EXACTLY THE SAME WAY AT FUTURE PRODUCTION MANAGEMENT IS REPETITIVE IN NATURE. PROJECT MANAGEMENT IS MORE OF A SINGLE. IN PROJECT MANAGEMENT WE PLAN AND CONROL: * BUDGET * TIME AIM IS TO MINIMIZE BUDGET AND TIME . MAJOR JOB.

DEVELOP PROJECT DESCRIPTION .DESCRIBE HOW TO ACCOMPLISH THE WORK .INITIATE BROAD DISCUSSION OF PROJECT PROJECT DEFINITION .DETERMINE TENTATIVE TIMING . TIMING.PROJECT LIFE CYCLE CONCEPT . RESOURCE REQUIREMENTS PLANNING . PERSONNEL.IDENTIFY BROAD BUDGET. BUDGETS AND RESOURCES .CREATE ORGANIZATION TO MANAGE THE PROJECT .DEVELOP DETAILED PLANS IDENTIFYING TASKS.

PROJECT LIFE CYCLE PRELIMINARY STUDIES .CONFIRM PROJECT RESULTS .EXECUTE THE PROCECT PLAN AND PERFORM WORK .VALIDATE THE ASSUMPTIONS MADE IN THE PROJECT PLAN BY DATA COLLECTION.DOCUMENT PROJECT FILES FOR FUTURE REFERENCE . LITERATURE SEARCH PERFORMANCE .REASSIGN PERSONNEL AND EQUIPMENT .USE PROJECT CONTROL TOOLS AND TECHNIQUES POSTCOMPLETION .

WHEN THERE ARE DEVIATIONS. INTERRELATIONS OF ACTIVITIES ARE NOT SHOWN. IS HARD TO MAKE. . IT IS NOT SUITED FOR MANAGEMENT OF LARGE PROJECTS.GANTT CHART ONE OF THE OLDEST TECHNIQUES USED IS GANNT CHART. RESCHEDULING. IT IS DIFFICULT TO SEE HOW PROJECT IS EFFECTED IF YOU DELAY AN ACTIVITY. IT SHOWS PLANNED ACTIVITIES VERSUS ACTUAL ACCOMPLISMENTS ON THE SAME TIME SCALE.

GANTT CHART 8 12 12A ACTIVITY START OPERATION 16 18 END OPERATION 18B PLANNED PROCESS TIME 22 ACTUAL TIME EXPANDED 0 5 10 NOW 15 WEEKS ACTIVITY 16 IS EXACTLY ON SCHEDULE. ACT 12 IS 2 WEEKS AHEAD OF SCHEDULE. ACT 18B IS 1/2 WEEK BEHIND SCHEDULE THE GANTT CHART MUST BE UPDATED VERY FREQUENTLY TO REFLECT THE CHANGING SITUATION SINCE CERTAIN ACTIVITIES WILL TAKE LONGER OR SHORTER THEN EXPECTED .

IN LATE 1950 s. USING CPM. PERFORMANCE EVALUATION AND REVIEW TECHNIQUE (PERT) WAS DEVELOPED DURING PLANNING POLARIS PROJECT. CRITICAL PATH METHOD (CPM) WAS DEVELOPED BY DUPONT COMPANY DURING PLANNING FOR MAINTENANCE OF A CHEMICAL PLANT. CPM AND PERT METHODS WERE DEVELOPED. THE ORIGINAL PROGRAM OF POLARIS DEVELOPMENT PROJECT WAS DECREASED BY 2 YEARS. PERT AND CPM HAVE SIMILARITIES. THEY BOTH ALLOW US TO DETERMINE THE MOST CRITICAL ACTIVITIES. BY PERT. DUPONT DECREASED THE DOWNTIME OF ITS PLANT FOR MAINTENANCE FROM 125 TO 78 HOURS.PROJECT PLANNING NETWORKS TO OVERCOME SOME SHORTCOMINGS OF GANTT CHART. .

PRESEDENCE RELATIONSHIPS AND TIMES. ITS PREDECESSOR AND ITS SUCCESSORS. CPM REQUIRES THAT WE BEGIN BY IDENTIFYING ALL PROJECT ACTIVITIES.F 4 E A 20 . ACTIVITY PREDECESSOR DURATION ACTIVITY PREDECESSOR DURATION A None 8 F B 9 B None 20 G C 10 C None 33 H D 8 D A 18 I E.CRITICAL PATH METHOD (CPM) CPM UTILIZE A NETWORK REPRESANTATION TO SHOW EACH TASK TO BE PERFORMED.

9 33 35 H.CRITICAL PATH METHOD (CPM) 8 17 8 A. 0 1 0 0 0 10 B. 9 ACTIVITY DURATION 39 29 29 39 6 NODE NUMBER EARLIEST TIME ACTIVITY ENDS . 20 39 29 29 39 6 0 G. 1 33 26 8 39 28 9 0 26 35 33 33 33 34 39 29 I. 18 35 81 26 9 8 E. 8 17 2 17 D. 20 30 0 20 C. 5 20 30 3 30 20 F. 4 43 43 43 43 33 43 43 7 LATEST ALLOWABLE EVENT OCCURANCE TIME 33 33 LATEST ALLOWABLE ACTIVITY START TIME 4 LATEST ALLOWABLE ACTIVITY FINISH TIME EARLIEST EVENT OCCURANCE TIME 20 30 3 EARLIEST TIME ACTIVITY CAN START 30 20 F.

 TOTAL ACTIVITY SLACK : LATEST ALLOWABLE OCCURANCE TIME OF AN ACTIVITY'S SUCCESSOR EVENT.CRITICAL PATH METHOD (CPM)  FORWARD PASS : CALCULATE THE EARLIEST TIME AN ACTIVITY CAN START.  CRITICAL PATH : SEQUENCE OF ACTIVITIES HAVING NO SLACK. TELLS AMOUNT OF DELAY WE CAN HAVE WITHOUT AFFECTING THE EARLIEST START OF AN ACTIVITY ON CP.  BACKWARD PASS : CALCULATE LATEST TIME AT WHICH EVENTS CAN BE COMPLETED. LESS THE EARLIEST FINISH TIME OF THE ACTIVITY. .

THIS PERMITS US TO TRADE OFF MANPOWER AND EQUIPMENT RESOURCES FROM NONCRITICAL ACTIVITIES TO CONCENTRATE ON AND SHORTEN THE CRITICAL PATH. .  AMOUNT OF SLACK OR FREE TIME ON NONCRITICAL PATHS MAY BE DETERMINED.  MANAGEMENT FOCUS MORE ATTENTION TO SMALL PERCENTAGE OF CRITICAL ACTIVITIES.CRITICAL PATH METHOD (CPM)  OFFERS A SYSTEMATIC PROCEDURE FOR SELECTING THE CRITICAL PATH.  EFFECTS OF CHANGES CAN BE SEEN EASILY.

PERT PROGRAM EVALUATION AND REVIEW TECHNIQUE (PERT) IS SIMILAR TO CPM. to : OPTIMISTIC TIME. MINIMUM TIME. MAXIMUM TIME. PERT IS USED WHERE GREAT DEAL OF UNCERTANITY EXISTS FOR DURATIONS OF ACTIVITIES.to 6 ) 2 . (AVERAGE) + VARIANCE OF DISTRIBUTION 4 tm + tp 6 = Vt = ( tp . PERT REQUIRES 3 : MOST LIKELY TIME. DIFFERENCE IS CPM REQUIRES SINGLE ESTIMATE FOR EACH ACTIVITY. te : EXPECTED TIME. tp : PESSIMISTIC TIME. te = to tm : MOST LIKELY TIME. LIKE RESEARCH PROGRAMS OR APPLICATION OF NEW TECHNOLOGIES.

PERT EXAMPLE : ACTIVITY t o C 21 G 7 tm 33 9 tp te Vt 45 33 16 17 10 2. G St St = 33 + 10 = 43 = 16 + = 18.778 2.333 THE PROJECT MOST PROBABLY WILL FINISH LATEST 43 + 4 = 47 DAYS . G C.778 SINCE THE CRITICAL PATH IS C AND G TE = Vt = STANDARD DEVIATION :  te  Vt C.778 = Vt = 18.788 = 4.

ALL JOBS CAN BE SHORTENED BY USING NEW MACHINES. EXTRA MANPOWER. OVER TIME WORK ETC. THESE INCREASE THE DIRECT COSTS. WE CALCULATE DIRECT COSTS FOR EACH ACTIVITY FOR NORMAL TIME AND CRASH TIME (MINIMUM TIME) AND INDIRECT OUTCOME AS TOTAL TIME DECREASE DURATION (TOTAL) : 43 42 41 40 39 38 37 36 35 34 REWARD (1000$) : - 10 18 25 31 36 40 43 45 46 . EARLY COMPLETION REWARDS MAY HAVE POSITIVE EFFECT TO COST BY SHORTENING PROJECT DURATION. BUT INDIRECT COST LIKE PENALTIES FOR TIME OVERRUNS.TIME-COST TRADE-OFFS IN CPM AND PERT WE USE NORMAL WORKING CONDITIONS SUCH AS REGULAR WORK DAY AND STANDARD EQUIPMENT.

x 1000 $ TIME-COST TRADE-OFFS ACTIVITY AB CD EF GH I NORMAL TIME CRASH TIME NORMAL COST CRASH COST SLOPE (Cost/Day) 820 616 1022 1538 2. .5 23 -3. KEEP LOWERING ACTIVITY TIMES ON CP TO CRASH TIMES UNTIL YOU ACHIVE THE MAXIMUM RESULT.5 4 3 6 39.5 PROJECT DURATION ACTIVITY CHANGE COST REWARD RESULT 43 110 42 C: 33 TO 32 111 10 +9 41 C: 32 TO 31 112 18 +16 40 C: 31 TO 30 113 25 +22 WHEN LOWERING DURATIONS CP MAY CHANGE.5 .5 3318 209 108 2114 177 78 3020 64 93 4226 7.5 818 41 1.

) OF SUBDIVIDING THE WORK AND THE BEST METHOD IS THE ONE THAT WORKS WELL FOR THAT PROJECT .WBS WORK BREAKDOWN STRUCTURE (WBS) THE PURPOSE OF WBS IS TO SUB-DIVIDE THE SCOPE OF WORK INTO MANAGEABLE WORK PACKAGES WHICH CAN BE ESTIMATED. MANAGEABLE COMPONENTS BY USING WBS.. PLANNED AND ASSIGNED TO A RESPONSIBLE PERSON OR DEPARTMENT FOR COMPLETION IT IS A NICE TOOL USED FREQUENTLY IN PROJECT MANAGEMENT BREAKING COMPLEXITY INTO SIMPLE. ESTIMATING THE DURATION AND THE COST OF THE PROJECT AND CONTROLLING IS EASIER THERE ARE MANY METHODS (SYSTEM BREAKDOWN. PRODUCT BREAKDOWN. CONTRACTOR BREAKDOWN.

WBS AN EXAMPLE FOR WBS HOUSE CIVIL FOUNDATIONS ELECTRICAL PLUMBING WALLS / ROOF PIPING SEWERAGE WIRING APPLIANCES .

THIS REWARD WILL BE CASH FLOW IN INDUSTRY. THE DECISION ALTERNATIVES ARE REPRESENTED AS BRANCHES FROM THE DECISION NODE. POSITIVE OR NEGATIVE. IN A SYSTEMATIC MANNER. TRAVERSING EACH BRANCH ON THE DECISION TREE WILL BRING SOME REWARD. alternative 1 alternative 2 alternative 3 . TO THE DECISION MAKER. IN MAKING THE DECISION TREE WE START WITH DECISION NODE.DECISION TREE ANALYSIS THE DECISION TREE TECHNIQUE FACILITATES PROJECT EVALUATION BY ENABLING THE FIRM TO WRITE DOWN THE POSSIBLE FUTURE EVENTS AS WELL AS THEIR MONETARY OUTCOMES. GENERALLY.

YOU CAN CALCULATE EMV. EXPECTED MONETARY VALUE. THAN. . MODERATE AND BAD CONDITIONS. THE ALTERNATIVE WITH THE LARGEST EMV IS THE BEST ALTERNATIVE. BY MULTIPLYING THE PRESENT VALUES OF EACH CONDITION BY THE PROBABILITY OF THAT CONDITION AND SUMMING THESE FOR EACH ALTERNATIVE. WITH THIS INFORMATION. FOR EACH CONDITION YOU SHOULD ESTIMATE THE PROBABILITY OF OCCURANCE.DECISION TREE ANALYSIS FOR EACH ALTERNATIVE SHOULD PREDICT AN OUTCOME FOR GOOD.

.60 POOR $ 50.000.000 AND NO SALVAGE VALUE AFTER 5 YEARS. IN THIS ALTERNATIVE YEARLY INCREASE IN EXPENSES WILL BE $20.000 0.000.000 0. INCREASE PROBABILITY REV. THE ESTIMATED INCREASE IN THE SALES REVENUES AND THE PROBABILITIES ARE AS FOLLOWS: LARGE EXPANSION SMALL EXPANSION REV.60 $35. WORKING CAPITAL IS $20. IN THE LARGE EXPANSION THE NEW MACHINERY INVESTMENT IS $140.000 0. WORKING CAPITAL IS $10.000. IN THE SMALL EXPANSION THE INVESTMENT REQUIRED IS $60.000.000 0. INCREASE PROBABILITY GOOD $100.000 0.000.25 MODERATE $ 80.15 $24. THE INCREASE IN THE YEARLY EXPENSES IS $10. LARGE EXPANSION.DECISION TREE ANALYSIS EXAMPLE: YOUR COMPANY IS DISCUSSING AN EXPANSION PROJECT. THE SALVAGE VALUE AFTER 5 YEARS IS ASSUMED TO BE 0. THERE ARE 3 ALTERNATIVES.15 FIND THE BEST ALTERNATIVE IF TAX RATE IS 30%. SMALL EXPANSION AND NO EXPANSION. MAAR 15% USING STRAIGHT LINE DEPRECIATION.25 $50.000 0.

000 100.000 20.400 64.400 36.400 PVGOOD = 64.000 64.000 20.400 64.600 15.400 20.600 15.000 100.400 84.000 100.400 36.400 /(1.000 20.600 15.400 36.15)4] + 84.917 PVPOOR = – 51.000 20.15(1.600 36.15)4 – 1} / .000 28.DECISION TREE ANALYSIS LARGE EXPANSION: REVENUE INCREASE EXPENSE INCREASE DEPRECIATION TAX NET INCOME WOR. CASH FLOW 1 2 3 4 5 100.000 20.000 28.000 28.400 36.000 15.400 [ {(1.400 64.852 PVMOD = 18.486 .000 28.15)5 – 160. CAP.600 15.000 100.000 = 65.000 28.

400 8.852)(0.486)(0.915)(0.15) = 20.15)5 – 70.400 19.915)(0.089 EMVSMALL EXPANSION= (40.101 EMVLARGE EXPANSION= (65.000 50.600 /(1.000 10.600 31.600 19.15)4] + 41.15) = 10.DECISION TREE ANALYSIS SMALL EXPANSION: REVENUE INCREASE EXPENSE INCREASE DEPRECIATION TAX NET INCOME WOR.15)4 – 1} / .000 12.15(1.600 19.000 10.000 41.915 PVMOD = 5.60 – (20.000 10.000 10.400 8. CAP.000 8.000 12.400 19.600 31.428)(0.600 31.471 .000 50.000 12.60) – (51.000 12.600 5 50.000 12.000 = 40.600 3 4 50.400 19.000 10.600 31. CASH FLOW 1 2 50.25) + (18.25) + (5.428 PVPOOR = – 20.101)/0.600 PVGOOD = 31.600 10.600 [ {(1.000 8.000 8.

XIII. BASIC ACCOUNTING .

. THE FIRST ACTIVITY IS CALLED ACCOUNTING. RECORDING. MONITORING AND CONTROLLING OF FINANCIAL CONSEQUENCES OF PAST AND CURRENT OPERATIONS. ALTHOUGH IT IS NOT NECESSARY TO KNOW THE DETAILS INVOLVED IN ACCOUNTING. ACQUIRING FUNDS TO MEET CURRENT AND FUTURE NEEDS. 2.ACCOUNTING FINANCE DEPARTMENTS HAVE TWO PRIMARY FUNCTIONS IN COMPANIES: 1. A KNOWLEDGE OF BASIC PRINCIPLES IS AN INVALUABLE AID TO THE ENGINEERS.

LEDGER IS A GROUP OF ACCOUNTS GIVING CONDENSED AND CLASSIFIED INFORMATION FROM THE JOURNAL .ACCOUNTING BUSINESS TRANSACTIONS JOURNAL LEDGER BALANCE SHEET INCOME STATEMENT JOURNAL IS A BOOK IN WHICH THE ORIGINAL RECORD OF TRANSACTIONS ARE LISTED DAILY.

LAND. TL) OR OTHER FORMS (BUILDING. . BALANCE SHEET : SHOWS THE WEALTH IN MONETORY (DOLLARS. ACCOUNTS RECEIVABLE) AVAILABLE TO THE OWNERS AND OBLIGATIONS DUE TO OWNERS AT A GIVEN TIME.ACCOUNTING BALANCE SHEET AND INCOME STATEMENT ARE TWO KEY DOCUMENTS OF FINANCIAL ACCOUNTING. INCOME STATEMENT : SHOWS THE FLOW OF WEALTH. THAT IS RECEIPT OR DISBURSEMENT OF WEALTH OCCURING BETWEEN TWO POINTS IN TIME.

TO WHICH ENTITY HAS PRIMARY CLAIM. MACHINERY ETC.ACCOUNTING BALANCE SHEET AS OF 1 APRIL 2004 BALANCE SHEET AS OF 31 MAY 2004 INCOME STATEMENT FOR THE PERIOD 1 APRIL . THE RIGHT HAND SIDE CONTAINS OUTSIDERS' (LENDERS + OWNERS) CLAIMS ON THE ASSETS OF THE ENTITY. INVESTMENTS. LAND.31 MAY 2004 BALANCE SHEET : THE FORMAT OF BALANCE SHEET CONSIST OF A T . ACCOUNTS RECEIVABLE. INVENTORIES. WITH THE ASSETS ON LEFT HAND SIDE. . LIABILITIES AND OWNERSHIP AT RIGHT ASSETS LIABILITIES OWNERSHIP ASSETS ARE CASH ON HAND.

LONG TERM LIABILITIES ARE CREDITS OR BONDS NOT DUE WITHIN THE NEXT FISCAL YEAR. BUILDING. EQUITY : CAPITAL. MACHINERY. . RETAINED INCOME.ACCOUNTING ASSETS = LIABILITIES + ASSETS EQUITY : CURRENT ASSETS CONSISTS OF CASH OR CLAIMS ON OUTSIDERS THAT CAN BE CONVERTED TO CASH IN LESS THAN ONE YEAR. FIXED ASSETS ARE THINGS LIKE LAND. LIABILITIES : CURRENT LIABILITIES ARE ACCOUNTS PAYABLE AND SHORT TERM CREDITS THAT ARE EXPECTED TO BE DISCHARGED IN LESS THAN A YEAR.

. . .000 ASSUME FOLLOWING HAPPENED IN JANUARY FOR COMPANY X : 1. $ 5. 3. . . . . . COMPANY X AS OF JANUARY 1. $ 5.000. . . RAW MATERIAL WORTH $ 200. .000 TOTAL EQUITIES . $ 5. $ 5 MILLION BY BANK CREDIT. . 2004 CASH : .000.000. EQUIPMENT WORTH $ 300. 2004 WITH 5 MILLION DOLLAR PAID CAPITAL. . $ 2 MILLION BY CASH. A BUILDING WAS BOUGHT FOR $ 7 MILLION. . .ACCOUNTING ASSUME COMPANY X FORMED IN JANUARY 1. BALANCE SHEET.000.000 TOTAL ASSETS : $ 5. . . .000 CAPITAL : .000 ACQUIRED BY CASH.000 BOUGHT BY CREDIT. 2.

000 CURRENT ASSETS : $ 2.000 5.000 FIXED ASSETS : $ 7.000.000.900.ACCOUNTING BALANCE SHEET.000 EQUIPMENT BUILDING : : 300.000 ACCOUNT PAYABLE : CREDIT : LIABILITES $ 200.700.000 EQUITIES : $ 5.200.000 200. COMPANY X AS OF JANUARY 31. 2004 CASH INVENTORIES : : $ 2.300.000 TOTAL LIABILITES AND EQUITIES : $ 10.000.000 : $ 5.000.000 CAPITAL : 5.000 7.000 .200.200.000 TOTAL ASSETS : $ 10.

EXPENSES: BOTH CASH (PURCHASES OF RAW MATERIAL. ADMINISTRATIVE COSTS ETC. PROFIT FROM OTHER FIRMS AND INTEREST GAINED. TAX: INCOME TAX. USED EQUIPMENT. THE SALE OF SCRAP. OTHER SOURCES INCLUDE THE SALE OF OLD. IT IS ALSO CALLED ‘PROFIT AND LOSS STATEMENT’. LABOR COSTS. CERTAIN PERCENT OF PROFIT DIVIDENDS: PAYMENT TO THE SHAREHOLDERS RETAINED INCOME: STAYS IN THE COMPANY AS A FUND .ACCOUNTING INCOME STATEMENT : TRANSACTIONS (REVENUES AND EXPENSES) IN A COMPANY DURING A PERIOD. REVENUE: CAN BE FROM THE SALE OF PRODUCTS OR SERVICES.) AND NONCASH (DEPRECIATION) EXPENSES ARE SHOWN. OR FROM OTHER SOURCES.

.ACCOUNTING INCOME STATEMENT REVENUE ……………………. OTHER INCOME EXPENSES ……………………B OPERATING EXPENSES.A SALES. DEPRECIATION INCOME BEFORE TAX………C = (A-B) TAX………………………………D NET INCOME OR NET PROFIT AFTER TAX…E = (C-D) DIVIDENDS…………………….E-F .F (CERTAIN % OF E) RETAINED INCOME………….. ADM.COSTS.

000 INCOME STATEMENT (1-28 FEBRUARY 2004) REVENUE : SALES ………………………………………………………………………………………….000 40.000 208.000 3.000 INCOME $ 18..000 $ 362.ACCOUNTING ASSUME FOLLOWING HAPPENED IN COMPANY X IN FEBRUARY : 1. RAW MATERIAL USED : $ 114.000 .000 4. INTEREST ON MORTGAGE : $ 40. SALARIES PAID : $ 208. RECEIPT FROM SALES : $ 380.000 EXPENSES : COST OF GOODS SOLD SALARIES INTEREST : : : $ 114.000 2. $ 380..

000 .000 + [ 380.000 7.000 ) ] = $ 2.000 = $ 86.+ EQU.000 : $ 5.000.000 LIABILITES CAPITAL RETAINED INCOME .114. 2004 CASH INVENTORIES : : $ 2.000 + 40.000 : : 300.218.000 .( 208.700.000 : $ 2.000 FIXED ASSETS : $ 7.300. COMPANY X AS OF FEBRUARY 28. : $ 10.000.000.832.000 CURRENT ASSETS EQUIPMENT BUILDING ACCOUNTS PAYABLE CREDIT : : $ 200.000 18.000 : : 5.000 NEW BALANCE SHEET IS : BALANCE SHEET.000 TOTAL ASSETS : $ 10.018.000 5.000 86.200.832.000 EQUITIES : $ 5.ACCOUNTING SO CASH IS : 2.000 TOTAL LIAB.218.000 INVENTORIES IS : 200.918.

MOSTLY USED RATIOS ARE AS FOLLOWS :  LIQUIDITY RATIOS : CURRENT RATIO QUICK RATIO (ACID TEST) : : CURRENT ASSETS CURRENT LIABILITES CURRENT ASSETS .INVENTORIES CURRENT LIABILITIES . THEY ARE KNOWN AS FINANCIAL RATIOS.FINANCIAL RATIOS SOME OF THE RELATIONSHIPS FROM THE BALANCE SHEET AND INCOME STATEMENT WERE JUDGED TO HAVE PARTICULAR SIGNIFICANCE AS INDICATORS OF FINANCIAL HEALTH AND GOOD MANAGEMENT.

FINANCIAL RATIOS  PROFITABILITY RATIO NET PROFIT ON SALES SALES : PROFIT AFTER TAXES ON EQUITY : EQUITY  ACTIVITY RATIOS SALES ASSETS TURNOVER TOTAL ASSETS : SALES INVENTORY TURNOVER INVENTORY :  LEVERAGE RATIOS TOTAL DEBT DEBT TO TOTAL ASSETS : TOTAL ASSETS .

TRADE CREDITS : THE USE OF MATERIALS WITHOUT IMMEDIATELY PAYING FOR THEM .FINANCIAL MANAGEMENT SHORT TERM FINANCING : .NOTES : WRITTEN PROMISE TO PAY LATER .FACTORING : TO SELL THE ACCOUNTS RECEIVABLE AT A DISCOUNT IN EXCHANGE FOR IMMEDIATE MONEY .BANK CREDITS : BORROWING FROM BANKS AND PAYING AN INTEREST .

BONDS : YOU SELL BONDS AND AGREE TO PAY A CHARGE ANNUALLY OR BUY WITH A HIGHER PRICE AT THE MATURITY DATE .PROFIT INVESTED IN CURRENT ASSETS . OWNERS GET SHARE FROM PROFIT .LONG TERM BANK CREDITS .SALES OF FIXED ASSETS .FINANCIAL MANAGEMENT LONG TERM FINANCING : .STOCKS : SELLING STOCKS.

THE BORROWED FUNDS ARE NOT CONSIDERED AS INCOME (SO ARE NOT TAXED). BUT THE INTERESTS PAID ARE CONSIDERED AS EXPENSE. THEY CAN SELL BONDS OR GET CREDITS FROM BANKS OR OTHER ORGANIZATIONS. WHEN THEY ARE REPAID. THIS IS NOT CONSIDERED AS AN EXPENSE (NOT INCLUDED IN YOUR COSTS). SO THE REAL COST OF BORROWING FUNDS CAN BE FOUND BY DEDUCTING THE TAX AMOUNT. THEY PAY INTEREST FOR THESE LOANS.FINANCIAL MANAGEMENT BORROWED FUNDS: COMPANIES MAY REQUIRE OUTSIDE FUNDS FOR THEIR INVESTMENTS OR PRODUCTION EXPENSES. .

SO YOUR TAX WILL DECREASE 0.000 / YEAR COST OF THE FUND = 100.000 WITH 10% INTEREST RATE? INTEREST/ YEAR = 0.000.000 = $70.FINANCIAL MANAGEMENT EXAMPLE: IF YOU PAY 30% INCOME TAX.30 x 100.000 INTO YOUR EXPENSES. WHAT IS THE COST OF BORROWING $1.000 / YEAR YOU CAN INCLUDE THIS $100.000 / YEAR OR 7% .000 = $30.000 = $100.000.000 – 30.1 x 1.

THE MOST COMMON TYPE IS BY CONSTANT PERIODIC PAYMENTS.FINANCIAL MANAGEMENT LOAN REPAYMENT: THE BORROWED FUNDS CAN BE REPAID BY DIFFERENT METHODS. pj IS THE jth PERIOD PRINCIPLE PAYMENT. L = I j + pj WHERE L IS THE CONSTANT PAYMENT EACH PERIOD. EACH PAYMENT COVERS THE INTEREST DUE ( INTEREST FOR THE REMAINING PORTION OF THE PRINCIPLE) AND SOME OF THE REMAINING PRINCIPLE. Ij IS THE jth PERIOD INTEREST PAYMENT. YOU CAN DRIVE AND USE THE FOLLOWING FORMULA TO CALCULATE THE CONSTANT PERIODIC REPAYMENT OF LOANS L = P0 [ 1 + i  1N (1 + i) j-1 ] /  1N (1 + i) j-1 WHERE P0 IS THE INITIAL AMOUNT OF LOAN. THE TOTAL PERIODIC PAYMENT IS CONSTANT. . BUT SINCE THE PRINCIPLE BALANCE DECREASES. THE INTEREST PORTION OF EACH PAYMENT IS SMALLER THAN THE PREVIOUS ONE AND THE PRINCIPLE PORTION OF EACH PAYMENT IS LARGER THAN THE PREVIOUS ONE.

59374] / 15.9374 = $16.1) j-1 ] /  1N (1.000 [ 1 + 1.1) j-1 = 100. L = P0 [ 1 + i  1N (1 + i) j-1 ] /  1N (1 + i) j-1 = 100.54 per year .1  1N (1.000 [ 1+ 0. DETERMINE THE CONSTANT PAYMENT PER PERIOD FOR ANNUAL. END-OF-THE-YEAR PAYMENTS.274.FINANCIAL MANAGEMENT EXAMPLE: A LOAN OF $100.000 AT AN INTEREST RATE OF 10% PER YEAR IS MADE FOR A REPAYMENT PERIOD OF 10 YEARS.

COST CONTROL .XIV.

THE COMPETING POWER AND THE PROFIT MARGIN OF A COMPANY DEPENDS ON THE PRODUCT COST. AND IN SOME CASES. REDUCING THE COSTS . MAY MAKE THE DIFFERENCE BETWEEN SURVIVAL AND EXTINCTION. CONTROLLING THE COSTS TO AVOID ANY INCREASE 2. COST CONTROL IS THE JOB OF EVERYONE IN THE ORGANIZATION AND IT CAN BE DONE EFFECTIVELLY BY GOOD ENGINEERING AND MANAGEMENT PRACTICES. SINCE THE SELLING PRICE IS LIMITED BY THE MARKET.COST CONTROL CONTROLLING THE COSTS IS ONE OF THE MOST IMPORTANT FUNCTIONS IN ANY COMPANY. COST CONTROL SHOULD BE DONE IN TWO STEPS: 1. INCREASING GLOBAL COMPETITION DEMANDS EFFECTIVE METHODS FOR IMPROVED OPERATIONAL PERFORMANCE AND EFFICIENCY AIMING LOWER COSTS. THE PRODUCT COSTS ARE BECOMING INCREASINGLY CRITICAL.

PRODUCTION EFFICIENCY. RAW MATERIAL USAGE. . COST STANDARDS FOR ALL ITEMS SHOULD BE SET UP AND CONSTANTLY UPDATED. UTILITY COSTS. CONTROLLING THE COSTS TO AVOID ANY INCREASE A MANAGEMENT INFORMATION SYSTEM (MIS) IS REQUIRED TO MONITOR ALL COST ITEMS IN THE COMPANY. ALL OVERHEAD COSTS SHOULD HAVE STANDARDS AND SHOULD BE RECORDED. RATIO OF ACTUAL TO STANDARD) CONSTITUDE THE MOST VALUABLE TOOLS OF COST MANAGEMENT. VARIANCES (OR VARIATIONS FROM STANDARD) AND THE COST PERFORMANCE INDEX (OR PERCENT EFFECTIVENESS. THE COMPARISON OF ACTUAL COSTS WITH STANDARDS WILL GIVE YOU THE MEASUREMENT OF PERFORMANCE AND ALARM YOU WHEN GOING IN THE WRONG DIRECTION. PURCHASING AND RELATED COSTS FOR ALL MATERIAL.COST CONTROL 1. LABOR COSTS.

COST CONTROL A GOOD MANAGEMENT PRACTICE FOR COST CONTROL IS TO DECENTRALIZE THE SYSTEM SO DEPARTMENTS HAVE THEIR OWN COST DATA AND ARE RESPONSIBLE FOR THE COST PERFORMANCE. SO DEFINING COST CENTERS AS SMALL AS POSSIBLE AND GIVING THE RESPONSIBILITY TO A SMALL GROUP OF MEN WILL IMPROVE THE COST CONTROL SYSTEM CONSIDERABLY. . THIS WILL BRING A CONSCIOUSNESS OF PROFIT RESPONSIBILITY AND WILL RESULT WITH THE CONTROL OF MINOR COST ELEMENTS EFFECTIVELY. THE RULE IS ‘THE BEST PLACE TO CONTROL COSTS IS AS CLOSE TO THE SOURCE AS POSSIBLE’.

BASED ON THE PAST HISTORY.COST CONTROL THERE ARE 3 MAJOR TYPES OF STANDARDS THAT CAN BE USED FOR COST CONTROL SYSTEMS: a) BUDGET STANDARD: MOST COMMONLY USED STANDARD. DETERMINED BY MATHEMATICAL AND STATISTICAL AVERAGES b) ENGINEERING STANDARD: DETERMINED BY ENGINEERING STUDIES AND BENCHMARKING c) COST REDUCTION STANDARD: DETERMINED BY ENGINEERING STUDIES INVOLVING IMPROVEMENT OR CHANGE OF PROCESS. MATERIAL OR EQUIPMENT .

DAILY INCREMENTAL IMPROVEMENTS USING THE EXISTING TECHOLOGY AND FACILITIES. SMALL IMPROVEMENTS IN ALL PROCESSES CAN BE MADE TO REDUCE COSTS .TECHNOLOGICAL CHANGES REDUCING THE COSTS BY CHANGING THE PROCESS OR EQUIPMENT .PRODUCT CHANGES DESIGNING NEW PRODUCTS WHICH CAN BE PRODUCED WITH LESS COST . REDUCING THE COSTS THE PRIMARY GOAL OF ALL COMPANIES IS TO INCREASE PROFIT WHICH IS POSSIBLE BY COST REDUCTION.COST CONTROL 2. THERE ARE THREE MAIN METHODS USED IN INDUSTRY FOR THIS PURPOSE: .

IDEAL IS ZERO INVENTORY) .BUY MATERIAL CHEAPER .IMPROVE YIELD SO USE LESS MATERIAL . LABOR.SUBSTITUDE LESS EXPENSIVE MATERIAL .DECREASE YOUR INVENTORY (INVENTORY IS MONEY KEPT WITH ZERO INTEREST. OVERHEAD COSTS) WITHOUT DECREASING THE QUALITY OF YOUR PRODUCTS. INCREASE TRAINING . BASIC PRINCIPLE IS TO INCREASE EFFICIENCY BY DECREASING THE INPUTS (MATERIAL.DECREASE THE COSTS OF PURCHASING.DECREASE THE LEAD-TIMES . TRANSPORTATION . IT IS HARD TO NAME ALL POSSIBILITIES BUT SOME FREQUENTLY USED METHODS ARE: .IMPROVE QUALITY ASSURANCE SYSTEMS.COST CONTROL THERE ARE MANY POSSIBILITIES OF COST REDUCTION.DECREASE LOSS AND SCRAP (TRY TO WORK ZERO-DEFECT) .

COST CONTROL .MINIMIZE BREAK-DOWNS BY EFFECTIVE MAINTENANCE .MINIMIZE UTULITY COSTS (AMOUNT AND UNIT COSTS) .INCREASE RATES OF FLOW IN PROCESSES .CHECK AND MINIMIZE ALL OVERHEAD COSTS .MINIMIZE MATERIAL FLOW .ELIMINATE UNUSED BUSINESS REPORTS AND DUPLICATIONS .MINIMIZE DISTRIBUTION COSTS .IMPROVE ALL PROCESSES .MINIMIZE SET-UP PERIODS. DECREASE CYCLE TIME . FIND BEST METHODS .USE AUTOMATION .ANALYZE JOBS.MINIMIZE SUPERVISION AND CONTROL ACTIVITIES .DO ‘MAKE-OR-BUY’ ANALYSIS REGULARLY .LOOK FOR IDLE TIMES OF PEOPLE AND FILL THEM .MINIMIZE PAPER WORK AND BUREAUCRACY .WORK WITH MINIMUM NUMBER OF PEOPLE IN ALL KIND OF JOBS .

BALANCE SHEET OF OUR LIFE • • • • • • • • • • • BIRTH IS YOUR OPENING STOCK WHAT COMES TO YOU IS CREDIT WHAT GOES FROM YOU IS DEBIT DEATH IS YOUR CLOSING STOCK YOUR IDEAS ARE YOUR ASSETS YOUR VIEWS ARE YOUR LIABILITIES YOUR HAPPINESS IS YOUR PROFIT YOUR SORROW IS YOUR LOSS YOUR SOUL IS YOUR GOODWILL YOUR HEART IS YOUR FIXED ASSETS YOUR DUTIES ARE YOUR OUTSTANDING EXPENSES .

BALANCE SHEET OF OUR LIFE • • • • • • • YOUR FRIENDSHIP IS YOUR HIDDEN ADJUSTMENT YOUR CHARACTER IS YOUR CAPITAL YOUR KNOWLEDGE IS YOUR INVESTMENT YOUR PATIENCE IS YOUR BANK BALANCE YOUR THINKING IS YOUR CURRENT ACCOUNT YOUR BEHAVIOR IS YOUR JOURNAL ENTRY BAD THINGS IS YOUR DEPRECIATION HAVE A PERFECT BALANCE SHEET .