CHE 422: PROCESS EVALUATION,

DESIGN AND PROJECT

MANAGEMENT

LECTURE SIX
PROJECT EVALUATION

31-Dec-14 Chem Eng Design 1

 Basic Principles of Engineering Economics
Production
• The conversion of inputs to outputs with
added value is called production.
• Production is an economic process that creates
a commodity for exchange or direct use.
• It is the rate of output of a commodity.
• It is the engine of economic growth.
• Any production venture involves serious
considerations of the relevant costs involved.
2
 Factors of Production and Economic
Efficiency
• These are inputs used in the production
process.
• They include primary factors of land,
capital, labor, energy, materials and
machinery; and entrepreneurship.
• Economic efficiency is how well a given
production process generates desired
outputs.
3
• Efficiency is improved if more output is
generated without changing inputs, i.e., less
non-conformity.
• Production efficiency is maximizing output for
a given total inputs avoiding waste.
• The ultimate goal of a chemical engineer is to
maximize production efficiency.

4
• Therefore, study of economics principles
enables a chemical engineer to maximize
profits.
• Chemical engineering profession is an
economic venture.

5
 Economic Growth
• This is the increase in market value of goods and
services produced by an economy over a period
of time.
• Economic growth is generally growth of
productivity.
• Economic growth has potential to alleviate
poverty due to increase in productivity.
• The market value is shown by the price of the
commodity and determined by the demand and
supply dynamics of the commodity or service.
6
 Demand and Supply Dynamics
• This is the description of how prices vary
as a result of the balance between
production (supply) and consumption
(demand).
• The price of goods and services is
depended on two major factors: supply
(quantity produced) and demand (quantity
purchased).
7
• Price determines the quantity produced
and the level of consumption.
• Individual consumers select the most
preferred quantity of each good/service
depending on level of income, price, taste,
quality, substitutes or alternatives, etc.
• These factors are constraints on demand.
• The law of demand states that the price of
goods/services and quantity demanded in a
given market are inversely related.
8
• The higher the price of a product/service, the
less of it consumers would be prepared to
purchase, other factors remaining constant.
• As the price falls, more of the consumers
move to purchase it.
• Therefore, price decline changes demand
positively.
• Change in other factors such as level of
income changes the demand, i.e., increase in
income shifts the demand curve outward
relative to the origin 9
Law of Demand

10
 Supply
• Supply is a relationship between the price
of a commodity and the quantity available
on market (production) for sale at that
price.
• The price of a commodity affects supply
positively, other factors such as cost of
supply, price of substitutes, technology
applied, etc., affecting production are
assumed to be constant.
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• The higher the price at which a commodity
can be sold the more of it the supplier will
produce.
• High market prices it make possible to
increase production.
• Change in production costs can shift the
supply curve in the same was the demand
curve is shifted.
• The law of supply states that a rise in price
will result in an increase in supply and vice
versa. 12
Supply Dynamics

13
 Equilibrium Price
• The intersection of demand and supply
curves represent market equilibrium where
the quantity produced is equal to the
quantity supplied.
• Below equilibrium price there is shortage of
quantity supplied compared to the quantity
demanded.
• This forces the price shift upward.
14
• Above equilibrium price, there is a surplus of
goods supplied compared to goods demanded
and this forces the price shift downward.
• Therefore, for a given production and
consumption domain the price and quantity
will stabilize at the price that makes quantity
supplied equal to the quality consumed, other
factors kept constant.
• Equilibrium price helps to forecast
uncertainties in the chemical and process
industries.
15
16
 Factors Affecting Profitability of an
Investment
These include:
• Cost of fixed investment
• Working capital
• Construction period
• Initial startup cost
• Sales volume forecast
• Product price forecast
• Economic life (project life)
• Depreciation life
• Salvage value
• Depreciation method
• Minimum acceptable rate of return
• Income tax rate
• Inflation/deflation rate
• Risk
• General business conditions
Cost of Fixed Investment
• This is the most important item to be
forecast before an investment decision is
made
Working Capital
• Extra funds held as cash or liquid
investment.
• The amount of which is a function of
production volume and estimated at
different production levels
Construction Period
• Every investment in new facilities takes
some delay in realization of income due to
construction time.
• The level of delay should be estimated
Initial Startup Expense
• During initial operation of a business, the
expenses are usually higher than normal
and should therefore be estimated
Forecast of revenue stream over project life
• This is sales volume and product price
forecast.
• It is not primarily an engineering function.
• However, when done they are important in
determining the success of an investment
Economic life
• This is the most probable period of
successful operation before any need for
subsequent significant investment is made
as a result of product and/or process
obsolesce and equipment deterioration.
Effective depreciation life of depreciable
fixed investment
• Different investments may have different
depreciation lives.
• If the allowable depreciation life is different
from the project life, cash flows to the
project is affected
Salvage value
• This is the value realized from equipment
or facility at the end of project life.
• At the close of the project or business the
facility may be sold to another firm.
• Salvage value is assumed to be zero in
profitability evaluation
Minimum acceptable rate of return
• Companies usually have a minimum
acceptable rate of return in a range such
that variations can be accounted for among
different projects
• Other factors depend on circumstances that
are beyond the chem. Eng. control.
• They include income tax rate,
inflation/deflation, risk and general
business conditions
Deflation/Inflation
• Inflation occurs when price of goods and
services rise while deflation is when the
price decrease
• Inflation occurs when goods/services are in
high demand creating a drop in availability.
The manufacturers charge more and
consumers are also willing to pay more for
the same goods

26
• Deflation occurs when too many goods
are in circulation or when there is not
enough money in circulation to purchase
the goods
• Deflation can lead to economic
depression while inflation will lead to
economic boom

27
 Time Value of Money
• As soon as money is available it can be
invested so as to earn profits or interest.
• For profitable investment, the sooner cash
is earned the earlier it should be invested
elsewhere to earn a return.
• The converse is true. The longer money
must be invested before it starts earning a
profit, the less beneficial the investment is
to the owner.
• Time value of money is integrated into
project evaluation by use of compound
interest relationships.
• For any assumed interest value of money, a
known amount at any one time can be
converted to an equivalent but different
amount at a different time.
• Time value of money is characterized by an
interest rate and the effect of time on
money is proportional to the volume of
money involved.
 𝐹𝑉
𝑃𝑉 =
1+𝑟 𝑛
Where: PV = present value of money; FV =
future value; r = rate and n = number of years

• For the same FV, more investment is required

at shorter time and less investment is required
at longer time
Example:
• Suppose you can get 10% interest on $
1,000 in one year, i.e. $ 1,000 now is
$1,100 a year later, the present value of $
1100 next year is $ 1000 now.
• Suppose you are to receive $1000 next
year.
• What is the present value at 10% value?
Solution:
𝐹𝑉
𝑃𝑉 = 𝑛
1+𝑟

1000
𝑃𝑉 = 1
= 909.09
1 + 0.1
• If you are to receive $1000 in 2, 3 years, what is
the present value:
1000
𝑃𝑉 = 2
= 826.446
1.1

1000
𝑃𝑉 = 3
= 751.314
1.1

1000
𝑃𝑉 = 4
= 683.073
1.1
Summary

End of Year PV (10%) FV

0 1000.00 1000
1 909.09 1000
2 826.45 1000
3 751.31 1000
4 683.01 1000
 Profitability Analysis
• Approaches used in quantification of
profitability include: net present value,
payback period, return on investment,
internal rate of return and accounting
rate of return
 Net Present Value
• This is the present worth of project
revenues less the present worth of costs.
• It calculates the present value of an
investment by using a discounted rate and a
series of future payments and income.
• The discount rate can be inflation rate or
the interest rate of a competing
investment. i.e., it is the comparison of the
project value over a given time period to
investment in another venture.
• Money can be invested in any business,
start a manufacturing firm, buy fixed
assets and sell later, or simply put it in
the bank to earn fixed interest rate.
• Profitability of different investments can
be analyzed by use of NPV method by
applying the same interest rate for each
investment.
Example 1
• If $ 1,000 is put on fixed account in a
bank at 10% interest rate per annum,

𝑛
𝐹𝑉 = 𝑃𝑉 1 + 𝑟
Money Year 2 years 3 years 4 years
now ($) later later later later
1,000 1100 1210 1331 1464.1
• Thus, the present value of $ 1,000 is $
1,100 next year; $ 1,210 in two years; $
1,331 in three years, etc.
• The increment due to interest rate is
compounded,
 PV ($) FV ($)

Colleague 1,000.00 1,140

Fixed deposit 1,036.36 1,140

• Net present value= -1000 + 1036.36
= +36.36
I.e. giving your colleague is 36.36 better
than a 10% investment.
• For you to get 1,140 in one year, you
either give your colleague 1,000 or deposit
1036.36 on fixed account.
• The 36.36 is the net positive value after
comparing the two lines of investment.
• It is a saving on investment if the money
was given to the colleague.
• The NPV compares investments against a
hypothetical rate.
• Positive NPV implies the investment is
profitable.
 NPV = -1,000 + 991.30 = - 8.69/=

The bank rate is better than given the colleague.

Investment Present Future Value
Line Value
Colleague 1,000.00 1,140/=

Bank rate 991.30 1,140/=

(15%)
Example 4
• ABC Company intends to invest $2,000
now and expect to receive 3 yearly
revenues of $200 each plus $2,000 in the
3rd year.
• Is the investment acceptable?
• Use 5% interest rate.
• The NPV is an indicator of how much value
an investment adds to the company.
• It is the present value of net cash inflows
generated by a project including salvage
value, if any, less the initial investment on
the project.
• It is one of the most reliable measures used
in capital budgeting since it accounts for
time value of money by using discounted
cash inflows.
Disadvantage:
• Based upon estimated future cash flows
of the project which may be far from
actual data
Advantage:
• NPV is used to analyze an investment
decision and give company management a
clear way to tell if the investment will add
monetary value to the company.
• Investment could be future acquisition of
future project or opening of new
production line.
 NPV for Uniform & non-Uniform Cash
Inflows
• The net cash flows may be a uniform (or
equal amounts of cash inflows) for each
year or non-uniform cash flows per year.
• If the net cash flows are uniform, NPV can
be evaluated using NPV annuity formula
given by:
• If the net cash inflows are not constant
for each period, the NPV of each
individual net cash inflow is calculated
separately, i.e.,
Example 5
• Calculate the NPV of a project that
requires an initial investment of $
243,000.00 and expected to generate a
cash inflow of $ 50,000.00 each month for
12 months.
• Assume that the salvage value of the
project is zero, and the target rate is 12%
p.a.
Given:
• Initial investment = $ 243,000.00
• Net cash inflow per period = $ 50,000.00
• Number of periods, n = 12
• Discount rate per period, r = 12%/12 =
1%.
Example 6
• An initial capital of $ 8,320.00 is to be
invested in plant and machinery.
• It is expected to generate cash inflows as
shown below:
Year Revenue (inflow)
1 $ 3,411.00
2 $ 4,070.00
3 $ 5,824.00
4 $ 2,065.00
• At the end of the fourth year, the
machinery is expected to be sold at $
900.00.
• Compute the net present value of
investment given that the discounted
rate is 18%.
Year Rate Future value Present
value
1 0.18 3411 2890.68
2 0.18 4070 2923.01
3 0.18 5824 3544.67
4 0.18 2965 1529.31
Total PVs 10887.67
Initial investment 8320.00
NPV 2567.67
NB:
• When comparing investments by NPV
approach, ensure that the same interest
rate is applied to all cases.
 Payback Period
• It is the time required after project start to
recover the fixed capital investment (FCI).
• It is also called payout time. It is a quick
measure of profitability.
• The shorter the PBP the better is the
investment.
• It is the time required for the cumulative
cash flow to achieve a zero value.
• It shows how long it will take to recoup
the money spent on the project.
 Example 1
• If a project costs $ 500,000 and it is expected
to return $ 120,000.00 annually, the PBP
would be:

$500,000
𝑃𝐵𝑃 = = 4.16 𝑦𝑒𝑎𝑟𝑠
$120,000
• If the annual returns are not uniform,
then add the expected returns for the
successive years until the total cost is
obtained.
 Example 2
• If the project costs $ 10,000.00 and the
expected returns (or cash inflows) are:
 Advantage
• Projects with shorter PBP are preferred to
those with longer paybacks.
• They are more liquid and less risky.
• There is less chance that the market
conditions, interest rates, economy and
other factors affecting the project will
change sharply
• A PBP of less than 3 years is recommended
for most profitable projects
 Disadvantage
• The PBP approach ignores cash flows
occurring after PBP, e.g., a project earning
$ 1,500.00 after a PBP of five years is not
preferred compared to one that earns $
500.00 after PBP of 4 years.
• It also ignores the time value of money.
• The NPV approach and IRR offer better
considerations for time value of money
(TVM).
 Internal Rate of Return
• Interest rate that makes NPV = zero is
called internal rate of return, i.e.,
• The IRR is the interest rate that makes
the NPV of a proposed investment to be
zero.
• The common method used to determine
IRR is the guess and check approach.
• IRR is also called discounted cash flow
rate of return (DCFROR
Example 1
• ABC Company intends to invest $
2,000.00 currently and expects to receive
3 years revenues of $ 200.00 each year
plus $ 2,000.00 in the 3rd year,
• What is the IRR?
Solution
• Test different discount rates, e.g., 15%,
12%, 10%, 8% and 6% as follows:
Year Rate Future value Present value
1 0.06 200 188.68
2 0.06 200 178.00
3 0.06 2200 1847.16
Total 2213.84
Initial investment 2000.00
NPV 213.84
 Rate NPV
15 -228.32

12 -96.07
10 0
8 103.08
6 213.84
• Therefore, the IRR is 10%
Example 2:
• Investing $ 2,000.00 now has expected
cash inflow of $ 100.00 each year for 5
years and additional $ 2,500.00 in the fifth
year.
• What could be the IRR?
Solution Rate NPV
15 -421.84
12 -220.96
10 -68.62
9.5 -27.96
9.2 -3.04
9.15 1.15
9 13.79
8 100.00
6 289.38
Therefore, IRR = 9.15%
• The IRR is also used to evaluate the
project attractiveness.
• If the IRR of a given investment project
exceeds the required rate of return, the
project is a good investment and
desirable.
• If it is below the required rate of return,
the project should be rejected.
Example 3:
• If company PQR has to decide whether to
purchase a factory equipment for $
300,000.00, that would last for 3 years and
expected to generate $ 150,000.00 of annual
profit for the 3 years.
• The equipment would also be resold at $
10,000.00 at the end of the 4 years.
• Use IRR method to determine whether
equipment purchase would be better than an
alternative investment with return of 10%.
• Solving IRR = 7.5%. Since IRR of 7.5% <
the alternative 10% return, the purchase
of equipment is not better and non-
desirable.
Rate NPV
10 -5,000.34
8 -1,251.33
7.5 -1.92
7.4 268.21
7 1,425.78
6 4,993.75
• The IRR cannot be derived analytically, it
is found by trial and error method.
• However, spreadsheets programs can be
used to automatically determine the IRR.
• IRR can also be used to determine the
expected returns on investment,
including yields to maturity on bonds.
Advantages of IRR:
• The method ranks investments by their
overall rates of return rather than NPV
and Investment with high IRR is selected.
• Presents ease of comparison and good
method of judging different investments.
Disadvantages:
• It is best for investments with initial cash
outflow followed by one or more cash
inflow.
• It does not measure absolute size of
investment and the return, i.e.
• IRR method can favor projects with high
rates of return even though the actual
amounts involved are small.
• It cannot be used if interim cash flows
are involved.
• It does not consider capital costs and
cannot compare projects with different
project lives.
 Accounting Rate of Return
• This is simple way of determining the return
on an investment in a major project. It is given
by:

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

𝐴𝑅𝑅 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
• Depreciation is determined using straight line
method as follows:

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐸𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
=
𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝑙𝑖𝑓𝑒
Example 1:
• An equipment costing $ 10,000.00 is
expected to return on average $3,000.00
per year for 5 years.
• After 5 years, the equipment is expected
to be sold at $ 1,000.00.
Example 1:
$ 10,000.00 − $ 1,000.00
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
5

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = $ 1,800.00

$ 3,000.00 − $ 1,800.00
𝐴𝑅𝑅 = = 12%
$ 10,000
• ARR gives a quick estimate of the
projects’ net profits, providing a basis for
comparing different projects.
• Also, returns over the entire project life
are considered unlike the PBP.
Disadvantage:
• The ARR method employs income data
only instead of considering the entire
cash flow statement.
• The method completely ignores time
value of money.
• The NPV and IRR offer better options
since they consider time value of money.
 Project Evaluation Allowing for Taxation
Depreciation:
• This is the fall in value or usefulness of
fixed assets used in operations over a
certain period of time.
• The drop in value of fixed assets can be
due to wear, tear, decay, fall in market
value, new technology, etc.
• It is also the measure of wearing out or
other loss of value arising from use.
• Depreciation of fixed assets helps to
establish the true profits of the business
and shows the reasonable value of assets
in the balance sheet.
• I.e., depreciation is a systematic method
of allocating equipment cost over its
useful lifetime.
 Factors affecting amount & level of
Depreciation
• Initial cost of asset
• Asset useful life
• Estimated residual value (salvage) at end
of its life.
• Method of depreciation
 Purpose of Charging Depreciation
The purpose of charging depreciation of fixed
assets is to:
• Show the assets at its reasonable value in
the balance sheet.
• Ascertain in the true profit of the business.
• Show the true presentation of financial
position.
• Provide fund for replacement of assets.
 Methods of Evaluating Depreciation
• Depreciations can be measured using
one of the following approaches:
• Straight line method
• Written down value method, also called
reducing method or diminishing balance.
• Annuity method
• Sinking fund method
• Revaluation (appraisal) method
• Insurance policy method
• Depletion method
• Sum of the digits method
• Machine hour rate method
 Straight Line Method:
• It is also called constant charge method, where
depreciations is charged annually at a constant
figure throughout the asset useful life.
• The periodic depreciation charge is given by:

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒, 𝐷
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
=
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
Example 1:
• Calculate the depreciation rate from the
following data:
• Cost of machine = $ 3,000.00; erection
Charges = $ 300.00; estimated useful life
= 12 years and salvage value = $ 300.00
• In terms of percentage:
$ 250.00
𝐷= 𝑥100 = 7.57% 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚
$ 3,300
 Disadvantages of Straight Line Method
• Does not consider intensity of asset use
• No opportunity costs considered
• Ignores effective utilization of fixed assets
• Assumption of constant charges for
maintenance of assets does not yield true
depreciation.
Advantages:
• Simple and easy to use method
• Original cost reduced to salvage value
• Easy to estimate asset useful life
 Diminishing Balance
• Here, the depreciation is charged at fixed
rate on the reducing balance, i.e., there is
less depreciation for subsequent years
and the amount of depreciation reduces
gradually each year.
• Initially, the depreciation charge is high
and reduces in the later periods.
Example 1:
• Determine the depreciation rate under
the diminishing balance method from the
following data: original cost of machinery
= $ 1,000.00; estimated asset life = 3
years; salvage value = $ 100.00.
• Amount of depreciation
= 1,000.00 x 0.53584
= $ 535.84
Example 2:
• Evaluate the depreciation rate for 2 years
using the reducing balance method (RBM).
• Initial cost of machine = $3,000.00;
erection charges = 300; equipment life =
12 years and salvage value = $ 300.00.
Depreciation to be charged at 10% on RBM
• Solution Solution
Cost of equipment 3,000
Erection charges 300
Less salvage 300
total 3,000
Depreciation for year 1 300
2,700
Depreciation for year 2 270
2,430
Depreciation for year 3 243
2,187
total Depreciation 813
Solution using Straight line method:
Cost of equipment 3,000
Erection charges 300
Less salvage 300
total 3,000
Depreciation for year 1 300
2,700
Depreciation for year 2 300
2,400
Depreciation for year 3 300
2,100
total Depreciation 900
• The difference between the original cost
of asset and asset value is the
depreciation base. The difference
between the original cost of asset and
accumulated (total) depreciation to-date
is the book value.
• The book value is not necessarily equal
to the market value and salvage Value.
Advantages of Diminishing Balance
Method:
• Impact of obsolescence can be lowered
• Method acceptable by income tax
authorities
• Fresh calculations not required
• Depreciation amount gradually reduces
affecting the periodic profits positively.
Disadvantages
• Residual value of asset is not correctly
estimated.
• It ignores interest on investment on
opportunity cost which will lead to
difficulty while determining the
depreciation rate.
• Difficult to establish the true profits due
to non-constant revenues from the asset.
• The original cost of the asset cannot be
brought down to zero value.
Example 3:
• On 1st April 2010, machinery was
purchased for $ 100,000.00.
• The rate of depreciation was charged at
20% under diminishing balance method.
• What is the machinery account for five
years from April 2010 to March 31st 2015
and the book value?
Date Particulars Amount Date Particular Amount
1st April Machine 100,000 31st Mar 2011 Depreciatio 20,000
2010 Bank A/c n Bal. c/d 80,000
100,000 100,000
1st April Bal. b/d 80,000 31st Mar 2012 Depreciatio 16,000
2011 80,000 n Bal. c/d 64,000
80,000
1st April Bal. b/d 64,000 31st Mar 2013 Depreciatio 12,800
2012 64,000 n Bal. c/d 51,200
64,000
1st April Bal. b/d 51,200 31st Mar 2014 Depreciatio 10,240
2013 51,200 n Bal. c/d 40,960
51,210
1st April Bal. b/d 40,960 31st Mar 2015 Depreciatio 8,192
2014 40,960 n Bal. c/d 32,768
40,960
1st April Bal. b/d 32,768
2015 Book value 32,768
 Sum-of-Years-Digit
• The sum of year’s digit method is
calculated by adding the years together for
a total sum that is then used as a fraction
for a given year. Under this method the
depreciation is given by:

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 𝐶𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑥𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛
𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑓𝑖𝑟𝑠𝑡 𝑦𝑒𝑎𝑟
𝑛
=
1+ 2+ 3+⋯+𝑛

𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑠𝑒𝑐𝑜𝑛𝑑 𝑦𝑒𝑎𝑟

𝑛−1
=
1 + 2 + 3 + ⋯+ 𝑛

𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑡ℎ𝑖𝑟𝑑 𝑦𝑒𝑎𝑟

𝑛−2
=
1 + 2 + 3 + ⋯+ 𝑛
 𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟
1
=
1 + 2 + 3 + ⋯+ 𝑛

• Where n = number of useful years for the

equipment
 Example
• The equipment purchase price is
$2,000,000; useful life is 5 years and
salvage value is $200,000.
• Determine depreciation using sum-of-
year-digit method
 Solution
• Obtain the sum of year’s useful life:
5 + 4 + 3 + 2 + 1 = 15
• Cost minus salvage value:
= 2,000,000 – 200,000
= $1,800,000
• Depreciation rate in first year:
= (5/15)*100 = 33.33%
• Depreciation in the first year:
5
= 1,800,000𝑥 = $600,000
15
• Depreciation in the second year:
4
= 1,800,000𝑥 = $480,000
15
• Depreciation in the third year:
3
= 1,800,000𝑥 = $360,000
15
• Depreciation in the fourth year:
2
= 1,800,000𝑥 = $240,000
15
• Depreciation in the fifth year:
1
= 1,800,000𝑥 = $120,000
15
 Useful
Year Cost Salvage value life
0 2,000,000 200,000 5
Dep.
Depreciation Balance (Sheet) Rate
1 600,000 1,400,000 (5/15)
2 480,000 920,000 (4/15)
3 360,000 560,000 (3/15)
4 240,000 320,000 (2/15)
5 120,000 200,000 (1/15)
 Summary of Depreciation Methods
• Generally all depreciation methods have
the following formula:

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐵𝑎𝑠𝑒 𝑥 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐵𝑎𝑠𝑒
= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
• Depreciation is a charge against income.
There is always a loss in value of the
equipment due to time or use in
operation.
• Since the useful life of the equipment is
longer than the accounting period, a
periodic charge is made for depreciation to
systematically apportion the asset cost
over its useful life
• Straight-line and diminishing balance
methods are the most common methods
used to depreciate equipment
 Salvage and Scrap Value
• The net amount of money obtained from
the sale of used equipment over and
above any charges involved in the removal
and sale of the property.
• This implies that the equipment can still
give some level of service.
• Scrap value is when the equipment has no
further useful life other than the value of
its material in it.
• Generally depreciation is that part of the
original cost of a fixed asset that is
consumed during period of use by the
business.
• It is an expense for services consumed in
the same way as expenses are incurred for
items such as wages, rent or electricity.
• Because it is charged as an expense to the
profit and loss account/income statement,
depreciation reduces net profit.
• Depreciation is used in engineering
accounting to match the expense of
equipment to the income earned using the
equipment.
• For example, if a company buys a piece of
machinery for $1 million and expects it to
have useful life of 10 years, it will be
depreciated over 10 years.
• Every accounting year, the company will
expense say $100,000 (assuming straight-
line depreciation), which will be matched
with the money that is earned using the
equipment each year.
• It is a decrease in value of a property over
a period of time.
• Depreciation plays a vital role in deciding
the taxable profits from business and
profession.
• It is a non-cash expense that is used to
write down the value of an asset over its
useful life.
• The intent of depreciation is to allow a
business to recover the cost of an asset
over a period of time.
• Depreciation begins when immediately the
equipment is put to use in a business for
generation of income.
• It ends when the cost of the equipment is
fully recovered or when the asset is retired
from use, whichever happens first.
• Depreciation expense is the amount of
cost allocation within an accounting
period.
• Only equipments that lose useful value
over time can be depreciated.
 Accounting Tools
• These are: project cash flow statement
and income statement.
• Income statement is the recording of
income for each revenue collected.
• It is prepared on an accrued basis.
• It outlines an overview about how much
the project is gaining during individual
years.
• Cash flow statement shows exact time that
cheques are written and income received.
• It is a statement of how money flows in
and out of the company at various points
in time.
• It is used as a planning tool when
considering expansion or diversification
into new markets.
• It helps to determine the need for a loan
or available funds are sufficient for
expansion.
• Unlike income statement, cash flow
statement excludes depreciation expense.
• The cash flow statement shows cash inflows
and outflows.
• A cash flow diagram (CFD) shows cash flows
for the project over a period of time. CFD
helps in product pricing and sales
projection.
• In the CFD below, initially the investment
capital is negative and all other investment
costs.
• The company starts realizing profits in the
3rd year and continues to make profits up
to the 6th year. Total profit is + 25 units and
total cost is - 22.
• The net profits in six years is + 3 units.
 Cumulative Cash flow diagram
• Figure below shows cumulative-
discounted-cash-flow curves. The cost of
capital may also be considered as the
interest rate at which money can be
invested instead of putting it at risk in a
manufacturing process.
• Consider the process data listed in Table
below and plotted in above figure.
• If the cost of capital is 10 percent, then the
appropriate discounted-cash-flow curve is
abcdef.
• Up to point e, or 8.49 years, the capital is
at risk.
• Point e is the discounted breakeven point
(DBEP).
• At this point, the manufacturing process
has paid back its capital and produced the
same return as an equivalent amount of
capital invested at a compound-interest
rate of 10 percent.
• Beyond the breakeven point, the capital is
no longer at risk and any cash flow above
the horizontal baseline, where NPV = 0, is
in excess of the return on an equivalent
amount of capital invested at a compound
interest rate of 10 percent.
• Thus, the greater the area above baseline
the more profitable the process
• When (NPV) and (DCFRR) are computed,
depreciation is not considered as a
separate expense.
• It is simply used as a permitted writing
down allowance to reduce the annual
amount of tax in accordance with the rules
applying in the country of investment.
• A DCFRR of, say, 15 percent implies that 15
percent per year will be earned on the
investment, in addition to which the
project generates sufficient money to
repay the original investment plus any
interest payable on borrowed capital plus
all taxes and expenses.
• It is not normally possible to make a
comprehensive assessment of profitability
with a single number.
• The shape of the cumulative-cash flow and
cumulative-discounted-cash-flow curves
both before and after the breakeven point
is also important factor to consider.
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