Chapter 3

Project Investment Evaluation

Chethan S.Gowda
Assistant Professor
Dept. of COTM, wollega University
Inflation
• Inflation is an increase in the overall level of prices.

• Inflation is not an increase in the price of a specific good or service

relative to the prices of other goods and services.
Types

1. Creeping – when inflation stays low for a long time

2. Chronic – when inflation steadily increases for a long time
3. Hyper Inflation
- worst type, out of control
- could go up to 500% a month
- leads to economic collapse
 Causes of Inflation
Changes in Aggregate Demand - changes in the total amount of spending by
individuals and businesses throughout the economy.
• Demand Pull Inflation- When aggregate demand increases faster than the
economy can produce the goods.
• The demand increases and “pulls” along higher prices because demand is increasing
faster than supply! (More people are chasing the same amount of goods; therefore
people can charge more for their goods).

Changes in Aggregate Supply - changes in the total amount of goods and

services produced throughout the economy.
• Cost Push Inflation-When producers raise prices to cover higher resources costs.
• Producers must raise prices in order to cover their higher costs.
• If they do not do this, then their profits are reduced or even eliminated!
• Must be careful not to raise prices too high.
Growth of the Money Supply
As more dollars enter the money supply in the U.S., the
value of that dollar or it’s purchasing power (the amount it
can buy) is less. So to keep prices “stable”, the money
supply should increase at the same rate as the economy is
growing.
Example-
1)If there is low unemployment (such as in expansion or
peak), companies must offer higher wages to attract
workers to their open positions and to keep their own
workers from looking elsewhere.
2)However, this increases companies’ costs. Therefore the
must raise the price of their products to keep there
profits up.
3) If prices are higher across most products (inflation),
then employers must raise wages again so that their
employees’ wages buy as much as it did the year before.
4) But wait…the companies’ costs went up again so they
raise the price of their products again.
5) And this continues on and on in an effect known as
The Wage-Price Spiral
Effects of Inflation
• Inflation causes changes in:
• The purchasing power
• The value of real wages
• Interest rates
• Saving and investing
• Production costs
Effects on Purchasing Power
• Decreased Purchasing Power—
• The decreasing value of the dollar falls and it buys less
“stuff”.
• It hurts people on fixed incomes (retirees).
• Many labor contracts have built in (COLA)

• Decreased Value of Real Wages—when the value of

workers wages fail to keep pace with rising prices.
• $20,000 per year in 1979
• $40,000 per year today
• Adjusted for inflation = the same $ today.
Effects on Interest Rates
• Increased Interest Rates –
• High unexpected rates of inflation cause banks to raise interest rates. High
interest rates can decrease consumer and business spending. Ex. Cars, houses
etc.

• Decreased Saving and Investing –

• Ex. Bank yield on savings 5% and inflation rate of 7%. Net loss of 2% per year!
Inflation hurts savers, lenders. (however, it helps borrowers and debtors
occasionally)

• Increased Production Costs –

• Inflation increases businesses costs of production.
Measuring Inflation
• Measuring Inflation—when economists measure the changes
in the average price level of goods/services in nation.

• The two measuring tools that economists use are

1) CPI (Consumer Price Index)
2) PPI (Producer Price Index)
Measuring Inflation
• Consumer Price Index (CPI)—is a measure of the
average change over time in the price of a fixed group of
products.
• Reported monthly
• Reported against a fixed period (or base) time period
• Market basket—representative sample of consumer goods.
Food, clothing, housing, utilities, entertainment, transportation,
health care.
Calculating CPI
CPI = weighted current price x 100
weighted base period price

Example = $3.00 (loaf of bread in 2019) X 100

$1.32 (loaf of bread in 1983)

CPI 2019 = 227.3

Rate of Inflation

Rate of inflation is the percentage rate of change in a price

index
the monthly or yearly % change in prices.
• The CPI is a tool that is used to calculate

• Rate of inflation = (PI2 – PI1) / PI1

Ex.Inflation rate= (CPI year A – CPI year B) x 100

CPI year B
Ex.Inflation Rate 145 – 140 x 100 = 3.57
140
Inflation Rate 3.57%
Understanding the Impact of Inflation

• Inflation is an increase of the amount of money necessary to

obtain the same amount of product or service before the
inflated price.
• It occurs because the value of the currency has changed, it
has gone down.
• This means that today money is not the same before and in
the future
Constant Value Money
• Future Money = Today’s money(1+f)n
• This means that due to inflation the prices of
commodities and services increases with time due to
inflation.
Different Interest Rates
1. Real or Inflation-free interest rates(i) –the actual
rate without the application of inflation rate
2. Inflation-adjusted interest rates(if)- combination of
the real interest rate and the inflation rate,
sometimes called inflated interest rate
3. Inflation rates (f)- measure of the rate of change in
the value of money
 Present Worth Calculations
Adjusted for Inflation

• Any future amount of money can be converted to its present

value using the real interest rate and the inflation rate

F
P
1  i f n
if - is the inflation-adjusted interest rate or the combination of the
real interest rate and the inflation rate
Future Worth Calculation Adjusted
for Inflation
• Four different interpretation
1. The actual amount of money that will be accumulated at time n
2. The purchasing power of the actual amount accumulated at time n but
stated in today’s value.
3. The number of future dollars required at time n to maintain the same
purchasing power as the money today; that is inflation is considered but
interest is not.
4. The number of money required at time n to maintain purchasing power
and earn a stated real interest rate
Case 1. Actual Amount Accumulated
• This can be determined by applying the inflation-adjusted
interest rate to determine the future amount of money

F  P 1  i f 
n
Case 2. Constant Value with
Purchasing Power
• It can be determine by using the market rate to calculate F and
then deflating the future amount through division by(1+f)n

P 1  i f 
n

F
1  f n
 Case 3. Future Amount Required, No Interest

• In this case, it recognizes that prices increase when inflation is

present. Only inflation is involve here, interest is excluded

F  P1  f 
n
Case 4. Inflation and Real Interest
• This is somewhat the same as case 1 but instead of using
inflation adjusted rate, if we will use inflation-adjusted
MARR, MARRf.

F  P 1  MARR f 
n

Real interest rate include actual interest the company is putting on its
money plus the expected rate of return. MARR is the combination of the
real interest and the inflation rate
Depreciation

• the decrease in value of assets (fair value depreciation)

• the allocation of the cost of assets to periods in which the assets are
used (depreciation with the matching principle).
Why do capital asset depreciates?
• It depreciates as its value fall as it ages over its useful life, for the
following reason
• It get closer to the end of its useful life
• Older asset produces lower income
• Other asset are less productive over time
• Some asset are obsolete compare to new and up-to-date asset
Significance of Depreciation
• Economic depreciation measures the expected decline in the
real market value of the asset each period
• Depreciation lowers taxes using
• Taxes=(income-deduction)(tax rate)
Terminology
• Book Value(BV)-remaining capital investment at the end of the year
after applying the depreciation
• Market Value(MV)-amount of an asset in an open market
• Salvage Value(S)- estimated trade-in value at the end of the asset’s
life
• First Cost(F)-initial purchase price and all the incurred cost in placing
the asset
Important Terms
• Recovery Period(n)-depreciable life of the asset
• Depreciation rate(d)- fraction of the first cost remove each
year
• Personal Property- all property except real property
• Real Property- real estate, improvements, buildings and
other structures
Depreciation Models
• There are several models for depreciating assets
• The straight line model is used most of the time
• Accelerated models such as declining balance method are more rapidly
than the SL method
• For classical methods, straight line, declining balance and sum-of-the
years digits and Excel function are available to determine annual
depreciation
 Depreciation
Methods

Financial Accounting Tax

Depreciation Methods Depreciation

Straight-line Accelerated Special

method methods methods

1. Declining Balance 1. Composite method

2. Sum-of-the-years’ digits 2. Hybrid methods
Straight Line Depreciation
• It is the most common method of depreciation which the
company estimates the value of the asset after its useful life. The
value is called salvage value
• The depreciation rate d=1/n is the same each year along the
recovery period n.

F S
D1 
n
where : F  first cost
D1  annual depreciation charge
S  estimated salvage value
n  recovery period
Book Value
• It is the value of an asset at a certain time less the
accumulated depreciation. It become the salvage value
directly after its useful life

BV0  First cost of an asset

BVn  FC  nD
Example
• Depreciation is 1/7 (14.28%) * Cost Basis
• 14.28% * $100K = $14,286
Straight Line Method

EOY Depreciation Book Value

0 - $100K
1 $14,286 $85,714
2 $14,286 $71,428
3 $14,286 $57,142
4 $14,286 $42,856
5 $14,286 $28,570
6 $14,286 $14,285
7 $14,285 0
Example
• A copy machine is purchased for $3,217.89. The
expected life is 4 years. Find the rate of depreciation
and the yearly book value, If the salvage value is 10%of
the first cost, find the rate of depreciation.
Declining Balance Method
• Also known as fixed percentage or uniform percentage
method
• If the rate of depreciation is not constant and is
decreasing yearly, then the method is called declining
balance method.
• The factor to be multiplied to the cost of the asset is
normally based on the life of an asset.
• The most used factor is twice the SL called the double
declining balance method
Declining Balance Method
The depreciation rate using the DB method is
always less than the DDB depreciation rate and
does not exceed twice the straight line method

The implied DB depreciation rate is determined using

1
S n
d  1  
F
D1  dF
D2  dBV1
DB
• For 1.25 (125%)DB, R = 1.25/ N
• Similarly, 1.5,1.75, 2DB or DDB
• Allowable Depreciation Dm = RP (1-R)m-1
• or Dm = (BVm -1 ) R
Book Value = BV m = P (1-R)m or
BV m = BV m-1 – D m, provided BV m >= F
DB Example

• Cost Basis is $100K

• Depreciable Life is 7 years
• 200% DB----
• Depreciation is 2/7 (28.56%) * Book Value of previous year
Declining Balance Method

EOY Depreciation Book Value

0 - $100K
1 28.56%*$100K=$28,560 $71,440
2 28.56%*$71,440=$20,403 $51,036
3 28.56%*$51,036=$14,576 $36,460
4 28.56%*$36,460=$10,413 $26,047
5 28.56%*$26,047=$7,439 $18,608
6 28.56%*$18,608=$5,314 $13,294
7 28.56%*$13,294=$3,797 $9,497
Comparing SLM and DBM
A piece of equipment is available for purchase for $12000 has an
estimated useful life of 5 years, and has an estimated salvage value of
$2000. Determine the depreciation and the book value for each of the 5
years using the SL method.

• Rm = (1/5) = 0.2
• Dm = 0.2 (12,000-2,000) = $ 2,000 per year

m BVm-1 Dm BVm

0 $0 $0 $ 12000

1 12000 2000 10000

2 10000 2000 8000

3 8000 2000 6000

4 6000 2000 4000

5 4000 2000 2000

 DB
• For the same example we shall solve by DDB
R = 2.0 / N = 2.0 /5 = 0.4
D m = R (BV m-1) = 0.4 (BV m-1)
BV m = BV m-1 - D m

Year Dm BVm

0 0 12000

1 0.4 x 12000 = 4800 7200

2 0.4 x 7200 = 2880 4320

3 0.4 x 4320 = 1728 2592

4 0.4 x 2592 = 592 2000

5 0 2000
Example

• Midroc Construction Company purchased a pneumatic tired roller for

it newly contracted roadway project in Awasa for B2.5M the unit has
an anticipated life of 10 years and a salvage value of B0.1M. Make a
table of depreciation.
Example

• A tunnel boring machine is to be depreciated using DDB method. It

has a first cost of B3.5M and an estimated salvage value of B800,000
after 12 years. Calculate the depreciation and book value for years 1
and 4. Calculate the exact salvage value after 12 years.
Sum-of-the years’ Digits Method
• This method results in a more accelerated rite-off than
SL, but less than declining balance method.
• A schedule of fraction is multiplied to depreciable cost
to determine the amount of depreciation
• Depreciable cost is taken as the difference of the first
cost and the salvage value.
Sum of digits
• Sum of the digits can be determined from the
expression(n x (n+1))/2, where n is the life of an asset.
• It can also be determined by directly summing up the
digits
• The multiplying fraction can be is the ration of the
corresponding year with the sum of the years digit.
SOY
• The rate of depreciation is a factor times the
depreciable value (P-F).
• SOY = N(N+1) / 2
• Depreciation rate Rm = (N-m+1) / SOY
• Annual Depreciation Dm for m th year
Dm = Rm (P-F) = (N-m+1)(P-F) / SOY
• Book value @ the end of m years
• BVm = P – (P-F) [m(N- 0.5m+0.5) / SOY]
SOY
• For the previous example, Calculate allowable
depreciation & Book value for each of 5 years using SOY
method.
SOY = 1+2+3+4+5 = 15 or 5(6)/2 = 15
Rm = 5 –m +1 / 15
Dm = Rm x (12000-2000) = (5-m+1)(10000)/ 15

Year Rm Dm BVm

0 - $0 $ 12000

1 5/15 3333 8667

2 4/15 2667 6000

3 3/15 2000 4000

4 2/15 1333 2667

5 1/15 667 2000

SOY – Points to noted

• Dep. In each year is different …

• So, hourly cost is also different…

• Similarly calculations dep. For unit cost…

• Hence, most of construction industries use SL..

Example
• If an asset has an original cost of $10000, a useful life
of 5 years and a salvage value of $1000, compute its
depreciation schedule.
Depletion
• Up to this point, we have discussed depreciation for
assets that can be replaced.
• Depletion, though similar to depreciation, is applicable
only to natural resources.
• When the resources are removed, they cannot be
replaced or repurchased in the same manner as can a
machine, computer, or structure.
• Depletion is applicable to natural deposits removed
from mines, wells, quarries, geothermal deposits,
forests, and the like.
• There are two methods of depletion - cost depletion
and percentage depletion.
Cost Depletion
• Cost depletion, sometimes referred to as factor
depletion, is based on the level of activity or usage, not
time, as in depreciation.
• It may be applied to most types of natural resources.
The cost depletion factor for year t, denoted by pt, is
the ratio of the first cost of the resource to the
estimated number of units recoverable.
• The annual depletion charge is pt times the year’s
usage or volume.
• If the capacity of the property is re-estimated some
year in the future, a new cost depletion factor is
determined based upon the undepleted amount and
the new capacity estimate.
Percentage Depletion
• Percentage depletion is a special consideration given
for natural resources.
• A constant, stated percentage of the resource’s gross
income may be depleted each year provided it does
not exceed 50% of the company’s taxable income.
• For oil and gas property, the limit is 100% of taxable
income.
• The annual depletion amount is calculated as using
percentage depletion, total depletion charges may
exceed first cost with no limitation.
Cost Estimation
Introduction
• All cost and revenues are assumed to be known but in
reality its not.
• It should be estimated and the technique is called cost
estimation.
• It is normally applied on project conception,
preliminary design, detailed design and economic
analysis

In engineering practice, estimation of cost is more

important than estimation of revenues
Estimation of cost can be classified into:
• Traditional Method of Estimation
• Activity-Based Costing Method
Cost Estimation
• It is a major activity performed in the initial stages of
every effort in industry, business and government.
• It is normally developed in in either project or system.
• Project- building, plant, platform
• System – processes, software and other non physical items
Classification of Cost
• First Cost
• Operation and Maintenance Cost
• Fixed Cost
• Variable Cost
• Incremental or Marginal Cost
• Sunk Cost
• Life-cycle Cost
Direct Cost and Indirect Cost

• Direct cost is normally estimated with some details

• Indirect cost are added using standard rates or factors
Cost Components
1. First Cost Components
1. Equipment cost
2. Delivery charges
3. Installation cost
4. Insurance coverage
5. trainings
2. Annual Operating Cost
1. Direct labor cost
2. Direct materials
3. Maintenance
4. Rework and rebuild
Qualification of a Good Estimator

1. Understand the architectural drawings

2. Have a sound knowledge of the material, construction methods
3. Experience in construction work
4. Have a systematic and orderly mind
5. Ability to do careful and accurate calculations
Common question asked during estimation

1. What cost components must be estimated?

2. What approached to cost estimation must be applied?
3. How accurate should the estimates be?
4. What estimation techniques will be applied?
Cost estimation Approach
• The bottom-up approach treats the required price as
an output variable and the cost estimates as input
variables

• The design-to-cost or top-down approach treats the

competitive price as an input variable and the cost
estimates as output variables.
Accuracy of the Estimates
• In dealing with accuracy of the estimates, unit method
is the most commonly use.
• Samples are:
• Cost of vehicle automation per mile
• Cost of house construction per square meter
• Cost of cable per mile
• Cost per parking space in a garage
• Cost of street per kilometer
Cost Associated with Constructed Facilities-
Capital Cost
• Land acquisition, including assembly, holding and improvement
• Planning and feasibility studies
• Architectural and engineering design
• Construction, including materials, equipment and labor
• Field supervision of construction
• Construction financing
• Insurance and taxes during construction
• Owner's general office overhead
• Equipment and furnishings not included in construction
• Inspection and testing
Cost Associated with Constructed Facilities-
M&O
• Land rent, if applicable
• Operating staff
• Labor and material for maintenance and repairs
• Periodic renovations
• Insurance and taxes
• Financing costs
• Utilities
• Owner's other expenses
Five different areas of unexpected cost

• Design development changes,

• Schedule adjustments,
• General administration changes (such as wage rates),
• Differing site conditions
• Third party requirements imposed during construction, such as new
permits.
Types of Construction Estimates
• Design Estimates
• Screening estimates
• Preliminary estimates
• Detailed estimates
• Engineer's estimates based on plans and specifications
• Bid Estimates
• Subcontractor quotations
• Quantity takeoffs
• Construction procedures
• Control Estimate
• Budget estimate for financing
• Budgeted cost after contracting but prior to construction
• Estimated cost to completion during the progress of
construction
Approaches to Cost Estimation
• Production Function
• Empirical Cost Inference
• Unit cost for bill of quantities
• Allocation of joint cost
Historical Cost Data
• Widely used for forecasting future cost
• Collected and organized for future use
• For continuous updates
• It may affect substantially if relatie price changes