Engineering Economy Cash flow diagram on the viewpoint of the lender

• The analysis and evaluation of the factors that will affect

the economic success of engineering projects to the end
that a recommendation can be made which will ensure the
best use of capital

Set 1A: Interest and Money-Time Relationships

Interest

• The amount of money paid for the use of borrowed capital

(borrower’s viewpoint) or the income produced by money
which has been loaned (lender’s viewpoint).
Cash flow diagram on the viewpoint of the borrower
𝐹 =𝑃+𝐼
Simple Interest
Where:
• Calculated using the principal only, ignoring any interest
I = Interest
that has been accrued in preceding periods.
P = Principal or present worth
𝐼 = 𝑃𝑛𝑖
F = Accumulated amount or future worth 𝐹 = 𝑃(1 + 𝑖𝑛)

Cash-Flow Diagrams Where:

• A graphical representation of cash flows drawn on a time I = Interest

scale.
P = principal or present worth
↑ - receipt (positive cash flow or cash inflow)
n = number of interest periods
↓ - disbursement (negative cash flow or cash outflow)
i = rate of interest per period
Example:
F = accumulated amount or future worth
A loan of P100 at simple interest will become P150 after 5 years.
For Ordinary Simple Interest:

Interest period = 1 year = 360 days

For Exact Simple Interest:

Interest period = 1 year = 365 days (ordinary year) = 366 days (leap
year)

Sample Problems

• Example 1: Determine the ordinary simple interest on P

20,000 for 9 months and 10 days if the rate of interest is
12%.

Ans. P 1,866.67

• Example 2: Determine the (a) ordinary and (b) exact simple

interests on P 100,000 for the period January 15 to June 20
2012 if interest is 15%.

Ans. (a) P 6,541.67; (b) P 6434.43

 • Example 3: Calculated the exact interest on an investment
of P2,000.00 for a period from January 30 to September
15, 2001 if the rate of interest is 10%.

Ans. P124.93

• Example 4: If P 4000 is borrowed for 75 days at 16% per

annum. How much will be due at the end of 75 days?

Ans. P 4,133.33

• Example 5: How long will it take for a deposit of P 1,

500.00 to earn P 186 if invested at the simple interest rate
of 7 1/3%?

Ans. 1.6909 years

• Example 6: If you borrow money from your friend with

simple interest of 12%, find the present worth of P 20,000
at the end of 9 months.

Ans. P 18,348.60
𝐹 = 𝑃(1 + 𝑖)𝑛
• Example 7: (CE Board) A deposit of P 110,000 was made 𝐹 𝐹
for 31 days. The net interest after deducting 20% = (1 + 𝑖)𝑛 = ( , 𝑖%, 𝑛)
𝑃 𝑃
withholding tax is P890.36. Find the rate of return
annually. 𝑃 = 𝐹(1 + 𝑖)−𝑛

Ans. 11.75% 𝑃 𝑃
= (1 + 𝑖)−𝑛 = ( , 𝑖%, 𝑛)
𝐹 𝐹
• Example 8: A man buys an electric fan from a merchant
that charges P1500.00 at the end of 90 days. The man Where:
wishes to pay cash. What is the cash price if money is
F = accumulated amount or future worth
worth 10% simple interest?
P = principal or present worth
Ans. P 1,463.41
i = rate of interest per interest period
• Example 9: What amount will be available in eight months
if P15,000.00 is invested now at 10% simple interest per n = number of compounding periods
year?
F/P = single payment compound amount factor
Ans. P 16,000.00
P/F = single payment present worth factor
• Example 10: P 1000.00 becomes P 1500.00 in three years.
Find the simple interest rate. Nominal Rate of Interest

Ans. 16.67% • Specifies the rate of interest and the number of interest
periods in one year.
• Example 11: An engineer borrowed a sum of money under
the following terms: P 650,000.00 if paid in 90 days, or P 𝑟
𝑖=
600,000.00 if paid in 30 days. What is the equivalent 𝑚
annual rate of simple interest? 𝑛 = 𝑚𝑦

Ans. 50% 𝑟 𝑚𝑦
𝐹 = 𝑃 (1 + )
𝑚
Compound Interest
Where:
• The interest for an interest period is calculated on the
principal plus total amount of interest accumulated in i = rate of interest per interest period
previous period.
n = number of compounding periods Example 7: Five years ago, you paid P 340,000 for a lot. Today you
sold it at P 500,000. What is the annual rate of appreciation?
r = nominal rate of interest
Ans. 8%
m = number of compounding periods per year
Example 8: John borrowed P50, 000.00 from the bank at 25%
y = number of years compounded semi-annually. What is the equivalent effective rate of
interest?

Ans. 26.56%

Example 9: Find the present worth of a future payment of P 300,000

to be made 5 years with an interest rate of 8% per annum.

Ans. P 204,174.96
Effecive Rate of Interest
Example 10: How long will it take money to double itself if invested
• The actual or exact rate of interest on the principal during at 5% compounded annually?
1 year, or simply the ratio of accumulated interest in one
year to the principal amount. Ans. 14.2 years

𝐹−𝑃 Example 11: The amount of P 50,000 was deposit in the bank
𝐸𝑅 =
𝑃 earning an interest of 7.5% per annum. Determine the total amount
at the end of 5 years, if the principal and interest were not
𝑟 𝑚
𝐸𝑅 = (1 + 𝑖)𝑚 − 1 = (1 + ) −1 withdrawn during the period?
𝑚

Sample Problems: Ans. P 71,781.47

Example 1: The amount of P 20,000 was deposited in a bank earning Example 12: Compute the equivalent rate of 6% compounded semi-
an interest rate of 6.5% per annum. Determine the total amount at annually to a rate compounded quarterly.
the end of 7 years if the principal and interest were not withdrawn
Ans. 5.96% compounded quarterly
during this period.
Example 13: If P5, 000.00 shall accumulate for 10 years at 8%
Ans. P 31,079.73
compounded quarterly. Find the compounded interest at the end of
Example 2: A man expects to receive P 25,000 in 8 years. How much 10 years.
is that money worth now considering interest at 8% compounded
Ans. P 6,040.20
quarterly?
Example 14: A sum of P 1,000.00 is invested now and left for eight
Ans. P 13,265.83
years, at which time the principal is withdrawn. The interest has
Example 3: How many years will P 100,000 earn a compounded accrued is left for another eight years. If the effective annual interest
interest of P 50,000 if interest is 9% compounded quarterly? rate is 5%, what will be the withdrawal amount at the end of the
16th year?
Ans. 4.56 years
Ans. P 705.42
Example 4: Find the effective rate of interest corresponding to 8%
compounded quarterly. Example 15: By the condition of a will, the sum of P 2,000 is left to a
girl to be held in trust fund by her guardian until it amounts to P
Ans. 8.24% 5,000, when will the girl received the money if the fund is invested
at 8% compounded quarterly?
Example 5: Find the nominal rate, which if converted quarterly could
be used instead of 12% compounded semiannually? Ans. 11.57 years

Ans. 11.825% Example 16: A student plan to deposit P1, 500 in the bank now and
another P3, 000 for the next 2 years. If he plans to withdraw P5, 000
Example 6: If money is worth 5% compounded quarterly, find the 3 years after his last deposit for the purpose of buying shoes, what
equated time for paying a loan of P 150,000 due in one year and P will be the amount of money left in the bank after one year of his
280,000 in 2 years. withdrawal? Effective annual interest rate is 10%.

Ans. 1.6455 years Ans. P 1,549.64

Example 17: If the interest rate of a certain account is 6.5%, Example 4: If the effective annual interest rate is 4%, compute the
compute the (a) single payment present worth factor; and (b) single equivalent nominal interest compounded continuously.
payment compound amount factor at the end of 18 years.
Ans. 3.922%
Ans. (a) 0.322; (b) 3.107
Example 5: What is the nominal rate of interest compounded
Continuous Compounding Interest continuously for 10 years if the compound amount factor is
1.34986?
From the compoung interest formula for m period per year:
Ans. 3%
𝑟 𝑚𝑦
𝐹 = 𝑃 (1 + )
𝑚 Example 6: Deposits of P35,000.00, P48,000.00 and P25,000.00 were
𝑚 made in a savings account eight years, five years, and two years ago,
Let = 𝑘, then m = rk , As m increases, so must k:
𝑟 respectively. Determine the accumulate amount in the account
𝑟𝑦 today if a withdrawal of P55,000.00 was made four years ago. The
𝑟 𝑚𝑦 1 𝑟𝑘𝑦 1 𝑘 applied interest rate is 11% compounded continuously.
(1 + ) = (1 + ) = [(1 + ) ]
𝑚 𝑘 𝑘
Ans. P 113,330.66
1 𝑘
Limit of (1 + ) as k approaches infinity is e, thus:
𝑘
Rate of Return Method (ROR)
𝐹= 𝑃𝑒 𝑟𝑦
Rate of Return
The effective rate of interest for contiuous compounding is:
• A measure of the effectiveness of an investment of capital
𝐸𝑅 = 𝑒𝑟 −1 and its financial efficency
• When this method is used, it is necessary to decide
Where: whether the computed rate of return is sufficient to justify
the investment.
F = accumulated amount or future worth
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
P = principal or present worth 𝑅𝑂𝑅 =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

r = nominal rate of interest 𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡

y = number of years Annual cost includes depreciation, labor and material cost,
overhead, rental, tax and insurances, etc.
e = Euler’s number
SAMPLE PROBLEMS
𝑒 𝑟𝑦 = continuous compound amount factor
Example 1: An investment of P 270,000 can be made in a project
1
= Present worth of continuous compounding factor that will produce a uniform annual revenue of P 185,400 for 5 years
𝑒 𝑟𝑦
and having a salvage value of 10% of the investment. Out of pocket
Sample Problems: costs for operation and maintenance will be P 81,000 per year. Taxes
and insurance will be 4% of the first cost per year. The company
Example 1: P 100,000 is deposited in a bank that earns 5%
expects capital to earn not less than 25% before income taxes. Using
compounded continuously. What will be the amount after 10 years? ROR method, determine the rate of return of the investment. Is this
a desirable investment?
Ans. P 164,872.13
Ans. ROR = 23.70%; It is not a desirable investment
Example 2: Money is deposited in a certain account for which
interest is compounded continuously. If the balance doubles in 6
Example 2: A young mechanical engineer is considering establishing
years, what is the annual percentage rate? his own small company. An investment of P 800,000 will be required
which will be recovered in 15 years. It is estimated that sales will be
Ans. 11.55%
P 800,000 per year and that operating expenses will be as follows.
Example 3: A man wishes to have P 40,000 in a certain fund at the
Materials P 160,000 per year
end of 8 years. How much should he invest in a fund that will pay 6%
Labor P 280,000 per year
compounded continuously?
Overhead P 40,000 +10% of sales per year
Ans. P 24, 751.34 Selling expense P 60,000
The man will give up his regular job paying P 216,000 per year and load balance equal to zero when the final payment is
devote full time to the operation of the business; this will result in made.
decreasing labor cost by P40,000 per year, material cost by P 28,000
per year and overhead cost by P32,000 per year. If the man expects In previous chapter we examined two (actually, it was four)
to earn at least 20% of his capital, should he invest? Compute for the plans to repay $5000 in five years with interest at 8%.
actual rate of return.
In each of the plans the amount loaned ($5000) and the loan
Ans. The man should not invest; ROR = 6.6118% duration (five years) was the same.

Example 3: The ABC Company is considering constructing a plant to Yet the total interest paid to the lender varied from $1200 to $2000,
manufacture a proposed new product. The land costs P 15,000,000, depending on the loan repayment plan.
the building costs P 30,000,000, the equipment costs P 12,500,000,
We saw, however, that the lender received 8% interest each year on
and P 5,000,000 working capital is required. At the end of 12 years,
the amount of money actually owed, and, at the end of five years,
the land can be sold for P 25,000,000, the building for P 12,000,000,
the principal and interest payments exactly repaid the $5000 debt
the equipment for P 250,000 and all of the working capital
with interest at 8%.
recovered. The annual disbursements for labor, materials, and all
other expenses are estimated to cost P 23,750,000. If the company
We say the lender received an “8% rate of return.”
requires a minimum return of 25%, what should be the minimum
annual sales for 12 years to justify the investment?

Ans. P 39,748,563.43

Example 4: A man formerly employed as chief mechanic of an

automobile repair shop has saved P 1,000,000.00 which are now
invested in certain securities giving him an annual dividend of 15%.
He now plans to invest this amount in his own repair shop. In his
resent job, he is earning P 25,000.00 a month, but he has to resign
to run his own business. He will need the services of the following:2
mechanics each earning P400.00 a day, and 8 helpers each earning
P200.00 a day. These men will work on the average 300 days per
year. His other expenses are the following:

Rental P30,000.00 a month

Miscellaneous P25,000.00 a month
Sales tax 3% of gross income
Insurance 2%
Instead of lending money, one might invest $5000 in a machine tool
• The length of his lease is 5 years. If the average charge for with a five-year useful life and an equivalent uniform annual benefit
each car repaired by his shop is P 1,000.00. Determine the of $1252
number of cars he must service in one year so that he will
An appropriate question is, “What rate of return would the person
obtain a profit of at least 20% on his investment?
receive on this investment?”
Ans. 2112 cars
The cash flow would be as follows:
Rate of Return Analysis
YEAR CASH FLOW ($)
• This is the third of the three major analysis techniques 0 -5000
1 +1252
• In this case, three aspects of ROR will be examined.
2 +1252
• First
3 +1252
o Meaning of ROR 4 +1252
• Second 5 +1252
o Calculation of ror
• Third
o ROR analysis problems. It is known that five payments of $1252 are equivalent to a present
sum of $5000 when interest is 8%. Therefore, the rate of return on
1st the meaning of ROR this investment is 8%

• Defined as the interest rate paid on the unpaid balance of Stated in terms of an investment, ROR can be defined as follows:
a loan such that the payment schedule makes the unpaid
 • Rate of return is the interest rate earned on the Example 1:
unrecovered investment such that the payment schedule
makes the unrecovered investment equal to zero at the An $8200 investment returned $2000 per year over a five-year
end of the life of the investment. useful life. What was the rate of return on the investment?

It must be understood that the 8% rate of return does not mean an Solution: using Equation 7-2.
annual return of 8% on the $5000 investment, or $400 in each of the
𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
five years. =1
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
𝑃
Instead, each $1252 payment represents an 8% return on the 2000 ( , 𝑖, 5)
𝐴 =1
unrecovered investment plus the partial return of the investment. 8200

This may be tabulated as follows: Rewriting the equation, we see that

𝑃 8200
( , 𝑖, 5) = = 4.1
𝐴 2000

Then look at the Compound Interest Tables for the value of i where
(P/A,i,5) – 4.1; if no tabulated value of i gives the value, we will then
find values on either side of the desired value (4.1) and interpolate
to find the ROR i. From the tables, we find:

i (P/A,i,5)
6% 4.212
7% 4.100
This cash flow represents a situation where the $5000 investment 8% 3.993
has benefits that produce an 8% ROR. But, in the five-year period,
the total ROR is only $1260, far less than $400 per year for five
years. The reason is because ROR is defined as the interest rate In this example, no interpolation is needed as the ROR. For this
earned on the unrecovered investment. investment is exactly 7%.

Although the two definitions of ROR are stated differently, one in Example 2:
terms of a loan and the other in terms of an investment, there is
only one fundamental concept being described. An investment resulted in the following cash flow. Compute the rate
of return.
It is that the rate of return is the interest rate at which the benefits
are equivalent to the costs. Year Cash flow ($)
0 - 700
2nd calculating ROR 1 +100
2 +175
To calculate a rate of return on an investment, we must convert the 3 +250
various consequences of the investment into a cash flow. Then we 4 +325
will solve the cash flow for the unknown value of i, which is the rate
of return.
Solution:
Five forms of the cash flow equation are:
𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 0
𝐴 𝐴
𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 = 0 → 𝑒𝑞(7 − 2) 100 + 75 ( , 𝑖, 4) − 700 ( , 𝑖, 4) = 0
𝐺 𝑃
𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
= 1 → 𝑒𝑞(7 − 2) In this situation, there are two different interest factors in the
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
equation. Thus, the problem will not be able to be solved easily as
𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ = 0 → 𝑒𝑞(7 − 3) Example 1. Since there is no convenient direct method of solution,
the equation will be solved by trial and error.
𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 0 → 𝑒𝑞(7 − 4)
Try:
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 = 𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 → 𝑒𝑞(7 − 5)
𝑖=5
The five equations represent the same concept in different forms. 𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 0
They can relate costs and benefits with ROR i as the only unknown. 𝐴 𝐴
100 + 75 ( , 5%, 4) − 700 ( , 5%, 4) = 0
𝐺 𝑃
 100 + 75(1.439) − 700(0.2820) = 0 = −100 + 95.98 = −4.02

𝐴𝑡 𝑖 = 5%, 𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 208 − 197 = +11

THE EUAC is too low, if the interest rate is increased, EUAC will
increase.

Try:

𝑖 = 8%
𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 0
𝐴 𝐴
100 + 75 ( , 8%, 4) − 700 ( , 8%, 4) = 0 These two points are plotted in Figure 1. By linear interpolation, the
𝐺 𝑃
100 + 75(1.404) − 700(0.3019) = 0 ROR can be computed as follows:

𝐴𝑡 𝑖 = 8%, 𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 205 − 211 = −6 10.16 1

𝑖 = 10% + (15% − 10%) [ ] = 13 %
10.16 + 4.02 2
This time the EUAC is too large. We see that the true ROR is
between 5% and 8%. Try i = 7% It can be proved that the ROR is very close to 13½% by showing that
the unrecovered investment is very close to zero at the end of the
𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 0 life of the investment.
𝐴 𝐴
100 + 75 ( , 7%, 4) − 700 ( . 7%, 4) = 0
𝐺 𝑃
100 + 75(1.416) − 700(0.2952) = 0

𝐴𝑡 𝑖 = 8%, 𝐸𝑈𝐴𝐵 − 𝐸𝑈𝐴𝐶 = 206 − 206 = 0

The ROR is 7%.

EXAMPLE 3

Given the cash flow below, calculate the rate of return on the
investment.
This small unrecovered investment indicates that the ROR is slightly
Year Cash flow ($)
less than 13½%.
0 -100
1 +20
Plot of NPW vs. Interest Rate i
2 +30
3 +20 A cash flow representing an investment followed by benefits from
4 +40
the investment would have an NPW vs. i plot (it will be called an
5 +40
NPW plot for convenience) in the form of Figure 2.

Year Cash flow

Solution: using NPW = 0, try i = 10%
0 -P
𝑃 𝑃 1 +Benefit A
𝑁𝑃𝑊 = −100 + 20 ( , 10%, 1) + 30 ( , 10%, 2) 2 +A
𝐹 𝐹
𝑃 𝑃 3 +A
+ 20 ( , 10%, 3) + 40 ( , 10%, 4) 4 +A
𝐹 𝐹
𝑃 . .
+ 40 ( , 10%, 5) . .
𝐹
= −100 + 20(0.9091) + 30(0.8264) + 20(0.7513) + 40(0.6830)
+ 40(0.6209)
= −100 + 18.18 + 24.79 + 15.03 + 27.32 + 24.84
= −100 + 110.16 = +10.13

The trial interest rate is too low. Select a second trial, i = 15%

For i = 15

𝑁𝑃𝑊 = −100 + 20(0.8696) + 30(0.7561) + 20(0.6575)

+ 40(0.5718) + 40(0.4972)
= −100 + 17.39 + 22.68 + 13.15 + 22.87 + 19.89
 Since $40 is received each six months, the problem will be solved
using a six-month interest period.

𝐿𝑒𝑡 𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = 𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠

If, on the other hand, borrowed money was involved, the NPW plot 𝑃 𝑃
would appear as in Figure 3. This form of cash flow typically results 1000 = 40 ( , 𝑖, 2) + 950 ( , 𝑖, 2)
𝐴 𝐹
when one is a borrower of money. In all cases where interest is 1000 = 40(1.956) + 950(0.9707)
charged, the NPW at 0% will be negative. = 78.24 + 922.17 = 1000.41

Year Cash flow The interest rate per six months is very close to 1½%. This means the
0 +P nominal (annual) interest rate is 2 x 1.5% = 3%. The effective
1 -Repayment A (annual) interest rate = (1 + 0.015)2 – 1 = 3.02%.
2 -A
3 -A Solution to Example 4b:
4 -A
. .
. .

There is the same $40 semi-annual interest payment. For six-month

interest periods:

𝑃 𝑃
950 = 40 ( , 𝑖, 18) + 1000 ( , 1, 18)
𝐴 𝐹

Try i = 5%

EXAMPLE 4 950 = 40(11.690) + 1000(0.4155) = 467.60 + 415.50 = 883.10

A new corporate bond was initially sold by a stockbroker to an The PW of benefits is too low. Try a lower interest rate, say, i = 4%.
investor for $1000. The issuing corporation promised to pay the
bondholder $40 interest on the $1000 face value of the bond every 950 = 40(12.659) + 1000(0.4936) = 506.36 + 493.60 = 999.96
six months, and to repay the $1000 at the end of ten years. After The value of i is between 4% and 5%. By interpolation,
one year the bond was sold by the original buyer for $950.
999.96 − 950.00
𝑖 = 4% + (1%) [ ] = 4.43%
a.What rate of return did the original buyer receive on his 999.96 − 883.10
investment?
The nominal interest rate is 2 x 4.43% = 8.86%. The effective interest
b.What rate of return can the new buyer (paying $950) expect to rate is (1 + 0.0443)2 – 1 = 9.05%.
receive if he keeps the bond for its remaining nine-year life?
3rd ROR analysis
Solution to Example 4a:
 • ROR analysis is probably the most frequently used exact each; Saleco will provide the equipment for $2783. If the MARR is
analysis technique industry. 10%, which supplier should be selected?
• Although problems in computing ROR sometimes occur, its
major advantage outweighs the occasional difficulty. Solution:
• The major advantage that can be computed as a single
Since both suppliers will provide equipment with the same useful
figure of merit that is readily understood.
life and benefits, this is a fixed-output situation. In ROR analysis, the
Consider these statements: method of solution is to examine the differences between the
alternatives. By taking (Saleco-Leaseco) an increment of investment
• The net present worth on the project is $32,000. will be obtained.
• The equivalent uniform annual net benefit is $2800.
Different
• The project will produce a 23% rate of return.
between
Year Leaseco Saleco
alternatives
While none of these statements tells the complete story, the third
Saleco Leaseco
one gives a measure of desirability of the project in terms that are 0 -1000 -2783 -1783
widely understood. -1000
1 +1200 +1000
+1200
It is this acceptance by engineers and businessmen alike of rate of
return that has promoted its more frequent use than present worth -1000
2 +1200 +1000
or annual cash flow methods. +1200
3 +1200 +1200 0
In both present worth and annual cash flow calculations, one must 4 +1200 +1200 0
select an interest rate for use in the calculations—and this may be a 5 +1200 +1200 0
difficult and controversial item.

In ROR analysis, no interest rate is introduced into the calculations. Compute the NPW at various interest rates on the increment of
investment represented by the difference between the alternatives.
Instead, a rate of return (more accurately called internal rate of
return) is computed from the cash flow.

To decide how to proceed, the calculated ROR is compared with a

preselected minimum attractive rate of return, or simply MARR.

This is the same value of i used for present worth and annual cash
flow analysis.

When there are two alternatives, ROR analysis is performed by

computing the incremental rate of return—ΔROR—on the difference
between the alternatives.
Each year the cash flow is multiplied by (P/F,i,n).

Two-alternative situation
At 0%: (P/F,0%,n) = 1 for all values of n

At ∞%: (P/F,∞%,0) = 1 (P/F,∞%,n) = 0 for all other values of n

Decision These data are plotted in Figure 4. From the figure it can be seen
Choose the higher-cost
∆𝑅𝑂𝑅 ≥ 𝑀𝐴𝑅𝑅 that NPW = 0 at i = 8%.
alternative
Choose the lower-cost
∆𝑅𝑂𝑅 < 𝑀𝐴𝑅𝑅
alternative

Example 5

If an electromagnet is installed on the input conveyor of a coal

processing plant, it will pick up scrap metal in the coal. The removal
of this metal will save an estimated $1200 per year in machinery
damage being caused by metal. The electromagnetic equipment has
an estimated useful life of five years and no salvage value. Two
suppliers have been contacted: Leaseco will provide the equipment
in return for three beginning-of-year annual payments of $1000
Thus, the incremental rate of return—ΔROR—of selecting Saleco P = principal or present worth
rather than Leaseco is 8%. This is less than the 10% MARR. Select
Leaseco Discount rate

Rate of Return on Additional Investment Method • The discount on one unit of principal per unit of time.

The formula for the ROR on additional investment is: 𝐹−𝑃

𝑑= = 1 − (1 + 𝑖)−1
𝐹
𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
𝑅𝑂𝑅 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = If the commodity is discounted in a certain period of time:
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡
𝐹𝑑 = 𝐹 − 𝑃
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑
𝑃 = 𝐹(1 − 𝑑) 𝐹𝑜𝑟 1 𝑦𝑒𝑎𝑟
If the rate of return on additional investment is satisfactory, then,
the alternative requiring a bigger investment is more economical
𝑃 = 𝐹(1 − 𝑛𝑑)𝐹𝑜𝑟 𝑛 𝑦𝑒𝑎𝑟𝑠
and should be chosen.
The relationship between discount rate and interest rate becomes:
Sample problems
𝑑
Example 1: A company is considering two types of equipment for its 𝑖=
1−𝑑
manufacturing plant. Pertinent data are as follows:
And
Type A Type B
First cost P 200,000 P 300,000 𝑖
𝑑=
Annual operating 1+𝑖
P 32,000 P 24,000
cost
Annual labor cost P 50,000 P 32,000 Where:
Insurance and
3% 3% d = discount rate for the period involved
property taxes
Payroll taxes 4% 4%
Estimated Life 10 10 i = rate of interest for the same period

SAMPLE PROBLEMS
If the minimum required rate of return is 15%, which equipment
Example 1: Mr. T borrowed money from the bank. He receives from
should be selected? What is the rate of return of return on
the bank P 1,340 and promised to pay P 1,500 at the end of 9
additional investment?
months. Compute: (a) Simple interest rate; and (b) Discount Rate.
Ans. Type B; 18.79%
Ans. (a) 15.92%; (b) 13.73%
Discount
Example 2: Find the discount if P 2,000 is discounted for 6 months at
• Is the difference between the future worth of a certain 8% simple discount.
commodity and its present worth.
Ans. P 80
2 Types of Discount:
Example 3: Discount 1650 for 4 months at 6% simple interest. What
Trade Discount is the discount?

• Discount offered by the seller to induce trading. Ans. P 32.35

Cash Discount Discounted Payback Rule

• Is the reduction on the selling price offered to a buyer to Example:

induce him to pay promptly.
• An asset costs $250 and generates $100/year for 4 years.
𝐷 =𝐹−𝑃 Discount rate is 10%

Where: Time year Cash Flow Recovered

0 -250
D = amount of discount 1 +100 +100
2 +100 +200
F = accumulated amount or future worth 3 +100 +300
 4 +100 +400 Now to get the discounted payback period
Payback period 2.5
At year 1, we recovered with $91

Payback period At year 2, we have $83, so 91 + 83 = $174 recovered

• The time that it takes to recover the initial investment At year 3, we have $75, so 75 + 174 = $249 recovered
($250)
At year 4, we have $68, so 68 + 249 = $317 recovered
Notice how we recovered $250 somewhere 2 and 3 years (so it’s
going to be 2.?) To recover the initial investment ($250), we recovered it somewhere
in between year 3 ($249) and year 4 ($317).
In 2nd year, we only recovered $200, so we’re going to need $50
more To get the 250, we only have to recover $1 more from the year 3.

And in 3rd year, we’re going to make +$100 And that $1, we divide it by the next year discounted cash flow ($68)

1
So: = 0.015
68
50 (𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑤𝑒 𝑛𝑒𝑒𝑑)
= 0.5 0.015 + 3 = 3.015
100 (𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟)
2.0 + 0.5 = 2.5 (𝑎𝑑𝑑𝑖𝑛𝑔 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑒𝑎𝑟𝑙𝑖𝑒𝑟) Note:

Time Cash Flow Discounted The discounted payback period is always greater than or equal to
0 -250 payback period
1 91
2 83 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 ≥ 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑
3 75
4 68 • A company accepts a project if the discounted cash flows
Discounted Payback Period 3.015 years
pay for the initial investment within a specific time frame

So in this case, the specific time frame is 4 years, and it is paid at

Discounted Payback Period
3.015 years. So it is accepted.
• The time that it takes to recover the initial investment with
Another Example:
the discount rate.
We have a given project:
To get the discounted payback period, take all the cash flows, and
present value at year 0. Year Cash Flow
0 $39,500
If we discount the value at year 0, it will be the same, not discounted 1 $20,900
2 $15,730
But at $100, at year 1, happens in one year 3 $19,965

We have to take the $100 and discount it for 1 year

As we can see, at year 0, we have invested 39,500 (outflow) and the
100
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑎𝑡 𝑦𝑒𝑎𝑟 1 = = $91 rest is inflow.
1.11

Same goes with year 2 to 4 So we have to know how long does it take this project to payback
with discounting.
100
𝑌𝑒𝑎𝑟 2 = = $83 Let’s say:
1.12
100
𝑌𝑒𝑎𝑟 3 = = $75 The company uses a discount rate of 10% and requires that project
1.13
100 to payback within 2 years.
𝑌𝑒𝑎𝑟 4 = = $68
1.14
We start with discounting year 1
So the formula for Cash flow discount is:
20,900
𝑣𝑎𝑙𝑢𝑒 𝑡ℎ𝑎𝑡 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒 = 19,000
1.101
(1 + (𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒)) 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟
 15,730 𝑃
= 13,000 𝐹=
1.102 (1 + 𝑓)𝑛

19,965 f interest is computed as the same time that inflation is occurring:

= 15,000
1.103
So we have: 1+𝑖 𝑛
𝐹 = 𝑃( )
1+𝑓
Time Cash Flow Discounted
0 $39,500 $39,500 Where:
1 $20,900 $19,000
2 $15,730 $13,000 F = future worth of today’s present amount P
3 $19,965 $15,000
f = annual inflation rate

As we can notice, the amount for year 0 is the same, there is no n = number of years
reason to discount it because it is invested.
i = rate of interest
So now we have the discounted cash flow, we have to recover the
39,500 If the uninflated present worth is to be determined:

At year 1, we have 19,000, that gives us 39,500 – 19,000 = 20,500 𝐹 𝐹

𝑃= =
left to go. (1 + 𝑖)𝑛 (1 + 𝑓)𝑛 (1 + 𝑖𝑐𝑓 )𝑛

At year 2, we have 13,000, that gives us 20,500 – 13,000 = 7,500 to 𝑖𝑐𝑓 = 𝑖 + 𝑓 + 𝑖𝑓

be paid.
SAMPLE PROBLEMS
That leaves us to the year 3, but it is greater than 7,500. So that
means between year 2 and 3, we already have paid. Example 1: A man invested P 130,000 at an interest rate of 10%
compounded annually. What will be the final amount of his
So what we have to do is: investment, in terms of today’s peso, after 5 years, if inflation
remains the same at the rate of 8% per year?
7,500
= 0.5
15,000 Ans. P 142,491

We know that the project paid back between year 2 and 3, and Example 2: What is the uninflated present worth of a P 200,000
that’s going to give us 2 + 0.5 = 2.5 years. future value in two years if the average inflation rate is 6% and
interest rate is 10%.
Since 2.5 years is greater than the required 2 years, this project
should be rejected. Ans. P 147,107

Inflation Present Worth Method

• is the increase in the prices for goods and services from • This method is based on the concept of present worth. If
one year to another, thus decreasing the purchasing the present worth of all net cash flows is equal to or
power of money. greater than zero, the project is justified. Cash inflow
includes annual revenue and salvage or scrap value.
𝐹𝐶 = 𝑃𝐶(1 + 𝑓)𝑛
Depreciation is excluded in cash outflow.
Where:
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ 𝑜𝑓 𝑎𝑙𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 ≥ 0
FC = future cost of a commodity
SAMPLE PROBLEMS
PC = present cost of a commodity
Example 1: An investment of P 270,000 can be made in a project
f = annual inflation rate that will produce a uniform annual revenue of P 185,400 for 5 years
and having a salvage value of 10% of the investment. Out of pocket
n = number of years costs for operation and maintenance will be P 81,000 per year. Taxes
and insurance will be 4% of the first cost per year. The company
In an inflationary economy, the buying power of money decreases as expects capital to earn not less than 25% before income taxes. Using
cost increases: present worth method, determine the present worth of all net cash
flows. Is this a desirable investment?
Ans. –P 9,436.00; It is not a desirable investment Ans. 2.6 years

Future Worth Method Example 2: A fixed capital investment of P 10,000,000.00 is required

for a proposed manufacturing plant and an estimated working
• this method is exactly comparable to the present worth capital of P 2,000,000.00. Annual depreciation is estimated to be
method except that all cash inflows and outflows are 10% of the fixed capital investment. Determine the rate of return on
compounded forward to a reference point in time called the total investment and the payout period is the annual profit is P
the future. 2,500,000.00.

𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ 𝑜𝑓 𝑎𝑙𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 ≥ 0 Ans. ROR = 12.5%; 4.8 years

SAMPLE PROBLEMS Depreciation methods:

Example 1: An investment of P 270,000 can be made in a project Depreciation

that will produce a uniform annual revenue of P 185,400 for 5 years
and having a salvage value of 10% of the investment. Out of pocket • is the decrease in value of physical property with the
costs for operation and maintenance will be P 81,000 per year. Taxes passage of time.
and insurance will be 4% of the first cost per year. The company
expects capital to earn not less than 25% before income taxes. Using Book Value
future worth method, determine the future worth of all net cash
flows. Is this a desirable investment? Ans. –P 28,796.50; It is not a • is the worth of property as shown on the accounting
desirable investment records of an enterprise

Payback (Payout) Period Method Salvage/Resale Value

• defined as the length of time required to recover the first • is the price that can be obtained from the sale of the
cost of an investment from the net cash flow produced by property after it has been used.
the investment for an interest rate of zero. Depreciation is
Scrap Value
not included in cash outflow.

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 • the amount of property would sell if disposed of as junk
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝐵𝑉𝑚 = 𝐹𝐶 − 𝐷𝑚
SAMPLE PROBLEMS
𝐷𝐿 = 𝐹𝐶 − 𝑆𝑉
Example 1: An investment of P 270,000 can be made in a project
Where:
that will produce a uniform annual revenue of P 185,400 for 5 years
and having a salvage value of 10% of the investment. Out of pocket BVm = book value of a property at any time m
costs for operation and maintenance will be P 81,000 per year. Taxes
and insurance will be 4% of the first cost per year. The company Dm = total depreciation of a property at any time m
expects capital to earn not less than 25% before income taxes.
Determine the payback period. DL = total depreciation at the end of its useful life

𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 FC = first cost

= 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
+ 𝑡𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 SV = salvage or scrap value

𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 = 81,000 + (270,000 ∗ 0.04) = 91,800 Straight Line Method

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑡𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 • a method which assumes that the loss in value is directly
proportional to the age of the property
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 185,000 − 91,000 = 93,600
𝑑1 = 𝑑2 = ⋯ = 𝑑𝑚 = 𝑑𝐿 = 𝑑
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐹𝐶 − 𝑆𝑉
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑=
𝐿
270,000 − 27,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐷𝑚 = 𝑚𝑑
93,600

𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 = 2.6 𝑦𝑒𝑎𝑟𝑠 𝐷𝐿 = 𝐿𝑑

Where: Example 6: What is the book value of electronic test equipment after
8 years of use if it depreciates from its original value of P 120,000.00
d = depreciation at any year to its salvage value of 13% in 12 years? Use straightline method.

Dm = total depreciation of a property at any time m Ans. P 50,400

DL = total depreciation at the end of its useful life Example 7: The initial cost of paint sand mill, including its installation
is, P800 000.00. The BIR approved life of this machine is 10 years for
L = useful life in years
depreciation. The estimated salvage value of the mill is P 50,000.00
and the cost of dismantling is estimated to be P 15,000.00. Using
FC = first cost
straight line depreciation, what is the annual depreciation charge
SV = salvage or scrap value and what is the book value of the machine at the end of six years?

SAMPLE PROBLEMS Ans. P 76,500; P 341,000

Example 1: A machine has an initial cost of P 50,000 and a salvage Example 8: An equipment has a salvage value of P1M at the end of
value of P 10,000 after 10 years. Using Straight Line Method of 50 years. The straight line depreciation charge is P2M.
Depreciation:
(a) What is the first cost of the machine?
(a) What is the annual depreciation?
(b) What is the book value after 25 years?
(b) What is the book value after 5 years?
(c) At what year will its total depreciation be P30M?
(c) What is the total depreciation after 3 years?
Ans. P 101M; P 51M; 15th year
Ans. (a) P 4,000; (b) P 30,000; (c) P 12,000
Sinking Fund Method
Example 2: An Engineer bought an equipment for P 500,000. He
spent an additional amount of P 30,000 for installation and other • a method which assumes that the sinking fund established
expenses. The salvage value is 10% of the first cost. If the book value in which funds will accumulate for replacement. The total
at the end of 5 years is P 291,500 using straight line depreciation, depreciation that has been taken place up to any given
compute the life of the equipment in years. time is assumed to be equal to the accumulated amount in
the sinking fund at any time.
Ans. 10 years
𝑑1 = 𝑑2 = ⋯ = 𝑑𝑚 = 𝑑𝐿 = 𝑑
Example 3: A machine which cost P 10,000 was sold as scrap after
(𝐹𝐶 − 𝑆𝑉)𝑖
being used for 10 years. The scrap value is P 500. Determine the 𝑑=
(1 + 𝑖)𝐿 − 1
total depreciation at the end of 5 years.
𝑑
Ans. P 4750 𝐷𝑚 = [(1 + 𝑖)𝑚 − 1]
𝑖
Example 4: An engineer bought an equipment for P 500,000.00. He 𝑑
spent an additional amount of P 30,000 for installation and other 𝐷𝐿 = [(1 + 𝑖)𝐿 − 1]
𝑖
expenses. The salvage value is 10% of the initial first cost. Life = 15
years. Compute the following: Where:

(a) Annual Depreciation. d = depreciation at any year

(b) Book Value after 6 years. Dm = total depreciation of a property at any time m

(c) Total depreciation after 10 years. DL = total depreciation at the end of its useful life

Ans. (a) P 31,800; (b) P 339,200; (c) P 318,000 L = useful life in years

Example 5: A machine cost P 73,500 and has a life of 8 years with a FC = first cost
salvage value of P 3500 at the end of 8 years. Determine the book
SV = salvage or scrap value
value at the end of 4 years using straight line method.
SAMPLE PROBLEMS
Ans. P 38,500
Example 1: Given FC = 100,000, SV = 10,000, L = 10 years, i = 5%.
(a) Annual Depreciation, d. 𝐿 𝑆𝑉
𝑘 =1− √
(b) Book Value after 3 years. 𝐹𝐶

(c) Book Value after 8 years. 𝐷𝑚 = 𝐹𝐶 − 𝐵𝑉𝑚

Ans. P 7,155.41; P 77,442.56; P 31,672.21 Note: This method is not applicable if there is no salvage value.

Example 2: An equipment cost P 100,000 with a salvage value of P Where:

5,000 at the end of 10 years. Using Sinking Fund Method with
dm = depreciation at any time m
interest rate= 4%.
BVm = book value of a property at any time m
(a) Compute the annual depreciation cost.
Dm = total depreciation of a property at any time m
(b) Find the book values at years 1 to 4.
L = useful life in years
Ans. (a) P 7,912.64; (b) P 92,087.36; P 83,858.21; P 75,299.90; P
66,399.26
FC = first cost
Example 3: A plant erected to manufacture socks with a first cost of
SV = salvage or scrap value
P 10,000,000 with an estimated salvage value of P 100,000 at the
end of 25 years. Find the appraised value to the nearest 100 by k = rate of depreciation
sinking fund method at 6% interest rate at the end of
SAMPLE PROBLEMS
a. 10 years
Example 1: A machine costing P 720,000 is estimated to have a book
b. 20 years value of P 40,545.73 when retired at the end of 10 years.
Depreciation cost is computed using a constant percentage of the
Ans. P 7,621,600; P 3,362,200
declining value.
Example 4: A factory is constructed at a 1st cost of P 8,000,000 and
(a) What is the annual rate of depreciation?
with an estimated salvage value of P 200,000 at the end of 25 years.
Find its appraised value to the nearest 100 at the end of 10 years by (b) What is the book value after 3 years?
using sinking fund of depreciation assuming an interest of 5%.
(c) What is the depreciation charge at the 4th year?
Ans. P 5,944,400
(d) What is the total depreciation after 6 years?
Example 5: A four-stroke motorbike costs P75 000.00. It will have a
salvage value of P10 000.00 when worn out at the end of eight Ans. (a) 0.25; (b) P 303,750; (c) P 75,937.50; (d) P 591,855.47
years. Determine the annual replacement deposit using the SFM at
5%. Ans. P 6,806.92 Example 6: A machine that costs P75 000.00 five Example 2: A machine having a certain 1st cost has a life of 10 years
years ago now cost P45 864.31, when 7% interest is applied using and a salvage value of 6.633% of the first cost of 10 years. If it has a
the sinking fund formula. Determine the salvage value of the book value of P 58,914 after 6 years, how much is the first cost of
machine for an estimated useful life of 10 years. the machine using Matheson’s Method?

Ans. P 5,000 Ans. P 300,049.23

Declining Balance Method (Matheson’s Method) Example 3: A machine has a current price of P 400,000. If its selling
price is expected to decline at the rate of 10% per annum, what will
• a method which assumes that the annual cost of be the selling price after 5 years?
depreciation is a fixed percentage (k) of the salvage value
at the beginning of the year. Ans. P 236,196.00

𝑑𝑚 = 𝐹𝐶(1 − 𝑘)𝑚−1 𝑘 Example 4: A radio service panel truck initially costs P 56,000. I
resale value at the end of the fifth year is estimated at P 15,000. By
𝐵𝑉𝑚 = 𝐹𝐶(1 − 𝑘)𝑚 means of the Declining Balance Method, determine the yearly
depreciation charge for the first and second years.
𝑆𝑉 = 𝐹𝐶(1 − 𝑘)𝐿
Ans. P 12,969.60; P 9,965.84
Example 5: An engineer bought an equipment for P 800,000. Other (b) What is the depreciation charge on the 4th year?
expenses, including installation, amounted to P 50,000. At the end of
its estimated useful life of 10 years, the salvage value will be 10% of (c) What is the total depreciation charge at the end of the 10th year?
the first cost. Using the constant percentage method of
Ans. P 334,898; P 115,740.74; P 1,006,193.30
depreciation, what is the book value after 5 years?
Example 5: A machine costing P 550,000 has an estimated scrap
Ans. P 268,793.20
value of P 85,000 at the end of its economic life of 8 years. Using
Double Declining Balance Method DDBM of depreciation:

• a method which is similar to declining balance method (a) What is the book value after 4 years of service?
except that the rate of depreciation k is replaced by 2/L.
(b) What is the book value at the end of its life?
𝑚−1
2 2
𝑑𝑚 = 𝐹𝐶 (1 − ) Ans. P 174,023; P 55,062.10
𝐿 𝐿
Sum of the Years Digit Method
2 𝑚
𝐵𝑉𝑚 = 𝐹𝐶 (1 − )
𝐿 (𝐹𝐶 − 𝑆𝑉)
𝑑𝑚 = (𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡)
𝐷𝑚 = 𝐹𝐶 − 𝐵𝑉𝑚 𝑠𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑖𝑔𝑖𝑡𝑠

Where: (𝐹𝐶 − 𝑆𝑉)

𝐷𝑚 = (𝑠𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡𝑠)
𝑠𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑖𝑔𝑖𝑡𝑠
dm = depreciation at any time m
𝐿
𝑠𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑖𝑔𝑖𝑡𝑠 = (𝐿 + 1)
BVm = book value of a property at any time m 2

𝑟𝑒𝑣𝑒𝑟𝑒𝑠𝑒 𝑑𝑖𝑔𝑖𝑡 = 𝐿 − 𝑚 + 1
Dm = total depreciation of a property at any time m
𝑚
L = useful life in years 𝑠𝑢𝑚 𝑜𝑓 𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡𝑠 = (2𝐿 − 𝑚 + 1)
2

FC = first cost Where:

SAMPLE PROBLEMS dm = depreciation at any time m

Example 1: A machine has a first cost of P 140,000 and a life of 8 Dm = total depreciation of a property at any time m
years with a salvage value of P 10,000 at the end of its useful life.
Using double declining balance method: L = useful life in years

(a) What is the Book Value on the 3rd year? FC = first cost

(b) What is the depreciation charge on the 4th year? SV = salvage or scrap value

Ans. P 59,062.50; P 14,765.63 SAMPLE PROBLEMS

Example 2: An equipment costs P 500,000 and has a salvage value of Example 1: An asset is purchased for P 9000. Its estimated life is 10
P 25,000 after its 25 years of useful life. Using Double Declining years, after which is will be sold for P 1,000. Using SOYD
Balance Method, what will be the book value after 8 years?
(a) Find the book value during the 3rd year.
Ans. P 256,609.44
(b) Find the depreciation during the 2nd year.
Example 3: XYZ Company has an equipment that cost P 90,000. After
8 years, it will have a salvage value of P 18,000.00. Using Double (c) Find the total depreciation after 4 years.
declining balance method, find the book value at the end of 5 years.
Ans. P 5,072.72; P 1,309.09; P 4,945.45
Ans. P 21,357
Example 2: Mr. Q purchased a Bulk Milk Cooler for P 480,000.00.
Example 4: Given the following data for a construction equipment: Shipping, tax, and installation costs amounted to P 25,000.00, P
Initial cost = P 1,200,000.00; Economic Life = 12 years; Estimated 20,000.00 and P 15,000.00. The machine has a useful life of 7 years
salvage value = P 320,000.00. and salvage value of P 40,000.

(a) What is the book value after seven years? (a) Determine the book value after four years.
(b) Determine the depreciation charge on its last year of service. scrap value of P 4,000, production of 400,000 units and working
hours of 120,000. The company uses the machinery for 14,000 hours
(c) Determine the total depreciation after 3 years. in 1979 and 18,000 hours is 1980. The machinery produces 36,000
units in 1979 and 44,000 units in 1980. Compute the depreciation
Ans. P 147,142.86; P 17,857.14; P 321,428.57
charge for 1980 using each method given below:
Example 3: A telephone company purchased microwave radio
(a) Straight Line Method
equipment for P 6 million, freight and installation charges amounted
to 4% of the purchased price. If the equipment will be depreciated (b) Working Hours Method
over a period of 10 years with a salvage value of 8%, determine the
depreciation cost during 5th year using SYD. (c) Output method Also compute the total depreciation at the end of
1980 using:
Ans. P 626,269.10
(d) Working Hours Method
Example 4: A company purchases an asset for P 10,000.00 and plans
to keep it for 20 years. If the salvage value is zero at the end of the (e) Service Output Method
20th year:
Ans. P 9,600; P 14,400; P 10,560; P 25,600; P 19,200
(a) What is the depreciation in the third year?
Example 2: An asphalt and aggregate mixing plant having a capacity
(b) What is the total depreciation at the end of 14 years? of 50 cu.m. every hour costs P 2,500,000. It is estimated to process
800,000 cu.m. during its life. During a certain year it processed
(c) What is the book value of the asset at the end of 8 years? Use 60,000 cu.m. If its scrap value is P 100,000, determine the total
sum-of-the-year’s digits depreciation. depreciation during the year and the depreciation cost chargeable to
each batch of 50 cu.m. using the service output method.
Ans. P 857.14; P 9,000; P 3,714.29
Ans. P 180,000.00; P 150.00
Example 5: An equipment costing P 500,000.00 has a life expectancy
of 5 years. Using some-of-the-year’s digit method of depreciation, SUPPLEMENTARY PROBLEMS
what must be its salvage value such that its depreciation charge for
the first year is P 100,000.00? Example 1: A machine costs P 7,000 which last for 8 years with a
salvage value at the end of its life of P 350. Determine the
Ans. P 200,000.00 depreciation charge during the 4th year and the book value at the
end of 4 years by:
Service-Output Method
(a) Straight Line Method;
• a method which assumes that the total depreciation that
has taken place is directly proportional to the quantity of (b) Declining Balance Method;
output of the property up to that time.
(c) SOYD Method;
(𝐹𝐶 − 𝑆𝑉)
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑢𝑡𝑝𝑢𝑡 =
𝑇 (d) Sinking Fund Method with interest of 12%;

(𝐹𝐶 − 𝑆𝑉) (e) Double Declining Balance Method

𝐷𝑚 = (𝑄)
𝑇
Ans. (a) P 831.25, P 3,675; (b) P 710.96, P 1,565.25; (c) P 923.61, P
Where:
2,197.22; (d) P 540.66, P 4,416.00; (e) P 738.28; P 2,214.84
Dm = total depreciation of a property at any time
Example 2: A P 110,000 chemical plant had an estimated life of 6
years and a projected scrap value of P 10,000. After 3 years of
FC = first cost
operation, an explosion made it a total loss. How much money
SV = salvage or scrap value would have to be raised to put up a new plant costing P 150,000, if
the depreciation reserve was maintained during its 3 years of
T = total units of output up to the end of its life operation by:

Q = total number of units of output at any time (a) Straight Line Method;

SAMPLE PROBLEMS (b) Sinking Fund Method at 6% interest

Example 1: A television company purchased machinery for P 100,000 Ans. P 100,000; P 104,359.08
on July 1, 1979. It is estimated that it will have a useful of 10 years,
Example 3: A contractor imported a bulldozer for his job, paying P QBEP = production quantity (volume) at which break-even will occur
250,000 to the manufacturer. Freight and insurance charges
amounted to P 18,000; customs’, broker’s fees and arresters CF = fixed costs
services amounted to P 8,500; taxes, permits, and other expenses
p = selling price per unit
which is 10% of the purchasing cost. If the contractor estimates the
life of the bulldozer to be 10 years with a salvage value of P 20,000,
cv = variable cost per unit
determine the book value at the end of 6 years using the:
Sample Problem
(a) Straight Line Method;
A firm has the capacity to produce 1,000,000 units of a product per
(b) Sinking Fund Method with interest at 8%;
year. At present, it is able to produce and sell only 600,000 units
yearly at a total revenue of Php720,000. Annual fixed costs are
(c) Matheson’s Formula;
Php250,000 and the variable costs per unit are Php0.70
(d) SOYD Method
• Calculate the firm’s annual profit or loss for this
Ans. P 132,600; P 158,949.69; P 59,201.53; P 71,181.82 production.
• How many units should be sold annually to break-even?
Example 4: An equipment costs P 10,000 with a salvage value of P • If the firm can increase its sales to 80% of full capacity,
500 at the end of 10 years. Calculate the annual depreciation cost what will its profit or loss be, assuming that its selling price
by: and variable cost per unit remain constant?
• Draw a break-even chart indicating the above result on the
(a) Straight Line Method;
chart

(b) Sinking Fund Method at 4% interest

Problem Details & Computation

Ans. P 950; P 791.26

a.)
Example 5: A radio service panel truck initially costs P 56,000. Its
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
resale value at the end of the 5th year is estimated at P 15,000. = Php720,000 − [Php250,000 + 0.70(600,000)]
= Php50,000
(a) Determine the annual depreciation charge by SLM.
b.) Computing for p =
(b) By means of the Matheson’s Formula, determine the yearly
depreciation charge for the first, second and third year. 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 Php720,000
= = Php1.20 per unit
𝑄 600,000 units
Ans. P 8,200; P 12,969.60, P 9,965.84, P 7,657.75
Php250,000
BREAK-EVEN ANALYSIS 𝑄𝐵𝐸𝑃 = = 500,000 𝑢𝑛𝑖𝑡𝑠
(Php1.20 − Php0.70)per unit

• Evaluation method employ to determine the point where c.) At 80% capacity (800,000 units per year)
revenues and expenses are equal which serve as an
indicator for businessman/investors/financiers to know at 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
what level of business activities they will be able to
𝑃𝑟𝑜𝑓𝑖𝑡 = (800,000 ∗ 𝑃ℎ𝑝1.20⁄𝑢𝑛𝑖𝑡 )
recover their capitals.
− [𝑃ℎ𝑝250,000 + (𝑃ℎ𝑝0.70⁄𝑢𝑛𝑖𝑡 ∗ 800,000)]
Assumptions for Break-even analysis
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑃ℎ𝑝960,000 – 𝑃ℎ𝑝810,000
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑃ℎ𝑝150,000
• All units produced are sold at a constant price per unit.
• There is no income other than that from operations.
d. break-even chart
• The variable costs are directly proportional to production
rate from zero to 100% capacity.
• Fixed costs are constant regardless of the number of units
produced.

Break-even Point (BEP) Formula

𝐶𝐹
𝑄𝐵𝐸𝑃 =
𝑝 − 𝐶𝑣

Where:
 85,908.32 ℎ𝑜𝑢𝑟𝑠 − 68,010.75 ℎ𝑜𝑢𝑟𝑠
% 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑄𝐵𝐸𝑃 =
85,908.32 ℎ𝑜𝑢𝑟𝑠
= 0.2083

A 10% reduction in variable cost per hour resulted to 20.83%

reduction in BEP.

If charge out rate per hour will be increased by 10%,

𝐶𝐹 20,240,000
𝑄𝐵𝐸𝑃 = = = 63,021.55 ℎ𝑜𝑢𝑟𝑠
𝑝 − 𝑐𝑣 [1.10(855.60) − 620]

85,908.32 ℎ𝑜𝑢𝑟𝑠 − 63,021.55 ℎ𝑜𝑢𝑟𝑠

% 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑄𝐵𝐸𝑃 =
85,908.32 ℎ𝑜𝑢𝑟𝑠
= 0.2664
Sample Problem
A 10% increse in charge-out rate per hour resulted to 26.64%
An engineering consulting firm measures its output in terms of reduction in BEP
standard service hour unit, which is a function of the personnel
grade levels in the professional staff. The variable cost is Php62 per
standard service hour. The charge-out rate is Php85.56 per hour.
The maximum output of the firm is 160,000 hours per year and its
fixed cost is Php2,024,000 per year. For this firm,

a. What is the break-even point in standard service hours and in the

percentage of total capacity?

b. What is the percentage reduction in the break-even point if fixed

costs are reduced by 10%?

c. What is the percentage reduction in the break-even point if the

variable costs per hour is reduced by 10%?

d. What is the percentage reduction in the break-even point if the

selling price per unit is increased by 10%?

a.)

𝐶𝐹 20,240,000
𝑄𝐵𝐸𝑃 = = = 85,908.32 ℎ𝑜𝑢𝑟𝑠
𝑝 − 𝑐𝑣 855.60 − 620

85,908.32 ℎ𝑜𝑢𝑟𝑠
% 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 = = 0.5369
160,000 ℎ𝑜𝑢𝑟𝑠

Or their BEP is 53.69% of their annual capacity

b.) If fixed costs will be reduced by 10%

𝐶𝐹 0.9(20,240,000)
𝑄𝐵𝐸𝑃 = = = 77,317.49 ℎ𝑜𝑢𝑟𝑠
𝑝 − 𝑐𝑣 855.60 − 620

85,908.32 ℎ𝑜𝑢𝑟𝑠 − 77,317.49 ℎ𝑜𝑢𝑟𝑠

% 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑄𝐵𝐸𝑃 =
85,908.32 ℎ𝑜𝑢𝑟𝑠
= 0.10

A 10% reduction in fixed cost resulted to 10% reduction in BEP.

If variable costs per hour will be reduced by 10%

𝐶𝐹 20,240,000
𝑄𝐵𝐸𝑃 = = = 68,010.75 ℎ𝑜𝑢𝑟𝑠
𝑝 − 𝑐𝑣 [855.60 − 0.90(620)]