ECONOMICS FOR CHEMICAL ENGINEERS

ICH 2219

PROJECT EVALUATION ALLOWING FOR TAXATION

Chemical Engineering projects often involve an investment in equipment, buildings, or other
assets that are put to productive use. As time passes, these assets lose value, or depreciate. This
module this is concerned with the concept of depreciation and several methods that are
commonly used to model depreciation. It also forms an important part of the decision of when to
replace an aging asset and when to make cyclic replacements, and has an important impact on
taxation.

An asset starts to lose value as soon as it is purchased. For example, a car bought for $20 000
today may be worth $18 000 next week, $15 000 next year, and $1000 in 10 years. This loss in
value, called depreciation, occurs for several reasons.

 Use-related physical loss: As something is used, parts wear out. An automobile engine
has a limited life span because the metal parts within it wear out. This is one reason why
a car diminishes in value over time. Often, use-related physical loss is measured with
respect to units of production, such as thousands of kilometers for a car, hours of use for
a light bulb, or thousands of cycles for a punch press.

 Time-related physical loss: Even if something is not used, there can be a physical loss
over time. This can be due to environmental factors affecting the asset or to endogenous
physical factors. For example, an unused car can rust and thus lose value over time. Time
related physical loss is expressed in units of time, such as a 10-year-old car or a 40-year-
old sewage treatment plant.

 Functional loss: Losses can occur without any physical changes. For example, a car can
lose value over time because styles change so that it is no longer fashionable. Other
examples of causes of loss of value include legislative changes, such as for pollution
control or safety devices, and technical changes. Functional loss is usually expressed
simply in terms of the particular unsatisfied function.

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Models of depreciation can be used to estimate the loss in value of an asset over time, and
also to determine the remaining value of the asset at any point in time. This remaining value
has several names, depending on the circumstances.

 Market value is usually taken as the actual value an asset can be sold for in an open
market. Of course, the only way to determine the actual market value for an asset is to
sell it. Consequently, the term market value usually means an estimate of the market
value. One way to make such an estimation is by using a depreciation model that
reasonably captures the true loss in value of an asset.

 Book value is the depreciated value of an asset for accounting purposes, as calculated
with a depreciation model. The book value may be more or less than market value.
The depreciation model used to arrive at a book value might be controlled by
regulation for some purposes, such as taxation, or simply by the desirability of an
easy calculation scheme. There might be several different book values for the same
asset, depending on the purpose and depreciation model applied.

 Scrap value can be either the actual value of an asset at the end of its physical life
(when it is broken up for the material value of its parts) or an estimate of the scrap
value calculated using a depreciation model.

 Salvage value can be either the actual value of an asset at the end of its useful life
(when it is sold) or an estimate of the salvage value calculated using a depreciation
model. It is desirable to be able to construct a good model of depreciation in order to
state a book value of an asset for a variety of reasons:

1. To make many managerial decisions, it is necessary to know the value of owned assets.
For example, money may be borrowed using the firm’s assets as collateral. In order to
demonstrate to the lender that there is security for the loan, a credible estimate of the
assets’ value must be made. A depreciation model permits this to be done.

2. One needs an estimate of the value of owned assets for planning purposes. In order to
decide whether to keep an asset or replace it, you have to be able to judge how much it is

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 worth. More than that, you have to be able to assess how much it will be worth at some
time in the future.

3. Government tax legislation requires that taxes be paid on company profits. Because there
can be many ways of calculating profits, strict rules are made concerning how to
calculate income and expenses.

To match the way in which certain assets depreciate and to meet regulatory or accuracy
requirements, many different depreciation models have been developed over time.
Straight-line and declining-balance are certainly the most commonly used. Straight-line
depreciation is popular primarily because it is particularly easy to calculate. The declining-
balance method is required by tax law in many jurisdictions for determining corporate taxes.
The straight-line method of depreciation assumes that the rate of loss in value of an asset is
constant over its useful life. For an asset worth $1000 at the time of purchase and $200 eight
years later. Graphically, the book value of the asset is determined by drawing a straight line
between its first cost and its salvage or scrap value. Algebraically, the assumption is that the rate
of loss in asset value is constant and is based on its original cost and salvage value. This gives
rise to a simple expression for the depreciation charge per period. We determine the depreciation
per period from the asset’s current value and its estimated salvage value at the end of its useful
life, N periods from now, by;

Where

is the depreciation charge for period n using the straight-line method.

is the purchase price or current market value.

is the salvage value after N periods

the useful life of the asset, in periods

Similarly, the book value at the end of any particular period is easy to calculate:

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Where, is the book value at the end of period n using straight-line depreciation

Example:
A heat exchanger was purchased four years ago for $380 000. It will have a salvage value of $30
000 two years from now. If we believe a constant rate of depreciation is a reasonable means of
determining book value, what is its current book value?

Solution

The straight-line depreciation method has the great advantage of being easy to calculate. It is also
easy to understand and is in common use. The main problem with the method is that its
assumption of a constant rate of loss in asset value is often not valid. Thus, book values
calculated using straight-line depreciation will frequently be different from market values. For
example, the loss in value of a car over its first year (say, from $20 000 to $15 000) is clearly
more than its loss in value over its fifth year (say, from $6000 to $5000). The declining-balance
method of depreciation covered in the next section allows for “faster” depreciation in earlier
years of an asset’s life.

Declining-Balance Depreciation

Declining-balance depreciation (also known as reducing-balance depreciation) models the loss in

value of an asset over a period as a constant fraction of the asset’s current book value. In other
words, the depreciation charge in a particular period is a constant proportion (called the
depreciation rate) of its closing book value from the previous period.

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Algebraically, the depreciation charge for period n is simply the depreciation rate multiplied by
the book value from the end of period (n – 1) Noting that;

Where
is the depreciation charge in period n using the declining-balance method

is the book value at the end of period n using the declining-balance method

is the depreciation rate

Similarly, the book value at the end of any particular period is easy to calculate by noting that the
remaining value after each period is times the value at the end of the previous period.

Where
is the purchase price or current market value
In order to use the declining-balance method of depreciation, we must determine a reasonable
depreciation rate. By using an asset’s current value, P, and a salvage value, S, n periods from
now, we can use Equation (x) to find the declining balance rate that relates P and S.

Example:
A process engineer wants to estimate the scrap value of a boiler 20 years after purchase. She
feels that the depreciation is best represented using the declining-balance method, but she doesn’t
know what depreciation rate to use. She observes that the purchase price of the boiler was $245
000 three years ago, and an estimate of its current salvage value is $180 000. What is a good
estimate of the value of the boiler after 20 years?

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By using the equation below, the book value 20 years after purchase can be estimated

An estimate of the salvage value of the smokehouse after 20 years using the declining-balance
method of depreciation is $31 372.

The declining-balance method has a number of useful features. For one thing, it matches the
observable loss in value that many assets have over time. The rate of loss is expressed in one
parameter, the depreciation rate. It is relatively easy to calculate, although perhaps not quite as
easy as the straight-line method.

Practicing Problem

Makerere university chemical society has purchased a new mass packaging line for $250 000. It
is expected to last six years, with a $10 000 salvage value. Using both the straight-line and
declining-balance methods, determine the following:

a) The depreciation charge in year 1

b) The depreciation charge in year 6

c) The book value at the end of year 4

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Replacement Decision
Survival of businesses in a competitive environment requires regular evaluation of the plant and
equipment used in production. As these assets age, they may not provide adequate quality, or
their costs may become excessive. When a plant or piece of equipment is evaluated, one of four
mutually exclusive choices will be made.

1. An existing asset may be kept in its current use without major change.

2. An existing asset may be overhauled so as to improve its performance.

3. An existing asset may be removed from use without replacement by another asset.

4. An existing asset may be replaced with another asset

The discussion herein is concerned with methods of making choices about possible replacement
of long-lived assets. While the comparison methods discussed in module 3 for choosing between
alternatives are often used for making these choices, the issues of replacement deserve a special
attention for several reasons. First, the relevant costs for making replacement decisions are not
always obvious, since there are costs associated with taking the replaced assets out of service that
should be considered.

Reasons for Replacement or Retirement

If there is an ongoing need for the service an asset provides, at some point it will need
replacement. Replacement becomes necessary if there is a cheaper way to get the service the
asset provides, or if the service provided by the existing asset is no longer adequate. An existing
asset is retired if it is removed from use without being replaced. This can happen if the service
that the asset provides is no longer needed. Changes in customer demand, changes in production
methods, or changes in technology may result in an asset no longer being necessary. For

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example, the growth in the use of MP3 players for audio recordings has led manufacturers of
compact discs to retire some production equipment since the service it provided is no longer
needed. There may be a cheaper way to get the service provided by the existing asset for several
reasons. First, productive assets often deteriorate over time because of wearing out in use or
simply because of the effect of time.

As a familiar example, an automobile becomes less valuable with age (older cars, unless they are
collectors’ cars, are worth less than newer cars with the same mileage) or if it has high mileage
(the kilometers driven reflect the wear on the vehicle). Similarly, production equipment may
become less productive or more costly to operate over time. It is usually more expensive to
maintain older assets. They need fixing more often, and parts may be harder to find and cost
more. Technological or organizational change can also bring about cheaper methods of providing
service than the method used by an existing asset. For example, the technological changes
associated with the use of computers have improved productivity. Organizational changes, both
within a company and in markets outside the company, can lead to lower-cost methods of
production.

A form of organizational change that has become very popular is the specialist company. These
companies take on parts of the production activities of other companies. Their specialization may
enable them to have lower costs than the companies can attain themselves. The second major
reason why a current asset may be replaced is inadequacy. An asset used in production can
become inadequate because it has insufficient capacity to meet growing demand or because it no
longer produces items of high enough quality. A company may have a choice between adding
new capacity parallel to the existing capacity or replacing the existing asset with a higher
capacity asset, perhaps one with more advanced technology. If higher quality is required, there
may be a choice between upgrading an existing piece of equipment or replacing it with
equipment that will yield the higher quality. In either case, contracting out the work to a
specialist is one possibility.

In summary, there are two main reasons for replacing an existing asset. First, an existing asset
will be replaced if there is a cheaper way to get the service that the asset provides. This can occur
because the asset ages or because of technological or organizational changes. Second, an existing
asset will be replaced if the service it provides is inadequate in either quantity or quality.
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Practicing Problems

A chemical processing plant purchases a new filtration system for $500,000. The system is
expected to have a useful life of 10 years and a salvage value of $50,000. Using the straight-line
depreciation method, calculate:
a) The annual depreciation charge
b) The book value at the end of year 6

A chemical company installs a new heat exchanger costing $120,000. The exchanger depreciates
using the declining-balance method with a rate of 20% per year. Calculate:
a) The depreciation charge in year 1
b) The book value at the end of year 3

Read and make notes on;

Optimal replacement cycle, price changes and uncertainty.

Drafted by Patrick Mulindwa (Patrick.mulindwa@mak.ac.ug)