Project Financial Appraisal

COTM 5104: CONSTRUCTION MANAGEMENT
Chapter 3
Project Financial Appraisal
GETANEH GEZAHEGNE
March 2013
School of Civil and Environmental Engineering
Contents
Project Financial Appraisal
1. General
2. Time Value of Money
3. Financial Appraisal Methods
4. Depreciation
AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. 2
1. General
1.1 Basic Definitions
1.1.1Asset
Assets represents howmuch a companyowns at a given
time of reporting usually, it is within the budget year.
Assets are divided into:
Current assets: include cash at hand other assets which
can easily be converted into cash in less than a year
(e.g. cash at hand, accounts receivable).
Fixed assets: permanent properties which cant be
easily converted into cash within a year (e.g. land,
equipment, buildings).
Other assets: include other investments and good will.
1. General
1.1 Basic Definitions
1.1.2 Liabilities
Liabilities represents what the companyowes like loans,
debtsetc.
Liabilities are divided into:
Current liabilities: debts to be settled in a short period
of time.
Other liabilities: includes long term loans,
performance bonds, wages, etc.
1.1.3StakeholdersEquity
Stakeholders equity (capital) represents the capital
provided by owners of the company.
1. General
1.2 Basic Finance Notes
1.2.1BalanceSheet
The balance sheet is a statement which shows the
financial position of a company at the end of a certain
reportingperiod, which is the fiscal year.
It mainly shows the assets, liabilities and stockholders
equity, based on the accounting equations:
Assets = Liabilities + Owners equity
1.2.2Profit
Profit is an earningof a given periodconcernedwhether
or not they have been received minus the expenses of the
same period whether or not they have been paid.
1. General
1.2.3I ncomeStatement
This is a form of financial statement that shows whether
the company has made or lost money during that
reporting period.
Income statements can be prepared monthly, quarterly,
etc. However, usual accounting periods extend to one
year, which is the fiscal year.
In the income statement one shows or itemizes:
Revenues and net sales;
Production costs and gross margin;
Gross profit and net profit; and
Earning per share.
1. General
1.2.4CashFlowStatement
The income statement shows how much the company has
lost or gained, but does not indicate financing and
investmentactivitiesduring the period.
Cash flowstatement showhowthe company generated
the cashand howit has spent or utilizedit.
1.2.5 Retained Earnings
This is moneywhich is retainedfromthe net profit to be
used for expansion purposes or saved as security for
risks. The remaining balance, which is net profit minus
retained earnings, will be given as dividend to owners.
2.1 Basic Concepts and Terminologies
2.1.1BasicConcepts
The concept of the time value of money is as old as
money itself which evolves from the fact that a dollar
today is worth considerably more than a promise to pay a
dollar at some future date.
A dollar today could be invested and be earning interest
such that, at sometime in the future, the interest earned
would make the investment worth considerably more than
one dollar.
Money has a time value because its purchasing power
changes over time (inflation).
Time value of money is measured in terms of interest
rate.
Interest is the cost of money i.e. a cost to the borrower
and an earningto the lender
2.1 Basic Concepts and Terminologies
2.1.2Terminologies
P (Principal): Initial amount of money invested or
borrowed.
i (I nterest rate): expressed as a percentage per period of
time.
n (I nterest period): determines how frequently interest is
calculated.
N(Number of interest periods): duration of transaction.
A
n
(a plan for receipts or disbursements): a particular
cash flow pattern.
F (FutureAmount): cumulative effects of the interest.
2.2 Cash Flow Diagrams
The graphic presentation of the costs and benefits over
the time is called the cash flow diagram. It is a
presentation of what costs have to be incurred and what
benefits are received at all points in time.
The following conventions are used in the construction
of the cashflowdiagram:
The horizontal axis represents time;
The vertical axis represents costsand benefits;
Costsare shownby downwardarrows; and
Benefitsare shownby upwardarrows.
All the benefits and/or costs incurred during a period are
assumed to have been incurred at the end of that period.
Since the period is normally a year, this is called the ''end
of theyear" rule.
2.2 Cash Flow Diagrams
In order to view problems clearly, cashflowdiagramsare
drawn in such a way that horizontal lines showtimeand
vertical ones represent cashflows.
This is the time profile of all the costs and benefits.
0
1
2 3
Disbursements
Receipt
Time
Cash Flow
2.3 Methods of Calculating Interest
2.3.1SimpleI nterest
Simple interest is the practiceof chargingan interest rate
onlyto an initial sum(principal amount).
F
n
= P+(iP) N = P(1+i N)
Example: calculate the future value of ETB 1,500 at the
end of three years with an interest rate of 9%.
Table 1: Simple Interest Calculation
End of
Year
Beginning
Balance (P)
Interest
(I = 9%)
Ending
Balance (F)
0 1, 500
1 1, 500 135 1, 635
2 1, 635 135 1, 770
3 1, 770 135 1, 905
2.3.2CompoundI nterest
Compound interest is the practiceof chargingan interest
rate to an initial sumand to anypreviouslyaccumulated
interest that has not been withdrawn.
Example: Compute example 1 using compound interest.
Table 2: Compound Interest Calculation
End of
Year
Beginning
Balance (P)
Interest
(I = 9%)
Ending
Balance (F)
0 1, 500
1 1, 500 135 1, 635
2 1, 635 147.15 1, 782.15
3 1, 782.15 160.40 1, 942.55
Compounding Process of compound interest is shown
below.
$1,500
$1,635
$1,635
$1,782.15
$1,782.15
$1,942.55
0
1
2
3
Compounding Process of compound interest is shown
below.
F = $1,500(1+0.09)
3
= $1,942.54
0
$1,500
$1,942.54
1 2 3
Compound interest compounding Process equation
derivation.
1
2
2 1
0:
1: (1 )
2: (1 ) (1 )
: (1 )
N
n P
n F P i
n F F i P i
n N F P i
=
= = +
= = + = +
= = +
2.3.3EquivalenceCalculation
Equivalence calculations are usually made to compare
alternatives.
There are certain rules that one should follow to make
these calculations.
They need to havea commontimebasis;
Equivalenceis dependent on interest rate; and
Equivalenceis maintainedregardlessof anything.
2.4 Interest Formula in Different Cash Flow Categories
2.4.1SingleCashFlows
2.4.1.1Future(Compound) Sum
F = P(1+i)
n
(1+i)
n
Single Payment Compound (Growth)
Amount Factor
= P(F/P, i, n)
Example: If you had $2,000 now and invested it at 10%,
how much would it be worth in 8 years?
$2,000
F = ?
8
0
i = 10%
2.4.1.1Future(Compound) Sum
Given: P = $2,000
I = 10%
N = 8 Years
Reqd: F
Solution: F = $2,000(1+0.10)
8
F = $2,000 (P/F, 10%, 8)
F = $4,287.18
EXCEL command: = FV(10%, 8, 0, 2000, 0)
= $4,287.20
F P i
F P F P i N
N
= +
=
( )
( / , , )
1
F
0
N
P
2.4.1.2PresentWorth(Discount) Sum
P = F(1+i)
-n
(1+i)
-n
Single payment Present Worth
(Discount) Factor
= F(P/F, i, n)
Given: F = $1,000
i = 12%
N = 5 Years
Reqd: P
Solution: P = $1,000(1+0.12)
-5
P = $1,000 (F/P, 12%, 5)
P = $567.40
F
N
0
P F i
P F P F i N
N
= +
=

( )
( / , , )
1
P
2.4.2MultiplePayments
2.4.2.1UnevenPayment Series
Example: how much do you need to deposit today (P) to
withdraw $25,000 at n =1, $3,000 at n = 2, and $5,000 at
n =4, if your account earns 10%annual interest?
0
1 2 3 4
$25,000
$3,000
$5,000
P
2.4.2.1UnevenPayment Series
0
1 2 3 4
$25,000
$3,000
$5,000
P
0
1 2 3 4
$25,000
P
1
0
1 2 3 4
$3,000
P
2
1 2 3 4
$5,000
P
4
+ +
1
$25, 000( / ,10%,1)
$22, 727
P P F =
=
2
$3, 000( / ,10%, 2)
$2, 479
P P F =
=
4
$5, 000( / ,10%, 4)
$3, 415
P P F =
=
1 2 3
$28, 622 P P P P = + + =
0
2.4.2.2Uniform(Equal) Payment Series
0
1 2 N
F
P
0
N
0 1 2
N
A A A
A. CompoundAmount Factor (FutureValue/Annuity)
0 1 2
N
0
1 2 N
A A A
F
A(1+i)
N-1
A(1+i)
N-2
1 2
(1 ) (1 )
N N
F A i A i A

= + + + + +
Example:
Given: A= $5,000, N = 5 years, and i = 6%
Reqd: F
Solution: F = $5,000(F/A,6%,5) = $28,185.46
F A
i
i
A F A i N
N
=
+
=
( )
( / , , )
1 1
0 1 2 3
N
F
A
F =?
0 1 2 3 4 5
$5,000 $5,000 $5,000 $5,000 $5,000
i = 6%
4
3
2
1
0
$5, 000(1 0.06) $6, 312.38
$5, 000(1 0.06) $5, 955.08
$5, 000(1 0.06) $5, 618.00
$5, 000(1 0.06) $5, 300.00
$5, 000(1 0.06) $5, 000.00
$28.185.46
+ =
+ =
+ =
+ =
+ =
B. SinkingFundFactor
Example: College Savings Plan
Given: F = $100,000, N = 8 years, and i = 7%
Reqd: A
Solution: A= $100,000(A/F,7%,8) = $9,746.78
0 1 2 3
N
F
A
( )
) , , / (
1 1
N i F A F
i
i
F A
N
=
+
=
C. Capital RecoveryFactor
Example: Paying Off Education Loan
Given: P = $21,061.82, N = 5 years, and i = 6%
Reqd: A
Solution: A= $21,061.82(A/P,6%,5) = $5,000
1 2 3
N
P
A = ?
A P
i i
i
P A P i N
N
N
=
+
+
=
( )
( )
( / , , )
1
1 1
D. PresentWorthFactor
Example: Powerball Lottery
Given: A= $7.92M, N = 25 years, and i = 8%
Reqd: P
Solution: P = $7.92M(P/A,8%,25) = $84.54M
( )
( )
) , , / (
1
1 1
N i A P A
i i
i
A P
N
N
=
+
+
=
1 2 3
N
P = ?
A
E. PresentWorthof Perpetuities
Perpetuity: A stream of cash flows that continues
forever.
1 2 3
N
P = ?
A
i
A
P =
2.4.2.3Gradient Series
A. Linear Gradient Series
) , , / (
) 1 (
1 ) 1 (
2
N i G P G
i i
iN i
G P
N
N
=
(
+
+
=
P
A. Linear Gradient Series
Example: Present value calculation for a gradient series
How much do you have to deposit now in a savings
account that earns a 12% annual interest, if you want to
withdraw the annual series as shown in the figure?
$1,000
$1,250
$1,500
$1,750
$2,000
1 2 3 4 5
0
P =?
B. Gradient SeriesasaCompositeSeries
C. GeometricGradient Series
C. GeometricGradient SeriesPresent Worth Factor
Present Worth Factor
=
|
.
|
\
|
+
=
(
+ +
=
g i
i
N
A
g i
g i
i g
A
P
N N
if
1
if
) 1 ( ) 1 ( 1
1
1
2.5 Standard Factors for Economic Analysis
A trial and error approach is no longer valid for the
construction industry and proper planning is now vital.
The amount of detailing in planning is likely to be the
function of the size of the firm, the complexity of the
project and the expertiseof the management.
Usually many things interfere with construction thus
making the task of planning and controlling much
difficult.
Obviously planning will not automatically solve or
answer these problems. It serves as a guideline, which is
flexible enough to accommodate the changes and be used
for checking planned against the actual executed work.
3.1 Investment Alternatives
There are two categories of investment alternatives while
dealing with multiple alternatives.
I ndependent I nvestment: This means that a decision on
one investment does not affect the other.
Mutually Exclusive I nvestment: In this case acceptance
of one automatically eliminates the others.
In this section only mutually exclusive alternatives are
considered for subsequent discussions.
3.2 Financial (Investment) Appraisal Methods
The common methods used for financial appraisal of
projects are:
Straight cost Method;
Pay back Method;
Rate of return Method;
Benefit - Cost Ratio;
Present worth or Net Present Value Method;
Future Value Method;
Annual Equivalent Cost Method; and
Internal Rate of Return Method.
2.1 Straight Cost Method
Comparesthe initial investment/immediatecostsonly.
E.g. Loader A ETB 4,500,000
Loader B ETB 5,000,000 Loader A
2.2 Payback Method
A simplecrudemethod for getting a quick evaluation of
the alternatives is to calculate how long it takes to
recover the initial investment.
The time in any unit that it takes to recover the initial
investment is called the payback period.
It is obvious that the payback period neglects the time
value of money and is only accurate when the interest rate
is zero.
Even with this shortcoming, many analysts consider this
method to be a useful quick and dirty way of comparison.
2.2 Payback Method
This method uses the number of years it takes to pay back
the initial investments from profits of the investment.
In computing the pay back period one can either consider
time value of money or disregard it.
When one considers time value of money, it is called
discountedpaybackmethod, otherwise it is conventional.
2.2 Payback Method
Example: For a dozer purchased at a cost of ETB 3.5
million, determine the pay back period if the hourly rental
rate is 900birr/hr and the cost for fuel, operator and
maintains is 150birr/hr with 5 years of economic life.
Solution:
Yearly profit = (900-150) 8652 = ETB 1,872,000
Year Cash Flow
0 -3,000,000
1 1,872,000
2 1,872,000Pay Back Period = 2yrs
3 1,872,000
4 1.872,000
5 1,872,000
2.3 Rate of Return Method
This method uses percentage of the average annual return
to the initial investment as:-
Rate of return =
Example: If the dozer given in the pay back problem can
have a life span of four years, determine the rate of
return.
Solution:
Rate of return= =53.5%
100
.
Re . .
Invested Capital
turn Annual Average
100
000 , 500 , 3
) 000 , 872 . 1 000 , 872 , 1 000 , 872 , 1 000 , 872 , 1 ( 4 / 1
+ + +
2.4 Benefit Cost Ratio
Another method of assessing the viability of a system or
comparing several systems is to calculate the net present
value of the costs and the benefits and obtain the benefit-
cost ratio (B/C).
If this ratio is greater than one, then the project is
profitable.
B/C > 1 Accept;
B/C = 1 Indifferent; and
B/C < 1 Reject.
2.5 Present Worth (Net Present Value) Method
In this case all disbursementsand receiptsare brought to
their net present worth and the comparison of their
present worth is made.
In the present value method, the present time (time zero
or start of year 1) equivalent value of all the costs and
benefits incurred during the life of the systemor the
project is calculated using a specific interest rate.
In this method all cash inflows and outflows of a given
project (having a given project life) are brought to time 0.
If the differencebetween the inflows minus the outflows
is positivethen the project isacceptable.
If it is to compare among various projects, the one
having more positive value is economically the best
alternative.
In order to evaluate projects one need to use discounted
cash flowtechniques (DCF). One of these is the method
of net present worth(NPW) or net present value(NPV).
PW
costs
= C
i
+ CS
n
(P/A, i ,n)
PW
incomes
= I
n
(P/A, i, n) + S (P/F, i, n)
NPW(NPV) = PW
incomes
- PW
costs
S
C
i
CS
n
I
n
Example 1
A construction company wants to introduce a new system
of billing/preparing invoices for payment certificates for
the next 5yrs after which the company will consider other
new options shown below. Two alternatives with identical
capacities and job are available.
Model A: It is semi-automatic that costs ETB 112,500 which
lasts 3yrs with annual operation and maintenance cost of
45,000 having a salvage value of 18,000.
Model B: It is a complete automatic that costs ETB 135,000
which lasts 4yrs with annual operation and maintenance
cost of 36,000 having a salvage value of 13,500.
Which model is acceptable if the interest rate is 15%?
Example 1 (Contd)
Option 1: to lease for the rest analysis period; obtain a
machine to lease at ETB 54,000 a year and a yearly
operation cost of ETB 45,000 for both models.
Option 2: to replace, provided that the price of the new ones
remain the same.
Example 2
The system is not going to be phased out at the end of
5yrs but continues for indefinite time. Assume both
models remain without changes in prices and operating
costs. Which model will be suggested better?
NB:- When analyzing options with different operation
periods, Consider the same time frame by using LCM
2.6 Future Worth (Net Future Value) Method
A corollaryto the present valueand net present worth is
the futurevalueand the net futureworth(NFW).
In this method all cash inflows and outflows of a given
project (having a given project life) are brought to time
n. If the difference between the inflows minus the
outflows is positive then the project is acceptable.
If it is to compare among various projects, the one
having more positive value is economically the best
alternative.
2.7 Annual Equivalent Worth Method
In this case all the cash flow is converted to an equal
uniformseriesof cost or income.
Then for mutual exclusive alternatives, the one with
higher annual income or lower annual cost will be
opted.
This helps to determine an investments worth in terms of
equal annual basis.
The main benefits of this method are:
Report format;
Need for unit cost/benefit analysis; and
Ease of analysis for mutually exclusive projects with
unequal project lives, as long as identical repetition is
to be made as the LCMwill not be required.
Example 3: Compute the AE of Example 1
2.8 Internal Rate of Return (IRR) Method
The internal rate of return, I RR is that interest rate at
which futurecash flows when discountedwill equateto
the initial investment i.e. their present valuewill bezero.
If I RR is Internal Rate of Return and MARR is the
Minimum Attractive Rate of Return (Market Interest
Rate), then if :
IRR > MARR Accept;
IRR = MARR Indifferent; and
IRR < MARR Reject.
4. Depreciation
IRR is the interest which makes the summation of present
worth value to be zero.
This expression only works for cash flows with 3yrs of
life. Cash flow projecting beyond three years involve
complex polynomial functions.
( )
IRR i
n
n
i
n
A
n
i
PW
n
i
n
A
i
A
i
A
i PW
= =
+
=
+
+ +
+
+
+
=
|
.
|
\
|
|
.
|
\
|
|
.
|
\
|
|
.
|
\
|
; 0
0 1
0
1
....
1
1
1
0
1
0
Computationof I RR
Plot the PWcash flow against interest (horizontal axis).
A. Simple Investment
B. Non-simple Investment
P
w
Computationof I RR
2.8.1Direct SolutionMethod
This applies when either there is only two flow
transaction of cash flow series or when the projects
servicelifedoesnt exceed2yrs.
Example: consider the following cash flow and compute
the IRR for both options.
n A B
0 -8,000 -16,000
1 0 10,400
2 0 12,000
3 12,000
Computationof I RR
2.8.1Direct SolutionMethod
Solution:
Project A:
E PW (i) = -8000 + 12,000 (P/F, i, 4) = 0
- 8000 +12000/(1+i)
4
= 0 (1+i)
4
= i= 10.6681%
Project B:
PW(i) = -16,000 + 10000/ (1+i)
1
+ 12000/ (1+i)
2
= 0
-16,000 (1+i)
2
+ 10,000 (1+i) + 12,000 = 0
16i
2
21.62 6.4 = 0
i = -1.6 = -160%; not feasible
i = 0.25 = 25%; therefore, i =25%
Computationof I RR
2.8.2Trial andError Approach
In this method, assumea certain valuefor i and compute
PW
(i)
= 0.
PW
(i)
PW
i
> 0-increase i
PW
i
< 0- decrease i
The computation process proceeds until PW
(i)
= 0.
Computationof I RR
2.8.3I ncremental Analysis: twoalternatives
I RR method cant give a clue on the best alternative
when used for investment analysis.
Thus it is recommended to use the incremental analysis.
It is done in such a way that by projecting a cash flow
which is the difference of cash flows of the alternatives
presented for comparative analysis.
Computationof I RR
2.8.3I ncremental Analysis
Example: Select a better option if MARR = 10%.
Yr A B B-A
0 -3,000 -12,000 -9,000
1 1,350 4,200 2,800
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43% 15%
Alternative B is selected
Selection Criterion:-
IRR (B-A) > MARR - select B
IRR (B-A) < MARR - select A
IRR (B-A) = MARR - select either
Computationof I RR
2.8.3I ncremental Analysis: alternativesmorethantwo
Considering two at a time, the selection can be easily
carried out.
Yr A B C B-A C-B
0 -1,000 -1,000 -2,000 0 -1,000
1 900 600 900 -300 300
2 500 500 900 0 400
3 100 500 900 400 400
4 50 100 900 50 800
IRR 21% 26.3%
First Comparison:- Alternative B is better, reject A
Second Comparison:- Alternative C is better; therefore
AlternativeC isacceptable.
2.9 Source of Finance
Collateral base of the domestic construction industry is
very weak.
There are two broad choices for financing construction
projects where as a combination of the two is also
possible:
EquityFinancing;
Debt Financing; and
Hybridof equity and debt.
2.9.1EquityFinancing
Share company:- retained earnings.
Private company:- re-investment of profits.
Issuance of Stocks:- Eg. Ayat Real Estate a couple of
years ago.
2.9.2Debt Financing
It can be grouped in to three main categories:
Short term (up to one year);
Medium term ( 1-5 years); and
Long term (>5 years).
2.9.2Debt Financing
A. Short TermFinancing
It requires more working capital (operating cost).
The current asset need to be much greater than current
liability to come up with a positive working capital.
When negative working capital encountered; the
following measures usually taken:
Delay wage payments and salaries;
Delay credit payment; and
Selling some fixed assets.
2.9.2Debt Financing
Short term financing schemes:
Bank overdraft;
Trade credit; and
Factoring.
i. Bank Overdraft
It has high interest rate.
If not paid, the company will be liquidated and declare
bankruptcy where the client will be sued.
2.9.2Debt Financing
ii. TradeCredit
Acquire supply of materials on a credit basis.
Depends on the credibility of the company.
It has no interest.
iii. Factoring
Delegating another company to fix the credit and collect
the revenues of the company; and finally share the profit
as per the agreement.
2.9.2Debt Financing
B. MediumTermFinancing
Bank loans.
Sale and lease back.
C. LongTermFinancing
Bank loans (International Bank loans).
Bond Financing.
Joint Venture Financing: due to size of the project and its
associated risk where:
Risk shared;
Good opportunity to knowledge;
Capital and material combined; and
Reduces competition.
4. Depreciation
4.1 Definition and Requirements
4.1.1Depreciation: Definition
The number of years over which a machine is depreciated
is called its depreciablelife.
Depreciation is a business expense the government
allows tooffset the lossinvalueof businessassets.
Depreciation deductions reduce the taxable income of
businesses and thus reduce the amount of tax paid.
Accountants define depreciation as follows:
the systematic allocation of the cost of an asset over
its useful, or depreciablelife.
The latter definition is used for determining taxable
income hence, income taxes.
4. Depreciation
4.1 Definition and Requirements
4.1.2DepreciationRequirements
In general business assets can only be depreciated if they
meet the following basic requirements:
The property must have a useful life that can be
determined, and this life must be longer than one year.
The property must be an asset that decays, gets used
up, wears out, becomes obsolete, or loses value to the
owner due to natural causes.
4. Depreciation
4.2 Depreciation Causes
Due to use and obsolescence every equipment loses its
value. This loss is accounted for by depreciating the
equipment every year. Depreciation is a decrease in
valueof anasset eachyear.
Depreciation: whenever any machine or equipment
performs useful work its wear and tear is bound to occur.
This can be minimized up to some extent by proper care
and maintenance but cant be totally prevented.
Obsolescence: is the depreciation of existing machinery
or asset due to new and better invention, design of
equipment of processes etc.
4. Depreciation
4.3 Classification of Depreciation
Depreciation
Depreciation due to
physical condition
Wear and Tear Physical decay Accidental
Deferred
Maintenance &
Neglect
Depreciation due to
functional condition
Inadequacy
Obsolescence
4. Depreciation
4.4 Depreciation Calculation Fundamentals and Methods
4.4.1DepreciationCalculationFundamentals
The following are the methods for calculating
depreciation.
BV
t
=cost basis (d
1
+d
2
+ + d
t
)
This equation is used to compute the book value of an
asset at the end of any time t.
Book value can be viewed as the remaining unallocated
cost of an asset:
Book value =Cost Depreciation charges made to date
Note:
If the item has a salvage value then the final book value
will be the salvage value.
4. Depreciation
4.4 Depreciation Calculation Fundamentals and Methods
4.4.2DepreciationCalculationMethods
The following are the methods for calculating
depreciation.
Straight lineMethods,
DecliningBalanceMethod(esp. DDB),
TheSumOf theYears Digits(SOYD) Method,
Sinking fund Method,
Annuity Charging method,
The Insurance policy method,
The Revaluation or Regular Valuation method, and
Machine Hour Basis method.
4. Depreciation
4.5 Calculation of Depreciation
4.5.1Straight LineMethod
This method assumes that the loss of value of machine is
directly proportional to its age. It means one should
deduct the scrap value from the original value and divide
the remaining value by the number of years of useful life.
D =(C-S)/N
Where: D = Depreciation amount per year.
C = Initial cost of a machine.
S = Scrap/Salvage value.
N = Number of years of life of machine.
4. Depreciation
4.5.2[Double] DecliningBalanceMethod
For straight line depreciation with N years, the rate of
decrease each year is 1/N.
Declining balance depreciation uses a rate of either 150%
or 200%of the straight-line rate.
Since 200% is twice the straight-line rate, it is called
double declining balance (DDB).
The DDB equation for any year is
DDB depreciation d
t
= (2/N) ( Book value)
Book value = Initial cost total charges to date,
So,
DDB deprec. d
t
= (2/N) (Initial cost total charges to date)
4. Depreciation
4.5.2[Double] DecliningBalanceMethod
It can be shown for DDB, that the depreciation schedule
in year t is given by:
DDB depreciation in year t =(2B/N)(1 2/N)
t-1
For 150% declining balance depreciation, the
depreciation in year t is given by:
DB depreciation in year t =(1.5 B/N)(1 1.5/N)t-1.
Where: B = Book Value
It is common usually to use DDB in many depreciation
computations.
4. Depreciation
4.5.3Sumof YearsDigits(SOYD) Method
SOYD depreciation causes larger decreases in book value
in earlier years than in later years.
d
t
=[(N+1-t)/SOYD](B-S) =[2(N+1-t)/(N(N+1))](B-S)
Where: 2(N+1-t)/N(N+1) = multiplier
B = Book Value
S = Scrap/Salvage value.
The product of the multiplier and B-S for the year is the
depreciation charge for the year. Note the multipliers add
to 1. i.e. (N+1-t)/SOYD=2(N+1-t)/N(N+1) =1
4. Depreciation
Example: Depreciation
An excavator costs Birr 5, 000,000.00 with a scrap value
of Birr 200,000 after its useful life of 5 years in the
taxpayers hand. Calculate the depreciation value in the
useful life of this machine using:
Straight line method,
SOYD method, and
DDB method.
Show your result in the entire useful life of the excavator.
Compare and comment on both results by the help of a
graph.
THANK YOU!

Project Financial Appraisal

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COTM 5104: CONSTRUCTION MANAGEMENT

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