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ngineering Economics Chapter 9

DEPRECIATION & INCOME TAX


. Depreciation -- concepts & methods
. Capital cost allowance (CCA)
. Tax concept
. After tax comparisons of projects & economic feasibility
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Depreciation: a decrease in worth of an asset; recognized by tax regulations as an
expense of operating a business for tax purposes.
Causes of Declining Value -- physical, technological, etc.
Depreciation Methods:
. Straight Line (constant depreciation) Method
. Declining Balance Method
. Other methods
___________________________________________________________
CHEER/SHEER Software: Use Depreciation Methods & After Tax Cash Flow
Modules (Canadian & U.S. regulations).
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Straight Line Method of Depreciation
P= purchase price S=Salvage value at the end of useful life N= useful life (yrs)
n= years from time of purchase
Annual depreciation charge DC=(P-S)/N

Book value at the end of year n = BV(n)=P-n[(P-S)/N]


Example: P = $7000 S=$1000 N=5 years
DC (Constant/Yr.)= (7000-1000)/5= 1,200
Accumulated depreciation (depreciation reserve) at the end of Yr.3 = BV(3) = Book
value at the beginning of Yr.4 = 7000-3[(7000-1000)/5]= 3,400
Or it could be found as:
= Purchase price - Sum(of depreciation charges) = 7000-3(1200)= $3,400
Note: This method is used for company asset valuation, etc. Revenue Canada requires
another method (described later).
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Capital Cost Allowance (CCA)
Under the Canadian Tax Regulations, businesses can claim allowances on property,
equipment, etc. used to earn income.
The depreciation deduction is referred to as a Capital Cost Allowance (CCA). Under
the CCA system, depreciable property or assets are grouped into specific classes.
Property and assets within each class have the same method and rate of depreciation.
See Tables 9.2 (CCA Declining Balance Classes and Rates) and Table 9.3 (CCA,
Straight Line Classes).
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Methods used to determine CCA:
. Declining Balance Method: CCA rate is applied to the Undepreciated Capital Cost
Allowance (UCC), also called Book Value.
. Straight Line Method: CCA rate is applied to the purchase price.
_______________________________________________________________
Note: Depreciation is the same as Capital Cost Allowance.

For Straight Line Depreciation, S may not specified. See Table 9.3 (of text book). A
percentage of purchase price (e.g., 50%) can be specified.
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Capital Cost Allowance, Straight Line Classes (Table 9.3)
Examples
Class 12 .. computer software(except system software) . CCA rate =100%
For example, if $10,000 is the purchase price, the CCA allowance is $10,000 in yr.1
Class 27 air pollution control equipment .. CCA rate = 50%
For example, if P=10,000, the CCA allowance is: 5000 for yr.1 and 5000 for year 2.
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Half-Year Rule
During year 1, for specified assets, one-half of the normally allowable depreciation
can be claimed.
Example: Class 8: 20% CCA => 10% for yr.1 is allowed.
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Capital Cost Allowance: Straight Line Classes
Class 29: CCA rate = 50%
Half-yr exempt.
Purchase price = $10,000 in 2001
CCA in 2001= 10,000x0.5= $5000
CCA in 2002= $5000
Sum of depreciation = $10,000

Now assume that for this class, half-year rule is applicable; CCA = 50%
CCA in 2001 = ($10,000)(0.5)(1/2) = $2,500
CCA in 2002 = ($10,000)(0.5) = $5,000
CCA in 2003 = ($10,000-($2500+$5000))= $2,500
Sum of depreciation = $10,000
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Declining Balance Method
It is a means of amortizing an asset at an accelerated rate early in its life.
For "Half-Year Rule" Exempt Assets:
BV(n) = P(1-depreciation rate) n
DC(n) = BV(n-1)(depreciation rate)
Where
P = purchase price
n= year from time of purchase
BV(n) = Book value at the end of year n (also called undepreciated capital cost UCC)
BV(n-1)= Book value at the end of year n-1
DC(n)= Depreciation charge for year n
For Assets with "Half-Year Rule" Applicable:
BV(n) = (P/2)(1-depreciation rate) n-1 +(P/2)(1-depreciation rate) n
DC(n) = BV(n-1)(depreciation rate)
Half-Year Rule & Declining Balance Method

Example: Purchase price of equipment = $700Million. CCA = 20%. Half-Yr. rule is


applicable.
Year 1 Depreciation = $700x20% CCA ratex0.5 = $140/2=$70
Yr.2 Depreciation = ($700-70)x20% rate = $126
Note: ($700/2)(0.2) + [($700/2)-$70](0.2) = $126
Yr.3 Depreciation = ($700-$196 total of yrs.1 and 2 depreciation)(0.2) = $101
Undepreciated Capital Cost (UCC) or Book value at the end of year 3=
[Undepreciated balance at the beginning of yr.3 of $504]-[Yr.3 depreciation of $101]=
$403
Another Approach:
UCC @ the end of yr.3 = (Purchase price/2)(1-CCA rate) 3 + (Purchase price/2)(1CCA rate)2
= ($700/2)(1-0.2)3 + ($700/2)(1-0.2)2 = $179.20 + $224.00 = $403.20
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Capital Cost Allowance: Declining Balance Method
Example: Purchase price of equipment = $700M. CCA = 20%. Half-yr. rule is not
applicable. Find depreciation for years 1,2,and 3 and book value at the end of year 3.
Solution: (drop M)
Yr.1: CCA=(700)(0.2)=140
Yr.2: UCC=700-140=560
CCA=560x0.2= $112
Yr.3: UCC=560-112=448
CCA=448x0.2= 89.6
Book Value at the end of Yr.3 = UCC= 448-89.6=358.4

Year

UCC @ beginning of year

UCC @ end of year

CCA

$700

$700

$560

$140

560

448

112

448

358.4

89.6

Income Tax Considerations


Types of Taxes: Governments (i.e. federal, provincial, and municipal) charge various
types of taxes. Some of these are: property taxes, excise taxes (on production of
certain products), income taxes.
Corporate Income Taxes
. Taxable income = (gross income - expenses - interest on debt - capital cost
allowance)
. Corporate income tax = (taxable income)x(effective tax rate)
. After tax cash flow (ATCF) = gross income - expenses - debt payment - income tax
Effective tax rates: See text book
Types of corporations & income/gains: a number of types. See text book.
Capital Gain, CCA Recapture, Tax Shield Adjustment
Capital Gain: If sale price (i.e., salvage or disposition) > original purchase price,
apply capital gain tax at 1/2(tax rate t) or any other capital gain tax rate specified.
Sale price - Purchase price = Capital gain

If sale price = purchase price, no capital gain.


CCA Recapture: If sale price is higher than UCC or book value, CCA recapture
applies.
CCA Recapture = (Sale price - UCC)(tax rate)
Note: Here, sale price < purchase price. On the other hand, if sale price > purchase
price, both capital gain tax and CCA recapture apply
Tax Shield Adjustment:
If (sale price - UCC) = 0, no CCA recapture or tax shield adjustment applies.
If (UCC-sale price) > 0, tax shield adjustment could be required.
Capital Gain & CCA Recapture: Example
Purchase price = $50,000 five years ago.
Sale price = $60,000
Effective tax rate = 46%
Class 8=> CCA rate = 20% Declining Balance class (half-yr. rule)
Capital Gain:
Capital Gain = 60,000-50,000 = 10,000
Assumed tax rate for capital gain = (1/2)(effective income tax rate)
Capital gain tax = (1/2)(0.46)(10,000) = $2,300
CCA Recapture:
UCC or book value after 5 yrs of use (half yr. rule) = (50,000/2)(1-CCA rate of 0.2) 4 +
(50,000/2)(1-CCA rate of 0.2)5 = $18,429
CCA recapture = (purchase price - UCC)(tax rate) = (50,000-18,429)(0.46) =
$14,522.66
Total tax on asset disposal = $2,300 + $14,522.66 = $16,822.66

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After-Tax Cash Flow Analysis
Example: For a 3 year project, the following estimates are provided. Find the Net
Present Worth (after-tax). Purchase price=$700M. Resale=$450M.
Income/yr=$500M. Expenses=$350M/yr. CCA=20% (half yr. rule applicable). Loan =
$550M, to be repaid in 3 years @ 8% interest rate. Tax rate = 40% and MARR (after
tax) = 9%.
Solution: Drop M.
Yr.

Income

Expenses

CCA

700

Loan

Loan

Principal

Interest

Taxable Income

Tax

550

After Tax
Cash
Flow

-150

500

350

70

169.42

44.00

36.00

14.40

-77.82

500

350

126

182.97

30.45

-6.45

-2.58

-60.84

500

350

100.8

197.61

15.81

33.39

13.36

-76.78

Salvage

450.00

CCA
recapture

-18.72

NPW= (-700+550)-77.82(P/F,9%,1)-60.84(P/F,9,2)+(-76.78+450.00-18.72)(P/F,9%,3)
= $1.14M (Feasible)

Calculations:
CCA for Yr.1=700(1/2)(0.2)= 70
CCA for Yr. 2 =(700-70)(0.2)=126
CCA for Yr.3=(700-70-126)(0.2)=100.80
UCC (at the end of Yr.3)=700- Sum of (70+126+100.80)=403.20<450 salvage
Since salvage > UCC, CCA recapture applies.
CCA recapture=[450-403.20](tax rate of 0.4)= 18.72 ( a tax, a negative cash flow
item).
Loan: principal = 550 Interest = 8%
Equal annual payment A = 550(A/P,8%,3)=213.42
Yr.1: Interest= 550x0.08= 44.00; Principal = 213.42-44.00=169.42
Yr.2: Balance of principal= 550-169.42=380.58; Interest=380.58x0.08=30.45;
Principal=213.42-30.45=182.97
Etc.
Taxable Income = income-expenses-CCA-interest
Yr.1: 500-350-70-44=36.00
Yr.2: 500-350-126-30.45=-6.45
Etc.
Tax @ 40% = (Taxable Income)(0.40)
Yr. 1: 36x0.4=14.40
Yr.2: -6.45x0.4 = -2.58
Etc.
After Tax Cash Flow (ATCF) = Income-Expenses-Loan repayment-Tax

Yr.1: 500-350-213.42-14.40 = -77.82


Etc.
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CCA Tax Shield (Tax Deductions/Savings)
Assumed investment of $1
CCA rate (depreciation) = d (declining balance)
Tax rate = t
Yr.1 capital cost allowance = $1(d)
Yr.1 tax saving due to CCA = $1(d)(t)
Yr.2 capital cost allowance = (1-d)(d)
Yr.2 tax savings due to CCA=(1-d)(d)(t)
Yr.3 capital cost allowance=[(1-d)-(1-d)(d)]d
Yr.3 tax savings=(1-d)2(d)(t)
..
Yr.N tax savings=(1-d)N-1(d)(t)
Sum of tax savings in PW = (P/F,i,1)[(dt)]+ (P/F,i,2)(1-d)(dt)]+ (P/F,i,3)[(1-d)2(dt)]+..
+..
= CCA Tax Shield = [td/(i+d)]
Capital Cost Tax Factor (i.e. actual cost to investor): CCTF=1-Tax Shield= 1-[td/
(i+d)]
Note: P/F,i,N = 1/(1+i)N
Tax Shield & Capital Cost Tax Factor

Full-Yr. Rule: PW of CCA Tax Shield = td/(i+d)


CCTF=1-Tax Shield= 1-[td/(i+d)]
Out of $1, the amount of capital cost for after-tax calculations -- the actual cost to the
investor
Example: If CCTF=0.7, you pay $0.70, not $1. You save$0.30 due to CCA allowance.
Half Yr.-Rule: PW of CCA tax shield= 0.5[td/(i+d)]+ 0.5[td/(i+d)][1 /(1+i)]
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Note: If (UCC-Sale price or salvage) = 0, no tax shield and no CCA recapture.
If (UCC-Sale price)>0, tax shield adjustment can be claimed.
If salvage(sale price)>UCC, CCA recapture applies.
If sale price>purchase price, capital gain and CCA recapture apply.
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After-Tax Cash Flow Analysis
Example: For a 3 yr. project, find the After Tax Cash Flow (ATCF) and Present Worth
of ATCF.
Purchase price=700M. Resale (salvage) =300M. Income/Yr.=500M.
Expenses=$200M/Yr.
Asset is declining balance type, with CCA rate=20%, half-yr. rule exempt. Tax
rate=40%. MARR (after tax)= 7.5%
Solution: (Drop M)

Yr.

Income

Expenses

CCA

Taxable
Income

Tax

ATCF

700

-700

500

200

140.00

160.00

64.00

236.00

500

200

112.00

188.00

75.20

224.80

500

200

89.60

210.40

84.16

215.84

Salvage

300.00

Tax shield
adjustment

16.99

NPW= - 700+236.00(P/F,7.5%,1)+224.80(P/F,7.5%,2)+(215.84+300.00+16.99)
(P/F,7.5%,3)
= $142.97 (Feasible).
Calculations:
CCA for Yr.1=(700)(0.2)= 140
CCA for Yr.2=(700-140)(0.2)=112.00
CCA for Yr.3=(700-140-112)(0.2)=89.60
UCC=700-Sum of (140+112+89.60)=358.40>300 salvage
Tax shield adjustment applies.
For t=0.4, d=0.2, i=0.075
Tax shield adjustment = [(358.40)-(300)]x[td/(i+d)]= $16.99

Taxable income:
Yr.1: Income -expenses-CCA = (500-200-140)=160
Yr.2: (500-200-112) = 188
Yr.3: (500-200-89.60)= 210.40
Tax @ 40%
Yr.1: (Taxable income)x0.4=160x0.4=64
Etc.
After Tax Cash Flow
Yr.1: (Taxable income - expenses - tax) = (500-200-64) = 236
Etc.
CCTF Method: If half-yr. rule is applicable, apply CCTF (half-yr rule) to investment
& CCTF full-yr. rule to salvage. In this case, half-yr. rule does not apply. So apply
CCTF full-year to both investment and salvage.
NPW = - (Investment)(CCTF) + PW of Net Income (after tax) + (Salvage)
(CCTF)x(P/F,7.5%,3)

Yr.

Income-Expenses

Taxable Income

Tax

ATCF

500-200=300

300

120

180

500-200=300

300

120

180

500-200=300

300

120

180

PW of after tax net income = $180(P/A,7.5%,3) = $468.09

CCTF=1-tax shield = 1-[td/(i+d)]=0.709


NPW = -700(CCTF 0.709) + 468.09 + 300(CCTF 0.709)(P/F,7.5%,3)
= $143.00M (feasible)
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Engineering Economics Chapter 10


EFFECTS OF INFLATION
Inflation: A general increase in the price level. A decline in the buying power of the
dollar.
Causes of Inflation:
"Too much money chasing too few goods".
Cost-push inflation
Demand-pull inflation
Impact of international forces on prices and markets (e.g. energy prices)
Unresponsive prices that seldom decline, regardless of market conditions -when wages are set by unions and prices are set by large firms
Inflation psychology "buy ahead" and repay loan with cheaper dollars.
Consequences of Inflation & Control of Inflation: See text book.
Measures of Inflation
. Consumer Price Index (CPI) : An index of general inflation -- for retail price change.
. Wholesale Price Index (WPI): for both consumer and industrial goods at the
wholesale level,

but not services.


. Construction Price Index
. Transportation Price Index
. Etc.
Rate of Inflation (Canada

Year

1991

1992

1993

1994

1995

CPI

98.5

100

101.8

102.0

104.2

Year

1996

1997

1998

1999

2000

CPI

105.9

107.6

108.6

110.5

113.5

Using an annual compound rate of inflation of f, average rate of inflation during 19962000 period:
104.2(1+f)5 = 113.5
f = 1.7%
Average rate of inflation during 1992-2000 period:
98.5(1+f)9 = 113.5
f = 1.58%
Inflation rate in 2000 = [(113.5-110.5)/110.5]x100 = 2.7%
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_________

Current or Actual dollars (i.e. inflated dollars) vs. Constant or Real dollars (i.e.
inflation removed)

1998

1999

2000

CPI

108.6

110.5

113.5

Revenue of ABC Co.


in current $(M)

$20

$20.35

20.90

Revenue in constant $
of 1998*

20

20

20

Revenue in constant $
of 2000**

20.9

20.9

20.9

Revenue in constant $
of 1999

20.35

20.35

20.35

Calculations:
* 1998 revenue is already in 1998$. No change.
1999 revenue: 20.35(108.6/110.5)= 20
2000 revenue: 20.9(108.6/113.5)=20
** 2000 revenue is already in 2000$. No change.
1998 revenue; 20(113.5/108.6)=20.9
1999 revenue: 20.35(113.5/110.5)=20.9
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Treatment of Inflation in Economic Evaluations


Estimate costs & revenues in current or actual dollars or convert to constant or real
dollars.
Inflation, Cost of Capital & MARR
. Cost of capital is generally higher than (experienced & expected) rate of inflation.
. Investors who obtain funds by borrowing -- they assign MARR higher than cost of
capital.
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_________
Note: MARR could be specified in actual dollars (i.e. inflation included) or in real
dollars (i.e. constant dollars -- inflation removed). Unless otherwise stated, consider
MARR to be in actual $ terms.
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_________
Example: For a project in country X, proposed initial cost in 2001$ = $2000. Net
income/yr for 3 years = $850/yr (in yr. 2001$ -- i.e. in the constant dollar of 2001).
Expected inflation = 5%/yr (average). MARR = 15% (in actual dollars) (includes
inflation). Feasible?
Solution:
Since MARR is in actual dollars, use actual dollar calculations (i.e. convert constant
dollars into actual dollars).
NPW = - $2,000+ $850(F/P,5%,1yr)(P/F,15%,1) + $850(F/P,5%,2)(P/F,15%,2)
+ $850(F/P,5%,3)(P/F,15%,3) = $132 (Feasible)
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Combined Interest-Inflation Rate
An interest rate (discount rate) can be found that represents both (a) the minimum
required rate-of-return (ireal) in constant dollars, and (b) the inflation factor or rate (f).

if = interest rate in actual dollars = (1+ ireal)(1+f) - 1


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Example: In country ABC, XYZ Co.
ireal = 12% (in constant $s), f=6%
if = interest rate in actual dollars = (1+ 0.12)(1+0.06)-1 = 0.1872 => 18.72%
Revenue in real or constant dollars of year 0

Proposal

Cost @ end of
Yr.0

Revenue

Revenue

Revenue

Revenue

Yr.1

Yr.2

Yr.3

Yr.4

$10,000

$4,000

$4,000

$4,000

$4,000

14,000

5,500

5,500

5,500

5,500

Difference

4,000

1,500

1,500

1,500

1,500

A=>B

Calculations in real $ terms @ ireal = 12%:


NPW A=>B = -$4000 + $1500(P/F,12%,1) + $1500(P/F,12%,2) + $1500(P/F,12%,3)+
$1500(P/F,12%,4) = $556 (feasible)
Calculation in actual $ terms @ if = 18.72%, f = 6%:
NPW A=>B = -$4000 + $1500(F/P,6%,1)(P/F,18.72%,1) + $1500(F/P,6%,2)
(P/F,18.72%,2) + $1500(F/P,6%,3)(P/F,18.72%,3)+ $1500(F/P,6%,4)(P/F,18.72%,4) =
$556 (feasible)

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Example: Investment = $100,000; Salvage = $5,000; N= 3 years; CCA=20%
declining balance & Half-yr. rule exempt. ireal = 8%. General inflation f = 4%. Tax rate
= 40%.
Two cost categories: cost category 1 inflation = 3%. Cost category 2 inflation = 4%

Yr.

Cost Item 1 (Actual $)

Cost Item 2 (Actual $)

Total

$30,000

$40,000

$70,000

30,900

41,600

72,500

31,827

43,264

75,091

Example calculations:
Item 1:
For yr.2: $30,000(F/P,3%,1) = $30,900
For yr.3: $30,000(F/P,3%,2)=$31,827
Item 2:
For yr.2: $40,000(F/P,4%,1) = $41,600
For yr.3: $40,000(F/P,4%,2) = $43,264
Sales :
1000 units in year 1, growth in sales = 5%/yr.
Yr. 2 sales = 1000(F/P,5%,1) = 1050 items

Yr. 3 sales = 1000(F/P,5%,2) = 1103 items


Price in yr. 1= $100/unit, price inflation = 4%
Price in yr.2 =$100(F/P,4%,1) = $104.00
Price in yr. 3 = $100(F/P,4%,2) = $108.16
Revenue in actual dollars:
Yr.1: $100/unitx1000 units = $100,000.00
Yr.2: $104/unitx1050 units = $109,200.00
Yr.3: $108.16/unitx1103units = $119,300.48
CCA
Yr.1: 0.2($100,000) = $20,000
Yr.2: 0.2($100,000-20,000) = $16,000
Yr.3: 0.2($100,000 - $20,000 - $16,000) = $12,800
UCC @ end of yr.3 = $100,000 - Sum(CCA) = $51,200
Since UCC>Salvage, tax shield adjustment applies.
Tax shield adjustment = (UCC-Salvage)x[td/(i+d)]
Here t = 0.4, d=0.2, i=0.1232 (see below)
Tax shield adjustment = $11,435.64
After-Tax Analysis (Actual$)
if = interest rate in actual dollars = (1+ ireal)(1+f) - 1 = = (1+ 0.08)(1+0.04) - 1 =>
12.32%

Yr

Revenue

Investment &
Expenses

CCA

Taxable
Income

Tax

ATCF

$100,000

-$100,000

$100,000

70,000

20,000

10,000

4,000

26,000

109,200

72,500

16,000

20,700

8,280

28,420

119,300

75,091

12,800

31,409

12,563.60

48,081.04

Salvage

5,000

Tax shield
adjustment

11,435.64

NPW= - $100,000 +$26,000(P/F,12.32%,1) + $28,420(P/F,12.32%,2)


+ ($48,081.04+$5,000+$11,435.64)(P/F,12.32%,3)
= - $20,393.05 (Not feasible)
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Engineering Economics Chapter 11


SENSITIVITY ANALYSIS
It involves repeated computations with different values of variables involved &
answer is checked.
Examples: Change demand, cash flow (costs, revenues), N, i, etc. and see change in
answer.

Example:
{Demand levels}=>{Corresponding network design or plant size, or organization
size}=>{Forecast of cost, revenues}=>{NPWs}
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Example:
For the following cash flow, find NPW @ 15% interest. Next vary interest and
revenue by 10%, 20%,-10% and -20%.

Period

Capital Investment

Gross Revenue

O&M Expenses

$10.0M

$5M

$1M

$5M

$1M

$5M

$1M

Salvage

$4.17M

Solution:
Base Case:
NPW = - $10M + $5.0M(P/A,15%,3) - $1M(P/A,15%,3) + $4.17M(P/F,15%,3) =
$1.87M
Change i by +10%: i=15%(1.1)=16.5%
NPW @ i =16.5% = $1.55M
Change revenue by 10%: new revenue/yr = $5M(1.1) = $5.5M/yr

NPW @ 15% with $5.5M/yr revenue = $3.02M


Results (in $M): sensitivity of proposal's NPW to changes in i values & revenue/yr.

% Deviation

Revenue

Interest Rate

-20%

- 0.41M

2.58M

-10%

0.73M

2.22M

0% (Base Case)

1.87M

1.87M

+10%

3.02M

1.55M

+20%

4.16M

1.24M

These results can be plotted for visual observation.


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Engineering Economics Chapter 12
BREAKEVEN ANALYSIS
. To define conditions when revenues = costs or benefits=costs
. To establish
- selling price
- no. of items to produce

- etc.
. To define regions of feasibility
Costs & Prices
a. Selling price/unit = (Fixed cost + Variable cost)/unit + Profit/unit
b. Examples of fixed costs:
These do not vary with units produced: rent, insurance, infrastructure
ownership cost, property taxes, executive salaries, research & development, etc.
c. Examples of variable costs: direct labour & supervision, direct supplies & raw
material, packaging, sales commission, royalties, etc.
Breakeven Analysis
At breakeven point(s):
TC=TR or Z=TR -TC=0
Where
TC is total cost = FC + VC
FC is fixed cost
VC is variable cost
Z is profit
TR is total revenue = (price/unit)x(no. of units sold)
Notes:
. Average Total Cost (ATC) = TC/n
. Average Revenue = TR/n
. Marginal Cost (Marginal total cost) = d(TC)/dn
(i.e., it is the slope of the total cost function)

. Marginal Revenue = d(TR)/dn


________________________________________________________________
______________
From basic principles, it can be shown that:
. Maximum profit occurs @ the point when marginal revenue = marginal cost
. At the point of minimum average total cost, average total cost = marginal cost
________________________________________________________________
______________
Example: Minimum Unit Cost Level of Production
Total cost TC = 0.005n2 + 4n + 200,000
Average total cost ATC = TC/n = 0.005n + 4 + (200,000/n)
To find n for min. ATC: d(ATC)/dn =0= 0.005-(200,000/n2)
n = 6,325
ATC @ n of 6,325 units = $67.25
Marginal total cost(MTC) = d(TC)/dn = 2x0.005xn +4
At n=6,325, MTC= $67.25
Note: At the point of minimum ATC, MTC=ATC
________________________________________________________________
______________
Costs, Revenues, Profit, Production Levels
Example: Total cost TC = 10,000 + 2n2 x10-4
Where n = number of units produced/yr.
Total revenue TR = 100n - 0.01n2

Find :(a) Min. unit cost & n for min. unit cost. (b) Production for max. profit.
(c) Breakeven level of production.
Solution:
(a) ATC= TC/n= [10,000 + 2n2 x10-4]/n = 10,000/n + 2n x10-4
To find Min. ATC: d(ATC)/dn=0= - 10,000/n2 + 2x10-4
n = 7,071 units/yr. ATC min = 2.83
(b) Total revenue = (price/unit) x (units sold)
Given TR = 100n - 0.01n2
Marginal revenue MR = d(TR)/dn = 100-0.02n (1)
Marginal cost MC = d(TC)/dn = d(10,000 + 2n2 x10-4)/dn
= 4n x10-4 . (2)
Since Max. Profit occurs @ Marginal Revenue = Marginal Cost, set (1) = (2)
and solve for n
n = 4,902 units for max. profit
d. Break-even point(s) (BEP):
At BEP, total cost = total revenue
10,000 + 2n2 x10-4 = 100n - 0.01n2
n = 100 or 9,700 units
_____________________________________________________________________
_________
Example: Given TC=$63,000+$30n and TR= $120n. Find (a) breakeven point (BEP),
(b) Average total cost, (c) Marginal total cost, (d) Average revenue, (e) Average
revenue, (f) Production level for min. unit cost, (g) Production level for max. profit.
Solution:

. BEP @ TC=TR
$63,000+$30n = $120n, solve for n
n = 700 units
. ATC = TC/n = ($63,000+$30n)/n
. Avg. Revenue = TR/n = 120n/n = $120
. Marginal Revenue = dTR)/dn = $120
. Marginal total cost = MTC = d(TC)/dn = $30
. BEP @ avg. revenue = avg. total cost
Ans. 700 units
. Production level for min. ATC @ n=> infinity
. Production level for max. profit @ MTC=MR.
Ans: n => infinity
_____________________________________________________________________
_________
Breakeven Analysis: Further information on Relationships
Total revenue = TR=n.SP
Where n is units sold and SP is sale price
Total cost = TC = nVC+FC
Where VC is variable cost per unit and FC is fixed cost
Gross Profit = Z = TR-TC = nSP-(nVC+FC) = n(SP-VC) - FC
(SP-VC) is called contribution.
It is a measure of the portion of the selling price that contributes to paying the fixed
cost.

If SP=VC, contribution = 0
At BEP: Z=0=n(SP-VC)-FC
FC=n(SP-VC)
n = FC/(SP-VC)
_____________________________________________________________________
_________
Example:
Given: Fixed Cost FC = $63,000
Selling Price SP = $120
Contribution (SP-VC) = 75% of SP = $90
Full capacity @ n = 1000 units
Tax rate = 40%
Find: (a) Net profit at full capacity. (b) Break-even level of production.
Solution:
a. SP-VC = $90
VC = $120-$90 = $30
Z = TR-TC = [n(SP-VC) - FC] = [1000($120-$30) - $63,000] = $27,000
Net profit after tax = (1- Tax rate)(Profit) = (1-0.4)($27,000) = $16,200
(b) BEP @ n = FC/(SP-VC) = 63,000/90 = 700 units
_____________________________________________________________________
_________
Engineering Economics Chapter 13
RISK ANALYSIS & UNCERTAINTY

Decisions are made under the following conditions:


Certainty assumption
. All outcomes are known
. Single "State of Nature" is assumed (e.g., a single demand level).
Risk
. Chances of loss or unfavourable impacts
. Cash flows or other outcomes may not be known with certainty, but probabilities can
be assigned (probabilities known/estimated).
Uncertainty
. Probabilities of chance events are not known but can be assigned subjectively or
other decision criteria have to be used.
Decision Making under Risk
. Expected value calculations (decision theory)
. Expected values & study of variances (standard deviations)
. Simulation of events -- Monte Carlo Simulation Technique
_____________________________________________________________________
_________
Statistical and probability concepts and methods are used in risk analysis. Some of
these are noted here.
Sigma = standard deviation
Sigma square = variance -- a measure of dispersion
Variance=[Sum for i=1 to N(Xi - Avg. value of X)2]/N
Where Xi is an estimate ( a data point)
N = no. of data points (for whole population).

Probability concepts: see Glossary 5 (Pages A-19 to A-20) of the Text Book.
Expected Value
EV(X)= Sum for i = 1 to n[P(X= Xi). Xi]
Where
n is number of possible outcomes of variable X
P(X= Xi) is the probability that X= Xi
and Sum of P(X= Xi) for i equal to 1 to n = 1.0
Measures of Variation
e.g. Variance (NPW)
Variance & St. Deviation
V(X) = Sum from i to n [Xi - EV(X)] 2 P(X= Xi)
This formula reduces to :
V(X) = Sum from i to n P(X= Xi) Xi 2 - [EV(X)] 2
or V(X) = EV(X 2 ) - [EV(X)] 2
St. deviation Sigma = Sq. root of V(X)
Also, Coefficient of Variation = [St. deviation/EV(X)]
Risk in Financial Analysis
Expected Value
Investment of $10,000 in a machine. Service duration is N years. Salvage = L.
Maintenance cost for Yr.1 = $1000. For following years, an increase of $200/yr.
MARR = 10%. Given the following information, find Expected Equivalent Annual
Cost.

Salvage L

P(N)

3,000

0.2

2,000

0.4

10

1,000

0.4

Solution:
EAC(N=6 yrs) = -10,000[A/P,10%,6]-1,000-200(A/G,10%,6) + 3,000(A/F,10%,6) = $3,3351.95
EAC(N=8 yrs) = -$3,300.46
EAC(N=10 yrs) = -$3,309.81
E(EAC) = (0.2)(-$3,3351.95) +(0.4)(-$3,300.46) + (0.4)(-$3,309.81) = -$3,314.47
_____________________________________________________________________
_________
Expected Values and Variances
Example: An asset has a first cost of $50,000. Salvage value depends upon how long
it remains in service.
Estimates of salvage value: for 4 yrs of service: $20,000, 5 years of service: 15,000, 6
years of service: 12,000 and 7 years of service: 10,000.
Given that all service periods are equally likely, find the Mean and Standard Deviation
of the asset's present worth. i=15%
Solution:
First find PW of salvage = Salvage(P/F,15%,N)

N= 4 yrs

N=5 yrs

N=6 yrs

N=7 yrs

$11,435

7,458

5,188

3,759

Expected value of PW of salvage = E(PW of salvage)= (0.25)($11,435) + (0.25)


(7,458) + (0.25)(5,188) +(0.25)(3,759) = $6,960
Note: P(4 yrs) = P(5 yrs) = P(6 yrs) = P(7 yrs) = 1/4=0.25
Now find E(NPW) = -$50,000+$6,960 = -$43,040
Variance of NPW: Use formula or V(NPW) = EV(NPW 2 ) - [EV(NPW)] 2
Since there is no variability in first cost,
V(NPW) = V(PW of salvage) = [(0.25)($11,435)2 + (0.25)(7,458)2+ (0.25)(5,188)2
+(0.25)(3,759) 2 ] - (6,960)2 = $8,415,003.5
St deviation of NPW = Sq. root of Variance = $2,900.85
Another approach to finding V(NPW) and St deviation of NPW

PW call it X

P(PW)

(Xi - Avg. value of X)2P(PW)

- 38,565*

0.25

5,006,406**

- 42,542

0.25

62,001

- 44,812

0.25

748,996

- 46,241

0.25

2,561,600

Avg. X=-$43,040

Sum=1.0

V(PW)=$8,415,003.25

V(PW)=$8,415,003.25
St. Deviation = Sq. Root of V(PW) = $2,900.86
Sample calculations:
* PW= - 50,000 + $20,000(P/F,15%,4yrs) = -50,000 + 11,435 = - 38,565
** (Xi - Avg. value of X)2P(PW) = [- 38,565 - (-43,040)] 2(0.25) = 5,006,406
_____________________________________________________________________
_________
Expected Values and Variances
Example: Proposals A & B have EV(A)=EV(B) = $1000
V(A) = $4000 V(B) = 144,000.
Choice?
Solution: Find St. deviations (sigma) and then find Sigma/EV= Coefficient of
variation.
The lower the coefficient of variation, the better. Choice is A.
_____________________________________________________________________
_________
Decision Theory
. Payoff matrix -- dollars are revenue or profit or benefits.
. States of Nature -- their occurrence is probabilistic.

. Actions of the decision maker.

Actions of decision
maker

State of Nature S1

State of Nature S2

P(S1) = 0.4

P(S2) = 0.6

A1

$x=$100M

$y=$125M

A2

$m=$110M

$n=$120M

Note: P(S1)+P(S2) = 1.0


Expected value calculations:
EV(A1) = P(S1)($x) + P(S2)($y)= (0.4)(100)+(0.6)(125) = $115
EV(A2) = P(S1)($m) + P(S2)($n)= (0.4)(110)+(0.6)(120) = $116 (Choice)
_____________________________________________________________________
_________
Risk Analysis: Use of Normal Probability Density Function
Assume that an outcome (e.g. NPW) is normally distributed. What is the probability
that the outcome is less than a selected value x?
That is:
P(Outcome < x) = P(z < (x-Mew)/Sigma)
Where z is the standard normal deviate
Mew is mean value
Sigma is the standard deviation
Example:

Outcome is NPW of a cash flow


x = $875
Mew = $1000
Sigma = $100
P(NPW<$875) = ?
P(z<((875-1000)/100) = P(z<-1.25)
= 0.1056 (read from normal distribution function table given in Appendix F)
_____________________________________________________________________
_________
Note: How to fund probabilities?
If the assumption of Normal Distribution can be made, use Appendix F.
Total area under the curve =1.0, one half the area = 0.5
The areas correspond to probabilities.
For example, the area between z=0 and z=2 is 0.4772
P(z>2) = 0.5-0.4772 = 0.0228
By symmetry:
P(z<-2) = 0.5-0.4772 = 0.0228
_____________________________________________________________________
_________
Risk Analysis:
Given the following cash flow, determine the probability that the investment will
provide a positive NWP. Interest = 15%

End of yr.

Expected value of cash

St. deviation of

P/F factors

E(PW)

flow (1)

cash flow (2)

(3)
(4)=(1)x(3)

-$30,000

1.0000

-$30,000

10,000

1,000

P/F,15%,1

8,696

9,000

1,200

P/F,15%,2

6,805

8,000

1,400

P/F,15%,3

5,260

7,000

1,600

P/F,15%,4

4,002

6,000

1,800

P/F,15%,5

2,983

E(NPW) = $-2,254 (Sum of column (4)= Mean value = Mew


Variance of NPW? Assumption of independence of variance is to be made so as to use
the formula:
V(NPW) = [1,000 (P/F,15%,1)] 2 + [1,200 (P/F,15%,2)] 2 + +[1,800 (P/F,15%,5)] 2
= $4.046 Million
St. Deviation Sigma = Sq. root of V(NPW) = $2,016
Note that investment of $30,000 has zero St. dev.; it does not enter into the equation.
Given the assumption that NPW is normally distributed.
P(NPW>0) = P(z>(0-Mew)/Sigma))?

Here, Mew = -2,254, Sigma = 1.12


(0-(-Mew))/Sigma) = 0-(-2,254))/2,016 = 1.12
P(NPW>0) = P(z>1.12) = 0.5-0.3684 = 0.1316 or 13.16%
_____________________________________________________________________
_________
Risk Analysis: Most Probable Future, Aspiration Level
Probability of returns from three equal size, equal-life investments are provided.

Alternatives NPW

NPW

NPW

NPW

NPW

NPW

Sum of

-$1000

$0

$1000

$2000

$3000

$4000

Prob.

0.11

0.26

0.22

0.02

0.39

1.00

0.29

0.18

0.07

0.46

1.00

0.14

0.10

0.11

0.37

0.28

1.00

Note: the numbers in the table are probabilities.


Most probable future:
Alt. A: P=0.39 & PW=$4000
Alt. B: P=0.46 & PW=$4000 (Choice)
Alt. C: P=0.37 & PW=$2000
For Aspiration Level of $2000 or higher, probability of $2000 or over
Alt A: 0.22+0.02++0.39 = 0.63

Alt. B: 0.46
Alt. C: 0.37+0.28 = 0.65 (Choice)
_____________________________________________________________________
_________
Decision Making Under Uncertainty
Criteria (Rules, Principles, Methods):
. Extremely optimistic criterion (Maximax)
. Extremely pessimistic criterion (Maximin)
. Expected Value Criterion:
Subjective probabilities used
Subjective probabilities modified as a result of "new information" -- Baye's
Theorem used
(Bayesian approach is not covered in this course).
. Laplace criterion -- equal likelihood criterion
. Hurwicz criterion -- blending of optimism & pessimism
. Regret criterion (minimax regret)
_____________________________________________________________________
_________
Example: Payoff matrix is shown below. Which alternative is the best? Use the
following criteria:
a. Maximax (b) Maximin (c) Hurwicz (alpha = 3/8) (d) Minimax regret (e)
Laplace
_____________________________________________________________________
_________
Payoff Matrix ($M of NPW); States of Nature are S1 to S4.

Alternatives

S1

S2

S3

S4

Solution:
a. Maximax -- for each alternative, find the max. payoff & then select the best (to
maximize the max. value).

Alternative

Payoff

5*

Answer=> Select B
b. Maximin -- for each alternative, find the minimum payoff & then select the
best.

Alternative

Payoff

2*

Answer=> Select A
c. Hurwicz Criterion (Alpha = 3/8)
Use of an index of optimism, alpha, applied to Maximax payoff and (1-alpha)
applied to Maximin payoff.

Alternative

Payoff

(3/8)(2)+

(3/8)(5)+

(3/8)(4)+

(3/8)(4)+

(3/8)(4)+

(1-3/8)(2)

(1-3/8)(0)

(1-3/8)(1)

(1-3/8)(1)

(1-3/8)(0)

=2

= 15/8

= 17/8*

= 17/8*

= 12/8

Answer=> Select C or D
d. Minimax Regret Criterion (Rule): to minimize the maximum regret.
Steps: (1) For each state S, find max. payoff. (2) Find (max. payoff -payoff
given) -- Rij Regret Matrix.
Alternative i , Sate j

Alternative

S1

S2

S3

S4

3-2 = 1

5-2 = 3*

3-2 = 1

4-2 = 2

3-1 = 2

5-5 = 0

3-1 = 2

4-0 = 4*

3-1 = 2

5-4 = 1

3-1 = 2

4-1 = 3*

3-1 = 2*

5-3 = 2*

3-1 = 2*

4-4 = 0

3-3 = 0

5-4 = 1

3-3 = 0

4-0 = 4*

Step (3): Find max. Rij for each alternative. See above.
Step (4): Find the alternative with min[max Rij]. Ans: Alt. D.
e. Equal Likelihood Criterion: Laplace Rule
Assume that all states have the same probability.

Alt.

Expected Value

(1/4)(2) + (1/4)(2) + (1/4)(2) + (1/4)(2) = 2.0

= 1.75

= 1.75

= 2.25

= 2.5*

Ans: Alt. E
Summary:
Maximax: Alt B
Maximin: Alt. A

Hurwicz (@ alpha = 3/8): Alt. C or D


Minimax Regret: Alt. D
Laplace (Equal likelihood): Alt. E
Engineering economics, previously known as engineering economy, is a subset of economics for
application to engineering projects. Engineers seek solutions to problems, and the economic viability
of each potential solution is normally considered along with the technical aspects.It is science as well
as an art.
Considering the time value of money is central to most engineering economic analyses. Cash
flows are discounted using aninterest rate, i, except in the most basic economic studies.
For each problem, there are usually many possible alternatives. One option that must be considered
in each analysis, and is often the choice, is the do nothing alternative. The opportunity cost of
making one choice over another must also be considered. There are also non-economic factors to
be considered, like color, style, public image, etc.; such factors are termed attributes.[1]
Costs as well as revenues are considered, for each alternative, for an analysis period that is either a
fixed number of years or the estimated life of the project. The salvage value is often forgotten, but is
important, and is either the net cost or revenue for decommissioning the project.
Some other topics that may be addressed in engineering economics are inflation, uncertainty,
replacements, depreciation, resource depletion, taxes, tax credits, accounting, cost estimations,
or capital financing. All these topics are primary skills and knowledge areas in the field of cost
engineering.
Since engineering is an important part of the manufacturing sector of the economy, engineering
industrial economics is an important part of industrial or business economics. Major topics in
engineering industrial economics are:

the economics of the management, operation, and growth and profitability of engineering
firms;

macro-level engineering economic trends and issues;

engineering product markets and demand influences; and

the development, marketing, and financing of new engineering technologies and products. [2]
[1]

economic environment

Definition

The totality of economic factors, such as employment,income, inflation, interest


rates, productivity, and wealth, thatinfluence the buying
behavior of consumers and institutions.

DEFINITION OF 'TIME VALUE OF MONEY - TVM'


The idea that money available at the present time is worth more than the same
amount in the future due to its potential earning capacity. This core principle of
finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received.
Also referred to as "present discounted value".
Everyone knows that money deposited in a savings account will earn interest.
Because of this universal fact, we would prefer to receive money today rather
than the same amount in the future.
For example, assuming a 5% interest rate, $100 invested today will be worth
$105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year
from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5%
interest rate.

Concept of Equivalence
To compare alternatives that provide the same service over extended periods of time when
interest is involved, we must reduce them to an equivalent basis that is dependent on: ---If two
alternatives are economically equivalent, then they are equally
desirable.

Equivalence factors are needed in engineering economy to make cash flows (CF) at different
points in time comparable. For example, a cash payment that has to be made today cannot be
compared directly to a cash flow that must be made in 5 years.
Since the time value of money changes according to:
1.The interest rate,
2.The amount of money involved,
3.The timing of receipt or payment,
4. The manner in which interest is compounded,
We need a way to reduce CF's at different times to an equivalent basis. Equivalence factors allow
us to do so.

Principles of Equivalence
Equivalent cash flows have the same economic value at the same point in time.
Cash flows that are equivalent at one point in time are equivalent at any point
in time.
Conversion of a cash flow to its equivalent, at another point in time must reflect
the interest rate(s) in effect for each
period between the equivalent cash flows.
Equivalence between receipts and disbursements: the interest rate that sets the
receipts equivalent to the disbursements is
the actual interest rate (IRR).
Economic equivalence is established, in general, when we are indifferent
between a future payment, or series of payments, and a present sum of money.
Notation and Cash Flow Diagrams (CFDs)
The following notation is utilized in formulas for compound interest calculations:
I = effective interest rate per interest period
N = number of compounding periods
P = present sum of money; the equivalent value of one or more cash flows at a
reference point in time called present
F= future sum of money; the equivalent value of one or more cash flows at a reference
point in time called future
A = end-of-period cash flows (or equivalent end-of-period values) in a uniform series

continuing for a specified number of periods, starting at the end of the first period and
continuing through the last period
1. The Horizontal line is a time scale, with progression of time moving from left to
right. The period (e.g., year, quarter, month) labels can be applied to intervals of time
rather than to points on the time scale.
2. The arrows signify cash flows and are placed at the end of the period. If a
distinction needs to be made, downward arrows represent expenses (negative cash
flows or cash outflows) and upward arrows represent receipts (positive cash flows or
cash inflows).
3. The cash flow diagram is dependent on the point of view. The situations shown in
the figure were based on the cash flows as seen by the lender. If the directions of all
arrows had been reversed, the problem will have to be diagrammed from borrower's
viewpoint.

Cash Flow Diagram

DEFINITION OF 'PRESENT VALUE - PV'


The current worth of a future sum of money or stream of cash flows given a
specified rate of return. Future cash flows are discounted at the discount rate,
and the higher the discount rate, the lower the present value of the future cash
flows. Determining the appropriate discount rate is the key to properly valuing
future cash flows, whether they be earnings or obligations.
Also referred to as "discounted value".

Future value is the value of an asset at a specific date.[1] It measures the nominal future sum of
money that a given sum of money is "worth" at a specified time in the future assuming a
certain interest rate, or more generally, rate of return; it is thepresent value multiplied by
the accumulation function.[2] The value does not include corrections for inflation or other factors that
affect the true value of money in the future.

RELATION SHIP BETWEEN PV AND FV

The future value (FV) measures the nominal future sum of money that a given sum of money is
"worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return.
The FV is calculated by multiplying the present value by the accumulation function.

PV and FV vary jointly: when one increases, the other increases, assuming that the interest
rate and number of periods remain constant.

the interest rate (discount rate) and number of periods increase, FV increases or PV decree.

DEFINITION OF 'DISCOUNTED CASH FLOW - DCF'


A valuation method used to estimate the attractiveness of an investment
opportunity. Discounted cash flow (DCF) analysis uses future free cash flow
projections and discounts them (most often using the weighted average cost of
capital) to arrive at a present value, which is used to evaluate the potential for
investment. If the value arrived at through DCF analysis is higher than the current
cost of the investment, the opportunity may be a good one.
Calculated as:

Also known as the Discounted Cash Flows Model.


There are many variations when it comes to what you can use for your cash flows
and discount rate in a DCF analysis. Despite the complexity of the calculations
involved, the purpose of DCF analysis is just to estimate the money you'd receive
from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF
is merely a mechanical valuation tool, which makes it subject to the axiom
"garbage in, garbage out". Small changes in inputs can result in large changes in
the value of a company. Instead of trying to project the cash flows to infinity,
terminal value techniques are often used. A simple annuity is used to estimate
the terminal value past 10 years, for example. This is done because it is harder to
come to a realistic estimate of the cash flows as time goes on.

obsolescence

Definition
Significant decline in the competitiveness, usefulness, orvalue of an article or property.
Obsolescence occurs generally due to the availability of alternatives that perform better or
are cheaper or both, or due to changes in userpreferences, requirements, or styles. It is distinct
from fall in value (depreciation) due to physical deterioration or normalwear and tear.
Obsolescence is a major factor in operating risk, and may require write of of the value of
the obsoleteitem against earnings to comply with the accountingprinciple of

showing inventory at lower of cost or market value. Insurance companies take obsolescence
into accountto reduce the amount of claim to be paid on damaged or destroyed property.
costing

Definition.
System of computing cost of production or of running abusiness, by allocating expenditure to
various stages ofproduction or to diferent operations of a firm.

cost factors

The cost of training requires two separate estimates. One estimate for start up costs
and one for ongoing costs or, in other words, the cost of each class held.
Start up costs are normally expended just once to develop the class lesson plan and to
obtain reusable tools and materials required to hold the classes. Tools and materials
might include the one time purchase of equipment such as overhead projectors, white
boards, televisions, and video cassette recorders. It may also include the cost of
specialized equipment associated specifically with the training to be held.
Development of the class includes the time for a training consultant to prepare a
lesson plan and handouts. This can be the one largest expenditure to develop a class
but is also the one place where money is well spent. The training will not be effective
if the class is not thoroughly planned, fun and interesting for students. A good lesson
plan that outlines almost minute by minute how class time is spent, the learning goals
to be achieved, and how those goals will be accomplished is essential to the training
success.
Finally, start up cost may include the preparation of displays, lab boards and lab areas
where students will practice their new skills. This cost can vary from zero to very
considerable depending on the subject of the training.
Ongoing costs will include consumable materials, replacement tools, lunch and sodas,
room rentals, and teachers fees. These costs will require a detailed estimate that takes
into consideration the unique aspects of the particular training being developed.

Definition: To establish a selling price for a


product
No matter what type of product you sell, the price you charge your customers or clients
will have a direct effect on the success of your business. Though pricing strategies can
be complex, the basic rules of pricing are straightforward:

All prices must cover costs and profits.

The most effective way to lower prices is to lower costs.

Review prices frequently to assure that they reflect the dynamics of cost, market demand,

response to the competition, and profit objectives.


Prices must be established to assure sales.

Before setting a price for your product, you have to know the costs of running your
business. If the price for your product or service doesn't cover costs, your cash flow will
be cumulatively negative, you'll exhaust your financial resources, and your business will
ultimately fail.
To determine how much it costs to run your business, include property and/or
equipment leases, loan repayments, inventory, utilities, financing costs, and
salaries/wages/commissions. Don't forget to add the costs of markdowns, shortages,
damaged merchandise, employee discounts, cost of goods sold, and desired profits to
your list of operating expenses.
Most important is to add profit in your calculation of costs. Treat profit as a fixed cost,
like a loan payment or payroll, since none of us is in business to break even.
Because pricing decisions require time and market research, the strategy of many
business owners is to set prices once and "hope for the best." However, such a policy
risks profits that are elusive or not as high as they could be.
When is the right time to review your prices? Do so if:

You introduce a new product or product line;

Your costs change;

You decide to enter a new market;

Your competitors change their prices;

The economy experiences either inflation or recession;

Your sales strategy changes; or

Your customers are making more money because of your product or service.

Prices are generally established in one of four ways:

Cost-Plus Pricing
Many manufacturers use cost-plus pricing. The key to being successful with this method
is making sure that the "plus" figure not only covers all overhead but generates the
percentage of profit you require as well. If your overhead figure is not accurate, you risk
profits that are too low. The following sample calculation should help you grasp the
concept of cost-plus pricing:
Cost of materials
$50.00
+ Cost of labor
30.00
+ Overhead
40.00
= Total cost
$120.00
+ Desired profit (20% on
30.00
sales)
= Required sale price
$150.00
Demand Price
Demand pricing is determined by the optimum combination of volume and profit.
Products usually sold through different sources at different prices--retailers, discount
chains, wholesalers, or direct mail marketers--are examples of goods whose price is
determined by demand. A wholesaler might buy greater quantities than a retailer, which
results in purchasing at a lower unit price. The wholesaler profits from a greater volume
of sales of a product priced lower than that of the retailer. The retailer typically pays
more per unit because he or she are unable to purchase, stock, and sell as great a
quantity of product as a wholesaler does. This is why retailers charge higher prices to
customers. Demand pricing is difficult to master because you must correctly calculate
beforehand what price will generate the optimum relation of profit to volume.
Competitive Pricing
Competitive pricing is generally used when there's an established market price for a
particular product or service. If all your competitors are charging $100 for a replacement
windshield, for example, that's what you should charge. Competitive pricing is used
most often within markets with commodity products, those that are difficult to
differentiate from another. If there's a major market player, commonly referred to as the
market leader, that company will often set the price that other, smaller companies within
that same market will be compelled to follow.
To use competitive pricing effectively, know the prices each competitor has established.
Then figure out your optimum price and decide, based on direct comparison, whether
you can defend the prices you've set. Should you wish to charge more than your
competitors, be able to make a case for a higher price, such as providing a superior
customer service or warranty policy. Before making a final commitment to your prices,
make sure you know the level of price awareness within the market.

If you use competitive pricing to set the fees for a service business, be aware that unlike
a situation in which several companies are selling essentially the same products,
services vary widely from one firm to another. As a result, you can charge a higher fee
for a superior service and still be considered competitive within your market.
Markup Pricing
Used by manufacturers, wholesalers, and retailers, a markup is calculated by adding a
set amount to the cost of a product, which results in the price charged to the customer.
For example, if the cost of the product is $100 and your selling price is $140, the
markup would be $40. To find the percentage of markup on cost, divide the dollar
amount of markup by the dollar amount of product cost:
$40 ? $100 = 40%
This pricing method often generates confusion--not to mention lost profits--among many
first-time small-business owners because markup (expressed as a percentage of cost)
is often confused with gross margin (expressed as a percentage of selling price). The
next section discusses the difference in markup and margin in greater depth.
Pricing Basics
To price products, you need to get familiar with pricing structures, especially the
difference between margin and markup. As mentioned, every product must be priced to
cover its production or wholesale cost, freight charges, a proportionate share of
overhead (fixed and variable operating expenses), and a reasonable profit. Factors
such as high overhead (particularly when renting in prime mall or shopping center
locations), unpredictable insurance rates, shrinkage (shoplifting, employee or other
theft, shippers' mistakes), seasonality, shifts in wholesale or raw material, increases in
product costs and freight expenses, and sales or discounts will all affect the final pricing.
Overhead Expenses. Overhead refers to all nonlabor expenses required to operate
your business. These expenses are either fixed or variable:

Fixed expenses. No matter what the volume of sales is, these costs must be met every
month. Fixed expenses include rent or mortgage payments, depreciation on fixed assets (such as
cars and office equipment), salaries and associated payroll costs, liability and other insurance,
utilities, membership dues and subscriptions (which can sometimes be affected by sales volume),
and legal and accounting costs. These expenses do not change, regardless of whether a company's

revenue goes up or down.


Variable expenses. Most so-called variable expenses are really semivariable expenses that
fluctuate from month to month in relation to sales and other factors, such as promotional efforts,
change of season, and variations in the prices of supplies and services. Fitting into this category are

expenses for telephone, office supplies (the more business, the greater the use of these items),
printing, packaging, mailing, advertising, and promotion. When estimating variable expenses, use an
average figure based on an estimate of the yearly total.

Cost of Goods Sold. Cost of goods sold, also known as cost of sales, refers to your
cost to purchase products for resale or to your cost to manufacture products. Freight
and delivery charges are customarily included in this figure. Accountants segregate cost
of goods on an operating statement because it provides a measure of gross-profit
margin when compared with sales, an important yardstick for measuring the business'
profitability. Expressed as a percentage of total sales, cost of goods varies from one
type of business to another.
Normally, the cost of goods sold bears a close relationship to sales. It will fluctuate,
however, if increases in the prices paid for merchandise cannot be offset by increases in
sales prices, or if special bargain purchases increase profit margins. These situations
seldom make a large percentage change in the relationship between cost of goods sold
and sales, making cost of goods sold a semivariable expense.
Determining Margin. Margin, or gross margin, is the difference between total sales and
the cost of those sales. For example: If total sales equals $1,000 and cost of sales
equals $300, then the margin equals $700.
Gross-profit margin can be expressed in dollars or as a percentage. As a percentage,
the gross-profit margin is always stated as a percentage of net sales. The equation:
(Total sales ? Cost of sales)/Net sales = Gross-profit margin
Using the preceding example, the margin would be 70 percent.
($1,000 ? $300)/$1,000 = 70%
When all operating expenses (rent, salaries, utilities, insurance, advertising, and so on)
and other expenses are deducted from the gross-profit margin, the remainder is net
profit before taxes. If the gross-profit margin is not sufficiently large, there will be little or
no net profit from sales.
Some businesses require a higher gross-profit margin than others to be profitable
because the costs of operating different kinds of businesses vary greatly. If operating
expenses for one type of business are comparatively low, then a lower gross-profit
margin can still yield the owners an acceptable profit.
The following comparison illustrates this point. Keep in mind that operating expenses
and net profit are shown as the two components of gross-profit margin, that is, their
combined percentages (of net sales) equal the gross-profit margin:

Business A
Business B
Net sales
100%
100%
Cost of sales
40
65
Gross-profit margin
60
35
Operating expenses
43
19
Net profit
17
16
Markup and (gross-profit) margin on a single product, or group of products, are often
confused. The reason for this is that when expressed as a percentage, margin is always
figured as a percentage of the selling price, while markup is traditionally figured as a
percentage of the seller's cost. The equation is:
(Total sales ? Cost of sales)/Cost of sales = Markup
Using the numbers from the preceding example, if you purchase goods for $300 and
price them for sale at $1,000, your markup is $700. As a percentage, this markup
comes to 233 percent:
$1,000 ? $300 ? $300 = 233%
In other words, if your business requires a 70 percent margin to show a profit, your
average markup will have to be 233 percent.
You can now see from the example that although markup and margin may be the same
in dollars ($700), they represent two different concepts as percentages (233% versus
70%). More than a few new businesses have failed to make their expected profits
because the owner assumed that if his markup is X percent, his or her margin will also
be X percent. This is not the case.

PROJECT CASH FLOWS


When beginning capital-budgeting analysis, it is important to determine a
project's cash flows. These cash flows can be segmented as follows:
1. Initial Investment Outlay
These are the costs that are needed to start the project, such as new equipment,
installation, etc.
2. Operating Cash Flow over a Project's Life
This is the additional cash flow a new project generates.

3. Terminal-Year Cash Flow


This is the final cash flow, both the inflows and outflows, at the end of the
project's life; for example, potential salvage value at the end of a machine's life.
Example: Expansion Project
Newco wants to add to its production capacity and is looking closely at investing
in Machine B. Machine B has a cost of $2,000, with shipping and installation
expenses of $500 and a $300 cost in net working capital. Newco expects the
machine to last for five years, at which point Machine B will have a book value
(BV) of $1,000 ($2,000 minus five years of $200 annual depreciation) and a
potential market value of $800.
With respect to cash flows, Newco expects the new machine to generate an
additional $1,500 in revenues and costs of $200. We will assume Newco has a
tax rate of 40%. The maximum payback period that the company has established
is five years.
Let's calculate the project's initial investment outlay, operating cash flow over the
project's life and the terminal-year cash flow for the expansion project.
Initial Investment Outlay:
Machine cost + shipping and installation expenses + change in net working
capital = $2,000 + $500 + $300 = $2,800
Operating Cash Flow:
CFt = (revenues - costs)*(1 - tax rate)
CF1 = ($1,500 - $200)*(1 - 40%) = $780
CF2 = ($1,500 - $200)*(1 - 40%) = $780
CF3 = ($1,500 - $200)*(1 - 40%) = $780
CF4 = ($1,500 - $200)*(1 - 40%) = $780
CF5 = ($1,500 - $200)*(1 - 40%) = $780
Terminal Cash Flow:
Tips and Tricks

The key metrics for determining the terminal cash flow are salvage value of the
asset, net working capital and tax benefit/loss from the asset.
The terminal cash flow can be calculated as illustrated:
Return of net working capital +$300
Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF5+$780
Total year-five cash flow $1,960
For determining the tax benefit or loss, a benefit is received if the book value of
the asset is more than the salvage value, and a tax loss is recorded if the book
value of the asset is less than the salvage value.

DEFINITION OF 'ABSORPTION COSTING'


A managerial accounting cost method of expensing all costs associated with
manufacturing a particular product. Absorption costing uses the total direct costs
and overhead costs associated with manufacturing a product as the cost base.
Generally accepted accounting principles (GAAP) require absorption costing for
external reporting.
Absorption costing is also known as "full absorption costing".
Some of the direct costs associated with manufacturing a product include wages
for workers physically manufacturing a product, the raw materials used in
producing a product, and all of the overhead costs, such as all utility costs, used
in producing a good.
Absorption costing includes anything that is a direct cost in producing a good as
the cost base. This is contrasted with variable costing, in which fixed
manufacturing costs are not absorbed by the product. Advocates promote
absorption costing because fixed manufacturing costs provide future benefits.

Debt Financing
The act of a business raising operating
capital or other capital by borrowing. Most often, thisrefers to the issuance of a bond, debenture, or ot
her debt security. In exchange for lending the money, bond
holders and others become creditors of the business and are entitled to thepayment of interest and to
have their loan redeemed at the end of a given period. Debt financingcan be long-term or short-term. L
ong-term debt financing usually involves a business' need to buythe basic necessities for its business, su
ch as facilities and major assets, while short-term debtfinancing includes debt securities with shorter rede
mption periods and is used to provide day-to-daynecessities such as inventory and/or payroll.

DEFINITION OF 'EQUITY FINANCING'


The process of raising capital through the sale of shares in an enterprise. Equity
financing essentially refers to the sale of an ownership interest to raise funds for
business purposes. Equity financing spans a wide range of activities in scale and
scope, from a few thousand dollars raised by an entrepreneur from friends and
family, to giant initial public oferings (IPOs) running into the billions by household
names such as Google and Facebook. While the term is generally associated
with financings by public companies listed on an exchange, it includes financings
by private companies as well. Equity financing is distinct from debt financing,
which refers to funds borrowed by a business.
Equity financing involves not just the sale of common equity, but also the sale of
other equity or quasi-equity instruments such as preferred stock, convertible
preferred stock and equity units that include common shares and warrants.
A startup that grows into a successful company will have several rounds of equity
financing as it evolves. Since a startup typically attracts diferent types of
investors at various stages of its evolution, it may use diferent equity instruments
for its financing needs.
For example, angel investors and venture capitalists who are generally the first
investors in a startup are inclined to favor convertible preferred shares rather
than common equity in exchange for funding new companies, since the former
have greater upside potential and some downside protection. Once the company
has grown large enough to consider going public, it may consider selling common

equity to institutional and retail investors. Later on, if it needs additional capital,
the company may go in for secondary equity financings such as a rights ofering
or an ofering of equity units that includes warrants as a sweetener.
The equity-financing process is governed by regulation imposed by a local or
national securities authority in most jurisdictions. Such regulation is primarily
designed to protect the investing public from unscrupulous operators who may
raise funds from unsuspecting investors and disappear with the financing
proceeds. An equity financing is therefore generally accompanied by an ofering
memorandum or prospectus, which contains a great deal of information that
should help the investor make an informed decision about the merits of the
financing. Such information includes the company's activities, details on its
officers and directors, use of financing proceeds, risk factors, financial statements
and so on.
Investor appetite for equity financings depends significantly on the state of
financial markets in general and equity markets in particular. While a steady pace
of equity financings is seen as a sign of investor confidence, a torrent of
financings may indicate excessive optimism and a looming market top. For
example, IPOs by dot-coms and technology companies reached record levels in
the late 1990s, before the tech wreck that engulfed the Nasdaq from 2000 to
2002. The pace of equity financings typically drops of sharply after a sustained
market correction due to investor risk-aversion during this period.

DEFINITION OF 'LEASE '


A legal document outlining the terms under which one party agrees to rent
property from another party. A lease guarantees the lessee (the renter) use of an
asset and guarantees the lessor (the property owner) regular payments from the
lessee for a specified number of months or years. Both the lessee and the lessor
must uphold the terms of the contract for the lease to remain valid.

Leases are the contracts that lay out the details of rental agreements in the real
estate market. For example, if you want to rent an apartment, the lease will
describe how much the monthly rent is, when it is due, what will happen if you
don't pay, how much of a security deposit is required, the duration of the lease,
whether you are allowed to have pets, how many occupants may live in the unit
and any other essential information. The landlord will require you to sign the
lease before you can occupy the property as a tenant.

DEFINITION OF 'CAPITAL ALLOCATION'


A process of how businesses divide their financial resources and other sources
of capital to diferent processes, people and projects. Overall, it is management's
goal to optimize capital allocation so that it generates as much wealth as possible
for its shareholders.
The process behind making a capital allocation decision is complex, as
management virtually has an unlimited number of options to consider.
For example, if a company ends up with a larger than expected windfall at the
end of the year, management needs to decide whether to use the extra funds to
buy back stock, issue a special dividend, purchase new equipment or increase
the research and development budget. In one way or another, each one of these
actions will likely benefit the shareholder, but the difficult part is in determining
how much money should be allocated to each action in order to yield the most
benefit.