1

ENGINEERING ECONOMY
I. Interest and Money-Time Relationship
 Simple Interest
Is an interest which is computed from the principal only, ignoring the interest that had
been accrued in the preceding periods.

𝐼 = (𝑃𝑖 )𝑛 = 𝑃𝑛𝑖
𝐹 = 𝑃 + 𝐼 = 𝑃 + 𝑃𝑛𝑖

𝐹 = 𝑃 (1 + 𝑛𝑖 )

Where:
I = interest
P = principal or present worth
n = number of interest period
i = rate of interest per interest period
F = accumulated amount or future worth
Interest period = length of time at which the interest is being drawn or
computed

Two types of Simple Interest

1. Ordinary Simple Interest (OSI)
1 yr = 360 days
1 month = 30 days
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠
If interest period is yearly then: 𝑛= 360

2. Exact Simple Interest (ESI)

1 yr = 365 days or 366 for leap yr
1 mo = exact number days corresponding to the month
If interest period is yearly then:
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠
𝑛= 𝑜𝑟
365 366

Note: If length of interest period is not specified, then assume it to be annually or

yearly
 Example: Simple Interest
Mike deposited on an investment trust fund an amount of P100,000 on July 17, 2020. He plans
to withdraw all the amount after two ye
ars or at exactly during his wedding day on April 29, 2022. If the interest rate is 10% how much
money will he get? Use a) OSI b) ESI

 Compound Interest
- Is an interest computed from the total accumulated amount, i.e. from the principal and the
interest accrued from previous interest period.

𝐅 = 𝐏(𝟏 + 𝐢)𝐧

or

𝐏 = 𝐅(𝟏 + 𝐢)−𝐧

Total Interest I : I=F–P

= P(1+i)n – P

I = P [(1 + i)n – 1] or I = F [1 – (1 + i)-n]

Types of rate of interest:

a. Nominal rate of interest (j) – is the specified interest rate

𝑗
𝑖= and 𝑛 = 𝑚𝑦
𝑚

Where:
i = rate of interest per interest period
j = nominal rate of interest
m = number of compounding periods per year
= 1 for annually
= 2 for semi-annual
= 4 for quarterly
= 12 for monthly
n = total interest period
y = number years

𝒋
𝐅 = 𝐏(𝟏 + )𝐦𝐲 or
𝒎
 𝒋
𝑷 = 𝐅(𝟏 + )−𝐦𝐲
𝒎

b. Effective rate of interest (e) – is the actual or exact rate of interest on the principal during
one year

Relationship between nominal rate of interest j and effective rate of interest e:

Let -
e = effective interest rate
P = principal
F = future or accumulated amount

𝑗
𝐼 𝐹−𝑃 P(1+𝑚)my −𝑃 𝑗
𝑒= = = = (1 + )my − 1
𝑃 𝑃 𝑃 𝑚

For one year, y = 1

Therefore:

𝒋 𝐦
𝒆 = (𝟏 + ) −𝟏
𝒎

Or
𝟏⁄
𝒋 = 𝒎 [(𝟏 + 𝒆) 𝒎 − 𝟏]

Note: if m = 1, i.e. compounded annually then

𝑗 𝑗 1
𝑒 = (1 + )m − 1 = (1 + ) − 1 = (1 + 𝑗) − 1
𝑚 1

𝑒= 𝑗

Example 1:
How long will it take money to triple itself at an interest rate of 8% compounded semi-annually?

Example 2:
Find the nominal rate of interest which, if compounded quarterly could be used instead of 12%
compounded semi-annually.
Cash Flow Diagram (CFD)
 A graphical representation of cash activities, both receipts and disbursement drawn on a time
scale.

Borrower’s point of view: 0 n

Lender’s point of view: 0 n

Receipt (positive cash flow or cash inflow) =

Disbursement (negative cash flow or cash out flow) =

Equation of Values
 Equation obtained by setting the sum of the values on a certain comparison or focal date of one
set of obligations equal to the sum of the values on the same date of another set of obligations.

Basic Principle:
At any valuation or focal date,
∑ 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑣𝑎𝑙𝑢𝑒𝑠 = 0

Or ∑ 𝑅𝑒𝑐𝑒𝑖𝑝𝑡𝑠 − ∑ 𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡 = 0

∑ 𝑅𝑒𝑐𝑒𝑖𝑝𝑡𝑠 = ∑ 𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡

Focal date – reference time at which all cash flows converges or bring to that date.

Basic Formula:

𝐅 = 𝐏(𝟏 + 𝐢)𝐧 And 𝐏 = 𝐅(𝟏 + 𝐢)−𝐧

 Illustration (in the board): equation of values are the same at any focal date

Example 1:
A man buys a house and lot worth P2,000,000 if paid in cash. On instalment basis, he pays
P500,000 downpayment; P200,000 after one year; P400,000 after two years and a final
payment after four years. What is the final payment if i = 15%?

Example 2:
If money is worth 12% effective, what equal payment x at the end of two years and four years
will equitably replace the following obligations: P300,000 due in three years and P500,000 due
in five years, both at an interest rate of 10% compounded semi-annually.

Continuous Compounding and Discrete Payments

Discrete compounding - Interest is compounded at the end of each finite length of period such
as moth, quarter, etc.
Continuous compounding – it is assumed that cash payments occur once per year (discrete
payment) but the compounding is continuous throughout the year.

CFD: Continuous Compounding (Lender’s Viewpoint)

F

0 n

P
Let:
j = nominal rate of interest
𝑗
i = , rate of interest per period
m
m = number of interest period per year
y = total number of years
n = my , total number of periods

j my
F = P (1 + )
m

m 𝑗 1
Let =k or =
j 𝑚 𝑘
As m increases, k also increases

m = kj
jy
j kjy 1 kjy 1 k
F = P (1 + ) = P (1 + ) = P [(1 + ) ]
kj k k

1 k
By definition (from calculus): lim (1 + ) = e
k→∞ k
 Therefore:

𝐅 = 𝐏𝐞𝐣𝐲 Or 𝐏 = 𝐅𝐞−𝐣𝐲

Task 1: solve in your notes

Compare the accumulated amount after 10 years of P10,000 invested at 10% per year
compounded at: a) annually b) semi-annually c) quarterly d) monthly
e) continuously.
Note: email your solution to this address: rcbustamante1968@gmail.com
Ans: P25,937.42; P26,532.98; P26,850.64 P27,070.41; P27,182.82

Discount
 On a negotiable paper, is the difference between the present worth P (the amount receive for
the paper in cash) and the worth of the paper in the future F (the face value of the paper or
principal)
 It is the interest paid in advance

Discount = Future Worth - Present Worth

D= F - P

d = rate of discount , is discount of one unit of principal for one unit of time

1.0
1
o

(1 + 𝑖)−1

1 1+𝑖−1
𝑑 = 1 − (1 + 𝑖)−1 = 1 − =
1+𝑖 1+𝑖

𝐢
𝐝=
𝟏+𝐢

Solving for i:
𝐝
𝐢=
𝟏−𝐝
 Where: d = rate of discount for the period invested
i = rate of interest for the same period

Example:
John borrowed money from a bank. He received from the bank P1,342 and promise to repay
P1,500 at the end of nine months. Determine the simple interest rate and the corresponding
discount rate often referred to as the banker’s discount.
Ans: i = 11.77%, d = 10.53%

Inflation
 Is the increase in prices of goods and services from one year to another, thus decreasing the
purchasing power of money.

PC

o n, f

FC

𝑭𝑪 = 𝑷𝑪 (𝟏 + 𝒇)𝒏

Where:
PC = present cost of commodity
FC = future cost of commodity
f = annual inflation rate
n = number of years

Purchasing power:
 In an inflationary economy, the buying power of money decreases as cost increases

o n, f

𝐏 = 𝐅(𝟏 + 𝐟)𝐧 or 𝐅 = 𝐏 (𝟏 + 𝐟)−𝐧

 Where:
F = is future worth, measured in today’s Peso, of present amount P

Interest vs Inflation
 If interest is being compounded at the same time that inflation is occurring

P(1 + f)−n

o n, i

F = P (1 + f)−n (1 + i)n

𝐏 (𝟏+𝐢)𝐧 𝐅 (𝟏+𝐟)𝐧
𝐅 = (𝟏+𝐟)𝐧
or 𝐏 = (𝟏+𝐢)𝐧

Example 1: Inflation
An item presently cost P5,000. If inflation is at the rate of 6% per year, what will be the cost of
the item in two years?
Ans: P5,618

Example 2: Interest vs Inflation

A man deposits P50,000 in a bank account at 6% compounded monthly for 5 years. If the
inflation rate of 6.5% per year is continuous for this period, will this effectively protect the
purchasing power of the original amount?
Ans: No, F = 49,224.99 < P50,000

Annuity
- Is a series of equal payments occurring at equal periods of time.

Symbols used:
P = value or sum of money at present (at zero period)
F = value or sum of money at some future time (after n period)
A = a series of periodic, equal amounts of money
n = number of interest periods
i = interest rate per interest period

Types of annuity:
1. Ordinary annuity
2. Deferred annuity
 3. Perpetuity

I. Ordinary Annuity
- An annuity in which payment is made at the end of each period.

Derivation in the board:

𝑨
𝑷= [𝟏 − (𝟏 + 𝒊)−𝒏 ]
𝒊

𝑗
From: 𝑖= and 𝑛 = 𝑚𝑦
𝑚

𝒎𝑨 𝒋 −𝒎𝒚
𝑷= [𝟏 − (𝟏 + ) ]
𝒋 𝒎

Soving for A:
𝑷𝒊
𝑨=
[𝟏 − (𝟏 + 𝒊)−𝒏 ]

Or: 𝑷𝒋
𝑨=
𝒎 [𝟏 − (𝟏 + 𝒊)−𝒏 ]
 Solving for F:
P
n , i
0

𝐴
𝐹 = 𝑃(1 + 𝑖)𝑛 = [1 − (1 + 𝑖)−𝑛 ] (1 + 𝑖)𝑛
𝑖

𝑨
𝑭= [(𝟏 + 𝒊)𝒏 − 𝟏]
𝒊

𝒎𝑨 𝒋 𝒎𝒚
𝑭= [(𝟏 + ) − 𝟏]
𝒋 𝒎

Example1: Ordinary Annuity

XYZ Inc plan to construct an additional building at the end of 10 years for an estimated cost of
P15 million. To accumulate this amount, it will make equal year-end deposits in a fund earning
13%. However, after the end of the 5th year, it was decided to have a larger building than
originally intended at an estimated cost of P25 million. What would be the new annual
deposit?

Example2: Ordinary Annuity

Five years ago you bought a house for P5M. You paid P1M in cash and signed a mortgage for
the balance. This mortgage to be paid off by making 20 equal yearend payments with the
interest on the unpaid balance of 12% per annum. You have just made the 5 th annual mortgage
payments and you found out that you need a larger house. If you sell your house and payoff
the mortgage balance in a single payment, you must pay a penalty of 3% of the balance. For
how much you sell your house in order to retire the mortgage, pay your penalty and recover
your P1M down payment together with 12% interest on this payment?
II. Deferred Annuity
- Is an annuity where the first payment is made several periods after the beginning of the
annuity. ( see derivation in the board)

𝑨
𝑋= [𝟏 − (𝟏 + 𝒊)−𝒏 ]
𝒊

𝑃 = 𝑋 (𝟏 + 𝒊)−𝒎

𝑨
𝑷= [𝟏 − (𝟏 + 𝒊)−𝒏 ] (𝟏 + 𝒊)−𝒎
𝒊

Solving for A:

𝑷𝒊
𝑨= [𝟏− (𝟏+𝒊)−𝒏 ] (𝟏+𝒊)−𝒎

Solving for F: (see derivation on the board)

𝑨
𝑭= [(𝟏 + 𝒊)𝒏 − 𝟏]
𝒊

Note: F for deferred annuity is the same to ordinary annuity

 III. Perpetuity
- Annuity in which the payments continue indefinitely. (see derivation in the board)
- Is an ordinary annuity with 𝑛 = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦 = ∞

𝐴
𝑃=
𝑖

Ex3: Ordinary, Deferred and Perpetuity Annuity

An endowment fund is to provide an annual scholarship of P100,000 for the 1st five years; P200,000 for
the next five years; and P500,000 thereafter. The fund will be established one year before the 1 st
scholarship is awarded. If the fund earns 12% interest what amount must be deposited?

Capitalized Cost
 Capitalized cost of a property is the sum of the 1 st cost and the present worth of all cost of
replacement, operation and maintenance for a long time period or forever.

Case 1: No Replacement, only Operation and Maintenance

Capitalized Cost = 1st cost + present worth of perpetual operation and maintenance

𝐴𝑂𝑀
CC = FC + POM = 𝐹𝐶 +
𝑖

Where:
CC = capitalized cost
FC = 1st cost
 POM = present worth of perpetual operation and maintenance
𝐴𝑂𝑀 = annual operation and maintenance cost for a long period of time

Case 2: Replacement only, No Operation and Maintenance

Capitalized Cost = 1st cost + present worth of perpetual replacement

CC = FC + Prep

Let:
S = amount needed to replace a property every k period
X = amount of principal invested at rate i %, the interest on which will amount to S
every k period
= basically the present worth of replacement cost
= Prep
Xi = interest of X every period, the periodic deposit toward accumulation of S

A
Fr: F= [(1 + i)n − 1]
i

Xi
S= [(1 + i)k − 1]
i

𝐒
𝐗=
(𝟏 + 𝐢)𝐤 − 𝟏
Difference between P and X in a perpetuity:

A S
P = X= (1+i)k − 1
i

At k = 1 (replacement period every year, which is equivalent to annuity with no limit)

S 𝑆 S
X= (1+i)1 − 1
= =
1+𝑖− 1 i

Where:
P = the amount invested now @ i% for period whose interest at the end of
every period is A
X = amount invested now at i% for period whose interest at end of every k
period forever is S

In general:

𝐒
𝐏𝐫𝐞𝐩 = 𝑿 =
(𝟏 + 𝐢)𝐤 − 𝟏

Case 3: With Operation, Maintenance and Periodic Replacement

Capitalized Cost = 1st cost + present worth of perpetual replacement + present worth
of annual operation and maintenance

CC = FC + Prep + P𝑂𝑀

Example: Capitalized Cost

Calculate the capitalized cost of a project that has an initial cost of P3M and an additional
investment cost of P1M at the end of every five years. The annual cost of operation and
maintenance will be P100,000 at the end of every year for the 1st four years and P160,000
 thereafter. In addition, there is expected to be recurring major rework cost of P500,000 every 7
years. Assume i = 15%.
Amortization
 Is any method of repaying debt, the principal and interest included, usually by a series of equal
payments at equal interval of time.

Amortization schedule – is a tabulated schedule of payments of an obligation

Period 𝐶2 𝐶3 𝐶4 𝐶5
Outstanding principal @ Interest due @ the end of Payment Principal repaid @ end of
beginning of period period period
1 𝑃 𝑃𝑖 𝐴 𝐴 − 𝑃𝑖
2 𝑃 − (𝐴 − 𝑃𝑖) [𝑃 − (𝐴 − 𝑃𝑖)] 𝑖 𝐴 𝐴 − [𝑃 − (𝐴 − 𝑃𝑖)] 𝑖
3 𝐶2 𝑝𝑟𝑒𝑣 − 𝐶5 𝑝𝑟𝑒𝑣 𝑖𝐶2 𝑐𝑢𝑟 𝐴 𝐶4𝑐𝑢𝑟 − 𝐶3 𝑐𝑢𝑟
⋮ ⋮ ⋮ ⋮ ⋮
𝑛 𝐶2 𝑝𝑟𝑒𝑣 − 𝐶5 𝑝𝑟𝑒𝑣 𝑖𝐶2 𝑐𝑢𝑟 𝐴 𝐶4 − 𝐶3 𝑐𝑢𝑟 = 𝐶2 𝑙𝑎𝑠𝑡

Note: If the equation: 𝐶4 − 𝐶3 𝑐𝑢𝑟 = 𝐶2 𝑙𝑎𝑠𝑡 is not satisfied then there is error in the
computation

Example – Amortization Schedule

A debt of P500,000 with interest of 12% compounded semi-annually is to be amortized by equal semi-
annual payments over the next 3 years, the 1st due is in 6 months. Find the semi-annual payment and
construct an amortization schedule.

Soln:
𝑃𝑗 𝑗 0.12
𝐴= 𝑖= = = 0.06 𝑛 = 𝑚𝑦 = (2)(3) = 6
𝑚 [1− (1+𝑖)−𝑛 ] 𝑚 2

𝑃𝑗 (500,000)(0.12)
𝐴= = = 101,681.31
𝑚 [1− (1+𝑖)−𝑛 ] 2 [1− (1+0.06)−2(3) ]

Amortization schedule:
Period 𝐶2 𝐶3 𝐶4 𝐶5
Outstanding principal @ Interest due @ the end of Payment Principal repaid @ end of
beginning of period period period
1 500,000 30,000 101,681.31 71,681.31
2 428,318.69 25,699.12 101,681.31 75,982.19
3 352,336.50 21,140.19 101,681.31 80,541.12
4 271,795.38 16,307.72 101,681.31 85,373.59
5 186,421.79 11,185.31 101,681.31 90,496.00
6 95,925.79 5,755.55 101,681.31 95,925.76
Uniform Arithmetic Gradient
 An annuity with uniform increase of payment

𝑃 = 𝑃𝐴 + 𝑃𝐺

𝑨
𝑷𝑨 = [𝟏 − (𝟏 + 𝒊)−𝒏 ]
𝒊

𝑮 (𝟏+𝒊)𝒏 −𝟏 𝟏
𝑷𝑮 = [ − 𝒏] [(𝟏+𝒊)𝒏]
𝒊 𝒊

𝑮 (𝟏 + 𝒊)𝒏 − 𝟏
𝑷𝑮 = [ − 𝒏] (𝟏 + 𝒊)−𝒏
𝒊 𝒊

Where:
𝑃𝐴 = present worth of A (annuity part)
𝑃𝐺 = present worth of G (arithmetic gradient part)
𝐺 = uniform gradient amount, the amount of increase or decrease (negative 𝑃𝐺 )

Example 1: Uniform Arithmetic Gradient

A contract has been signed to lease a building at P20,000 per year with an annual increase of 1500 for 8
years. Payments are to be made at the end of each year, starting one year from now. The prevailing
interest rate is 7%. What Lump sum paid today be equivalent to 8-year lease payment.

Sol’n:
𝐴 = 20,000 𝑛=8
 𝐺 = 1,500 𝑖 = 7%

𝐴 20,000
𝑃𝐴 = [1 − (1 + 𝑖)−𝑛 ] = [1 − (1 + 0.07)−8 ] = 119,425.97
𝑖 0.07

𝐺 (1+𝑖)𝑛 −1 1 1500 (1+0.07)8 −1 1

𝑃𝐺 = [ − 𝑛] [(1+𝑖)𝑛 ] = [ − 8] [(1+0.07)8 ] = 28,183.41
𝑖 𝑖 0.07 0.07

𝑃 = 𝑃𝐴 + 𝑃𝐺 = 119,425.97 + 28,183.41 = 147,609.37

Example2: Uniform Arithmetic Gradient

The author of the bestselling novel was offered the following alternatives by a movie company for the
rights to make her novel into movie.
a) A single lump sum payment of P5M or
b) An initial payment of P2.5M plus 2% of the movies gross receipts for the next 5 years estimated
to be as follows:

End of year Gross receipts 2% of gross receipt

1 P100,000,000 P2,000,000
2 80,000,000 1,600,000
3 60,000,000 1,200,000
4 40,000,000 800,000
5 20,000,000 400,000

After the 5th year, the author will receive no further royalties. If the money is worth 14%, which
alternative should she select? Disregard income tax considerations.

II. Depreciation

Depreciation – is the decrease in value of a physical property with the passage of time.

Definition of Value:

Value – in a commercial sense, is the present worth of all future profits that are to be received
through ownership of a particular property.
Market value – the amount which a willing buyer will pay to a willing seller for the property where
each has equal advantage and under no compulsion to buy or sell.
Utility value or used value – is what the property is worth to the owner as an operating unit.
Fair value – is usually determined by a disinterested third party in order to establish a price that is
fair to both seller and buyer.
Book value – sometimes called the depreciated value, is the worth of as property as shown in the
accounting records of an enterprise
Salvage or resale value – is the price that can be obtained from the sale of a property after it has
been used.
Scrap value – is the amount the property would sell for if disposed off as junk
Purpose of Depreciation
1. To provide for the recovery of capital which has been invested in physical property
2. To enable the cost of depreciation to be charge to the cost of producing products or
services.

Types of depreciation:
1. Normal depreciation
a) Physical
b) Functional
2. Depreciation due to changes in price level
3. Depletion

Physical Depreciation - is due to the lessening of the physical ability of a property to produce
results. Its common causes are wear and deteriorate.
Functional depreciation – is due to the lessening in the demand for the function which the
property is designed to render. Its common causes are inadequacy, changes of styles,
population center shift, saturation of market or more efficient machines are produced.
Depletion – refers to the decrease in the value of property due to gradual extractions of it
contents.

Physical and Economic Life:

Physical life – of a property is the length of time during which it is capable of performing the
function for which it was designed and manufactured.
Economic life – is the length of time during which the property may be operated at a profit.

Requirements of depreciation method:

1. It should be simple
2. It should recover capital
3. Book value will be reasonably close to market value at any time
4. Method should be accepted by BIR

Depreciation method:
1. Straight line method (SLM)
2. Sinking fund method (SFM)
3. Declining balance method (DBM)
4. Double declining balance method (DDBM)
5. Sum of years-digit method (SYDM)
6. Service-output method (SOM)

Symbols used:
L = useful life of the property
Co =original cost or 1st cost
CL = the value at end the of life
= salvage value
d = annual cost of depreciation
Cn = book value at the end of n years
 Dn = total/accumulated depreciation up to age n years

A. Straight Line Method (SLM)

 This method assumes that the loss in value (𝐶𝑜 − 𝐶𝐿 ) is directly proportional to the age
of property.
 Annual depreciation is constant

Annual depreciation:
𝑪𝒐 − 𝑪𝑳
𝒅=
𝑳

Accumulated depreciation after n years:

𝑪𝒐 − 𝑪𝑳
𝑫𝒏 = 𝒏𝒅 = 𝒏 ( )
𝑳

Book value at the end of n years:

𝑪𝒏 = 𝑪𝒐 − 𝑫𝒏
Analysis using analytic geometry:

𝑟𝑖𝑠𝑒 𝐶𝑜 − 𝐶𝐿 𝐶𝑜 − 𝐶𝐿
𝑑 = 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑙𝑖𝑛𝑒 = = = −( )
𝑟𝑢𝑛 0− 𝐿 𝐿

Note: Negative sign means the book value Cn is decreasing

Solving for book value 𝐶𝑛 :

𝐶𝑜 − 𝐶𝐿 𝐶𝑛 − 𝐶𝐿
=
0−𝐿 𝑛−𝐿

𝐶𝑜 − 𝐶𝐿 𝐶𝑛 − 𝐶𝐿
=
−𝐿 𝑛−𝐿

𝑛−𝐿
𝐶𝑛 − 𝐶𝐿 = − ( ) (𝐶𝑜 − 𝐶𝐿 )
𝐿

𝐶𝑜 𝐶𝐿
𝐶𝑛 − 𝐶𝐿 = − (𝑛 − 𝐿) + (𝑛 − 𝐿)
𝐿 𝐿

𝑛𝐶𝑜 𝑛𝐶𝐿
𝐶𝑛 = 𝐶𝐿 − + 𝐶𝑜 + − 𝐶𝐿
𝐿 𝐿

𝐶𝑜 − 𝐶𝐿
= 𝐶𝑜 − 𝑛 ( )
𝐿

𝐶𝑜 − 𝐶𝐿
Let: 𝐷𝑛 = 𝑛 ( )
𝐿

Therefore: 𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛
B. Sinking Fund Method (SFM)
 Annual depreciation is constant but draws interest
 Concept is similar to annuity

From annuity:

𝐴
𝐹= [(1 + 𝑖)𝑛 − 1]
𝑖
𝑑
𝐶𝑜 − 𝐶𝐿 = [(1 + 𝑖)𝐿 − 1]
𝑖

Annual depreciation:
𝒊 (𝑪𝒐 − 𝑪𝑳 )
𝒅= (𝟏+𝒊)𝑳 −𝟏

𝑑
Accumulated depreciation after n periods: 𝐷𝑛 = [(1 + 𝑖)𝑛 − 1]
𝑖

Book value at the end of n periods: 𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

C. Declining Balance Method (DBM)

 Also known as Matheson formula
 This method assumes that the annual cost of depreciation is a fixed percentage of the
book value at the beginning of the year.
 The ratio of depreciation in any one year to the book value at the beginning of that year
is constant throughout the life of the property and designated by k, the rate of
depreciation.
𝒅
i.e.: 𝒌= 𝒊
𝑪𝒊−𝟏

 Annual depreciation is not constant but declining

Note: DBM is not applicable if there is no salvage value, i.e. CL = 0`

(See derivation in the board:

Depreciation charge at nth year: 𝒅𝒏 = 𝒌 𝑪𝒐 (𝟏 − 𝒌)𝒏−𝟏

𝒏
𝑪 𝑳
Book value after nth year: 𝑪𝒏 = 𝑪𝒐 (𝟏 − 𝒌)𝒏 = 𝑪𝒐 ( 𝑳 )
𝑪𝒐

𝑛 𝐶
Rate of depreciation: 𝑘 = 1− √ 𝑛
𝐶 𝑜

𝑳 𝑪
𝒌=𝟏− √ 𝑳
𝑪 𝒐

Accumulated depreciation after n years: 𝐷𝑛 = 𝐶0 − 𝐶𝑛

Derivation:
Year Book value at beginning Depreciation during the Book value at the end of the year
of year year
1 𝐶𝑜 𝑑1 = 𝑘𝐶𝑜 𝐶1 = 𝐶𝑜 − 𝑑1 = 𝐶𝑜 − 𝑘𝐶𝑜
= 𝐶𝑜 (1 − 𝑘)
2 𝐶1 = 𝐶𝑜 (1 − 𝑘) 𝑑2 = 𝑘𝐶1 𝐶2 = 𝐶1 − 𝑑2
= 𝑘𝐶𝑜 (1 − 𝑘) = 𝐶0 (1 − 𝑘) − 𝑘𝐶𝑜 (1 − 𝑘)
= 𝐶𝑜 (1 − 𝑘)(1 − 𝑘)
𝐶2 = 𝐶0 (1 − 𝑘)2
3 𝐶2 = 𝐶0 (1 − 𝑘)2 𝑑3 = 𝑘𝐶2 = k𝐶0 (1 − 𝑘 )2 𝐶3 = 𝐶2 − 𝑑3
= 𝐶0 (1 − 𝑘)2 − k𝐶0 (1 − 𝑘)2
= 𝐶0 (1 − 𝑘)2 (1 − 𝑘)
 𝐶3 = 𝐶0 (1 − 𝑘)3
⋮ ⋮ ⋮ ⋮
𝑛 𝐶𝑛−1 = 𝐶0 (1 − 𝑘)𝑛−1 𝑑𝑛 = 𝑘𝐶𝑛−1 𝐶𝑛 = 𝐶0 (1 − 𝑘)𝑛
⋮ ⋮ ⋮ ⋮
L 𝐶0 (1 − 𝑘)𝐿−1 𝑑𝐿 = 𝑘𝐶𝐿−1 𝐶𝐿 = 𝐶0 (1 − 𝑘)𝐿

From:

𝐶𝑛 = 𝐶0 (1 − 𝑘)𝑛

1
𝐶𝑛 𝑛
𝑛
[ = (1 − 𝑘 ) ]
𝐶0

1⁄
𝐶𝑛 𝑛
( ) = 1−𝑘
𝐶0

1⁄
𝐶𝑛 𝑛 𝑛 𝐶𝑛
𝑘 = 𝐶0 − ( ) =1− √
𝐶0 𝐶0

From:

𝐶𝐿 = 𝐶0 (1 − 𝑘)𝐿

Same process above:

1⁄
𝐶𝐿 𝐿 𝑛 𝐶𝐿
𝑘 = 𝐶0 − ( ) =1− √
𝐶0 𝐶0

D. Double Declining Balance Method (DDBM)

 Is similar to DBM except that k is predetermined.
 Salvage value should not be subtracted from the first cost in calculating the depreciation
charge.

𝟐
Rate of depreciation: 𝒌=
𝑳

Depreciation charge at nth year: 𝑑𝑛 = 𝑘 𝐶𝑜 (1 − 𝑘)𝑛−1

𝟐 𝟐 𝒏−𝟏
𝒅𝒏 = 𝑪 (𝟏 − )
𝑳 𝒐 𝑳

Book value after nth year: 𝐶𝑛 = 𝐶𝑜 (1 − 𝑘)𝑛

 𝟐 𝒏
𝑪𝒏 = 𝑪𝒐 (𝟏 − )
𝑳
Accumulated depreciation after n years: 𝑫𝒏 = 𝑪𝟎 − 𝑪𝒏

E. Service-Output Method (SOM)

- This method assumes that the total depreciation that has taken place is directly
proportional to the quantity of output up that time.
- This method has the advantage of making the unit cost of depreciation constant and low
depreciation expense during periods low production.

𝑑𝑛 ∝ 𝑜𝑢𝑡𝑝𝑢𝑡

Let:
T = total units of output up to the end of life L
Qn = units of output during n year
DL = total depreciation after L years

𝑑𝑛 𝐷𝐿 𝐶0 − 𝐶𝐿
= =
𝑄𝑛 𝑇 𝑇

Depreciation during n year:

𝑸𝒏
𝒅𝒏 = (𝑪𝟎 − 𝑪𝑳 )
𝑻

Book value at the end of nth year:

𝑪𝒏 = 𝑪𝟎 − 𝑫𝒏

Total depreciation after n years:

𝐷𝑛 = 𝑑1 + 𝑑2 + ⋯ + 𝑑𝑛
 𝑄1 𝑄2 𝑄𝑛
𝐷𝑛 = (𝐶0 − 𝐶𝐿 ) + (𝐶0 − 𝐶𝐿 ) + ⋯ + (𝐶0 − 𝐶𝐿 )
𝑇 𝑇 𝑇

𝐶0 − 𝐶𝐿 𝐶0 − 𝐶𝐿
𝐷𝑛 = (𝑄1 + 𝑄2 + ⋯ + 𝑄𝑛 ) ( ) = ∑ 𝑄𝑛
𝑇 𝑇

𝑪𝟎 − 𝑪𝑳
𝑫𝒏 = ∑ 𝑸𝒏
𝑻

F. Sum of Years-Digit Method (SYDM)

- Similar to DBM where depreciation charge is constantly declining and is based on the
reversed order of year

Let:
𝑑𝑛 = depreciation charged during the nth year

𝑑𝑛 = (𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟) (𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)

𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡
𝑑𝑛 = (𝐶0 − 𝐶𝐿 )
𝑠𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠

Year Year in reversed Depreciation factor Depreciation during

order the year
1 L 𝐿 𝐿
𝑑1 = (𝐶 − 𝐶𝐿 )
Σ Σ 0
2 𝐿−1
3 ⋮
⋮
𝑛
𝑛+1
⋮
L

Where Σ = sum of years digit

Using arithmetic progression (AP) to solve for Σ :

AP : 1, 2, 3, 4 , 5 ⋯ 𝑎𝑛

𝑛
Sum of AP: Σ= (𝑎1 + 𝑎𝑛 )
2

Where: 𝑎1 = 1st term of AP3

𝑎𝑛 = last term of AP
𝑛 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟𝑠 𝑜𝑓 𝑡𝑒𝑟𝑚𝑠
 Therefore:
𝑳
𝚺= (𝟏 + 𝒂𝒏 )
𝟐

Total depreciation up to n years: 𝐷𝑛 = 𝑑1 + 𝑑1 + ⋯ 𝑑𝑛

Book value up to n years: 𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

`
Example 1
An industrial plant bought a generator set for P90,000. Other expenses including installation
amounts to P10,000. The generator set is to have a life of 15 yrs with a salvage value at the end
of his life at P5,000. Determine the depreciation charge during the 13 th year and the book value
at the end of 13 yrs using: a) SLM, b) DBM, c.) DDBM; d) SFM at i = 12%, and e.) SYDM

III. Capital Financing

A. Methods of Financing
 Funds for financing an engineering or any business enterprise may be classified into:
1) Equity or
2) Borrowed capital

Equity capital – is supplied and used by the owners of an enterprise and they expect a profit
in their investment.
Borrowed capital – supplied by others on which a fixed rate of interest must be paid and
the debt must repaid at a specified time.

B. Methods of Bond Retirement

1) Issuance of another bond – a corporation will issue another sets of bond of equal value
upon due date.
2) Periodic sinking fund – is a periodic deposits of equal fund with accumulated value equal
to the amount needed to retire a bond.

Let:
A = periodic deposit to the sinking fund
F = accumulated amount, the amount needed to retire a bond
i = rate of interest in the sinking fund
r = bond rate per period
I = interest in the bond per period
A + I = total periodic expense of the corporation issuing the bond
 𝐴
𝐹 = [(1 + 𝑖)𝑛 − 1]
𝑖

𝐹𝑖
𝐴 = (1 + 𝑖)𝑛 − 1

𝐼 = 𝐹𝑟

Example1
A corporation sold an issue of 20-yr bonds having a total value of P10,000,000 for P9,500,000.
The bonds bear interest at 16% payable semi-annually. The company wishes to establish a
sinking for retiring the bond issue and will make semi-annual deposits that will earn 12%
compounded semi-annually. Compute the annual cost for interest and redemption of these
bonds.

C. Bond Value
 Is the present worth of all future amounts that are expected to be received through the
ownership of the bond.
Let:
F = face or par value of the bond
C = redemption or disposal price (often equal to F)
r = bond rate per period
n = number of periods before redemption
i = investment rate or yield per period
P = value of the bond n periods before redemption

𝑭𝒓
𝑷= [𝟏 − (𝟏 + 𝒊)𝒏 ] + 𝑪(𝟏 + 𝒊)𝒏
𝒊
 Example
A company has issued a 10-yr bond with a face value of P1,000,000 in a P1,000 units.
Interest at 16% is paid quarterly. If an investor desires to earn 20% nominal interest on
P100,000 worth of this bonds, what would the selling price have to be?

IV. Present Economy

 Is an engineering economy studies where interest is not a factor.
 Such studies usually involve selection between alternatives designs, materials or methods
 Analysis does not involve fundamental laws, principle or formula, but basically is purely
analytical and solution is usually algebraic and dimensional analysis
 Present economy studies occur in the following situations:
1. Selection of materials
2. Selection of methods to be used
3. Selection of design
4. Selection of site location for a project
5. Comparison of proficiency among workers
6. Economy of tool and equipment maintenance
7. Economy of number of workers

Example 1: Selection of Materials

A machine part to be machined may be made either from an alloy of aluminum or steel. There is
an order of 8,000 units. Steel costs P38 per kg, while aluminum costs P87 per kg. If steel is used,
the steel per unit weighs 110 grams; for aluminum, 30 grams. When the steel is used, 50 units
can be produced per hour; for aluminum, 80 units per hour with the aid of a tool costing P6,400,
which will be useless after 8,000 units are finished. The cost of the machine and operator is
P108 per hour. If all other cost is identical, determine which material will be more economical.

Example 2: Selection of Methods

A construction company will bid on the digging of an irrigation canal which measures 2 m wide,
1 m deep and 2 km long. Twenty laborers will be employed at P400 each per day and can dig, on
the average ½ cubic meters per hour. In addition, two foremen will also be employed at P800
each per day.
A ditch digging machine may be rented at a cost of P7000 per day, in actual use or in transit to
and from the construction site. In actual use, fuel and oil will cost P5,000 per day. It takes one
day, each way for transporting the machine. Freight charges for transporting the machine will be
P5,000 each way. The machine operator accompanies the machine and is paid P1,000 each day.
The services of two laborers would also be needed, in addition to the services of the machine.
The machine can dig one cubic meter in four minutes. Allowing P100,000 for profit and
contingencies, determine the lowest bid price of the company. Use 8-hr a day work basis.
 V. Basic Method for Making Economy Studies

 In general, capital is invested in an enterprise for the purpose of obtaining a profit

𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑰𝒏𝒄𝒐𝒎𝒆 − 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔

𝑨𝒎𝒏𝒕 𝒐𝒇 𝒓𝒆𝒒𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 = 𝑫𝒆𝒗𝒆𝒍𝒐𝒑𝒎𝒆𝒏𝒕 𝒄𝒐𝒔𝒕 + 𝒑𝒓𝒐𝒎𝒐𝒕𝒊𝒐𝒏 𝒄𝒐𝒔𝒕 + 𝒄𝒐𝒏𝒔𝒕𝒓𝒖𝒄𝒕𝒊𝒐𝒏 𝒄𝒐𝒔𝒕

+ 𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

Note: A financial economy studies are required (usually done by engineers) to determine
whether a capital invested in a new product or enterprise is justifiable.

Basic methods/pattern for economy studies

1. ROR method
2. Annual worth (AW) method
3. Present worth (PW) method
4. Future worth (FW) method
5. Payback (Payout ) Period method

A. Rate of Return (ROR) Method

 ROR is a measure if financial efficiency of capital investment

 Is used to justify investment

 Has advantage of being easily understand by management and investor

𝑵𝒆𝒕 𝑨𝒏𝒏𝒖𝒂𝒍 𝑷𝒓𝒐𝒇𝒊𝒕 𝑨𝒏𝒏𝒖𝒂𝒍 𝒓𝒆𝒗𝒆𝒏𝒖𝒆−𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕

𝑹𝑶𝑹 = = , in %
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑭𝒊𝒓𝒔𝒕 𝑪𝒐𝒔𝒕

 Conditions for applicability of ROR method:

1. Single investment at the beginning of first year of project life
2. Annual cost and annual revenue must be constant

 Criteria for justification:

𝑹𝑶𝑹 ≥ 𝒑𝒓𝒆𝒔𝒄𝒓𝒊𝒃𝒆𝒅 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆

B. Annual Worth (AW) Method

 In this method, interest of original investment (aka minimum required profit) is included
as cost.
 Condition of applicability is similar to ROR method

𝑨𝑾 = 𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘 − 𝒂𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘

  Criteria:

𝑨𝑾 ≥ 𝟎 or positive

C. Present Worth (PW) Method

 Is based on the concept of capitalized cost
 This method is flexible and can be used in any economy study
 Depreciation and minimum required profit (interest on investment) are excluded
 Criteria:

𝑷𝑾𝒊𝒏 − 𝑷𝑾𝒐𝒖𝒕 ≥ 𝟎 or positive

D. Future Worth (FW) Method

 Same with PW except that the focal date is in the future L
 Criteria:

𝑭𝑾𝒊𝒏 − 𝑭𝑾𝒐𝒖𝒕 ≥ 𝟎 or positive

E. Payback (Payout) Period Method

 Payback period – is the length of time required to recover the first cost (original
investment) from net cash flow at zero interest rate.
 Does not consider time value of money or interest

𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝒔𝒂𝒍𝒗𝒂𝒈𝒆 𝒗𝒂𝒍𝒖𝒆

𝑃𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 (𝒊𝒏 𝒚𝒆𝒂𝒓𝒔) =
𝒏𝒆𝒕 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒇𝒐𝒘

 Note:
1. In computing total annual cost, depreciation is not included since time
value of money is not considered in the analysis.
2. For making investment decision, payback period method should not be
used since it may produce misleading result.

F. Summary Highlights
 Depreciation is included as cost in ROR and AW method
 Aside from depreciation, minimum profit (or interest) is included as cost in AW
method
 Depreciation and minimum profit are not included in costs computation for PW,
FW and Payback Period method
 Example
On a land worth P8,000,000, an investor construct a building worth P30,000,000
containing theater, a bank, store and offices. The owner estimated that the annual
receipts from rentals will be P7,200,000 and annual expenses to cover taxes, insurance
and maintenance of the building will be P800,000. He also estimated that the land can
be sold for P12,000,000 at the end of 20 years. The building for P20,000,000 at the end
20 years. If his money is now earning 15% before taxes, will this property earn enough
for the investment to be justified?

VI. Comparing Alternatives

 Most engineering enterprise can be accomplished by more than one method or alternatives.
 Alternatives that require minimum investment of capital and will produce satisfactory
functional result shall always be adopted.
 Methods/pattern in comparing alternatives:
1. ROR on additional investment method
2. Annual Cost (AC) method
3. Equivalent Uniform Annual Cost (EUAC) method
4. Present Worth Cost (PWC) method
5. Capitalized Cost (CC) method
6. Payback/Payout Period method

 Note : Cost is the only element in the analysis, since it is assumed that every alternative will
result in the same functional product, hence they will have the same revenue.

A. ROR on Additional Investment Method

 If there is additional investment, then there should be a reduction of annual cost,
otherwise no need for comparison.

𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

𝑅𝑂𝑅 𝑜𝑛 𝑎𝑑𝑑 ′ 𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑎𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒𝑠

Criteria:
𝑅𝑂𝑅 𝑜𝑛 𝑎𝑑𝑑 ′ 𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 > prescribed rate of interest
Note
 Annual cost should be uniform

B. Annual Cost (AC) Method

 Interest or minimum profit is included as cost
  Annual cost should be uniform

Criteria: Alternatives with lesser annual cost should be adopted

C. Equivalent Uniform Annual Cost (EUAC) Method

 Same with AC method but can be applicable even if annual cost is not uniform
 In this method, EUAC is calculated in one life cycle only

Criteria: Adopt alternative with least EUAC

D. Present Worth Cost (PWC) Method

 Same with PW method

Criteria : adopt alternative with least PWC

E. Capitalized Cost (CC) Method

 Same with PWC except for the periodic replacement cost given by the formula:

𝐒
𝐗=
(𝟏 + 𝐢)𝐤 − 𝟏
Where:
S = amount needed to replace a property every k period
X = amount invested now at i% for period whose interest at end of every k
period forever is S

F. Payback (payout) Period Method

 Select alternative with shortest payback period

Example 1 – Equal Life

It is proposed to place a cable on an existing pole line along the shore of a lake to connect two
points on the opposite side.

Land route Submarine route

Length, miles 10 5
First cost of cable per mile P 4,000,000 P6,800,000
Annual maintenance per mile 95,000 350,000
Interest on investment, % 18 % 18 %
Taxes and insurance 3% 3%
Net salvage value per mile 1,200,000 2,200,000
Life, years 15 15

Which is economical?
Example 2: Non equal life
A gasoline-driven pump and an electric power pump are being considered for use in a mine for a
period of 10 years.

Gasoline Electric
First cost P120,000 P250,000
Life in yrs 5 10
Salvage value 10,000 20,000
Annual operating cost 32,000 18,000
Annual repair 6,000 4,000
Annual taxes (% of FC) 3% 3%

If money is worth 12%, which would you recommend?

VII. Classification of Cost

Type of cost:
1. First cost
2. Fixed cost
3. Variable cost
4. Increment cost
5. Differential cost
6. Marginal cost
7. Sunk cost

First cost – the initial capital investment including all the initial expenses in starting an
enterprise
= promotion cost + research and development cost + construction cost + working
capital

Fixed cost – cost that remains relatively constant regardless of any change in operations or
policies
- It includes: rentals, depreciation, maintenance, taxes, insurance, interest on
borrowed capital, and some administrative cost
 Variable cost – cost that varies relative to number of production output or change in
activities and policies
- It includes: direct labor, direct material, and any other related cost that that
can be computed and attributed to production per unit such as power, etc.

Increment cost – refers to any increase in cost. It is important in problems where it will be
determined whether a production will be profitable for the enterprise.

Differential cost – cost that arises as a result in change of operation or policy (de Garmo)
- The ratio of a small increment of output (Theusen)
- Basically synonymous increment cost

Marginal cost – additional cost of producing one more unit of product

- May be considered as increment cost for an additional unit

Sunk cost – money spent or capital invested which cannot be recovered due to certain
reason.
- Arises when the expected result from an investment is not materialized
- Basically losses due to error in past decision.

Example 1
The total cost of manufacturing 350 and 500 units of product are P92,000 and P110,000.
a. Determine the total fixed cost and variable cost per unit.
b. Determine the average fixed cost per unit for the first 350 units
c. Determine the profit or loss if 80 units in excess of the 1st 350 units can be sold at
P320 each

Example 2
A machine costing P950,000 is expected to produce 10,000 units of product during its entire
life before being replaced. At the end of its life, it will have a scrap value of P50,000. The
cost of housing the machine is P25,000 a year. Power consumption per unit is P9.00 and
maintenance per unit is P7.00. Labor and material cost is P350 per unit. If depreciation is
sinking fund at 12%, determine the cost per unit if annual production is:
a.) 10,000 b.) 5,000 c.) 2,500 d.) 1000

VIII. Replacement Studies

Four major reasons for replacement
1. Physical impairment
2. Inadequacy
3. Obsolescence
4. Rental or lease possibilities
 Instances of replacement analysis
1. Replace due to constant increasing maintenance
2. Replace due to declining efficiency
3. Replace due to inadequacy
4. Replace due to obsolescence
5. Replace due to combination of causes above

Unamortized value of equipment or property – is the difference between its book value and resale
value.
- Considered as sunk cost if the result is negative

Basic Pattern for Replacement Studies

1. ROR method
2. Annual cost method
3. EUAC method
4. PWC method

Example
An existing compressor will supply only 70% of the estimated future compressed air requirement of
a manufacturing plant. It cost P240,000 a year to operate and maintain and it can be sold now for
P150,000. A new compressor will just furnished the required 30% additional air can be purchased
for P270,000. Its annual operating expenses is P135,000.
A full-capacity machine which can supply the entire air requirements is available for P600,000 and
its annual operational costs are expected to be P320,000. Each machine is expected to last 10 years
with 10% of present values as salvage value. The minimum required rate of return is 18%. Which of
the two alternatives is economical?

IX. Break-Even (BE) Analysis

A. BE Analysis Between Alternatives

 Applicable to alternatives with common variables

Total cost = fixed cost + variable cost

TC = FC + VC

Alternative 1: TC1 = FC1 + VC1

Alternative 2: TC2 = FC2 + VC2

Break-even – for two alternatives is when two alternatives have equal total cost, i.e.:

TC1 = TC2

If VC1 = f(x) and VC2 = f(x), where x = unit of output/production

 Then at TC1 = TC2, x = number of products that results in equal total cost

Break-Even Chart
 Is the graphical representation of break-even analysis
 Break-even point – is the intersection of the curve representing the total cost function
of two alternatives
 See chart in the board

Method of analysis:
1. ROR on additional investment method
2. Annual cost (AC) method
3. PW method
4. EUAC method
B. BE Analysis for Business Enterprise
 Income function: I = f(x)
 Total cost function: TC = FC + VC, where VC = f(x)

 At break-even: TC = I

Break-Even Chart:

 If capital finacing is by share of stocks, add the dividends to the total cost to determine
at unhealthy point:

I = TC + Dividends paid

I = FC + VC + Dividends

Unhealthy Point – is a point at which income is just enough to cover total cost and dividends
paid.
 See chart in the board

Example 1
Data for two 50-Hp motors are as follows:

Alpha motor Beta motor

Original cost P375,000 P480,000
Annual maintenance 15,000 7,500
Life, years 10 10
Efficiency 87% 92%
Taxes and insurance 3% 3%
Power cost is P20/kWh. If money is worth 20%, how many hours per year would the motors
have to be operated at full load for them to be equally economical? If the expected number of
hours of operation per year exceeds the BE point, which motor is more economical? Draw BE
chart

Example 2
A local company assembling usb produces 300 units per month at a cost of P800 per unit. Each
usb sells for P1,200. If the firm makes a profit of 10% on its 10,000 shares with par value of P200
per share, and the fixed cost are P20,000 per month:
a. What is the break-even point?
b. What is the unhealthy point?
c. How much is the loss or profit if only 100 units are produced and sold in given month?
d. Draw BE chart