Chapter 1

Time Value of Money

1.1 Basic Concepts and Definitions
Money has the capacity to generate more money.
 If a given sum of money is deposited in a savings account; it earns interest.
 If it is used to start a business, it earns profit
 If it is used to purchase a share in a business, it earns dividends.
Dividend is that part of the money made by a business, which is divided
among those who own shares in the business.
 If it is used to purchase an office building or apartment house, it earns rent.
Thus, the original sum of money expands as time elapses through the
accretion of these periodic earnings.
Interest: the money earned by the original sum of money, regardless of
whether the earned money is referred to as “interested”, “profits”, “dividends”
, or “rent” in ordinary commercial parlance.
Interest rate: the time rate at which a sum of money earns interest (it is
usually expressed in percentage form).
Investment: the productive use of money to earn interest.
Capital: the money that earns interest.
The interest earned by the original capital can itself be invested to earn
interest, and this process can be continued indefinitely. This capacity of
money to enlarge itself with the passage of time is referred to as the time
value of money.
Why money possesses a time value & simply we accept this condition as a
fact? Since it is assumed that money is invested the instant it is received.
1.2 Cash Flow and Cash-Flow Diagrams
Cash flow is nothing but the set of payments associated with an investment;
and cash flow diagram is a diagram that shows these payments.

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 In the cash flow diagram:
 Time is plotted on a horizontal axis
 The payments are represented by vertical bars
 The amount of each payment is recorded directly above or below the bar
representing it.
 The bars are generally not drawn to scale
Note: If the set of payments under consideration consists exclusively of
receipts or of disbursements, the bars may all be placed above the horizontal
axis. Where both types of payments are present, the bars representing
receipts will be placed above the horizontal axis and those representing
disbursements will be placed below it.
E.g. assume that a project has the following cash flow:
1) a disbursement of $ 50,000 now
2) a receipt of $ 10,000 after three years
3) a receipt of $ 15,000 after five years and
4) a receipt of $ 20,000 eight years hence
Taking the unit of time one year, the cash flow diagram is represented as in
fig 1.1
Receipts $10,000 $15,000 $20,000

Year
1 2 3 4 5 6 7 8 9 10
Disbursements
$ 50,000
Fig 1.1 Cash flow diagram
Note: In order to specify the timing of a payment, it will often be convenient
to select a particular date as zero time and number the units time from that
date.
Year 1 Year 4
Years
1 2 3 4 5
Fig 1.2 numbering of time units

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As shown in fig 1.2, year 1 starts at zero time, and in general year a starts n-
1 years zero time.
1.3 Basic Relationship between Money & Time
The sum of money that is earning interest at a given instant is known as the
principal in the account. At the expiration of a time interval called the
interest period, the interest that has been earned up to that date is converted
to principal there by causing it to earn interest during the remainder of the
investment. This process of converting interest to principal is referred to as
the compounding of interest; it represents an investment of the interest in
the same investment.
The recurring cycle of events for this investment is shown diagrammatically
in fig. 1.3.
Earning of interest during
Principal Interest period
Interest

Compounding of interest at the

end of interest period
Figure 1.3 Compounding of Interest
This cycle consisting of the earning of interest & its conversion to principal is
repeated during each interest period, with the principal and the interested
earning becoming progressively larger.
E.g. At the beginning of a particular year, the sum of $10,000 was deposited
in a savings account that earned interest of 10% per annum. The growth of
this sum during a three-year period is explained as follows:
During the first year, the principal is $10,000, and the interest earned by the
end of that year is 10,000(0.10) = $1,000
At that time, the interest is compounded, there by increasing the principal to
10,000 + 1,000 = $11,000.
The interest earned by the end of the second year is 11,000(0.10) = $1,100

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At that time, this interest is compounded, there by increasing the principal to
11,000 + 1,100 = $12,100
The interest earned by the end of the third year is 12,100(0.10) = $1,210
At that time, this interest is compounded, there by increasing the principal to
12,100 + 1,210 = $13,310
In general, let
P = sum deposited in savings account at the beginning of an interest period
F = Principal in account at expiation of n interest periods
i = interest rate
The principal at the end of the first period is P + Pi = P (1+i)
The principal at the end of the second period is P (1+i) + P (1+i) i
= P (1+i) (1+i) = P (1+i)2
The principal at the end of the 3rd period is
= P (1+i) (1+i ) + P (1+i) (1+i) i
= P (1+i) (1+i) (1+i) = P(1+i)3
The principal at the end of the 4th period is:
=P (1+i) (1+i) (1+i) + P (1+i) (1+i) (1+i)i
= P (1+i) (1+i) (1+i) (1+i) = P(1+i)4
From this we conclude that the principal is multiplied by the factor (1+i)
during each period.
Therefore, the principal at the end of the nth period is
F = P (1+i) n-------- 1.1
1.4 Significance of Time Value of Money
To analyze an investment or compare alternative investments, it is necessary
to consider the timing as well as the amount of each payment. To simplify
this, let us consider the following question? Is it preferable to receive $ 1000
today or $ 1000 one year hence?
Ans: it is preferable to receive $1000 now, since it can be invested
immediately to earn interest. For instance, if the money is invested at 20%
per year, it will have grown to $ 1200 one year hence.

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Similarly, is it preferable to expend $ 1000 now or $ 1000 one year hence?
Ans: It is preferable to expend $ 1000 one year hence, since by retaining the
money for 1 year, we earn interest for that year.
Therefore, clearly the significance of time value of money is unquestionable.
1.5 Notation for Compound Interest Factors
As our study of finance progresses, we shall define and apply several
compound-interest factors. Each factor will be represented symbolically in the
following general format:
(A/B, n, i)
A & B denoted two sums of money
A/B denotes the ratio of A to B
n denotes the number of interest periods
i denotes the interest rate
For brevity the interest rate can be omitted, and the expression will be given
simply as (A/B, n)
1.6 Calculations of Future Worth, Present Worth, Interest Rate,
and Required Investment Duration
Recall Equation. (1.1)
F = P (1+i)n
P is referred to as the present worth of the given sum of money
F is referred to as the future worth of the given sum of money
The terms “present” and “future” are applied in a purely relative sense as a
means of distinguishing between the beginning and end of the time interval
consisting of n periods.
The factor (1+i)n is termed as the single-payment future-worth factor.
Conventionally we introduce the following notation.
(F/P, n, i) = (1+i) n------ 1.1a
Thus, eqn (1.1) can be rewritten as
F = P (F/P, n, i) ----1.1b

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Similarly, P  F 1  i  ......... 1.2
n

The factor (1+i)-n is termed as the single-payment present-worth factor.

N.B when a future sum is converted to its present worth, it is said to be
discounted.
i = (F/P)1/n-1--------.1.3

log F
n P .......... ..1.4
log1  i 

Example 1: If $ 5,000 is invested at an interest rate of 10% per annum, what

will be the value of this sum of money at the end of 2 years?
Soln.
Given: P = $5,000, n = 2, i = 0.10
Applying eqn 1.1b
F = P (F/P, n, i) = 5,000 (F/P, 2, 10%)
= 5,000 (1.1)2 = $6,050
Example 2: Smith loaned Jones the sum of $ 2000 at the beginning of year 1,
$3000 at the beginning of year 2 and $ 4000 at the beginning of year 4. The
loans are to be discharged by a single payment made at the end of year 6. If
the interest rate of the loans is 6% per annum, what sum must Jones pay?

Soln:
Refer to figure below. To maintain consistency and there by simplify the
calculation of time intervals, convert the date of payment to the beginning of
year 7.
$2000 $3000 $4000
Years
0 1 2 3 4 5 6 7
F
Soln: Applying eqn 1.1b and using Table A.B
F = 2000 (F/P, 6, 6%) + 3000 (F/P, 5,6%) + 4,000 (F/P, 3, 6%)

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 = 2000 (1.41852) + 3000 (1.33823) + 4000 (1.19102)
= $ 11,616
This is the amount that Jones must pay to discharge the debt.
N.B where the given interest rate is not among those appearing in the tables
of appendixes, it is necessary to find the required value of F by applying (1.1)
directly.
When the interest period of a savings account is less than 1 year, the interest
rate is described by expressing a nominal annual rate and the interval b/n
successive compounding, which of course equals the interested period. The
true interest rate is then found by dividing the nominal rate by the number of
interest periods contained in 1 year.
Example 3: If $5000 is deposited in an account earning interest at 8% per
year compound quarterly, what will be the principal at the end of 6 years?
Soln
p = $ 5000
n = 6 x 4 = 24
no min al rate
true int erest rate 
the no of int erest periods contained in 1year

8%
  2%
4
 F = 5000 (F/P, 24, 2%)
= 5000 (1.60844) = $ 8,042
Example 4: An individual possesses two promissory notes. The first note has
a maturity value of $1000 and is due 2 years hence. The second note has a
maturity value of $1500 and is due 3 years hence. As this individual requires
cash for his immediate needs, he wishes to discount these notes (i.e. to assign
them to another individual or organization). If an investor wishes to earn 7%,
at what price should she offer to purchase the notes?
Soln

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The maturity value of a note is the amount of money that the holder of the
note is entitled to receive at the specified date. The proposed purchase price
is
P = 1000 (P/F, 2, 7%) + 1500 (P/F, 3, 7%)
= 1000 (0.87344) + 1500 (0.81630)
= $ 2098
Example 5: An individual borrowed $3000 and discharged the debt by a
payment of $ 4500 four later. What annual interest rate did this individual
pay, to the nearest tenth of percent?
Soln P = $ 3000
F = $ 4500
n=4
0.25
 4500
By eqn (1.3) i =    1  1.07  1  10.7%
 3000 

Example 6: If $ 6,000 is invested at 6%, in how many years will it expand to $

24,000?
Soln
F = 6,000
P =24,000
i = 0.06
log 4
eqn (1.4) yields n   24 years
log1.06

1.7 Meaning of Equivalence

In general two alternative payments are equivalent to one another if the
monetary worth of the firm will eventually be the same regardless of which
payment is made.
Consider that a firm received the sum of $10,000 at the beginning of year 6
and immediately invested this at 8%, by the beginning of year 9, this sum of
money has expanded to 10,000 (F/P, 3, 8%) = 12,597. Therefore, if the firm

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had received the sum of $12,597 at the beginning of year 9 rather than the
sum of $10,000 at the beginning of year 6, its monetary worth at the
beginning of year 9 and at every instant thereafter would have been the
same. Thus, these two alternative events receipt of $10,000 at the beginning
of year 6, and receipt of $12,597 at the beginning of year 9- yield an identical
monetary worth if money is worth 8%. We therefore can say that these two
events are equivalent to one another.
Now, consider that this firm made a disbursement of $10,000 at the
beginning of year 6. If this money had remained in its possession and earned
8% interest, it would have expanded to $12,597 by the beginning of year 9.
Therefore, if this firm had made a disbursement of $10,000 at the beginning
of 6th year, its monetary worth at the beginning or year 9 and at every instant
thereafter would have been the same. Thus, these two alternative events-a
disbursement of $10,000 at the beginning of year 6, and a disbursement of
$12, 597 at the beginning of year 9- are equivalent to one another if money is
worth 8%.
1.8 Comparison of Sets of Payments
Two sets of payments may be compared by finding the value of each set at a
common valuation date. If their values are coincident, the two sets of
payments are equivalent to one another.
Example 7: Given the following set of payments:
$ 800 at the beginning of year 2, and
$ 500 at the beginning of year 6
On the basis of an 8% interest rate, this set of payments is to be transformed
to an equivalent set consisting of the following:
A Payment of X at the beginning of year 5, and
A payment of 2X at the beginning of year 9.
Find the payments under the second set, and verify the values.
Soln.
Refer to fig. 1.8 select the beginning of year 9 as the valuation date.

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 $800 $500 X 2X
Years Years
0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9
(a) First Case (b) Second Case
Value of the first set = 800 (F/P, 7) + 500 (F/P, 3)
= 800 (1.71382) + 500 (1.25971)
= $2001
Value of the second set = X (F/P, 4) + 2X = X (1.36049) +2X = $ 2001
Solving, X = $ 595, 2X = 1191
To verify these results, assume that a savings account has an interest rate of
8% & that the given payments represent withdrawals from the account. Also
arbitrarily assume that the account had a principal of $2000 at the end of
year 1. The history of the account is as follows:
First set of withdrawals:
Principal at the beginning of year 2 = 2000-800 = $1200
Principal at the beginning of year 5 = 1200 (1.36049) _500 = $1133
Principal at the beginning of year 9 = 1133 (1.25971) = $ 1427
Second set of withdrawals:
Principal at the beginning of year 2 = $2000
Principal at the beginning of year 5 = 2000 (1.25971) – 595 = $1924
Principal at beginning of year 9 = 1924 (1.36049) _ 1191 = $1427
The equivalence of the two sets of payments if thus established.
1.9 Change of Interest Rate
The interest rate changes at a particular date. This date serves to divide time
into two intervals, each characterized by a specific interest rate. If a given
sum of money is to be carried from one interval to the other, it is necessary to
find its value at the boundary point.
Example 8: The sum of $ 5000 will be required 10 years hence. To ensure its
availability, a sum of money will be deposited in a reserve fund at the present
time. If the fund will earn interest at the rate of 4% for the first three years &
6% thereafter, what sum must be deposited?

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Soln:
The problem requires that we find the present worth of the specified sum of
money. We move this sum of $5000 backward 7 years at 6% and then
backward another 3 Years at 4 %. Then
Deposit = 5000 (P/F, 7, 6%) (P/F, 3, 4%)
= 5000 (0.66506) (0.88900) = $ 2956
1.10 Equivalent & Effective Interest Rates
If a given rate applies to a period less than a year, its equivalent rate for an
annual period is referred to as its effective rate.
Illustration:
Consider that at the beginning of a given year the sum of $100,000 is
deposited in each of three funds designated A, B & C. The interest rates are
as follows.
Fund A, 8% per year compounded quarterly
Fund B, 8.08% per year compound semiannually
Fund C, 8.243% per year compounded annually
The principal in each fund at the beginning of the following year is as
follows?
Fund A: 100,000 (1.02) 4 = $ 108,243
Fund B: 100,000 (1.04) 2 = $ 108,243
Fund C: 100,000 (1.08243) = $ 108,243
Thus, the effective rate corresponding to a rate of 2 % per quarterly period (or
8% per year compound quarterly) is 8.243%.
In general, let
r = nominal annual interest rate
ie = effective interest rate
m = No. of interest periods contained in 1 year.
m
 r
Then ie  1    1        (1.5)
 m

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 m
 r
Prove that ie  1    1
 m
The concept of effective interest rates affords a simple basis for comparing
interest rates that apply to unequal intervals of time.
1.11 Effect of Taxes on Investment Rate
If the rate of taxation varies according to the amount of the income, it is
necessary to establish the rate at which the income from a specific venture
will be taxed.
Definitions:
Original income: income received by a firm before taxation.
Residual income: the income that remains after the payment of taxes.
Before-tax rate: investment rate calculated on the basis of original income.
After-tax rate: investment rate calculated on the basis of residual income.
Assume Q as the sum of money received & this income is taxed at the rate t.
Assume also that the tax payment in which Q is reflected occurs
immediately.
The tax payment = Qt
 Re sidual income  original income  tax payment

= Q – Qt = Q (1-t)
Assume Q as the sum of money expended. Let M denote the taxable income
for this tax period as calculated with out reference to Q, and let t denote the
tax rate. Then,
Net taxable income = M-Q
Tax payment = (M- Q) t = Mt -Qt
 Re sidual Income  Net taxableincome  Tax payment

= (M-Q) – (Mt – Qt)

= M – Q – Mt + Qt
= M – Mt – Q + Qt
= M (1 – t) – Q (1 – t)

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Thus, the expenditure of amount Q reduced the residual income by the
amount Q (1 – t).
A receipt or expenditure of amount Q serves to increase or decrease the
residual income, respectively, by the amount Q (1-t). We shall refer to this
amount as the after-tax value of Q and denote it by Qc.
Then, Qc = Q (1 –t) …...2.6
We shall now develop the relationship between the before-tax & after-tax
investment rates. Assume that a given investment pays a constant annual
dividend during its life & that the firm recovers the money originally invested
when the venture terminates. Let
C = amount invested
I = annual income from investment rate
ib = before-tax investment rate
ia = after-tax investment rate
We have the following
Original income = I, & ib = I/C= original income/amount investment
Residual Income = Net taxable income – Tax payment
= I – It = I (1 – t),
& ia = I (1-t)/C = residual income/amount invested
Then ia = ib (1 –t)
Problem: A firm expended $560 to have an employee attend a seminar. If this
expenditure is tax deductible and the tax rate of the firm is 45%, what was
the after tax value of the expenditure?
1.12 Opportunity Costs and Sunk Costs
Consider that an organization has a choice of two alternative investments, A
and B. If it undertakes investment A, it forfeits the income that would accrue
under B. Therefore, the income associated with investment B is referred to as
an Opportunity Cost of investment A.

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A Sunk Cost is an expenditure that was made in the past and that exerts no
direct influence on future cash flows. Therefore, it is irrelevant in an economy
analysis.
1.13 Inflation
Inflation is the general increase of costs with the passage of time respect to a
given commodity. Let
Co = cost of commodity at the beginning of the first year
Cr = Cost of commodity at the end of the rth year
q = (effective) rate of inflation of rth year
The rate of inflation for a given year is taken as the ratio of the increase in
cost of the commodity during that year to the cost at the beginning of the
year. Expressed symbolically,
Cr  Cr 1
q -------1.8
Cr 1
If the annual rate of inflation remains constant for a year, the cost of
commodity at the end of that period is

Cn  Co 1  q 
n
----1.9

This equation is analogous to eqn 1.1

? Take any commodity, which you know in your life experience and calculate
its inflation rate.
1.14 Uniform Series of Payments
Many Sets of payments that occur in practice exhibit uniformity in both the
amount and timing of the payments. We shall now investigate sets of
payments of this type.
Definitions:
Uniform Series/Annuity: a set of payments each of equal amount made at
equal intervals of time.
Payment Period: the interval between successive payments.

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For example, if a corporation makes an interest payment of $50,000 to its
bondholders at 3-month intervals, these interest payments constitute a
uniform series, and the payment period is 3months. Similarly, if a
construction company rents equipment for which it pays $4000 at the end of
each month, these rental payments constitute a uniform series, and the
payment period is 1 month.
Ordinary Uniform Series: one in which a payment is made at beginning or
end of each interest period. The payment period and interest period coincide
in all respects in ordinary uniform series.
By convention, the origin date of a uniform series is placed one payment
period prior to the first payment, and the terminal date is placed at the date
of the last payment. The value of the entire set of payments at the origin date
is called the present worth of the series, and the value at the terminal date is
called the future worth.
$600

0 1 2 3 4 5 6 7 Years

Origin Terminal
Date Date

Fig. Uniform Series

Figure is the cash-flow diagram of a uniform series that consists of seven
annual payments of $600 each.
As in the case of a single payment, it is necessary to select an appropriate
interest rate in evaluating a uniform series. Generally, the appropriate
interest rate is implicit in the nature and purpose of the calculation. We shall
illustrate this point by considering two specific instances of uniform series.
First, assume that deposits of equal amount are made in a fund at equal
intervals of time. This fund is labeled a sinking fund, and it is seen that
sinking-fund deposits constitute a uniform series. If we are to calculate the
principal in the fund at any date, it is simply necessary to apply the interest

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rate of the fund. Now assume that a loan is to be discharged by a set of equal
payments made at equal
intervals of time. When the payments have been completed, the loan is said
to be amortized, and amortization payments yield a uniform series. If we are
to calculate the principal of the loan at some intermediate date, it is
necessary to apply the interest rate that the lender is charging the borrower.
1.14.1 Calculation of Present Worth and Future Worth
With reference to an ordinary uniform series, let
A= Periodic Payment
Pu= Present worth of series
Fu= Future worth of series
n= number of payments
i= interest rate
Evaluating all payments at the origin date of the series and summing the
results, we obtain
Pu= A (1+i)-1 + (1+i)-2 + ………+ (1+i)-n
Then Pu = A 1-(1-i)-n = A 1-1/(1+i)n
i i (1.10)
Similarly,
Fu = A (1 + i)n -1 (1.11)
i
The quantities Pu and Fu are of course related by Eq. (1.1) and therefore
Fu = Pu (1 + i)n
In accordance with the convention stated earlier, we introduce the following
notation:
(Pu/A,n,i) = 1 – (1+i)-n (1.10a)
i
(Fu/A,n,i) = (1+i) n –1 (1.11a)
i
Equations (1.10) and (1.11) may now be rewritten in this form:

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 Pu = A(Pu/A,n,i) (1.10b)
Fu = A(Fu/A.n.i) (1.11b)
The factors (Pu/A,n,i) and A(Fu/A.n.i) are known as the uniform-series
present-worth and future-worth factors, respectively. Values of these factors
are presented in tables of Appendixes
1.14.2 Calculation of Periodic Payment
In many instances, the present worth of future worth of a uniform series is
known and it is necessary to calculate the periodic payments. Solving
Equations (1.10) and (1.11) for A gives the following result:
A = Pu i = Pu i (1.12)
1 – (1+i)-n 1-1/(1+i)n
A = Fu i (1.13)
(1+i)n-1
We introduce the following notation:
(A/Pu,n,i) = i (1.12a)
1-1/(1+i)-n
(A/Fu,n,i) = i (1.13a)
(1+i)n -1
Equations (1.12) and (1.13) may now be rewritten in this from:
A = Pu( A/Pu,n,i) (1.12b)
A = Fu(A/Fu,n,i) (1.13 b)
The factors (A/Pu,n,i) and (A/Fu,n,i) are known as the capital-recovery and
sinking-fund factors, respectively. Values of these factors are presented in the
tables of Appendixes. It can be demonstrated that
(A/Pu, n, i) – (A/Fu.n.i) = 1 (1.14)
We also have
(A/Pu,n,i) > 1/n (A/Fu,n,i) < 1/n (1.15)
Example: You have just graduated from college & plan to begin a retirement
fund. It is your desire to withdraw money every year for 30 years starting 25
years from now. The fund earns 7% interest. What uniform annual amount

17
will you be able to withdraw when you retire in 25 years if you deposit $1,000
per year for the 1st 20 years starting one year hence?

1.14.3 Series with Unequal Payment and Interest Periods

We shall now consider an extraordinary uniform series having the following
characteristics: Each payment is made at the beginning or end of an interest
period and the payment period is a multiple of the interest period. This type
of series is illustrated by a sinking fund in which deposits are made at the
beginning or end of each year and interest is compounded quarterly.
Let
n = number of payments
m = number of interest periods contained in one payment period
The remaining notation is identical with that for an ordinary uniform series.
The relationships are as follows:
Pu = A 1-(1+i)-mn = A 1-(1+i)-mn (1.16)
(1+i)m - 1 (1+i)m - 1
Fu = A 1+i)mn - 1 (1.17)
(1+i)m - 1
If we divide the numerator and denominator of each fraction by i, we obtain
equations composed of the basic compound-interest. The result is as follows:
Pu = A(Pu/A.mn) (A/Fu, m) (1.18)
Fu = A(Fu/A,mn) (A/Fu,m) (1.19)
A = Pu (A/Pu,mn) (Fu/A,m) (1.20)
A = Fu(A/Fu,mn) (Fu/A,m) (1.21)
1.14.4 Calculation of Interest Rate
Assume that the know quantities concerning an ordinary uniform series are
the periodic payment and either the present or future worth, and it is
necessary to determine the interest rate pertaining to the series. In general,
Equations (1.10) and (1.11) are not susceptible of direct solution for i, and
therefore recourse must be had to a trial-and-error procedure.

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 1.14.5 Equivalent Uniform Series
Earlier, we stated that two sets of payments are equivalent to one another if
they have an identical value on any valuation date. For comparative
purposes, it is often desirable to transform a given set of non uniform
payments to an equivalent set of uniform payments The periodic payment
under the equivalent set is termed the equivalent uniform payment. This
transformation can readily be accomplished by selecting any convenient
valuation date, calculating the value of the given set of payments at that
date, and on this basis calculating the equivalent uniform payment.
Example: A Couple owning 50 hectares of available land has decided to sell
the mineral rights on their property to a mining company. Their primary
objective is to obtain long-term investment income & sufficient money to
finance the college education of their two children. Since the children are
currently 12 & 2 Years of age, the couple estimates that the children will
start college in 6 & 16 Years, respectively, from the present time. They
therefore make a proposal to the mining company that it pay $20,000 per
year for 18 years beginning 3years hence, plus $10,000 six years from now
and $15,000 sixteen years from now. If the company wants to pay off its lease
for equal end of year amount through a 20 years period starting one year
hence, how much should it pay each year if the investment could make 16%
per Year?

1.14.6 Perpetuities
A uniform series in which the number of payments is infinite is termed
perpetuity. A simple illustration of a perpetuity is offered by an endowment,
which is established for the purpose of providing periodic payments to an
educational, cultural, or humanitarian institution, with payments to be equal
in amount to be placed in the endowment fund is equal to the value at that
date of the endless stream of payments, this value being a finite amount.

19
As in the case of a uniform series of finite duration, the origin date of
perpetuity is placed one payment period before the first payment, and the
value of the perpetuity at the origin date is termed its present worth.
Let
Pup = present worth of perpetuity
m = number of interest periods contained in one payment period
In Equation (1.16), the term (1+i)-mn vanishes when n is infinite, and
therefore
Pup = A (1.22)
(1+i)m – 1
An alternative expression for Pup is
Pup = A (A/Fu, m,i)
i (1.23)

In the special case where the payment period and interest period are
coincident, Equation (1.22) reduces to
Pup = A when m=1 (1.22a)
i
Example: A fund having an interest rate of 5% per annum was established to
provide an endless stream of end of year payments of $10,000 each. However,
the actual payments made during the 1st three year period were as follows:
end of 1st year, $12,000; end of 2nd year, $13,400; end of 3rd year, $14,200. If
the remaining payments are to be uniform and are to continue indefinitely,
what can be the amount of each payment?
End of 3rd year, value of exces payment = 2000 (1.05)2 + 3400 (0.05)
+ 4200
= - B// = Pu = 9975
The reduction in individual payment = pui = = 498.75
The amount of each remainicy payment = 10,000 Pui
= 10,000 Pui
= $ 9,501.25

20
Let Q denote the value at the beginning of the rth payment period of all
payment to be made in the future. Since the number of payments is infinite,
it follows that Qr is a constant and therefore equal to Pup. Thus, an
endowment fund must have a principal Pup not simply at the origin date, but
at the beginning of every payment period. It follows that the interest earned
in each period must equal precisely the periodic withdrawal, thereby
preserving the original principal Pup and sustaining the endless stream of
payments. Equation (1.22) is in accord with this conclusion, for the
denominator of the fraction is the amount of interest earned by $1 in one
payment period.

1.15 Uniformly Varying Series of Payments

In many sets of payments that occur in practice, the payments are uniformly
spaced and their amounts form an arithmetic or geometric progression. We
shall now investigate such sets of payments.
1.15.1 Value of Uniform Gradient Series
A uniform – gradient series (UGS) is a set of payments having the following
characteristics: All payments are made at equal intervals of time, and each
payment beyond the first differs from the preceding payment by a constant
amount. The interval between successive payments is termed the payment
period, and the difference between successive payments is called the
gradient. The gradient is positive if the payments increase with time,
negative if the reverse is true. As in the case of uniform series, the origin date
of a UGS is placed one payment period prior to the first payment, and the
terminal date is placed at the date of the last payment. The values of the
UGS at its origin date and terminal date are referred to as its present worth
and future worth, respectively. An ordinary UGS is one in which a payment
is made at the beginning or end of each interest period, and therefore the
payment and interest periods are fully coincident. Let

21
Hr = rth payment
G = Gradient
Pug = Present worth of series
Fug = Future worth of series
n = Number of payment
i = Interest rate
Then Hr = H1 + (r-1)G (1.24)
The present and future worth of an ordinary UGS are as follows.
G 1  (1  i )  n G
Pug  ( H1   nG )  n (1.25)
i i i
G G
Or Pug  ( H1   nG)( pu / A, n, i)  n (1.25a)
i i
G (1  i)n  1 G
Fug  ( H1  )  n (1.26)
i i i
G G
Or Fug  ( H1  )(Fu / A, n, i)  n (1.26a)
i i
Two special types of UGS often arise. When H1 = nHn and therefore
G=-H1/n, Eq.(1.25a) reduces to
H 1  ( pu / A, n, i) 
Pug  1 (1.27)
i  n 

When Hn = nH1 and therefore G = H1 Eq, (1.26a) reduces to

Fug 
H1
( Fu / A, n  1, i)  (n  1) (1.28)
i
Example: A manufacturing company is undertaking a program to reduce
operating costs. The Production & Planning head in charge of operations has
established a goal of saving an equivalent total present amount of $100,000
in the next 4 years through reduced finished product losses. He estimates
that the company will be able to save $50,000 the 1st year, but cost reductions
will become more difficult each year. If the reductions are expected to follow a
uniformly decreasing gradient series, what must the reductions be in years 2,

22
3 & 4 in order for the company to meet its estimated goal? The company‟s
interest rate is 15% per year compounded monthly.
Pug = (H1 + G + nG) 1- (1+i) –n - G n
i i

1.15.2 Uniform Gradient Series of Infinite Duration

Consider that a UGS will have an infinite number of payments, and let Pugp
denote the present worth of the series. If the payment period coincides with
the interest period, we have
Pugp = H1 + G (1.29)
i i2

Example: The sum of $250,000 has been deposited in a fund to provide

annual scholarships that are to continue indefinitely. The 1 st payment will be
made 1 year after the date of deposit, & each payment beyond the first will be
$ 200 more than the preceding payment. If the interest rate of the fund is 7%
per year compounded quarterly, what can be the amount of the 1st payment?
$ 15,182
G =200 i = 7% , ie = (1+0.07/4 )4- 1 = 7.19%
H1 = ?
Pugp = Hi + G
i i2

1.15.3 Value of Uniform Rate Series

A uniform-rate series (URS) is a set of payments having the following
characteristics: All payments are made at equal intervals of time, and each
payment beyond the first is obtained by multiplying the preceding payment
by a constant. If 1 is subtracted from the constant, the remainder is the rate
of increase of the payments.
As an illustration, assume that the initial payment is $1000 and the rate of
increase is 20 percent. Then

23
 Second payment = 1000 (1.20) = $1200
Third payment = 1200 (1.20) = $ 1440
Fourth payment = 1440 (1.20) = $1728
The definitions pertaining to a URS are similar to those pertaining to a
uniform series and a UGS. The interval between successive payments is
termed the payment period. The origin date of a URS placed one payment
period prior to the first payment, and the terminal date is placed at the date
of the last payment. The values of the URS at its origin date and terminal
date are referred to as its present worth and future worth, respectively. An
ordinary URS is one in which the payment and interest periods are fully
coincident.
Let
Hr = rth payment
s = rate of increase of payments
Pur = present worth of series
Fur = future worth of series
n = number of payments
i = interest rate
Then Hr = H1 (1 + s) r-1 (1.30)
The present and future worth of an ordinary UGS are as follows:
Pur = H1 [(1 + s)/(1 + i)]n -1 (1.31)
s–i
or Pur = H1 (F/P,n,s) (P/F,n,i) - 1 (1.31a)
s–i
Fur = H1 (1 + s)n - (1 + i)n (1.32)
s–i
or Fur = H1 (F/P,n,s)- (F/P,n,i) (1.32a)
s–i
In the special case where s = i, Eqs. (1.31) and (1.32) assume the following
forms:

24
 Pur = H1n (1.31)
1+i
Fur = H1n (1 + i)n-1 (1.32)
Uniform-rate series play an important role in economic analyses in which
provision must be made for inflation.
Example: Deposits were made in a fund at the end of each year for 7
consecutive years. The 1st deposit was $18,000, with each deposit decreasing
thereafter at the rate of 15%. If the interest rate of the fund was 6% per
annum compounded quarterly, what was the principal in the fund 3 years
after the seventh deposit was made?

$ 121,872

18,000 7

S = -15%, i = 6% , ie = (1+r/m)m -1 = 6.14%

H1 = 18,00
Fur = H1 (1+5)n – (1+i)n
5-i

1.15.4 Uniform-Rate Series of Infinite Duration

Consider that a URS will have an infinite number of payments, and let Purp
denote the present worth of the series. If the payment period coincides with
the interest period, we have the following: When s> i Purp is infinite. When s <
i,
Purp = H1 (1.33)
i–s

25
Example: An endowment fund is to provide perpetual annual contribution to
a hospital, the 1st contribution to be made 1 year hence. The 1st four
payments will each be $20,000, & the payments will then increase at the rate
of 3% per annum. Thus the 5th payment will be $20,600, the 6th payment will
be $21,218, and etc. If the interest rate of the fund is 8% per annum
compounded semiannually, what sum must be deposited in the fund at the
present date?

$20,000 $20,600 $21,218

Pu = A 1 – (1+ie)-3 + H1 (1+ie)-3
ie i-s
ie = (1+0.08)4 – 1 = 8.24%
4

Chapter 2
Depreciation
Definitions

26
Asset: property that is acquired and exploited for monetary gain such as
machines, vehicles, office building, planes, ships, boats, computers, etc.
First Cost of an Asset: total expenditure required to place an asset in
operating condition.
E.g. If an asset is purchased, it includes the purchase price related and all
incidental expenses such as transportation, tax, telephone, assembly, expert
advice, etc.
Salvage Value or Residual Value: the price at which a fixed asset is expected
to be sold at the end of its useful life.
Book Value: the value of an asset displayed on the documents of the firm.
E.g. if the first cost of an asset is $20,000 and the depreciation charges to
date total $14,000 the current book value is $6,000
Depreciation: the decline in the value of the asset.
As time elapses, every asset undergoes a progressive loss of value resulting
from:
1) Physical factors: wear and tear, exposure to elements
2) Functional factors: technological change
In contrast to other business expenses, depreciations does not manifest itself
in the form of cash transactions during the life of the asset, and consequently
it is necessary to make an entry in the books of the firm at the close of each
accounting period, for two reasons:
1) to record the depreciation that occurred during that period, and there by
permit a true determination of the earnings for that period
2) to display the current value of the asset.
This entry is known as a depreciation charge, and the process of entering
depreciation charges is known as writing-off the asset.
2.1 Tax Effects of Depreciation
Since depreciation is a recognized business expense, it reduces the taxes the
firm is required to pay. Thus, every depreciation charge creates a tax savings

27
for that year, and amount of the savings is the function of the amount of the
depreciation charge and the rate at which the firm‟s profits are taxed.
2.2 Depreciation Allocation Methods
A firm in its accounting records is constrained to follow an officially approved
depreciation method. However, in its informal records it may prefer to follow
some other method it considers more realistic, there by obtaining a more
accurate appraisal of the value of its assets and the profitability of its
operations.
The notational system for depreciation is as follows
Bo = first cost of asset
Br = book value of asset at the end of rth year
L = estimated salvage value
Dr = depreciation charge for rth year
n = estimated life span of asset, years
2.2.1 Straight- Line Method
 It is the simplest method of depreciation.
 It is almost rough estimate.
 It has the disadvantage of yielding a slow write-off of the asset.
 It assumes as the total depreciation cost to be assigned uniformly over the
life of the asset.
Bo  L
Then, Dr   cons tant.........( 2.1)
n
Example 1: A machine costing $15,000 has an estimated life span of 8 years
and an estimated salvage value of $3000. Compute the annual depreciation
charge and the book value of the machine at the end of each year under the
straight line depreciation method.
Soln
Given:
Bo = $15,000
L = $3000

28
 n = 8 years
Applying equation (2.1)
Bo  L $15,000  $3000
D   $1500
n 8
B1 = Bo - D
= 15,000 – 1,500 = $12,000
B2 = B1 –D = 15,000 – 1,500-1500 = Bo –2D
„
„
Bn = Bo - nD
B3 = 15,000 – 3 x 1,500 = $10,000
B4 = 15,000 – 4 x 1,500 = $9,000
B5 = 15,000 – 5 x 1,500 = $7,500
B6 = 15,000 – 6 x 1,500 = $6,000
B7 = 15,000 – 7 x 1,500 = $4,500
B8 = 15,000 – 8 x 1,500 = $3,000
2.2.2 Sum-of-Years‟ Digits Method
It avoids the problem of straight-line depreciation method (that is, it
accelerates the write-off of the asset). By this method, the depreciation
charges form a descending arithmetic progression in which the first term is n
times the last term. It follows that
Dr  (n  r  1) Dn.......... .......... .......... .......( 2.2)

The depreciation charge for the final year is the total depreciation divided by
the sum of the integers from 1 to n, inclusive. Since this sum is n(n+1)/2, we
have
2( Bo  L)
Dn  .......... .......... .......... .......... ..( 2.3)
n(n  1)

Under the Sum-of-Years‟ Digits Method

29
Example 2: An asset with a first cost of $70,000 is expected to have a service
life of 10years and a salvage value of $4,000. Depreciation will be allocated by
the sum-of-years‟-digits method. Find the book value of the asset at the end of
the sixth year. Verify the result by computing the depreciation charges for
the first 6years.
2.2.3 Declining-Balance Method
This method postulates that the depreciation of an asset for a given year is
directly proportional to its book value at the beginning of that year. i.e.
Dr αBr-1
Let h denote the constant of proportionality, then
Dr = h Br-1
h is expressed as k/n, where k is assigned the value 1.25, 1.5, and 2,
depending on the nature of the asset.
Then

k
Dr  Br 1................................................(2.4)
n
Since book value diminishes as the asset ages, the depreciation charges form
a decreasing series, and the declining-balance also yields an accelerated
write-off.
Assume the salvage value of the asset as zero, and let
D1s denotes the depreciation charge for the first year calculated by straight-
line method.
D1d denotes the depreciation charge for the first year calculated by the
declining-balance method.
Then
Bo  L Bo  o Bo
D1s   
n n n
k
D1d  Br 1 , where r  1
n

30
 k Bo
 D1d  Bo  k
n n
Bo Bo
D1d = k but = D1s
n n
Thus D1d = kD1s
For this reason, the declining-balance method is called the “double declining-
balance method” when k = 2.
Since the value of h bears no relation to salvage value, the final book value
obtained by applying h consistently will generally differ from the estimated
salvage value. As a result, it is necessary to abandon the declining-balance
method at some point, and the straight-line method is applied for the
reaming life.
Example 3: Applying the double-declining-balance method, calculate the
depreciation charges for an asset having a first cost of $20,000, a life span of
8 years and an estimated salvage value of
a) $4000
b) $500
Soln a) given Bo =$20,000
L= $4,000
k = 2, n = 8
Required: Depreciation charges
We shall first establish the depreciation charges & final book value that
result if the declining-balance method is applied throughout the life of the
asset
h = k/n = 2/8 = 0.25
Dr= hBr-1
D1 =hBo B1 = Bo – D1 B1 = Bo – hBo = Bo (1-h)
= 0.25 (20,000) = 20,000-5,000
= $5,000 = $15,000
D2 =hB1 B2 = B1 – D2 B2 = Bo (1-h) – hBo (1-h)

31
 = 0.25 (20,000) = 15,000-3750 = Bo (1-h) (1-h)
= $3750 = $11,250 = Bo (1-h)2
D3 =hB2 B3 = B2 – D3 B3 = Bo(1-h)2 – hBo (1-h)2
= 0.25 (20,000) = 11,250-2813 = Bo (1-h)2 (1-h)
= $2813 = $8,437 = Bo (1-h)3
„ „ „
„ „ „
Bn = Bo (1-h)n
Consistently using the above equations, the depreciation charge and final
book values can be summarized as below:
Year Book value at beginning, $ Depreciation change, $ Book value at end, $
1 20,000 5,000 15,000
2 15,000 3,750 11,250
3 11,250 2,813 8,437
4 8,437 2,109 6,328
5 6,328 1,582 4,746
6 4,746 1,187 3,559
7 3,559 890 2,669
8 2,669 667 2,002
Since the book value can never fall below the salvage value, the declining-
balance method must be abandoned at the end of the 5th year. Depreciation is
charged for the sixth year but not for the 7th & 8th years. Then
D1 = $ 5000 D3= $ 2813 D5= $ 1582
D2= $ 3750 D4= $ 2109 D6= 4746 – 4000 = $ 746
D7= D8= 0
(b) The declining-balance method yields a final book value of $2002, but the
salvage value is only $500. One possibility is to apply the declining balance
method for the first 7 years and then set the depreciation for the 8th year
equal to 2669-500 = $2169. However, if the objective is to write-off the asset
as rapidly as the IRS allows, it is more advantageous to transfer to the

32
straight-line method at the point where this method yields a higher
depreciation charge than does the declining- balance method.
Assume that the transfer from declining-balance to straight-line method
occurs at the beginning of the rth year. The remaining depreciation must be

Year Depreciation if transfer is Depreciation if transfer

made at beginning of year, $ is differed, $
2 (15,00-500)/7 = 2071 3750
3 (11,250-500)/6 = 1792 2813
4 (8437-500)/5 = 1587 2109
5 (6328-500)/4 = 1457 1582
6 (4746-500)/3 = 1415 1187
7 (3559-500)/2 = 1530 890

allocated uniformly among the remaining years of the life of the asset.
Therefore, the depreciation charge for the rth year (and all subsequent years)
is
Br 1  L
Dr  .......... .......... .......( 2.5)
n  r 1

Refer to the table above, which is constructed by applying the values obtained
in the first table. The depreciation charge for the rth year as given by eqn (2.5)
is recorded in column 2, and the depreciation charge as obtained by a
continuation of the declining-balance method is recorded in column 3. A
comparison of the values in the two columns discloses that a reversal occurs
at the beginning of the 6th year & therefore the transfer from declining
balance method to straight-line method should be made at that date. Then
D1 = $5000 D3= $2813 D5= $1582
D2= $ 750 D4= $2109 D6= D7= D8= $1415

33
 2.2.4 Accelerated-Cost-Recovery System (ACRS)
Definitions
Ordinary Expenses: expense that has short-term effects such as wages paid
to a machine operator, wages paid to laid off laborers.
Capital Expenses: expenses that has long-term effects such as the cost of
purchasing land on which to build a new factory, etc.
The Characteristics of ACRS are as follows:
1) A newly acquired asset is assigned a cost-recovery period (as
distinguished from an estimated service life), & the entire first cost of the
asset can be written off during this period. Thus, salvage is ignored in
calculating depreciation charges. The recovery period is 3, 5, 10, or 15
years, depending on the nature of the asset.
2) The firm is called to consider part of the first cost of a newly acquired
asset as an ordinary expense incurred in the year of acquisition. This
practice is known as first-year expensing (or simply expensing). Through
first-year expensing, part of the cost of the asset is written off
immediately.
3) The firm is granted an investment tax credit for a newly acquired asset.
Let,
Bo = first cost of the asset
E = amount of first-year expensing
I = Investment tax credit
M = depreciation basis of asset
The value of I is as follows:
 For an asset with a recovery period of 3 years 6 % (Bo –E)
 For an asset with a recovery period of 5 years or more, 10% (Bo – E)
The tax credit is taken the year the asset is placed in service. However, if the
credit exceeds a certain limit, the excess can be carried back to reduce the
taxes for prior years or it can be carried forward to subsequent years.
The depreciation basis of an asset is taken as:

34
 M = Bo – E – 0.5I……………….. (2.6)
The depreciation charge for a given year is found by multiplying the
depreciation basis by a prescribed factor. The table below presents the values
of their factors for assets having 3 and 5-year recovery periods.
Table: Depreciation Factors

Recovery period
Year 3 years 5 years
1 0.25 0.15
2 0.38 0.22
3 0.37 0.21
4 N.A* 0.21
5 N.A* 0.21
Total 1.00 1.00

* Not applicable
Example 4: At the beginning of a certain year, a firm placed in service an
asset having a first cost of $30,000 & recovery period of 5years. As this was
the only asset acquired that year, the firm can assign the full expense
allowance of $10,000 to this asset. Compute the deprecation charges for the 5-
year period (a) with expensing (b) with out expensing.
Solution
Part a:
Given: Bo = $ 30,000
E = 10,000
n=5
For n = 5 years
I = 0.1 (Bo – E) = 0.1 (30,000 – 10,000) = $ 2000
M = Bo –E – 0.5I
= 30,000 – 10,000 – 0.5 (2000) = $ 19,000
D1 = 19,000 (0.15) = $ 2850

35
 D2 = 19,000 (0.22) = $ 4180
D3 = D4 D5 = 19,000 (0.21) = $ 3950
Part b = I = 0.10 Bo = $ 3000
M = 30,000 – 1,500 = $ 28,500
D1 = 28,500 (0.15) = $ 4275
D2 = 28,500 (0.22) = $ 6270
D3 = D4 = D5 = 28,500 (0.21) = $ 5985

2.2.5 Units-of Production Method

If deterioration of an asset is primarily of exploitation rather than
obsolescence, we have to use production volume as the base of depreciation
charge. Moreover, if the asset is a machine that is used to produce a standard
commodity, the magnitude of its use can be measured by the number of units
it produces.
The depreciation charge/unit of production = Bo–L/Units produced by the
asset
 Depreciation charges for consecutive years are allocated by multiplying
the volume of production by this unit charge.
N.B Depreciation can be allocated on the basis of profitability rather than
production alone. Assume that the net profit per unit of production declines
as the asset ages. Each unit can be assigned a weight proportional to its net
profit, and the depreciation charges are then calculated on the basis of these
weighted units, which are termed depreciation units.
Example: 5 A machine with a first cost of $76,000 will be used to produce
8000units of a standard commodity. Production will be distributed over a
6year period, and the number of units produced per year is expected to be as
follows: 1st year, 1100; 2nd year, 2100; 3rd year, 1800; 4th year, 1200; 5th year,
1000; 6th year, 800. The machine will be scraped at the end of six years, and
its salvage value is estimated to be $4,000. Depreciation will be allocated on
the basis of profitability of production, and the units are considered to have
the following relative values of profitability: first 2,000units, 1.20; next

36
2,000units, 1.15; next 3,000units, 1.10; last 1,000units, 1.00. Compute the
depreciation charges.

Chapter 3
Cost Comparison of Alternative Methods
Every need that arises in our industrial society can be satisfied in multiple
ways. For example, there are alternative manufacturing processes for
producing a commodity, and there are alternative designs for constructing a
bridge. Consequently, the engineering economist has the task of identifying
the most desirable way of satisfying each need that arises. Generally, the
disbursements associated with each alternative method span a period of
several years, and therefore it is necessary to weave the time value of money
into any investigation.
As the name implied the alternative methods differ solely with respect to cost
but are alike with respect to income, serviceability, general convenience, etc.
For example, in determining whether a commodity is to be produced
manually or by automated equipments, we assume that the quality of the
product is identical under the two methods.
3.1 Selection of Interest Rate
The first problem in a cost comparison of alternative methods is to select the
interest rate on which the calculations are to be based. We assume that all
savings that accrue from using one method in preference to the others are
invested at the same interest rate, and it is the rate to be applied in the cost
comparison.
3.2 Description of Simplified Model
Our immediate objective is to formulate standard techniques of cost
comparison. To avoid making our task prohibitively arduous, we shall

37
construct a simplified model of the industrial world with the following
characteristics.
1) All economical & technological conditions remain completely static, except
where changes are expressly described. As a result, interest rates and
costs remain constant as time elapsed, and each asset is replaced with an
exact duplicate when it is retired.
2) The future can be foreseen with certainty. Consequently, all forecasts and
projections prove to be accurate in every respect.
3) Interest is compounded annually
4) All disbursements and receipts associated with an asset occur at the
beginning or end of a year.
There are several techniques of cost comparison, and we shall study each
method in turn.
1. Present Worth of Costs (PW)
Where two alternative assets are to be compared with respect to cost, we may
establish a basis of comparison in this manner:
 Select a period of time that encompasses an integral number of lives of
each asset.
 Select the beginning of this time period as the valuation date, and find the
value at this date of the entire set of payments associated with each asset
during this time period.
This value is called the present worth of costs, and the period of time selected
is known as the analysis period.
Example 1: Two types of equipment are available for performing a
manufacturing operation; the cost data associated with each type are
recorded in the accompanying table. Applying an interest rate of 8%,
determine which type is more economical.

Type A Type B

38
 First cost, $ 88,000 45,000
Salvage value, $ 7,500 4,000
Annual maintenance, $ 4,300 5,200
Life, years 12 6
Solution:
We shall compute the present worth of costs. Select a 12- year analysis
period; this encompasses one life of type A and two lives of type B. The
capital payments that occur during this period are recorded in fig. 3.1, where
expenditures are shown below the base line and income above it. With
respect to type A, the salvage value pertaining to the first life falls within the
analysis period, but the first cost of the second life falls beyond this period.
Similar comments apply with respect to type B. payments for annual
maintenance is treated as lump sum, end-of-year expenditures.
$ 7500
0 years
12
$ 88,000 (a)
$ 4000 $ 4000
Years
12
$ 45,000 $ 45,000 (b)

Fig 3.1 Capital payments (a) Type A; (b) Type B.

PWA = 88,000 + 4300 (Pu/A, 12) – 7500 (P/F, 12)
= 88,000 + 4300 (7.53608) – 7500 (0.39711) = $ 117,430
PWB = 45,000 + (45,000 – 4000) (P/F,6) +5200 (Pu/A, 12) – 4000(P/F, 12)
= 45,000 + 41,000 (0.63017) + 5200 (7.53608) – 4000 (0.39711)
= $ 108,440
Type B equipment is more economical

39
 2. Capitalized Cost
The present worth of costs technique encompasses on integral number of lives
of the asset for analysis, but this technique encompasses an infinite number
of lives for analysis. The present worth of costs for an infinite period is known
as the capitalized cost (CC) of the asset.
Where the life of an asset may be considered infinite, the present worth of
costs and the capitalized cost are coincident. Mathematically, the capitalized
cost of an asset may be interpreted as sum of money that must be deposited
in a fund at the date of purchase at the stipulated interest rate to just
provide all payments for perpetual service.
As usual let:
Bo = first cost of asset
L = salvage value
n = Service life of asset, years
C = annual operating cost, including maintenance & normal repairs.
We define a standard asset as one having these characteristics: The only
capital payments are Bo & L and C remains constant during the life of the
asset.
CC

One service
Life of asset

Years
C C C C C C
Bo Bo-L Bo-L……………

CC is the sum of above cash- flows

 A 
( Bo  L)  ,n
CC  Bo   Fu  C
 .......... .3.1
i i

40
This is because,
i. Bo is a single present payment and so we take it as it is.
ii. Bo-L is the periodic payment made indefinitely. Therefore, by equation
1.23

Bo  L   A Fu, n 
Pup   
i
iii. And in the special case where the payment period & interest period are
coincident, Equation (1.22) reduces to
A
Pup  Where m = 1 … (1.22a)
i
C is annual operating cost, including maintenance & normal repairs, which is
made annually, thus m = 1
Therefore, by equation (1.22a)
C
Pup 
i

From equation (1.14) we know that

(A/Pu, n, i) – (A/Fu, n, i) = i …….1.14
 (A/Fu, n, i) = (A/Pu, n, i) – i
Substituting it in equation 3.1

Bo  L   A Pu, n, i   i 

CC  Bo    C
i i

Bo  L  A Pu, n, i 
 Bo     Bo  L  C
i i
Bo  L   A Pu, n, i 
=    L  C .......... ........... .......... .3.2
i i
Return back to equation 3.1

41
 Bo  L   A 
CC  Bo   Fu , n C
i i
In the special case where the life of the asset is infinite, the value of (A/Fu, n)

decreases drastically, thus

Bo  L   AFu, n  o
i
C
Thus CC = Bo + ........ 3.1a
i
Example 2: Two alternative machines have the cost data shown in the
accompanying table. Compute these machines on the basis of capitalized cost,
applying an interest rate of 11.5 %.
Machine A Machine B
First cost, $ 95,000 63,000
Salvage value,$ 6,000 5,000
Annual 9,200 12,500
maintenance, $
Life, years 8 5

Solution:
Since the compound-interest tables do not include the specified interest rate.
We have to apply eqn. (2.30)

 A   i
 Pu, n, i  1  1  i  n

  A  0.125
  0.19780
 Pu, 11.5%  1
1
1.1158
A  0.115
 Pu, 5, 11.5%    0.27398
  1
1
1.1155
By eqn 4.2

42
 89,0000.19780 9200
CCA   6000   $239,080
0.115 0.115
58,0000.27398 12,500
CCB   5000   $251,880
0.115 0.115
Conclusion: Machine A is less costly
Example 3: Compare the assets having the cost date shown in the following
table on the basis of capitalized-cost method
Asset A Asset B
First cost, $ 46,000 34,000
Selvage value,$ 4,000 0
Annual Maintenance,$ 3,700 3,200
Life, Years 7 5

Solution:
Applying egn 3.2

Bo  L   A Pu , n 
CCA    LC
i i

46,000  4000   A Pu,7,10% 

=    4000  3700
0.1 0.1
= $ 127,270

34,000 A 
 Pu, 5,10%  3200
CCB    $121,690
0.1 0.1
B is more economical
Example 4: two alternative assets have the cost data shown below. Compare
these assets by the capitalized-cost method with an interest rate of 9.8 %
Asset A Asset B
First cost, $ 120,000 65,000

43
 Salvage Value $ 10,000 0
Life, Years 5 3
Annual operating cost, $
Year 1 15,000 26,000
Year 2 18,000 30,000
Year 3 22,000 35,000
Year 4 28,000 N.A*
Year 5 37,000 N.A*
* Not applicable
Solution:
Since the annual operating cost varies, each asset is non-standard, and thus
the above equations are not applied directly. We have to follow the following
steps.
1) draw the cash flow diagram that shows the set of payments
2) Convert the set of payments to an equivalent single payment made of the
date of retirement
3) Since the equivalent single payments constitute perpetuity apply equation
2.13 to determine the present worth of costs for an infinite period.
According to our simplified model of the industrial world the equivalent end-
of-life of payment associated is an asset will remain constant & continue
forever.
10,000
1) 0 1 2 3 4 5 years
15,000 18,000 22,000 28,000 37,000
120,000
Cash flow diagram of asset of for one life
0 1 2 3
26,000 30,000 35,000
65,000
Cash flow diagram of asset B for one life

44
 2) Equivalent payment at the date of retirement for Asset A:
= 12,000 (1+0.098)5 +15,000 (1+0.098)4+22,000(1.098)2+28,000 (1.098) +
37,000-10,000
=$ 321,410
for Asset B
=65,000 (1.098) 3+ 26,000 (1.098) 2 + 30,000 (1.098) + 35,000
= $ 185,330
3) 5 years Asset A

A A A A
A
Pup .......... .. 2.13
1  i m  1
Perpetuity: a uniform series in which the no of payments is infinitive
Pup = present worth of perpetuity m: no of interested periods contained in
one payment period
3years for Asset B

A A A
The capitalize cost of the asset is the value of this perpetuity at its origin
date. By egn. (2.13)
321,410
CCA   $ 539,350
1.0985  1
185,330
CCB   $ 572,440
1.0983  1
Conclusion Asset A is more economical

Example 5: The floor surfacing in a factory costs B 4000 and must be

replaced every 5 years. An alternative type of surfacing will cost $ 6000.
Applying the capitalized- cost method with an interest rate of 9%, determine
how long the alternative type must to warrant the higher expenditure.
Solution:

45
All payments beyond the initial constitute a perpetuity having the present as
origin date. To find the capitalist cost, we must add the initial payment.
Let x denote the life in years of the alternative type of surfacing we apply
equ. 2.13
For the present type of surfacing
4000
CC  4000   $11,426
1.095  1
For the alternative type,

6000
CC  6000 
1.09x 1
CC

$ 11,476 Q

X
4 6 8.04 2
fig. Variation of capitalization cost with in year‟s life of asset

The point Q at which the two capitalization costs are equal is called the
break-even point. At this point,
6000
600   11,426
1.09x  1
x = 8.64 years
The alternative type of surface is preferable is its life exceeds this value.
3. Equivalent Uniform Annual Cost (EUAC)
* This is the 3rd technique of alternative cost comparison.
Procedures to be followed to apply this technique of comparison:
Select an interest rate, if not given

46
 Draw the cash flow diagram in the manner discussed in 3.1 of the true set
of the payments of the asset.
Transform the set of payments associated with an asset to an equivalent
uniform series having the following characteristics:
 Its origin date & terminal date coincide respectively with the purchase
date & retirement date of the asset
 It consists of payments made at the end of each year
The periodic payment under this equivalent uniform series is known as the
equivalent uniform annual cost (EUAC) or (simply annual cost) of the asset.
Note: since we are assuming that each life of the asset is a duplicate of the
original life, it follows that the EUAC of the asset remains constant as time
elapses. Therefore the EUAC is a valid base for comparing the costs of
alternative assets.
For a standard asset the EUAC is given by the following alternative
equations:
EUAC = (Bo-L) (A/Fu,n) + Boi + C ………………..3.3
EUAC = (Bo-L) (A/Pu,n) + Li +C …………………..3.4
The EUAC of an asset is an equivalent end-of-year payment that is assumed
to recur indefinitely; and the CC of the asset is the present worth of costs for
an endless period of time. Therefore, in accordance to equation (1.22a), we
have the following relation between the two quantities.
EUCA = (CC) i…………………………………………3.5
Example 6: Two alternative tools have the cost data shown in the
accompanying table. Identify the tool that is more economical if money is
worth (a) 8% or (b) 12%. Compute the difference in EUCA corresponding to
each interest rate.
Tool A Tool B
First cost,$ 4000 9000
Selvage value.$ 500 800

47
 Annual 1000 953
maintenance,$
Life, years 3 8
Solution:
EUACA = 3500 (A/Pu, 3.8%) + 500 (0.08) + 1000
= 1358 + 40 + 1000 = $ 2398
EUACB = 8200 (A/Pu, 8, 8%) + 8000(0.08) +950
= 1427 +64 + 950
= $ 2441
Tool A is more economical
Differences = 2441-2398 = $ 43
Example 7: A construction firm is considering whether it should buy or rent a
certain facility that is required for its operations. The cost data associated
with owing the facilities are as follows:
Initial cost $130,000; Life 4 years; Salvage value $20,000; Fixed maintenance
cost $2000 per year; Operating cost $160 for each day the facility is used; the
charge for renting the facility is $400 per day.
If money is worth 15%, determine the number of days the facility must be
used per year to justify its purchase.
Solution
The annual rental charge is also treated as a lump-sum, end-of-year payment
for simplicity.
Let X denoted the number of days per year the facility is used
Case i. The annual cost of ownership is
EUAC = (Bo-L) (A/Pu, n) +Li +C
= (130,000 –20,000) (A/Pu, 4, 15%) + 20,000(0.15) +160x
= 43,530 + 160x

48
Case ii. The annual cost of renting the facility = 400x
Annual cost

Own Q

$43,530
Rent

0 181 x

number of days used per year variation of annual cost facility with frequency
of use
400x = 43,530 + 160x
x = 180 days/year
Conclusion case i is feasible if we utilize the asset more frequently then 181
days/year. If not case ii is feasible.
For non-standard asset
Example 8: An asset is a life of 15 years required the following payments for
repair: end of year 3, 3600; end of year 8, $4300; end of year 12, $4,600. If
money is worth 13%, what was the equivalent uniform annual repair cost of
the asset?
Solution:
Step 1 since interest rate is given, no need of determining the interest rate
Step 2 Draw the cash flow diagram of the true set of the payments of the
asset.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

3600 4,300 4,600 F

49
Step 3 transform these payment to an equivalent uniform series select the
retirement date of the asset as the sate of the equivalent single payment. Its
amount is 3600 (1.13) 12 + 3000 (1.13) 7 + 4600 (1.13) 3 = B 32,358
This is the value of the equivalent uniform series at its terminal date. Thus,
the equivalent uniform annual repair is determined by eqn (0.4)

i
i.e A = A  Fu
1  i n 1
0.13
A  EUAC  32,358  $ 800.00
1.1315  1

Cost comparison on after-tax Basis

-All tax payments of all tax savings must be taken into account, before
alternative methods of cost comparison are to be compared.
- Calculations involving the time value of money must be based on the after-
tax interest rate.
Let PW sev = present worth of tax savings from deprecation (including
investment tax credit, if any)
t = effective tax rate for an ordinary income
ia = after-tax interest rate
L‟ = residual income from salvage after payment of fexed
EUAC = (Bo – L‟ – PW sev) (A/Pu, n, ia) + L‟ ia + C (1-t)----4.6
If L = L‟ & deprecation is allocated by straight-line method.

EUAC = (Bo –L) (A/Pu, n, i) -

Bo  L  t + Lie +C (1-t)
n

Bo  L' Pw sev  A pu, n, ie 

CC     L' C 1  t  ----4.8
ia ia
  Pu 
2 Bo  L    A, n, ia  
Pw sev  1   t -----5.1
ia n  1  n 
 

50
When an asset is deprecated by ACRS & the investment tax credit is
included,

PWsav I  Et  1  ia   t  or 1  ia 
1 r
------5.9

E = amount of first-year expensing

G = Investment tax credit
M = deprecation basis of asset
I = 6% (Bo-E) for an asset having recovery period of 3 year
= 10% (Bo-E) for an asset having recovery period of 5 years or more
M = Bo – E- 0.5 I
Depreciation factors
Recovering period
Year 3years 5years
1 0.25 0.15
2 0.38 0.22
3 0.37 0.21
4 NA 0.21
5 NA 0.21

Economical Retirement Date

In theory an asset can be held for any length of time with in reason.
Therefore, before alternative assets can be compared with respect to costs, it
is necessary to identify the most economical life span of each.
Condition to be considered:
-The given asset will be replaced with an exact duplicate
- Effect of taxation is ignored
Steps to be followed
*Transform the true set of payments corresponding to a given value of n to an
equivalent end of life of payment by a cumulative process
n – the life span in years

51
* Obtain the equivalent net disbursement for each prospective life span by
deducting selvage value from an equivalent end of life of payment
* Since the equivalent payments constitute operating having a payment
period of n years, the cost of the asset can be obtained by applying the
formula.
A
Pup = Cost =
1  l m  1
* Finally the optimal cost is selected
eg 6.35

Chapter 4
Decision Making with Probability
Part I:
Introduction about Probability
Since future events cannot be clearly foreseen, managerial decisions and
planning must be based on probability rather than certainty. As a result, it is
imperative that the engineering economist be profitability. An understanding
of probability requires a prior understanding of permutations and
combinations.
1) Performance of a set of acts
Theorem: Assume that n acts to be performed in sequence. If the first act can
be performed in m, alternative ways, the second act in my alternative
ways,… the nth act in mn alternative ways, the entire set of n acts can be
performed in m1, m2, m3 … mn alternative ways.
Eg. An engineer engaged in supervising construction must travel from town
A to town B and then to town C. He has a choice of two roads (R1 & R2) in
going from A to B, and a choice of four roads (Ra, Rb, Rc, and Rd) in going
from B to C. How many alternative routs does the engineer have in going
from A to C?

52
 Soln
m1 = 2
m2 = 4
Therefore, the entire set of n activities in our case, two activities can be
performed in m1 x m2 = 2 x 4 = 8 alternative ways.
Ra
Rb
Town B Rc town C
Rd
R1
R Ra
R2 Rb
Town A
Rc
Rd

Tree diagram for generating alternative routs from town A to town C

Example: Assume that there are two boxes containing colored spheres. The
first box contains 1 red & 1 green sphere, and the second box contains 1 blue,
1 yellow, and 1 brown sphere. If 1 sphere is to be drawn at random from each
box, what are the numbers of possible colour combinations?
Soln The first act can be performed in two alternative ways i.e m1 =2 the 2 nd
act can be performed in 3 alternative ways, m2 =3
 The no of possible colour combination is (the entire set of acts);
m1 x m2 = 2 x 3 = 6
1 2 3 4 5 6
R Y RY, RBl, RBr, GY, GBl, GBr

G Bl Br

53
2) Permutations with Distinct Items
Permutation: An arrangement of a group of items in which the order or rank
is of significance.
The arrangement may contain the entire group of items or only part of group.
Eg.1 the permutations of the first 4 letters of the alphabet taken all at a time
is as follows:

abcd bacd cabd dadc m1 = 4

abdc badc cadb dacb m2 = 3
acbd bcad cbad dbac m3 = 2
acdb bcda cbda dbca m4 = 1
adbc bdac cdab dcab The entire set of acts can be performed
adcb bdca cdba dcda M1 xm2 xm3xm4 = 4x3x2x1 =n! =24

Let Pn, r denote the no of possible permutations of n items taken r at a time

Example: The complete set of permutations of the first 3 letters of the
alphabet taken 2 at a time is as follows:
Ab ba ac ca bc cb
n!
Pn , r  ........ from exp ermental
n  r !
Skeletor formal (not deriven)

First we determine the complete list of permutes by taking n ites at a time

this equals n!
Second we determine the compete list of permutations by taking r items at a
time.
n! (Permutation by taking n items at a time) = positive (Permutations taken r
items at a time)
n! = (n-r)! Pn, r
 Pn, r = n!
(n-r)!

54
Permutations with some items alike
We note that permutations are not possible for those containing similar
items, i.e, permutation can not be transformed to a new permutation by
interchanging items
e.g we can not from different permutation for aaa by changing the position of
one a by another a.
In general, Let Pn, n(j) denote the no of possible permutations of n items
taken all at a time; where j items are a like. Then
Pn, n(i) = n!
j!
Let Pn, n(j,k) denote the no of possible permutations of n items taken all at a
time, where j items are like & k other items are a like. Then
Pn , n (j,k) = n!
j!,k!
Combinations
A grouping items in which the order is of on significance.
In general , Cn, r = n!
r!(n-r!)

Definitions pertaining to probability

If the value that a variable will assume on a given occasion cannot be
predetermined b/c it is influenced by chance, this quantity is referred to as a
random or stochastic variable.
Example: * The no of variables traversing a bridge on a given day
* The no of organisms of a specified type contained in 1-cm3 specimen of
water drawn from a lake.
* The amount of time a customer must wait after entering a service center.
A process that yields of a random valuable is known as a trial or experiment,
& the value the variable assumes in a given trial is called the out come.
e.g when a die is tosses, the manner in which it lands is governed by chance,
& the no of dots on the face that lands on top is a random variable. In this

55
situation, the process of tossing the die is the trial, & the no of dots on the top
face is the outcome. There are 6 possible out comes, namely, the integers from
1 to 6 inclusive.
Assume that a trial has n possible outcomes, designated 01, 02, 03, …, 0n and
that one outcome is just as likely as any other. The probability of a particular
outcome is defined as 1/n. Let P (0i) denote the probability of 0i, then
P(0i) =1/n
A specified out come or set of outcomes is termed an events:
Example: With reference to tossing a die, we may define the following events:
Event E1: the outcome is 4
Event E2: the outcome is even. This event comprises the outcomes
2,4,& 6
Events E3: the out come is at least 3. This event comprises the
outcomes 3, 4, 5, & 6.
Two events are said to be mutually exclusive or disjoint if it is impossible for
both to result from a single trial. Thus, with reference to tossing a die, the
following events are mutually exclusive:
Event E4: the out come is even
Event E5: the outcome is 3 or 5
Two events are said to be over lapping if true is one or more outcomes that
will satisfy both events.
E.g. With reference to tossing a die, consider the following pair of events.
Event E6: the outcome is even
Event E7: the outcome is less than 4
There is one outcome (namely,2) that satisfies both events, and therefore they
are overlapping.
Theorem: Assume that a trial has n possible out comes of equal probability. If
any one of r outcomes will produce an event E, the probability that E will
occur is P(E) = r/n

56
Theorem: If two events E1 & E2 are mutually exclusive, the probability that
either E1 or E2 will occur is the sum of either respective probabilities
Expressed symbolically,
P ( E1 or E2) = P(E1) + p (E2)
Theorem: Assume that a trial T1 has n, possible outcomes of equal
probability and that a trial T2, independent of T1, has n2 possible outcomes
of equal probability. The two trial may be performed in sequence or
simultaneously.
1) the no of possible combined outcomes of the two trial is n1, n2, all of equal
probability.
2) If an event E1 can be produced by any one of r1 outcomes of T1 and an
event E2 can be produced by any one of r2 outcomes of T2, then both E1 &
E2 can be produced by any one of r1 r2 combined out comes.
* Both statements stem directly from the law of multiplication properties of a
probability distribution.
A value of a random variable X is obtained by performing a trial. Consider
that this trial is repeated indefinitely, each trial being independent of all
predecessors. This process generates an infinite set of values of x. the set
contains every possible value of x, and the relative frequency of each value in
the set is equal to its probability. The arithmetic mean and standard
deviation of this infinite set of values are referred to as the arithmetic mean
and standard deviation, respectively, of the probability distribution of x.
The notation is as follows:
N= arithmetic mean of probability distribution
 = standard deviation of probability distribution
E (x) = Expected value of X
 = E (x) =  x (p(x))

   x     px 
2

57
 Negative Exponential Probability Distribution
A random variable x is said to have a negative-exponential (or simply
exponential) probability distribution if its probability distribution if its
probability-density function f(x) is of this form:
F(x) = ae –ax If x >0
F(x) = 0 If x<0
Where a is a positive constant.
This type of probability distribution is wifely prevalent for example, the
longevity of an electronic device often has a negative –exponential
distribution and consequently this distribution is of major importance in the
study of reliability.
By integrating f(x) dx b/n the limits of 0 and k, where k > 0, we obtain the
following:
P (x < k ) = 1- e ak ……expresses cumulative probability
Therefore p(x-k) = e-ak
The arithmetic mean and standard deviation of the negative exponential
distribution are as follows:
M=  =1/ 

F(x)
a

Negative- exponential probability distribution curve

P(x < k)

58
Negative- exponential probability distribution curve

P(x < k)

1/a 2/a 3/a

Cumulative- probability curve

e.g the mean life span of an electronic device that operates continuously is 2
months. If the life span of the device has a negative-exponential distribution,
what is the probability that the life span will exceed the following values 1
month, 2 months, and 3 months?
Soln Let x denoted the life span in months
1 1
a   0.5
 2

P( x  1)  e0.51  e0.5  0.6065

P( x  2)  e0.52  e1.0  0.3679
P( x  3)  e1.5  0.2231
Part II
Application of Probability as Decision Making
1) Calculations of expected value

59
Where there is uncertainty concerning the cost of industrial operation of the
profit that accrues from an investment, a decision is often made on the basis
of the expected cost or profit.
Example: Time taken to do the construction = 1 day cost of job is dependent
on weather the job can be performed in two alternative methods the state of
weather is probabilistic.
Since the events are mutually events are mutually exclusive the expected
costs are determined by taking the sum of the probabilistic costs
Method A:
Expected cost = 2200 x 2500 (0.4) + 3000 (o.45) = $ 2680
Method B:
Expected cost = 1500(0.15) +2100 (0.4) +4000 (0.45) = $ 2865
On the basis of the forecast, the firm should apply method A.

Example: 1st determine the cost of testing corresponding to the possible

alternative ways:
X = no of units that are tested
C = the cost of testing
We have four alternatives
1) x = 3 c = 18
2) x = 4 c = 22.75
3) x = 5 c = 27.25
4) x = 6 c = 31.75
2nd the no of possible permutation:
P7,7( 4,3) = 7! =35
4! 3!

We have 35 possible out comes

3rd determine the possible events.

1) Events E1 = the number units tested is 3

60
 This is satisfied only when all 3 type B units are identified and
has the following permutation
B BB AAA A
Event E2
2) The no of units tested is 4

Note the testing of units is completed when either all 4 type A

units or all 3 type B units have been identified
i) AAAA BBB
ii) BBABAAA

The two B‟s and 1 A can be varied

3! = 3x2! = 3
1+3 = 4 permutations is possible
1) Events E3 the no of units tested is 5
i) AABBBAA ii) AAABABB

4! = 4x3 =6 4! = 4
2! 2! 3! 1!

= 6+4 =10
2) Events E4 the no of units tested is 6
i) B AA B A B A BAABAAB
5! 5! = 10
3! 2! 3! 2!

= 5X4 =10
2

Total permutation = 20
The probability distribution of x is deterred
p(3) = 1/35 p(4) = 4/35 p(5) = 10/35 p(6) = 20/35.

61
 Chapter 4
Economic Analysis of Industrial Operations
Objectives: to formulate techniques for obtaining the maximum economic
efficiency of an operation.
4.1 Definition pertaining costs
Cost: is the amount of expenditure actual or notational incurred or
attributable to a given thing.
Attribute: equality belonging to or formulating part of the nature of the
person or thing.
Business costs: representative the value of economic resources that are
scarified to obtain more desirable resources. These resources scarified may be
money, material, time or expertise. Incur to receive (some unpleasant thing)
as the result of certain action.
Remand J. chamber distinguishes three different senses in which the term
cost is uses as:
a) the expected cost of a particular action
b) the cost of some thing purchased
c) the cost of attaining some end
In simple cost represents that portion of acquisition of price of goods,
property or services which have been differed or not to utilize in connection
with the realization of revenues. The purchase price of fixed assets, Material,
supplies etc are the examples of since differed costs.
4.2 Classification of Costs
The classification of costs can be made as follows:
1) the classification by nature or element
2) functional classification
3) classification on the bases of behavior
4) the classification by managerial decisions and control

62
 Classification of cost

By nature By function By behavior By managerial

decisions & control

Direct cost Indirect cost

1) Classification of costs on the bases of name

According to the nature or elements of costs can be broadly classified as
direct costs and in direct costs.

a) Direct costs: are the costs which can be conveniently identified with
and collect to a particular unit of final product. Such costs are treaded as the
costs of unit produced.
E.g. Labor cost, raw material cost, & other direct expenses
The direct costs can further be classified as:
i) direct material
ii) direct labor
iii) direct expenses
All materials which become on integral part of the finished product and
which can be conveniently assigned to specific physical units is called direct
material. Direct materials include all material specifically for a specific cost
unit.
Direct labor cost consists of wages spent to workers directly engaged in
manufacturing or lending a product, job or a process. It includes the
payments of wages to workers engaged in the actual production of the
product or on operation process.
All expenses that are other than direct material or direct labor that are
specifically incurred for a particular job, product or a process are called direct
expenses.

63
E.g. costs of specific tools made for a specific job, hiring changer for a specific
equipment, royalty, freight charges, insurance charges on special materials
etc.

b) Indirect costs The indirect costs are those costs which can not be

assigned to any particular constituent. Indirect costs are usually incurred for
a business as a whole and therefore should be divided among the various cost
units on some reasonable basis. Like direct costs indirect costs include
indirect materials such as fuel, small tools, materials consumed for repairs
and maintenance workers etc.
The indirect labor includes wages of general supervisors, inspectors,
workshop cleaners, storekeepers, timekeepers etc.
The indirect expenses shall as rent, lighting, insurances, canteen expenses,
hospital expense and welfare expenses.
Indirect costs are called over head costs.

Functional cost classification

Functional cost can be divided into:
1) Prime cost: it consists of costs of direct materials that go into the product,
the cost of direct labor and indirect expenses.
2) Factory cost or works cost: it consists of prime cost plus factory overhead
or works expenses.
3) The cost of production: it consists of factory cost plus office and
administrative expenses.
4) The total cost (cost of sales); it includes the cost of production plus selling
of distribution overheads.
The classification of costs on basis of managerial control
1) The controllable and uncontrollable costs
Controllable costs are those costs, which can be controlled or influenced by a
specified person or level of management of an undertaking.

64
The costs which can not be controlled or influenced by the action of a
specialized individual in undertaking are know as un controllable costs.
2) Normal and abnormal costs
The costs which are normally incurred of given level of out put are called
normal costs while the costs which are not norm\ally incurred at a given
level of output in conditions at which that levels is normally achieved is
called abnormal cost.
3) Avoidable and unavoidable cost
Avoidable costs are those costs, which can be escaped or avoided if business of
activity to which can not be escaped or eliminated.
4) Shut down costs
Those fixed costs, which have to be incurred even if production or operations
of business are discontinued temporary due to certain reasons such as strike
shortage of raw material, are shut down cost.
5) Differential incremental and decremental costs
Differences in costs due to change in level of activity or method of production
is known as differential cost. In case the change increases the cost it is called
incremental cost and incase the change decreases the cost, it is called decree
mental costs.

Production costs can also be classified as:

1. Variable cost
2. Fixed cost
3. Semi-variable cost
Let x denote a variable that strongly influences the cost of an operation.
Assume that x undergoes relatively small changes. A cost that remains
constant during this change is a fixed cost with respect to x, and one that
changes is a variable cost.
Intermediate between these extremes are semi variable costs, which are
composite costs, that conation both fixed & variable element.

65
Variable costs can often be divided into three subgroups:
 Those that are directly proportional to x these are know as directly
varying cost.
 Those that are inversely proportional to x these are know as inversely
costs.
 Those that vary in some more complex manner.

5.1 Minimization of cost

Let C denoted the total cost of a project or operation, and assume that x is the
only variable that influences C. Also assume that C is composed exclusively
of directly varying costs, inversely varying costs, and fixed costs. Then

C = ax + b/x + c = ax +bx-1 + c ----------5.1

Where a, b, and c are constants

Now let Cmin and Xo denote, respectively, the minimum value of C and the
value of X corresponding to Cmin..
The derivative dc/dx equal to zero and solving for differential C by the
variable X and solve for x by equating to zero.
X: dc/dx = d/dx [ax + bx-1 + c] = o
a – bx-2 = 0

a = b/x2 =Xo = b a

 Cmin  C  Xo   a b 
b b
 c  axo  c
a b xo
a
 a b b a c
a b
a 2b b2a
  c
a a

ab  ab  c

66
  2 ab  c
Conclusion: C is minimum when the sum of the directly varying costs
equals the sum of the inversely varying costs, and this is known as the
Kelvin‟s law.

Y 1
3
Cmin

X
o
Xo

Fig 5.2 a graphic demonstration of Kelvin‟s law

3 Directly verifying cost
4 Inversely varying cost
5 The combination of these costs
Fixed cost has been neglects this is\t doesn‟t affect X

Location of Break-Even point

Generally break-even can be defined as the point in the diagram at which
lines intersect> In other words it is a point at which two variables are equal.
At the break-even point both the independent & dependent variables of two
lines are equal.
Example:
Break-even point may refer to the point at which revenue from the sale of
community is equal to the cost of producing the community.

67
 Break-down point may refer to the point at which the cost of production is
identical under alternative methods of manufacture
Break-even point may refer to the point of which the volume of production
is identical under alternative methods of manufacture
Break- even point may refer to the point on the curve of the production
function that makes the company no loss, no profit
Example: Two companies A & B, manufacture the same commodity company.
A uses a mechanized process, and company B relies mainly on manual labor.
The fixed cost is $ 40,000 per month for A and $ 15,000 per month for B. The
directly varying cost is $ 14 per unit for A and $ 52 per unit for B. The selling
price is $ 85 per unit for each company.
a) At what volume of production are the unit costs of the two companies
identical?
b) How many units must each company sell each month merely to avoid a
loss”
Soln
Let x = no of units produced and sold per month
C = total cost of producing X units
U = Unit cost
P = monthly profit
We shall append a subscript to identify the company. The cost of
company, A = CA = fixed cost + directly varying cost
= fixed cost + no of units produced & sold per month (unit
cost)
= fixed cost + XU
= 40,000 + 14 x
Similarly cost of company B = CB = 15.000 + 52 x
The unit costs are equal at the point where the lines of the costs of the two
companies intersect
At this point, 40,000 + 14x = 15,000 + 52x

68
 X = 658 units/month

C
Break- even point
CB
$ 40,000 CA

$ 15,000
x
658
Fig. A break-even point in the respect that it reveres the minimum
production that is needed to justify use of the mechanized process.
b) the profit of the companies can be calculated as:
PA = Revenue- cost of production
= ( no of units produces & sold per month) Selling price per unit
- 40, 000+ 14 x
= 85 x – (40, 000 + 14 x)
71 x – 40, 000
Similarly PB = Revenue – CB
= 85 x- (15,000 + 52x)
= 33x – 15,000
Recall the definition of break-even point
 Break-even point is that makes the company no loss, no profit
No profit means p = 0
Then equate the profit lines to zero to determining the volume of production
per month to avoid a loss
PA = 0 = 71x –40,000 units/month

69
PB = 0 = 33x – 15,000 = 0
Thus, companies A & B must sell 563 & 455 units per month, respectively,
merely to avoid a loss.
C
Revenue =85A
CB
M CA
N

455 563 658 X

Points M & N are break-even points in the respect that they reveal the
minimum no of units each firm must produce and sell to cover expenses.
Profitability rather than production alone.
Example: A machine costing $ 2,000 will have a life of 5 years and a selvage
value of $ 3000. It is estimated that 10, 000 units will be produced with this
machine, distributed in this manner:
1st year 2000
2nd year 2400
3rd year 2100
4th year 1800
5th year 1700
If deprecation is located on the basis of production, calculate the deprecation
charges.
Soln. given Bo= $ 42,000
1= $ 3000
n=5
Volume of production = 10,000

70
Required: Deprecation charges by the units- of- production method
The deprecation charge
Bo  L 42,000  3000
Per unit of production =   $3.90
volume of production 10,000

 D1 = 2000 (3.90) = $ 7,800

D2 = 2400 (3.90) = $9,360
D3 = 2100 (3.90) = $8,190
D4 = 1800 (3.90) = $7020
D5 = 1700 (3.90) = $ 6630

71
 8) Basics of Capital Budgeting

Introduction
Capital budgeting is the process of analyzing investment opportunities and
making long-term decisions.
A capital expenditure is a cash out lay whose benefits or returns are expected
to extend beyond one year such as the purchase of fixed assets or plant
assets.
 These capital expenditures have long term effects and once made can not
be easily reversed.
 Sound capital investment decisions can lead to higher earnings, which
help the firm to achieve its objects.
 Capital budgeting is a dynamic process because the firm‟s changing
environment may affect the desirability of current or proposed
investments.
 The capital budgeting process involves five major steps as indicated below.

1) Generating project proposals

 Top-down approach: the idea is generated by top management & it is
informed to low level for their suggestion, comment, approval, critism, etc.
 Bottom-up approach: just the reverse of top-down approach
 Investment proposals may be classified into four distinct types indicated
below
a) Expansion projects: to increase existing capacity, to produce new products,
or to enter into a new market
b) Replacement Projects: to replace worn out or absolute facilities
c) Modernization Projects: to improve or up grade existing facilities such as
to rebuild an existing machine

72
d) Safety or environmental projects: these are required to maintain a good
working condition initiated by governments, labour unions (Trade unions),
Insurance compares such as expenditures needed for pollution control
devices, ventilation etc,
2) Estimating cash flows
 Cash inflow: benefit we get in a long period
 Cash outflow: money we pay in a long period
Net cash flows: cash inflows- cash out- flow
3) Evaluating project proposals using
1) Unsophisticated or tradition techniques
2) Sophisticated or time adjusted or discounted cash flow techniques
4) Selecting project proposals, which depends up on
 Project type: - Independent (un related)
Mutually exclusive project eg. Computer model x model y we have to
select only one model
 Availability of funds
 Decision criteria:- Ranking projects according to a proposed hurdle rate
or minimum acceptable rate of return.
5) Implementing & Reviewing projects
 Implementation stage: means developing for mal procedure for
authorizing the expenditures of funds needed for the capital project
 Review stage: Means analyzing the projects that have been already
implemented to determine if they should be continued, or modified, or
terminated it.

Capital Budgeting Techniques

Our assumption here is that capital expenditures involve single &
independent projects.
a) Unsophisticated or traditional capital budgeting techniques: This
technique include

73
  the accounting rate of return (ARR)
 the pay back period (PB)
1) The Accounting Rate of Return
This technique also called the average rate of return is a measure of a
project‟s profitability from a conventional accounting standpoint. It is based
on accounting information rather than cash flows.
ARR= Average Annual net income
Average net investment
Eg. ACL Corporation is considering on investment in project a based on the
following information;
Net investment …………………………..$ 12,000
Estimated annual net income ……………………. 2000
Estimated project life ……………………………… 5 years
Target ARR ……………………………………………… 25%
Required: Compute the ARR and interpret your result.
Soln. Average Annual net income = Total profit over the project life
Estimated life of the project
= ($ 2000) (5 Years) = $ 2000
5 Years
Average net investment = Net investment
2
= 12, 000 = $ 6000
2
ARR = Average Annual NI = $ 2000 = 33.3%
Average Net investment $ 6000
Decision rule: the project is accepted if the computed or actual ARR is greater
than the minimum target ARR set by the firm.
Interpretation: ACL corporation should accept the investment in project a
because the actual ARR (33.3%) is greater than the target ARR 25%

74
Note: In ranking projects having the same target ARR, the project with the
highest actual ARR should be selected, as it is the most profitable.
e.g Projects Computes ARR Project cost
A 30% $70,000
B 28% $50,000
C 26% $80,000
D 25% $60,000
E 20% $45,000
Target ARR 23%
 A, B, C, and D should be selected
 If only $200,000 is available, A, B, & C, will be selected.
Eg2. Determine the ARR from the following data of two machines A & B and
interpret your result assuming that target ARR is 15%.
Machine A Machine B
Cost $ 60,000 $ 60,000
Profit before depreciation & the taxes, ($)
1st year 20,000 29,000
2nd year 22,000 27,000
3rd year 25,000 25,000
4th year 27,000 22,000
5th year 29,000 20,000
Estimated service 5 years 5 years
Life in years
Estimated salvage value $ 5000 $ 5000
Average income tax rate
Average income tax rate 55% 55%
Additional information: Depreciation is to be computed based on the straight-
line method.

Soln. Annual Depreciation for machines A & B

75
 = $ 60,000 - $ 5000 = $ 11000 per year
5 years
Calculation of net income for machine A is shown below
Year (a) (b) ( c) (d) (e)
Profits before Less annual Income 55% less Net
depreciation & taxes depreciation before income tax income (c-
taxes d)
1st 20,000 11000 9000 4950 4050
2nd 22,000 11000 11000 6050 4950
3rd 25,000 11000 14000 7700 6300
4th 27,000 11000 16000 8800 7200
5th 29,000 11000 18000 9900 8100
Total income from machine A $ 30,600

Similarly Calculation of the net income for machine B is shown below

Year (a) (b) ( c) (d) (e)

1st 29,000 11000 18,000 9900 8100

2nd 27,000 11000 16,000 8800 7200
3rd 25,000 11000 14,000 7700 6300
4th 22,000 11000 11,000 6050 49500
5th 20,000 11000 9,000 4950 4050
Total income from machine B $ 30,600

Average annual net income of machines A & B

= total profit for the project life = $ 30,6000 = $6120
Estimated project life 5
Average net investment of machines A & B
(Cost – Salvage value) + Salvage
2
= (60,000 – 5000) + 5000
2

76
 = $ 32,500
ARR = Average Annual Net Income = 6120 = 18.83%
Average Net Investment 3250

Interpretation: Both machine A & B are equally desirable and therefore both
should be accepted (Computes ARR > Target ARR)
18.83%> 15%
Advantages of ARR
1) It is easy to calculate
2) It is easy understandable
3) It considers total profitability (not sample)

Disadvantages of ARR
3) It is based on accounting income rather than cash flow
4) It ignores the time value of money for it values benefits in earlier years
the some
as benefits in latter years
2 The Pay back Period Method
The pay back period is the length of time for a projects cumulative net cash
inflows (cash inflows after taxes) needed to receiver the net investments
made on the project, i.e, the pay back period is a measure of the time needed
for a project to break even all its net investments. A) pay back period with
cash in flows. In this case the expected annual net cash in flows are equal
(i.e, annuity form)
PB = NI
NCF
Where, NI = net investment
NCF = Annual net cash inflows
Accept Reject Rule

77
A project is accepted if the actual or computed apy back period is less than
the maximum allowable pay back period set by the firm‟s management.
Otherwise the project is rejected.
Eg1. The information provided below pertains to project A of XYZ
Corporation. The maximum pay back period set the firms management is 4
years.
Net investment …………………………………… $ 12, 000 project cost
Annual net cash inflows …………………………. $ 4000
Estimated life ……………………………………. 5 years
Required: Compute the pay back periods and interpret your result.
Soln. P.B. = NI = 12,000 = 3 years
NCF 4000
Interpretation
XYZ – corporation should accept and make investments on project A becuaus
the actual or computed pay back period of project A (3 years) is less than the
target pay back period (4 years).
Year Project A Cumulative inflows
0 $ 12,000 -
1 4000 4000
2 4000 8000
3 4000 12,000 PB period
4 4000 16,000
5 4000 20,000
Note: In raking two projects that have the same target pay back period, the
project with shorter payback period should be chosen because it pay for it self
more quickly.
Let cost of project A = $ 21,000
Cost of project B = $ 21,000
Life of A & B = 5 years
Target PB period = 4 years  for both A & B

78
Annual cash inflows
Year Project A Project B
1 $ 7000 $ 15,000
2 8000 6000
3 6000 0
4 4000 0
5 5000 0

PB Period for project A = 3 years

PB period for project B = 2 years
PB method will select project B

b) If the expected cash inflows are un equal, the pay back period is
calculated by determining the length of time required for cumulative
cash inflows to equal the net investment.
Eg. Compute the pay back period and interpret your result for the following
cash flows, assuming a net investment of $ 25,000 and a target Pay back
period of 3 years
Year Net investment Yearly cash Cumulative inflows
inflows
0 $ 25,000 0 -
1 $ 10,000 10,000
2 7,000 17,000
3 6,000 23,000
4 2,000 25,000 PB period
5 20,000 45,000

PB = 4 Years

Interpretation: Reject the project

79
Assignment ABC Company is evaluating 2 projects with the following cash
flows
Following cash flows
Year Cash flows project – x Project - y
0 $ 56,000 56,000
1 14,000 22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000

Required: Compute the payback period for each for each project and show
that which one of them should management prefer or consider as more
desirable.
Soln.
Year Cumulative cash Inflows
project x Project Y
0 0 0
1 14,000 22,000
2 30,000 42,000
3 48,000 62,000
4 68,000 76,000
5 93,000 93,000
PB period for project = 3 years + 56,000 – 48,000
20,000
= 3 years + 8000 = 3.4 years
20,000
= 3 years + 4 month + 24 days
PB for project Y = 2 years + 56,000 – 42,000
20,000
2.7 Years

80
Interpretation: ABC company should prefer project Y over project X because
it has a shorter payback period of 2.7 years
Advantages of payback period
1. It is easy to calculate, understand and interoperate
2. It measures the time required for a project to recover the initial
investment & therefore it provides a measure of liquidity. This is so because
of the payback method is based on cash flow analysis rather than on
accounting income.
Liquidity is the projects ability to recover its initial investment within a short
period of time.
3. It provides a crude measure of risk because it considers projects with
shorter pay back periods as less risky
Disadvantages of payback method
1. It doesn‟t measure the profitability of an investment because it ignores the
cash inflows
beyond the payback period.
Eg. Project x Project Y
Cost of project $ 15,000 $ 15,000
Cash inflows
Year 1 5000 4000
2 6000 5000
3 4000 6000
4 0 6000
5 0 3000 ignored by the PB me
6 0 3000
PB period of project X = 3 years
PB period of project Y = 3 years

81
Under the pay back method both projects will be given equal weights or
ranking which is apparently incorrect. However from the profitability point of
view project Y is more profitable than Project X.
2. It ignores the time value of money for it fails to consider the magnitude
and timing of cash of inflows
Project cost Project x Project y
Cash inflows $ 15,000 $ 15,000
Year
1 10,000 1,000
2 4,000 4,000
3 1,000 10,000
Total cash inflows $ 15,000 $ 15,000
 Both projects have the some cost = $ 15,000
 Both projects have the some total cash inflows = $ 15,000
 Both projects have the same PB period = 3 years
Although pay back method ranks the two projects as being equally desirable,
project X would be more acceptable than project Y from the Standpoint of the
time value of money.
3. It biases capital budgeting decisions in favor of short-term projects and
against long term projects
Note: The payback method is a measure of liquidity of investment rather
than profitability.
B. Sophisticated Techniques of Capital Budgeting
These techniques are called time adjusted or discounts cash flow techniques
and they include.
1) The Net present value (NPV)
2) Profitability Index (PI)
3) Internal Rate of Return (IRR)
1) The Net present value (NPV)

82
This is considered to be the best method for evaluating the capital investment
proposals. In case of this method cash inflows & cash out flows associated
with each project are first worried out. The present values of these cash
inflows and outflows are then calculated at the rate of return acceptable to
the management. This rate of return is considered as the cut of rate and
generally determined in the bases of capital suitably adjustable to allow the
risk element involved in the project. Cash out flows represent the investment
and commitments of cash in the project at the various points of time.
The working capital is taken as cash out flow in the year the project starts
commercial production. Profit after tax but before depreciation represents
cash inflows. The net present value is the difference between the total
present value & of the future cash inflow values.

Npv = FV1 + FV2 + FV3 + ……………… + FVn ]

(1+i) (1+i)2 (1+i)3 (1+i)n
Where I = cash out flow
Npv = [ FV1 + FV2 + FV3 + FVn ] - [ Io + I1 + I2 + ….
In ]
(1+i)1 (1+i)2 (1+i)3 (1+i)n (1+i)1 (1+I) 2

(1+I)n
I = out flow (for varying I)
Eg. Calculate the net present value (NPV) for a small sized plant requiring
an initial investment of 20,000 birr & which provides a net cash inflow of
6000 Birr each for 6 years.
Assume the cost of the funds to be 8%
Soln. Given : A = 6000
n= 6
Io = 20000
i = 8%
Required Npv = ?

83
 Npv = Pv –Io
= 6000 (Pv/A, 6,8%)-20,000
= 6000 (4.62288) – 20000
= 27,737 – 20,000 = 7,737 Birr
Eg. Class work: A company is considering two mutually exclusive projects
both require an initial investment of 50,000 each and have a life of 5 years.
The cost of capital of the company is 10% & the cash inflows from the two
projects are as follows.
Year Cash inflows of Cash inflows
project A of project B
1 15,000 20,000
2 16,000 18,500
3 19,000 16,500
4 17,500 17,500
5 20,000 15,000
Which project should be accepted as per Net present value method?
Soln. Computation of NPV for project A
Year Cash Factor Pv Pv
inflows at 10%
1 15,000 20,000 13,635.5
2 16,000 18,500 13,222.4
3 19,000 16,500 14,274.7
4 17,500 17,500 11,952.5
5 20,000 15,000 12,418
Total Pv 65,503.1
Less initial investment 50,000
Npv 15,503.1
Computation of NPV for project B

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 Year Cash Factor Pv
inflows at 10% Pv
1 20,000 0.9091 12,418
2 18,500 0.8264 15,288.4
3 16,500 0.7513 12,396.45
4 17,500 0.6830 11,952.5
5 15,000 0.6209 9,313.5
Total Pv 67,132.85
Less initial investment 50,000
Npv 17,132.85
As the Net present value of project B is higher than project A we accepted
project B and reject project A.
Q. Calculate NPv for two projects X and Y, X requires an investment of
26,000 Birr while Y requires an investment of 38,000. The cost of the capital
is 12% .
Required which project should be accepted?
Years Cash flow of Project X Cash flow of Project Y
1 9000 8000
2 7000 -10000
3 6000 22000
4 -5000 14000
5 4000 8000
6 4000 -1000
7 10000 20000
8 3000 -
9 3000 -
10 3000 -

85
 Soln. For project X
Years Cash flow Factor of Pv PV
at 12%
1 9000 0. 8929 8036.1
2 7000 0.7972 5580.4
3 6000 0.7118 4270.8
4 -5000 0.6355 -3177.5
5 4000 0.5674 2269.6
6 4000 0.5066 2026.4
7 10000 0.4523 4523
8 3000 0.4039 1211.7
9 3000 0.3606 1081.8
10 3000 0.3220 966
Total Pv 26788.3
Less initial investment 26,000
Net Pv 788.3
For project Y
Years Cash flow Factor of Pv PV
at 12%
1 8,000 0. 8929 7143.2
2 -10,000 0.7972 -7972
3 22,000 0.7118 15659.6
4 14,000 0.6355 8897
5 8000 0.5674 4539.2
6 -1,000 0.5066 -506.6
7 20,000 0.4523 9046
Total Pv 36,806
Less initial investment 38,000
NPv -1193.6
Project X should be accepted
2) Profitability Index
Profitability Index or Benefit cost Ratio = present value of cash inflow
Present value of cash out flow

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This is a refinement of NPV method instead of working out net present value
a PV index is found by comparing the total of PV of future cash inflows and
the total of PV of future out flows.
Fore example for A, PI = 65503.1 = 1.31
50,000
If PI is > 1, we accept the project if PI <1 we reject the project.
3) The Internal Rate of Return
IRR = minimum + difference b/n PV at minimum
rate & cash outlay X difference in
rate
Difference in present value

Eg. A company had to select one of the two projects. The cost of project A is
11,000, the
cost of project B is 10,000 Birr. The cash flows of the projects are
shown below.
Years Cash flow of Project A Cash inflow for Project
B
1 6,000 1,000
2 2,000 1,0000
3 1,000 2,000
4 5,000 10,000
Using the IRR suggest which project is profitable.
Calculation of IRR for Project A
Years Cash inflow PV factor Present Pv factor PV
at 10% Value at 12%
1 6,000 0.9091 5454.6 08929 5357.4
2 2,000 0.8264 1652.8 0.7972 1894.6
3 1,000 0.7513 751.3 0.7118 711.8
4 5,000 0.6830 3415 0.6305 3177.5
Total 11273.7 10,841.3

IRR = Minimum + d/nce b/n prat X dlnce in rate

Rate minimum rate of
Cashout lay
D/nce in present value
= 10% + 11273.7 – 11,000 (12 – 10)

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 11273.7 - 10841.1
= 10% + 273.7 x 2 = 10+1.265
432.6 11.265%

Budgets and Budgeting Control

Budget: A budget is a monetary or a quantitative expression of business
plants and policies to be persued on the future period of time.
Budget: The term budgeting is used for preparing budgets and other
procedures for planning, coordination & control of business enterprise.
Budgeting control: The budgeting control is a process of determining various
budgeted figures for the enterprises for the future period and them
comparing the budgeted figures with the actual performance for calculating
variances.

Purpose of budgeting
1) ensure planning
2) to coordinate the activities in different departments
3) to eliminate waste of the organization
4) to anticipate correctly about the future capital expenditures
5) to anticipate correctly about future working capital needs of the
organization
6) to make corrective measures
7) Fixation of responsibility is possible
Preparing a Budget
Classification of Budgets
a) Classification of budgets according to time
 short term budgets
 long term budgets
b) Classification of budgets according to function
 Operating budgeting
 Financial budgeting
 Master budgeting

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 c) Classification of budgets according to fluctuations
 fixed budgets
 flexible budgets
Essentials of budgeting control
There are certain steps which are necessary for the successful completion of
budgeting control system.
1) Organization for budgeting control: The proper organization is essential for
the successful preparation, maintenance & administration of budget. A
budgeting committee is formed which comprises the departmental heads of
different dept., all the functional heads interested with the responsibility of
ensuring proper implementation of their respective departmental budgets.
The organization chart for budgeting control is given below

Organization for budgeting control

Chief executive

Budgeting committee

Production Sales Financial Personal Research & development

Manger Manager Manager Manager Manager

Production Sales budget Receipt Labor Research & develop

Budget (revenue) Budget ment
budget
Budget

Plant advertisement Expenditure

Utilization budget budget
Budget
Sales expenditure
budget
The chief executive is the overall in charge of the budgeting system. He
constitutes a budget committee for preparing realistic budgets.

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A budget officer would be acting as the head of the budget committee who
coordinates the budgets of different departments. The managers of the
different departments are the main responsible for their departmental
budgets.
2) Budget center
A budget center is that part of the organization for which budget is prepared.
A budget center may be a department, a section or any part of the
organization. The establishment of budget centers is essential for covering all
parts of the organization. The budget centers are also necessary for cost
control process. The appraisals of the performance of the different parts of
the organization become easy when different budget centers are established.
3) The budget manual
A budget manual is the document which spells out the duties &
responsibilities of the various executives concerned with budgets.
4) A budget period
A budget period is the length of time for which a budget is prepared. The
budget period depends on the no of factors. It may be different for different
industries & it may be different from department to department and different
from budget to budget.
Usually long term budgets for 2-4 years are prepared on the bases if existing
capacity. For the control purpose the budget for a year and a month would be
prepared.
5) The determination of the key factor
The budgets are prepared for all the functional areas. Budgets are
interdependent & interrelated. A proper coordination among different
budgets is necessary for making a budget successful. The constraints on some
budgets may have the effect on other budgets. The factor which influences all
other budgets will be known as a key factor or a budget factor. This may be a
limitation on the quantity of goods a concern may sell or it may be the
quantity of goods that the firm can produce.

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The raw materials may be limited so that production sells, cash budgets will
be decided according to the raw materials supply or the raw material budget.
Similarly plant capacity may be a key factor if the supply of other factors is
easily available. The sales may be a key factor in the event the competition is
heavy and all other budgets will depend up on the sales budgets.

Classification of budgets on the basis of flexibility

1) Fixed: a fixed budget is the budget for a given level of activity. These
budgets are prepared for before the beginning of the financial year. If the
financial year starts in Jan. the budget will be prepared a month or two
earlier (It is Nov. or Dec.). The changes in expenditures arising out of the
anticipated changes will not be adjusted in the budget. There is a difference
of about 12 months in the budgeted and actual figures. In simple, a fixed
budget is the budget, which is designed to remain un changed irrespective of
the level of activity actually defined.
Fixed budgets are suitable under static conditions. If sales, expenses and
costs can be forecasted with greater accuracy then this budget can be
advantageous used.
Flexible budget: a flexible budget consists of a series of budget for different
levels of activities. A flexible budget is prepared after taking into
consideration un forcing changes in the conditions of business. A flexible
budget is defines as the budget which recognizes the difference b/n fixed,
semi-fixed and variable costs and is designed to change in relation to the
level of activity, i.e, some expenditure remain constant irrespective of the
change in the level of activity. Some expenditures vary slightly with the
changes in activity where some costs are fixed and some are variable & there
are some expenditures varying depending up on the size of the activity.
e.g1) The expenses for the production of 5000 units in a factory is given.
Particular Per unit
Material 50

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 Labor 20
Variable over heads 15
Fixed over heads (50,000) 10
Administrative expenses (5% variable) 10
Selling expenses (20% fixed) 6
Distrn Expenses (10% fixed) 5
Total cost of sales per unit 116
You are required to prepare budget for 7000 units
Soln.
Out put
Particular 5000 units 7000 units
Per unit Total Per unit Total
Direct materials
Direct material 50 250,000 50 350,000
Labour 20 100,000 20 170,000
Prime Cost 70 350,000 70 490,000
Variable costs 15 75,000 15 105,000
Fixed over heads 10 50,000 7.14 50,000
Factory Cost 95 475,000 92.14 645,000
Administrative 10 50,000 7.29 51,000
expenses
Cost of production 105 525,000 99.43 696,000
Add selling expenses 6 30,000 5.66 39,600
Distribution costs 5 25,000 4.86 34,000
Cost of Sales 116 580,000 109.95 769,000
Eg 2 from the following forecasts of income and expenditure prepare a cash
budget for the months Jan. to April 1996

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 (Amount Birr)
Months Sales Purchases Wages Mfg Administrative Selling
(credit) (credit) Expenses Expenses Expenses
1995 30,000 15,000 3000 1150 1060 500
Nov. 35,000 20,000 3200 1225 1040 550
Dec.
1996 25,000 15,000 2500 990 1100 600
Jan. 30,000 20,000 3000 1050 1150 610
Feb. 35,000 22,000 2400 1100 1220 570
Mar. 40,000 25,000 2600 1200 1180 710
Apr.

The additional information is as follows:

1) The customers are allowed a credit period of two months
2) A dividend of 10,000 Birr is payable in April
3) Capital expenditure to be incurred plant purchased on 15 Jan.
for 5,000 Birr
4) Creditors are allowed a credit of 2 months
5) Wages are paid on the first of next month
6) Lag in payment of other expenses is one month
7) The balance of each in hand on 1st Jan 1996 is 15,000

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soln
Particulars Jan Feb March April
Opening balance of cash 15,000 18,985 28,795 32,975
receipt
Receipt from customers 30,000 35,000 25,000 30,000
Payments 45,000 53,985 53,795 62,975
Dividend payment 10,000
Purchase of plant 5000
Payment to creditor 15,000 20,000 15,000 20,000
Wages 3,200 2,500 3,000 2400
Manufacturing expenses 1,225 990 1050 1100
Administrative expenses 1,040 1100 1150 1220
Selling expenditures 550 600 620 570
Balance at the end of the 26,015 25,190 20,820 35,290
month
18,985 28,795 32,975 27,685

Control Ratio
The management wants to know whether the performance of the business id
going according to the schedule or not. With this purpose in view some
control ratios are calculated. If the ratios are more than 100, then the
performance will be favorable but if these ratios are less than 100%, then the
performance will be unfavorable or unsatisfactory. The following ratios are
calculated as under:
1) capacity Ratio = Actual hours work x 1000
budgeted hours
2) Activity Ratio = standard hours for actual prodn x 100
budgets hours
3) Efficiency Ratio = standard hours for actual prodn x 100

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 actual hours worked

4) Calendar Ratio = No of actual working days in a period x

100
No of working days in the budgeted period

Assignment
1) Calculate IRR for project A & B, both projects required
an initial investment of 50,000 Birr.

Year Project A Project B

1 20,000 30,000
2 22,000 27,000
3 28,000 22,000
4 25,000 25,000
5 30,000 20,000

By the IRR technique, which project should be selected? Why?

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