ENGG 404

DECISIONS
UNDER
CERTAINTY
GROUP 4
 LESSON CONTENT
EVALUATION OF
01 MUTUALLY EXCLUSIVE
REPLACEMENT ANALYSIS
04
ALTERNATIVES

EVALUATION
02 INDEPENDENT PROJECTS
BREAK-EVEN ANALYSIS

DEPRECIATION AND
05
03 DEPLETION
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 EVALUATION OF
01 MUTUALLY EXCLUSIVE
ALTERNATIVES
 BASIC CONCEPTS FOR
COMPARING
PRINCIPLE 1. DEVELOP THE
ALTERNATIVES:
ALTERNATIVES
Emphasized that a choice or decision is among
alternatives. Such choices must incorporate the
fundamental purpose of capital investment. In
practice, there are usually a limited number of
feasible alternatives to consider for an engineering
project. The problem of deciding which mutually
exclusive alternative should be selected is made
easier if we adopt different methods.
 BASIC CONCEPTS FOR
COMPARING
PRINCIPLE 2. FOUCUS ON THE
DIFFERENCE:
ALTERNATIVES
The alternative that requires the minimum
investment of capital and produces
satisfactory functional results will be chosen
unless the incremental capital associated with
an alternative having a larger investment can
be justified with respect to its incremental
benefits.
 BASIC CONCEPTS FOR
COMPARING ALTERNATIVES

PRINCIPLE 3. USE A CONSISTENT

VIEWPOINT:
The prospective outcomes of the alternatives,
economic and other, should be consistently
developed from a defined viewpoint (perspective).
Often perspective of decision maker is owner’s
point of view.
 BASIC CONCEPTS FOR
COMPARING ALTERNATIVES

PRINCIPLE 4. USE A COMMON UNIT OF

MEASURE:
Using a common unit of measurement to
enumerate as many of the prospective outcomes
as possible will make easier the analysis and
comparison of the alternatives.
 BASIC CONCEPTS FOR
COMPARING
PRINCIPLE 5. CONSIDER ALL
RELEVANT CRITERIA:
ALTERNATIVES
Selection of preferred alternative (decision making)
requires the use of a criterion (or several criteria). The
decision process should consider both the outcomes
enumerated in the monetary unit and those expressed
in some other unit of measurement or made explicit in
a descriptive manner. Apart from the long term
financial interest of owner, needs of stakeholders
should be considered
 BASIC CONCEPTS FOR
COMPARING
PRINCIPLE 6. MAKE UNCERTAINTY
EXPLICIT:
ALTERNATIVES
Uncertainty is inherent in projecting (or estimating)
the future outcomes of the alternatives ad should be
recognized in their analysis and comparison. The
magnitude & impact of future impact of any course
of action are uncertain or probability of occurrence
changes from the planned one. Thus dealing with
uncertainty is important aspect of engineering
economic analysis.
 BASIC CONCEPTS FOR
COMPARING
ALTERNATIVES
PRINCIPLE 7. REVISIT YOUR
DECISIONS:
Improved decision making results from an adaptive
process; to the extent practicable, the initial
projected outcomes of the selected alternative
should be subsequently compared with actual results
achieved. If results significantly different from the
initial estimates, appropriate feedback to the
decision making process should occur
METHODS OF COMPARING
ALTERNATIVES
1. Present Worth Method

2. Future Worth Method

Needs

50%
3. Annual Cost Analysis

4. Rate of Return
 METHODS OF COMPARING ALTERNATIVES
1. Present Worth Method
When two or more alternatives are capable of performing the same
functions, the economically superior alternative would be the largest present
worth. The present worth method is restricted to evaluating alternatives that
are mutually exclusive and that have the same lives. This method is suitable
for ranking the desirability of alternatives.
Needs

In this method, we consider the possible inflows (cash-in) and outflows

(cash-out) in anengineering projects. All inflows and outflows were turned into
the present value of money. In this case, we choose best alternative based on
the largest present value. On the other hand,some cases considers only the cost
of the project. From that point since we are pertaining to cost, the alternative
with least present worth cost is the best option.
 METHODS OF COMPARING ALTERNATIVES
2. Future Worth Method
When two or more alternatives are capable of performing the
same functions, the economically superior alternative would be the largest
present worth. The present worth method is restricted to evaluating
alternatives that are mutually exclusive and that have the same lives. This
method is suitable for ranking the desirability of alternatives.

Same with present value, all inflows and outflows should be forwarded to
future. The alternative with highest future value is desirable. On the other
hand, if it pertains to cost, alternative with least value is desirable.
 METHODS OF COMPARING ALTERNATIVES
3. Annual Cost Analysis
Alternatives that accomplish the same purpose but that have unequal lives must
be compared by the annual cost method. The annual cost method assumes that each
alternative will be replaced by an identical twin at the end of its useful life (i.e., infinite
renewal).
Needs
Decisions Under Certainty
At this case, we need to get the depreciation cost of an investment using sinking fund
methodof depreciation. The alternative with least cost is advisable or desirable.

The calculated annual cost is known as the equivalent uniform annual cost (EUAC) or
equivalentannual cost (EAC). Cost is a positive number when expenses exceed income.
METHODS OF COMPARING ALTERNATIVES 4. Rate of Return
An intuitive definition of the rate of return (ROR) is the effective annual interest rate
at which an investment accrues income. That is, the rate of return of an investment
is the interest rate that would yield identical profits if all money was invested at
that rate. Although this definition is correct, it does not provide a method of
determining the rate of return.

In this case, choose the alternative that satisfy the minimum rate of
return. For the computation of the rate of return, use the formula;
 EVALUATION
02 INDEPENDENT
PROJECTS
PUBLIC PROJECTS
Decisions made are often politically influenced.
Larger than private ventures.
Often very long project lives.
Capital source is ultimately tax payers.
Benefits are often nonmonetary and are difficult to measure
These elements make engineering economy studies more
challenging. There can be difficulty defining benefits, and
even in establishing costs.
ANY PROJECT

The proper perspective is to consider the net benefits

to the owners of the enterprise
GOVERNMENT PROJECTS
The owners are ultimately the taxpayers.
Benefits are favorable consequences of the project to the
public (owners).
Costs represent monetary disbursements required of the
government, the anticipated expenditure for construction,
maintenance, operation, etc.
Disbenefits represent negative consequences of a project to
the public (owners)
SELF-LIQUIDATING PROJECTS

Projects that are expected to repay their costs.

Earns direct revenue.
Provides utility services.
COST ALLOCATIONS IN MULTIPLE-PURPOSE,
PUBLIC-SECTOR PROJECTS TEND TO BE
ARBITRARY
• Production and selling costs of the
services provided are also arbitrary.
• Naturally have multiple purposes.
• Often support for a public project,
and its many purposes, is politically
sensitive.
DIFFICULTIES INHERENT IN ENGINEERING
ECONOMY STUDIES IN THE PUBLIC SECTOR.
Profit standard not used to measure
effectiveness
Monetary effect of many benefits is difficult to
quantify
May be little or no connection between the
project and the public (owners).
Often strong political influence whenever public
funds are used, with little consideration to long-
term consequences.
DIFFICULTIES INHERENT IN ENGINEERING
ECONOMY STUDIES IN THE PUBLIC SECTOR.
Public projects are more subject to legal
restrictions than private projects
The ability of governmental bodies to obtain
capital is more restricted than that of private
enterprise
The appropriate interest rate for discounting
benefits and costs is often controversially and
politically sensitive.
SELECTING THE INTEREST RATE
TO USE IN PUBLIC PROJECTS IS
CHALLENGING.
Main considerations are
the rate on borrowed capital,
the opportunity cost of capital to the
governmental agency, and
the opportunity cost of capital to the taxpayers.

If money is borrowed specifically for a project, the

interest rate on the borrowed capital is appropriate to
use as the rate.
APPLYING THE BENEFIT-COST
RATIO METHOD
The consideration of the time value of money
means this is really a ratio of discounted
benefits to discounted costs.
Recommendations using the B-C ratio method
will result in identical recommendations to
those methods previously presented.
B-C ratio is the ratio of the equivalent worth of
benefits to the equivalent worth of costs.
TWO B-C RATIOS
CONVENTIONAL B-C RATIO WITH PW
MODIFIED B-C RATIO WITH PW
CONVENTIONAL B-C RATIO WITH AW
MODIFIED B-C RATIO WITH AW
ADDED BENEFITS VS.
REDUCED COST
The question arises if classifying certain
cash flows as either added benefits or
reduced costs.
While the numerical value of the ratio
may change, there is no impact on project
acceptability
SELECTING PROJECTS
If projects are independent, all
projects that have a B-C greater than
or equal to one may be selected.
For projects that are mutually
exclusive, a B-C greater than one is
required, but selecting the project that
maximizes the B-C ratio does not
guarantee that the best project is
selected.
INCREMENTAL B-C ANALYSIS
FOR MUTUALLY EXCLUSIVE
PROJECTS.
Incremental analysis must be used in
the case of B-C and mutually
exclusive projects.
Rank alternatives in order of
increasing total equivalent worth of
costs.
COMPARISON OF SINGLE PROJECT AND THE
TWO OR MORE ALTERNATIVE

FOR SINGLE PROJECT

B/C > 1 : accept the investment
B/C = 1 : remain different
B/C < 1 : reject the investment
FOR TWO OR MORE ALTERNATIVE
Compute B/C on the increment of investment
between alternatives

If B/C > 1 : choose higher cost alternative

If B/C < 1 : choose lower cost alternative
SOME CRITICISMS OF
B-C ANALYSIS.
B-C is often used as an “after-the-fact”
justification tool.
Distributional inequities (one group benefits,
another pays the cost) may not be accounted for.
Qualitative information is often ignored.
Bottom line: these are largely reflective of the
inherent difficulties in evaluating public
projectsrather than the B-C method itself.
03 DEPRECIATION &
DEPLETION
 DEPRECIATION
Depreciation is an allowable expenses in
general accounting purposes and income
tax accounting purposes. But it differ
categorically from other conventional
expenses because depreciation charge does
not occur any outflow of business fund.
 DEPRECIATION
Depreciation allows for the companies to
recover cost of an asset when it was
purchased. It allows the companies to cover
the total cost of an asset over it’s lifespan.
This is important aspect in analyzing cost
because it represents a significant portion
of expenses
METHODS OF
DEPRECIATION
1. the cost of the asset;
2. the life of the asset;
3. the expected residual value of the asset;
4. and, by the method of depreciation
selected for amortization of the asset which
must be systematic and rational.
TYPES OF
DEPRECIATION
1. Physical depreciation – this is
due to the reduction of the physical
ability of an equipment or asset to
produce results.

2. Functional depreciation – this is

due to the lessening in the demand
for the function which the property
was designed to render.
PURPOSE OF
DEPRECIATION
1. To enable the cost of
depreciation to be included as a
cost in the production of goods
and services.
2. Annual costs of depreciation are
being put up in a fund called
depreciation reserve for
replacement of the property.
PURPOSE OF
DEPRECIATION
3. To recover capital invested in the
property.
4. Provide as an additional capital
termed as depreciation reserve.
 PROPERTIES DEPRECIABLE ASSETS
1. It must have a determinable life and the life
must be greater than 1 year.
2. It must be something used in business or held
to produce income.
3. It must be something that gets used up, wears
out decays, become obsolete, or loses its
value due to natural causes.
4. It must not be an inventory stock in trade or
investment property.
DEPRECIATION
TERMINOLOGY
 DEPRECIATION TERMINOLOGY

INITIAL INVESTMENT/
FIRST COST (FC)

SALVAGE VALUE (SV) BOOK VALUE (BV)

 DEPRECIATION TERMINOLOGY

ECONOMIC LIFE

PHYSICAL LIFE USEFUL LIFE (L)

 DEPRECIATION TERMINOLOGY

RECOVERY PERIOD (n) RECOVERY RATE (i)

NOTATION USE
FOR DEPRECIATION
 DEPRECIATION TERMINOLOGY

d L

n dn
 DEPRECIATION TERMINOLOGY

Dn FC

SV BV
METHODS OF DEPRECIATION
1. Straight Line Method (SLM) – The simplest depreciation method. this
method assumes that the loss in the value is directly proportional to the age
of the equipment or asset.

a. Annual cost of depreciation

b. Total depreciation after n years

c. Book value at the end of n years

METHODS OF DEPRECIATION
2. Sinking Fund Method (SFM) - This method assumes that a sinking fund is
established in which funds will accumulate for replacement. The total
depreciation that has taken place up to any given times is assumed to be
equal to the accumulated amount in the sinking fund at that time.

a. Annual cost of depreciation

b. Total depreciation after n years

c. Book value at the end of n years

 METHODS OF DEPRECIATION
3. Declining Balance Method - In this method, sometimes called the constant percentage
method or the Matheson Formula, it is assumed that the annual cost of depreciation is a
fixed percentage of the salvage value at the beginning of the year. The ratio of the
depreciation in any year to the book value at the beginning of that year is constant
throughout the life of the property and is designated by k, the rate of depreciation.

a. Annual depreciation (d)

b. Salvage Value

c. Total depreciation (Dn)

 METHODS OF DEPRECIATION
4. Double Declining Balance Method (DDBM)
This method is very similar to the DBM except that the rate of depreciation k is replaced by 2/L
Annual depreciation d Salvage Value

Total deprediation Dn Book value at the end

of n years
 METHODS OF DEPRECIATION
5. Sum of the year digit method (SOYDM)
It is a method of evaluating depreciation where the depreciation changes from year to year.
Annual depreciation d

Book value at the end

of n years

Total deprediation Dn
 METHODS OF DEPRECIATION

6. Service-Output Method (SOM)

This method assumes that the total depreciation that has taken place is directly proportional
to the quantity of output of the property up to that time. This
the method has the advantage of making the unit cost of depreciation constant and giving low
depreciation expense during periods of low production.
METHODS OF DEPRECIATION
6.1 Service Method (Number of hours used)
Let H= total units of hours used and within the useful life
Hn = total number of hours used at nth year.
METHODS OF DEPRECIATION
6.2 Output Method (Number of units produced)
Let T= total number of units produced w/in the useful life.
Tn = number of units produced at the nth year
TYPES OF
DEPRECIATION

1. Physical depreciation – this is

due to the reduction of the
physical ability of an equipment
or asset to produce results.
PURPOSE OF
DEPRECIATION
1. To enable the cost of
depreciation to be included as a
cost in the production of goods
and services.
2. Annual costs of depreciation are
being put up in a fund called
depreciation reserve for
replacement of the property.
 DEPLETION

This method is generally applied in

case of wasting assets e,g, mines,
quarries and natural resources. Here the
rate of production is measured by the
rate of exhaustion of the asset.
 COST DEPLETION
The capitalized costs that generally go into the cost
depletion basis for petroleum and mining projects are for
mineral rights acquisition and/or lease bonuses or their
equivalent ascertained costs:
THREE STEPS

INVOLVED IN

COMPUTATION OF

DEPRECIATION UNDER

DEPLETION METHOD
STEP 1:

DETERMINATION

OF THE DEPLETION

BASE
STEP 2:

COMPUTATION OF

DEPLETION RATE

PER UNIT
STEP 3:

COMPUTATION OF

DEPLETION/DEPR

ECIATION CHARGE
THESE THREE STEPS CAN BE COMBINED TOGETHER TO MAKE
THE FOLLOWING FORMULA FOR COMPUTING DEPLETION OR
DEPRECIATION CHARGE FOR A PARTICULAR PERIOD.
DECISIONS UNDER
CERTAINTY
B-C is often used as an “after-the-fact”
justification tool.
Distributional inequities (one group benefits,
another pays the cost) may not be accounted for.
Qualitative information is often ignored.
Bottom line: these are largely reflective of the
inherent difficulties in evaluating public
projectsrather than the B-C method itself.
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04 REPLACEMENT
ANALYSIS
REPLACEMENT
ANALYSIS
Replacement analysis plays a vital role in the
economic running of any concern for years or
decades. As a business firm, they have to
face different types of replacement decisions
such as the replacement of capital equipment
as it wears out or becomes obsolete, the
capital equipment required for expansion,
and the displacement of old technology by
new one.
FOUR MAJOR
REASONS FOR
REPLACEMENT
Physical Impairment
Inadequacy
Obsolescence
Rental or lease possibilities
PHYSICAL IMPAIRMENT
The existing asset is completely or
partially worn out and will no longer
function satisfactorily without
extensive repairs.
INADEQUACY
The existing asset does not have
sufficient capacity to meet the present
demands that are placed on it.
OBSOLESCENCE
This may be caused either by a
lessening in the demand for the
service rendered by the asset or the
availability of more efficient assets
which will operate with lower out-of-
pocket costs.
RENTAL OR LEASE
POSSIBILITIES
It is possible to rent identical or
comparable assets or property, thus
freeing capital for others and
more profitable use.
SUNK COST DUE
TO UNAMORTIZED
VALUE
UNAMORTIZED
VALUE

It is the difference between its book value

and its resale value when replaced. The
unamortized value should be considered a
sunk cost or a loss.
BASIC PATTERNS
FOR REPLACEMENT
STUDIES
REPLACEMENT
ECONOMY STUDIES

May be made by any of the basic

procedures or patterns (Methods of
Comparing Alternatives). However, in most
cases either the rate of return method or
the annual cost method is used.
 BREAK-EVEN
05 ANALYSIS
BREAK-EVEN ANALYSIS
A method of determining when value
of one alternative becomes equal to
the value of another. It is commonly
used to determine when costs exactly
equal revenue
A critical tool for determining the
capacity or facility must have to
achieve profitability
BREAK-EVEN ANALYSIS

One of the most important business

tools.
Usually done as part of a business
plan to see how practical the business
idea is, and whether or not it is worth
pursuing.
BREAK-EVEN POINT
It can be determined by
calculating the points at which
revenue received equals the
total costs associated with the
production of goods or
services.
 BREAK-EVEN CHART

a graphical representation of
break even analysis
 BREAK-EVEN CHART
The break-even point is the quantity of production at
which the income is equal to total cost. It is the
intersection of the income line and the total cost line on
the break-even chart. When two alternatives are to be
compared, the break-even point is the intersection of the
total cost line for each alternative on the break-even chart.
BREAK-EVEN CHART
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