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For Straight Line Depreciation, S may not specified. See Table 9.3 (of text book). A
percentage of purchase price (e.g., 50%) can be specified.
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Capital Cost Allowance, Straight Line Classes (Table 9.3)
Examples
Class 12 .. computer software(except system software) . CCA rate =100%
For example, if $10,000 is the purchase price, the CCA allowance is $10,000 in yr.1
Class 27 air pollution control equipment .. CCA rate = 50%
For example, if P=10,000, the CCA allowance is: 5000 for yr.1 and 5000 for year 2.
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Half-Year Rule
During year 1, for specified assets, one-half of the normally allowable depreciation
can be claimed.
Example: Class 8: 20% CCA => 10% for yr.1 is allowed.
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Capital Cost Allowance: Straight Line Classes
Class 29: CCA rate = 50%
Half-yr exempt.
Purchase price = $10,000 in 2001
CCA in 2001= 10,000x0.5= $5000
CCA in 2002= $5000
Sum of depreciation = $10,000
Now assume that for this class, half-year rule is applicable; CCA = 50%
CCA in 2001 = ($10,000)(0.5)(1/2) = $2,500
CCA in 2002 = ($10,000)(0.5) = $5,000
CCA in 2003 = ($10,000-($2500+$5000))= $2,500
Sum of depreciation = $10,000
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Declining Balance Method
It is a means of amortizing an asset at an accelerated rate early in its life.
For "Half-Year Rule" Exempt Assets:
BV(n) = P(1-depreciation rate) n
DC(n) = BV(n-1)(depreciation rate)
Where
P = purchase price
n= year from time of purchase
BV(n) = Book value at the end of year n (also called undepreciated capital cost UCC)
BV(n-1)= Book value at the end of year n-1
DC(n)= Depreciation charge for year n
For Assets with "Half-Year Rule" Applicable:
BV(n) = (P/2)(1-depreciation rate) n-1 +(P/2)(1-depreciation rate) n
DC(n) = BV(n-1)(depreciation rate)
Half-Year Rule & Declining Balance Method
Year
CCA
$700
$700
$560
$140
560
448
112
448
358.4
89.6
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After-Tax Cash Flow Analysis
Example: For a 3 year project, the following estimates are provided. Find the Net
Present Worth (after-tax). Purchase price=$700M. Resale=$450M.
Income/yr=$500M. Expenses=$350M/yr. CCA=20% (half yr. rule applicable). Loan =
$550M, to be repaid in 3 years @ 8% interest rate. Tax rate = 40% and MARR (after
tax) = 9%.
Solution: Drop M.
Yr.
Income
Expenses
CCA
700
Loan
Loan
Principal
Interest
Taxable Income
Tax
550
After Tax
Cash
Flow
-150
500
350
70
169.42
44.00
36.00
14.40
-77.82
500
350
126
182.97
30.45
-6.45
-2.58
-60.84
500
350
100.8
197.61
15.81
33.39
13.36
-76.78
Salvage
450.00
CCA
recapture
-18.72
NPW= (-700+550)-77.82(P/F,9%,1)-60.84(P/F,9,2)+(-76.78+450.00-18.72)(P/F,9%,3)
= $1.14M (Feasible)
Calculations:
CCA for Yr.1=700(1/2)(0.2)= 70
CCA for Yr. 2 =(700-70)(0.2)=126
CCA for Yr.3=(700-70-126)(0.2)=100.80
UCC (at the end of Yr.3)=700- Sum of (70+126+100.80)=403.20<450 salvage
Since salvage > UCC, CCA recapture applies.
CCA recapture=[450-403.20](tax rate of 0.4)= 18.72 ( a tax, a negative cash flow
item).
Loan: principal = 550 Interest = 8%
Equal annual payment A = 550(A/P,8%,3)=213.42
Yr.1: Interest= 550x0.08= 44.00; Principal = 213.42-44.00=169.42
Yr.2: Balance of principal= 550-169.42=380.58; Interest=380.58x0.08=30.45;
Principal=213.42-30.45=182.97
Etc.
Taxable Income = income-expenses-CCA-interest
Yr.1: 500-350-70-44=36.00
Yr.2: 500-350-126-30.45=-6.45
Etc.
Tax @ 40% = (Taxable Income)(0.40)
Yr. 1: 36x0.4=14.40
Yr.2: -6.45x0.4 = -2.58
Etc.
After Tax Cash Flow (ATCF) = Income-Expenses-Loan repayment-Tax
Yr.
Income
Expenses
CCA
Taxable
Income
Tax
ATCF
700
-700
500
200
140.00
160.00
64.00
236.00
500
200
112.00
188.00
75.20
224.80
500
200
89.60
210.40
84.16
215.84
Salvage
300.00
Tax shield
adjustment
16.99
NPW= - 700+236.00(P/F,7.5%,1)+224.80(P/F,7.5%,2)+(215.84+300.00+16.99)
(P/F,7.5%,3)
= $142.97 (Feasible).
Calculations:
CCA for Yr.1=(700)(0.2)= 140
CCA for Yr.2=(700-140)(0.2)=112.00
CCA for Yr.3=(700-140-112)(0.2)=89.60
UCC=700-Sum of (140+112+89.60)=358.40>300 salvage
Tax shield adjustment applies.
For t=0.4, d=0.2, i=0.075
Tax shield adjustment = [(358.40)-(300)]x[td/(i+d)]= $16.99
Taxable income:
Yr.1: Income -expenses-CCA = (500-200-140)=160
Yr.2: (500-200-112) = 188
Yr.3: (500-200-89.60)= 210.40
Tax @ 40%
Yr.1: (Taxable income)x0.4=160x0.4=64
Etc.
After Tax Cash Flow
Yr.1: (Taxable income - expenses - tax) = (500-200-64) = 236
Etc.
CCTF Method: If half-yr. rule is applicable, apply CCTF (half-yr rule) to investment
& CCTF full-yr. rule to salvage. In this case, half-yr. rule does not apply. So apply
CCTF full-year to both investment and salvage.
NPW = - (Investment)(CCTF) + PW of Net Income (after tax) + (Salvage)
(CCTF)x(P/F,7.5%,3)
Yr.
Income-Expenses
Taxable Income
Tax
ATCF
500-200=300
300
120
180
500-200=300
300
120
180
500-200=300
300
120
180
Year
1991
1992
1993
1994
1995
CPI
98.5
100
101.8
102.0
104.2
Year
1996
1997
1998
1999
2000
CPI
105.9
107.6
108.6
110.5
113.5
Using an annual compound rate of inflation of f, average rate of inflation during 19962000 period:
104.2(1+f)5 = 113.5
f = 1.7%
Average rate of inflation during 1992-2000 period:
98.5(1+f)9 = 113.5
f = 1.58%
Inflation rate in 2000 = [(113.5-110.5)/110.5]x100 = 2.7%
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Current or Actual dollars (i.e. inflated dollars) vs. Constant or Real dollars (i.e.
inflation removed)
1998
1999
2000
CPI
108.6
110.5
113.5
$20
$20.35
20.90
Revenue in constant $
of 1998*
20
20
20
Revenue in constant $
of 2000**
20.9
20.9
20.9
Revenue in constant $
of 1999
20.35
20.35
20.35
Calculations:
* 1998 revenue is already in 1998$. No change.
1999 revenue: 20.35(108.6/110.5)= 20
2000 revenue: 20.9(108.6/113.5)=20
** 2000 revenue is already in 2000$. No change.
1998 revenue; 20(113.5/108.6)=20.9
1999 revenue: 20.35(113.5/110.5)=20.9
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Proposal
Cost @ end of
Yr.0
Revenue
Revenue
Revenue
Revenue
Yr.1
Yr.2
Yr.3
Yr.4
$10,000
$4,000
$4,000
$4,000
$4,000
14,000
5,500
5,500
5,500
5,500
Difference
4,000
1,500
1,500
1,500
1,500
A=>B
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Example: Investment = $100,000; Salvage = $5,000; N= 3 years; CCA=20%
declining balance & Half-yr. rule exempt. ireal = 8%. General inflation f = 4%. Tax rate
= 40%.
Two cost categories: cost category 1 inflation = 3%. Cost category 2 inflation = 4%
Yr.
Total
$30,000
$40,000
$70,000
30,900
41,600
72,500
31,827
43,264
75,091
Example calculations:
Item 1:
For yr.2: $30,000(F/P,3%,1) = $30,900
For yr.3: $30,000(F/P,3%,2)=$31,827
Item 2:
For yr.2: $40,000(F/P,4%,1) = $41,600
For yr.3: $40,000(F/P,4%,2) = $43,264
Sales :
1000 units in year 1, growth in sales = 5%/yr.
Yr. 2 sales = 1000(F/P,5%,1) = 1050 items
Yr
Revenue
Investment &
Expenses
CCA
Taxable
Income
Tax
ATCF
$100,000
-$100,000
$100,000
70,000
20,000
10,000
4,000
26,000
109,200
72,500
16,000
20,700
8,280
28,420
119,300
75,091
12,800
31,409
12,563.60
48,081.04
Salvage
5,000
Tax shield
adjustment
11,435.64
Example:
{Demand levels}=>{Corresponding network design or plant size, or organization
size}=>{Forecast of cost, revenues}=>{NPWs}
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Example:
For the following cash flow, find NPW @ 15% interest. Next vary interest and
revenue by 10%, 20%,-10% and -20%.
Period
Capital Investment
Gross Revenue
O&M Expenses
$10.0M
$5M
$1M
$5M
$1M
$5M
$1M
Salvage
$4.17M
Solution:
Base Case:
NPW = - $10M + $5.0M(P/A,15%,3) - $1M(P/A,15%,3) + $4.17M(P/F,15%,3) =
$1.87M
Change i by +10%: i=15%(1.1)=16.5%
NPW @ i =16.5% = $1.55M
Change revenue by 10%: new revenue/yr = $5M(1.1) = $5.5M/yr
% Deviation
Revenue
Interest Rate
-20%
- 0.41M
2.58M
-10%
0.73M
2.22M
0% (Base Case)
1.87M
1.87M
+10%
3.02M
1.55M
+20%
4.16M
1.24M
- etc.
. To define regions of feasibility
Costs & Prices
a. Selling price/unit = (Fixed cost + Variable cost)/unit + Profit/unit
b. Examples of fixed costs:
These do not vary with units produced: rent, insurance, infrastructure
ownership cost, property taxes, executive salaries, research & development, etc.
c. Examples of variable costs: direct labour & supervision, direct supplies & raw
material, packaging, sales commission, royalties, etc.
Breakeven Analysis
At breakeven point(s):
TC=TR or Z=TR -TC=0
Where
TC is total cost = FC + VC
FC is fixed cost
VC is variable cost
Z is profit
TR is total revenue = (price/unit)x(no. of units sold)
Notes:
. Average Total Cost (ATC) = TC/n
. Average Revenue = TR/n
. Marginal Cost (Marginal total cost) = d(TC)/dn
(i.e., it is the slope of the total cost function)
Find :(a) Min. unit cost & n for min. unit cost. (b) Production for max. profit.
(c) Breakeven level of production.
Solution:
(a) ATC= TC/n= [10,000 + 2n2 x10-4]/n = 10,000/n + 2n x10-4
To find Min. ATC: d(ATC)/dn=0= - 10,000/n2 + 2x10-4
n = 7,071 units/yr. ATC min = 2.83
(b) Total revenue = (price/unit) x (units sold)
Given TR = 100n - 0.01n2
Marginal revenue MR = d(TR)/dn = 100-0.02n (1)
Marginal cost MC = d(TC)/dn = d(10,000 + 2n2 x10-4)/dn
= 4n x10-4 . (2)
Since Max. Profit occurs @ Marginal Revenue = Marginal Cost, set (1) = (2)
and solve for n
n = 4,902 units for max. profit
d. Break-even point(s) (BEP):
At BEP, total cost = total revenue
10,000 + 2n2 x10-4 = 100n - 0.01n2
n = 100 or 9,700 units
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Example: Given TC=$63,000+$30n and TR= $120n. Find (a) breakeven point (BEP),
(b) Average total cost, (c) Marginal total cost, (d) Average revenue, (e) Average
revenue, (f) Production level for min. unit cost, (g) Production level for max. profit.
Solution:
. BEP @ TC=TR
$63,000+$30n = $120n, solve for n
n = 700 units
. ATC = TC/n = ($63,000+$30n)/n
. Avg. Revenue = TR/n = 120n/n = $120
. Marginal Revenue = dTR)/dn = $120
. Marginal total cost = MTC = d(TC)/dn = $30
. BEP @ avg. revenue = avg. total cost
Ans. 700 units
. Production level for min. ATC @ n=> infinity
. Production level for max. profit @ MTC=MR.
Ans: n => infinity
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Breakeven Analysis: Further information on Relationships
Total revenue = TR=n.SP
Where n is units sold and SP is sale price
Total cost = TC = nVC+FC
Where VC is variable cost per unit and FC is fixed cost
Gross Profit = Z = TR-TC = nSP-(nVC+FC) = n(SP-VC) - FC
(SP-VC) is called contribution.
It is a measure of the portion of the selling price that contributes to paying the fixed
cost.
If SP=VC, contribution = 0
At BEP: Z=0=n(SP-VC)-FC
FC=n(SP-VC)
n = FC/(SP-VC)
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Example:
Given: Fixed Cost FC = $63,000
Selling Price SP = $120
Contribution (SP-VC) = 75% of SP = $90
Full capacity @ n = 1000 units
Tax rate = 40%
Find: (a) Net profit at full capacity. (b) Break-even level of production.
Solution:
a. SP-VC = $90
VC = $120-$90 = $30
Z = TR-TC = [n(SP-VC) - FC] = [1000($120-$30) - $63,000] = $27,000
Net profit after tax = (1- Tax rate)(Profit) = (1-0.4)($27,000) = $16,200
(b) BEP @ n = FC/(SP-VC) = 63,000/90 = 700 units
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Engineering Economics Chapter 13
RISK ANALYSIS & UNCERTAINTY
Probability concepts: see Glossary 5 (Pages A-19 to A-20) of the Text Book.
Expected Value
EV(X)= Sum for i = 1 to n[P(X= Xi). Xi]
Where
n is number of possible outcomes of variable X
P(X= Xi) is the probability that X= Xi
and Sum of P(X= Xi) for i equal to 1 to n = 1.0
Measures of Variation
e.g. Variance (NPW)
Variance & St. Deviation
V(X) = Sum from i to n [Xi - EV(X)] 2 P(X= Xi)
This formula reduces to :
V(X) = Sum from i to n P(X= Xi) Xi 2 - [EV(X)] 2
or V(X) = EV(X 2 ) - [EV(X)] 2
St. deviation Sigma = Sq. root of V(X)
Also, Coefficient of Variation = [St. deviation/EV(X)]
Risk in Financial Analysis
Expected Value
Investment of $10,000 in a machine. Service duration is N years. Salvage = L.
Maintenance cost for Yr.1 = $1000. For following years, an increase of $200/yr.
MARR = 10%. Given the following information, find Expected Equivalent Annual
Cost.
Salvage L
P(N)
3,000
0.2
2,000
0.4
10
1,000
0.4
Solution:
EAC(N=6 yrs) = -10,000[A/P,10%,6]-1,000-200(A/G,10%,6) + 3,000(A/F,10%,6) = $3,3351.95
EAC(N=8 yrs) = -$3,300.46
EAC(N=10 yrs) = -$3,309.81
E(EAC) = (0.2)(-$3,3351.95) +(0.4)(-$3,300.46) + (0.4)(-$3,309.81) = -$3,314.47
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Expected Values and Variances
Example: An asset has a first cost of $50,000. Salvage value depends upon how long
it remains in service.
Estimates of salvage value: for 4 yrs of service: $20,000, 5 years of service: 15,000, 6
years of service: 12,000 and 7 years of service: 10,000.
Given that all service periods are equally likely, find the Mean and Standard Deviation
of the asset's present worth. i=15%
Solution:
First find PW of salvage = Salvage(P/F,15%,N)
N= 4 yrs
N=5 yrs
N=6 yrs
N=7 yrs
$11,435
7,458
5,188
3,759
PW call it X
P(PW)
- 38,565*
0.25
5,006,406**
- 42,542
0.25
62,001
- 44,812
0.25
748,996
- 46,241
0.25
2,561,600
Avg. X=-$43,040
Sum=1.0
V(PW)=$8,415,003.25
V(PW)=$8,415,003.25
St. Deviation = Sq. Root of V(PW) = $2,900.86
Sample calculations:
* PW= - 50,000 + $20,000(P/F,15%,4yrs) = -50,000 + 11,435 = - 38,565
** (Xi - Avg. value of X)2P(PW) = [- 38,565 - (-43,040)] 2(0.25) = 5,006,406
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Expected Values and Variances
Example: Proposals A & B have EV(A)=EV(B) = $1000
V(A) = $4000 V(B) = 144,000.
Choice?
Solution: Find St. deviations (sigma) and then find Sigma/EV= Coefficient of
variation.
The lower the coefficient of variation, the better. Choice is A.
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Decision Theory
. Payoff matrix -- dollars are revenue or profit or benefits.
. States of Nature -- their occurrence is probabilistic.
Actions of decision
maker
State of Nature S1
State of Nature S2
P(S1) = 0.4
P(S2) = 0.6
A1
$x=$100M
$y=$125M
A2
$m=$110M
$n=$120M
End of yr.
St. deviation of
P/F factors
E(PW)
flow (1)
(3)
(4)=(1)x(3)
-$30,000
1.0000
-$30,000
10,000
1,000
P/F,15%,1
8,696
9,000
1,200
P/F,15%,2
6,805
8,000
1,400
P/F,15%,3
5,260
7,000
1,600
P/F,15%,4
4,002
6,000
1,800
P/F,15%,5
2,983
Alternatives NPW
NPW
NPW
NPW
NPW
NPW
Sum of
-$1000
$0
$1000
$2000
$3000
$4000
Prob.
0.11
0.26
0.22
0.02
0.39
1.00
0.29
0.18
0.07
0.46
1.00
0.14
0.10
0.11
0.37
0.28
1.00
Alt. B: 0.46
Alt. C: 0.37+0.28 = 0.65 (Choice)
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Decision Making Under Uncertainty
Criteria (Rules, Principles, Methods):
. Extremely optimistic criterion (Maximax)
. Extremely pessimistic criterion (Maximin)
. Expected Value Criterion:
Subjective probabilities used
Subjective probabilities modified as a result of "new information" -- Baye's
Theorem used
(Bayesian approach is not covered in this course).
. Laplace criterion -- equal likelihood criterion
. Hurwicz criterion -- blending of optimism & pessimism
. Regret criterion (minimax regret)
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Example: Payoff matrix is shown below. Which alternative is the best? Use the
following criteria:
a. Maximax (b) Maximin (c) Hurwicz (alpha = 3/8) (d) Minimax regret (e)
Laplace
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Payoff Matrix ($M of NPW); States of Nature are S1 to S4.
Alternatives
S1
S2
S3
S4
Solution:
a. Maximax -- for each alternative, find the max. payoff & then select the best (to
maximize the max. value).
Alternative
Payoff
5*
Answer=> Select B
b. Maximin -- for each alternative, find the minimum payoff & then select the
best.
Alternative
Payoff
2*
Answer=> Select A
c. Hurwicz Criterion (Alpha = 3/8)
Use of an index of optimism, alpha, applied to Maximax payoff and (1-alpha)
applied to Maximin payoff.
Alternative
Payoff
(3/8)(2)+
(3/8)(5)+
(3/8)(4)+
(3/8)(4)+
(3/8)(4)+
(1-3/8)(2)
(1-3/8)(0)
(1-3/8)(1)
(1-3/8)(1)
(1-3/8)(0)
=2
= 15/8
= 17/8*
= 17/8*
= 12/8
Answer=> Select C or D
d. Minimax Regret Criterion (Rule): to minimize the maximum regret.
Steps: (1) For each state S, find max. payoff. (2) Find (max. payoff -payoff
given) -- Rij Regret Matrix.
Alternative i , Sate j
Alternative
S1
S2
S3
S4
3-2 = 1
5-2 = 3*
3-2 = 1
4-2 = 2
3-1 = 2
5-5 = 0
3-1 = 2
4-0 = 4*
3-1 = 2
5-4 = 1
3-1 = 2
4-1 = 3*
3-1 = 2*
5-3 = 2*
3-1 = 2*
4-4 = 0
3-3 = 0
5-4 = 1
3-3 = 0
4-0 = 4*
Step (3): Find max. Rij for each alternative. See above.
Step (4): Find the alternative with min[max Rij]. Ans: Alt. D.
e. Equal Likelihood Criterion: Laplace Rule
Assume that all states have the same probability.
Alt.
Expected Value
= 1.75
= 1.75
= 2.25
= 2.5*
Ans: Alt. E
Summary:
Maximax: Alt B
Maximin: Alt. A
the economics of the management, operation, and growth and profitability of engineering
firms;
the development, marketing, and financing of new engineering technologies and products. [2]
[1]
economic environment
Definition
Concept of Equivalence
To compare alternatives that provide the same service over extended periods of time when
interest is involved, we must reduce them to an equivalent basis that is dependent on: ---If two
alternatives are economically equivalent, then they are equally
desirable.
Equivalence factors are needed in engineering economy to make cash flows (CF) at different
points in time comparable. For example, a cash payment that has to be made today cannot be
compared directly to a cash flow that must be made in 5 years.
Since the time value of money changes according to:
1.The interest rate,
2.The amount of money involved,
3.The timing of receipt or payment,
4. The manner in which interest is compounded,
We need a way to reduce CF's at different times to an equivalent basis. Equivalence factors allow
us to do so.
Principles of Equivalence
Equivalent cash flows have the same economic value at the same point in time.
Cash flows that are equivalent at one point in time are equivalent at any point
in time.
Conversion of a cash flow to its equivalent, at another point in time must reflect
the interest rate(s) in effect for each
period between the equivalent cash flows.
Equivalence between receipts and disbursements: the interest rate that sets the
receipts equivalent to the disbursements is
the actual interest rate (IRR).
Economic equivalence is established, in general, when we are indifferent
between a future payment, or series of payments, and a present sum of money.
Notation and Cash Flow Diagrams (CFDs)
The following notation is utilized in formulas for compound interest calculations:
I = effective interest rate per interest period
N = number of compounding periods
P = present sum of money; the equivalent value of one or more cash flows at a
reference point in time called present
F= future sum of money; the equivalent value of one or more cash flows at a reference
point in time called future
A = end-of-period cash flows (or equivalent end-of-period values) in a uniform series
continuing for a specified number of periods, starting at the end of the first period and
continuing through the last period
1. The Horizontal line is a time scale, with progression of time moving from left to
right. The period (e.g., year, quarter, month) labels can be applied to intervals of time
rather than to points on the time scale.
2. The arrows signify cash flows and are placed at the end of the period. If a
distinction needs to be made, downward arrows represent expenses (negative cash
flows or cash outflows) and upward arrows represent receipts (positive cash flows or
cash inflows).
3. The cash flow diagram is dependent on the point of view. The situations shown in
the figure were based on the cash flows as seen by the lender. If the directions of all
arrows had been reversed, the problem will have to be diagrammed from borrower's
viewpoint.
Future value is the value of an asset at a specific date.[1] It measures the nominal future sum of
money that a given sum of money is "worth" at a specified time in the future assuming a
certain interest rate, or more generally, rate of return; it is thepresent value multiplied by
the accumulation function.[2] The value does not include corrections for inflation or other factors that
affect the true value of money in the future.
The future value (FV) measures the nominal future sum of money that a given sum of money is
"worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return.
The FV is calculated by multiplying the present value by the accumulation function.
PV and FV vary jointly: when one increases, the other increases, assuming that the interest
rate and number of periods remain constant.
the interest rate (discount rate) and number of periods increase, FV increases or PV decree.
obsolescence
Definition
Significant decline in the competitiveness, usefulness, orvalue of an article or property.
Obsolescence occurs generally due to the availability of alternatives that perform better or
are cheaper or both, or due to changes in userpreferences, requirements, or styles. It is distinct
from fall in value (depreciation) due to physical deterioration or normalwear and tear.
Obsolescence is a major factor in operating risk, and may require write of of the value of
the obsoleteitem against earnings to comply with the accountingprinciple of
showing inventory at lower of cost or market value. Insurance companies take obsolescence
into accountto reduce the amount of claim to be paid on damaged or destroyed property.
costing
Definition.
System of computing cost of production or of running abusiness, by allocating expenditure to
various stages ofproduction or to diferent operations of a firm.
cost factors
The cost of training requires two separate estimates. One estimate for start up costs
and one for ongoing costs or, in other words, the cost of each class held.
Start up costs are normally expended just once to develop the class lesson plan and to
obtain reusable tools and materials required to hold the classes. Tools and materials
might include the one time purchase of equipment such as overhead projectors, white
boards, televisions, and video cassette recorders. It may also include the cost of
specialized equipment associated specifically with the training to be held.
Development of the class includes the time for a training consultant to prepare a
lesson plan and handouts. This can be the one largest expenditure to develop a class
but is also the one place where money is well spent. The training will not be effective
if the class is not thoroughly planned, fun and interesting for students. A good lesson
plan that outlines almost minute by minute how class time is spent, the learning goals
to be achieved, and how those goals will be accomplished is essential to the training
success.
Finally, start up cost may include the preparation of displays, lab boards and lab areas
where students will practice their new skills. This cost can vary from zero to very
considerable depending on the subject of the training.
Ongoing costs will include consumable materials, replacement tools, lunch and sodas,
room rentals, and teachers fees. These costs will require a detailed estimate that takes
into consideration the unique aspects of the particular training being developed.
Review prices frequently to assure that they reflect the dynamics of cost, market demand,
Before setting a price for your product, you have to know the costs of running your
business. If the price for your product or service doesn't cover costs, your cash flow will
be cumulatively negative, you'll exhaust your financial resources, and your business will
ultimately fail.
To determine how much it costs to run your business, include property and/or
equipment leases, loan repayments, inventory, utilities, financing costs, and
salaries/wages/commissions. Don't forget to add the costs of markdowns, shortages,
damaged merchandise, employee discounts, cost of goods sold, and desired profits to
your list of operating expenses.
Most important is to add profit in your calculation of costs. Treat profit as a fixed cost,
like a loan payment or payroll, since none of us is in business to break even.
Because pricing decisions require time and market research, the strategy of many
business owners is to set prices once and "hope for the best." However, such a policy
risks profits that are elusive or not as high as they could be.
When is the right time to review your prices? Do so if:
Your customers are making more money because of your product or service.
Cost-Plus Pricing
Many manufacturers use cost-plus pricing. The key to being successful with this method
is making sure that the "plus" figure not only covers all overhead but generates the
percentage of profit you require as well. If your overhead figure is not accurate, you risk
profits that are too low. The following sample calculation should help you grasp the
concept of cost-plus pricing:
Cost of materials
$50.00
+ Cost of labor
30.00
+ Overhead
40.00
= Total cost
$120.00
+ Desired profit (20% on
30.00
sales)
= Required sale price
$150.00
Demand Price
Demand pricing is determined by the optimum combination of volume and profit.
Products usually sold through different sources at different prices--retailers, discount
chains, wholesalers, or direct mail marketers--are examples of goods whose price is
determined by demand. A wholesaler might buy greater quantities than a retailer, which
results in purchasing at a lower unit price. The wholesaler profits from a greater volume
of sales of a product priced lower than that of the retailer. The retailer typically pays
more per unit because he or she are unable to purchase, stock, and sell as great a
quantity of product as a wholesaler does. This is why retailers charge higher prices to
customers. Demand pricing is difficult to master because you must correctly calculate
beforehand what price will generate the optimum relation of profit to volume.
Competitive Pricing
Competitive pricing is generally used when there's an established market price for a
particular product or service. If all your competitors are charging $100 for a replacement
windshield, for example, that's what you should charge. Competitive pricing is used
most often within markets with commodity products, those that are difficult to
differentiate from another. If there's a major market player, commonly referred to as the
market leader, that company will often set the price that other, smaller companies within
that same market will be compelled to follow.
To use competitive pricing effectively, know the prices each competitor has established.
Then figure out your optimum price and decide, based on direct comparison, whether
you can defend the prices you've set. Should you wish to charge more than your
competitors, be able to make a case for a higher price, such as providing a superior
customer service or warranty policy. Before making a final commitment to your prices,
make sure you know the level of price awareness within the market.
If you use competitive pricing to set the fees for a service business, be aware that unlike
a situation in which several companies are selling essentially the same products,
services vary widely from one firm to another. As a result, you can charge a higher fee
for a superior service and still be considered competitive within your market.
Markup Pricing
Used by manufacturers, wholesalers, and retailers, a markup is calculated by adding a
set amount to the cost of a product, which results in the price charged to the customer.
For example, if the cost of the product is $100 and your selling price is $140, the
markup would be $40. To find the percentage of markup on cost, divide the dollar
amount of markup by the dollar amount of product cost:
$40 ? $100 = 40%
This pricing method often generates confusion--not to mention lost profits--among many
first-time small-business owners because markup (expressed as a percentage of cost)
is often confused with gross margin (expressed as a percentage of selling price). The
next section discusses the difference in markup and margin in greater depth.
Pricing Basics
To price products, you need to get familiar with pricing structures, especially the
difference between margin and markup. As mentioned, every product must be priced to
cover its production or wholesale cost, freight charges, a proportionate share of
overhead (fixed and variable operating expenses), and a reasonable profit. Factors
such as high overhead (particularly when renting in prime mall or shopping center
locations), unpredictable insurance rates, shrinkage (shoplifting, employee or other
theft, shippers' mistakes), seasonality, shifts in wholesale or raw material, increases in
product costs and freight expenses, and sales or discounts will all affect the final pricing.
Overhead Expenses. Overhead refers to all nonlabor expenses required to operate
your business. These expenses are either fixed or variable:
Fixed expenses. No matter what the volume of sales is, these costs must be met every
month. Fixed expenses include rent or mortgage payments, depreciation on fixed assets (such as
cars and office equipment), salaries and associated payroll costs, liability and other insurance,
utilities, membership dues and subscriptions (which can sometimes be affected by sales volume),
and legal and accounting costs. These expenses do not change, regardless of whether a company's
expenses for telephone, office supplies (the more business, the greater the use of these items),
printing, packaging, mailing, advertising, and promotion. When estimating variable expenses, use an
average figure based on an estimate of the yearly total.
Cost of Goods Sold. Cost of goods sold, also known as cost of sales, refers to your
cost to purchase products for resale or to your cost to manufacture products. Freight
and delivery charges are customarily included in this figure. Accountants segregate cost
of goods on an operating statement because it provides a measure of gross-profit
margin when compared with sales, an important yardstick for measuring the business'
profitability. Expressed as a percentage of total sales, cost of goods varies from one
type of business to another.
Normally, the cost of goods sold bears a close relationship to sales. It will fluctuate,
however, if increases in the prices paid for merchandise cannot be offset by increases in
sales prices, or if special bargain purchases increase profit margins. These situations
seldom make a large percentage change in the relationship between cost of goods sold
and sales, making cost of goods sold a semivariable expense.
Determining Margin. Margin, or gross margin, is the difference between total sales and
the cost of those sales. For example: If total sales equals $1,000 and cost of sales
equals $300, then the margin equals $700.
Gross-profit margin can be expressed in dollars or as a percentage. As a percentage,
the gross-profit margin is always stated as a percentage of net sales. The equation:
(Total sales ? Cost of sales)/Net sales = Gross-profit margin
Using the preceding example, the margin would be 70 percent.
($1,000 ? $300)/$1,000 = 70%
When all operating expenses (rent, salaries, utilities, insurance, advertising, and so on)
and other expenses are deducted from the gross-profit margin, the remainder is net
profit before taxes. If the gross-profit margin is not sufficiently large, there will be little or
no net profit from sales.
Some businesses require a higher gross-profit margin than others to be profitable
because the costs of operating different kinds of businesses vary greatly. If operating
expenses for one type of business are comparatively low, then a lower gross-profit
margin can still yield the owners an acceptable profit.
The following comparison illustrates this point. Keep in mind that operating expenses
and net profit are shown as the two components of gross-profit margin, that is, their
combined percentages (of net sales) equal the gross-profit margin:
Business A
Business B
Net sales
100%
100%
Cost of sales
40
65
Gross-profit margin
60
35
Operating expenses
43
19
Net profit
17
16
Markup and (gross-profit) margin on a single product, or group of products, are often
confused. The reason for this is that when expressed as a percentage, margin is always
figured as a percentage of the selling price, while markup is traditionally figured as a
percentage of the seller's cost. The equation is:
(Total sales ? Cost of sales)/Cost of sales = Markup
Using the numbers from the preceding example, if you purchase goods for $300 and
price them for sale at $1,000, your markup is $700. As a percentage, this markup
comes to 233 percent:
$1,000 ? $300 ? $300 = 233%
In other words, if your business requires a 70 percent margin to show a profit, your
average markup will have to be 233 percent.
You can now see from the example that although markup and margin may be the same
in dollars ($700), they represent two different concepts as percentages (233% versus
70%). More than a few new businesses have failed to make their expected profits
because the owner assumed that if his markup is X percent, his or her margin will also
be X percent. This is not the case.
The key metrics for determining the terminal cash flow are salvage value of the
asset, net working capital and tax benefit/loss from the asset.
The terminal cash flow can be calculated as illustrated:
Return of net working capital +$300
Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF5+$780
Total year-five cash flow $1,960
For determining the tax benefit or loss, a benefit is received if the book value of
the asset is more than the salvage value, and a tax loss is recorded if the book
value of the asset is less than the salvage value.
Debt Financing
The act of a business raising operating
capital or other capital by borrowing. Most often, thisrefers to the issuance of a bond, debenture, or ot
her debt security. In exchange for lending the money, bond
holders and others become creditors of the business and are entitled to thepayment of interest and to
have their loan redeemed at the end of a given period. Debt financingcan be long-term or short-term. L
ong-term debt financing usually involves a business' need to buythe basic necessities for its business, su
ch as facilities and major assets, while short-term debtfinancing includes debt securities with shorter rede
mption periods and is used to provide day-to-daynecessities such as inventory and/or payroll.
equity to institutional and retail investors. Later on, if it needs additional capital,
the company may go in for secondary equity financings such as a rights ofering
or an ofering of equity units that includes warrants as a sweetener.
The equity-financing process is governed by regulation imposed by a local or
national securities authority in most jurisdictions. Such regulation is primarily
designed to protect the investing public from unscrupulous operators who may
raise funds from unsuspecting investors and disappear with the financing
proceeds. An equity financing is therefore generally accompanied by an ofering
memorandum or prospectus, which contains a great deal of information that
should help the investor make an informed decision about the merits of the
financing. Such information includes the company's activities, details on its
officers and directors, use of financing proceeds, risk factors, financial statements
and so on.
Investor appetite for equity financings depends significantly on the state of
financial markets in general and equity markets in particular. While a steady pace
of equity financings is seen as a sign of investor confidence, a torrent of
financings may indicate excessive optimism and a looming market top. For
example, IPOs by dot-coms and technology companies reached record levels in
the late 1990s, before the tech wreck that engulfed the Nasdaq from 2000 to
2002. The pace of equity financings typically drops of sharply after a sustained
market correction due to investor risk-aversion during this period.
Leases are the contracts that lay out the details of rental agreements in the real
estate market. For example, if you want to rent an apartment, the lease will
describe how much the monthly rent is, when it is due, what will happen if you
don't pay, how much of a security deposit is required, the duration of the lease,
whether you are allowed to have pets, how many occupants may live in the unit
and any other essential information. The landlord will require you to sign the
lease before you can occupy the property as a tenant.