CHAPTER 3 Engineering Economics

Project Investment Evaluations

Taxes
Most rational person appreciate such taxpayers-government sponsored services as a
schools and collages, national defense, law enforcement, fire protection, construction a
and operation of roads, parks, and so on. The government collects funds for these
services through various kinds of taxes, including property, sale, and income taxes. For
the investor these taxes are a necessary part of the cost of doing business and must be
accounted for when estimating costs versus income on any investment.

Source of tax revenues

Traditionally the greater part of the revenues needed to support the various levels of the
government has come from three major sources.

Major Source Of Revenue Level Of Government

Property ad valorem tax Local( country, city, school, etc)
Sales tax State
Income tax Federal

In addition to these prominent tax sources, legislators have devised a number of

additional means (excise taxes, license fees, franchise taxes, inheritance taxes, etc) for
raising the revenue needed to fund the government. The main criteria for evaluating a
potential tax source are generally:

1. The cost of collation should be low. (For example, the cost of collecting income
tax is less than 2% of revenue received, where as the cost of collecting a B 0.10
toll at abridge could easily exceed one half of the revenues.)
2. The amount of tax collected should relate to the ability to pay. (For example, the
property tax related to the value of the property owned, sales tax relates to
purchasing power, and the graduated income tax is proportional to income.

Property taxes

Most local governments (country, municipality, school board, etc) depend on property
taxes as an important source of revenue. Property taxes are usually assessed in
propitiation to the value of the property and thus are termed ad valorem taxes.
Basically there are two types of property for tax purposes.

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 CHAPTER 3 Engineering Economics

1. Real property consists of relatively unmovable property such as land, building,

and fixed attachments thereto. It is subjected to annual ad valorem tax usually by
local government only (country, city, school, etc)
2. Personal property consists of any kind of readily movable property. It is sub
divided in to i) tangible, and ii) intangible

i. Tangible personal property is any readily movable property that has

inherent value (rather than being a piece of paper representing value),
for example, a bulldozer or other movable construction equipment, a
car, clothing, jewelry, and appliance that are not fixed to a building. A
kitchen rage that is free-standing would usually be classified as
personal property, held for income producing purpose is usually taxed
by local government, but personal property held for private use only
often is exempted or ignored by taxing authority.
ii. Intangible property consisting largely of paper represents a right or
title to the value inherent in some other object, property, or enterprise,
for example, money, bond, stocks, mortgages, notes, accounts
receivable, and other certificates of indebtedness of promises to pay.
Intangible property is often subjected to a one-time or annual ad
valorem state or local tax, but usually a very low rate.

Sale taxes

The largest single source of income for state government in about two-third of the state is
sales tax. This usually consists of a fixed percentage of tax on retail sales, collected by
the retailer at the time of sale to the customer, and forwarded periodically to the state
treasure. The amount typically ranges from 3 to 5 percent. Some cities and countries are
empowered by their respective states to levy an additional sale tax, and have done so.

Income tax

The federal government derives most of its revenue from income taxes.

Investment tax credit

Tax law is one very powerful tool that modern governments use to help stabile and
stimulate the national economy. Experience teaches that gains in national productivity are
necessary for sustainable long-term increases in standard of living. One key to increasing
product any is to continually update and modernize productive plant and equipment.
Many governments in progressive nations around the world now provide tax incentives to
business to encourage continual modernization of productive capacity. The amount of tax
credit allowed changes fawn time-to-time depending upon whether the government feels
the economy needs stimulation or restraint.

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 CHAPTER 3 Engineering Economics

Capital gain

When an asset is sold, part of the money received usually represents the original
purchasing price, plus any other expenses involved in the cost of purchase and
ownership. If the selling price is higher than these costs, the balance represents a profit
called capital gain and if the selling price is lower, then the difference represents a loss
called capital loss. Profits on qualified assets held longer than one year may be
considered as long-term capital gains and 60% of the gain may be excluded from taxable
income. For example, assume an investor in the 30% tax bracket, purchases a land for
$10,000. Two years latter he sells the land for $12,000 for a capital gain of $2,000 only
40% of the gain taxed at investors ordinary income tax level of 30%.

Thus
Selling price = $12,000
Purchasing price =$10,000
Capital gain = $2,000
40% of capital gain reported as ordinary income.
Taxable income =0.4X$2,000 =$800
Income tax due to 30% =0.3X$800 =$240

If the profit resulted from the sale of an asset held for less than one year, the profit is a
short- term capital gain and is taxed at the same rate as ordinary income.

Exceptions to the capital gains treatment include assets held as stock for regular business.
Investors in real estate sometimes find the profit from sale or real estate held more than
one year is ruled taxable as ordinary income, if the IRS (Internal Revenue Service) has
reason to regard them as dealers, and the land as their stock in trade. This may occur
where an investor makes a regular habit of buying and selling real estate, or buys large
tracts and subdivides for resale.

For the connivance of the students, the federal income tax is usually shown in textbooks
as a percentage of net pretax income, where net income is the income left over after
subtraction of allowable expenses and deductions. Allowable expenses are usually
includes all normal business expenses such as interest payments, payroll, other taxes and
depreciation allowances.

In actual practice tax payers usually pay a fixed amount based on their income strata plus
a percentage of any net income overlapping into the next higher strata. Thus the
percentage used in textbook example and problem s represents the marginal tax bracket,
or the percent tax on each additional birr earned in the highest strata attained by the
taxpayer in question. For instance, using the slightly simplified tax book approach, a
taxpayer in the 30% tax bracket with a gross income of Birr 50,000 and allowable
expenses and deductions of Birr 30,000would pay a tax of :-
[Birr 50, 0000-Birr 30,000)*0.30=Birr 6,000income tax]

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 CHAPTER 3 Engineering Economics

The tax bracket percentage rises by steps as the amount of net income increases, so that
taxpayers with Birr 30,000 net income normally find them selves in a higher percentage
tax brackets than those with Birr 20.000 net incomes.

Similarly, corporations pay income taxes on a graduate scale. The internal Revenue
Service (IRS) in US schedule for corporations is

Tax rate
1982 1983 Taxable income
16% 15% First Birr 25,00
19% 18% Second Birr 25,000
30% 30% Third Birr 25,000
40% 40% Forth Birr 25,000
46% 46% All over Birr 100,000

Personal income taxes

Taxable income is defined as earned income minus adjustments and minus allowable
deductions. The adjustments and allowable deductions depend primarily up on the type of
entity (Personal Corporation).

Key expression used in this section

AGI=Adjusted Gross income
AD=Allowable deductions
PE=Personal exemptions
TI=Taxable income
EI=Earned income
AJ=Adjustments (deductions from earned income)
ITC=Investment tax credit

Earned income (EI) of individuals includes all wage, salaries, tips, and anything else of
value (money, goods, or services) received from an employer or through self-
employment for services performed, subtracted from this income are a number of items,
termed adjustments(AJ), which includes such items as moving expenses in connection
with employment to a retirement plan. After subtracting the amount remaining is termed
as adjusted gross income (AGI) From the AGI is subtracted personal exemptions of Birr
1,000 per person (PE) plus either the standard deduction (automatically figured into
Internal Revenue Services (IRS) tax table) or itemized allowable deductions (AD)
(includes excess medical expenses, certain state and local tax expenses, interest expenses,
contributions, normal business expenses, etc). The remainder is termed as taxable income
(TI). Thus, the taxable income for individuals is
TI= AGI-PE-AD
Where AGI= EI-AJ
The following example illustrate the use of the table above

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 CHAPTER 3 Engineering Economics

Example 1
A married couple with two children filing a joint income earned Birr 42,754 from wage
and salaries. In addition the husband received honorarium of Birr 2,500 from making
after- dinner speeches. During the year they changed employment and spent Birr 1,532 in
moving expenses of which employer reimbursed them Birr 1,000, initialized allowable
deductions from the year totaled Birr 6,532. How much federal income tax do they owe?

Solution
EI(Birr 42,754+Birr 2,500) =Birr 45,254
AJ(Birr 1,532-Birr 1,000) = Birr 532 (-ve)
AGI Birr 44,722
Exemption (4*Birr1,000) = Birr 4,000 (-ve)
AD =Birr 6,532 (-ve)
TI =Birr 34,190

Effect of taxes on cash flow

When evaluating the feasibility of any project to taxes, the taxes may be treated as other
expenses of doing business.

Example 2
Assume an investor has an opportunity to invest Birr 10,000 for five years in a proposal
estimated to yield the net cash flow before taxes, illustrated in figure-1. Since the Birr
10,000 principal is returned intact at End Of Year (EOY) 5, the before-tax rate of return
is obviously Birr 1,000/Birr 10,000= 10% Rate of return
However if the investor is required to pay taxes on the income, and she is in the 40% tax
bracket, she will pay the government Birr 0.4 of each net income or interest earned by
this investment. The Birr 10,000 invested at EOY 0 is not taxed upon withdrawal from
the investment at EOY 5, since this old investment capital returned and not new earned
income or interest. The after-tax cash flow diagram now appears as in figure 2.
The after-tax rate of return now is (annual income- income tax)( intact principal)
(Birr 1,000-0.40xBirr 1,000)/Birr 10,000=6%ROR after taxes

Birr 10,000
A=Birr 1,000

1 2 3 4 5 ROR=?

Birr 10,000

Figure 1: Before- tax Cash flow Diagram for example 2

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 CHAPTER 3 Engineering Economics
Birr 10,000
A=Birr 1,000

ROR=?
1 2 3 4 5

Tax payments
A2=Birr 400

Birr 10,000
Figure 2: After-tax Cash Flow diagram assuming 40% of income tax rate

For more common cases where the original investment is not returned intact, the after tax
rate or return is calculated as in previous rate of return problems with but one simple
innovation, that is, the taxes are now calculated and added on as a new cost item. An
example involving taxes follows,

Example 3

A client proposes a project with estimated net cash flows illustrated in figure-3, and asks
you to calculate the after-tax rate if return. He is in the 40% tax bracket (for every Birr of
net income, Birr0.40 is paid in taxes). For this investment assume that the Birr 2,000
profit from resale is not eligible for taxation at the lowest capital gains rate discussed
later.
B 3,000
B4, 000 + B 12,000
B 2,000
B1, 000
4

1 2 3

Birr 10,000

Figure 3: Before-tax cash flow for example 3

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 CHAPTER 3 Engineering Economics

Solution
All the annual net incomes are taxable at 40%, so the client retains B0.60 out of every
Birr of income after tax. At EOY 4, Birr 12,000 of principal is returned where only Birr
10,000 was invested. Therefore only the extra Birr 2,000 (from Birr 12,000-Birr 10,000)
is taxable at 40%, and the net after-tax amount received at EOY 4 is Birr 10,000 + Birr
2,000x0.60= Birr 11,200.

Thus the after-tax net cash flow diagram will appear as in figure 4, with after-tax income
equal to 0.6times before-tax income.

The after-tax rate of return is determined as in previous chapters by formulating present

worth equations and substituting trial values of i until the value of i is found at which the
total present worth equals zero.

15% 20%
P1 = Birr 10,000 - Birr 10,000 - Birr 10,000
P2 =+Birr (1,000-400)(p/G,i,4)(F/P,i,1) +Birr 3,984.89 +Birr 3.532.46
P3 = +Birr (12,000-800)(P/F,i,4) +Birr 6,403.71 +Birr 5,401.31
+Birr 388.60 -Birr 1,066.23

388.60
i = 15%+ 5%* =16.3% after tax ROR
388.6 + 1,066.23

After-tax Revenue
For every Birr of taxable income received, the government wants a certain percentage by
way of taxes. If the taxpayer is in the 30% tax bracket, he gets to keep Birr 0.70 out of
every one birr of income taxable at the rate and pays the other Birr 0.30 in taxes.

B 2,100
B2,800 + B 11,760
B 1,400
B700
4

1 2 3

Birr 10,000

Figure 4: After tax cash flow diagram

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 CHAPTER 3 Engineering Economics

Calculation is simply multiply the pretax revenue by (1-tax rate) in order to obtain the
after-tax revenue.

Example 4
Find the after tax cash flow as
After-tax cash flow = taxable income *(1-tax rate)
After-tax cash flow = Birr 10,000/yr *(1-03-.3)
= Birr 10,000/yr*0.70
Then P = Birr 10,000*0.70*(P/A,i, 10) = Birr 43, 010

After tax Expenses

The government recognizes legitimate business expenses and doesnt tax revenue Birr
that are used to pay these expenses. For instance, if a consulting engineer receives gross
revenue of Birr 50,000 per year, but has expense of Birr 20,000 per year, then the
government only taxes the Birr 30,000 net income after expenses. For every Birr one
spent on expense the engineer saves the tax rate times the Birr one. Thus every birr of
expense only costs the consultant Birr*(1-tax rate). If the consultant is in the 30% tax
bracket and takes several clients out to a business lunch and spends Birr30 as business
expense, it only costs him Birr 30X0.70 = Birr 21. here is how it works.

Before lunch After lunch

Gross income +Birr 50,000 +Birr 50,000
Expenses -Birr 20,000 -Birr 20,030
Net income before- tax +Birr 30,000 +Birr 29,970
Tax bracket 30% 30%
Income tax Birr9,000 Birr 8.991
After tax income Birr 21,000 Birr 20,979
cost of birr 30 Birr 30 Birr 21

Thus the Birr 30 lunch actually reduced the consultant after-tax income by only Birr 21,
and it is evident that the government shares both our income as well as our business
expenses required to earn the income.

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 CHAPTER 3 Engineering Economics

Depreciation

Depreciation is the loss in value of property such as machine, building, vehicle, or other
investment over a period of time, caused by one or more of the following
1. unrepaired wear
2. Deteriorations
3. Obsolescence
4. reduction in demand

1. Wear, accumulates as a function of hours of use, severity of use, and level of preventive
maintenance. Each hour of wear on moving parts of an engine, for instance, brings them
closer to the point of requiring repair or salvage. Fro time to time, decisions are made
whether or not to invest in repairs, and to what extent. The investment in repair is
economically justifiable only if the value added by the repair exceeds the cost of the repair.
When the engine reaches the point of its life where the cost of a needed repair exceeds the
value added to the engine, it is typically sold for whatever it will bring, or junked.

2. Deterioration, the gradual decay, corrosion, or erosion of the property, occurs as a function
of time and severity of exposure conditions. It is similar to wear depreciation in many
ways, except it occurs whether or not the property has moving parts in actual use.
Deterioration can usually be controlled by good maintenance. Many structures that are
hundreds of years old in fem maintenance, one or two thousand years old are still in usable
condition, usually due to a consistent of good maintenance.

3. Obsolescence Depreciation is the reduction of value and due to competition from newer
and/or more productive models. Obsolescence can be subdivided into two types:
(a) Technological and (b) style and taste.

a. Technological obsolescence can be measured in terms of productivity. Over the short

term, technological obsolescence has typically at a fairly constant rate. Earth moving
equipment, for instance, has typically decreased in productivity at the rate of about 5 %
per year over the last 20 years, according to the manufactures. In theory however,
sudden drastic breakthroughs are possible in any area. For instance, in the construction
industry, invention of a new cheep building materials, light, strong, and easily workable
could make billions of birr worth of existing manufacturing facilities obsolete with
commensurate rapid depreciation as a result. As a practical matter technology progress
has historically come gradually at a fairly constant rate, with a few notable exceptions.

b. Style Obsolescence depreciation occurs as a function of customers taste. This is much

less predictable, although just as a real in terms of lost value. As style change, both men
and women typically reuse to purchase clothing, cars, houses, and so forth, that do not
incorporate feature considered up-to-date. Style and taste are to some extent
influenced by large expenditures of funds for advertising.

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 CHAPTER 3 Engineering Economics

4. Reduced Demand normally results in decreasing value (increased depreciation) of an asset

in accordance with the market place law supply and demand. Reduce demand resulted
from a number of factors, such as a general business recession, change in development
patterns, consumer habits, or even change in weather patterns. The consent of a prolonged
dry weather cycle, for example, may reduce the demand for drainage facilities and enhance
the demand of irrigation, resulting demand-induced changes in depreciation. The effect of
the combined types of depreciation is shown graphically in figure 1. the typical pattern is a
gradual decreasing value, interrupted by jogs indicating decision to invest in repair,
overhaul, or renovations. For each such investment the value added is presumed to exceed
the cost. Finally, there comes as a time when the cost exceeds the value added and the item
is junked, sold, or abandoned.

Measuring depreciation
Since Depreciation is the loss in value over a period of time it may be traced by simple
graphing the market value as a function of time.
Cost New
80,000 Birr 80,00 Depreciation,
Birr 8,000/year
Book Value

60,000

40,000 Resale Value,

Birr 24,000

20,000

1 2 3 4 5 6 7
Time (yr)
.
Figure 5: Schematic graph o depreciation

In determining market value, several variables are usually encountered. For instance, in
the automobile market there is on market price for retail and one for wholesale, with
other variables affected by mileage, condition, location and so forth.

Depreciation accounting
Depreciation accounting is the systematic division of the depreciable value of capital
investment into annual allocations over a period of years. There are two basic reasons for
need of depreciation accounting.

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 CHAPTER 3 Engineering Economics

1. To provide owners and manager with an estimate of the current value of their
capital investment. Depreciation accounting for this purpose should approximate
actual market values.
2. To account for depreciation in a manner that yields the maximum possible tax
benefits. Depreciation accounting for this purpose may not exceed strict legal
guideline but need not approximate market values.

Since the two purposes are so divergent, usually two different methods of depreciation
accounting are employed simultaneously on the same capital item. This double
accounting is quite legal and ethical and is done openly. While the government requires
strict adherence to its tax regulations regarding depreciation accounting, it does not
expect the methods allowed or required by tax law are going to provide the type of
depreciation information required to efficient manage a business.

Estimates of three impotent items are required in order to calculate depreciation by any
depreciation method. They are:-
1. Estimate the purchasing price or cost when new.
2. Estimate the economical life (time between purchase new and disposal at resale or
salvage value), or recovery period for tax purpose.
3. Estimate the resale or salvage value (zero for tax purpose).

Based on these three items of information, accountants have derived a number of

methods of accounting for depreciation at a regular predictable rate over the expected
economic life. Of these many methods four have emerged as noteworthy and the first
three have found wide acceptance in professional practice.

i. Straight line method

ii. Sum Of-Year Digit method
iii. Decline balance method
iv. Sinking fund method (this method is not widely used)

Straight line method

Straight line (SL) method depreciation is the simplest method to apply the most widely
used method of deprecation. The annual depreciation, Dm, is constant and thus the book
value, BVm, decrease by a uniform amount each year. The equation for SL depreciation
is
1
Depreciation rate, Rm= -----------------------------------------------1
N
Annual Depreciation, Dm = Rm*(P-F)=
(P F ) ---------------------2
N
An example and graph of straight line depreciation follows

Example 1
Given the data below, find the annual depreciation and graph showing the depreciation
each year.

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 CHAPTER 3 Engineering Economics

Dragline purchase price, P=Birr 80,000

Resale value after 7 yrs, F= Birr 24,000
Solution
Purchase price, P=Birr 80,000
Resale value after 7 yrs, F= Birr 24,000
Value to depreciate N=7 equal installments, (P-F)= Birr 56,000
Dm = Annual depreciation (P-F)/N = Birr 56,000/7 = Birr 8,000
A graph of the values is shown below.

Cost New
80,000 Birr 80,00 Depreciation,
Birr 8,000/year
Book Value

60,000

40,000 Resale Value,

Birr 24,000

20,000

1 2 3 4 5 6 7
Time (yr)
Figure 6: Straight Line Depreciation for Example 1

The Sum-Of-Year Digit Method

This is an accelerated depreciation (fast write-off) method, which is a term applied to any
method that permits depreciation at rate faster than straight line. This method calculates
depreciation for each year as the total original depreciable value times a certain fraction.
The fraction is found as follows: the denominator of the fraction is the sum of the digits
including 1 through the last year of the life of the investment the numerator is the number
that represents the years remaining for investment.

The sum of the ordinary digits for each of years I through N is

N ( N + 1)
1. SOYD =
2
2. the annual depreciation at end of year m is
N m +1
Dm = (P F )
SOYD
3. The book value at the end of year m is

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 CHAPTER 3 Engineering Economics

m( N m / 2 + 0.5)
Bvm = P (P F )
SOYD
An example of sum- of Year digits depreciation is shown below.

Example 2
Using the same, Birr 80,000 draggling as in example 1, find and plot the allowable
depreciation using the SOYD method.
Solution
A machine with a seven year life uses a denominator of 1+2+3+4+5+6+7=28, or
SOYD= N*(N+1)/2=28
The depreciation allowed for the first year is 7/28 of total depreciation; the allowance
for the second year is 6/28 of the total, and so on to 1/28 for the seventh year. Using
the sum of the year digits method,
Purchase price, P=Birr 80,000
Resale value after 7 yrs, F= Birr 24,000
Depreciable Value (P-F)= Birr 56,000
Results
Year Depreciation allowed For this year, Book Value, Bvm at EOYm
m Dm (in Birr )
7/28 X Birr 56,000 14,000 80,000-14,000 66,000
6/28 X Birr 56,000 12,000 66,000-12,000 54,000
5/28 X Birr 56,000 10,000 54,000-10,000 44,000
4/28 X Birr 56,000 8,000 44,000-8,000 36,000
3/28 X Birr 56,000 6,000 36,000-6,000 30,000
2/28 X Birr 56,000 4,000 30,000-4,000 26,000
1/28 X Birr 56,000 2,000 26,000-2,000 24,000
56,000
A graphed value from example 2 is shown in the figure below.
Cost New
80,000
Birr 80,000
Book Value

60,000

40,000 Resale
Value,
20,000 Birr 24,000

1 2 3 4
5 6 7
Time in year

Figure 7: SOYD Depreciation for example 2

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 CHAPTER 3 Engineering Economics

To find the book value in any year, either use the equation

m( N m / 2 + 0.5)
Bvm = P (P F )
SOYD
Or
1. find the unused depreciation by:
a. sum of the fraction for the remaining years
b. Multiply this sum by the total depreciable value (Birr 56,000 in this case)
2. Add this unused depreciation to the resale (salvage ) value (Birr 24,000 in this
example)

Example 3
Find the book value at the end of the fourth year for example 2

Solution
3 + 2 +1 6
The fraction for the remaining three years of the seven year life total is = .
28 28
Multiplying the depreciable value by this fraction we will
6
find * Birr 56,000 = Birr12,000 . The book value at the end of the fourth year then
28
equals the unused depreciation plus the salvage value, or Birr 12, 0000 + Birr 24,000 =
Birr 36,000 is the book value at the end of fourth year.

The equation of course, yields the same value.

m( N m / 2 + 0.5) 4(7 4 / 2 + 0.5)
Bvm = P (P F ) = B80,000 (B56,000)
SOYD 28

=Birr 36, 0000 Book Value at EOY 4

Declined balance method

The declined balance methods are the accelerated depreciation methods that provide for a
larger share of the cost of depreciation to be written of in the early year less in the later
years. This system more approximates the actual decline in the market value for many
types of property, especially mechanical equipments. Using this system the annual
depreciation is taken as 2.0 (for the 200% rate called Double Decline Balance method,
DDB) or 1.5 (for the 150% rate), or 1.25 (for the125% rate), times the current book value
of the property divided by the total year of economic life. For example, if the economic
life is seven years, then if it were not for accelerated depreciation, 1/7 of the value could
logically be deducted each year. The DDB method doubles this deduction to 2/7 of the
current value each year. The machine is depreciated down to the resale value and then no
more depreciation is taken. Book value, Bvm, is not permitted to fall below salvage
value, F.

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 CHAPTER 3 Engineering Economics

Equation for Decline balance Method

The abbreviation R= depreciation rate for declined balance depreciation.

1. The depreciation rate, R is the depreciation multiple divided by the estimated life,
n.
2
For double decline balance depreciation rate R=
N
1.75
For 1.75 decline balance depreciation R=
N
1.5
For 1.5 decline balance depreciation R=
N
2. The depreciation Dm for any given year, m, and given depreciation rate, R is

Dm = RP(1 R ) or (BVm 1 )R
m 1

3. the book value for any year BVm is :

Bvm=P(1-R)m provided that Bvm F

4. the age m, at which book value, Bvm will decline to any future value, F, is:
ln (F / P )
m=
ln (1 R )

Note that the depreciation amount Dm is determined by the book value only, and is not
influenced by the salvage value F (expecting the Bvm-Dm-1 F). Therefore, the book
value during later years may follow any of the following
a) If F is Zero or very low, then Bvm may never reach F
b) BV may intersect F before N (BV is not permitted to be less than F)
c) BV may intersect F at N (very rare case)

Graphically these three situations are given in figure 8. Since the book value must be less
than salvage value in the decline balance method the latter values of Bvm are usually
force fit to equal F, as depicted in the previous figure.
An example of DDB depreciation, is shown below using the same Birr 80,000 dragline
as in example 3

Example 4
Find the depreciation allowed each year, using double (200%) decline balance method,
(DDB),
Depreciation rate, R=2/7
Dragline purchase price, P= Birr 80,000
Resale Value, F, after 7 years=Birr 24,000
Depreciable value, P-F= Birr 56,000

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 CHAPTER 3 Engineering Economics

Solution
Year, Book Value X DDB Factor Depreciation Dm, allowable
m (Bvm X R) Depreciation for
each year
1 B80,000*2/7 B22,857 -B22,857
2 B57,173*2/7 B16,327 -B16,327
3 B40,816x2/7 B11,662 -B11,662
4 B29,154x2/7 B8,330 -B5,154**
5 B24,000 0 0
6 B24,000 0 0
7 B24,000 0 0
Total depreciation using DDB method of Depreciation B56,000
** This value is less than the annual depreciation amount because the book value at year
4 tend to become less than the resale vale and due to the restriction of the book value
not to be less than the resale or salvage value. Thus the adjustment made to make the
book value equal with Salvage value.

P DB
Book Value

Force Fit
F

Time (Yr) N

Figure 8: DB Depreciation

80,000= cost New

60
DDB Depreciation
Book Value

24,000

Figure 9: DDB Depreciation for example 4

Lecture Note 2008/9 16

 CHAPTER 3 Engineering Economics

Sinking Fund method

This method first set up saving account (sinking fund) and calculates the amount of
annual payments required to go into fund so that accumulated principal plus interest will
equals the accumulated depreciation on the asset by the end of the assets economic life.

Find the depreciation allowed for each year, using the sinking fund method. Assuming
interest, i= 10%.

Dragline purchase price, P= Birr 80,000

Resale Value, F, after 7 years=Birr 24,000
Depreciable value, P-F= Birr 56,000

Solution
The theoretical annual deposit into the sinking fund method

A= B56,000 (A/F,10%,7) =B5,902.70

Then the accumulated depreciation is simply the sinking fund balance of equal annual
deposits plus accumulated interest at the end of each year. The accumulated depreciation
at the end of each year for the B80,000 dragline with B24, 000 resale values after seven
years is tabulated below.

End of year Sinking fund Balance or Accumulate Annual

Depreciation Depreciation
1 B5,902.70*(F/A,10%,1) B5,902.70 5,902.70
2 B5,902.70*(F/A,10%,2) B12,903 7,000.30
3 B5,902.70*(F/A,10%,3) B19,588 6,685.00
4 B5,902.70*(F/A,10%,4) B27,395 7,807.00
5 B5,902.70*(F/A,10%,5) B36,037 8,642.00
6 B5,902.70*(F/A,10%,6) B45,543 9,506.00
7 B5,902.70*(F/A,10%,7) B56,00 10,457.00

The book value at the end of year m is Bvm = P-(P-F)(A/F,i,n)(F/A,i,m)

Or book value after four years BV4=B80,000-B27,395 = B52,605

The amount of depreciation allowed in any one year can be determined by either of two
methods.
1. Simply subtracting the accumulated depreciation at the end of the prior year from
the accumulated depreciation at the end of current year. (see the last column of
the above table.)
2. The depreciation allowed for any year m may be determined as the future value of
one lump sum deposit of A made (m-1) years previously. For instance the
depreciation of the seventh year equals B5, 902.70(F/P,10%,6)=B10,457. the
depreciation allowed for each individual year may be totaled to equal the full
allowable depreciation for the seven-year period, as follows.

Lecture Note 2008/9 17