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ENGINEERING ECONOMY

by

Nilo T. Aldon, ChE


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Preview Problems
What will be the equivalent amount at the end of five years of a uniform 5 yearly deposit
of P5,000. if the nominal annual interest rate is 12% compounded monthly?

Determine the present value of 10 semi-annual payments of P10,000 , the first of


which to be paid 2 years from now. Money is worth 12% pa compounded semi-
annually.

A bond issue of P100,000 redeemable at par in 10-years, in P1,000 units paying10%


interest per annum payments, must be retired by the use of sinking fund that earns 8%
pa. What is the total annual expense?

An economy is experiencing inflation at an annual rate of 7%. If the market interest rate
is also 5% per annum, what will be the real value of P500 two years from now ?

A company purchased an equipment for P 110,000. It is estimated that it will have a


useful life of 10 years. The scrap value of the equipment is P10,000,
a. Compute the book value of the equipment at the start of the 6th year using
declining-balance method.
b. Compute the book value at the end of the 5th year using Sinking Fund
method, i=10% pa
c. Compute the book value at the start of the 6th year using SYDM
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ENGINEERING ECONOMY
_ study of economic theories and their
applications to engineering problems with the
concept of obtaining maximum benefit at the
least cost.
Time value of money is central to this study.

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Course Objectives

After completing this course, the student must be able to:

1. Solve problems involving interest and the time value of


money;
2. Evaluate project alternatives by applying engineering
economic principles and methods and select the most
economically efficient one; and
3. Deal with risk and uncertainty in project outcomes by
applying the basic economic decision making concepts.

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Course Outline
1. Introduction
2. Money-Time Relationship
2.1. Time Value of Money
2.2. Types of Interest
2.3. Inflation/Deflation
2.4. Annuity
3. Depreciation
4. Capital Investments
5. Operational Costs
6. Accounting Fundamentals
7. Basic Methods of Profitability Analysis
8. Methods of Financial Analysis
9. Optimization

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References
Plant Design and Economics for Chemical Engineers, Max S. Peters and Klaus D.
Timmerhaus, 4th Ed 2001
Process Engineering Economics, Schweyer
Engineering Economy, de Garmo, Sullivan, Canada, 7th Ed
Engineering Economy, Arreola, 2nd Ed
Engineering Economy Sta. Maria, 3rd Ed
Engineering Economy, Sullivan, Bentadilli and Wichs, 12th Ed 2003
Contemporary Engineering Economics, Chan S. Park, 3rd Ed 2002
Engineering Economy by L.T. Blank and A.J. Tarquin, 6th ed., McGraw Hill, 2005.
Engineering Economy by W.G. Sullivan, E.M. Wicks, and J.T. Luxhoj, 13th ed.,
Prentice Hall, 2006.
Contemporary Engineering Economics by Chan S. Park, 4th ed., Prentice Hall,
2007.
Excel for Engineering Economics by R.W. Larsen and Chan S. Park, Prentice Hall,
2003.
Engineering Economy and the Decision Making Process by J.C. Hartman,
Prentice Hall, 2007.
Engineering Economic Analysis by D. G. Newman, T. G. Eschenbach, and J. P.
Larelle, 9th ed., Oxford University Press, 2004.

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1. INTRODUCTION

Engineering Economy _ study of economic theories and


their applications to engineering problems with the concept
of obtaining maximum benefit at the least cost.
Economics_ is the study of scarcity. Resources are limited, and
every society wants to figure out how to allocate its resources for
maximum benefit._Jodie Beggs, PhD (Harvard U)

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Reasons for Studying Engineering Economy:
Engineering designs and operations must be equated with
costs for practical applications
Engineers evolve into managers of their own or other
enterprises

Uses of Engineering Economy


Application on various fields of engineering
Determining of limiting factors
Tool in selection of alternates
Investment of capital
Tool in decision making

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Economists study topics such as:
How prices and quantities of items are determined in market
economies
How much value markets create for society
How taxes and regulation affect economic value
Why some goods and services are under-supplied in a market
economy
How firms compete and maximize profit
How households decide what to consume, how much to save, and
how much to work (or, more generally, how people respond to
incentives)
Why some economies grow faster than others
What effect monetary and fiscal policy has on economic well-
being
How interest rates are determined

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It is NOT an economists job to tell
people what stocks and bonds they
should be investing in.

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SELECTION AND EQUIVALENCE IN PRESENT ECONOMY

Present economy involves the analysis of problems for


manufacturing a product or rendering a service upon the
basis of present or immediate costs. It is highlighted when the
effects of time such as interest and depreciation are
negligible. Present economy is employed when the
alternatives to be compared will provide the same result and
the period involved in the study is relatively short.
When alternatives for accomplishing a specific task are being
compared over one year or least-and influence of time on
money can be ignored, engineering economic analyses are
referred to as present economy studies.

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SELECTION AND EQUIVALENCE IN PRESENT
ECONOMY
Present economy studies occur in the following situations:
a. Selection of material_ In many cases, economic selection among materials cannot be
based solely on the costs of materials. Frequently, a change in materials will affect the
design and processing costs, and shipping costs may also be altered.

b. Selection of method to be used_ In mechanical or chemical operations a product


may be made by two or more methods giving equivalent results. Some goods may be
delivered by various methods such as using different capacity trucks, and the results
would still be the same regardless of the truck used. These are but a few of the
examples that may be cited to show that certain operations are capable of being done
by two or more methods.

c. Selection of design_ In the design of a machine to produce a certain product, the


engineer responsible for the work will usually make as many designs as possible and
from which, by a process of elimination, he will select the design best fitted for the
work to be done with particular care being given to the one which will do the work
with most economy.

d. Selection location or site for a project_ In the choice of a factory site many factors
are often considered such as the cost of the land, the cost of construction in the
NTAldon
12 different sites, and the difference in transportation cost, and many other factors.
e. Comparison of proficiency among workers_ In industrial operations
where the efficiency of the workers is a factor affecting costs, it is
usually observed that workers have varying efficiencies. In some
occupations only those with better average proficiencies are acceptable.
In teaching for example, other factors being equal, preference should be
given to those teachers who did better than average in their studies.
f. Economy of tool and equipment maintenance_ In many activities,
tools have to be sharpened from time to time, and equipment have to be
kept in good operating condition all the time. In certain cases,
experience will show the best time to perform certain operations to
maintain equipment at the optimum operating efficiency.
g. Economy of number of laborers_ In certain industrial operations it is
observed that a certain number of workers cooperating on a certain
phase of work will lead to the highest efficiency. An increase beyond this
number will usually cause the taking into effect of the law of diminishing
returns. In certain cases, the excess of laborers will result in some
laborers not working at certain times while waiting for the work of
other laborers to be finished.

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SAMPLE PROBLEMS:
A machine part to be machined may be made either from an alloy of
aluminum or steel. There is an order for 8000 units. Steel costs
P380/kg, while aluminum costs P870/kg. If steel is used, the steel per
unit weighs 110 grams; for aluminum, 30 grams. When steel is used, 50
units can be produced per hour; for aluminum, 80 units per hour
with the aid of a tool costing P64,000, which will be useless after
8,000 units are finished. The cost of the machine and the operator is
P1080 per hour. If all other costs are identical, determine which
material will be more economical.
Solution:

Steel Aluminum
Material Cost 0.11kg (P380/kg)= P41.80 0.030 kg (P870) = P26.10
Labor and Machine P1,080/50 = P 21.60 P1,080/80 = P13.50
Tool P64,000/8,000 = P8.00
Cost per piece P63.40 P47.60
Answer: Aluminum is cheaper!

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A company manufactures 1 million units of a product
annually. A new design of the product will reduce material
cost by 12%, but will increase processing cost by 2%. If
materials cost is P 12/unit and processing will cost P4/unit,
how much can the company afford to pay for the preparation
of the new design and making changes in equipment?
Solution:

Decrease in materials 1,000,000 (0.12) (P12) = P 1,440,000


Increase in processing 1,000,000 (0.02) (P4) = P 80,000
costs
Net Savings P 1,360,000

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Time Value of Money
Time affects the cost of money.
A peso now is worth more than a peso a year from now because it can
earn interest during the year.

Interest represents two things:


1.The compensation paid for the use of the borrowed capital
2. The risk taken in making the loan.

The rate at which interest will be paid is usually fixed at the time the
capital is borrowed, and a guarantee is made to return the capital at
some set of time in the future or on an agreed-upon pay-off schedule.
Riskier loans require more interest to make them attractive.
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History of Interest
The concept of interest goes back to earliest recorded history.

Babylon 2000 B.C. money paid for use of grain that was borrowed.
Typical rates were 6 to 25% per annum.

Usury is prohibited in the Law of Moses, and in Islamic cultures.


In the middle ages, interest on loans was prohibited based on these
restrictions.
In 1536, John Calvin adopted a theory of what constituted usury that
allowed interest.
Islamic conventions developed to allow those with money to buy a stake in a
business in return for an portion of the profit from that business.
Interest and the cost of capital have become an essential part of doing
business.

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INTEREST DEFINED
Interest __ the time value of money
__ money paid for the use of money
__ compensation paid for the use of borrowed capital.

Elements of Interest
1. Principal, P = the sum of money lent or borrowed
2. Interest, I = the price paid or charge made for the use
of money
3. Time, n = the period of time during which interest is charged,
measured in some specific unit. The unit may be day,
week, month, 3 months, 6 months, or a year.
4. Rate, i = the price paid for the use of money for a unit of time. It
is given as a percentage of the original amount.
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CASH FLOW

Cash Flow _ is a systematic presentation of cash


receipts and disbursements for a given operating
period

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Cashflow Diagram: Investment Transaction

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Cashflow Diagram: Loan Transaction

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Types of Interest
A. Simple Interest:The interest is proportional to the original amount of the loan
I Pin
Requires compensation payment at a constant interest rate based only on the original amount
The principal P must be repaid eventually; therefore the entire amount F, of principal plus simple interest due after n periods
is;
PFI

In the payment of simple interest, it makes no difference whether interest is paid at the end of each time unit or after
any number of time units. The same total amount of money is paid during a given length of time, no matter which method is used.
Under these conditions, there is no incentive to pay the interest until the end of the total loan period.

( P)(i)(d ) P i m
I Pin
1. Ordinary Simple Interest 360 12
The time unit used to determine the number of interest period is usually one year, and the interest rate is expressed on a
yearly basis. When an interest period of less than one year is involved, the ordinary way to determine the simple interest is to assume
the year consists of twelve 30-day months, or 360 days.

( P)(i)(d ) ( P)(i)(d )
2. Exact Simple Interest I Pin ; or
365 366
The exact method accounts for the fact that there are 365 days in a normal year and 366 days in a leap year.
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Example:
Determine the ordinary simple interest on P1000 for 8 months
and 15 days if the rate of interest is 15%.
I Pin
Solution:

For ordinary simple interest, it is assumed that 1 year = 12 months;


n= 8.5 months
P = 1000
i = 0.15/12
8.5
I Pin I 10000.15 P 106.25
12

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Example:
Determine the exact simple interest on P1000 for the period
January 1 to October 15, 2012 if the rate of interest is 15% pa.

Solution: 2012 is a leap year = 366 days

Jan 1-31 31 August 31


February 29 September 30
March 31 October 15
April 30
May 31
June 30
July 31
213 76 289 days

I Pin
Pid

10000.15289
P 118.44
25 NTAldon 366 366
3. Discounted Interest, id
The interest for the money borrowed (discount) is
deducted from the principal in advance.

I d P id n
P = amount loaned
P = actual amount received
Id = interest payment deducted in advance
P' P I d
i Id
id
1 i P

id Id
Effective Interest Rate, i
i
NTAldon
1 id P'
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Example:
Man borrowed P10,000 from a bank and agreed to pay the loan at
the end of 1 year. The bank discounted the loan and gave him P8,000

1. What was the discounted rate?

I d 10,000 8,000
id 20% pa
P 10,000
2. What was the effective rate of interest?
I d 10,000 8,000
i 25% pa
P' 8,000
id 0.20
i 0.25 25% pa
1 id 1 0.2

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Compound Interest: The interest is proportional to the balance at any point in
time
Stipulates that interest is due regularly at the end of each interest period. If
payment is not made, the amount due is added to the principal, and the interest is charged
on this converted principal during the following unit time.
Thus an initial loan of P at an annual interest rate i would require payment of Pi
as interest at the end of the first year. If this payment were not made, the interest for the
second year would be ( P + Pi ) i and the total amount due for interest after 2 years
would be :

IT2 Pi ( P Pi)i

Therefore, the total amount of principal plus interest after 2 years equals

F2 P Pi ( P Pi)i P1 i
2
Future Worth

Fn P1 i
n

NTAldon
n

I Fn P P1 i P P 1 i 1
n

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1. Nominal Interest Rates, r
Interests are compounded other than on annual basis. It always
includes a qualifying statement indicating the compounding period.
Example, 12% per annum compounded quarterly.

2. Effective Interest Rates, i


Are always compounded on an annual basis.

Conversion of
Nominal Interest rate , r to Effective Interest Rate, i :
m
r
i 1 1
m
where: r = nominal interest rate per year
m = number of interest periods per year
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Compounding Periods
2
Compounded Semi-annually r
(every six months) i 1 1
2

4
r
Compounded Quarterly i 1 1
(every three months)
4

12
r
Compounded Monthly i 1 1
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Continuous Interest
The concept of continuous interest is that the cost or income
due to interest flows regularly.
If we let the change in the accumulated amount, F over the
change in the unit period, n a function of both the accumulated amount
F, and rate, r, then;

dF Conversion of continuous interest rate to


rF effective interest rate
dn
F dF i er 1
P F r 0 dn
n

F
Ln rn
P
Fn Pern P 1 i
n

e r 1 i
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F
Future Worth Factor = 1+i ; (F/P,i%,n)
n

Example:
A person deposits P100,000 in the bank.

a. How much would be his money in the bank after 5 years if interest is
6% per annum compounded annually?

F=P 1+i =100,000 1.06 =P 133,822.56


n 5

b. How much would be his money in the bank after 5 years if interest is
6% per annum compounded monthly?
5 12
0.06
F=P 1+i
n
=100,000 1+ =P 134,885.02
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SAMPLE PROBLEMS:
A person wishes to accumulate P100,000 in the bank after 5 years.
a. How much is he going to deposit now assuming that his money earns 6% per annum ?
P 1 F 100, 000
PresentWorth Factor ; ( P / F , i %, n) P P 74, 726
1 i 1 0.06
n 5
F 1 i n

CASHFLOW-Annual

1 year 2 years 3 years 4 years 5 years


74,726) x 79,209.56 x 83,962.13 x 88,999.86 x 94,339.85 x
(1.06) (1.06) (1.06) (1.06) (1.06)
= 79,209.56 = 83,962.13 = 88,999.86 = 94,339.85 = 100,000

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SAMPLE PROBLEMS:
A person wishes to accumulate P100,000 in the bank after 5 years.
b. How much is he going to deposit now assuming that his money earns 6% per annum ?
compounded monthly

F 100, 000
P 512
P 74,137.22
1 i
n
0.06
1
12

Alternative solution (compute first, i )

m 12
r 0.06
i 1 i 1 1 0.061677 6.1677%
m 12

F 100, 000
P 5
P 74,137.50
1 i 1 0.061677
n

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Example:
Find the nominal interest compounded monthly which is
equivalent to 12% pa compounded quarterly?

Solution:

m 12 4
r r 0.12
i 1 1 1 1 1 1
m 12 4
r 11.88% pa compoundedmonthly

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INFLATION or DEFLATION: f

Inflation is the increase in the price of goods and services from one year to
the other, thus decreasing the purchasing power of money.

Deflation involves a decrease in the average price of goods and services


resulting to the increase in the purchasing power of money. It is usually
associated with a prolonged erosion of economic activity and high
unemployment.

Some measures of price changes in our economy are the Consumer Price
Index (CPI) and Producer Price Index (PPI).

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Consumer Price Index (CPI)
Consumer price index (CPI) measures changes in the price level of consumer
goods and services purchased by households.
The CPI is a statistical estimate constructed using the prices of a sample of
representative items whose prices are collected periodically. Sub-indexes and sub-
sub-indexes are computed for different categories and sub-categories of goods and
services, being combined to produce the overall index with weights reflecting
their shares in the total of the consumer expenditures covered by the index. It is
one of several price indices calculated by most national statistical agencies.
The annual percentage change in a CPI is used as a measure of inflation. A
CPI can be used to index (i.e., adjust for the effect of inflation) the real value of
wages, salaries, pensions, for regulating prices and for deflating monetary
magnitudes to show changes in real values.

Indexn Indexn 1
Annual Change Rate f 100%
38 NTAldon Indexn 1
Producer Price Index (PPI)
Producer Price Index (PPI)_ is a family of indexes that measure the
average change over time in the prices received by domestic producers of
goods and services. PPIs measure price change from the perspective of the
seller.

The headline PPI (for finished goods) is a measure of the average price
level for a fixed basket of capital and consumer goods for prices received
by producers. The producer price index for finished goods is a major
indicator of commodity prices in the manufacturing sector. These prices
are more sensitive to supply and demand pressures than the more
comprehensive consumer price index. Changes in the producer price
index are considered a leading indicator for consumer price changes,
although only a small portion of the PPI is directly connected to less than
half of the CPI.
39 NTAldon
Example:
An economy is experiencing inflation at an annual rate of 5%. If this
continues, what will P500 be worth two years from now in terms of todays
pesos?
Solution: F 500
P 453.51
1 f n
1 0.05 2

Example:
An item presently costs P500. If inflation is at the rate of 5% per
year, what will be the cost of the item in 2 years?
Solution:

F P 1 f F2 P 1 f 500 1 0.05 551.25


n 2 2

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Sixteenth Rule:
The cost of the equipment at a new capacity can be computed if the cost of
the same equipment is known at a given capacity. The cost adjustment is
the ratio of the two capacities raised to the power 0.6
0.6
S
CB C A B
SA

Combination of Price Cost Index and Sixteenth Rule:


0.6
I S B
CB C A n
IK S A

Example: Six years ago, an 80-kw diesel electric generator costs


P400,000. The cost index for this class of equipment six years ago was 187
and is now 194. Determine the cost of a 120 kw unit now?

X
I S
0 .6
194 120
C B C A n B 400 ,000
I K S A 187 80
41 NTAldon P 529 ,267
Real Interest Rate, i'
The real interest rate, i' would be the REAL value of your moneys actual
earnings, i after considering the loss in its purchasing power due to inflation, f .

1 i' 1 i 1 i
1 f i' 1
1 f
Example
IF you P100 deposit in the bank earning 8% pa, what would be the real interest
rate if inflation is 5% pa.
Solution:
After a year your P100 will become
F 100 1.08 108 ( ACTUAL)
But after a year your P108 is only worth 108
F' 102.86 ( REAL)
1.05
due to inflation.Therefore the real earnings is only 102.86 100 2.86
2.86
Therefore, the real interest rate is x100% 2.86%
i f NTAldon
0.08 0.05 100
i'
42 0.0286 2.86%
1 f 1 0.05 or
DIFFERENTIAL PRICE ESCALATION OR DEESCALATION RATE: '
e j
_ is a real price change in good or service caused by various
factors in the market . It is the increment (%) of price change above
or below the general inflation rate f, during a period (normally a year).
The increase or decrease in price is in REAL pesos.
1 ej 1 ej
1 e '
e
'
1
j
1 f j
1 f
For example, if the unit price of the goods is P100 and after a year its price
will be escalated or increased by 10% (ej ) , then its unit price will
becomeP110 (ACTUAL increase in pesos). But during that time if inflation
rate (f) is 5%, therefore the inflated cost should have been
P110/1.05=104.76, then the differential price escalation or increase in
REAL pesos is 104.76-100= P 4.76; ej= 4.76%
1 ej 1.10
e
'
1 1 0.0476 4.76%
43 NTAldonj
1 f 1.05
ej
Total PRICE ESCALATION: _ The price escalation or de-
escalation rate is total rate (%) of price change in the unit price,
or cost for a fixed amount during the period (normally) a year for
good or service. It is the sum of the general price inflation rate
and the differential inflation rate plus their product.The increase
or decrease in price is in ACTUAL pesos.


1 e j 1 e 'j 1 f
For example, if the unit price of the goods is P100 and after a year its price will be escalated or
increased by 10% (ej ) , then its unit price will becomeP110. But if inflation projected for the
year of 5% is considered, then the actual unit selling price of the goods would be:


FC PC 1 e j PC 1 e 'j 1 f

NTAldon
100 1 0.10 1 0.05 P115 .50
44
N.2.4. Annuity
It is a series of equal PAYMENTS, A occurring at equal time
intervals. Interest is paid on all accumulated amounts, and the
interest is compounded each payment period. The amount of an
ANNUITY F, is the sum of all payments A, plus interest if
allowed to accumulate at a definite rate of interest from the
initial payment up to the end of the annuity term.

An annuity term, n is the time from the beginning of the first


payment period to the end of the last payment period.

It must be noted that the sum F, is expressed at the end of the


last payment period
45 NTAldon
A. Ordinary Annuity

The most common type of annuity. It involves the payment of


amount, A at the end of each interest period.

1 i n 1
Future Worth of Ordinary Annuity Fn A
i
P

0 1 2 3 4 n
A A A A A

Fn
A 1 i n 1
P
1 i
Present Worth of Ordinary Annuity
n
46 NTAldon i
B. Annuity Due
The uniform payments, A are made at the beginning of
each interest period.
1 i n 1 1 i
Fn A
Future Worth of Annuity Due

i
P

0 1 2 3 4 n
A A A A A

Fn
Present Worth of Annuity Due

A 1 i n 1 1 i
P n
47 NTAldon
1 i i
C. Deferred Annuity
It is also an ordinary annuity but the payment of the first amount is deferred a certain
number of periods after the first. For example, the first annuity payment could be made after 3
annuity terms instead of after the first annuity term.

1 i n 1
Future Worth of Deferred Annuity Fn A
i
m
P 0 1 2 3 4 n
A A A A A
0 1 2 3
Fn

A 1 i n 1
Present Worth of Deferred Annuity
P
48 NTAldon 1 i n m i
D. Continuous Cash Flow Continuous Compounding
Continuous flow of funds means a series of cash flows occurring
at infinitesimally short intervals of time, corresponding to an annuity
having an infinite number of short periods.

1 i 1 n
Fn A
i
r
i
m
A= cash flow in a period

A A = sum of cash flows in a year


A m = number of periods in a year
n = total number of periods
m
49 NTAldon
Continuous Cash Flow Continuous Compounding..

r r m
rn
1 1 1 1
mn r

A m m
Fn A
m r r

m


m
r r
As m approaches infinity,
1 m e

e 1
rn
A e 1
rn
Fn A P rn
r e r

50
Where
NTAldon A is the sum of continuous cash flows in one year
Ordinary Annuity
1 i n 1 A 1 i n 1
Fn A ; P
i 1 i n
i

Discrete Cash Flow -Continuous Compounding


e rn 1 A e rn 1
Fn A r ; P rn r
e 1 e e 1

Continuous Cash Flow- Continuous Compounding


e rn 1 A e 1
rn
Fn A ; P rn
51 NTAldon
r e r
Interest Factors
1. Single-Payment Future-Worth Factor; F= P (F/P, i%, n)

1 i F/P,i%, n
F n

2. Single-Payment Present-Worth Factor; F= P (F/P, i%, n)

P/F,i%, n
P 1

F 1 i n

3. Future Worth Annuity Factor; F= A (F/A, i%, n)


F 1 i 1
n
F/A,i%, n
A i
4. Present Worth Annuity Factor; F= A (P/A, i%, n)
P


1 i 1
n
P/A,i%, n
52
ANTAldon 1 i i
n
Example:
1. A loan of one million pesos is to paid in 10 years at an interest rate of 8.5% pa.
a. How much should the 10 annual payments be?
Solution:
P
0 1 2 3 4 5 6 7 8 9 10
A A A A A A A A A A
F

n 10 0.085
A P1 i
i
1,000 ,000 1.085 152,407 .71
1 i 1 1.085 1
n 10

b. What would the balance be after the 6th payment ?


1 i n 1
Balance P1 i A
n

i
1 0.085 6 1
1,000,000 (1.085) 152,407 .71
6
499,226 .13
0 .085

2. If one million pesos is to be accumulated in 10 years at an interest rate of 8.5% pa,


how much should the 10 annual payments be?
i 0.085
A F 1,000,000 67,407 .70
53 NTAldon
1 i n
1 1.085 10
1
GRADIENT

1. Uniform Arithmetic Gradient


It is also an ordinary annuity but disbursement or
payment A increases or decreases by a uniform amount
G each period.
P
0 1 2 3 n
A A+G A+2G A+(n-1)G
FAn+FGn
Future Worth of Arithmetic Gradient, G : FGn

G 1 i 1 1 i n 1
n
FGn n FAn A
i i i

54
F FAn FGn
NTAldon
n
GRADIENT
2. Geometric Gradient
It is also an ordinary annuity but disbursement or
payment A increases or decreases by a uniform rate
g each period
P
0 1 2 3 n
A A(1+g) A(1+g)2 A(1+g)n-1
Fn
Future Worth of Geometric Gradient, G : Fn

1 i n 1 g n
Fn A
ig
When g=i
Fn nA1 i
n 1
55 NTAldon
SAMPLE PROBLEM

1.What is the accumulated amount of a series of payments when the initial payment of
P1000 increases by P200 each period, until the third period if cost of money is 10% pa.
Required: Fn
Solution: A= P1000 ,G =P200, and i =10%
CASH FLOW
A A+G A+2G
0 1 2 3
P1,000 P1,200 P1,400
F3

Fn FAn FGn
1 i n 1 G 1 i n 1
Fn A n
i i i
1 0.10 3 1 200 1 0.10 3 1
Fn 1000 3 P3,930
0.10 0.10 0.10

Another way of solving this is to project individually the


Future Worth of each payment.
F3 1000 1.1 1200 1.1 1400 P 3,930
2

56 NTAldon
2. What is the accumulated amount of a series of payments when the initial
payment of P1,000 increases by 15% each period, until the third period if
cost of money is 10% pa.

Required: Fn
Solution: A= P1,000 , g =15%, and i =10%
CASH FLOW
A A(1+g) A(1+g)2
0 1 2 3
P1000 P 1000(1.15)=1,150 2
P1000(1.15) = P1,725
F3
1 i n 1 g n
Fgn A
ig

3
1 0.10 1 0.15
3
F 1, 000 P3, 798
g3 0.10 0.15

Another way of solving it is to project individually the Future Worth of each payment.
Fg 3 1000 1.1 1150 1.1 1725 P3,798
2

57 NTAldon
BONDS
_is a certificate of indebtedness of a corporation
usually for a period not less than ten years and
guaranteed by a mortgage on certain assets of the
corporation or its subsidiaries.
Bonds are issued when there is a need for more
capital such as for expansion of the plant or the services
rendered by the corporation.
The face or par value of a bond is the amount stated
on the bond.
When the face value has been repaid, the bond is
said to have been retired or redeemed.
The bond rate is the interest quoted on the bond.
58 NTAldon
Classification of Bonds

1. Registered Bonds _ The name of the owner of this bond is


recorded on the record books of the corporation and interest
payments are sent to the owner periodically without any action
on his part.
2. Coupon Bonds _ Have a coupon attached to the bond for each
interest payment that will come due during the life of the bond.
The owner of the bond can collect the interest due by
surrendering the coupon to the offices of the corporation or at
specified banks.

59 NTAldon
BONDS

Equipment obligation bonds _ refer primarily to bonds whose


guarantee is a lien on equipment.
Registered bonds _ the owner's name is recorded in the books of the
corporation, and the interest is paid periodically to the owner
without their asking for it.
Joint bonds _ bonds which are issued by two or more corporations
Par value of the bond or face value_ is the amount stated on the
bond.
Bond rate _ is the rate of interest quoted on the bond.
Redemption or disposal priceusually equal to par value.
Mortgage bonds _ bonds whose security is mortgaged on certain
specified assets of the corporation.

60 NTAldon
BONDS

Debenture bonds _ bonds without security behind them except a


promise to pay by the issuing corporation
Callable bond _entitles the issuer to pay off the principal prior to the
stated maturity date. Similarly, the owner of a putable bond _can force
the issuer to pay off the principal before the maturity date.
Convertible bond _gives the bondholder the right to exchange the
bond for shares of the issuer's common stock at a specified date.
Municipal bonds _are issued by state and local governments and other
public entities, such as colleges and universities, hospitals, power
authorities, resource recovery projects, toll roads, and gas and water
utilities. Municipal bonds are often attractive to investors because the
interest is exempt from federal income taxes and some local taxes.
There are two types of municipal bonds: general obligation bonds and
61 NTAldon
revenue bonds.
62 NTAldon
Retirement of Bonds
The corporation may issue another set of
bonds equal to the amount of bonds due for
redemption.
The corporation may set up a sinking fund into
which periodic deposits of equal amount are
made. The accumulated amount in the sinking
fund is equal to the amount needed to retire
the bonds at the time they are due.

63 NTAldon
Bond Periodic Expense
A = periodic deposit to the sinking fund
I = interest on the bonds per period

A+I = total periodic expense

F = accumulated amount, (par value of the bond)


needed to retire the bond

i = rate of interest in the sinking fund


r = bond rate per period

64 NTAldon
to the sinking fund, A i
A F
1 i 1
n

Interests
on the Bonds per Period, I I Fr

Total Periodic Expense: A+I


i
A I F Fr
1 i 1
n

i = rate of interest in the sinking fund


r = bond rate per period
n = number of periods
65 NTAldon
Bond Value, P
The present worth of all future amounts that are expected to be
received through ownership of the bond.

C 1 i n 1
P Fr n
1 i n
i1 i
P = value of the bond n periods before redemption
F = amount needed to retire the bond
C = redemption price, usually equal to F (also known as
Principal, Face Value, Par Value)
r = bond rate per period
n = number of periods before redemption
i = investment rate or yield period
66 NTAldon
Sample Problems-BONDS
1. A bond issue of P200,000, in 10-years, in P1,000 units paying 16%
nominal interest in semi-annual payments, must be retired by the use
of sinking fund that earns 12% pa compounded semi-annually. What is
the total semi-annual expense?
Solution:
F = P200,000
r = 16%/2= 8% per semi-annual
i = 12%/2 = 6% per semi-annual

Total semi-annual expense = A + I


i
Total Semi annual Expense F Fr
1 i 1
n

0.06
200, 000 200, 000 0.08
1 0.06 1
20

67 NTAldon P 21, 437


Sample Problems-Bonds
2. Find the current price of a 10-year bond paying 6% per year
that is redeemable at par value, if bought by a purchaser to yield
10% per year. The face value of the bond is P100,000
Solution:

P
C
Fr
1 i 1
n


100,000
100,0000.06
1 0.1 1
10

n 10
1 i n
i1 i 1 0.1
10
0.101 0.10
P 38,554.33 38,867.40 75,421.73

68 NTAldon
Sample Problems-Bonds

3. Find the price of a 10-year bond , two years before


its redemption, paying 6% per year that is
redeemable at par value if bought by a purchaser to
yield 10% per year. The face value of the bond is
P100,000
Solution:
1 i n 1 100,000 1 0.12 1
100,0000.06
C
P Fr n
2
1 i n
i1 i 1 0.1
2
0.10 1 0.10
P 82,644.83 10,413.22 93,058.05
69 NTAldon
Sample Problems-Bonds
4. A 10-year bond with a par value of P1,000 and with bond rate of
10% payable annually is sold now for P1080. If the yield is to be
12%, how much should the redemption price be at the end of 8
years?
Solution:

C 1 i n 1 C 1 0.128 1
P Fr 1080 1,0000.10 8
1 i n
i 1 i n
1 0.12 8
0.121 0.12
C 1,444.07

70 NTAldon
DISCOUNT FACTORS and EQUIVALENCE

71 NTAldon
DEPRECIATION
The decrease in the value of equipment, building or other structures
due to the passage of time. The causes of depreciation may be physical
or functional.

Examples of physical depreciation are, wear and tear, corrosion, accident,


deterioration due to age or elements.

The rest are functional depreciation and one good example is


obsolescence. This is caused by technological advances or developments
which make an existing property obsolete. Even though the property
has suffered no physical change, its economic serviceability is reduced
because it is inferior to improved types of similar assets that have been
made available through advancements in technology

Depletion_ Another kind of depreciation is material loss due to


consumption or exploitation particularly applicable to natural
72
resources.
NTAldon
Purposes of Depreciation

To provide for the recovery of capital which has been invested in


physical property

To enable the cost of depreciation to be charged to the cost of


producing products or services that results from the use of
property.

For engineers, depreciation is included as cost of production of


any product or the rendering of any service where equipment is
used to provide for the replacement either at the end of its
physical or economic life or at the time when its operation no
longer results in satisfactory profit or to provide for the
maintenance of capital to replace the decrease in the value of
equipment

73 NTAldon
Maintenance _conveys the idea of constantly keeping a property in good condition;
Repairs _connotes replacing or mending broken or worn parts of a property.
Service life of the property _is the period during which the use of property is economically
feasible. Both physical and functional depreciation are taken into consideration in determining
service life. The term is synonymous with economic or useful life. In estimating the probable
service life, it is assumed that a reasonable amount of maintenance and repairs will be carried out at
the expense of the property owner.
Recovery Period_ The number of years over which the basis of the property is recovered through
the accounting process. For the classical methods of depreciation, this is normally the useful life.
Under the MACRS, this period is the property class for the General Depreciation System (GDS),
and it is the class life for the Alternative Depreciation System (ADS)
Present Value _ The value of the asset in its condition at the time of valuation
Salvage Value_ is the net amount of money obtainable from the sale of the used property over and
above any charges involved in removal and sale.
If a property is capable of further service, its salvage value may be higher. This is not necessarily true, however, because
other factors, such as location of the property, existing price levels, market supply and demand, and difficulty in
dismantling, may have an effect. The term salvage value implies that the asset can give some type of further service and is
worth more than merely its scrap or junk value.

74 NTAldon
Scrap or junk value_ is the amount of money obtained when the property cannot
be disposed as a useful unit but rather dismantled and sold as junk to be used again as
a manufacturing raw material.
Book value _ also known as depreciated value, is the worth of the property as
recorded in the books of account of the enterprise and is equal to the original cost
less the amounts which have been charged to depreciation. It is sometimes called the
unamortized value.
Market value _ The price which could be obtained for an asset if it were placed on
sale in the open market. Is the amount which a willing buyer will pay to a willing
seller for the property when neither one is under compulsion to buy or sell.
Fair Value _ The value is usually determined by a disinterested third party in order
to establish a price that is fair to both the seller and the buyer
Replacement value _ The cost necessary to replace an existing property at any
given time with one at least equally capable of rendering the same service.
Adjusted Cost basis_ The original cost of the asset, adjusted by allowable
increases or decrease , is used to compute depreciation and depletion deductions.
For example, the cost of any improvement to a capital asset with a useful life greater
than one year increases the original cost basis, an d a casualty or theft loss decreases
it. If the basis is altered , the depreciation deduction may need to be adjusted.
Basis, or cost basis_ The initial cost of acquiring an asset (purchase price plus tax)
, including transportation expenses and other normal costs of making an asset
serviceable for its intended use. This amount is also called the unadjusted cost
75 basis.
NTAldon
Methods of Depreciation
A. Uniform Depreciation
1. Straight Line Method
This is the simplest and most widely used method compared to any other method. It is
based on uniform annual charge. It doesnt take into account the interest or profit earned
on accumulated depreciation fund. It is a standard accounting method acceptable by the
Bureau of Internal Revenue.

d Tn n d
where:
d = periodic depreciation
dTn= total depreciation after nth period
FC SV FC = First cost
d SV= Salvage Value
L
BVn= Book value after nth period
BVn FC n d L = Service Life
n = nth period
76 NTAldon
2. Sinking Fund Method
It is based on uniform annual charge. It is assumed that a sinking
fund is created to replace the original cost of equipment. All amounts
in the sinking fund (including interest) earn interest. The company
uses the amount accumulated in its operations, and therefore assumed
to earn interest. It is generally used for economy-study purposes.

i
d FC SV

1 i 1
L

1 i n 1
d Tn d
i
BVn FC d Tn
NTAldon
77
B. Non-Uniform Depreciation
1. Declining-Balance-Method
Also known as Matheson formula. The annual
depreciation cost is a constant percentage of the salvage value at
the beginning of the year. The annual depreciation cost differs
every year, and decreases in absolute value as time progresses.
The salvage value of the property can never depreciate to zero.

f = fractional depreciation
d n FC1 f f
n 1

BVn FC1 f SV FC1 f


n L

1/ L
BVn
1 f
n L SV
78 NTAldon
SV f 1
FC
2. Double-Declining Balance Method
This method is similar to the declining balance method except
that the f is replaced by 2/L.

3. Sum-of-the-Years Digit Method


The annual depreciation cost differs each year and decreases as
time progresses. It provides for a rapid depreciation during the early
years of life of property, hence faster recovery of capital

dn
FC SV L 1 n
L 1L / 2

d Tn
FC SV 2L 1 nn BVn FC dTn
L 1L
79 NTAldon
4. Service-Output Method
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 method has the
advantage of making the unit cost of depreciation constant and giving low depreciation
expense during periods of low production.

FC = first cost of equipment


SV = salvage value of equipment after its service life
QT = total units of output up to its service life
Qn = number of units of output during the nth year
QTn = total number of units of output on the nth year
dn = annual depreciation during the nth year
dTn = total depreciation on the nth year
Depreciation
d
FC SV
unit output QT

FC SV dTn
FC SV
Q
dn Q n QT
Tn
QT

BVn FC dTn
80 NTAldon
5. Working Hours Method
This method assumes that the total depreciation that has taken place is directly
proportional to the operating time of the equipment. This method has the advantage of making
the unit cost of depreciation constant and giving low depreciation expense during low
operating or utilization period.

FC = first cost of equipment


SV = salvage value of equipment after its service life
HT = total hours of operation up to its service life
Hn = hours of operation during the nth year
HTn = total hours of operation on the nth year
dn = annual depreciation during the nth year
dTn = total depreciation on the nth year

Depreciation
d
FC SV
Operating Period HT

dn
FC SV H
n
HT

dTn
FC SV H
Tn
81 NTAldon HT
C. Depletion
This method is usually applicable to natural resources such as petroleum
deposits, natural gas, mines, timberlands, etc. A depletion fund is provided for the
recovery of the capital invested in the said undertaking. The annual charge set aside
for the gradual extraction is called depletion cost.

1. Unit Method
This method is similar to service output method of depreciation. The
depletion charge depends upon the initial cost of the property and the number of
units in the property.

dn
Fc SV
Q n
QT

2. Percentage Method
This method allows a fixed percentage of the gross income received during
the year to be the depletion charge. Considering that the total depletion charge may
exceed the initial cost of the property, it is required that for any year the depletion
charge should not exceed 50% of the net taxable income for that year obtained by
deducting all expenses excluding depletion from the gross income.
82 NTAldon
SAMPLE PROBLEMS

1. An asset for drilling was purchased and placed in service by a petroleum production
company. Its cost basis is P6M and has an estimated book value of P1.2 M at the end of an
estimated useful life of 14 years. Compute the book value at the end of the fifth year of life by
the straight-line method
FC SV 6 1.2
d3 P 0.3429M
L 14
BV5 6 0.3429 5 P 4.2855
2. The original cost of a certain piece of equipment is P500,000 and is depreciated by a 12% sinking
fund method. Determine the annual depreciation charge if the book value of the equipment after 10
years is the same as if it had been depreciated at P40,000 each year by straight line formula.

Using straight line Method:

Total depreciation 40,000 (10) 400,000


SalvageValue 500,000 400,000 100,000

Using sinking fund Method:

i 0.12
d FC SV 400,000 22,793.67
NTAldon 1 i 1 1 0.12 10
1
83
3. In order to make it worthwhile to purchase a piece of equipment, the annual depreciation costs for the
equipment cannot exceed P295,000 at any time. The original cost of the equipment is P3M and a salvage
value of P50,000. Determine the length of service life necessary if the equipment is depreciated by

a. Sum-of-the-years-digit method

d1
FC SV L 1 n
L 1L / 2
Maximum depreciation occurs on the 1st year:

295,000
3,000,000 50,000 L 1 1
L 1L / 2
L 19 years
b. Straight-line method

d
FC SV
295,000
3,000,000 50,000
L L
L 10 years

84 NTAldon
4. Solve, using the declining-balance- method, the
depreciation cost of an equipment on the 8th year, if its book
value on the 7th year is P250,000. The Book value of the
equipment is computed to be P460,512 on the 5th year.
Soln:

FC
BV7

BV5 250,000 460,512 250,000
; 1 f 7 5

1 f 7 1 f 5 1 f 7 1 f 5 460,512
1
250,000 2
1 f 0.7368
460,512
f 0.2632
d8 BV7 f 250,0000.2632) 65,800

85 NTAldon
5. An asset for drilling was purchased and placed in service by
a petroleum production company.
Its cost basis is P6M and has an estimated book value of
P1.2 M at the end of an estimated useful life of 14 years.
Compute the depreciation amount in the third year and the
book value at the end of the fifth year of life by SYD method
Solution:

d3 FC SV
L 1 n 6 1.2 14 1 3 P 0.5486 M
L 1L/ 2 14 114/ 2

BVn FC dTn FC
FC SV 2L 1 nn 6 6 1.2 214 1 55 3.257
L 1L 14 114

or

BV5 FC dT 5 6 6 1.2
14 13 12 11 10 P 3.257 M
105

86 NTAldon
6. To develop an oil well containing an estimated 4M barrels of oil
required an initial investment of P3B. in a certain year, 400,000
barrels were produced from this well. Determine the depletion
charge during that year.

dn
FC SV
Q n
QT

d
3x10 9
400,000 P300 M
6
4 x10

87 NTAldon
88 NTAldon
8. An equipment was purchased at a cost of P1,000,000 with an expected
service life of 10 years and a salvage value P100,000. Solve for the annual
depreciation cost and book value during the 8th year using
a. Straight-line method
b. Sinking fund method, i=10% pa
c. Declining balance method
d. Sum-of-the-years-digit method

Solution:
a. Straight line method

d
FC SV
d
1,000,000 100,000 P 90,000 / year
L 10
BVn FC dTn FC d (n)
1,000,000 90,000 8 P 280,000

89 NTAldon
8. An equipment was purchased at a cost of P1,000,000 with an expected service life
of 10 years and a salvage value P100,000. Solve for the annual depreciation cost and
book value during the 8th year using
a. Straight-line method
b. Sinking fund method, i=10% pa
c. Declining balance method
d. Sum-of-the-years-digit method

Solution:
b. Sinking fund method

d FC SV
i

1 i 1
L


1,000000 100,000
0.1
P56,471
1 0.10 1
10

1 i n 1
BV8 FC dT 8 FC d
i
1 0.10 8 1
1,000,000 56,471 P534,204
NTAldon
90 0.10
8. An equipment was purchased at a cost of P1,000,000 with an expected service life
of 10 years and a salvage value P100,000. Solve for the annual depreciation cost and
book value during the 8th year using
a. Straight-line method
b. Sinking fund method, i=10% pa
c. Declining balance method
d. Sum-of-the-years-digit method

Solution:
c. Declining balance method

d n FC1 f f ; BVn FC1 f SV 1 f


n 1 n n L

1 1
SV L 100,000 10
f 1 ; 1 0.2057
FC 1,000,000

d n FC 1 f f d8 1, 000, 000 1 0.2057 0.2057 P 41, 032


n 1 81

BVn FC 1 f 1, 000, 00 1 0.2057 P158, 444


n 8

91 NTAldon
8. An equipment was purchased at a cost of P1,000,000 with an expected service life
of 10 years and a salvage value P100,000. Solve for the annual depreciation cost and
book value during the 8th year using
a. Straight-line method
b. Sinking fund method, i=10% pa
c. Declining balance method
d. Sum-of-the-years-digit method

Solution:
d. Sum-of-the-years-digit method (SYDM)

dn
FC SV L 1 n 2 d 1,000,000 100,000 10 1 8 2 P49,091
L 1L 8
10 110
BVn FC dTn dTn
FC SV 2 L 1 n n
L 1L
BV8 1,000,000
1,000,000 100,000 210 1 88 P149,090
10 110

92 NTAldon
C. Modified Accelerated Cost Recovery System (MACRS)
The principal method for computing depreciation deductions for property in engineering projects in the U.S.. Unlike
the conventional method of computing depreciation which requires estimates of useful life (L) and salvage value
(SV) at the end of useful life, in MARCS, the SV is defined to be zero, and the useful life estimates are not
used directly in calculating depreciation amounts.
MACRS consists of two systems for computing depreciation deductions; The main system is called
General Depreciation System (GDS), and the second system is called the Alternative Depreciation
System (ADS).

When an asset is depreciated under MACRS, the following information is needed before deductions can be calc:
The cost basis (B)
The date the property was placed in service
The property class and recovery period
The MACRS depreciation method to be used (GDS or ADS)
The time convention that applies (half-year)

Note: The depreciation period during the first year is only year. The other is extended after the last year of the
recovery period:
Example: Recovery period = 3 years
1st year = 0.5 year; 2nd year = 1 year; 3rd year = 1 year; 4th year = 0.5 year

2 200% using Declining Balance method with switch-over to Straight-Line-


dn for 3,5,7,10
L method (whichever is higher)

1.5NTAldon 150% using Declining Balance method with switch-over to Straight-Line-method


93
dn for 15,20
L (whichever is higher)
3. Depreciation Methods, Time Convention, Recovery Rates

GDS 3,5,7 and 10-year personal property classes: The 200% DB


method, which switches to the SL method when that method provides
a greater deduction.
GDS 15 and 20-year personal property classes: The 150% DB method,
which switches to the SL method when that method provides a greater
deduction.
GDS nonresidential real and residential rental property classes: SL
method over the fixed GDS recovery periods.
ADS: The SL method for both personal and real property over the
fixed ADS recovery periods.
Half-year time convention is used in depreciation calculations for
tangible personal property. If asset is disposed of before the full
recovery period is used, then only half of the normal depreciation
deduction can be taken for that year.
If the asset is disposed of in year n+1 the final BV of the asset will be
zero.
94 NTAldon
When are you going to Switch-over from Declining-
Balance Method to Straight-Line?

Compare the value of recovery rate:


Once the value of SL recovery rate is equal or greater than DB, then you have to switch-
over to SL.

For example for 7-year recovery period


The recovery rate=2/L (except the first year, 1/L)
DB SL period
1st year 2/2L= 1/L 1/7 use DB
2nd year 2/7=1/3.5 > (7-0.5 )= 1/6.5 1.5 use DB
3rd year =1/3.5 > 1/(7-1.5) =1/5.5 2.5 use DB
4th year =1/3.5 > 1/(7-2.5) = 1/4.5 3.5 use DB
5th year =1/3.5 = 1/(7-3.5) = 1/3.5 4.5 switch-over to SL
6th year =1/3.5 < 1/(7-4.5) = 1/2.5 5.5
7th year =1/3.5 < 1/(7-5.5) =1/1.5 6.5
8th year =1/3.5 1-(sum of 1 to 6)7.0

95 NTAldon
For a 5-year recovery period
The DB recovery rate=2/L (except the first year, 1/L)
The SL recovery rate=1/LREMAINING

DB SL
1st year 1/5=0.2 0.2
2nd year (1-0.2)(2/5)=0.32 (1-0.2)/4.5=0.1778
3rd year (1-0.52)(2/5)=0.192 (1-0.52)/3.5=0.1371
4th year (1-0.712)(2/5)=0.1152 (1-0.712)/2.5=0.1152
5th year (1-0.8272)/1.5=0.1152
6th year (1-0.9424) =0.0576

96 NTAldon
Sample MACRS Problem

1. A firm purchased and placed in service a new piece of


semiconductor manufacturing equipment. The cost basis for the
equipment is P100,000. Using MACRS Method, determine
(a) the depreciation charge permissible in the
fourth year,
(b) the cumulative depreciation through the third
year, and
(c) the BV at the end of the fourth year,
(d) the BV at the end of the fifth year if the
equipment is disposed of at that time.

97 NTAldon
Solution:
From Table N-1, the semi-conductor (electronic manufacturing equipment has a class life of six years and a GDS recovery
period of five years (Asset Class 36).
d4 0.1152 (100,000) P11,520
(a) The depreciation deduction, or cost-recovery allowance , that is allowable in year four (d4) is =0.1152

b) Accumulated depreciation through year three,d3, is the sum of depreciation amounts in years one through three:
dT3=d1+d2+d3
dT 3 100,000(0.20 0.32 0.192) P71,200
c) The BV at the end of year four (BV4) is the cost basis less depreciation charges in years from one through four:
BV4 100,000 100,000 (0.20 0.32 0.192 0.1152) P17,280
e) The depreciation deduction in year five when the equipment is disposed of prior to year six.
d5=(0.5)(0.1152)(100,00)= P5,760
BV5= BV4-d5 = 17,280-5,760 = P11,520
DB SL
1st year 1/5 =0.2000 0.2000
2nd year (1-0.2)(2/5) =0.3200 (1-0.2)/4.5=0.1778
3rd year (1-0.52)(2/5) =0.1920 (1-0.52)/3.5=0.1371
4th year (1-0.712)(2/5)=0.1152 (1-0.712)/2.5=0.1152
5th year 1-0.8272)/1.5=0.1152
98 th NTAldon
6 year (1-0.9424) =0.0576
CAPITAL
_ refers to wealth in the form of
money or property that can be
used to produce more wealth.

Two forms of capital, debt and


equity
99 NTAldon
CAPITAL INVESTMENT

FIXED CAPITAL
WORKING CAPITAL

100 NTAldon
CAPITAL INVESTMENT

FIXED CAPITAL
The capital needed to supply the
necessary manufacturing and plant
facilities

WORKING CAPITAL
The capital necessary for the operation
of the plant

101 NTAldon
TOTAL CAPITAL INVESTMENT
The sum of the fixed-capital investment
and the working capital is known as the
total capital investment.

Fixed Capital Investment


+ Working Capital
Total Capital Investment

102 NTAldon
FIXED CAPITAL INVESTMENT
Before an industrial plant can be put into operation, a large
amount of money must be supplied to purchase and install
the necessary machinery and equipment. Land and service
facilities must be obtained, and the plant must be erected
complete with all piping, controls and services. In addition,
it is necessary to have money available for the payment of
expenses involved in the plant operation.

The fixed-capital portion may be further subdivided into


manufacturing fixed-capital investment and
non-manufacturing fixed-capital investment.

103 NTAldon
FIXED CAPITAL INVESTMENT

Manufacturing fixed-capital
investment represents the capital necessary for
the installed process equipment with all
auxiliaries that are needed for complete
process operation. Expenses for piping,
instruments, insulation, foundations, and site
preparation are typical examples of costs
included in the manufacturing fixed-capital
investment.
104 NTAldon
FIXED CAPITAL INVESTMENT
Non-manufacturing fixed capital investments
are fixed capital required for construction overhead and for all plant
components that are not directly related to the process operation is
designated as the non-manufacturing fixed-capital investment.
These plant components include the land, processing buildings,
administrative and other offices, warehouse, laboratories,
transportation, shipping and receiving facilities, utility and waste-
disposal facilities, shops, and other permanent part of the plant.
The construction overhead cost consists of field-office and supervision
expenses, home-office expenses, engineering expenses, miscellaneous
construction costs, contractors fees, and contingencies. In some cases,
construction overhead is proportioned between manufacturing and
non-manufacturing fixed-capital investment.
105 NTAldon
FIXED CAPITAL INVESTMENT
1. Direct Costs
Process equipment, Instrumentation/controls,
piping, electrical, buildings, yard improvements,
service utilities, land

2. Indirect Costs
Engineering and supervision, construction
expenses of temporary facilities

106 NTAldon
WORKING CAPITAL
The working capital for an industrial plant consists of the total
amount of money invested in
1. raw materials and supplies carried in stocks,
2. finished products in stock and semi-finished
products in the process of being manufactured,
3. accounts receivable,
4. cash kept on hand for monthly payment of
operating expenses, such as salaries, wages, and
raw-materials purchases,
5. accounts payable, and
6. taxes payable.

107 NTAldon
ACCOUNTING FUNDAMENTALS
All accounting is based on the fundamental accounting equation, which is ;

Assets = liabilities + owners equity

Where:
assets _are those things of monetary value that the firm possesses, liabilities _are those
things of monetary value that the firm owes, and owners equity _is the worth of what the
firm owes to the stockholders (also referred to as equities, net worth, etc.)

Basic Engineering Accounting Terms:


Revenue = total income (or total savings)
Net profits = Gross Profits - income tax
Gross profits = Net sales Costs of Sales
Income tax = (Gross Profits) ( tax rate)
Cash flow = Net Profits + Depreciation

108 NTAldon
Generally Accepted Accounting Principles

GAAP is a codification of how CPA firms and corporations prepare and


present their business income and expense, assets and liabilities on their
financial statements. GAAP is not a single accounting rule, but rather the
aggregate of many rules on how to account for various transactions. The
basic principles underlying GAAP accounting are set forth below.

The Basic Principles

1. Principle of regularity: Regularity can be defined as conformity to enforced rules


and laws.
2. Principle of consistency: This principle states that when a business has once fixed a
method for the accounting treatment of an item, it will enter all similar items that
follow in exactly the same way.
3. Principle of sincerity: According to this principle, the accounting unit should
reflect in good faith the reality of the company's financial status.
4. Principle of the permanence of methods: This principle aims at allowing the
coherence and comparison of the financial information published by the company.
5. Principle of non-compensation: One should show the full details of the financial
information and not seek to compensate a debt with an asset, revenue with an
expense, etc.
109 NTAldon
Generally Accepted Accounting Principles

6. Principle of prudence: This principle aims at showing the reality "as is": one should
not try to make things look prettier than they are. Typically, revenue should be
recorded only when it is certain and a provision should be entered for an expense
which is probable.
7. Principle of continuity: When stating financial information, one should assume
that the business will not be interrupted. This principle mitigates the principle of
prudence: assets do not have to be accounted at their disposable value, but it is
accepted that they are at their historical value.
8. Principle of periodicity: Each accounting entry should be allocated to a given
period, and split accordingly if it covers several periods. If a client pre-pays a
subscription (or lease, etc.), the given revenue should be split to the entire time-span
and not counted for entirely on the date of the transaction.
9. Principle of Full Disclosure/Materiality: All information and values pertaining
to the financial position of a business must be disclosed in the records.
10. Principle of Utmost Good Faith: All the information regarding to the firm should
be disclosed to the insurer before the insurance policy is taken

110 NTAldon
ACCRUAL
a method of accounting that counts income or expenses at the time they are earned or
incurred, irrespective of when money is received or paid

when the business performs a service, makes a sale or incurs an expense, the
accountant enters the transaction into the books, whether or not cash has been
received or paid.

it measures the performance and position of a company by recognizing economic


events regardless of when cash transactions occur. The general idea is that economic
events are recognized by matching revenues to expenses (the matching principle) at
the time in which the transaction occurs rather than when payment is made (or
received). This method allows the current cash inflows/outflows to be combined with
future expected cash inflows/outflows to give a more accurate picture of a company's
current financial condition

111 NTAldon
FINANCIAL STATEMENTS
A. Income Statement

The income statement is a computation of the projects total


revenue and total costs for one period of fiscal year, thereby arriving at
the concerns net income or deficit within the period, together with
its performance in terms of profitability and cost control. It differs
from the cash budget in the sense that it follows the actual concept
in accounting, by which revenues should be associated with the costs
involved in realizing the former within the period of occurrence. A
model format for income statement preparation is presented. An
analysis of each account in the presentation follows:

Profit (loss) = revenues expenses

Gross Profit = net Sales cost of Sales

112 NTAldon
NET SALES
Net sales_ in pesos are arrived at by subtracting sales returns,
allowances, and discounts from gross sales.

Sales returns_ represent goods sold which could not meet


customer requirements and thus have been returned.
Allowance_ refer to goods which cannot be sold due to spoilage,
wrong specification, and similar cause;
Sales discount_ are price reduction occasionally given in favor of
customer. The latter items are to be considered as different from
sales discount favoring the project, which are entered in the
other income account of the statement.

113 NTAldon
COST OF SALES
Cost of sales_ is a function of
raw materials used,
direct labor expenses, and
factory overhead accounts.

The factory overhead accounts are itemized as follows:


materials and labor expenses indirectly related with production;
heat, light, and power required for manufacturing;
maintenance costs associated with productive fixed assets supplies
needed to produce fixed assets;
taxes associated with the manufacturing fixed assets;
and insurance expenses related to the productive operation.

114 NTAldon
Operational costs
A. Variable Costs
Raw materials, direct labor, utilities, direct supervision,
laboratory charges, royalty, packaging, spoilage, losses
A. Fixed costs
Depreciation, taxes, insurance, interest, overhead,
management expenses (GAE)

115 NTAldon
Pro-f orma Income Statements
Y ears ending: 31 December

1st year 2nd year 3rd year

P ro ductio n (in Units) 308,000 300,000 300,000


A dd: Invento ry, beginning (8,000) (8,000)
Units available fo r sale 308,000 308,000 308,000
Less: Invento ry investments (8,000) (8,000) (8,000)
Sales, gro ss 300,000 300,000 300,000
Sales, gro ss (in P ) 750,000 789,000 828,000
Less: sales returns and allo wances (60,000) (63,120) (66,240)
sales disco unts (15,000) (15,780) (16,560)
Sales, net 675,000 710,100 745,200

Co st o f sales:
Raw materials:
P urchases 57,500 56,160 58,890
A dd: freight in 420 441 463
To tal purchases 57,920 56,601 59,353
A dd:invento ry beginning 5,000 6,000
Co st o f raw materials available fo r use 57,920 61,601 65,353
Less: Invento ry, ending (5,000) (6,000) (7,000)
Co st o f raw materials 52,920 55,601 58,353
A dd: Direct labo r 17,280 18,144 19,051
Overhead:
Indirect materials 113,009 118,659 124,632
Indirect labo r 13,200 13,860 14,553
Heat, light and po wer 50,640 25,162 26,764
M aintenance 7,126 7,126 7,126
Supplies 10,499 11,010 11,471
Depreciatio n 43,010 43,010 43,010
Taxes 2,600 2,600 2,600
Insurance, etc. 4,751 3,819 2,887
M anufacturing co sts 315,035 298,991 310,447
A dd: Go o ds-in pro cess invento ry, begnng 9,000 10,000
Less:Go o ds- inpro cess invento ry, ending (9,000) (10,000) (11,000)
Co sts o f go o ds available fo r sale 306,035 297,991 309,447

A dd: finished-go o ds invento ry, beginning 20,000 21,000


Co sts o f go o ds available fo r sale 306,035 317,991 330,447
Less: finished-go o ds invento ry, ending (20,000) (21,000) (22,000)
286,035 296,991 308,447
116 NTAldon Co sts o f sales

Gro ss pro fit 388,965 413,109 436,753


Gro ss pro fit 388,965 413,109 436,753
Operating expenses: 1s t year 2nd year 3rd year
General and administrative salaries:
General and administrative salaries36,480 38,304 40,220
Fringe benefits 6,511 6,794 7,051
Research and develo pment 180 189 198
Engineering co sts 36,387
Depreciatio n 3,600 3,600 3,600
Taxes
Insurance
Office supplies 5,520 6,012 6,550
Heat, light and po wer 114 120 126
Telepho ne 768 806 846
Water supply
M iscellaneo us: A mo rtizatio n 700 700 700
To tal 90,260 56,525 59,291

Selling expenses:
Salaries 7,439 7,794 8,168
Sto rage o f go o ds 16,620 17,451 18,324
B illing
Transpo rtatio n
P ublic relatio ns
A dvertisment, sales taxes 43,188 45,435 47,681
M iscellaneo us: bad debts 13,500 14,202 14,904
To tal 80,747 84,882 89,077

Operating expenses 171,007 141,407 148,368

Operating pro fit 217,958 271,702 288,385

Financial expenses (net o f o ther inco me):


Interest 28,506 27,714 24,546
B o rro wing co sts
To tal 28,506 27,714 24,546

P ro fit befo re inco me tax 189,452 243,988 263,839

P ro visio n fo r inco me tax (56,308) (75,396) (82,344)

Net inco me (net lo st) 133,144 168,592 181,495

A dd: Retained earnings, beginning 35,106 105,660

117 NTAldonLess: Cash dividends, declared (98,038) (98,038) (98,038)


Retainend earnings, ending 35,106 105,660 189,117
CASH FLOW
The cash-flow statement or the cash budget is a systematic presentation of cash receipts
and disbursements for a given operating period or fiscal year, taking for granted the accrual
concept in account illustrates a cash budget model , showing the inflow and presenting a
large-scale schedule for the determination of ending cash balance sheet. The budget is used to
estimate future loans or financing needs, optimize the timing of project financing, and
maximize profitability by efficient cash utilization.
a. Cash receipts are subdivided into those which flow from financing the project and
those coming from sales revenues.
Cash flow from financing may take the form of stocks issued including stock premium or
discount being closed, the net of the latter two accounts being closed to the paid-in surplus
account; bond issues: and long-terms loans.
In computing for cash in-flows from sales revenues; the profit before-income tax account is
entered in the budget, and this is increased to the period such as depreciation and
amortization.
Other account which increase the entries are increases in account payable, accrued expenses,
and deferred income.
b. Under cash disbursement, out-of-pocket expenses on intangible assets acquisition are
entered. Other account included here are decreases in account payable, notes payable, bank-
drafts payable, accrued expenses, mortgage bonds payable and long-terms notes receivable,
inventories, and investment. Cash dividends issued and income tax payments also comprise
cash disbursements.
The beginning cash balance for the period is then added to the net cash flow to arrive at
ending cash balance in the balance sheet. It should be noted that all accounts entered in the
118
cash budget should tally with the same account in the income statement and balance sheet.
NTAldon
Pro-formal cash-flow statements
Years ending 31 December
(in pesos)
CASH RECEIPTS: 1st year 2nd year 3rd year
Common stocks issued 400,000
Preffered stocks issued 90,192
Paid-in surplus
Mortgage bonds payable-increases 11,151
Long-term notes payable-increases 200,000
Total receipts from financing 701,343
Profit before income tax 189,452 243,988 263,839
Add: Depreciation of fixed assest 46,610 46,610 46,610
Amortization of pre-paid expenses
Amortization of deferred charges
Amortization of intangible assets 700 700 700
Other non-out-of-pocket expenses
Accounts payable 6,394
Notes payable-increases 20,000
Bank drafts payable-increases
Accrued expenses-increases
Deferred income-increases
Total inflow from production,
operations and financial accounts 263,156 291,298 311,149
TOTAL ASSUMED CASH RECEIPTS 964,499 291,298 311,149

119 NTAldon
TOTAL ASSUMED CASH RECEIPTS 964,499 291,298 311,149

CASH DISBURSEMENTS: 1st year 2nd year 3rd year


Expenses on intangible assets (Out of Pocket)
Good will
Patents 500
Copyrights
Leases
Licenses 500
Franchises 500
Organization and pre-operating expenses 2,000
Acquisitions of fixed assets (out-of-pocket):
Land 200,000
Buildings 60,000
Equipment 77,545
Machinery 100,000
Accounts payable-decreases
Notes payable-decreases
Bank drafts payable-decreases
Accrued expenses-decreases
Treasury stocks-increases
Mortgage bonds payable-decreases 1,394 1,394
Long-term notes payable-decreases 25,000 25,000
Cash dividends issued 98,038 98,038
Marketable securities-increases 85,507 78,196 89,297
Accounts receivable-increases 317,520 16,511 16,511
Notes receivable-increases
Inventories-increases:
Raw materials 5,000 1,000 1,000
Supplies 2,000 1,000 1,000
Goods in process 9,000 1,000 1,000
Finished goods 20,000 1,000 1,000
Income tax payments 56,308 75,396
Investment-increases (pre-paid and deferred charges) 2,000 2,000 2,000
TOTAL CASH DISBURSEMENTS 882,072 281,447 311,636
NET CASH FLOW (Net cash deficit) = receipts - disbursements 82,427 9,851 (487)
Add: balance, beginning 82,427 92,278
CASH BALANCE, ENDING 82,427 92,278 91,791

120 NTAldon
BALANCE SHEET
The balance sheet shows the assets derived by the project from corresponding liabilities and equities
(net worth).It is an overall picture of a films financial condition as of a certain time. Furthermore, it
shows the major changes brought about by the projects operation within the fiscal period. The assets are
entered under the debit portion of the balance sheet while the liability and equity claims on these assets
are found under the credit portion. Exhibit F-3 present a model balance sheet.

Comprising the asset portion of the statement are current asset, fixed asset, and intangible assets.

Current assets _ to those type with are either cash account or other account expected to be converted
into cash with one year. The item listed in this division are of course cash, marketable securities,
receivables, inventories, prepaid expense, and deferred change. The latter two accounts signify cash
expenditures for the services of a creditor not yet received in full by the project in question, such as pre-
paid insurance.

Fixed assets _ are the tangible assets of an enterprise of an enterprise, the service life of which usually
extends to over one year. Land, building, machinery, and equipment are typical example of fixed assets.
The balance sheets or book value of these assets are derived by subtracting their accumulated depreciation
from their cost of acquisition, depreciation being the portion of cost allocated to one fiscal period.

Intangible assets _service life, like fixed will, patents, copyrights, leases, licenses, franchises, and
organization and pre-operation expenses fall under other assets. When an intangible asset is amortized,
the accumulated amortization account is not entered in the balance sheet, which contains only the net
book value of assets in this category.

Assets = liabilities + (beginning owners equity + revenue expenses)


121 NTAldon
Intangible assets _ have not physical substance. Examples are,
goodwill, leaseholds, copyrights, patents, franchises, licenses, and
trademarks.
Accounting for an intangible asset is rendered somewhat difficult
because the lack of physical substance makes evidence of its
existence more elusive, may make its value debatable and its
useful life may be questionable.

122 NTAldon
LIABILITIES
_ are debts or claims anyone other than the owners
of the property upon the assets of the company.

Current liabilities:
Accounts payable ,Notes payable, Bank-drafts
payable , Estimated tax liability, Accrued
expenses (Dividends payable):

Other liabilities:
Mortgage bonds payable ,Long-term notes
123 payable
NTAldon
OWNERS EQUITY
COMMON STOCK
_ represents the ownership of stockholders who have residual claim
on the assets of the corporation after all other claims have been
settled. No return is guaranteed on the investment of common
stockholders. They have the right to call meetings, to vote, to elect
members of the board of directors, amend charter and
constitution and by-laws, inspect books of the corporation, receive
dividends, share remaining assets if corporation is dissolved.
PREFERRED STOCK_
_ also represent ownership. And it possesses the same rights as
common stock, but in addition, it enjoys certain preferences, not
possessed by common stock. It has priority over common stock in
receipt of dividends, and it is usually guaranteed a fixed annual
dividend, regardless of the amount of the earnings of the
corporation. In case the corporation is dissolved, the owner of the
preferred stock, has priority over the common stockholders. They
124 NTAldon
may have right to vote in meetings.
(in pesos)

ASSETS: 1st year 2nd year 3rd year


Current assets
Cash 82,427 92,278 91,791
M arketable securities 85,507 163,703 253,000
Account receivable, net 317,520 334,031 350,542
Notes receivable
Inventories
Raw materials 5,000 6,000 7,000
Supplies 2,000 3,000 4,000
Goods-in-process 9,000 10,000 11,000
Finished goods 20,000 21,000 22,000
Pre- paid expenses 1,000 2,000 3,000
Deferred charges 1,000 2,000 3,000
Tota current assets 523,454 634,012 745,333

Fixed assets:
Land 200,000 200,000 200,000
Building 60,000 60,000 60,000
Equipment 77,545 77,545 77,545
M achinery 100,000 100,000 100,000
Total fixed assets, 437,545 437,545 437,545
Less:accumulated depreciation (46,610) (93,220) (139,830)
125 NTAldon
Total fixed assets, net 390,935 344,325 297,715
1st year 2nd year 3rd year
Other assets:
Investments
Intangible assets, net of amortization:
Goodwill
Patents 400 300 200
Copyrights
Lease
Licenses 400 300 200
Franchises 400 300 200
Organization and pre-operating expenses 1,600 1,200 800
Total other assets 2,800 2,100 1,400

TOTAL ASSETS (current, fixed, other) 917,189 980,437 1,044,448

LIABILITIES AND EQUITY:


Current liabilities
Accounts payable 6,394 6,394 6,394
Notes payable 20,000 20,000 20,000
Bank-drafts payable
Estimated tax liability 56,308 75,396 82,344
Accrued expenses:
Dividends payable 98,038 98,038 98,038
Deferred income
Total current liabilities 180,740 199,828 206,776
Other liabilities:
Mortgage bonds payable 11,151 9,757 8,363
Long-term notes payable 200,000 175,000 150,000
Total other liabilities 211,151 184,757 158,363

TOTAL LIABILITIES 391,891 384,585 365,139

OWNER'S EQUITY:
Common stocks 400,000 400,000 400,000
Preferred stocks 90,192 90,192 90,192
Less: treasury stocks
Paid-in surplus
Retained earnings 35,106 105,660 189,117
TOTAL EQUITIES 525,298 595,852 679,309

TOTAL LIABILITIES AND EQUITY 917,189 980,437 1,044,448


126 NTAldon
WHOLE-LIFE COSTS
Total Cost of Ownership(TCO)
Refers to the total cost of ownership over the life of an asset. Also commonly
referred to as cradle to grave or womb to tomb costs.

Areas of expenditure:
Planning
Design
Construction/acquisition
Operations
Maintenance
Rehabilitation
Financial
Replacement/disposal

These costs are converted into present value together with benefits in
order to compute the benefit-cost ratio.
NTAldon
127
EBITDA
EBITDA_ an initialism for earnings before interest, taxes,
depreciation, and amortization. It is a non-GAAP (generally accepted
accounting principles) metric that is measured exactly as stated. All interest,
tax, depreciation and amortization entries in the income statement are
reversed out from the bottom-line net income. It purports to measure cash
earnings without accrual accounting, canceling tax-jurisdiction effects, and
canceling the effects of different capital structures.
EBITDA differs from the operating cash flow in a cash flow statement
primarily by excluding payments for taxes or interest as well as changes in
working capital.
EBITDA also differs from free cash flow because it excludes cash
requirements for replacing capital assets (capex). EBITDA margin refers to
EBITDA divided by total revenue. EBITDA margin measures the extent to
which cash operating expenses use up revenue.
Use by debtholders_EBITDA is widely used in loan covenants. The theory
is that it measures the cash earnings that can be used to pay interest and repay
the principal. Since interest is paid before income tax is calculated, the
debtholder can ignore taxes. They are not interested in whether the business
can replace its assets when they wear out, therefore can ignore capital
amortization
NTAldon
and depreciation.
128
BASIC METHODS OF PROFITABILITY ANALYSIS
1. Return on Investment, ROI

Profit or savings (before income tax) divided by investment required.

Profit x 100%
ROI
Investment

Incremental Profit x 100%


ROI
Incremental Investment

129 NTAldon
Minimum Acceptable Rate o Return (MARR)
Also known as Minimum Attractive Rate of Return or known as hurdle
rate, the interest rate used in the valuation of profitability of a project in
Present Worth, FutureWorth and Annual Worth Methods.

It is usually a policy issue by the top management of an organization in view


of the following considerations:
The amount of money available for investment,
Number of good projects available for investment,
The amount of perceived risk associated with investment opportunities available
and
Type of organization involved.

In business and engineering, the minimum acceptable rate of return,


often abbreviated MARR, or hurdle rate is the minimum rate of return on
a project a manager or company is willing to accept before starting a project,
given its risk and the opportunity cost of forgoing other projects.

130 NTAldon
Minimum Acceptable Rate of Return; Hurdle Rate
The hurdle rate is usually determined by evaluating existing opportunities in
operations expansion, rate of return for investments, and other factors deemed
relevant by management.
A risk premium can also be attached to the hurdle rate if management feels
that specific opportunities inherently contain more risk than others that could
be pursued with the same resources.
A common method for evaluating a hurdle rate is to apply the discounted cash
flow method to the project, which is used in net present value models.
The hurdle rate determines how rapidly the value of the dollar decreases out in
time, which, parenthetically, is a significant factor in determining the payback
period for the capital project when discounting forecast savings and spending
back to present-day terms.
Most companies use a 12% hurdle rate, which is based on the fact that the
S&P 500 typically yields returns somewhere between 8% and 11%
(annualized). Companies operating in industries with more volatile markets
might use a slightly higher rate in order to offset risk and attract investors.
The hurdle rate is frequently used as synonym of cutoff rate, benchmark and
cost ofNTAldon
capital.
131
SAMPLE PROBLEMS; ROI

Given:
Investment Total Investment Net profit

1 P 100,000 P 23,000

2 P 150,000 P 28,000

3 P 180,000 P 37,000

Required: Select the best alternative if minimum acceptable return on investment


required is 10%
Solution:
ROI based on initial total investment:

ROI1
23, 000 100 23% 10%, ok
100, 000
28,000
ROI 2 100 18.67% 10%, ok
150,000
37,000
ROI3 100 19.05% 10%, ok
132 NTAldon 180,000
All three investments passed the MARR therefore evaluate the investments
using ROI based on incremental investment:

Comparing 1 and 2
Additional investment of P50,000 will yield additional
net profit of P5,000)

ROI12
28, 000 23, 000 100 10%, ok investment 2 is better than 1
150, 000 100, 000

Comparing 2 and 3;
Additional investment of P30,000 will yield additional
net profit of P9,000)

ROI 23
37, 000 28, 000 100 30% 10%, ok Therefore, select # 3
180, 000 150, 000

133 NTAldon
2. Annual Cost Method
The annual cost of the alternatives including the
minimum return on investment is determined. The
alternative with the least annual cost is chosen. This method,
like the rate of return on investment method, applies only to
alternatives which have a uniform cost data for each year and
a single investment of capital at the beginning of the project
life.
Typical cost factors
a. Depreciation Costs(usually as sinking fund)
b. Annual Operating Costs
c. Annual Labor Costs
d. Insurance and Taxes
e. Other Costs
f. Return on Investment or Cost of Money
134 NTAldon Total Annual Costs
Sample Problem
A company is considering two types of equipment for its new plant. The following data
are given. If the minimum return on investment is 15%, which equipment should be selected
using Annual Cost Method.
Given:
Equipment A Equipment B
First Cost P 2.0 M P 3.0 M
Annual Operating Cost/yr P 350,000 P 250,000
Annual Labor Cost/yr P 500,000 P 350,000
Insurance and Taxes/yr 3.5% of First Cost 3.5% of First Cost
Other Cost/yr 8% of first Cost 8% of First Cost
Salvage Value P200,000 P300,000
Estimated life 10 years 10 years

Solution: Annual Cost Method


Annual Costs Equipment A, Pesos Equipment B, Pesos
a. Depreciation Cost (Sinking fund) 88,654 132,981
b. Annual Operating Cost 35,0000 250,000
c. Annual Labor Cost 50,0000 350,000
d. Insurance and Taxes,3.5% FC 70,000 105,000
e. Other Cost, 8% FC 160,000 240,000
f. Return on Investment,15% FC 300,000 450,000
Total Annual Costs 1,468,654 1,527,981
FC1 i SV
L
a f capital re cov ery CR
1 i L 1 Since total annual cost of equipment A
135 NTAldon i is less than equipment B, therefore chose A
3. Discounted Cash Flow,
Internal Rate of Return (IRR)
The method of approach for discounted cash flow takes into account the time value of money
and is based on the amount of the investment that is unreturned at the end of each year during
the estimated life of the equipment.

A trial-and-error method is used to establish a rate of return which can be applied to yearly
cash flow so that the original investment is reduced to zero (or to salvage and land value plus
working capital investment) during the project life.

Thus, the rate of return by this method is equivalent to the maximum interest rate (normally
after taxes) at which money could be borrowed to finance the project over its life that would just
be sufficient to pay all principal and interest accumulated on the outstanding principal.

The discount rate reflects two things:


1. The time value of money - investors would rather have cash immediately than
having to wait and must therefore be compensated by paying for the delay.
2. A risk premium - reflects the extra return investors demand because they want
to be compensated for the risk that the cash flow might not materialize after
all.NTAldon
136
3. Discounted Cash Flow,
Internal Rate of Return (IRR)
Internal Rate of Return is the most widely used rate of return method for
performing engineering economic analyses. It is sometimes called by several names,
such as the investors method, the discounted cash flow method, and the profitability
index. Also means that the value of this measure depends only on the cash flows from an
investment and not on any assumptions about reinvestment rates.

The internal rate of return (IRR) is a rate of return used in capital budgeting to
measure and compare the profitability of investments. It is also called the discounted
cash flow rate of return (DCFROR) or simply the rate of return (ROR). In the
context of savings and loans the IRR is also called the effective interest rate. The
term internal refers to the fact that its calculation does not incorporate
environmental factors (e.g. the interest rate).
The internal rate of return is the rate of return promised by an investment project
over its useful life. It is some time referred to simply as yield on project. The
internal rate of return is computed by finding the discount rate that equates the
present value of a project's cash out flow with the present value of its cash inflow In
other words, the internal rate of return is that discount rate that will cause the net
present value of a project to be equal to zero.

CF1 CF2 CFn


Total Capital Investment ...
137 NTAldon 1 i 1 i
1 2
1 i n
Sample Problem: Discounted Cash Flow
Compute for the IRR given by the sequence of cash flows

i=29% solving by
trial and error

1 A B
2 year, n Cash Flow, Cn
3 0 -100
4 1 40
5 2 59
6 3 55
7 4 20
8 IRR 29% Solving using Excel program
=IRR(B3:B7)
138 9 NTAldon
YEAR Cash-flow, P
SAMPLE PROBLEM : Discounted Cash-flow
IRR 1 30,000
Given: Initial Fixed-Capital Investment = P100,000 2 31,000
Working capital Investment = P10,000 3 36,000
Service life = 5 years
Salvage value @ the end of service life = P10,000 4 40,000
5 43,000
Required: Internal Rate of Return (IRR)
Solution:
By Trial-and-Error: i = 0.207 (20.72%)
30,000 31,000 36,000 40,000 43,000 10,000 10,000
110,000
1 i 1 i 1 i 1 i 1 i
1 2 3 4 5
1 i 5

Solving using Excel program


YEAR Cash-flow, P
0 -110,000
1 30,000
2 31,000
3 36,000
4 40,000
5 63,000
139 IRRNTAldon 20.72%
Pay-out Period, N
This method determines the number of years within which the invested capital can be recovered out of
the expected cash flow. It does not consider the possible earnings of the reinvested capital during the
pay-put period.

A.Without Interest Depreciable Fixed Capital Investment


N
AverageCashFlow / yr

Fixed Capital Investment SalvageValue


N
AverageNet Pr ofit / yr AverageDepreciation / yr

Depreciable Fixed Capital Investment Interest On Total Investment


N
B.With Interest Average CashFlow / yr

N

DFCI TCI 1 i 1
n

AverageNet Pr ofit / yr AverageDepreciation / yr as annuity

Note: Depreciable Fixed Capital Investment= Fixed Capital Investment- Salvage Value
TCI=Total capital Investment=Fixed Capital Investment +Working Capital
NTAldon
140
SAMPLE PROBLEM: PAY-OUT PERIOD

Given:
Total fixed Working Salvage Service Life, Net Profit
capital capital Value years

P 100,000 P 11,000 P 10,000 6 P21,000

Required: Pay-out Period, N, without interest

Solution: Depreciable Fixed Capital Investment


N=
Net Profit+ Depreciation ave
year

100,000 10,000
Annual Dep 15,000
6

N
100,000 10,000 2.5 years
21,000 15,000

141 NTAldon
SAMPLE PROBLEM: PAY-OUT PERIOD

Given:
Total fixed Working Salvage Service Life, Net Profit
capital capital Value years

P 100,000 P 11,000 P 10,000 6 P21,000

Required: Pay-out Period, N, with interest; i = 10% pa

Solution: Depreciable Fixed Capital Investment Interest On Total Investment


N
Average CashFlow / yr

d FC SV
i

1 i 1
L

0.10
100,000 10,000 11,664 .66
1.10 6
1

100, 000 10, 000 100, 000 11, 000 1.10 1


6

N 5.4 years
21, 000 11, 664.66

142 NTAldon
SAMPLE PROBLEM: PAY-OUT PERIOD

Given:
Total Fixed Working Salvage Value Service Annual
Capital capital life, years Cash flow
P 100,000 P 11,000 P10,000 6 P 36,000

Required: Pay-out Period, N, with interest; i = 10% pa

Solution:
Depreciable Fixed Capital Investment Interest On Total Investment
N
Average CashFlow / yr

N

100,000 10,000 100,000 11,000 1.10 1
6
4.88 years
36,000

143 NTAldon
Present Worth (Net Present Worth)

The difference between the present value of the annual cash flows (CF)
and the total initial investment (TCI). If the present worth of the net cash flow is
equal to or greater than zero, the project is justified economically.
CF1 CF2 CFn
NPW .. TCI
1 i 1 i 2
1 i n

SAMPLE PROBLEM

GIVEN:
Total Fixed Working Salvage Value Service Annual
Capital capital life, years Cash flow
P 100,000 P 11,000 P10,000 6 P 36,000

Required: Net Present Value


Solution: CF1 CF2 CFn
Net Pr esent Worth .. FC
1 i 1 i 2

1 i
n

1 0.12 6 1 11, 000 10, 000


36, 000 100, 000 11, 000 47, 650
0.12 1 0.12 1 0.12
6 6

144 NTAldon
Future Worth Method
This method is comparable to the present worth method except that
all cash inflows and outflows are compounded forward to a reference point in
time called the future. If the future worth of the net cash flow is equal or greater
than zero, the project is justified economically.

F CF1 1 i CF2 1 i .. CFn TCI 1 i


n 1 n2 n

145 NTAldon
Capitalized Cost, K
The total amount of money that must be available initially to purchase the equipment
and simultaneously provide funds for interest accumulation to permit perpetual
replacement of the equipment.
In perpetuity, the amount required for replacement must be earned as compounded
interest over a given length of time. Let P be the amount of present principal or present
worth which can accumulate to an amount F during the interest periods at periodic
interest i. Then, F = P(1+i)n
If perpetuation is to occur, the amount F accumulated after n periods minus cost for
the replacement must equal the present worth P. If we let CR represent the replacement
cost,
I CR F P P1 i P
n

CR
P
1 i n 1
K FC P
CR
K FC
1 i n 1
where:
FC = First Cost of the equipment
CR = Replacement/Maintenance Cost of the equipment after certain period ,n
K = Capitalized Costs
146P = additional investment which interest will take care of the perpetual replacement of the equipment
NTAldon
Sample Problem

Working in millions

CR
K FC
1 i 1
n

2
K 25 41.67
1 0.12
1
1

147 NTAldon
Sample Problem:

Given:
The initial cost of the equipment is P100,000, a salvage vale of
P20,000 after 5 years and a maintenance cost of P10,000 per year,
and cost of money of 10% pa.
Required: Capitalized Cost
Solution:

K 100, 000
100, 000 20, 000

10, 000
P 331, 038
1 0.10 1 1 0.10 1
5 1

148 NTAldon
Capital Recovery, CR
The minimum income that must be earned by the investor in
order to recover the cost of depreciation of the equipment plus the
interest earned by the initial investment made.
1 i L 1
FL FC1 i CR SV
L

FC1 i SV
L
CR FC A/P,i%, n SV A/F,i%, n
1 i 1
L

i
where:
FC = First cost of the equipment
SV = salvage value at the end of service life
L = service life,
i = periodic interest

149 NTAldon
Sample Problem: Capital Recovery
Given: Installed cost of Equipment = P400,000
Service life = 5 years
Salvage value = P40.000
Cost of money = 10% p.a.
Required: Capital Recovery, CR
Solution:

FC 1 i SV 400, 000 1.1 40, 000


L 5

CR P 98,969
1 i 1 1.1 1
L 5

i 0.1

Explanation:
i 0.10
annual dep d FC SV 400, 000 40, 00 58,967.09
1 i 1 1 0.10 1
L 5

Interest
I 400, 000 0.10 40, 000
year
150 NTAldon annual earnings=Capital Recovery 58,967.09 40, 000 98,967.09
Minimum
SAMPLE PROBLEM:

A company requires an initial fixed capital investment of P100,000 and a working


capital of P10,000. The fixed capital investment has a salvage value of P10,000 after 5
years, The projected annual cash flow is P36,000 and annual expenses is P44,000.
Assume a minimum yield on investment of 15% pa. Determine the ff.
a. ROI
b. Minimum pay-out period, w/o and w/ interest
c. Present worth
d. Capitalized costs

SOLUTION:
a. ROI
Profit = Cash flow Annual depreciation
Total Investment = FCI + working capital
Annual depreciation = (100,000 10,000)/ 5 = P18,000
Total investment = 100,000 + 10,000 = P110,000
Profit = 36,000 18,000 = 18,000

Profit 18,000
ROI 100% 16.36%
Investment 110,000
151 NTAldon
a. Minimum pay-out period, without interest

Depreciable Fixed Capital Investment


N
Cash Flow
100, 000 10, 000
2.5 years
36, 000

b. Minimum pay-out period, with interest

Depreciable Fixed Capital Investment Interest on Total Investment


N
Cash Flow
100, 000 10, 000 110, 000 1 0.15 1
5

5.6 years
36, 000

152 NTAldon
c. Net Present Worth

CF1 CF2 CFn


NPW .. FC
1 i 1 i 2
1 i
n

1 0.155 1 10, 000 10, 000


36, 000 110, 000 P20, 622
1 0.15 0.15 1 0.15
5 5

d. Capitalized Costs

CR
K FC
1 i n 1
44, 000 100, 000 10, 000
110, 000 P 492,322

5
0.15 1 0.15 1
153 NTAldon
Break Even Analysis
Break-even point _ level of production where the total income is equal to the total
expenses

Basic Production Assumptions:


1. That the variable costs are substantially directly proportional to production rate over the
range from 0 to 100% capacity.
2. That the fixed charges are constant regardless of the annual production.
3. That there are no financial costs.
4. That there is no income other than from operations.
5. That all units produced are sold at a constant price per unit.

Gross Profit = net Sales cost of Sales


= net Sales (Variable costs + Fixed Costs)

Z nS nV F
Where: Z= gross profit in pesos

0 nS V F
n = number of units sold per year
S = nets sales, pesos/unit
F V= variable cost, pesos/unit
n F= annual fixed cost, pesos
S V
Note: If S and V are in terms of total sales pesos and total
variable cost pesos, respectively, at 100% capacity,
then n is terms of fractional capacity.
154 NTAldon
SAMPLE PROBLEM
A company has the capacity to produce one million units of product per year. At present it can
only produce and sell 800 thousand units annually at a total sales of P800 million. Variable costs
per unit is P500 with an annual fixed costs of P50 million.
a. Calculate the company's annual profit or loss for this present production.
b. What is its break-even point?

Use analytical and graphical method

Solution: a. Profit Sales Cost of Sales


Z S-(FC VC)
500
800 ,000 ,000 50 ,000 ,000 800 ,000 units P350 M
unit
P 800 ,000 ,000 P 1,000
selling price/unit s ;
800 ,000 unit
P 500
variable cost/unit vc
unit
FC 50 ,000 ,000
b. BEP n 100 ,000 units
155 NTAldon s-vc 1,000 500
SAMPLE PROBLEM:

The annual fixed costs of a plant are P100,000, and the variable costs
are P140,000 at 70% capacity with net sales of P280,000. What is the break-even
point in units of production if the selling price per unit is P40?

Solution:
The variable costs and net sales are based on 70% capacity, therefore we
express them based on 100% capacity:

V = P 140,000/0.7 = P200,000 ;
S = P 280,000/0.7 = P400,000
FC = P 100,000

F 100, 000
n 100% 50%
S V 400, 000 200, 000
P 400, 000
NTAldon
0.50 5, 000 units
156 P 40 / unit
Graphical
500
Solution
450

400

350 Sales
Thousand Pesos

300 BEP
Sales=Cost of Sales
250 Costs of Sales
FC+VC
200

150 VariableCosts
100 Fixed Costs
50

0
10 20 30 40 50 60 70 80 90 100
-50
-100 % Capacity
157 NTAldon
OPTIMIZATION

Sample Problem:

The cost of operating a large ship (Co) varies as the square of


its velocity (v); specifically, Co=kLv2, where L is the trip length
in kilometers and k is a constant of proportionality. It is known
that at 12 kilometers per hour the average cost of operation is
P10,000 per kilometer. The owner of the ship wants to
minimize the cost of operation, but it must be balanced against
the cost of perishable cargo (Cc), which the customer has set
at P150,000 per hour. At what velocity should the trip be
planned to minimize the total cost (CT), which is the sum of the
cost of operating the ship and the cost of perishable cargo?

158 NTAldon
SOLUTION:

kv k 12 10,000; k 69.444
Co
k 2 2

L
L
CT kLv 150,000;
2

v
CT 69.444 Lv
2 150,000 L
;
v
dCT 150,000 L
138.888 Lv 2
0; v 10.26km / h
dv v
CT 69.444 Lv
2 150,000 L
v
69.444 L10.26
150,000 L
21,930
2
CT NTAldon
159 10.26
A company produces circuit boards used to update
outdated computer equipment The fixed cost is
P2.0 M per month, and the variable cost is P2,700
per circuit board. The selling price is S=7500-2n.
Where n is the number of units produced.
Maximum plant capacity is 4,000 units a month.

a. Determine the optimum demand for this product.


b. What is the maximum profit per month
c. At what volume does breakeven occurs

160 NTAldon
a. Daily Profit
Z 7500 2n 2,700 n 2.1x10 6 4,800 n 2n 2 2.0 x10 6
dZ
4,800 4n 0; n 1,200
dn

b. Maximum Profit per month


Z 4,8001200 21,2000 2.0 x10 6
2

P0.880 M

c. BEP :
Z 0 4,800 n 2n 2 2.0 x10 6 2n 2 4,800 n 2.0 x10 6

n

4,800 4,800 2 42 2 x10 6
1863; 537
22
161 NTAldon
A plant produces a type of product at a rate of P units
per day. The variable costs per unit have been
determined to be P4,773 + 10P1.2. The total daily fixed
charges are P 175,000, and all other expenses are
constant at P732,000 per day. If the selling price per
unit of product is P17,300.
a. Determine the daily profit at a production schedule
giving the minimum cost per unit of product
b. Determine the daily profit at a production schedule
giving the maximum daily profit

c. Determine the production schedule at the break-even


162 NTAldon
Economic Order Quantity,
EOQ

The order quantity which minimizes the inventory


cost unit time.

2aK
EOQ
h
where:
a= constant depletion rate (items/unit time)
K= the fixed cost per order (peso)
163 NTAldon h= the inventory storage cost (peso/unit item)
Sample Problem

Given:
a= constant depletion rate (items/unit time) = 1000 kg/month
K= the fixed cost per order (peso) = P 2,000
h= the inventory storage cost (peso/unit item) = P100/kg/month

2aK 21000 2000


EOQ 200 kg
h 100

164 NTAldon
FINANCIAL ANALYSIS
1. Test of Liquidity
These measures are used to determine a firms ability to meet short-term obligations,
and to remain solvent in the event of adversities.

Liquidity ratios are used to measure your enterprise's ability to pay its bills on time.
They can be overall measures of liquidity or measures of specific assets.
Liquidity is the availability of liquid assets to an enterprise.
Liquid assets are those assets held in or easily converted into cash.

Current Assets
1. A. Current Ratio
Current Liabilities
The ratio is mainly used to give an idea of the company's ability to pay back its short-
term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).
The higher the current ratio, the more capable the company is of paying its obligations. A ratio
under 1 suggests that the company would be unable to pay off its obligations if they came due
at that point. While this shows the company is not in good financial health, it does not
necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is
definitely not a good sign.
165 NTAldon
Current Assets Inventories
1.B. Quick or Acid Test Ratio
Current Liabilities
A stringent indicator that determines whether a firm has enough short-
term assets to cover its immediate liabilities without selling inventory.
The acid-test ratio is far more strenuous than the working capital ratio,
primarily because the working capital ratio allows for the inclusion of
inventory assets.
Companies with ratios of less than 1 cannot pay their current liabilities
and should be looked at with extreme caution. Furthermore, if the acid-
test ratio is much lower than the working capital ratio, it means current
assets are highly dependent on inventory. Retail stores are examples of
this type of business.
The term comes from the way gold miners would test whether
their findings were real gold nuggets. Unlike other metals, gold does not
corrode in acid; if the nugget didn't dissolve when submerged in acid, it
was said to have passed the acid test. If a company's financial statements
pass the figurative acid test, this indicates its financial integrity.

166 NTAldon
Cost of Goods
1.C. Inventory Turn-Over Ratio
Average Inventory
The liquidity of a firm's inventories is reflected in the number of time the firm's average
inventory is turned over during the year. The inventory ratio requires confirmation by other
measures and a more thorough examination of contents because rapid turnover on a few items
or a slow turnover on others could skew the results.

Example:
Cost of Goods Sold = P 1,520,891
Inventory Beginning = P 139,725
Inventory Ending = P 141,410

Cost of Gods Sold 1,520,891


Inventory Turn-Over Ratio 10.82
Average Inventory 139,725 141,410
2

The company turns its inventory almost eleven times a year (almost every month). It's a good
strategy to mention in your plan the false assumptions associated with this conclusion.
Average inventory is the average of the beginning and ending inventories. Sales are sometimes
used in the numerator of the inventory ratio rather than the cost of goods sold. This would
include markup, a variable which fluctuates across different situations.
167 NTAldon
Cash Short Term or Marketable Securities
1.D. Cash Ratio
Current Liabilities

The cash ratio is the most conservative liquidity ratio of all. It


only measures the ability of a firm's cash, along with
investments that are easily converted into cash, to pay its short-
term obligations. Along with the quick ratio, a higher cash ratio
generally means the company is in better financial shape.

168 NTAldon
2. Tests of Debt-Service
These tests are employed to present the
projects ability to meet long-term obligations.
Total Liabilities
2. A. Debt to Net Worth Ratio
Total Equities
Measure used in the analysis of financial statements to show the
amount of protection available to creditors. The ratio equals total
liabilities divided by total stockholders' equity; also called debt to net
worth ratio. A high ratio usually indicates that the business has a lot of
risk because it must meet principal and interest on its obligations.
Potential creditors are reluctant to give financing to a company with a
high debt position. However, the magnitude of debt depends on the
type of business. For example, a bank has a high debt ratio but its assets
are generally liquid. A utility can afford a higher ratio than a
manufacturer because its earnings can be controlled by rate
adjustments. Usually, book value is used to measure a firm's debt and
equity securities in calculating the ratio. Market value may be a more
realistic measure, however, because it takes into account current
169 market
NTAldon conditions.
Long term Liabilites
2.B. Total Capitalization Ratio
Long term Liabilities Equities
The capitalization ratio measures the debt component of a
company's capital structure, or capitalization (i.e., the sum of
long-term debt liabilities and shareholders' equity) to support a
company's operations and growth.

Long-term debt is divided by the sum of long-term debt and


shareholders' equity. This ratio is considered to be one of the more
meaningful of the "debt" ratios - it delivers the key insight into a
company's use of leverage.
There is no right amount of debt. Leverage varies
according to industries, a company's line of business and its stage
of development. Nevertheless, common sense tells us that low
debt and high equity levels in the capitalization ratio indicate
investment quality.

170 NTAldon
Earnings before Interest and Taxes
2.C. Debt Service Ratio
Interest

The ratio measures debts servicing capacity of a business so far as


interest on long-term loans is concerned. This ratio shows how many
times the interest charges are covered by the earnings. Debt service
ratios is also known as interest coverage ratio.
The interest coverage ratio is used to determine how easily a
company can pay interest expenses on outstanding debt. The ratio is
calculated by dividing a company's earnings before interest and taxes
(EBIT) by the company's interest expenses for the same period. The
lower the ratio, the more the company is burdened by debt expense.
When a company's interest coverage ratio is only 1.5 or lower, its
ability to meet interest expenses may be questionable. The ability to
stay current with interest payment obligations is absolutely critical for
a company as a going concern. While the non-payment of debt
principal is a seriously negative condition, a company finding itself in
financial/operational difficulties can stay alive for quite some time as
long as it is able to service its interest expenses.
NTAldon
171
2.D. Fixed Ch arg e Coverage Ratio
Earnings before Interest & Taxes Lease Payments

Lease Payments Interest Ch arg es

Equation that indicates whether the company is able to meet its fixed commitments (i.e.,
interest) from its profits. A high ratio reflects favorably upon the firm's ability to refinance
obligations as they mature. The ratio equals earnings available to meet fixed charges divided by
fixed charges. Fixed charges include rent and interest.
The fixed charge coverage ratio includes lease payments as well as interest payments.
Lease payments, like interest payments, must be met on an annual basis. The fixed charge
coverage ratio is especially important for firms that extensively lease equipment, for example.

Here is the calculation for the fixed charge coverage ratio:


EBIT, Taxes, and Interest Expense are taken from the company's income statement. Lease
Payments are taken from the balance sheet and are usually shown as a footnote on the balance
sheet. The result of the fixed charge coverage ratio is the number of times the company can
cover its fixed charges per year. The higher the number, the better the debt position of the
firm, similar to the times interest earned ratio.
Like all ratios, you can only make a determination if the result of this ratio is good or bad
if you use either historical data from the company or if you use comparable data from the
industry.
172 NTAldon
The above formula can be explained with the help of an example:
For example, a company has P13,000 as EBIT and P2,000 as lease payments
and P1,000 as interest payments the fixed charge coverage ratio is measured as:

Fixed charge coverage ratio 13,000 2,000


5
1,000 3,000
This means that the company has earned five times its fixed charges, the
company is able to pay the fixed charges of the company.

Therefore this means that by calculating the fixed charge coverage ratio, it
helps in ascertaining the companys ability to pay the various fixed costs of the
company in case the business tends to fall. Every business would have its own
share of risks involved and every company must be well prepared to handle all the
expenses and losses that can occur to the company. This is why it is important to
calculate the fixed charge coverage ratio and it enables a business to understand
the loss or expense taking capacity of the business in case some misfortune strikes
the company. This ratio like all other ratios can provide a basic idea of the standing
of the companys finances based on the historical data provided to you. Therefore
it is important that you determine fixed charge coverage ratio to ascertain the
standing of the company.
173 NTAldon
Amortization _ method of repaying a debt, the principal and interest
included, usually by a series of equal payments at periodic interval of
time.
Assets _ anything of value possessed by a enterprise, classified as
current, fixed and other assets (goodwill, copyrights, franchises, etc. )
Authorized capital_ The authorized capital of a company
(sometimes referred to as the authorized share capital,
registered capital or nominal capital, is the maximum amount
of share capital that the company is authorized by its constitutional
documents to issue (allocate) to shareholders. Part of the authorized
capital can (and frequently does) remain unissued. This number can be
changed by shareholders' approval
Average cost method _ all materials in the store room are mixed and
no attempt is made to determine which materials came in first or
last, and therefore all materials issued are to be priced at the average
price of the all the materials in the store room at that time.
174 NTAldon
Bond _ is a certificate of indebtedness of a corporation usually for a period
not less than 10 years, and guaranteed by a mortgage on certain assets of
the corporation or its subsidiaries.
Coupon bonds _ bonds which are attached coupons indicating the interest
due and the date which such interest is to be paid. The owner of the bond
can collect the interest due by surrendering the same to the officers of the
corporation or the same may be cashed at specified banks.
Collateral bonds _ the corporation pledges securities which it owns, such as
stocks or bonds of one of its subsidiaries
Equipment obligation bonds _ refer primarily to bonds whose guarantee is a
lien on equipment.
Registered bonds _ the owner's name is recorded in the books of the
corporation, and the interest is paid periodically to the owner without their
asking for it.
Joint bonds _ bonds which are issued by two or more corporations
Mortgage bonds _ bonds whose security is mortgaged on certain specified
assets of the corporation.

175 NTAldon
Debenture bonds _ bonds without security behind them except
a promise to pay by the issuing corporation
Callable bond _entitles the issuer to pay off the principal prior to
the stated maturity date. Similarly, the owner of a
putable bond _can force the issuer to pay off the principal before
the maturity date.
Convertible bond _gives the bondholder the right to exchange the
bond for shares of the issuer's common stock at a specified date.
Municipal bonds _are issued by state and local governments and
other public entities, such as colleges and universities, hospitals,
power authorities, resource recovery projects, toll roads, and gas
and water utilities. Municipal bonds are often attractive to investors
because the interest is exempt from

Par value of the bond or face value_ is the amount stated on the
bond.
Bond rate _ is the rate of interest quoted on the bond.
Redemption
176 NTAldon or disposal priceusually equal to par value.
Leveraged _ company that raises funds by issuing bonds.
Book costs_ are those that do not involve cash payments, but rather represent the recovery of
past expenditures over a fixed period of time. The most common of which is the depreciation
charge for the use of assets such as plant and equipment.
Book value _ also known as depreciated value, is the worth of the property as recorded in the
books of account of the enterprise and is equal to the original cost less the amounts which have
been charged to depreciation.
Bookkeeping _ is the systematic recording of all business transactions in financial terms.
Borrowed capital_ are those supplied by others on which a fixed rate of interest must be paid
and the debt must be repaid at a specified time.
Break-even point _ level of production where the total income is equal to the total expenses
Break-even analysis_ a means of identifying the value of a particular project variable that causes
the project to exactly break even.
Capacity or plant factor _ the ratio between the average load and the total available capacity.
Capitalized cost _ is the sum of the first cost and the additional investment necessary in
order to take care of the replacement and operating costs of the equipment etc. to perpetually
operate it. Only the interest of the additional investment will take care all the replacement and
operating
177 expenses.
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1. Equity capital_ capital owned by individuals who have invested their money or property in
a business project or venture in the hope of receiving profit.
2. Debt capital _ also known as borrowed capital. Capital obtained from lenders (e.g.
obtained from sale of bonds) for investment. In return, the lenders receive interest from the
borrowers.
Capital_ collective term for a body of goods and monies from which future income can be
derived. Land, buildings, equipment, inventory, and raw materials, as well as stocks, bonds,
and bank balances available are considered as capital. Generally, consumer goods and monies
spent for present needs and personal enjoyment are not included in the definition or
economic theory of capital. Homes, furnishings, cars, and other goods that are consumed for
personal enjoyment (or the money set aside for purchasing such goods) are not considered
capital in the traditional sense.
Paid-in-capital_ amount of money received from the sale of stock more than the par value of
the stock. Outstanding stock is the number of shares issued that is actually held by the public.
If the corporation buys back part of its own issued stock, it is listed as Treasury Stock on
balance sheet.
Subscribed capital_ also known as issued share capital_ the total of a companys shares that
are held by shareholders. A company can, at any time, issue new shares up to the full amount
of authorized share capital.
178 NTAldon
Capital gains tax_ tax on sale of assets; a tax on profit above a fixed
level made from the sale of financial assets
Capital Recovery_ The minimum income that must be earned by the
investor in order to recover the cost of depreciation of the equipment
plus the interest earned by the initial investment made.
Cartel_ a group of businesses controlling market: an alliance of
companies formed to control production, competition and prices. A
formal organization of producers within industry forming perfect
collusion purposely formed to increase profit and block new comers
from the industry.
Cash Costs_ are those that involves payment of cash (and results in
cash flow). It is distinguished from non-cash costs or book costs like
depreciation.
Cash Flow _ is a systematic presentation of cash receipts and
disbursements for a given operating period or fiscal year, taking for
granted the accrual concept in accounting. It details how the company
generated the cash and how the company used the cash during the reported
179
period.
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Common stock _ represents the ownership of stockholders who have residual
claim on the assets of the corporation after all other claims have been settled.
No return is guaranteed on the investment of common stockholders. They have
the right to call meetings, to vote, to elect members of the board of directors,
amend charter and constitution and by-laws, inspect books of the corporation,
receive dividends, share remaining assets if corporation is dissolved.
Consumer goods and services_ are those products or services that are directly
used by people to satisfy their wants. Food, clothing, homes, cars, television
sets, haircuts, cinema, and medical services are examples.
Consumer price index (CPI) _measures changes in the price level of consumer
goods and services purchased by households. The CPI is a statistical estimate
constructed using the prices of a sample of representative items whose prices
are collected periodically. Sub-indexes and sub-sub-indexes are computed for
different categories and sub-categories of goods and services, being combined
to produce the overall index with weights reflecting their shares in the total of
the consumer expenditures covered by the index. It is one of several price
indices calculated by most national statistical agencies. The annual percentage
change in a CPI is used as a measure of inflation. A CPI can be used to index
(i.e., adjust for the effect of inflation) the real value of wages, salaries,
pensions, for regulating prices and for deflating monetary magnitudes to show
changes
180 in real values.
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Copyright _ is an exclusive right granted by the government to protect the
production and sale of literary or artistic works for a period of 50years.
Corporation _ is a distinct legal entity, separate from the individuals who
own it, and which can engage in practically any business transaction which a
real person could do. It may sue, or be sued in its own name. It is separate
from its owners and managers.
This separation gives the corporation four major advantages:
1) It can raise capital from large investors by issuing stocks and bonds;
2) it permits easy transfer of ownership interest by trading shares of stock;
3) it allows limited liability-personal liability is limited to the amount of the
individuals investment in the business;
4) it is taxed differently than the proprietorships and partnerships, and under
certain conditions, the tax laws favor corporations. On the negative side, it
is expensive to establish a corporation. Furthermore, a corporation is
subject to numerous governmental requirements and regulations.
Cost accounting _ is the process of determining the actual cost of
manufacturing a product or of rendering a service. Methods used are, post-
mortem cost accounting, method of predicted cost, and method of standard
cost. Elements of cost are materials, direct labor and overhead.
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Current liabilities _ these are liabilities which mature within a short
time, usually a year.
Current or liquid assets - include cash, accounts receivables within a
short period of time or at least within the present accounting period
and inventories (Examples are, raw materials, goods in the process of
production, and finished goods ready for sale).
Types of current assets
1. Cash_ represents actual money. Cash equivalent like marketable
securities and short term investments.
2. Accounts receivable_ money which is owed to the firm but has yet
to be received.
3. Inventories_ money invested in raw materials, work-in-process,
finished goods available.
Demand _ is the quantity of a certain commodity bought at a certain
price at a given place and time.
Demand
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factor _ the ratio between the maximum power demand and
182
the sum of the connected loads of the system
Depression _ in economics, a period in an industrial nation
characterized by low production and sales and a high rate of
business failures and unemployment.
Depreciation and devaluation are sometimes incorrectly
used interchangeably, but they always refer to values in terms of
other currencies.
Inflation, on the other hand, refers to the value of the currency in
goods and services (related to its purchasing power). Altering the
face value of a currency without reducing its exchange rate is a
redenomination, not a devaluation or revaluation.

183 NTAldon
Direct Costs_ are costs that can be reasonably measured and
allocated to a specific output or work activity. The labor and
material costs directly associated with a product, service, or
construction activity are direct costs.
Direct materials _ are materials which are used in the finished
product itself.
Discount _ the difference between the value of a negotiable
paper between now and the future.
Discounted interest_ The interest for the money borrowed
(discount) is deducted from the principal in advance
Disposal costs_ includes those nonrecurring costs of shutting
down the operation and the retirement and disposal of assets at
the end of the life cycle.

184 NTAldon
Discounting_ is a financial mechanism in which a debtor obtains the
right to delay payments to a creditor, for a defined period of time, in
exchange for a charge or fee. Essentially, the party that owes money in
the present purchases the right to delay the payment until some future
date. The discount, or charge, is simply the difference between the
original amount owed in the present and the amount that has to be paid
in the future to settle the debt
Duopoly_ concentration of power in two forces: an economic situation
in which two powerful groups or organizations dominate commerce in
one business market or commodity.
Duopsony_ two rival buyers control over sellers: a situation in which
two competing buyers exert controlling influence over many sellers.
Economic life_ is the length of time during which an equipment or
property will operate at a satisfactory profit.
Effective interest _ is the actual rate of interest on the principal for one
year.
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Efficiency
185 _ output divided by input
Elastic demand _ occurs when a decrease in selling price will
cause greater than proportionate increase in sales. Usually
applicable to luxury goods.
Equipment obligation bonds _ refer primarily to bonds whose
guarantee is a lien on equipment.
Equities _ are the claims of anyone against the asset of the
enterprise. It includes the liabilities to the creditors as well as the
claims of the owners.
Equity capital_ or ownership funds_ are those supplied and used
by the owners of an enterprise in the expectation that a profit
will be earned.
Expense _ the cost of producing income or revenue, or the value
of commodities and services needed in the operation of the
business. Also classified as operating and non-operating expenses.
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Fair value _ is the value which a disinterested third
party, different from the buyer or the seller, will
determine in order to establish a price that is fair and
acceptable to both the buyer and the seller.
FIFO _ first-in, first out method. The principle behind
this method is that the materials issued at any time are
taken from the oldest stock and should be priced at
the cost when they are purchased. Ex food
manufacturing.
First cost of property _ includes original purchase
price, freight and transportation, installation, taxes,
permits and all other expenses to put it into
operation.
Fixed liabilities _ liabilities which are not due for
payment until sometime in the future, usually after a
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period
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Franchise_ the right and privilege granted to an individual or corporation to
do business in a certain region.
Franchise value _ is an intangible item of value arising from the exclusive right
of a company to provide a specific product or service in a stated region of the
country.
Going concern value_ The value of a company as an ongoing entity. This
value differs from the value of a liquidated company's assets, because an
ongoing operation has the ability to continue to earn profit, while a liquidated
company does not.
Goodwill_ an intangible value_ is that element of value which a business has
earned through the favorable consideration and patronage of its customers
arising from its well-known and well conducted policies and operation.
Gratuitous_ an obligation with no condition attached.

188 NTAldon
Gross Domestic Product (GDP)_ measures the value of all goods and
services produced within a nations borders regardless of the nationality of the
producer. GDP measures a countrys economic activity regardless of who owns
the productive assets in that country. For example, the output United States-
owned companies based in the Philippines is considered part of Philippines GDP
rather than part of the U.S.. GDP may be calculated in three ways: (1) by adding
up all the value of all goods and services produced (2) by adding up the
expenditures on goods and services at the time of sale, or (3) by adding up
producers incomes from the sale of goods or services .
GDP is usually divided by its population to arrive at GDP per head. The figure is
then converted to dollars to allow for its comparison between countries. If GDP
grows at a higher rate than the population, standards of living are said to be
rising. If the population is growing higher than GDP, living of standards are said
to be falling. GDP per head does not take the cost of living into account.
Gross National Product (GNP)_ used to describe in monetary value the
total annual flow of goods and services in the economy of a nation. It is
measured by totaling all personal spending, all government spending, and all
investment spending by a nations industry both domestically and all over the
world. In other words, the income earned by a U.S.-owned business based in the
Philippines would be considered part of the U.S.
Gross Margin_ net sales less the cost of goods sold.

189 NTAldon
Hedge funds_ risk-taking investment company: an investment
company that is organized as a limited partnership and uses high-
risk techniques in the hope of making large profits
Income _ the value of personal and professional services
rendered or of goods sold in the operation of the business.
Usually classified as operating and non-operating income.
Income statement _ or a profit and loss statement, is a summary
of the incomes and expenses of an individual or enterprise for a
given period. The next in importance to the balance sheet.
Incremental Costs _ are additional costs that result from
increasing the output of a system by one (or more) units.
Indirect Costs_ are costs that are difficult to attribute or allocate
to a specific output or work activity. For example, the costs of
common tools, general supplies, and equipment maintenance in
plant are treated as indirect costs.
Indirect materials _ are materials not directly part of the product
being produced
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Inelastic
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will cause a little a less than proportionate increase in sales.
Inflation_ is the increase in the prices of goods and services from one
year to another, thus decreasing the purchasing power of money.
Intangible assets _ have not physical substance. Examples are,
goodwill, leaseholds, copyrights, patents, franchises, licenses, and
trademarks. Accounting for an intangible asset is rendered somewhat
difficult because the lack of physical substance makes evidence of its
existence more elusive, may make its value debatable and its useful life
may be questionable.
Inventory_ stock of goods; the merchandise or stock a store or
company has on hand
Investment Cost_ is the capital required for most of the activities in
the acquisition phase. This cost is often called a capital investment.
Joint bonds _ bonds which are issued by two or more corporations.
Journal _ is an accounting book where the original record of all
transaction is ordinarily recorded. It is the book of original entry
191 NTAldon
Kelvin's Law _ the most economical cross sectional area for a
conductor is that one for which the investment cost just equals
the annual cost of lost energy.
Law of Diminishing returns _ when one of the factors of
production is fixed in quantity or is difficult to increase,
increasing the other factors of production will result in a less
than proportionate increase in output.
Law of diminishing utility _ an increase in the quantity of any
good consumed or acquired by an individual will decrease the
amount of satisfaction derived from that good.
Ledger _ serves as a secondary record of business transactions.
The ledger sheets are used as intermediates, between journal
records, balance sheets, income statements, and general records.
Examples are, cash, equipment, accounts receivables, inventory,
accounts payable and manufacturing expense.
Liabilities _ are debts or claims anyone other than the owners of
192 theNTAldon
property upon the assets of the company.
Life-cycle cost_ refers to a summation of all costs, both recurring and
non-recurring, related to a product, structure, system, or service
during its life plan.
Life cycle_ refers to the notion that a fair, holistic assessment requires
the assessment of raw material production, manufacture, distribution,
use and disposal including all intervening transportation steps
necessary or caused by the product's existence. The sum of all those
steps - or phases - is the life cycle of the product. The concept also can
be used to optimize the environmental performance of a single
product (ecodesign) or to optimize the environmental performance of
a company.
LIFO _ last-in. last out method. The materials last to obtained are the
first to be issued. Ex sand and gravel industry
Load factor _ the ratio between the average demand and the maximum
demand.
Luxuries_ are those products or services that are desired by humans
and will be purchased if money is available after the required
193 necessities
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Marginal cost _ is the additional cost of producing one more
unit.
Marginal revenue _ is the amount received from the sale of an
additional unit of a product.
Marginal utility _ is the utility of the last unit of the same
commodity which is consumed or acquired. If a man has three
shirts of the same kind of brand, the marginal utility of the 2nd
unit is greater than the marginal utility of the fourth unit.
Market - is a place where sellers and buyers come together
Market value _ is the amount which a willing buyer will pay to a
willing seller for the property when neither one is under
compulsion to buy or sell.

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Monopoly _ a unique product or service is available only from a
single supplier and entry of all other possible suppliers are
prevented.
Monopsony_ single-customer market: a situation in which a
product or service is only bought and used by one customer
Mortgage bonds _ bonds whose security is mortgaged on
certain specified assets of the corporation.
Mutual Fund_ form of management-investment company that
combines the money of its shareholders and invests those funds in
a wide variety of stocks, bonds, and so-called money market
instruments. The latter include short-term investments such as
United States Treasury bills and other federal securities,
commercial paper, and bank certificates of deposit. Mutual funds
provide the investor with professional management of funds and
diversification of investment among the securities offered by
leading corporations, federal and state governments, and other
195 entities.
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Necessities _ are those products or services that are required to
support human life activities that will be purchased in somewhat the
same quantity even though the price varies considerably.
Non-recurring costs_ are those which arte non-repetitive, even
though the total expenditure may be cumulative over a relatively short
period of time.. For example, the purchase of a real estate upon which
the plant will be constructed is a non-recurring cost, as the cost of
constructing the plant itself.
Obsolescence - refers to the changes external to the equipment such
as, decrease or disappearance of demand, invention of more efficient
equipment or style of products may have changed considerably.
Organization cost_ an intangible value_ is the amount of money spent
in organizing a business and arranging for its financing and building.
Oligopoly _ occurs when there are few suppliers and any action taken
by one of them will definitely affect the course of action of the others.
196 NTAldon
Operation and maintenance cost_ includes many of the recurring
annual expenses associated with the operation phase of life cycle.
The direct and indirect costs of operation associated with the five
primary resource areas- people, machines, materials, energy,
and information- are a major part of the costs in this category.
Opportunity Cost_ is incurred because of the use of limited
resources, such as the opportunity to use those resources to
monetary advantage in an alternative use is foregone.
Overhead expenses _ consist of those expenses which cannot be
readily included under direct materials and direct labor. Also
known as indirect costs or burden.
Ownership or proprietorship _ it represents the investment of a
person or several persons in the enterprise.

197 NTAldon
Partnership _ is an association of two or more persons for the
purpose of engaging in a business profit. Usually formed by the
voluntary agreement of the partners either verbally or in writing.
The agreement among the partners usually states the relations
between partners on matters relating to the proportion in which
profits or losses are to be shared, their investments , rights and
duties of each partner, and provisions for the withdrawal of any
partner or the dissolution of the partnership.
A partnership has many advantages, among which are its low cost
and ease of formation. Because more than one person makes
contributions, a partnership typically has larger amount of capital
available for business use. Since the personal assets of all partners
stand behind the business, a partnership can borrow money more
easily from a bank. Each partner pays only personal income tax
on his or her share of a partnerships taxable income.
Patent _ is an exclusive right granted by the government for the
manufacture, use, and sale of a specific product. When a company
acquires a patent or copyright by purchase of from the owner,
the purchase price is classified as an intangible asset.
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198
Payout period _ the minimum period needed to recover an
investment. Depreciable fixed capital/ net cash flow
Perfect competition_ a situation where a commodity or service
is supplied by a number of vendors and there is nothing to
prevent additional vendors entering the market.
Perpetual Inventory _ consists of the preparation of inventory
cards, and their being kept up-to-date for each type of equipment
or materials used or issued, and for the products completed or in
the process of manufacture.
Perpetuity _ is an annuity where the payments periods extend or
in which the periodic payments continue indefinitely.

199 NTAldon
Physical Life of an equipment _ is the length of time during which it is
capable of performing the function for which was designed and
manufactured.
Power factor _ ratio of the power output in watts and the product of
volts and amperes
Preferred stock _ also represent ownership. And it possesses the same
rights as common stock, but in addition, it enjoys certain preferences,
not possessed by common stock. It has priority over common stock in
receipt of dividends, and it is usually guaranteed a fixed annual
dividend, regardless of the amount of the earnings of the corporation.
In case the corporation is dissolved, the owner of the preferred stock,
has priority over the common stockholders. They may have right to
vote in meetings.

200 NTAldon
Prepaid expense _ assets in the form of money paid for certain
materials not yet delivered or services not yet rendered to the
company.
Prepaid income _ these are liabilities representing income which
have been paid to the enterprise but for which the goods have
not been delivered or any service rendered to the payer.
Present economy _ involves the analysis of problems for
manufacturing a product or rendering a service upon basis of
present or immediate costs.
Present value _ is the amount which if invested now will give a
value of F after n interest periods. It is also defined as projected
cash inflows and outflows expressed or discounted to the
present time.
Price _ is defined as the amount of money or its equivalent
which is given in exchange of the goods being sold.
201 NTAldon
Producer goods and services_ are used to produce consumer goods and services or
other producer goods. Machine tools, factory buildings, buses, and farm machinery
are examples.
Project Risk_ the possibility that an investment project will not meet the minimum
requirements for acceptability and success.
Producer Price Index (PPI)_ is a family of indexes that measure the average change
over time in the prices received by domestic producers of goods and services. PPIs
measure price change from the perspective of the seller. The headline PPI (for
finished goods) is a measure of the average price level for a fixed basket of capital and
consumer goods for prices received by producers. The producer price index for
finished goods is a major indicator of commodity prices in the manufacturing sector.
These prices are more sensitive to supply and demand pressures than the more
comprehensive consumer price index. Changes in the producer price index are
considered a leading indicator for consumer price changes, although only a small
portion of the PPI is directly connected to less than half of the CPI.
Proprietorship_ the simplest form of business organization wherein the business is
owned entirely by one person.
Pyramid scheme_ a fraudulent scheme in which the perpetrators recruit people
to pay money to those above them in a hierarchy on the expectation that they will
get payments from those below. When the number of newly recruited people
eventually dwindles, the payment structure collapses. Also known as Ponzi scheme.

202 NTAldon
Recurring Costs _are those that are repetitive and occur when an
organization produces similar goods or services on a continuing basis. Variable
costs are also recurring costs because they repeat with each unit of output. A
fixed cost that is paid on a repeatable basis is also a recurring cost.
REER (Real effective exchange rate)_ measures the competitiveness of a
currency in terms of making exports more or less expensive. It takes into
account the movement of one currency against several others, and the
inflation rates in other countries. Inflation is taken into account to measure
currency competitiveness in real terms because affordability of export goods
is determined not just by the movement of an exchange rate, but also by
movement of prices of raw materials.
Replacement value _ The cost necessary to replace an existing property at any
given time with one at least equally capable of rendering the same service.
Retained earnings_ the cumulative net income of the firm since its beginning,
less the total dividends that have been paid to stockholders. It indicate the
amount of assets that have been financed by plowing profits back into the
business. Therefore, these retained earnings belong to the stockholders.
Revenue_ the price of goods sold and services rendered during a given
accounting period.
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Scenario analysis_ a means of comparing a base-case or expected
project measurement (such as NPW) to one or more additional
scenarios, such as best and worst case, to identify the extreme and
most likely project outcomes.
Sole proprietorship _ or individual ownership, is the simplest of
business organization, wherein the business is owned entirely by one
person who is responsible for the operation, firms policies, and is
personally liable for its debts. The proprietorship has two major
advantages. First, it can be formed easily and inexpensively. No legal
and organizational requirements are associated with setting up a
proprietorship, and organizational costs are therefore, virtually nil.
Second, the earnings of a proprietorship are taxed at the owners
personal tax rate, which may be lower than the rate at which corporate
income is taxed. Apart from personal liability considerations, the
disadvantage of a proprietorship is that it cannot issue stocks and
bonds, making it difficult to raise capital for any business expansion.
Standard Costs _ are representative costs per unit of output that are
established in advance of actual production or service delivery. The are
developed from anticipated direct labor hours, materials, and
overhead categories (with their established cost per unit).
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Stock _ in business and finance, a share of ownership in a corporation. Shares in a
corporation can be bought and sold, usually on a public stock exchange.
Consequently, the owner of shares can realize a profit or capital gain if the stock is
sold at a price above what the owner originally paid for it.
Stock Exchange_ organized market for buying and selling financial instruments
known as securities, which include stocks, bonds, options, and futures. Most stock
exchanges have specific locations where the trades are completed. For the stock of a
company to be traded at these exchanges, it must be listed, and to be listed, the
company must satisfy certain requirements. But not all stocks are bought and sold at
a specific site. Such stocks are referred to as unlisted. Many of these stocks are
traded over the counterthat is, by telephone or by computer.
Stock Holder_ share holder, owner of company stock,
Stockholders Equity_ the amount available to the owners after all other debts have
been paid
Sunk cost _ money which has been spent or capital which has been invested and
which cannot be recovered due to certain reasons. They are non-refundable cash
outlay, such as earnest money on a house, capital that has been invested and cannot
be retrieved or money spent on passport.

205
Supply _ is the quantity of a certain commodity that is offered for sale at a certain
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price at a given place and time.
Income taxes_ expressed as a function of gross revenues minus allowable deductions.
Property taxes_ are assessed as a function of the value of property owned, such as land,
buildings, equipment, and so on, and the applicable tax rates. They are independent of the
income or profit of the company.
Sales taxes_ are assessed on the basis of purchases of goods or services and are thus
independent of gross income or profits.
Excise Taxes_ assessed as a function of the sale of certain goods or services often considered
non-necessities (alcohol, tobacco), and are hence independent of the income or profit of a
business.
The Law of Demand _ the demand for a commodity varies inversely as the price of
commodity, though not proportionately.
The Law of Supply _ the supply of commodity varies directly as the price of the
commodity, though not proportionately.
The Law of Supply and Demand _ when free competition exists, the price of a product will be
that value where supply is equal to the demand.
Time value of money_ is the value of money figuring in a given amount of interest earned
over a given amount of time. The time value of money is the central concept in finance
theory.
For example, P100 of today's money invested for one year and earning 5% interest will be
worth $105 after one year. Therefore, P100 paid now or P105 paid exactly one year from now
both have the same value to the recipient who assumes 5% interest; using time value of
money terminology, P100 invested for one year at 5% interest has a future value of P105.

206 NTAldon
Tort_ a wrongful act that causes injury to a person or property and for
which the law allows a claim by the injured party to recover damages.
Unitary elasticity of demand _ occurs when the mathematical product
of price and volume of sales remain constant regardless of any change
in price. PV=C
Utility _ is the capacity of a commodity to satisfy human wants and
needs.
Utility or use value _ is what it is worth to the owner of a property
when in actual operation.
Value_ the price that must be paid in order to obtain a particular item

Valuation_ or appraisal_ is the process of determining the value of


certain property for specific reasons.
Variable Costs_ are those associated with an operation that vary in
total with the quantity of output or other measures of activity level.
Working capital_ refers to the funds required for current assets (other
than fixed assets) that are needed for the start-up and support of
operational activities. Also known as the circulating capital, includes all
funds which are required to make the enterprise a going concern.
207 NTAldon
Thank You!

208 NTAldon