CHE 423-Ayhan Gerceker

ENGINEERING ECONOMICS
Ayhan Gereker
CHEMICAL ENGINEERING ECONOMICS

I.
INTRODUCTION
II.
PLANT DESIGN PROCESS
III.
GENERAL CONSIDERATIONS
IV.
CAPITAL INVESTMENT
V.
PRODUCT COST ECONOMIC PRODUCTION
VI.
TIME VALUE OF MONEY
VII.
PROFITABILITY
VIII. ANALYSIS OF ALTERNATIVES

IX.
ANALYSIS OF REPLACEMENTS
X.
INFLATION
XI.
OPTIMIZATION
XII.
PROJECT MANAGEMENT
XIII. BASIC ACCOUNTING

XIV. COST CONTROL
I. INTRODUCTION
DESIGN THE
PLANT
INSTALL THE
PLANT
SELL THE
PRODUCTS
MAKE
PRODUCTION
PROFIT
THE FINAL AIM OF ALL ACTIVITIES IN INDUSTRY IS TO
HAVE REASONABLE PROFIT
WHEN THERE IS NO PROFIT, THERE IS NO INVESTMENT
OR PRODUCTION
* ANY PRODUCT DEVELOPED OR PRODUCED WHICH CANNOT BE
MARKETED AT A PRICE ABOVE ITS COST IS A FAILURE
* ENGINEERS SHOULD NEVER FORGET THAT ECONOMICS IS THE
ONLY GUIDE IN INDUSTRY BECAUSE ALL ENGINEERING
PRACTICES REQUIRE THE USE OF LARGE AMOUNT OF CAPITAL;
AND CAPITAL OWNERS EXPECT MAXIMUM RETURN ON
THEIR CAPITAL INVESTED
THEREFORE
* SELECTION OF ALTERNATIVES TO ALLOCATE CAPITAL
* DETERMINATION OF CAPACITY, PROCESS AND EQUIPMENT
* RUNNING THE PLANT
SHOULD BE QUIDED BY ECONOMIC PRINCIPLES IN INDUSTRY
SO ENGINEERS SHOULD KNOW ENGINEERING ECONOMY
THE LITERATURE ON ENGINEERING ECONOMY STARTED BY
WELLINGTONS THE ECONOMIC THEORY OF LOCATION OF
RAILWAYS IN 1887
IN 1920 : GOLDMAN - FINANCIAL PLANNING
FISH
- ENGINEERING ECONOMICS
IN 1930 : E.L.GRANT (USUALLY CALLED THE FATHER OF
ENGINEERING ECONOMY) PUBLISHED
PRINCIPLES OF ENGINEERING ECONOMY
IN INDUSTRY AN ENGINEER MAY ENCOUNTER QUESTIONS LIKE:
* HOW MUCH MONEY YOU NEED TO MAKE AN INVESTMENT?
* IS THIS INVESTMENT OR PROJECT PROFITABLE OR NOT?
* WITH LIMITED CAPITAL AVAILABLE, WHICH INVESTMENT
ALTERNATIVE SHOULD BE SELECTED?
* WHICH ONE OF SEVERAL COMPETING ENGINEERING
DESIGNS SHOULD BE SELECTED?
* SHOULD THE MACHINE (OR PROCESS) NOW IN USE BE
REPLACED WITH A NEW ONE?
* WOULD IT BE PREFERABLE TO PURSUE A SAFER COURSE OF
ACTION OR TO FOLLOW A RISKIER ONE THAT OFFERS HIGHER
POTENTIAL RETURNS?
* HOW MANY UNITS OF PRODUCT HAVE TO BE SOLD BEFORE A
PROFIT CAN BE MADE?
* SHOULD A PLANT PRODUCE A PART IN ITS OWN FACILITY, KNOWING
THAT INVESTMENT WILL BE NEEDED, OR SHOULD
THE PLANT
SUBCONTRACT (MAKE OR BUY) ?
ENGINEERS SHOULD BE ABLE FIND THE CORRECT ANSWERS TO

THESE QUESTIONS
THE CORE OF ENGINEERING ECONOMICS IS DECISION
MAKING BASED ON COMPARISONS OF THE WORTH OF
ALTERNATIVE COURSES OF ACTION WITH RECPECT TO
THEIR COSTS
IN THIS COURSE WE WILL STUDY THE ECONOMIC
PRINCIPLES THAT IS USED FOR DESIGNING PLANTS OR
PROCESSES IN INDUSTRY AND GUIDE THE ENGINEERS
IN THEIR DECISIONS.
EFFICIENCY
THE OBJECTIVE OF ENGINEERING IS TO GET THE GREATEST END
RESULT PER UNIT OF RESOURCE EXPENDITUTE.
ENGINEER MUST BE CONCERNED WITH TWO LEVELS OF EFFICIENCY.
ON THE FIRST LEVEL IS PHYSICAL EFFICIENCY EXPRESSED AS
OUTPUT DIVIDED BY INPUTS OF SUCH PHYSICAL UNITS AS BTUS,
KILOWATTS OR KG.
PHYSICAL EFFICIENCY = OUTPUT / INPUT
THIS KIND OF EFFICIENCY IS ALWAYS LESS THAN UNITY.
ON THE SECOND LEVEL ARE ECONOMIC EFFICIENCIES. THESE ARE
EXPRESSED IN TERMS OF ECONOMIC UNITS SUCH AS MONEY.
ECONOMIC EFFICIENCY = WORTH / COST
ECONOMIC EFFICIENCIES CAN EXCEED UNITY AND MUST DO SO FOR
ECONOMIC PROJECTS TO BE SUCCESSFUL.
II. PLANT DESIGN PROCESS

DETERMINATION OF THE PROCESS AND CAPACITIES, SIZES AND
KINDS OF PROCESS EQUIPMENT TO BE USED BEFORE THE
CONSTRUCTION AND OPERATION OF A PLANT IS CALLED
PROCESS DESIGN
DEVELOPMENT OF A NEW PLANT OR PROCESS FROM CONCEPT
EVALUATION TO PROFITABLE REALITY IS OFTEN AN
ENORMOUSLY COMPLEX PROBLEM. A PLANT DESIGN PROJECT
MOVES TO COMPLETION THROUGH A SERIES OF STAGES:
1. INSPECTION OF THE BASIC IDEA AND INITIAL ANALYSIS
2. MARKET SURVEY AND PRELIMINARY EVALUATION
3. PROCESS DEVELOPMENT (MAY INCLUDE LAB EXPERIMENT OR
PILOT PLANT)
4. PRELIMINARY DESIGN (INCLUDING THE NECESSARY
INFORMATION TO ESTIMATE THE INVESTMENT AND PRODUCTION
COST WITH A NARROW ERROR MARGIN)
5. FEASIBILITY STUDY AND ECONOMIC EVALUATION

6.
7.
8.
9.
10.
11.
DECISION
DETAILED ENGINEERING DESIGN
PROCUREMENT
ERECTION
START-UP AND TRIAL RUNS
PRODUCTION
AFTER EACH PHASE OF THE DESIGN, AN EVALUATION SHOULD BE

MADE AND ENGINEERS SHOULD BE REALISTIC AND PRACTICAL;
SHOULD ELIMINATE UNPROFITABLE VENTURES BEFORE THE
DESIGN PROJECT APPROACHES ITS FINAL STAGES. COST
ESTIMATES SHOULD BE MADE THROUGHOUT ALL THE EARLY
STAGES USING VARIOUS COST ESTIMATION METHODS COVERING
BOTH INVESTMENT COSTS AND PRODUCTION COSTS. DESIGN
ENGINEERS SHOULD KEEP IN MIND THAT THE AIM OF INVESTING
MONEY IS TO HAVE A RETURN COVERING THE TIME VALUE OF
MONEY AND REASONABLE AFTER-TAX PROFIT.

WHEN THERE ARE SEVERAL ALTERNATIVE METHODS WHICH CAN BE
USED FOR OBTAINING THE SAME RESULTS, THE PREFERRED
METHOD SHOULD BE THE ONE INVOLVING THE LEAST TOTAL
COSTS. THIS IS CALLED OPTIMUM DESIGN.
AN IMPORTANT STAGE IN THE DESIGN PROCESS IS THE FEASIBILITY
STUDY WHICH LEADS TO FINAL DECISION.
FEASIBILITY STUDY SHOULD CONTAIN:
1. MARKET SURVEY (PRESENT AND FUTURE DEMAND AND SUPPLY,
NEW USES, PRICE RANGE OF PRODUCTS, CONSUMER
CHARACTERISTICS)
2. COMPETITION (PRODUCTS,PROCESSES AND PRICES OF
COMPETITORS)
3. PRODUCTION METHOD (PRELIMINARY DESIGN)
4. PLANT LOCATION AND LAYOUT
5. TECHNOLOGY AND PATENT SITUATIONS

6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
ORGANIZATION AND LABOR REQUIREMENTS

RAW MATERIALS (COST AND AVAILABILITY)
WASTE DISPOSAL AND SAFETY/SECURITY CONSIDERATIONS
STORING, PACKAGING, SHIPPING REQUIREMENTS
FACILITIES AND EQUIPMENT THAT SHOULD BE BUILT OR
PURCHASED ( INCLUDING LAND, BUILDINGS, UTILITIES,
SERVICES, ADMINISTRATIVE FACILITIES, PRODUCTION AND TEST
EQUIPMENT)
SALES METHODS AND REQUIREMENTS
INVESTMENT COST
PRODUCTION COST
FINANCIAL ANALYSIS
PROFIT AND RETURN ON INVESTMENT
IMPLEMENTATION PLAN
EXECUTIVE SUMMARY
III. GENERAL CONSIDERATIONS
1. PLANT LOCATION
THE PLANT SHOULD BE LOCATED WHERE THE MINIMUM TOTAL
COST OF PRODUCTION AND DISTRIBUTION CAN BE OBTAINED.
FIRST GENARAL LOCATION THEN EXACT SITE SHOULD BE
DETERMINED. YOU SHOULD CONSIDER:
* RAW MATERIALS ( AVAILABILITY, PURITY, PRICE,
TRANSPORTATION EXPENSE)
* MARKET ANALYSIS
* POWER AND FUEL (AVAILIBILITY, PRICE)
* LAND PRICE, SOIL STRUCTURE, EXPANSION FACTOR
* CLIMATE, NATURAL EVENTS (FLOOD,EARTQUAKE), WATER
SUPPLY
* TRANSPORTATION FACILITIES
* WASTE DISPOSAL SITUATION
* LABOR (AVAILABILITY, COST, COMPETITION)
* TAX BENEFITS
* COMMUNITY FACTOR (LIVING CONDITIONS, SOCIAL FACILITIES)
2. PLANT LAYOUT
BESIDES THE BASIC PROCESS, YOU SHOULD CONSIDER:
* MINIMUM MATERIAL FLOW
* OPERATIONAL CONVENIENCE
* UTILITIES, SERVICES, ADMINISTRATIVE FACILITIES
* HEALTH, SAFETY, FIRE PROTECTION
* WASTE DISPOSAL
* STORAGE
* TRANSPORTATION
* SECURITY
3. INSTRUMENTATION
A QUALITY PLAN SHOULD BE MADE; APPLYING QUALITY
ASSURANCE, MINIMIZING THE CONTROLS.
THE LABORATORIES AND KIND OF EQUIPMENT TO BE USED FOR
QUALITY ASSURANCE SHOULD BE DECIDED BEFORE FINAL
DESIGN
USE BUILT-IN-TESTERS WHERE POSSIBLE
4. MAINTENANCE
MAINTENANCE REQUIREMENTS AND PLANS SHOULD BE
CONSIDERED BEFORE LAYOUT AND COST CALCULATION
TOTAL PRODUCTIVE MAINTENANCE (TPM) SHOULD BE APPLIED
5. UTILITIES
ELECTRICITY, FUEL AND WATER ARE MAJOR COST ITEMS IN MOST
CHEMICAL INDUSTRIES. THE SUPPLY METHODS, ALTERNATIVES
AND NECESSARY FACILITIES (PIPING, STORAGE
TANKS,GENERATORS) SHOULD BE CONSIDERED DURING DESIGN
6. STRUCTURAL DESIGN
FOUNDATION DESIGN IS ESPECIALLY IMPORTANT FOR HEAVY AND
VIBRATING EQUIPMENT. FLOORS SHOULD BE DESIGNED TO BE
RESISTANT TO CHEMICALS, EASY TO CLEAN AND SAFE.
CORROSIVE EFFECTS SHOULD BE CONSIDERED WHEN
CHOOSING CONSTRUCTION MATERIAL
7. STORAGE
STORAGE SPACE, PROPER EQUIPMENT FOR GASES AND LIQUIDS
AND SAFETY IS IMPORTANT
8. MATERIALS HANDLING
IMPORTANT COST IN CHEMICAL INDUSTRY. PUMPS, BLOWERS,
PIPES, DUCTS ARE USED FOR LIQUIDS AND GASES; ELEVATORS,
TRUCKS AND PNEUMATIC SYSTEMS ARE USED FOR SOLIDS.
PROPER EQUIPMENT SHOULD BE CHOSEN CONSIDERING
PROPERTIES OF MATERIALS, TYPE AND DISTANCE OF MOVEMENT
AND COST
9. WASTE DISPOSAL - AIR POLLUTION
IMPORTANT COST IN CHEMICAL INDUSTRY. TRY TO ELIMINATE AT
SOURCE OR RECOVER BEFORE WASTE TREATMENT
10. HEALTH AND SAFETY
CAREFULL ANALYSIS SHOULD BE MADE DURING THE DESIGN TO
PREVENT HAZARDOUS ENVIRONMENT OR FIRE AND ACCIDENT
POTENTIALS
11. PATENTS
A NEW DESIGN SHOULD BE EXAMINED TO MAKE CERTAIN NO
PATENT INFRINGEMENTS ARE INVOLVED
IV. CAPITAL INVESTMENT
CASH FLOW
TAX
GROSS
SALES
NET PROFIT + DEPRECIATION

PROFIT
OPERATIONS
WORKING
EXPENSES
CAPITAL
FIXED CAPITAL
TOTAL CAPITAL
INVESTMENT
REPAYMENTS
DISTIBUTED
PROFIT
CAPITAL SOURCE
AND
SINK
OTHERS
CAPITAL
BONDS
LOANS
CASH FLOW
THE BOX CAPITAL SOURCE IS THE COMPANY TREASURY SERVING AS
RESERVOIR AND SOURCE OF NECESSARY FUNDS. THE INPUTS OF THIS
BOX ARE CAPITAL PAID BY THE STOCKHOLDERS, BONDS SOLD, LOANS
FROM BANKS, NET PROFIT + DEPRECIATION COMING FROM OPERATIONS
AND OTHERS ( SALES OF ASSETS, PROFIT OF OTHER OPERATIONS). THE
OUT GOING MONEY IS THE TOTAL INVESTMENT, BACK PAYMENTS OF
BORROWED MONEY AND PROFIT DISTRIBUTED.
THE BOX OPERATIONS IS THE PRODUCTION, ENGINEERING, MARKETING

ACTIVITIES OF THE COMPANY. INPUT IS WORKING CAPITAL AND SALES.
OUT GOING MONEY IS THE EXPENSES (ALL COSTS EXCEPT
DEPRECIATION) AND GROSS PROFIT. TAX IS PAID FROM THE GROSS
PROFIT AND THE REST (NET PROFIT + DEPRECIATION) GOES TO THE
TREASURY.
CASH POSITION
Cumulative
cash position, $
Land,salvage,working
capital recovery
Cumulative cash position
Construction
period
-2
-1
10
FC Investment
Book value of investment
WC Investment
Years
CASH POSITION
ASSUMING THAT THE CONSTRUCTION STARTS TWO YEARS BEFORE THE
PRODUCTION, CASH POSITION GOES DOWN TO NEGATIVE VALUES AS WE
SPEND FOR THE FIXED INVESTMENT. AT TIME ZERO WE HAVE THE
WORKING CAPITAL AS A NEGATIVE VALUE.
AFTER TIME ZERO, THE CASH POSITION STARTS GOING UP. CUMULATIVE
CASH POSITION = NET PROFIT AFTER TAX + DEPRECIATION TOTAL
CAPITAL INVESTMENT. DEPENDING ON THE PROFIT, CUMULATIVE CASH
POSITION GOES TO POSITIVE VALUES AFTER SEVERAL YEARS.
LAND, SALVAGE VALUE OF THE PLANT AND THE WORKING CAPITAL ARE
RECOVERED AT THE END OF THE PROJECT.
THE DEPRECIATION IS 10 YEAR STRAIGHT- LINE DEPRECIATION.
COST
A PLANT DESIGN MUST PRESENT A PROCESS THAT IS CAPABLE OF
OPERATING UNDER CONDITIONS WHICH YIELD A PROFIT.
SINCE
PROFIT EQUALS INCOME MINUS COSTS, ENGINEERS SHOULD BE
AWARE OF ALL TYPES OF COSTS INVOLVED IN THE INDUSTRY.
IN AN ANALYSIS OF COSTS IN INDUSTRIAL PROCESSES,
* CAPITAL INVESTMENT COST AND
* PRODUCTION COST
MUST BE TAKEN INTO CONSIDERATION
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, EQUIPMENT AND
BUILDINGS. AN ADDITIONAL AMOUNT OF MONEY IS REQUIRED TO
START THE PRODUCTION. THE SUM OF ALL THESE AMOUNTS IS
CALLED TOTAL CAPITAL INVESTMENT.
TOTAL CAPITAL INVESTMENT HAS TWO COMPONENTS:
* FIXED CAPITAL INVESTMENT
COVERS LAND, BUILDINGS, UTILITIES, PROCESS AND CONTROL
EQUIPMENT AND INSTALLATION
* WORKING CAPITAL
COVERS THE EXPENSES NECESSARY FOR THE OPERATION OF
THE PLANT
CAPITAL INVESTMENT
BREAKDOWN OF FIXED CAPITAL INVESTMENT
DIRECT COSTS
1. PURCHASED EQUIPMENT
2. PURCHASED EQUIPMENT INSTALLATION
3. INSTRUMENTATION AND CONTROLS
4. PIPING
5. INSULATION
6. ELECTRICAL
7. BUILDINGS
8. YARD IMPROVEMENTS
9. UTILITIES
10. SERVICE FACILITIES
11. LAND
INDIRECT COSTS
12. ENGINEERING AND SUPERVISION
13. CONTRACTORS FEE
14. CONTINGENCY
15. OTHER COSTS (START - UP, DISTRIBUTION, R& D, LICENSE)
CAPITAL INVESTMENT
AN ESTIMATE OF THE CAPITAL INVESTMENT FOR A PROCESS MAY
VARY FROM A PREDESIGN ESTIMATE BASED ON LITTLE
INFORMATION (+/- 30%) TO A DETAILED ESTIMATE PREPARED
FROM COMPLETE DRAWINGS AND SPECIFICATIONS (+/- 5%).
PREDESIGN COST ESTIMATES ARE EXTREMELY IMPORTANT FOR
DETERMINING IF A PROPOSED PROJECT SHOULD BE GIVEN
FURTHER CONSIDERATION AND TO COMPARE ALTERNATIVE
DESIGNS.
EQUIPMENT COST ESTIMATES ARE USUALLY THE FIRST STEP FOR
MORE DETAILED PLANT COST ESTIMATES. ONCE THE EQUIPMENT
COST IS DETERMINED, THE OTHER COST ITEMS OF THE PLANT
CAN BE ESTIMATED USING PERCENTAGES AND PREVIOUS DATA.
CAPITAL INVESTMENT
PLANT COST ESTIMATION ITEMS:
1. PURCHASED EQUIPMENT COST (PEC) ESTIMATION
EQUIPMENT COST IS USUALLY 20-30% OF THE TOTAL PLANT COST
IN CHEMICAL INDUSTRIES AND IS EITHER FOUND BY QUOTATIONS
OR BY USING CHARTS.
A. MANUFACTURERS QUOTATIONS
ACCURATE AND PREFERABLE METHOD; BESIDES PRICE,
USEFULL TECHNICAL INFORMATION CAN BE OBTAINED BUT
NEEDS TIME AND AUTHORIZATION AND DESIGN DETAILES MAY BE
REQUIRED BY EQUIPMENT MANUFACTURERS.
B. LITERATURE - ESTIMATING CHARTS
* PRICE CHARTS FOR DIFFERENT PROCESS EQUIPMENT IS
AVAILABLE IN LITERATURE AS PRICE vs CAPACITY. THESE ARE
ROUGH COST ESTIMATES
CAPITAL INVESTMENT
EQUIPMENT COST DATA ARE CORRELATED ON LOG-LOG
PLOTS AS FUNCTIONS OF EQUIPMENT SIZE PARAMETER
(HEAT TRANSFER AREA FOR HEAT EXCHANGERS, WORKING
CAPACITY FOR MIXERS).
OVER A LIMITED RANGE OF SIZES THE LOG-LOG CURVE CAN
BE APPROXIMATED BY A STRAIGHT LINE, WHICH IS
EQUIVALENT TO THE EQUATION
C2 / C1 = (S2 / S1)n
WHERE C IS COST, S IS SIZE AND n IS SLOPE ON THE
LOG-LOG PLOT. THE VALUE OF n IS FREQUENTLY AROUND
0.6 0R 0.7 FOR MANY TYPES OF EQUIPMENT.
CAPITAL INVESTMENT
IF WE ASSUME THAT n = 0.6 THAN THE RELATION BECOMES:
C2 / C1 = (S2 / S1)0.6
C2 = C1 (S2 / S1)0.6
WHICH IS REFERRED AS SIX-TENTHS-RULE.
EXAMPLE: USE THE SIX-TENTHS-RULE TO ESTIMATE THE %
INCREASE IN PURCHASED COST WHEN THE CAPACITY OF A PIECE
OF EQUIPMENT IS DOUBLED.
C2 = C1 (S2 / S1)0.6
C2 = C1 (2 / 1)0.6
C2 = 1.52 C1
THIS SIMPLE EXAMPLE SHOWS THAT WHEN YOU DOUBLE THE
CAPACITY, THE COSTS OF EQUIPMENT INCREASES ONLY 52%.
SO WE CAN STATE : THE LARGER THE EQUIPMENT, THE LOWER
THE COST OF EQUIPMENT PER UNIT OF CAPACITY.
WHEN ESTIMATING THE COST OF A SINGLE EQUIPMENT IT IS SAFER
TO USE SPECIFIC COST EXPONENTS; THE SIX-TENTH-RULE MAY
BE USED MORE RELIABLY FOR A TOTAL PROCESS.
CAPITAL INVESTMENT
ANY COST DATA REFER TO A PARTICULAR YEAR AND IT IS
NECESSARY TO KNOW THIS YEAR BEFORE THE DATA ARE USED.
SINCE COSTS CHANGE WITH TIME, PUBLISHED COST DATA MUST
BE CORRECTED TO THE PRESENT YEAR. THIS IS ACCOMPLISHED
WITH COST INDICES USING THE RELATION
Cost in year m
Cost in year n
Index value for year m

Index value for year n
EQUIPMENT COST INDEX IS PUBLISHED MONTHLY IN

Chemical Engineering. INDEX VALUES ARE GIVEN FOR VARIOUS
CATEGORIES OF EQUIPMENT (HEAT EXCHANGERS, PROCESS
MACHINERY, PIPES ), CONSTRUCTION LABOR, BUILDINGS,
ENGINEERING AS WELL AS COMPOSITE PLANT COST INDEX
(CEPCI).
CAPITAL INVESTMENT
EXAMPLE: THE CAPITAL COST OF A 30,000 TONS/YEAR
ISOPROPONAL PLANT IN 1986 WAS ESTIMATED TO BE $7 MILLION.
ESTIMATE THE CAPITAL COST OF A NEW PLANT WITH A
PRODUCTION RATE OF 50,000 TONS/YEAR IN 2004.
COST IN 2004 = (COST IN 1986) (CAPACITY COR.) (INFLATION COR.)
THE CEPCI IS 318 FOR YEAR 1986 AND 442 FOR YEAR 2004
COST IN 2004 = $7,000,000 ( 50/30)0.6 (442/318) = $13,223,000
EXAMPLE :ASSUME A PUMP (4 hp) WAS BOUGHT FOR $1000 EIGHT
YEARS AGO AND YOU WILL BUY A NEW PUMP (6 hp) NOW.
EXPONENT FOR SIZE OF PUMPS = 0.61
COST INDEX NOW : 580
COST INDEX 8 YEARS AGO: 520
COST OF THE NEW PUMP = (1000)(580/520) (6/4)0.61 = $1428
CAPITAL INVESTMENT
THE DATA IN LITERATURE IS USUALLY FOR EQUIPMENT MADE FROM
MOST COMMON MATERIAL AND USED IN AMBIENT PRESSURE. THE
EFFECT OF BETTER MATERIAL AND HIGHER PRESSURES ON THE
COST OF THE EQUIPMENT SHOULD BE FOUND AND NECESSARY
CORRECTIONS SHOULD BE MADE.
THE COSTS FOUND THROUGH QUOTATIONS OR LITERATURE

ARE USUALLY THE PRICE OF THE EQUIPMENT.
ALL ADDITIONAL COSTS NECESSARY TO BRING THE
EQUIPMENT TO THE FACTORY SITE SHOULD BE ADDED.
FOB OR EX-WORKS PRICE
FREIGHT CHARGES (DEPENDS ON DISTANCE VEHICLE)
INSURANCE
ANY OTHER CHARGES ( SPECIAL PACKING, DOCUMENT,
TRAINING)
TOTAL CIF(ANKARA) PRICE
CAPITAL INVESTMENT
2. INSTALLATION COST OF EQUIPMENT
THE INSTALLATION OF EQUIPMENT INVOLVES COSTS FOR LABOR,
FOUNDATIONS,SUPPORTS, PLATFORMS, CONSTRUCTION
EXPENSES AND OTHER FACTORS DIRECTLY RELATED TO THE
ERECTION OF PURCHASED EQUIPMENT. IT IS ESTIMATED TO
VARY FROM 30 TO 45% OF THE PEC
3. INSTRUMENTATION AND CONTROL
TOTAL INSTRUMENTATION COST DEPENDS ON THE AMOUNT OF
CONTROL REQUIRED (QUALITY PLAN OF THE COMPANY) AND
MAY AMOUNT TO 6-30 % OF THE PEC
CAPITAL INVESTMENT
4. PIPING
ONE OF THE IMPORTANT COSTS IN CHEMICAL INDUSTRIES.
IT COVERS VALVES, FITTINGS, PIPES, SUPPORTS AND LABOR OF
PIPING USED FOR RAW MATERIALS, INTERMEDIATE PRODUCTS,
PRODUCTS, STEAM, WASTE, AIR. IT IS 15 70 % OF PEC.
5. INSULATION COST
WHEN HIGH OR LOW TEMPERATURES ARE INVOLVED, INSULATION
COST IS IMPORTANT. INCREASING ENERGY COSTS MAKE
INSULATION MORE IMPORTANT. IT IS 2 8% OF PEC.
6. ELECTRICAL INSTALLATIONS
POWER WIRING, LIGHTING, TRANSFORMATION,
INSTRUMENTCONTROL WIRING ARE THE MAIN COSTS,
ADDING UP TO 10
15%OF PEC
7. BUILDINGS
40 70% OF PEC INCLUDING ADMINISTRATIVE SERVICES, LABS,
WAREHOUSES, SOCIAL BUILDINGS, MAINTENANCE FACILITIES
CAPITAL INVESTMENT
8. YARD IMPROVEMENTS
LANDSCAPING, FENCING, ROADS, SIDEWALKS, PARKING.
ABOUT 10 15% OF PEC
9. UTILITIES
INCLUDE GENERAL SERVICES REQUIRED TO OPERATE THE
PLANT SUCH AS WATER, FUEL, STEAM, ELECTRICITY, FIRE
PROTECTION, COMPRESSED AIR, EMERGENCY GENERATOR,
TELEPHONE AND WASTE DISPOSAL. 30 60% OF PEC
10. SERVICE FACILITIES
OFFICE FURNITURE, CAFETERIA EQUIPMENT, SAFETY AND
MEDICAL EQUIPMENT, HOUSE KEEPING EQUIPMENT, MATERIAL
HANDLING AND PACKAGING EQUIPMENT. 20 40% OF PEC
11. LAND
4 8% OF PEC
12. ENGINEERING AND SUPERVISION
COSTS FOR CONSTRUCTION DESIGN, DRAFTING, PURCHASING,
ENGINEERING AND SUPERVISION. ABOUT 35% OF PEC
CAPITAL INVESTMENT
13. CONSTRUCTION EXPENCES
THE COST OF TEMPORARY FACILITIES, ROADS, OFFICES USED
DURING CONSTRUCTION, CONSTRUCTION TOOLS, SECURITY
EXPENCES. UP TO 30% OF PEC
14. CONTRACTORS FEE
VARIES BETWEEN 2 6% OF FIXED CAPITAL INVESTMENT
15. CONTINGENCY
UNPREDICTABLE COSTS. 5 10% OF FIXED CAPITAL INVESTMENT
16. OTHER COSTS
COSTS FOR PLANT START-UP (TRIALS, CHANGES), OFF-SITE
FACILITIES LIKE DISTRIBUTION CENTERS AND OFFICES,
RESEARCH AND DEVELOPMENT DEPARTMENTS, LICENSE FEES
ARE THE OTHER COSTS THAT SHOULD BE CONSIDERED
CAPITAL INVESTMENT
METHODS FOR ESTIMATING FIXED CAPITAL INVESTMENT
THERE ARE DIFFERENT METHODS THAT CAN BE USED.
IN DECREASING DETAIL, PREPARATION TIME AND ACCURACY
THEY CAN BE SUMMARIZED AS:
METHOD A DETAILED ITEM ESTIMATE
ALL ITEMS ARE DESIGNED AND DETERMINED ACCURATELY; SITE
SURVEYS ARE MADE, QUOTATIONS FOR EQUIPMENT AND
SERVICES ARE OBTAINED, ALL ITEMS ARE SPECIFIED FOR
PRICING INCLUDING LABOR.
VERY TIME CONSUMING AND EXPENSIVE WORK.
USUALLY DONE AT THE FINAL STAGE OR BY THE CONTRACTORS
FOR QUOTING. +/- 5% ACCURACY CAN BE OBTAINED
CAPITAL INVESTMENT
METHOD B: MODULE COSTING TECHNIQUE
FIND THE BASE CASE COST (C0P) OF EACH EQUIPMENT FROM
LITERATURE. BASE CASE MEANS, EQUIPMENT MADE OF THE
MOST COMMON MATERIAL (USUALLY CARBON STEEL) AND
OPERATING AT NEAR AMBIENT PRESSURE.
FIND THE BARE MODULE FACTOR (F0BM) WHICH IS THE
MULTIPLICATION FACTOR TO ACCOUNT FOR OTHER ASSOCIATED
COSTS (PIPING, INSULATION, FOUNDATIONS, SUPPORTS,
INSTRUMENTATION AND ELECTRICAL, LABOR FOR INSTALLATION,
TRANSPORTATION, ENGINEERING AND PROJECT MANAGEMENT).
NOW YOU CAN CALCULATE BARE MODULE COST AT BASE
CONDITIONS FOR EACH EQUIPMENT:
C0BM = C0P F0BM
CAPITAL INVESTMENT
FOR EQUIPMENT MADE FROM OTHER MATERIALS OF
COSTRUCTION ( STAINLESS STEEL, ALUMINUM, TITANIUM )
AND/ OR OPERATING AT NONAMBIENT PRESSURE, YOU SHOULD
MAKE THE NECESSARY CORRECTIONS.
FIND FBM WHICH IS THE MULTIPLICATION FACTOR TO ACCOUNT
FOR ASSOCIATED COSTS PLUS THE SPECIFIC MATERIALS OF
CONSTRUCTION AND OPERATING PRESSURE. THIS IS FOUND
FROM LITERATURE. THE BARE MODULE EQUIPMENT COST CAN
NOW BE CALCULATED:
CBM = C0P FBM
CAPITAL INVESTMENT
EXAMPLE: FIND THE BARE MODULE COST OF A FLOATING-HEAD
SHELL-AND-TUBE HEAT EXCHANGER WITH A HEAT TRANSFER
AREA OF 100 m2. THE OPERATING PRESSURE IS 100 barg AND
MATERIAL OF CONTRUCTION IS STAINLESS STEEL.
C0P = 250 $/ m2 x 100 m2 = $ 25,000 ; YEAR 2001 (Turton, Appendix A)
FBM = B1 + B2FMFP = 1.63 + 1.66 (2.73) (1.383) = 7.9
ALL THE CONSTANTS ARE FOUND FROM Turton, Appendix A
CBM = C0P x FBM = 25,000 x 7.9 = $197,500
197,500 x 468 / 397 = $232,821 AT YEAR 2005, FEBRUARY
CAPITAL INVESTMENT
WHEN FINDING THE TOTAL COST OF AN ALTERATION OR A NEW
PLANT YOU SHOULD CONSIDER THE ADDITIONAL COSTS.
TOTAL MODULE COST(CTM) : THE COST OF MAKING EXPANSIONS OR
ALTERATIONS TO AN EXISTING PLANT. YOU SHOULD ADD
CONTRACTORS FEE AND CONTINCENCY (18%):
CTM = 1.18 CBM, i
WHERE CBM IS THE BARE MODULE COST OF EACH EQUIPMENT
USED IN THE ALTERATION AND i = 1 TO n.
GRASS ROOTS COST(CGR) : THE COST OF MAKING A NEW FACILITY.
YOU SHOULD ADD LAND, YARD IMPROVEMENT, UTULITIES,
ADMINISTRATIVE AND SERVICE FACILITIES AND BUILDINGS. THESE
ARE GENERALLY UNEFFECTED BY MATERIAL OR PRESSURE AND
IS TAKEN AS 50% OF C0BM
CGR = CTM + 0.50 C0BM, i
WHERE C0BM IS THE BARE MODULE COST OF EACH EQUIPMENT AT
BASE CONDITIONS USED IN THE NEW PLANT AND i = 1 TO n.
CAPITAL INVESTMENT
METHOD C PERCENTAGE OF PURCHASED EQUIPMENT COST
DETERMINE THE PURCHASED EQUIPMENT COST. ALL OTHER
ITEMS ARE THEN ESTIMATED AS PERCENTAGE OF PEC.
THERE IS DATA AVAILABLE FOR AVERAGE PERCENTAGE VALUES
FOR DIFFERENT TYPES OF INDUSTRIES
METHOD D LANG FACTORS FOR APPROXIMATION
MULTIPLY PEC BY A FACTOR TO OBTAIN TOTAL INVESTMENT COST
(USUALLY 4 6). GREATER ACCURACY IS OBTAINED BY USING
MORE THAN ONE FACTOR, DIFFERENT FACTORS FOR DIFFERENT
KINDS OF EQUIPMENT (4 FOR PUMPS, 3.5 FOR HEAT
EXCHANGERS)
METHOD E POWER FACTOR
THE CAPITAL INVESTMENT OF A NEW PLANT CAN BE FOUND BY
GETTING THE EXPONENTIAL POWER OF A SIMILAR PREVIOUS
PLANT INVESTMENT. Cn = C (R)X
R: CAPACITY RATIO, C: CAPITAL INVESTMENT
FOR X THERE IS DATA FOR DIFFERENT INDUSTRIES;
IN AVARAGE IT IS 0.6- 0.8
n
n
CAPITAL INVESTMENT
METHOD F COST PER UNIT OF CAPACITY
THERE IS DATA GIVING THE FIXED CAPITAL INVESTMENT REQUIRED
PER ANNUAL TON OF A PRODUCT
METHOD G TURNOVER RATIO
FIXED CAPITAL INVESTMENT =
ANNUAL SALES / TURNOVER RATIO
TURNOVER RATIO IS BETWEEN 0.4 3 IN GENERAL.
FOR CHEMICAL INDUSTRIES IT IS ABOUT 0.5
CAPITAL INVESTMENT
WORKING CAPITAL (WC)
EVERY PLANT HAS A REQUIREMENT FOR A CERTAIN AMOUNT OF
CAPITAL TO BE AVAILABLE TO PAY THE BILLS AND SUSTAIN THE
OPERATION BEFORE THE PRODUCT IS SOLD AND PAYMENT IS
RECEIVED.
WORKING CAPITAL CONSISTS OF
* RAW MATERIALS AND SUPPLIES CARRIED IN STOCK
* SEMIFINISHED PRODUCTS IN THE PROCESS
* FINISHED PRODUCTS NOT SOLD YET
* ACCOUNTS RECEIVABLE
* CASH REQUIRED FOR WAGES,TAXES AND ALL OTHER EXPENSES
CAPITAL INVESTMENT
FOR MOST CHEMICAL PLANTS WORKING CAPITAL IS ABOUT
10 20% OF TOTAL CAPITAL INVESTMENT.
A MUCH MORE RELEVANT METHOD OF ESTIMATING WORKING

CAPITAL IS TAKING A FRACTION OF THE YEARLY PRODUCTION
COST AND IT MAY TYPICALLY BE 20 35% OF THE YEARLY
OPERATING COSTS.
WC = (ANNUAL PRODUCTION COST / 12) (TOTAL LEAD TIME IN

MONTHS)
CAPITAL INVESTMENT
WE NEED THE WORKING CAPITAL ONLY IN THE BEGINNING OF
PRODUCTION SINCE WE ASSUME NO INFLATION, NO INCREASE OF
CAPACITY AND NO PROBLEM IN SELLING WHAT WE PRODUCE
IN INDUSTRY IT IS IMPORTANT TO DECREASE THE WORKING CAPITAL
REQUIREMENT SINCE FINANCIAL COSTS INCREAE WITH
INCREASING WORKING CAPITAL
JUST IN TIME OPERATING METHODS AND GOOD PLANNING MAY BE
EFFECTIVE IN DECREASING THE WORKING CAPITAL
V. PRODUCT COST
ECONOMIC PRODUCTION
PRODUCT COST
CONSISTS OF MANUFACTURING COSTS AND GENERAL EXPENSES.
PRODUCT COST SHOULD BE ESTIMATED DURING DESIGN PHASE IN
ORDER TO CALCULATE RETURN ON INVESTMENT AND
PROFITABILITY AND DECIDE ON ALTERNATIVES. DURING THE
PRODUCTION PHASE, PRODUCT COST SHOULD BE CALCULATED
AND CONTROLLED CONTINUOUSLY SINCE COST IS ONE OF THE
MAIN FACTORS DETERMINING THE SUCCESS OF AN INDUSTRY.
PRODUCT COST
MANUFACTURING COST
1. RAW MATERIALS
2. OPERATION AND SUPERVISION LABOR
3. UTILITIES
4. MAINTENANCE AND REPAIR
5. OPERATING SUPPLIES, LABORATORY CHARGES
6. PATENTS AND ROYALTIES
PRODUCT COST
7.
8.
9.
10.
11.
PLANT OVERHEAD COSTS

RENT
INSURANCE
PROPERTY TAXES AND OTHER DUTIES
DEPRECIATION
GENERAL EXPENSES
12. ADMINISTRATIVE EXPENSES
13. DISTRIBUTION AND MARKETING COSTS
14. RESEARCH AND DEVELOPMENT COSTS
15. FINANCING COSTS
OTHER
16. CONTINGENCIES
PRODUCT COST
PRODUCT COST ITEMS
1. RAW MATERIALS: AMOUNT OF MATERIALS USED IN THE PLANT
SHOULD BE FOUND FROM PROCESS FLOW DIAGRAMS. WHEN
CONVERTING HOURLY RATES TO YEARLY CONSUMPTION, THE
FRACTION OF TIME THAT THE PLANT IS OPERATING IN A YEAR
MUST BE KNOWN (CALLED STREAM FACTOR,SF, WHICH IS DAYS
OF OPERATION / 365 AND IS MOSTLY LESS THEN 0.9). YOU
SHOULD ALSO CONSIDER SCRAPS, LOSES AND INEFFICIENCIES.
BESIDES THE MAIN MATERIALS, TREATING AGENTS, CATALYSTS
AND FILTER AIDS SHOULD BE CALCULATED.
PRICE FOR MATERIALS CAN BE FOUND FROM LITERATURE OR
QUOTATIONS. YOU SHOULD ADD ALL EXPENSES TO THE
FACTORY: INSURANCE, TRANSPORTATION AND OTHER COSTS.
SINCE THE LARGEST OPERATING COST IS NEARLY ALWAYS THE
COST OF RAW MATERIALS IN CHEMICAL PLANTS, IT IS
IMPORTANT TO FIND CORRECT MATERIAL COSTS IN ORDER TO
MAKE REALISTIC EVALUATIONS.
PRODUCT COST
2. OPERATION AND SUPERVISION LABOR
NUMBER OF PEOPLE (SKILLED AND UNSKILLED) REQUIRED FOR
MANUFACTURING SHOULD BE CALCULATED.
LABOR REQUIREMENT FOR DIFFERENT PROCESSES CAN BE
FOUND FROM LITERATURE. WHEN CALCULATING TOTAL NUMBER
OF OPERATORS YOU SHOULD KNOW NUMBER OF SHIFTS AND
WORKING HOURS. MOST CHEMICAL PLANTS WORK 24 HOURS A
DAY AND 365 DAYS A YEAR.
ONE WORKER: 48 WEEKS/YEAR x 5 DAYS/WEEK x 8 HOURS/DAY
: 1920 HOURS/ YEAR
365 DAYS/YEAR x 24 HOURS/DAY = 8760 HOURS/YEAR
8760 / 1920 = 4.56
THAT MEANS FOR SUCH A PLANT 4.56 OPERATORS SHOULD BE
HIRED FOR EACH OPERATOR NEEDED.
PRODUCT COST
BESIDES THE OPERATING LABOR YOU NEED SUPPORT AND
SUPERVISORY STAFF (TECHNICIANS, ENGINEERS) IN THE
MANUFACTURING PROCESS. THE AMOUNT OF SUCH PEOPLE FOR
EACH SHIFT SHOULD BE FOUND FROM LITERATURE OR PREVIOUS
EXPERIENCES.
TO ESTIMATE THE COST FOR LABOR, AVERAGE WAGE RATES ARE
REQUIRED. THE AVERAGE NET WAGES MAY SHOW SIGNIFICANT
VARIATIONS DEPENDING ON PLANT LOCATION AND TYPE OF
WORK. BUT WHEN CALCULATING THE COSTS YOU SHOULD
ALWAYS CONSIDER ADDITIONAL EXPENSES ON THE NET WAGE.
COST TO COMPANY = (NET WAGE)+(TAX)+(SOCIAL SECURITY)+(OTHERS)
IN AVERAGE YOU CAN USE THE FOLLOWING FIGURES:

COST TO COMPANY = (NET WAGE)(1+ 0.20 + 0.40 + 0.10)
COST TO COMPANY = (NET WAGE)(1.70)
PRODUCT COST
3.UTILITIES: THE COST OF ELECTRICITY, FUEL, WATER, STEAM,
COMPRESSED AIR AND WASTE TREATMENT IN CHEMICAL
INDUSTRIES IS A CONSIDERABLE PERCENTAGE OF THE PRODUCT
COST.
MOST OF THE UTILITIES COST IS INFLUENCED BY THE COST OF
FUEL. IN TURKEY, COAL AND NATURAL GAS ARE THE CHEAPEST,
BUT COAL HAS HANDLING AND ENVIRONMENTAL PROBLEMS AND
NATURAL GAS MAY NOT BE AVALIABLE. LPG AND FUEL OIL ARE
THE OTHER (MORE EXPENSIVE) ALTERNATIVES.
THERE ARE LOCAL RATES FOR FUEL, ELECTRICITY AND WATER
WHICH CAN BE FOUND FROM RELATED ORGANIZATIONS. THE
COSTS FOR STEAM, COMPRESSED AIR, COOLING WATER AND
WASTE TREATMENT CAN BE CALCULATED OR FOUND FROM
LITERATURE.
PRODUCT COST
4. MAINTENANCE AND REPAIRS: DEPENDS ON THE QUALITY OF
EQUIPMENT INVESTED AT THE BEGINNING AND INCREASES AS
THE PLANT GETS OLDER. 2 10% OF FIXED CAPITAL COST
5. OPERATING SUPPLIES, LABORATORY CHARGES: MATERIAL
WHICH IS NOT LISTED SEPARATELY BUT NEEDED FOR
PRODUCTION (LUBRICANTS, TEST CHEMICALS) ARE
OPERATING SUPPLIES. LABORATORY CHARGES INCLUDE
QUALITY CONTROL FUNCTIONS FOR INCOMING INSPECTION,
PRODUCTION CONTROL AND FINAL PRODUCT CONTROL. CAN BE
ESTIMATED AS 10 20% OF OPERATING LABOR
6. PATENTS AND ROYALTIES: EITHER TO PAY A SET AMOUNT OF
PATENT RIGHTS OR A ROYALTY ON THE QUANTITY PRODUCED OR
SOLD MAY BE REQUIRED. SHOULD BE CALCULATED
CASE BY
CASE.
7. PLANT OVERHEAD COSTS: INCLUDE COSTS FOR MEDICAL CARE,
GENERAL ENGINEERING, SAFETY, SECURITY, CAFETERIA,
CLEANING, STORAGE, PACKAGING ETC. CAN BE CALCULATED
ITEM BY ITEM IF DATA IS AVAILABLE OR ESTIMATED AS 10 15%
OF TOTAL PRODUCT COST
PRODUCT COST
8. RENT: IF THERE IS RENTED LAND OR BUILDINGS
9. INSURANCE: THE FACILITIES AND ALL MATERIAL AND PRODUCTS
IN THE INVENTORY SHOULD BE INSURED. AVARAGE %1 ANNUALY
OF INSURED VALUE
10. PROPERTY TAXES AND OTHER DUTIES: SHOULD BE
CALCULATED LOCALLY
11. DEPRECIATION: MEANS OF DISTRIBUTING THE ORIGINAL
EXPENSE FOR A PHYSICAL ASSET OVER THE PERIOD DURING
WHICH THE ASSET IS IN USE.
IN COMPUTING INCOME TAX ON THE PROFIT, GOVERNMENT
ALLOWS A DEDUCTION FOR A FRACTION OF THE INITIAL COST OF
THE PLANT AS A HYPOTHETICAL EXPENSE TO BE SUBTRACTED
FROM THE GROSS PROFIT. THIS DEDUCTION, CALLED
DEPRECIATION, MAY BE CONSIDERED AS A FUND TO ALLOW
EVENTUAL REPLACEMENT OF THE PLANT.
YOU CAN DEPRECIATE ALL FIXED INVESTMENT EXCEPT LAND
PRODUCT COST
GOVERNMENTS PUBLISH LISTS OF ALLOWABLE DEPRECIATION
RATES FOR DIFFERENT EQUIPMENT
AND OTHER ITEMS. ACCOUNTING DEPARTMENTS KEEP SEPARATE
DEPRECIATION RECORDS ON EACH ITEM. DEPRECIATION CREDIT
STOPS WHEN THE TOTAL GOVERNMENT- ALLOWED USEFULL LIFE
PERIOD HAS BEEN USED UP, EVEN IF THE EQUIPMENT IS STILL IN
SERVICE.
IN TURKEY, DEPRECIATION PERIODS ARE 40-50 YEARS FOR
BUILDINGS; 5-10 YEARS FOR MACHINERY, EQUIPMENT AND
FURNITURE; 10-20 YEARS FOR UTILITIES; LESS THAN 5 YEARS FOR
COMPUTERS AND SPECIAL PUMPS, FILTERS.
METHODS OF DEPRECIATION:
* STRAIGHT LINE DEPRECIATION
ORIGINAL COST SALVAGE VALUE
YEARLY DEPRECIATION =
EQUIPMENT LIFE
SAME PERCENTAGE EVERY YEAR. SALVAGE VALUE IS USUALLY 0.
PRODUCT COST
* DOUBLE DECLINING BALANCE DEPRECIATION
2 X (ORIGINAL COST PREVIOUS DEPRE. SALVAGE VALUE)

EQUIPMENT LIFE
* SUM OF YEARS DIGIT DEPRECIATION
THE NUMBERS FOR EACH YEAR OF THE PLANT LIFE ARE ADDED
(FOR 5 YEAR LIFE: 1+2+3+4+5 = 15) AND DEPRECIATION FOR THE
FIRST YEAR IS 5/15 OF THE ORIGINAL COST; SECOND YEAR 4/15
EXAMPLE: MACHINE PRICE $1000, LIFE 5 YEARS, SALVAGE 0
YEARS
STR. LINE
DOUBLE-DEC
SUM OF DIGITS
1
$200
$400
$333.33
2
200
240
266.67
3
200
144
200.00
4
200
108
133.32
5
200
108
66.67
$1000
$1000
$1000
PRODUCT COST
IN DECLINING BALANCE METHOD, YOU CANNOT DEPRECIATE
COMPLETELY IF YOU CONTINUE WITH THE METHOD TO THE END.
THEREFORE IT IS ALLOWABLE TO DEPRECIATE AN ASSET OVER
THE EARLY PORTION OF ITS LIFE USING DECLINING BALANCE AND
THEN SWITCHING TO STRAIGHT LINE DEPRECIATION. IF YOU DO
SO, BALANCE WILL BE DIVIDED TO REMAINING YEARS. (YOU
CANNOT CHANGE THE METHOD IF YOU START WITH STRAIGHT
LINE)
IN TURKEY EITHER STRAIGHT LINE (NORMAL AMORTSMAN) OR
DOUBLE DECLINING BALANCE (AZALAN BAKYELER) CAN BE
USED. STRAIGHT LINE IS EASY TO APPLY. DECLINING BALANCE
HAS FINANCIAL ADVANTAGES DUE TO HIGHER DEPRECIATIONS IN
THE EARLY-LIFE YEARS. DIFFERENT DEPRECIATION METHODS DO
NOT CHANGE THE COMPANYS OVERALL TAX OBLIGATION;
THEY CAUSE THE ANNUAL TAX OBLIGATION TO VARY.
PRODUCT COST
12. ADMINISTRATIVE EXPENSES: WAGES FOR MANAGERS, OFFICE
PERSONNEL, ADMINISTRATORS, SECRETARIES, ACCOUNTANTS,
COMPUTER OPERATORS AND EXPENSES FOR OFFICE SUPPLIES,
COMMUNICATIONS. CAN BE ESTIMATED USING LOCAL RATES.
13. DISTRIBUTION AND MARKETING COSTS: WAGES, SUPPLIES AND
OTHER EXPENSES OF SALES OFFICES, TRAVELLING EXPENSES,
COMMISSIONS, SHIPPING EXPENSES, ADVERTIZING EXPENSES.
MAY BE UP TO 20% OF PRODUCT COST.
14. RESEARCH AND DEVELOPMENT COSTS: ALL EXPENSES
RELATED TO DEVELOPING NEW METHODS AND PRODUCTS.
INDUSTRY AVERAGE IS 5 10% OF PRODUCT COST.
15. FINANCING COSTS: THE INTERESTS PAID FOR THE BARROWED
MONEY. DEPENDS ON THE COMPANY CAPITAL AND THE
REQUIREMENT FOR THE WORKING CAPITAL.
16. CONTINGENCIES: 1 5% CONTINGENCY FACTOR SHOULD BE
ADDED.
PRODUCT COST
SUMMARY FOR FINDING TCI:
A.
1. FROM THE PRELIMINARY DESIGN, FIND THE LIST OF EQUIPMENT
2. FIND PEC (MAKE THE NECESSARY CORRECTIONS)
3. CALCULATE FIX CAPITAL INVESTMENT
(USE LANGS FACTOR OR % METHOD)
B.
1. CALCULATE THE YEARLY PRODUCTION COST
2. FIND THE WORKING CAPITAL
(FRACTION OF YEARLY PRODUCTION COST, USUALLY 20 35 %)
C.
TOTAL CAPITAL INVESTMENT = FCI + WC
PRODUCT COST
THE PRODUCT SALES REVENUE (INCOME) MINUS THE TOTAL
PRODUCT COST GIVES THE GROSS PROFIT:
SALES REVENUE TOTAL PRODUCT COST = GROSS PROFIT
THE INCOME TAX IS CALCULATED ON THE GROSS PROFIT, AS A
CERTAIN PERCENTAGE (t) OF IT:
INCOME TAX (T) = GROSS PROFIT x t / 100
NET PROFIT IS GROSS PROFIT MINUS THE INCOME TAX:
NET PROFIT = GROSS PROFIT T = GROSS PROFIT (1 t /100)
CASH FLOW IS NET PROFIT PLUS DEPRECIATION:
CASH FLOW = NET PROFIT + DEPRECIATION
PRODUCT COST
EXAMPLE :
A COMPANY WAS FORMED TO PRODUCE HOUSEHOLD CLEANING
CHEMICALS. THIS COMPANY BOUGHT LAND FOR $220,000, HAD A $900,00
FACTORY BUILDING ERECTED, AND INSTALLED $700,000 WORTH OF
CHEMICAL AND PACKAGING EQUIPMENT. THE SALES INCOME FOR THE
FIRST YEAR WAS $450,000. SUPPLIES AND ALL OPERATING EXPENSES,
EXCLUDING THE DEPRECIATION, WERE $100,000. ALLOWABLE
DEPRECIATION PERIODS ARE 5 YEARS FOR EQUIPMENT, 50 YEARS FOR
BUILDINGS. FIND THE TAX, NET PROFIT AND CASH FLOW FOR THE FIRST
YEAR IF TAX RATE IS %20,USING
a) STRAIGHT LINE b) DOUBLE DECLINING BALANCE DEPRECIATION
a)
DEP: (900,000).02 + (700,000) .2 = 158,000

TAX : (450,000 100,000 158,000) .20 = 38,400
NET PROFIT = (450,000 100,000 158,000 38,400) = 153,600
CASH FLOW = 158,000 + 153,600 = 311,600
b)
DEP: 2 x (900,000).02 + 2 x (700,000) .2 = 316,000

TAX: (450,000 100,000 316,000) .20 = 6,800
NET PROFIT = (450,000 100,000 316,000 6,800) = 27,200
CASH FLOW = 316,000 + 27,200 = 343,200
PRODUCT COST
DEPLETION
A WASTING OR DEPLETING ASSET IS A NATURAL RESOURCE IN
WHICH NATURE IS INCAPABLE OF REPLACING THE MINERAL THAT
IS EXTRACTED (LIKE COAL MINE OR OIL WELL).
SINCE THE CAPITAL INVESTED IN A DEPLETING ASSET IS CONSUMED
AS THE MINERAL IS EXTRACTED, IT IS NECESSARY TO ADJUST
THE ACCOUNTING RECORDS OF THE FIRM TO REFLECT THE LOSS.
THE DEPLETION ALLOWANCE FOR A GIVEN YEAR IS DETERMINED BY
MULTIPLYING THE GROSS INCOME FROM OPERATIONS OF THAT
YEAR BY A SPECIFIED PERCENTAGE SET BY GOVERMENTAL
REGULATIONS. SO FOUND DEPLETION ALLOWANCE CANNOT
EXCEED %50 OF THE PROPERTYS TAXABLE INCOME COMPUTED
WITHOUT THE DEPLETION DEDUCTION.
PRODUCT COST
EXAMPLE:
AN OIL WELL YIELDED A GROSS ANNUAL INCOME OF $300,000. THE
DEDUCTION OF ALL BUSINESS EXPENSES EXCEPT DEPLETION
REDUCED THIS AMOUNT TO $125,000. FIND THE DEPLETION
AMOUNT IF DEPLETION RATE ON GROSS INCOME IS %22 AND
RESTRICTED TO %50 OF THE INCOME AS COMPUTED PRIOR TO
DEPLETION.
(300,000)(.22) = 66,000
UPPER LIMIT : (125,000)(.50) = 62,500
SO DEPLETION IS $62,500
GROSS PROFIT = 125,000 62,500 = 62,500
PRODUCT COST
EXAMPLE :
A COAL MINE HAS A GROSS INCOME OF $250,000 FOR THE YEAR.
MINING EXPENSES EQUAL $190,000. IF COAL MINES HAVE %10
DEPLETION ALLOWANCE AND RESTRICTED TO %50 OF THE
INCOME AS COMPUTED PRIOR TO DEPLETION, CALCULATE THE
DEPLETION.
(250,000) .10 = 25,000
UPPER LIMIT:
250,000 190,000 = 60,000
(60,000) .50 = 30,000
ALLOWABLE DEPLETION REDUCTION IS 25,000
GROSS PROFIT = 60,000 25,000 = 35,000
PRODUCT COST
SOME COST ITEMS ARE FIXED, THAT IS, THEY DO NOT VARY WITH
THE LEVEL OF OUTPUT. COSTS LIKE PROPERTY TAX, PLANT
INSURANCE, DEPRECIATION AND RENT ARE FIXED COSTS (F).
SOME OF THE PLANT OVERHEAD COSTS AND ADMINISTRATIVE
COSTS ARE ALSO FIXED. OTHER COSTS THAT CHANGE WITH THE
LEVEL OF OUTPUT (RAW MATERIALS, LABOR ..) ARE CALLED
VARIABLE COSTS (VC).
TOTAL COST C = F + VC
MARGINAL COST (MC) IS THE INCREMENT OR ADDITION TO COST
THAT RESULTS FROM PRODUCING ONE MORE UNIT OF OUTPUT.
AVARAGE COSTS (AVERAGE TOTAL COST, AVERAGE VC..) ARE THE
COSTS DIVIDED BY THE OUTPUT.
MARGINAL COST CAN BE EITHER ABOVE OR BELOW AVERAGE COST
PRODUCT COST
OUTPUT
0
1
2
3
4
5
6
7
8
9
10
.
.
.
FIXED
COST
100
100
100
100
100
100
100
100
100
100
100
VARIABLE TOTAL COST AVERAGE

COST
COST
.. 0
.. 10
.. 19
.. 25
.. 32
. 40
. 49
. 60
. 73
. 88
.. 108
..
..
..
..
..
..
..
..
100
110
119
125
132
140
149
160
173
188
208
110
59.5
41.7
33
28
24.8
22.9
21.6
20.9
20.8
MARGINAL
COST
10
.
9
.
6
.
7
.
8
.
9
. 11
. 13
. 15
. 20
PRODUCT COST
ECONOMIES OF SCALE
IF AVERAGE COST FALLS AS OUTPUT INCREASES, THE FIRM IS SAID
TO HAVE ECONOMIES OF SCALE (OR INCREASING RETURNS TO
SCALE)
IF AVERAGE COST DOES NOT VARY WITH OUTPUT, THE FIRM HAS
CONSTANT RETURNS TO SCALE
IF AVERAGE COST RISES WITH OUTPUT, THE FIRM IS SAID TO HAVE
DISECONOMIES OF SCALE (OR DECREASING RETURNS TO SCALE)
PRODUCT COST
REASONS OF AVERAGE COST DECREASE :
* FIXED COSTS ARE FIXED
* SPECIALIZATION SO MORE EFFICIENT USE OF LABOR
* CHEAPER RAW MATERIAL (QUANTITY DISCOUNTS)
AS LONG AS MARGINAL COST IS BELOW AVERAGE COST,

ECONOMIES OF SCALE EXIST; IF MARGINAL COST EXCEEDS
AVERAGE COST THERE ARE DISECONOMIES OF SCALE.
IF WE DEFINE AC/MC = S;
ECONOMIES OF SCALE EXIST IF S>1;
CONSTANT RETURN OF SCALES EXIST IF S=1;
DISECONOMIES OF SCALE EXIST IF S<1.
PRODUCT COST
NUMBER OF PRODUCTION PLANTS
WHEN DECIDING ON THE NUMBER OF PLANTS, PRODUCTION COST
IS AN IMPORTANT FACTOR, BUT NOT THE ONLY ONE. EVEN IF
YOU HAVE ECONOMIES OF SCALE IN PRODUCTION, HAVING TWO
PLANTS WITH LOWER CAPACITIES MAY BE MORE PROFITABLE
DUE TO TRANSPORTATION COSTS. SO COST OF RAW MATERIAL
TRANSPORTATION AND PRODUCTS TRANSPORTATION SHOULD
ALSO BE CONSIDERED AND THE DECISION SHOULD BE
ACCORDING TO THE TOTAL COST.
OPPURTUNITY COST
AN ACTIONS OPPURTUNITY COST IS THE VALUE OF THE BEST
FORGONE ALTERNATIVE USE OF THE RESOURCES EMPLOYED IN
THAT ACTION. IF A FIRM OWNS THE BUILDING IT OCCUPIES AND
IF THE BUILDING COULD BE RENTED FOR $1000 / MONTH, THAN
THE FIRM SHOULD COUNT THAT AMOUNT (OPPURTUNITY COST)
AS ITS COST OF OCCUPYING THE BUILDING.
PRODUCT COST
ECONOMIES OF SCOPE
WHEN IT IS CHEAPER TO PRODUCE TWO PRODUCTS TOGETHER RATHER
THAN SEPARATELY, THERE IS AN ECONOMY OF SCOPE. FIRMS OFTEN
PRODUCE MANY PRODUCTS TO GAIN ECONOMIES OF SCOPE IN
MARKETING AND DISTRIBUTION.
CONSIDER THE PRODUCTION OF q1 UNITS OF PRODUCT 1 AND q2 UNITS
OF PRODUCT 2.
THE COST OF PRODUCING EACH SEPARATELY IS C (q1 , 0) + C (0 , q2); THE
COST OF PRODUCING THEM TOGETHER IS C (q1 , q2).
ECONOMIES OF SCOPE (SC) IS MEASURED AS:
C (q1 , 0) + C (0 , q2) C (q1 , q2)
SC =
C (q1 , q2)
SC MEASURES THE RELATIVE INCREASE IN COST THAT WOULD RESULT IF
THE PRODUCTS WERE PRODUCED SEPARATELY. IF SC IS POSITIVE, IT IS
CHEAPER TO PRODUCE THE PRODUCTS TOGETHER.
ECONOMIC PRODUCTION
BREAKDOWN OF RETAIL PRICE:
RETAILERS SELLING PRICE TO CUSTOMER
100
NET PROFIT OF RETAILER
a
RETAILERS EXPENSES (RENT, LABOUR,ENERGY, TELEPHONE,
TAXES, ETC.)
b
WHOLESALERS PRICE TO RETAILER
NET PROFIT OF WHOLESALER
WHOLESALERS EXPENSES (RENT,LABOUR,
TELEPHONE, DELIVERY, TAXES, ETC)
d
100-a-b
c
ENERGY,
FACTORY PRICE TO WHOLESALER

100-a-b-c-d
THE TOTAL OF a,b,c,d MAY CHANGE BUT NORMALLY IT IS IN THE
RANGE OF 30-50, SO FOR A PRODUCT SOLD TO 100 YTL,
FACTORY PRICE IS ABOUT 50-70 YTL.
ECONOMIC PRODUCTION
RATE OF PRODUCTION IS A VERY IMPORTANT FACTOR FROM
ECONOMY POINT OF VIEW. THE DESIGN CAPACITY MAY NOT BE
ACHIEVED BECAUSE OF SEVERAL REASONS:
- SALES DEMAND MAY BE LOW
- DUE TO POOR DESIGN OR BAD/OLD EQUIPMENT THE RATE MAY
DECREASE
- DUE TO POOR MAINTENANCE LONG IDLE PERIODS MAY OCCUR
- DUE TO BAD MANAGEMENT, BAD PLANNING OR QUALITY
PROBLEMS YIELD MAY DECREASE
THE FIXED COSTS WILL NOT DECREASE AS THE RATE OF
PRODUCTION DECREASE OR AS THE PLANT STAYS IDLE.
THE UNIT COST OF THE PRODUCT WILL INCREASE AND
PROFIT WILL DECREASE.
SO
THE
ECONOMIC PRODUCTION
THE RELATION BETWEEN SALES, COSTS AND PROFIT CAN BE
EXPRESSED MATHEMATICALLY IF FOLLOWING ASSUMPTIONS ARE
MADE :
- VARIABLE COSTS ARE DIRECTLY PROPORTIONAL TO
PRODUCTION RATE
- FIXED COSTS ARE CONSTANT
- THERE ARE NO FINANCIAL COSTS
- UNIT SELLING PRICE IS CONSTANT
- THERE IS NO INCOME OTHER THAN THE SALES
Z = nS (nV + F) = n (S V) F
Z : GROSS PROFIT, S : NET SALES PRICE / UNIT
n : NUMBER OF UNITS PRODUCED / YEAR
V : VARIABLE COST / UNIT, F : FIXED ANNUAL COST
IF PROFIT TAX IS CONSIDERED : NET PROFIT Y = Z ( 1 t)
ECONOMIC PRODUCTION
WHEN THE GROSS INCOME (SALES) EQUALS THE TOTAL COST OF
THE SALES, THE PROFIT IS ZERO :
Z = 0 = nS (nV + F) = n (S V) F
nS = nV + F AND n = F / (S V)
THIS CAPACITY IS CALLED BREAK EVEN POINT. ABOVE THIS
POINT A PROFIT RESULTS. BREAK EVEN POINT IS SAME
REGARDLESS OF WHETHER OR NOT PROFIT TAX IS INCLUDED.
WHEN A PLANT OPERATES BELOW THE BREAK EVEN POINT, THAT
IS AT A LOSS, IT DOES NOT MEAN THE PLANT SHOULD BE SHUT
DOWN, BECAUSE THE FIXED COSTS WOULD HAVE TO BE PAID IN
ANY EVENT. THE SHUT DOWN POINT OCCURS WHEN THE ANNUAL
LOSS IS EQUALS OR EXCEEDS THE VALUE OF THE FIXED COSTS.
ECONOMIC PRODUCTION
EXAMPLE:
THE ANNUAL FIXED COSTS FOR A PLANT ARE $100,000, AND THE
TOTAL VARIABLE COSTS ARE $140,000 PER YEAR AT 70%
CAPACITY WITH SALES INCOME OF $280,000. WHAT IS THE
BREAK-EVEN POINT IN UNITS OF PRODUCTION IF THE SELLING
PRICE PER UNIT IS $40?
280,000 / 40 = 7,000 UNITS SOLD AT 70% CAPACITY
140,000 / 7,000 = $20 / UNIT VARIABLE COST
n = F / (S-V) = 100,000 / 20 = 5,000 UNITS AT BREAK-EVEN
ECONOMIC PRODUCTION
EXAMPLE:
IF THE RATIO OF VARIABLE COSTS TO SALES PRICE IS 0.5 AND
THE FIXED COSTS ARE $100,000 FOR A PRODUCT SELLING AT $40
PER TON, WHAT IS THE COST FOR UNIT OF PRODUCT
a) AT MAXIMUM CAPACITY OF 10,000 TONS AND
b) AT $200,000 TOTAL SALES?
a) V / S = 0.5 V = 0.5 x 40 = $20
CTOTAL ={ ( 10,000 TONS x $20 / TON ) + $100,000 } / 10,000 TON
= $ 30 / TON
b) $200,000 / $40 /TON = 5,000 TONS SOLD
CTOTAL ={ ( 5,000 TONS x $20 / TON ) + $100,000 } / 5,000 TON
= $ 40 / TON
ECONOMIC PRODUCTION
EXAMPLE: ANNUAL FIXED COSTS ARE $100,000; VARIABLE COSTS
ARE $20 PER TON; DESIGN CAPACITY IS 10,000 TONS/YEAR;
SELLING PRICE IS $40 PER TON. WHAT IS THE BREAK EVEN
POINT CAPACITY?
n = F / (S V) = 100,000 / (40 20) = 5,000 TONS
DUMPING OCCURS WHEN A COMPANY SELLS A PORTION OF HIS

PRODUCTION AT ONE SALE PRICE S1 AND THE REMAINING AT A
LOWER PRICE S2. HE OBTAINS GREATER TOTAL PROFIT BY
RUNNING HIS PLANT AT HIGHER CAPACITY TO OBTAIIN LOWER
UNIT COSTS THAN WOULD RESULT FROM PRODUCING AT A
LESSER CAPACITY. IF n1 IS THE NUMBER OF UNITS SOLD AT PRICE
S1, AND n2 AT PRICE S2, THE GROSS PROFIT IS:
Z = n1S1 + n2S2 (n1V + n2V + F)
ECONOMIC PRODUCTION
chart
$, x1000
400
Net Sales, nS
300
Total Cost
Break-even Point
200
Variable Costs
100
Fixed Costs
10
TONS / YEAR, x1000
ECONOMIC PRODUCTION
THE RELATION BETWEEN PRODUCTION RATE COST SALES CAN
BE USED FOR EVALUATION OF NEW PLANTS, EXISTING PLANTS OR
NEW PRODUCTS. BREAK EVEN POINT IS AN IMPORTANT
INFORMATION TO JUDGE ON THE RISK OF A NEW PLANT OR A NEW
PRODUCT. IF WE DEFINE RATE OF RETURN (ROI) AS THE RATIO
OF YEARLY NET PROFIT TO TOTAL INVESTMENT :
ROI = NET ANNUAL PROFIT / TOTAL INVESTMENT
= n [ S (V + F / n)] (1 t) / P
FROM THIS RELATION WE CAN CALCULATE THE NUMBER OF UNITS
THAT SHOULD BE SOLD YEARLY FOR A CERTAIN TOTAL
INVESTMENT (P) TO ACHIEVE THE REQUIRED ROI
ECONOMIC PRODUCTION
EXAMPLE:
A PLANT IS DESIGNED TO PRODUCE 1,200 TONS/YEAR OF CHEMICAL
X WITH A TOTAL INVESTMENT OF $10,000,000. THE FIXED COSTS
PER YEAR ARE $2,000,000 AND VARIABLE COSTS ARE $4/kg. THE
INCOME TAX RATE IS 30% AND DESIRED ROI IS 0.20.
WHAT
SHOULD BE THE YEARLY SALES IF SELLING PRICE IS
a) $10/kg, b) $12/kg
ROI = n [ S (V + F/n)] (1 t) / P
a) 0.20 = n [10 (4 + 2,000,000/n) ] 0.70 / 10,000,000
2,000,000 = (10n 4n 2,000,000) 0.70
4,857,142 = 6n n = 809,524 kg/year
b) 0.20 = n [12 (4 + 2,000,000/n) ] 0.70 / 10,000,000
2,000,000 = (12n 4n 2,000,000) 0.70
4,857,142 = 8n n = 607,143 kg/year
ECONOMIC PRODUCTION
BY LOWERING OUR UNIT SELLING PRICE, WE CAN INCREASE SALES.
IN THAT CASE WE HAVE A NEW BREAK- EVEN CURVE. HERE WE
HAVE TWO POSSIBLE REVENUE LINES. THE TOTAL PROFIT AT
POINT B MAY BE LARGER OR SMALLER THAN THE PROFIT AT
POINT A. BY DISCUSSING ON THESE CURVES, MANAGEMENT MAY
DECIDE ON THE OPTIMUM SELLING PRICE MAXIMIZING THE PROFIT
revenue at
low price
TC
revenue at
high price
FC
a
QUANTITY
ECONOMIC PRODUCTION
EXAMPLE:
THE FIXED COSTS OF MAKING A PRODUCT ARE $2000 AND THE
VARIABLE COSTS ARE $10 PER KG. THE PRODUCT IS SOLD FOR
$12 PER KG AND 2000 KG IS SOLD.
IF THE SELLING PRICE IS REDUCED TO $11 PER KG, HOW MUCH THE
PRODUCT SHOULD BE SOLD BEFORE THE REDUCED SELLING
PRICE INCREASES PROFIT?
TCA = 2,000 + 20,000 = 22,000
RA = 12 x 2,000 = 24,000
PA = 2,000
TCB = 2,000 + 10B
RB = 11B
PB = 11B 2,000 10B > 2,000
B > 4000 KG
ECONOMIC PRODUCTION
BREAK- EVEN CURVES MAY ALSO BE USED TO DECIDE ON THE
LEVEL OF INVESTMENT. IN MOST OF THE CASES, HIGHER
INVESTMENT COSTS (FC), LOWER THE VARIABLE COSTS. SO
DEPENDING ON THE SALES VOLUME, MANAGEMENT DECIDES ON
THE INVESTMENT TYPE (MANUAL VS. AUTOMATIC) TO MAXIMIZE
THE PROFIT.
$
revenue
TC for low FC
TC for high FC
high FC
low FC
a b
QUANTITY
ECONOMIC PRODUCTION
EXAMPLE:
WITH FIXED COSTS OF $2,000, VARIABLE COSTS OF $10 A UNIT AND A
SELLING PRICE OF $12 A UNIT, 2000 OF A PRODUCT ARE SOLD.
THE COMPANY IS CONSIDERING IMPROVING ITS MACHINERY. THIS
WILL RAISE FIXED COSTS TO $4,000 BUT REDUCE VARIABLE
COSTS TO $8 A UNIT. IF THE SELLING PRICE IS REDUCED TO $10,
TO WHAT FIGURE THE SALES BE INCREASED TO JUSTIFY THE
EXTRA INVESTMENT ON TOOLING?
TCA = 2,000 + 20,000 = 22,000
RA = 12 x 2,000 = 24,000
PA = 2,000
TCB = 4,000 + 8B
RB = 10B
PB = 10B 4,000 8B > 2,000
B > 3000
ECONOMIC PRODUCTION
NON LINEAR BREAKEVEN
IN SOME CASES, COSTS AND SALES REVENUES MAY BE NONLINEAR.
SECOND OR THIRD SHIFTS OR OVERTIME PAYMENTS MAY HAVE
INCREASING EFFECT ON THE UNIT VARIABLE COSTS.
TO INCREASE SALES QUANTITY, MORE ADVERTISING OR
PROMOTIONS MAY BE REQUIRED WHICH WILL ALSO INCREASE
THE UNIT COSTS. THE REVENUE MAY ALSO BE NONLINEAR DUE
TO LOWER SELLING PRICE REQUIREMENT FOR INCREASING THE
SALES QUANTITY.
IN NONLINEAR CASES WE HAVE TWO BREAKEVEN POINTS AND
BETWEEN THESE POINTS WE HAVE THE PROFIT AREA. IN THESE
CASES WE HAVE THE MAXIMUM PROFIT AT A OPTIMUM POINT.
ECONOMIC PRODUCTION
be2
sales
$
max. profit
tc
be1
vc
fc
output
ECONOMIC PRODUCTION
ASSET INTENSIVE INDUSTRIES
AUTOMATED PRODUCTION PLANTS ARE LIKE THIS; THEY HAVE HIGH
FIXED COSTS AND RELATIVELY LOW VARIABLE COSTS
THE TOTAL-COST LINE HAS A LOW SLOPE SO WHEN SALES ARE LOW
IT IS HARD TO LOWER THE TOTAL COST. IN THESE INDUSTRIES,
PROFIT LOSS IS MORE SENSITIVE TO QUANTITY
TR
$
TC
FC
VC
Q
ECONOMIC PRODUCTION
LABOR INTENSIVE INDUSTRIES
THESE ARE LESS AUTOMATED PLANTS, WHERE MOST OPERATIONS
ARE MANUAL; THEY HAVE RELATIVELY HIGH VARIABLE COSTS
AND LESS FIXED COSTS
IN THESE PLANTS, TOTAL COST CAN BE MORE EASILY CONTROLLED
SO THE PROFIT - LOSS IS LESS SENSITIVE TO QUANTITY
TC
$
TR
VC
FC
Q
CAPITAL INVESTMENT - PROBLEM

THE TOTAL CAPITAL INVESTMENT FOR A CHEMICAL PLANT IS
$1 MILLION AND THE WORKING CAPITAL IS $100,000. IF THE PLANT
CAN PRODUCE AN AVERAGE OF 8000 KG OF FINAL PRODUCT PER
DAY DURING A 365-DAY YEAR, WHAT SELLING PRICE IN DOLLARS
PER KG OF PRODUCT WOULD BE NECESSARY TO GIVE A
TURNOVER RATIO OF 1.0? (ASSUME ALL PRODUCTION IS SOLD)
FIXED CAPITAL INVESTMENT = 1,000,000 100,000 = $900,000
TURNOVER RATIO = GROSS ANNUAL SALES / FIXED CAPITAL INV.
GROSS ANNUAL SALES = 900,000 x 1.0
GROSS ANNUAL SALES = SELLING PRICE x ANNUAL PRODUCTION
$900,000 = SELLING PRICE x (8000 KG/DAY)(365 DAYS/YEAR)
SELLING PRICE = $0.308
PRODUCT COST - PROBLEM

A PIECE OF EQUIPMENT ORIGINALLY COSTING $40,000 WAS PUT
INTO USE 12 YEARS AGO. AT THE TIME THE EQUIPMENT WAS PUT
INTO USE, THE SERVICE LIFE WAS ESTIMATED TO BE 20 YEARS
AND THE SALVAGE VALUE WAS ASSUMED TO BE ZERO. ON THIS
BASES, A STRAIGHT-LINE DEPRECIATION FUND WAS SET UP. THE
EQUIPMENT CAN NOW BE SOLD FOR $10,000 AND A MORE
ADVANCED MODEL CAN BE INSTALLED FOR $55,000. ASSUMING
THE DEPRECIATION FUND IS AVAILABLE FOR USE, HOW MUCH
NEW CAPITAL MUST BE SUPPLIED TO MAKE THE PURCHASE?
YEARLY DEPRECIATION = 40,000 / 20 = 2,000
TOTAL DEPRECIATION FOR 12 YEARS = 12 x 2,000 = $24,000
55,000 24,000 10,000 = $21,000 REQUIRED
PRODUCT COST - PROBLEM

A COMPANY HAS A TOTAL INCOME OF $1 MILLION/YEAR AND ALL
EXPENSES EXCEPT DEPRECIATION ARE $600,000/YEAR. THE
COMPOSITE AMOUNT OF ALL DEPRECIABLE ITEMS HAS A VALUE
OF $850,000, OVERALL SERVICE LIFE OF 20 YEARS AND SALVAGE
VALUE OF $50,000. THE INCOME TAX RATE IS 35%. WHAT WOULD
BE THE REDUCTION IN INCOME TAX CHARGES FOR THE FIRST
YEAR OF OPERATION IF DOUBLE DECLINING BALANCE METHOD
WERE USED FOR DEPRECIATION INSTEAD OF STRAIGHT-LINE
METHOD?
STARIGHT-LINE: d = (850,000 50,000) / 20 = $40,000/YR
TAX : T = (1,000,000 600,000 40,000)(0.35) = $126,000/YR
DOUBLE DECLINING: d = 2 (850,000 50,000) / 20 = $80,000/ FIRST YR
TAX : T = (1,000,000 600,000 80,000)(0.35) = $112,000/ FIRST YR
REDUCTION IN TAX FOR FIRST YEAR = 126,000 112,000 = $14,000
ECONOMIC PRODUCTION - PROBLEM

*A COMPANY HAS FIXED COSTS OF $100,000 WITH VARIABLE COSTS
EQUAL TO 50% OF NET SALES AND IS PLANNING TO INCREASE
ITS PRESENT CAPACITY OF $400,000 SALES BY 30% WITH A 20%
INCREASE IN FIXED COSTS. THE PROFIT TAX RATE IS 38%.
a) WHAT NEW SALES DOLLARS ARE REQUIRED TO OBTAIN THE
SAME GROSS PROFIT AS THE PRESENT PLANT OPERATION?
b) WHAT WOULD BE THE NET PROFIT IF THE ENLARGED PLANT IS
OPERATED AT FULL CAPACITY?
c) WHAT WOULD BE THE NET PROFIT FOR THE ENLARGED PLANT
IF SALES REMAINED THE SAME AS AT PRESENT?
a) Z = 400,000 100,000 0.5(400,000) = $100,000
Z* = Z = 100,000 = S* 120,000 0.5S* S* = $440,000
b) Y* = [1.3(400,000) 120,000 0.5 (1.3)(400,000)] 0.62 = $86,800
c) Y* = [400,000 120,000 0.5(400,000)] 0.62 = $49,600

* A COMPANY DESIGNED A PLANT TO PRODUCE A CHEMICAL TO BE
SOLD AT $50,000 PER TON. THE EXPECTED PROFIT AT DESIGN
CAPACITY IS $10,000 PER TON. THE TOTAL CAPITAL INVESTMENT
REQUIRED FOR THE PLANT IS $800,000. THE WORKING CAPITAL
REQUIREMENT IS 15% OF THE TOTAL CAPITAL INVESTMENT. THE
EXPECTED SERVICE LIFE IS 10 YEARS AND STRAIGHT LINE
DEPRECIATION IS USED.
DURING THE TESTING PERIOD THE PLANT WAS PUT INTO TRIAL
RUNS OF OPERATION AT 60% OF ITS DESIGN CAPACITY AND IT
WAS FOUND OUT THAT VARIABLE COSTS ARE $15,000 PER TON
AND ANNUAL FIXED COSTS OTHER THAN DEPRECIATION IS
$200,000.
WHAT IS THE BREAK EVEN POINT PRODUCTION RATE AS PERCENT
OF THE DESIGN CAPACITY OF THE PLANT?

TCI : $800,000
WCI = .15 x TCI = $120,000
FIXED CAPITAL INVESTMENT (FCI) = $680,000
DEPRECIATION PER YEAR = 680,000 / 10 = 68,000
THE TOTAL PROFIT AT DESIGN CAPACITY, A :
PROFIT = CAPACITY x PROFIT PER TON = A x 10,000
= A x PRICE [ DEPRECIATION + FC + (A x VC) ]
10,000A = 50,000A ( 68,000 + 200,000 + 15,000A)
A = 10.72 TONS PER YEAR
LET B = BREAK EVEN CAPACITY WHERE SALES = COSTS
50,000B = 68,000 + 200,000 + 15,000B
B = 7.66 TONS PER YEAR
B / A = 7.66 / 10.72 = .715

A PLANT MAKING 4,000 TONS PER YEAR OF PRODUCT AND SELLING AT $0.8
PER kg HAS ANNUAL VARIABLE COSTS OF $2,000,000 AT 100% CAPACITY
AND ANNUAL FIXED COSTS OF $700,000. WHAT IS THE FIXED COSTS PER
kg AT THE BREAK EVEN POINT ? IF THE SELLING PRICE IS INCREASED
BY 10%, WHAT IS THE DOLLAR INCREASE IN NET PROFIT AT FULL
CAPACITY IF THE INCOME TAX RATE IS 20% OF GROSS PROFIT?
V = 2,000,000 / 4,000,000 = $0.5 PER kg
AT BREAK EVEN :
n = 700,000 / (0.8 0.5) = 2,333,333
FC PER kg = 700,000 / 2,333,333 = $0.30 PER kg
ORIGINAL NET PROFIT = [(0.8)(4,000,000) 2,700,000](0.80) = $400,000
NEW NET PROFIT = [(0.8)(1.1)(4,000,000) 2,700,000](0.80) = $656,000
INCREASE IN NET PROFIT = 656,000 400,000 = $256,000
ECONOMIC PRODUCTION-PROBLEM
A COMPANY WITH 50,000 kg/YEAR CAPACITY HAS A TURNOVER RATIO OF 0.5.
TOTAL VARIABLE COST OF THE COMPANY AT FULL CAPACITY 5,000,000
TL/YEAR, AND ANNUAL FIXED COST IS 30% OF THE FIXED CAPITAL
INVESTMENT. AT FULL CAPACITY YEARLY GROSS PROFIT IS 2,000,000 TL.
COMPANY MAKES A NEW INVESTMENT INCREASING THE FIXED CAPITAL
INVESTMENT 20% RESULTING WITH 10% INCREASE IN CAPACITY AND
SALES. THE YEARLY VARIABLE COST AT THE NEW FULL CAPACITY IS
4,400,000 TL AND ANNUAL FIXED COST IS AGAIN 30% OF THE NEW FIXED
CAPITAL INVESTMENT. WHAT IS THE NEW GROSS PROFIT AT THE NEW
CAPACITY?
TR = SALES/FCI
SALES = 0.5FCI,
V = 100 TL, F = 0.3FCI
PROFIT = 2,000,000 = 0.5FCI 100 x 50,000 0.3FCI
FCI = 35,000,000
NEW PROFIT = 35,000,000 x 0.5 x 1.1 4,400,000 35,000,000 x 0.3 x 1.2

= 2,250,000
VI. TIME VALUE OF MONEY
TIME VALUE OF MONEY

INTEREST REPRESENTS THE EARNING POWER OF MONEY. IT IS THE
PREMIUM PAID TO COMPENSATE A LENDER FOR THE LOSS OF USE
OF THE LOANED MONEY, THE RISK OF NONREPAYMENT AND THE
ADMINISTRATIVE COST OF MAKING A LOAN. ON THE OTHER HAND
A BORROWER PAYS INTEREST CHARGES FOR THE OPPURTUNITY
TO DO SOMETHING NOW THAT OTHERWISE WOULD HAVE TO BE
DELAYED OR WOULD NEVER BE DONE.
THE AMOUNT OF INTEREST DEPENDS UPON THE SCARCITY OF
MONEY AT THE TIME OF THE LOAN AND WHAT ALTERNATIVE
INVESTMENTS MIGHT HAVE YIELDED. IT ALSO DEPENDS UPON
THE RISK THE LENDER FEELS THAT HE IS TAKING THAT THE
MONEY MIGHT NOT BE REPAID OR WHAT SECURITY MAY BE
PLEDGED TO THE LENDER THAT HAS AN EQUAL OR SOMEWHAT
GREATER VALUE.
THE ECONOMIC GAIN THROUGH THE USE OF MONEY IS WHAT GIVES
MONEY ITS TIME VALUE. BECAUSE MONEY CAN EARN AT AN
INTEREST RATE THROUGH ITS INVESTMENT FOR A PERIOD OF
TIME, A DOLLAR RECEIVED AT SOME FUTURE DATE IS NOT WORTH
AS MUCH AS A DOLLAR IN HAND AT PRESENT.
THIS LEADS
TO THE CONCEPT OF TIME VALUE OF MONEY.
TIME VALUE OF MONEY

A DOLLAR IN HAND NOW IS WORTH MORE THAN A DOLLAR
RECEIVED n YEARS FROM NOW SINCE HAVING A DOLLAR NOW
PROVIDES THE OPPURTUNITY FOR INVESTING THAT DOLLAR
FOR n YEARS MORE THAN THE DOLLAR TO BE RECEIVED n YEARS
HENCE. THIS OPPURTUNITY WILL EARN A RETURN SO THAT
AFTER n YEARS THE ORIGINAL DOLLAR PLUS ITS INTEREST WILL
BE A LARGER AMOUNT THAN THE ONE DOLLAR RECEIVED AT
THAT TIME.
THE TIME VALUE OF MONEY IS LIMITED TO THE FACT THAT MONEY
HAS AN EARNING POWER. THE EFFECT OF INFLATION IS
SEPARATE.
SINCE ENGINEERING PROJECTS REQUIRE THE INVESTMENT OF
MONEY, IT IS IMPORTANT THAT THE TIME VALUE OF THE MONEY
USED BE PROPERLY REFLECTED IN THE EVALUATION OF THE
PROJECTS.
TIME VALUE OF MONEY

THE AMOUNT OF CAPITAL ON WHICH INTEREST IS PAID IS
DESIGNATED AS THE PRINCIPAL (P), AND THE AMOUNT OF
INTEREST EARNED BY A UNIT OF PRINCIPAL IN A UNIT OF TIME
AS THE RATE OF INTEREST (i). THE TIME UNIT IS USUALLY TAKEN
AS ONE YEAR. FOR EXAMPLE, IF $100 WERE THE COMPENSATION
DEMANDED FOR GIVING SOMEONE THE USE OF $1000 FOR A
PERIOD OF ONE YEAR, THE PRINCIPAL WOULD BE $1000 AND THE
RATE OF INTEREST WOULD BE 100 / 1000 = 0.1 OR 10% / YEAR.
TYPES OF INTEREST:
1. SIMPLE INTEREST
THE SIMPLEST FORM OF INTEREST REQUIRES COMPENSATION
PAYMENT AT A CONSTANT INTEREST RATE BASED ONLY ON THE
ORIGINAL PRINCIPAL. THE AMOUNT OF SIMPLE INTEREST I
DURING n INTEREST PERIOD IS:
I = (P)(i)(n)
TIME VALUE OF MONEY

THE PRINCIPLE MUST BE REPAID EVENTUALLY; THEREFORE THE
ENTIRE AMOUNT S OF PRINCIPLE + INTEREST DUE AFTER n
INTEREST PERIOD IS:
S = P + I = P + (P)(i)(n) = P(1 + in)
IF THE INTEREST RATE IS EXPRESSED ON THE REGULAR YEARLY
BASIS AND d REPRESENTS THE NUMBER OF DAYS IN AN INTEREST
PERIOD:
ORDINARY SIMPLE INTEREST = P(i)(d/360)
EXACT SIMPLE INTEREST
= P(i)(d/365)
TIME VALUE OF MONEY

2. COMPOUND INTEREST
INTEREST HAS AN IMPORTANT TIME VALUE AND WHENEVER THE
INTEREST IS PAID THE RECEIVER CAN IMMEDIATELY PUT THE
INTEREST TO WORK AND EARN ADDITIONAL INTEREST. THIS IS
CALLED COMPOUND INTEREST WHICH ASSUMES THAT THE
INTEREST RECEIVED IS NOT WITHDRAWN BUT ADDED TO THE
PRINCIPLE AND INTEREST IS RECEIVED UPON THIS ENLARGED
PRINCIPLE DURING THE FOLLOWING PERIOD. THE COMPOUND
AMOUNT (S) DUE AFTER DISCREET NUMBER OF INTEREST
PERIODS CAN BE DETERMINED AS FOLLOWS:
YEAR P AT THE START INTEREST EARNED S AT THE END
1
P
P(i)
P + P(i) = P(1 + i)
2
P(1+i)
P(1+i)(i)
P(1+i)+P(1+i)(i) = P(1+i) 2
3
P(1+i)2
P(1+i)2(i)
P(1+i)2+P(1+i)2(i) = P(1+i)3
n
P(1+i)n-1
P(1+i)n-1(i)
P(1+i)n
TIME VALUE OF MONEY

SO IN COMPOUND INTEREST :
S = P(1+i)n
EXAMPLE:
IF P = $1000 AND i = 10%
n
1
COMPOUND
S1 = 1000(1+0.1) = 1100 ;
SIMPLE
= 1000(1+0.1) = 1100
S2 = 1000(1+0.1)2 = 1210 ;
= 1000(1+0.2) = 1200
S3 = 1000(1+0.1)3 = 1331 ;
= 1000(1+0.3) = 1300
S7 = 1000(1+0.1)7 = 1949 ;
= 1000(1+0.7) = 1700
COMPOUND INTEREST IS THE MOST USED TYPE OF INTEREST AND IF

NOTHING ELSE IS INDICATED WE SHALL UNDERSTAND
COMPOUND INTEREST COMPOUNDED YEARLY
TIME VALUE OF MONEY

NOMINAL AND EFFECTIVE INTEREST RATES: THERE ARE CASES
WHERE TIME UNITS OTHER THAN ONE YEAR ARE USED.
CONSIDER AN EXAMPLE IN WHICH THE INTEREST RATE IS 3% PER
PERIOD AND INTEREST IS COMPOUNDED AT HALF-YEAR PERIODS.
A RATE OF THIS TYPE WOULD BE REFERRED TO AS
6% COMPOUNDED SEMIANNUALLY. INTEREST RATES STATED IN
THIS FORM ARE KNOWN AS NOMINAL INTEREST RATES. THE
ACTUAL ANNUAL RETURN ON THE PRINCIPAL WOULD NOT BE
EXACTLY 6% BUT WOULD BE SOMEWHAT LARGER BECAUSE OF
THE COMPOUNDING EFFECT AT THE END OF THE SEMIANNUAL
PERIOD. NOMINAL INTEREST RATES SHOULD ALWAYS INCLUDE A
QUALIFYING STATEMENT INDICATING THE COMPOUNDING PERIOD
(IF NO STATEMENT, WE WILL ASSUME ONE YEAR).
P = $100,NOMINAL INTEREST RATE 6% COMPOUNDED YEARLY:
S1 = $106
P= $100,NOMINAL INTEREST RATE 6% COMPOUNDED SEMIANNUALLY
S1 = $100(1.03)(1.03) = $106.09
TIME VALUE OF MONEY

SOMETIMES IT IS DESIRABLE TO EXPRESS THE EXACT INTEREST
RATE BASED ON THE ORIGINAL PRINCIPAL AND THE TIME UNIT OF
ONE YEAR. A RATE OF THIS TYPE IS KNOWN AS THE EFFECTIVE
INTEREST RATE (6.09% IN THE ABOVE CASE). THE ONLY TIME THAT
THE NOMINAL AND EFFECTIVE INTEREST RATES ARE EQUAL IS
WHEN THE INTEREST IS COMPOUNDED ANNUALLY.
LET r BE THE NOMINAL INTEREST RATE UNDER CONDITIONS WHERE
THERE ARE m CONVERSIONS OR INTEREST PERIODS PER YEAR.
THEN THE INTEREST RATE BASED ON THE LENGTH OF ONE
INTEREST PERIOD IS r / m .
SINCE S = P (1+i)n
Safter 1 year = P (1+r/m)m
IF WE DESIGNATE EFFECTIVE INTEREST RATE AS ieff
S1 = P (1+ieff) = P (1+r/m)m
ieff = (1+r/m)m - 1
TIME VALUE OF MONEY

EXAMPLE
FIND S AND ieff FOR P = 100 TL, n = 1, AND
a) INTEREST IS 6 %
ieff = i = 0.06 ; S = 100 (1.06) = 106
b) INTEREST IS NOMINAL 6%, COMPOUNDED SEMIANNUALLY
ieff = (1+r/m)m 1 = 1. 03 2 1 = 0.0609; S = 100 (1.0609) = 106.09
c) INTEREST IS NOMINAL 6%, COMPOUNDED QUARTERLY
ieff = (1+r/m)m 1 = 1. 015 4 1 = 0.06136; S = 100 (1.06136) = 106.136
d) INTEREST IS NOMINAL 6%, COMPOUNDED MONTHLY
ieff = (1+r/m)m 1 = 1. 005 12 1 = 0.06168; S = 100 (1.06168) = 106.168
TIME VALUE OF MONEY

EXAMPLE : P = $1000, MONTHLY INTEREST RATE OF 2%
* TOTAL AMOUNT PRINCIPAL + SIMPLE INTEREST DUE AFTER 2
YEARS IF NO INTERMEDIATE PAYMENTS ARE MADE
S = P(1+in) = $1000 ( 1+ 0.02 X 24) = $1480
a) TOTAL AMOUNT PRINCIPAL + COMPOUNDED INTEREST AFTER 2
YEARS IF NO INTERMEDIATE PAYMENTS ARE MADE
S = P (1+I)n = $1000 (1.02)24 = $1608
b) NOMINAL INTEREST RATE WHEN THE INTEREST IS COMPOUNDED
MONTHLY
r = 0.02 X 12 = 0.24 OR 24% COMPOUNDED MONTHLY
c) EFFECTIVE INTEREST RATE WHEN THE INTEREST IS
COMPOUNDED MONTHLY
ieff = (1+r/m)m 1 = (1+0.24/12)12 1 = 0.268 OR 26.8%
TIME VALUE OF MONEY

3. CONTINUOUS INTEREST
FOR INTEREST ACCUMULATION YOU CAN TAKE SHORTER TIME
INTERVALS THAN ONE YEAR LIKE ONE MONTH, ONE DAY, ONE
HOUR OR EVEN SHORTER; AND THE EXTREME CASE IS WHEN
THE TIME INTERVAL BECOMES INFINITESIMALLY SMALL SO THAT
THE INTEREST IS COMPOUNDED CONTINUOUSLY.
r : NOMINAL INTEREST RATE ; m : INTEREST PERIODS / YEAR
Sn = Plim m (1+r/m)mn = Plimm (1+r/m)m/r x rn
SINCE limm(1+r/m)m/r = e
Sn = Pern
TO USE ieff WHICH IS (1+r/m)m 1 = (1+r/m)m/r x r- 1

SO ieff = er 1 AND Sn = P(ieff +1)n
TIME VALUE OF MONEY

EXAMPLE : IF r = 0.2 (NOMINAL INTEREST RATE OF 20%)
a) TOTAL AMOUNT TO WHICH $1 OF INITIAL PRINCIPAL WOULD
ACCUMULATE AFTER ONE YEAR IF COMPOUNDED DAILY
S = P (1+r/m)m = 1(1 + 0.2/365)365 = $ 1.2213
b) TOTAL AMOUNT TO WHICH $1 OF INITIAL PRINCIPAL WOULD
ACCUMULATE AFTER ONE YEAR WITH CONTINUOUS
COMPOUNDING
S = Pern = 1 (e)0.2 = $ 1.2214
c) ieff FOR CONTINUOUS COMPOUNDING
ieff = er 1 = 1.2214 1 = 0.2214 OR 22.14%
TIME VALUE OF MONEY

PRESENT WORTH AND DISCOUNT
THE PRESENT WORTH (OR PRESENT VALUE) OF A FUTURE
AMOUNT IS THE PRESENT PRINCIPLE WHICH MUST BE DEPOSITED
AT A GIVEN INTEREST RATE TO YIELD THE DESIRED AMOUNT AT
SOME FUTURE DATE.
SINCE S = P (1 + i)n
P = S / (1 + i)n FOR COMPOUND INTEREST
AND SINCE S = Pern
P = S / ern FOR CONTINUOUS INTEREST
THE DISCOUNT = FUTURE VALUE PRESENT VALUE
=SP
TIME VALUE OF MONEY

EXAMPLE : A BOND HAS A MATURITY VALUE OF $1000 AND IS PAYING
DISCRETE COMPOUND INTEREST AT AN EFFECTIVE ANNUAL
RATE OF 3%. DETERMINE THE FOLLOWING AT A TIME
4 YEARS
BEFORE THE BOND REACHES MATURITY VALUE:
a) PRESENT WORTH
P = S/ (1 + i)n = 1000 / (1 + 0.03)4 = $888
b) DISCOUNT
DISCOUNT = 1000 888 = $112
c) DISCRETE COMPOUND RATE OF EFFECTIVE INTEREST WHICH
WILL BE RECEIVED BY A PURCHASER IF THE BOND WAS
OBTAINED FOR $700
P = S / (1+i)n ; 700 = 1000 / (1+i)4 i = (1000/700)1/4 1 = 0.0933
d) REPEAT (a) FOR THE CASE WHERE THE NOMINAL BOND
INTEREST IS 3% COMPOUNDED CONTINUOUSLY
P = S / ern = 1000 / e(0.03)x4 = $887
TIME VALUE OF MONEY

ANNUITIES : AN ANNUITY IS A SERIES OF EQUAL PAYMENTS
OCCURING AT EQUAL TIME INTERVALS. AN ANNUITY TERM IS THE
TIME FROM THE BEGINNING OF THE FIRST PAYMENT PERIOD TO
THE END OF THE LAST PAYMENT PERIOD. THE AMOUNT OF AN
ANNUITY IS THE SUM OF ALL THE PAYMENTS PLUS INTEREST.
LET R REPRESENT THE UNIFORM PERIODIC PAYMENTS MADE
DURING n DISCRETE PERIODS IN AN ORDINARY ANNUITY. THE
INTEREST RATE BASED ON THE PAYMENT PERIOD IS i, AND S IS
THE AMOUNT OF ANNUITY. THE FIRST PAYMENT R IS MADE AT THE
END OF THE FIRST PERIOD AND WILL BEAR INTEREST FOR n 1
PERIODS. THUS AT THE END OF THE ANNUITY TERM, THIS FIRST
PAYMENT WILL HAVE ACCUMULATED TO AN AMOUNT OF R(1 + i)n-1.
THE SECOND PAYMENT WILL BE R(1 + i)n-2 AND SO ON.
S = R(1+i)n-1+ R(1+i)n-2 + . + R(1+i) + R
MULTIPLY BOTH SIDES BY (1+i) S + Si = R(1+i)n + R(1+i)n-1+R(1+i)
SUBTRACT THE FIRST EQUATION FROM THIS ONE
Si = R (1+i)n R
S = R { (1+i)n - 1} / i
TIME VALUE OF MONEY

FOR DISCRETE CASH FLOW AND CONTINUOUS COMPOUNDING:
SINCE S = Rern ; THE FIRST PAYMENT WILL BE Rer(n-1) AT THE END,
SECOND WILL BE Rer(n-2) AND SO ON.
S = Rer(n-1) + Rer(n-2) + . + Rer + R

MULTIPLY BOTH SIDES BY er
Ser = Rern + Rern-1 + . + Rer
SUBTRACT THE FIRST EQUATION FROM THIS
Ser S = Rern R
S (er 1) = R (ern 1)
S = R { ( ern 1) / ( er 1) }
TIME VALUE OF MONEY

FOR CONTINUOUS CASH FLOW AND INTEREST COMPOUNDING, LET r
REPRESENT NOMINAL INTEREST RATE WITH m INTEREST
PERIODS PER YEAR SO THAT i = r / m AND THE TOTAL NUMBER OF
INTEREST PERIODS IN n YEARS IS mn. LET REPRESENT THE
TOTAL OF ALL ORDINARY ANNUITY PAYMENTS OCCURING
UNIFORMLY THROUGHOUT THE YEAR SO THAT / m IS THE
UNIFORM ANNUITY PAYMENT AT THE END OF EACH PERIOD:
S = / m [ { (1 + r/m)mrn/r 1 } / r/m ]
= { (ern 1) /r }
(THE SYMBOLS S, R REPRESENT DISCRETE LUMPSUM PAYMENTS. A
BAR ABOVE THE SYMBOL, SUCH AS , MEANS THAT THE
PAYMENTS ARE MADE CONTINUOUSLY THROUGHOUT THE TIME
PERIOD.)
TIME VALUE OF MONEY

PRESENT WORTH OF ANNUITY:
SINCE P = S / (1 + i)n ; P = R [ { (1 + i)n 1 } / i(1 + i)n ]
FOR CONTINUOUS CASH FLOW AND INTEREST COMPOUNDING :
P = { (ern 1) / rern }
ANNUITY DUE : IF PAYMENTS ARE MADE AT THE BEGINNING OF EACH
PERIOD INSTEAD OF END OF THE PERIODS
DEFERRED ANNUITY : IF THE FIRST PAYMENT IS DUE AFTER A
DEFINITE NUMBER OF YEARS
EXAMPLE : YOU WANT TO ACCUMULATE $10,000 IN 10 YEARS BY
MAKING EQUAL INSTALMENTS EACH YEAR, BEGINNING AT THE
END OF THE FIRST YEAR ; DETERMINE THE YEARLY INSTALMENTS
a) IF i = 0.06 ANNUALLY
R = S [ i / { (1 + i)n 1 } ] = $10,000 [ 0.06 / { (1.06)10 - 1} ] = $759 / YEAR
b) IF ANNUAL INTEREST OF 0.06 COMPOUNDED CONTINUOUSLY
WITH CONTINUOUS CASH FLOW
= S { r / (ern 1) } = $10,000 { 0.06 / (e0.6 1) } = $730 / YEAR
TIME VALUE OF MONEY

SUMMARY OF BASIC INTEREST RELATIONS
SIMPLE INTEREST :
S = P (1 + in)
n: NUMBER OF PERIODS
i : INTEREST PER PERIOD
COMPOUND INTEREST: S = P (1 + i)n
CONTINUOUS COMPOUNDING:
S = Pern = P (ieff + 1)n
ANNUITIES WITH DISCRETE PAYMENTS, R :

S = R [ {(1 + i)n 1} / i ]
P = R [ {(1 + i)n 1} / i (1 + i)n ]
r:NOMINAL INTEREST RATE

R:UNIFORM PERIODIC PAYMENTS
MADE AT EACH n DISCRETE
PERIOD
ANNUITIES WITH DISCRETE PAYMENTS,R, CONTINUOUS COMPOUNDING:

S = R { (ern 1) / (er 1) }
P = R { (ern 1) / ern(er 1) }
ANNUITIES WITH CONTINUOUS CASH FLOW, , AND CONTINUOUS
COMPOUNDING:
S = { (ern 1) / r
: TOTAL ANNUITY PAYMENT
P = { (ern 1) / rern
PER YEAR
TIME VALUE OF MONEY

WHAT HAPPENS WHEN THE INVESTMENT IS CONSIDERED TO BE
PERMENANT, THAT IS n ?
WHEN n , (1 + i)n =
SINCE S = P (1 + i)n S = FOR ANY P
P = S / (1 + i)n P = 0 FOR ANY S
SINCE R = P [{i (1 + i)n} / { (1 + i)n 1 }]
{i (1 + i)n} / { (1 + i)n 1 } = [ i / { (1 + i)n 1} ] + i
WHEN n
=
0 +i
R = Pi
TIME VALUE OF MONEY

CAPITILIZED COST
WE MAY DESIRE TO DETERMINE A TOTAL COST FOR A PIECE OF
EQUIPMENT UNDER CONDITIONS WHICH PERMIT THE EQUIPMENT
TO BE REPLACED PERPATUALLY WITHOUT CONSIDERING
INFLATION OR PRICE CHANGES.
IF REPLACEMENT AT THE END OF n YEARS COSTS CR , THEN WE
SHOULD HAVE A PRINCIPAL (P) IN THE BEGINNING WHICH WILL
ACCUMULATE TO S IN n YEARS, SUCH THAT WHEN YOU SPEND
CR, YOU STILL HAVE P IN HAND TO ACCUMULATE AGAIN TO S IN n
YEARS AND SO ON.
S = P + CR
SINCE S = P(1 + i)n = P + CR
(1 + i)n = 1 + CR / P
P = CR / {(1 + i)n 1 }
TIME VALUE OF MONEY

THE CAPITILIZED COST (K) IS DEFINED AS THE ORIGINAL COST OF
THE EQUIPMENT (CV) PLUS P
K = CV + CR /{ (1 + i)n 1 }
IF CV = CR
K = CV [ 1 + 1/{ (1 +i)n 1 }]
ENGINEERS USE CAPITILIZED COST PRINCIPALLY FOR COMPARING

ALTERNATIVES
EXAMPLE : A NEW EQUIPMENT COSTS $12,000 AND WILL HAVE A
SCRAP VALUE OF $2000 AT THE END OF ITS USEFULL LIFE OF 10
YEARS. WHAT IS THE CAPITILIZED COST IF INTEREST IS 0.06 ?
K = CV + CR /{ (1 + i)n 1} = 12,000 + 10,000 / (1.0610 - 1 ) = $24,650
THAT MEANS OUT OF THIS AMOUNT $12,000 WILL BE USED FOR
BUYING THE EQUIPMENT IN THE BEGINNING; REMAINING $12,650
WILL ACCUMULATE TO $22,650 IN 10 YEARS, OUT OF WHICH
$10,000 WILL BE USED TOGETHER WITH THE SCRAP VALUE TO
RENEW THE EQUIPMENT; AND THIS WILL GO ON.
TIME VALUE OF MONEY

EXAMPLE : IF A REACTOR IS MADE FROM MILD STEEL IT COSTS
$5000 AND ITS USEFULL LIFE IS 3 YEARS. IF IT IS MADE FROM
STAINLESS STEEL IT COSTS $15,000. WHAT SHOULD BE THE
USEFULL LIFE PERIOD OF THE STAINLESS STEEL REACTOR TO
HAVE EQUAL CAPITILIZED COST IF SCRAP VALUES ARE ZERO
AND MONEY IS WORTH 6% COMPOUNDED ANNUALLY ?
FOR THE MILD STEEL REACTOR :
K = CV + CR /{ (1 + i)n 1} = 5000 + 5000 / (1.063 1) = $31,176
FOR THE STAINLESS STEEL TO HAVE EQUAL K
31,176 = 15,000 + 15,000 / (1.06n 1)
1.06n = 1.9273
n = 11.3
THAT MEANS, IF THE LIFE IS > 11.3 YEARS, CHOOSE STAINLESS
STEEL FOR MAKING THE REACTOR
TIME VALUE OF MONEY

WHEN THERE IS A PAYMENT AT THE END OF EACH YEAR (LIKE
MAINTANENCE COST), WE SHOULD ADD IT TO THE CAPITILIZED
COST FORMULA:
P = R [ (1 + i )n 1 / i (1 + i )n ]
DIVIDE BY (1 + i )n
P = R [ 1 1/ (1 + i )n / i ]
WHEN n GOES TO
P=R/i
CAPITILIZED COST FORMULA BECOMES:
K = R / i + CV + CR / (1 + i )n 1 WHERE R IS THE YEARLY EXPENSE
TIME VALUE - PROBLEM

AT WHAT RATE WILL $65.07 YIELD $8.75 IN SIMPLE INTEREST IN
3 YEARS 6 MONTHS?
S = P(1 + in)
73.82 = 65.07 (1 + i x 3.5) i = 3.84%
FIND THE COMPOUND AMOUNT OF $100 FOR 4 YEARS AT 6%

COMPOUNDED ANNUALLY.
S = P(1 + i)n = 100(1.06)4 = $126.25
ACCUMULATE A PRINCIPLE OF $1000 FOR 5 YEARS 9 MONTHS AT A

NOMINAL RATE OF 12% COMPOUNDED MONTHLY. HOW MUCH
INTEREST IS EARNED?
S = 1000(1 + 0.12/12)69 = $1986.9 ; I = $986.9

AT WHAT ANNUAL INTEREST RATE WILL $1000 INVESTED TODAY
BE WORTH $2000 IN 9 YEARS ?
P = 1000 ; S = 2000 ; n = 9
S = P(1 + i)n
2000 / 1000 = (1 + i)9 21/9 = 1 + i i = 0.08
A LOAN OF $1000 IS MADE TODAY UNDER AN AGREEMENT THAT

$1400 WILL BE RECEIVED IN PAYMENT SOMETIME IN FUTURE.
WHEN SHOULD THE $1400 BE RECEIVED IF THE LOAN IS TO EARN
INTEREST AT A RATE OF NOMINAL YEARLY 8% COMPOUNDED
QUARTERLY?
P = 1000 ; S = 1400 ; r = 0.08 ; m = 4
ieff = (1 + r/m)m 1 = (1 + 0.08/4)4 1 = 0.0824
S = P(1 + ieff)n
1400 = 1000(1.0824)n
1.4 = (1.0824)n
ln 1.4 = nln1.0824
n = 4.25
TIME VALUE PROBLEM

NOW IS JUNE 30, 2002. 3 PAYMENTS, EACH OF $500, ARE TO BE
RECEIVED EVERY 2 YEARS FROM NOW AND DEPOSITED IN A BANK
WHERE THEY WILL EARN INTEREST AT 7% PER YEAR. HOW LARGE
WILL THE BANK ACCOUNT BE ON JUNE 30, 2010?
2004 $500 ; 2006 $500 ; 2008 $500
S = P (1 + i)n = 500 { (1.07)6 + (1.07)4 + (1.07)2 } = $1978.3
A PERSONAL LOAN OF $1000 IS MADE FOR A PERIOD OF 18
MONTHS AT A INTEREST RATE OF 1.5% PER MONTH ON THE
UNPAID BALANCE. IF THE ENTIRE AMOUNT IS PAID AS A LUMP SUM
AT THE END OF 18 MONTHS, DETERMINE
a) THE EFFECTIVE ANNUAL INTEREST RATE
b) THE TOTAL AMOUNT OF INTEREST PAID
a) SINCE r/m = 0.015
ieff = (1 + r/m)m 1 = (1 + 0.015)12 1 = .1956
b) S = P (1 + i)n = 1000 ( 1 + 0.015)18 = $1307.4 ; I = $307.4

FIND THE COMPOUND AMOUNT OF $500 AT 6% FOR 4, 8, 12 YEARS.
S = P (1 + i)n = 500 (1.06)4,8,12 = $631.24 ; $796.92 ; $1006.10
A LOAN OF $200 IS MADE FOR A PERIOD OF 13 MONTHS AT A
SIMPLE INTEREST RATE OF 10%. WHAT FUTURE AMOUNT IS DUE
AT THE END OF THE LOAN PERIOD?
S = P(1 + in) = 200 { 1 + 0.10(1 + 1/12) } = $221.67
A CREDIT PLAN CHARGES INTEREST AT A RATE OF NOMINAL
YEARLY 18% COMPOUNDED MONTHLY. WHAT IS THE EFFECTIVE
INTEREST RATE ?
ieff = (1 + r/m)m 1 = (1 + 0.18/12)12 1 = 0.1956 OR 19.56%
HOW MUCH WOULD A PERSON HAVE HAD TO INVEST 1 YEAR AGO
TO HAVE $2500 AVAILABLE TODAY WHEN NOMINAL YEARLY
INTEREST r = 0.12 COMPOUNDED MONTHLY ?
S = P(1 + r/m)m 2500 = P (1 + 0.12/12)12 P = $2218.6

HOW MANY YEARS DOES IT TAKE FOR A MONEY TO DOUBLE IF
a) r = 0.08 COMPOUNDED ANNUALLY?
S = P(1 + i)n 2P = P(1.08)n
n = 9 YEARS
b) r = 0.08 WITH CONTINUOUS INTEREST?
S = Pern
2P = Pe0.08n
n = 8.66 YEARS
AT WHAT NOMINAL INTEREST RATE WILL A MONEY DOUBLE USING
CONTINUOUS COMPOUNDING IN 5 YEARS?
S = Pern 2P = Pe5r
r = 0.138 OR 13.8%
A BUILDING WAS PURCHASED 10 YEARS AGO FOR $50,000 AND
HAS RECENTLY BEEN SOLD FOR $120,000. DISREGARDING ANY
TAXES, DETERMINE THE RATE OF INTEREST OBTAINED ON THE
INITIAL INVESTMENT.
S = P(1 + i)n 120,000 = 50,000 (1 + i)10 i = 0.0915 OR 9.15%

A CONSTRUCTION FIRM CAN LEASE A CRANE REQUIRED IN A
PROJECT FOR 3 YEARS FOR $180,000 PAYABLE NOW, WITH
MAINTENANCE INCLUDED. THE ALTERNATIVE IS TO BUY A CRANE
FOR $240,000 AND SELL IT AT THE END OF 3 YEARS FOR $100,000.
ANNUAL MAINTENANCE COSTS FOR THIS ALTERNATIVE IS $5000
THE FIRST 2 YEARS AND $10,000 THE THIRD YEAR (PAYABLE AT
THE END OF EACH YEAR). WHICH ALTERNATIVE IS GOOD IF
i = 0.07?
FIRST ALTERNATIVE : P1 = $180,000
SECOND ALTERNATIVE : P2 = $240,000 PS + PM
PS = S / (1 + i)n = 100,000 / (1.07)3 = $81,630
PM = 5000 / (1.07) + 5000 / (1.07)2 + 10,000 / (1.07)3 = $17,203
P2 = 240,000 81,630 + 17,203 = $175,573 2nd ALT. IS BETTER
IF i = 0.10 THAN PS = $75,131 ; PM = $16,191
P2 = 240,000 75,131 + 16,191 = $181,060 1st ALT. IS BETTER

ASSUME THAT YOU SOLD A PROPERTY TODAY FOR $2421 WHICH
YOU HAD PURCHASED 4 YEARS AGO WITH $2000 WITHDRAWN
FROM YOUR SAVING ACCOUNT. DURING THE FOUR YEAR PERIOD
YOUR SAVINGS WOULD HAVE EARNED 6% PER YEAR. COMPARE
THE NOMINAL INTEREST RATE RECEIVED FROM YOUR PROPERTY
PURCHASE.
S = P(1 + i)n 2421 = 2000 (1 + i)4
i = 0.0489 < 0.06
ln 1.2105 = 4 ln (1+i)

WHAT ANNUAL YEAR- END PAYMENT MUST BE MADE EACH YEAR
TO HAVE $20,000 AVAILABLE 5 YEARS FROM NOW IF THE
COMPOUND ANNUAL INTEREST RATE IS 6% ?
S = R [{(1 + i)n 1} / i ] 20,000 = R [{(1.06)5 1} / 0.06] R = $3,548
IF YOU DEPOSIT $10,000 TODAY WHAT EQUAL AMOUNTS CAN YOU
WITHDRAW AT THE END OF EACH QUARTER FOR THE NEXT 4
YEARS WHEN THE NOMINAL INTEREST RATE IS 10%,
COMPOUNDED QUARTERLY ?
n = 4 x 4 = 16 ; i = .10 / 4 = 0.025
P = R [{(1 + i)n - 1} / i (1 + i)n ]
10,000 = R [{ (1.025)16 1} / 0.025 (1.025)16] R = $765.74
A LOAN OF $5000 IS SCHEDULED TO BE PAID IN EQUAL MONTHLY
INSTALLMENTS OVER 2.5 YEARS. THE NOMINAL INTEREST RATE IS
6% COMPOUNDED MONTHLY. HOW LARGE IS EACH PAYMENT ?
n = 2.5 x 12 = 30 i = .06 / 12 = 0.005 P = R [{(1 + i)n 1} / i (1 + i)n ]
5000 = R [{(1.005)30 1} / 0.005 (1.005)30]
R = 179.89

THERE IS A TRAINING PROGRAM WHICH WILL COST $12,000 IN THE
BEGINNING AND $4000 PER YEAR. IT IS ESTIMATED TO PRODUCE
SAVINGS OF $7000 EACH YEAR FOR 5 YEARS. SHOULD WE START
THE PROGRAM IF i = 0.06 ?
ANNUAL SAVING = 7000 4000 = 3000 P = R [{1 + i)n 1} / i(1 + i)n ]
P = 3000 [{1.06) 5 1} /
0.06 (1.06)5 ] = $12,636
SINCE PRESENT WORTH OF SAVINGS IS > $12,000 , START .
YOU CAN BUY A NEW CAR FOR $12,000, PAYING $2000 DOWN AND
THE DEALER WILL FINANCE THE REMAINDER AT A NOMINAL
ANNUAL RATE OF 6%, COMPOUNDED MONTHLY FOR 5 YEARS.
DETERMINE THE AMOUNT OF YOUR MONTHLY PAYMENTS
n = 5 x 12 = 60 ; i = 0.06 / 12 = 0.005 ; P = R[{(1 + i) n 1} / i(1 + i)n ]
10,000 = R[{(1.005)60 1} / 0.005(1.005)60] R = $193.33
THE AMOUNT OF $1200 PER YEAR IS TO BE PAID INTO AN ACCOUNT OVER

EACH OF THE NEXT 5 YEARS. USING A NOMINAL INTEREST RATE OF 12%
PER YEAR, DETERMINE THE TOTAL AMOUNT THAT THE ACCOUNT WILL
CONTAIN AT THE END OF THE FIFTH YEAR UNDER THE FOLLOWING
CONDITIONS :
a) DEPOSITS MADE AT THE BEGINNING OF EACH YEAR WITH SIMPLE
INTEREST
S = P(1 + ni) = 1200{ (1+5x.12)+(1+4x.12)+(1+3x.12)+(1+2x.12)+(1+.12) } = $8160
b) DEPOSITS MADE AT THE END OF EACH YEAR WITH INTEREST
COMPOUNDED ANNUALLY
S = R [{ (1+i)n 1} / i ] = 1200 [{ (1.12)5 1} / .12] = $7623.42
c) DEPOSITS MADE AT THE END OF EACH MONTH ($100) WITH INTEREST
COMPOUNDED MONTHLY
S = R [{ (1+i)n 1} / i ] = 100 [{ (1+.12/12)60 - 1} / (.12/12) ] = $8166.97
d) DEPOSITS MADE AT THE END OF EACH YEAR WITH INTEREST
COMPOUNDED MONTHLY
ieff = (1 + r/m)m 1 = (1 + .12/12)12 1 = 0.1268
S = R [{ (1+i)n 1} / i ] = 1200 [{ (1.1268)5 1} / .1268] = $7727.08

A MANUFACTURING FIRM IN A FOREIGN COUNTRY HAS AGREED
TO PAY $25,000 IN ROYALTIES AT THE END OF EACH YEAR FOR THE
NEXT 5 YEARS. IF THE PAYMENTS ARE LEFT IN THE FOREIGN
COUNTRY, INTEREST ON THE RETAINED FUNDS WILL BE PAID AT
AN ANNUAL RATE OF 15%.
a) WHAT TOTAL AMOUNT WILL BE AVAILABLE IN 5 YEARS?
S = R [{(1 + i)n 1} / i ] = 25,000 [{ (1.15)5 1} / 0.15] = $168,560
b) HOW LARGE WOULD THE UNIFORM ANNUAL PAYMENTS HAVE
TO BE IF THE PATENT OWNERS INSISTED THAT A MINIMUM
$175,000 BE ACCUMULATED BY THE END OF 5 YEARS ?
175,000 = R [{(1.15)5 1} / 0.15]
R = $25,955

A COMPANY 3 YEARS AGO BORROWED $40,000 TO PAY FOR A NEW
MACHINE TOOL, AGREEING TO REPAY THE LOAN IN 100 MONTHLY
PAYMENTS AT AN ANNUAL NOMINAL INTEREST RATE OF 12%
COMPOUNDED MONTHLY. THE COMPANY NOW WANTS TO PAY OFF
THE LOAN. HOW MUCH WOULD THIS PAYMENT BE?
i = 0.12 / 12 = 0.01 MONTHLY ; n (total) = 100
P = R [{(1 + i)n - 1} / i(1 + i)n]
40,000 = R [{(1.01)100 1} / 0.01(1.01)100]
R = $634.63
n (up to now) = 3 x 12 = 36
S = R [{(1 + i)n 1} / i ] = 634.63 [{(1.01)36 1} / 0.01]
= $27,337.88 (today value of what was paid)
ieff = (1 + r/m)m 1 = (1 + 0.12 / 12)12 = 0.126825
S = P (1 + ieff)n = 40,000 (1.126825)3
= $57,230.75 (today value of 40,000)
57,230.75 27,337.88 = $29,892.87 SHOULD BE PAID

COMPARE THE COST TO PAY OFF A $3000 LOAN IN 1 YEAR WITH
12 EQUAL PAYMENTS WHEN INTEREST IS 12% COMPOUNDED
MONTHLY AS OPPOSED TO MAKING A SINGLE PAYMENT WHEN THE
EFFECTIVE INTEREST RATE IS 12%
a) AS OUT OF POCKET AMOUNT
P = R [{ (1 + i)n 1} / i(1 + i)n]
3000 = R [{(1+.12/12)12 1} / .12/12(1+.12/12)12]
R = 266.67 12 x 266.67 = $3200 when paid in installments
S = 3000 (1 + i)n = 3000 (1.12) = $3360 when paid as single payment
3200 3360 = - $160
b) AS S AMOUNT
S = R [{(1 + i)n 1} / i] = 266.67 [{(1.01)12 - 1} / 0.01] = $3382
3382 3360 = $22
c) WHICH IS ADVANTAGEOUS AND WHY?
single payment is advantageous because :
ieff = (1 + r/m)m 1 = (1 + 0.01)12 = 0.1268 which is > 0.12

AT THE END OF EACH YEAR A SINGLE PAYMENT OF $1766 IS
DEPOSITED IN AN ACCOUNT THAT EARNS 6% COMPOUNDED
CONTINUOUSLY. WHAT IS THE AMOUNT IN THE ACCOUNT AFTER 5
YEARS?
S = R {(ern 1) / (er 1)} = 1766 {(e5x0.06 1) / (e0.06 1)} = $9992
THE EXPECTED LIFE OF A NEW MACHINE IS 5 YEARS. ANNUAL
CASH FLOW DUE TO THIS MACHINE IS $27,000. ASSUMING
CONTINUOUS CASH FLOW AND CONTINUOUS COMPOUNDING,
WHAT IS THE AMOUNT THAT CAN INITIALLY BE PAID TO THIS
MACHINE IF WE WANT TO EARN 15% ON THE INVESTMENT ?
= 27,000 ; ieff = er 1 0.15 = er 1 r = 0.1398
P = {(ern 1) / rern} = 27,000 {(e5x0.1398 1) / 0.1398e5x0.1398}
= $97,130

USING THE CAPITILIZED COST PROCEDURE COMPARE THE MERITS
OF BUYING A PUMP THAT COSTS $2000, NEEDS REPLACEMENT
EVERY 5 YEARS AND REQUIRES $300 / YEAR AS MAINTENANCE
EXPENSE WITH ANOTHER ONE THAT COSTS $4000 BUT WOULD
HAVE A 10 YEAR LIFE AND ONLY NEEDS $100 / YEAR FOR
MAINTENANCE. ASSUME 10% INTEREST RATE PER YEAR.
K1 = R / i + CV + CR / {(1 + i)n 1}
= 300 / .1 + 2000 + 2000 / {(1.1)5 1} = $8,276
K2 = R / i + CV + CR / {(1 + i)n 1}
= 100 / .1 + 4000 + 4000 / {(1.1)10 1} = $7,510
SECOND ALTERNATIVE IS BETTER
VII. PROFITABILITY
PROFITABILITY
BEFORE CAPITAL IS INVESTED IN A PROJECT, IT IS NECESSARY TO
KNOW HOW MUCH PROFIT CAN BE OBTAINED AND WHETHER OR
NOT IT MIGHT BE MORE ADVANTAGEOUS TO INVEST THE CAPITAL
IN ANOTHER FORM OF ENTERPRICE. THUS, DETERMINATION OF
PROFIT IS A MAJOR GOAL OF AN ECONOMIC ANALYSIS.
PROFIT CAN BE CALCULATED WITH SOME ASSUMPTIONS ABOUT
FUTURE (DEMAND, PRICE, AMOUNT OF PRODUCTION), SO IT IS
NOT AN UNFAILING VALUE AND CAN ONLY SERVE AS A GUIDE.
PROFIT ALONE CANNOT BE USED FOR DETERMINING IF AN
INVESTMENT SHOULD BE MADE. SUPPOSE TWO INVESTMENTS
ARE UNDER CONSIDERATION : ONE REQUIRES $100,000 OF
CAPITAL AND WILL YIELD A PROFIT OF $10,000/ YEAR;
THE OTHER REQUIRES $1 MILLION OF CAPITAL AND WILL YIELD
$50,000/ YEAR. THE SECOND GIVES A GREATER YEARLY PROFIT,
BUT THE RATE OF RETURN IS ONLY 5% WHILE THE RATE OF
RETURN OF THE FIRST IS 10%.
PROFITABILITY
THE MOST COMMONLY USED METHODS FOR PROFITABILITY
EVALUATION ARE:
1. RATE OF RETURN
2. PAYOUT PERIOD
3. NET RETURN
4. DISCOUNTED CASH FLOW
5. NET PRESENT WORTH
6. EQUIVALENT ANNUAL COST ANNUAL WORTH
EACH OF THESE METHODS HAVE ITS ADVANTAGES AND
DISADVANTAGES AND SINCE NO SINGLE METHOD IS BEST FOR
ALL SITUATIONS THE ENGINEER SHOULD KNOW THEM ALL AND
CHOOSE THE BEST SUITING ONE.
PROFITABILITY
1. RATE OF RETURN ON INVESTMENT
THE YEARLY PROFIT DIVIDED BY THE TOTAL INITIAL INVESTMENT
(FIXED + WORKING CAPITAL) REPRESENTS THE RETURN ON
INVESTMENT.
PROFITS AND THEREFORE RATE OF RETURNS MAY BE
EXPRESSED ON THE BEFORE-TAX OR AFTER-TAX BASIS AND THIS
SHOULD BE INDICATED.
ROI = NET PROFIT PER YEAR / TOTAL INVESTMENT
RATE OF RETURN MAY BE COMPARED FOR ALTERNATIVE
INVESTMENTS, INCLUDING PUTTING THE MONEY IN THE BANK,
AND GIVES A FIRST APPROXIMATION OF HOW ATTRACTIVE THE
NEW PROJECT MAY BE. IF THE PROFIT VARIES FROM YEAR TO
YEAR, AN AVERAGE MAY BE ASSUMED.
IN RATE OF RETURN CALCULATION, WE DO NOT CONSIDER THE
TIME VALUE OF MONEY.
PROFITABILITY
EXAMPLE : A PROPOSED MANUFACTURING PLANT REQUIRES AN
INITIAL FIXED CAPITAL OF $900,000 AND A WORKING CAPITAL OF
$100,000. IT IS ESTIMATED THAT ANNUAL INCOME WILL BE
$800,000 AND ANNUAL EXPENSES (INCLUDING DEPRECIATION)
WILL BE $520,000 BEFORE INCOME TAX. INCOME TAX IS 20%.
FIND % RETURN ON INVESTMENT BEFORE AND AFTER TAX.
800,000 520,000 = $280,000 / YEAR PROFIT BEFORE TAX
280,000 / 1,000,000 = 0.28
28% ROI BEFORE TAX

(280,000)(0.80) / 1,000,000 = .224 22.4% ROI AFTER TAX
THE MINIMUM ACCEPTABLE RATE OF RETURN (MARR) IS THE RATE

SET BY AN ORGANIZATION TO DESIGNATE THE LOWEST LEVEL OF
RETURN THAT MAKES AN INVESTMENT ACCEPTABLE. IT IS A
DEVICE DESIGNED TO MAKE THE BEST POSSIBLE USE OF MONEY
AND APPLIED FOR EVALUATING NEW PROJECTS, COST
REDUCTION PROPOSALS, RESEARCH AND DEVELOPMENT
PROGRAMS.
PROFITABILITY
MARR IS THE KEY FOR DECIDING ON THE PROFITABILITY OF A NEW
INVESTMENT.
HAVING PROFIT DOES NOT MAKE A PROJECT FEASIBLE OR
PROFITABLE . YOU WOULD NOT CONSIDER A NEW INVESTMENT
PROFITABLE IF YOU INVEST 1,000,000$ AND HAVE A PROFIT OF
1,000 $ / YEAR.
TO HAVE PROFITABLE INVESTMENT, YOU SHOULD EARN MORE THAN
MARR.
PROFITABILITY
THE VALUE OF MARR DEPENDS MAINLY ON
* THE REAL INTEREST RATE IN THE COUNTRY
* THE RISK OF THE INVESTMENT
* THE POLITICAL AND ECONOMIC STABILITY
AS THE MARR VALUE DECREASE, TO HAVE PROFITABLE

INVESTMENTS BECOMES EASIER AND CAPITAL OWNERS PREFER
TO MAKE NEW INVESTMENTS.
PROFITABILITY
2. PAYOUT PERIOD (PAYBACK METHOD)
PAYOUT PERIOD OR TIME IS THE MINIMUM LENGTH OF TIME
THEORETICALLY NECESSARY TO RECOVER THE ORIGINAL FIXED
CAPITAL INVESTMENT IN THE FORM OF CASH FLOW TO THE
PROJECT (NET PROFIT + DEPRECIATION).
DEPRECIABLE FIXED CAPITAL INVESTMENT
PAYOUT PERIOD =
AV. PROFIT/YEAR + AV. DEPRECIATION/YEAR
INTEREST IS NEGLECTED AND ONLY DEPRECIABLE FIXED
INVESTMENT IS CONSIDERED. IF TIME VALUE OF MONEY IS ALSO
CONSIDERED, THAN WE HAVE PAYOUT PERIOD INCLUDING
INTEREST. IN THIS CASE THE ANNUAL CASH FLOWS ARE
DISCOUNTED.
PROFITABILITY
EXAMPLE: A COMPANY PLANS AN INVESTMENT OF $300,000 TO
MANUFACTURE A NEW PRODUCT. ALLOWABLE DEPRECIATION IS
10 YEARS, ANNUAL NET PROFIT IS $45,000. STRAIGHT- LINE
DEPRECIATION WILL BE USED. WHAT IS THE PAYOUT PERIOD
a)
IF TIME VALUE OF MONEY IS NOT CONSIDERED?
b) IF TIME VALUE IS CONSIDERED AND i IS 8%?
ANNUAL CASH FLOW = NET PROFIT + DEPRECIATION
= 45,000 + 30,000 = 75,000
a) PAYOUT PERIOD = 300,000 / 75,000 = 4 YEARS
b) P = R [ {(1 + i)n 1} / i (1 + i)n
300,000 = 75,000 {(1.08)n 1} / 0.08 (1.08)n
4 x 0.08 (1.08)n = (1.08)n 1
0.68(1.08)n = 1 n = log 1.47 / log 1.08
PAYOUT PERIOD n = 5 YEARS
PROFITABILITY
THE PAYOUT PERIOD METHOD IS USED WIDELY TO RATE RELATIVELY
SMALL INVESTMENT PROPOSALS IN PRODUCTION DEPARTMENTS.
IT MAY LEAD TO INCORRECT CONCLUSIONS SINCE IT DOES NOT
RECOGNIZE THE CASH FLOW OCCURING AFTER THE PAYOUT
PERIOD. FOR EXAMPLE AN INVESTMENT OF $1000 WITH LIFE OF 1
YEAR AND HAS A NET RETURN OF $1000 WILL YIELD A PAYOUT
PERIOD OF 1 YEAR. ANOTHER INVESTMENT OF $1000 PROMISES
TO RETURN $250/YEAR DURING ITS ECONOMIC LIFE TEN YEARS.
THIS WILL YIELD A PAYOUT PERIOD OF 4 YEARS. IF YOU
CONSIDER ONLY PAYOUT PERIODS, YOU SHALL CHOOSE THE
FIRST ALTERNATIVE WHICH ACCUALLY EARNS NOTHING.
PROFITABILITY
3. NET RETURN
NET RETURN IS THE AMOUNT OF CASH FLOW OVER AND ABOVE
THAT REQUIRED TO MEET THE MINIMUM ACCEPTABLE RATE OF
RETURN AND RECOVER THE TOTAL CAPITAL INVESTMENT. THIS
IS CALCULATED BY SUBTRACTING THE TOTAL AMOUNT EARNED
AT THE MINIMUM RATE OF RETURN AND THE TOTAL CAPITAL
INVESTMENT FROM THE TOTAL CASH FLOW. IN THIS
CALCULATION WE NEGLECT THE TIME VALUE OF MONEY.
TOTAL CASH FLOW: TOTAL NET PROFIT + TOTAL DEPRECIATION
+SALVAGE VALUE + RECOVERED WORKING CAPITAL
INVESTMENT + EARNING OF INVESTMENT: TOTAL CAPITAL
INVESTMENT (FIXED + WORKING) + MARR MULTIPLIED BY TOTAL
CAPITAL INVESTMENT FOR ALL YEARS
PROFITABILITY
N
Rn =
(NP,j + dj) + S + WC TC (MARR)(N)(TC)
j 1
WHERE NP,j IS NET PROFIT, dj IS DEPRECIATION FOR YEAR
j, S IS THE SALVAGE VALUE
IN CASES
WHERE
N
dj + S + WC = TC
Rn =
NP,j - (MARR)(N)(TC)
j 1
IF WE HAVE AN AVERAGE PROFIT (PAVE), THEN

Rn,AVE = PAVE (MARR)(TC)
PROFITABILITY
EXAMPLE: A COMPANY PLANS TO START A NEW PRODUCT WHICH
REQUIRES $24 MILLION OF NEW MACHINERY AND $4 MILLION
WORKING CAPITAL. ALL FIXED COSTS EXCEPT DEPRECIATION IS
$1 MILLION/YEAR, VARIABLE COSTS AT FULL CAPACITY IS
$5
MILLION/YEAR. DEPRECIATION IS BY DOUBLE-DECLINING IN 5
YEARS, INCOME TAX IS 35%. THE PRODUCTION RATE AT 100%
CAPACITY IS 2 x 106 kg/YEAR. IN THE FIRST YEAR CAPACITY IS
USED 50%, IN THE SECOND YEAR 90% AND AFTER THE SECOND
YEAR 100%. MARR IS 30%.
CALCULATE THE SALES PRICE (p) REQUIRED TO ACHIEVE MARR
IN TEN YEARS BY NET RETURN METHOD.
USING THE TABLE : PAVE = 1/10 (18.8p 81)(1 - 0.35) 106
= (1.222p 5.265) 106
Rn = 0 = (1.222p) 106 (5.265) 106 (0.30)(28) 106
p = $11.18
PROFITABILITY
YEAR
1
2
3
4
5
6
7
8
9
10
SUM
----------------------------------------------------------------------------------A. PERCENT OF
OPERATING TIME
B. PRODUCT RATE,
106 kg/yr
C. ALL VARIABLE
COSTS, $ 106/yr
D. ALL FIXED COSTS
(EXCEPT DEP.) $ 106/yr
E. DEPRECIATION,
$ 106/yr
F. TOTAL PRODUCT
COST(C+D+E) $ 106/yr
50
1
90 100 100 100 100 100 100 100 100

1.8
18.8
2.5 4.5
47
10
9.6 5.76 3.456 2.592 2.592 0
24
13.1 11.26 9.456 8.592 8.592 6
81
PROFITABILITY
4. NET PRESENT WORTH
THE NET PRESENT WORTH OF A PROJECT IS THE DIFFERENCE
BETWEEN THE PRESENT VALUE OF THE ANNUAL CASH FLOWS
AND THE INITIAL REQUIRED INVESTMENT ,
OR MORE GENERALLY:
P = PRESENT WORTH OF BENEFITS PRESENT WORTH OF COSTS
YOU CAN USE PRESENT WORTH TO
A. COMPARE ALTERNATIVES (ALLWAYS USING SAME NUMBER OF
YEARS AND CONSTANT i); LARGER P IS BETTER
B. DECIDE IF A PROJECT IS FEASIBLE OR NOT (TAKING i = MARR);
IF P 0, YOUR PROJECT IS EQUAL OR BETTER THAN MARR,
IF P < 0, LESS THAN MARR
PROFITABILITY
EXAMPLE : THERE ARE TWO ALTERNATIVE MACHINES YOU CAN BUY
TO YOUR FACTORY, A AND B. A COSTS $9000, B COSTS $14,500.
THE NET CASH FLOWS ARE:
1.YEAR
2.YEAR
3.YEAR
MACHINE A :
$ 4,500
4,500
4,500
MACHINE B :
$ 6,000
6,000
8,000
FIND PRESENT WORTH IF i = 0.8 AND SALVAGE VALUE IS ZERO
PW(A) = (4500) [{(1+0.08)3 - 1} / 0.08 (1+0.08)3] 9000 = $2594
PW(B) = (6000) [{(1+0.08)2 - 1} / 0.08 (1+0.08)2] + 8000 / (1+0.08)3 14,500
= $2550
MACHINE A IS BETTER
PROFITABILITY
EXAMPLE : FIXED CAPITAL INVESTMENT IS $100,000 AND WORKING
CAPITAL INVESTMENT IS $10,000, SALVAGE IS $10,000 AT THE END
OF 5 YEAR LIFE; FIND PW IF i = 0.15 AND AFTER TAX CASH FLOW
AT THE END OF EACH YEAR IS AS FOLLOWS:
YEAR
1
2
3
4
5
$
30,000 31,000 36,000 40,000 43,000
PWINCOME = 30,000 / (1.15) + 31,000 / (1.15)2 + 36,000 / (1.15)3
+ 40,000 / (1.15)4 + 43,000 / (1.15)5 + (10,000+10,000) / (1.15)5
= $127,327
NET PRESENT WORTH IS 127,327 110,000 = $17,327
PROFITABILITY
A COMPANY IS CONSIDERING A NEW INVESTMENT WHICH COSTS
12,000,000 TL AS TCI. THE LAND COST IS 2,000,000 TL AND REST
OF THE FCI COST IS 8,000,000 TL. THE YEARLY EXPECTED CASH
FLOW IS 2,500,000 TL.
IF MARR IS 20% AND LIFE OF THE PLANT IS 15 YEARS, IS THIS
INVESTMENT FEASIBLE?
WC = 12,000,000 10,000,000 = 2,000,000
P = 2,500,000 [ (1.215 1) / .20 (1.215)] + 4,000,000 / 1.215 - 12,000,000
P = - 51,696 TL
NOT FEASIBLE
PROFITABILITY
EXAMPLE: IN AN EXISTING PLANT A NEW CHEMICAL WILL BE
PRODUCED WITH A RATE OF 100,000kg/YEAR. THE ESTIMATED LIFE
OF THIS PROJECT IS 8 YEARS. NECESSARY INVESTMENT IS 800,000
TL WORTH MACHINERY WHICH WILL BE DEPRECIATED BY
STRAIGHT- LINE IN 8 YEARS. YEARLY PRODUCTION COST IS
ESTIMATED TO BE 1,200,000 TL EXCEPT DEPRECIATION AND
WORKING CAPITAL IS 20% OF THE TOTAL YEARLY PRODUCTION
COST. IF TAX RATE IS 20%, AND i = 6%, WHAT SHOULD BE THE
SELLING PRICE OF THE CHEMICAL IF MANAGEMENT REQUIRES A
PRESENT WORTH OF MINIMUM 1,000,000 TL?
WC = (1,200,000 + 100,000) .20 = 260,000
P=1,000,000 = -800,000 -260,000 + 260,000/1.068 +(CF) (1.068 -1)/.06(1.068 )
CF (CASH FLOW) = 120,245 = NET PROFIT + DEPRECIATION
120,245 = (100,000p 1,300,000)0.80 + 100,000
p = 13.25 TL
PROFITABILITY
WORK SHEET FOR NET PRESENT WORTH
YEARS
0
1. FIXED CAPITAL INVESTMENT
2. WORKING CAPITAL
3. TOTAL CAPITAL INVESTMENT (1+2)
4.OPERATING RATE (% OF CAPACITY)
5. ANNUAL INCOME (SALES)
6. ANNUAL MANUFACTURING COST
7. DEPRECIATION
8. ANNUAL GENERAL EXPENSES
9. TOTAL PRODUCT COST (6 + 7 + 8)
10. ANNUAL GROSS PROFIT (5 - 9)
11. INCOME TAX
12. ANNUAL NET PROFIT (10 11)
13.ANNUAL OPERATING CASH FLOW (12 + 7)
14.TOTAL ANNUAL CASH FLOW (13 + 3)
1 st
2nd
3rd
4th
5th
PROFITABILITY
15.NET PRESENT WORTH
ENTER EXPENDITURES AS NEGATIVE, INCOMES AS POSITIVE
ASSUME ALL INVESTMENT IS MADE IN YEAR 0 AND PRODUCTION STARTS IN
THE BEGINNING OF YEAR 1; WORKING CAPITAL AND SALVAGE VALUE IS
RECOVERED AT THE END AND SINCE THEY ARE LUMP-SUM, FINITE CASH
FLOW SHOULD BE APPLIED IN ALL CASES.
PROFITABILITY
5. DISCOUNTED CASH FLOW
RATE OF RETURN BASED ON DISDOUNTED CASH FLOW IS ALSO
CALLED PROFITABILITY INDEX, TRUE RATE OF RETURN OR
INTERNAL RATE OF RETURN. THIS METHOD TAKES INTO ACCOUNT
THE TIME VALUE OF MONEY. A TRIAL AND ERROR PROCEDURE 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.
EXAMPLE : FIXED CAPITAL INVESTMENT IS $100,000 AND WORKING
CAPITAL INVESTMENT IS $10,000, SALVAGE IS $10,000 AT THE END
OF 5 YEAR LIFE; WHAT IS THE INTERNAL RATE OF RETURN IF
PREDICTED AFTER-TAX CASH FLOW AT THE END OF EACH YEAR IS
AS FOLLOWS:
YEAR
1
2
3
4
5
$
30,000
31,000 36,000 40,000
43,000
S = (30,000)(1+i)4 + (31,000)(1+i)3 + (36,000)(1+i)2 + (40,000)(1+i) + 43,000
= (110,000)(1+i)5 10,000 10,000
BY TRIAL AND ERROR i = 0.207
PROFITABILITY
6. EQUIVALENT ANNUAL COST ANNUAL WORTH
EQUIVALENT ANNUAL COST (EAC) IS THE COST PER YEAR OF
OWNING AND OPERATING AN ASSET OVER ITS ENTIRE LIFESPAN.
EAC= NPV/Atr
Atr (annuity factor)= [1-1/ (1+i)n]/i
PROFITABILITY
EXAMPLE: A MACHINE COSTS $1,600, HAS 5 YEARS LIFE.
ANNUAL OPERATING COSTS IS $500 PER YEAR AND i =
0.08. WHAT IS EAC a) IF SALVAGE VALUE IS 0 , b) IF
SALVAGE VALUE IS $300 ?
a) Atr=[1-1/ (1.08)5]/0.08=3.99
NPV=1600+500/(1.08)+500/(1.08)2+ 500/(1.08)3 + 500/(1.08)4
+ 500/(1.08)5
NPV=3596
EAC=900
b) NPV= 3596-300/(1.08)5=3391
EAC=849
PROFITABILITY
EXAMPLE:
EQUIPMENT CAN BE PURCHASED FOR $10,000 AND LAST FOR N
YEARS (WITH NO SALVAGE VALUE), OR IT CAN BE LEASED FOR
2,200 A YEAR. IF INTEREST IS 12% PER YEAR, WHAT IS THE
MINIMUM N TO JUSTIFY PURCHASING?
a) PRESENT WORTH METHOD
P = R [ (1 + i)n 1 / i (1 + i)n ]
10,000 = 2,200 [ (1.12)N 1 / .12 (1.12)N ]
.545 = (1.12)N 1 / (1.12)N
(1.12)N = 2.2
N ln 1.12 = ln 2.2
N=7
b) EAC METHOD
R = P [ i (1 + i)n / (1 + i)n 1]
2,200 = 10,000 [.12 (1.12)N / (1.12)N 1]
N=7
PROFITABILITY
TO MAKE A DECISION ON THE PROFITABILTY OF A PROJECT:
- DECIDE ON A MARR VALUE,
- CALCULATE ROI; IF ROI MARR
OR
CALCULATE NET RETURN; IF Rn 0
OR
CALCULATE PRESENT WORTH USING i = MARR; IF P 0
OR
CALCULATE IRR; IF IRR MARR
THAN THE PROJECT IS PROFITABLE.
PAYBACK PERIOD METHOD IS APPLIED ONLY FOR SMALL PROJECTS
EQUIVALENT ANNUAL COST METHOD IS USUALLY APPLIED FOR COMPARING
ALTERNATIVES
PROFITABILITY
RISK ANALYSIS AND ACCEPTABLE RETURNS:
IN INDUSTRIAL OPERATIONS THERE IS ALWAYS A DEGREE OF
UNCERTANITY AND CALCULATED RETURN DEPENDS ON SOME
ASSUMPTIONS ABOUT THE FUTURE. SO THERE IS ALWAYS A RISK
FACTOR. A SIMPLE METHOD IS TO MAKE THE CALCULATIONS FOR
WORST, AVERAGE AND BEST CASES. A BETTER METHOD IS TO
MAKE RISK ANALYSIS USING PROPER SOFTWARES. YOU SHOULD
FIRST DECIDE ON THE RANGE OF VALUES FOR EACH FACTOR
(TOTAL INVESTMENT, PLANT LIFE, ANNUAL CASH FLOW) AND
THE LIKELIHOOD OF OCCURANCE OF EACH VALUE. COMPUTER
THAN CALCULATES THE PROBABILITY OF ALL RETURNS.
DUE TO THE UNCERTANITIES, IN AVERAGE 20 30% RETURN
BEFORE TAX (NOT CONSIDERING THE EFFECT OF INFLATION)
WHICH MEANS 14 20% RETURN AFTER TAX IS REQUIRED FOR
INVESTING IN INDUSTRY.
VIII. ANALYSIS OF ALTERNATIVES
ALTERNATIVES
AN ALTERNATIVE IN ENGINEERING ECONOMICS IS AN INVESTMENT
POSSIBILITY. IT IS A SINGLE UNDERTAKING WITH A
DISTINGUISHABLE CASH FLOW.
IN INDUSTRIAL OPERATIONS, IT IS OFTEN POSSIBLE TO PRODUCE
EQUIVALENT PRODUCTS IN DIFFERENT WAYS. ALTHOUGH THE
PHYSICAL RESULTS MAY BE APPROXIMATELY THE SAME, THE
CAPITAL REQUIRED AND THE EXPENSES INVOLVED CAN VARY
CONSIDERABLY DEPENDING ON THE METHOD CHOSEN.
SIMILARLY, ALTERNATIVE METHODS INVOLVING VARYING CAPITAL
AND EXPENSES CAN OFTEN BE USED TO CARRY OUT OTHER
TYPES OF BUSINESS VENTURES. IT MAY BE NECESSARY,
THEREFORE, NOT ONLY TO DECIDE IF A GIVEN BUSINESS
VENTURE WOULD BE PROFITABLE, BUT ALSO TO DECIDE WHICH
OF SEVERAL POSSIBLE METHODS WOULD BE THE MOST
DESIRABLE. DECISION USUALLY HAS LONG-TERM
CONSEQUENCES SO IT IS IMPORTANT FOR THE ENGINEERS TO BE
COMPETENT ECONOMIC ANALYSTS.
ALTERNATIVES
ANALYSIS START WITH THE IDENTIFICATION OF ALTERNATIVES.
AFTER PREPARING ENOUGH DATA FOR EACH ALTERNATIVE,
COMPARISON IS MADE.
HOW MANY ALTERNATIVES SHOULD WE HAVE? YOU CAN NEVER
DECIDE IF YOU CONTINUE SEARCHING FOR A STILL- BETTER
OPTION. ON THE OTHER SIDE, ACTING ON THE FIRST OPTION
THAT COMES TO MIND MAY RESULT WITH A WRONG DECISION. AIM
SHOULD BE TO DEVELOP A SET OF ALTERNATIVES LARGE
ENOUGH TO INCLUDE THE BEST POSSIBLE SOLUTION.
WE CAN CLASSIFY ALTERNATIVES INTO DEPENDENT AND
INDEPENDENT CATEGORIES. AN INDEPENDENT ALTERNATIVE IS
NOT AFFECTED BY THE SELECTION OF ANOTHER ALTERNATIVE.
EACH PROPOSAL IS EVALUATED ON ITS MERIT AND IS APPROVED
IF IT MEETS THE CRETERIA OF ACCEPTABILITY. COMPARISONS OF
INDEPENDENT INVESTMENT PROPOSALS ARE DESIGNED TO
DETERMINE WHICH PROPOSALS SATISFY A MINIMUM LEVEL OF
ECONOMIC VALUE. ALL THOSE THAT SURPASS THE MINIMUM
LEVEL MAY BE IMPLEMENTED AS LONG AS SUFFICIENT CAPITAL IS
AVAILABLE.
ALTERNATIVES
DEPENDENT ALTERNATIVES ARISE WHEN ALTERNATIVES ARE
RELATED IN A WAY THAT INFLUENCES THE SELECTION PROCESS.
THERE ARE TWO CLASSIFICATIONS FOR DEPENDENT
ALTERNATIVES : MUTUALLY EXCLUSIVE DEPENDENT AND
CONTINGENCY DEPENDENT. ALTERNATIVES ARE MUTUALLY
EXCLUSIVE WHEN THE SELECTION OF ONE ELIMINATES THE
OPPURTUNITY TO ACCEPT ANY OF THE OTHERS. OPERATIONAL
PROBLEMS NORMALLY FIT INTO THIS CATEGORY, BECAUSE A
SINGLE COURSE OF ACTION IS SOUGHT TO SOLVE A PARTICULAR,
OFTEN URGENT, PROBLEM.
THE CONTINGENCY DEPENDENT ALTERNATIVES ARISE WHEN
INDIVIDUAL INVESTMENT OPPURTUNITIES ARE LINKED TO OTHER
ALTERNATIVES. THEN THE ACCEPTANCE OF ONE ALTERNATIVE
DEPENDS ON THE SIMULTANEOUS ACCEPTANCE OF ONE OR
MORE RELATED ALTERNATIVES. THE PURCHASE OF NEW
COMPUTER TERMINALS IS CONTINGENT ON THE PURCHASE OF
HARDWARE INCREASING THE CAPACITY OF THE MAIN COMPUTER.
ALTERNATIVES
1. ANALYSIS OF MUTUALLY EXCLUSIVE ALTERNATIVES
WE CAN USE DIFFERENT METHODS FOR EVALUATION:
A. PRESENT WORTH METHOD
RELIABLE, EASY
YOU CAN USE IT IN ALL CASES
WHEN ECONOMIC LIFE OF EQUIPMENT IS DIFFERENT, YOU HAVE
TO FIND THE COMMON NUMBER OF YEARS, AND IN SOME CASES
IT CAN BE A LONG CALCULATION.
B. EQUIVALENT ANNUAL COST (WORTH) METHOD
RELIABLE, EASY
MAY BE USEFULL WHEN ECONOMIC LIFES OF ALTERNATIVES ARE
DIFFERENT
ALTERNATIVES
C. CAPITILIZED COST METHOD
EASY
MAYBE USEFULL WHEN ECONOMIC LIFES OF ALTERNATIVES ARE
DIFFERENT
YOU CAN USE THIS METHOD WHEN YOU ARE COMPARING ONLY
COST DATA (INCOMES SAME)
D. INTERNAL RATE OF RETURN (IRR) METHOD
MAYBE MISLEADING, SO YOU HAVE TO USE INCREMENTAL IRR
METHOD
NOT EASY
ALTERNATIVES
EXAMPLE:
TWO TYPES OF EQUIPMENT ARE AVAILABLE FOR PERFORMING A
MANUFACTURING OPERATION AND THE COST DATA ARE RECORDED AS:
TYPE A
FIRST COST,$
88,000
SALVAGE, $
7,500
ANNUAL MAINTENANCE, $ 4,300
LIFE, YEARS
12
TYPE B
45,000
4,000
5,200
6
DETERMINE THE MORE ECONOMIC TYPE IF i = %8
ALTERNATIVES
a. PRESENT WORTH METHOD
WE SELECT A 12- YEAR ANALYSIS PERIOD:
PA = 88,000 + 4,300 [ (1.0812 1) / .08 (1.0812 )] - 7,500 / 1.0812
= $ 117,415
PB = 45,000 + 41,000 / 1.086 + 5,200 [ (1.0812 1) / .08 (1.0812 )] - 4,000 / 1.0812
= $ 108,432
TYPE B IS BETTER
b. EAC METHOD
EACA = 88,000 [.08 (1.0812 ) / (1.0812 1) ] + 4,300 - 7,500 [.08 / (1.0812 1) ]
= 15,582.4
EACB = 45,000 [.08 (1.086 ) / (1.086 1) ] + 5,200 4,000 [.08 / (1.086 1) ]
= 14,387.9
TYPE B IS BETTER
ALTERNATIVES
EXAMPLE:
COMPARE THE INVESTMENTS HAVING THE FOLLOWING COST DATA ON THE
BASIS OF PRESENT WORTH OF COSTS USING i = %10:
TYPE A
TYPE B
FIRST COST,$
46,000
34,000
SALVAGE,$
4,000
0
ANNUAL MAINTENANCE,$
3,700
3,200
LIFE, YEARS
7
5
SINCE THE LOWEST COMMON MULTIPLE OF 7 AND 5 IS 35, WE SELECT AN
ANALYSIS PERIOD OF 35 YEARS:
PA = 46,000 + 42,000 / 1.17 + 42,000 / 1.114 + 42,000 / 1.121 + 42,000 / 1.128
4,000 / 1.135 + 3,700 [ (1.135 1) / .1(1.135 ) = $122,720
PB = 34,000 + 34,000 / 1.15 + 34,000 / 1.110 + 34,000 / 1.115 + 34,000 / 1.120
+ 34,000 / 1.125 + 34,000 / 1.130 + 3,200 [ (1.135 1) / .1(1.135 ) = $117,378
TYPE B IS BETTER AND PA / PB = 122,720 / 117,378 = 1.046
ALTERNATIVES
SOLVE THE SAME PROBLEM USING CAPITILIZED COST METHOD:
K = R / i + CV + CR / [(1 + i)n 1]
KA = 3,700 / .1 + 46,000 + 42,000 / (1.17 1)
= 127,270
KB = 3,200 / .1 + 34,000 + 34,000 / (1.15 1)
= 121,691
TYPE B IS BETTER AND KA / KB = 127,270 / 121,691 = 1.046
WE HAVE THE SAME RESULT BOTH METHODS AND CAPITILIZED COST
CALCULATION IS SIMPLER
ALTERNATIVES
IN IRR INCREMANTAL APPROACH, YOU START WITH THE LOWEST
INVESTMENT ALTERNATIVE, CALCULATE IRR, COMPARE WITH
MARR; IF IRR > MARR, THAT IS AN ACCEPTABLE ALTERNATIVE.
NOW CALCULATE IRR FOR THE INCREMENT OF THE NEXT
ALTERNATIVE. IF THIS SATISFIES MARR IT IS ACCEPTABLE;
IF NOT ELIMINATE. CONTINUE LIKE THIS TILL YOU EVALUATE ALL
ALTERNATIVES.
THE BIGGEST INVESTMENT THAT SATISFIES THE MARR IS THE BEST
ALTERNATIVE
ALTERNATIVES
STEP 1A: CALCULATE THE IRR FOR
THE ALTERNATIVE REQUIRING
THE LEAST INVESTMENT
STEP 1B: IF THE ALTERNATIVES ARE BASED

ONLY ON RELATIVE COST, ASSUME THE
LOWEST COST OPTION IS ACCEPTABLE
STEP 2: COMPARE THE IRR WITH THE MARR TO DETERMINE

WHETHER THE ALTERNATIVE IS ACCEPTABLE
STEP 3A: IF IRR < MARR , ELIMINATE
THE ALTERNATIVE, CONSIDER
THE NEXT HIGHER INVESTMENT
STEP 3B: FOR AN ACCEPTABLE

ALTERNATIVE, DETERMINE THE NEXT
INCREMENT OF INVESTMENT
STEP 4: COMPARE THE IRR FOR THE INCREMENT OF INVESTMENT WITH THE MARR.
IRR < MARR, ELIMINATE THE ALTERNATIVE. OTHERWISE ALTERNATIVE IS
ACCEPTABLE
IF
STEP 5: IF NO HIGHER LEVEL OF INVESTMENT, GO TO STEP 6. OTHERWISE CALCULATE

IRR FOR THE TOTAL INCREMENT OF INVESTMENT BETWEEN THE LAST
ACCEPTABLE ALTERNATIVE AND NEXT HIGHER LEVEL OF INVESTMENT.GO TO ST4
STEP 6: DECISION. WE HAVE FOUND THE ACCEPTABLE ALTERNATIVE WITH THE
GREATEST INVESTMENT ASSUMING AVAILABILITY OF CAPPITAL
ALTERNATIVES
EXAMPLE :
INITIAL INVESTMENT
ANNUAL CASH FLOW:
MARR = 10%
A
: 170,000
44,000
B
260,000
49,000
C
300,000
66,000
D
330,000
68,000
IRR FOR A : P = R [{ (1 + i)n 1} / i(1 + i)n]

170,000 = 44,000 [{ (1+i)10 1} / i(1+i)10]
i = 0.225 by trial and error > MARR; ALTERNATIVE A IS ACCEPTABLE
INCREMENT OF ALT. B : 260,000 170,000 = 90,000 inc. investment
49,000 44,000 = 5,000 inc. annual return ; 10 x 5,000 = 50,000 inc. for 10 years
SINCE INC. RETURN FOR 10 YEARS < INC. INVEST., ALT B NOT ACCEPTABLE
IRR FOR INCREMENT OF C TO A :
300,000 170,000 = (66,000 44,000) [{ (1 + i)10 1} / i(1 + i)10]
i = 0.109 by trial error > MAAR ; ALTERNATIVE C IS ACCEPTABLE
INCREMENT OF ALT. D : 330,000 300,000 = 30,000 inc. investment
68,000 66,000 = 2,000 inc. annual return ; 10 x 2,000 = 20,000 inc. for 10 years
SINCE INC. RETURN FOR 10 YEARS < INC. INVEST., ALT D NOT ACCEPTABLE
CHOOSE ALTERNATIVE C
ALTERNATIVES
WHEN WE DIRECTLY COMPARE ALTERNATIVES :
A
B
C
INVESTMENT
:
170,000
260,000
300,000
ANNUAL CASH FLOW 44,000
49,000
66,000
IRR (%)
:
22.5
13.5
17.7
D
330,000
68,000
15.9
IF WE DO NOT USE THE INCREMENTAL METHOD, WE MAY MAKE

MISTAKES. IF WE CHOOSE ALTERNATIVE A (SINCE IT HAS THE
GREATEST IRR) WE WILL LOOSE MONEY COMPARED WITH
CHOOSING ALTERNATIVE C. IF WE CHOOSE ALTERNATIVE D
(GREATEST INVESTMENT WITH IRR > MARR) WE WILL AGAIN
LOOSE MONEY BY INVESTING AN EXTRA 30,000 WITH LOWER
RETURN.
ALTERNATIVES
IF WE USE PRESENT WORTH FOR COMPARISON, WE WILL GET THE
SAME (CORRECT) RESULT (MUCH EASIER)
P = R [{ (1 + i)n 1} / i(1 + i)n] ; i = 0.10
P = R{ (1.110 1) / 0.1(1.1)10} = R (6.14475)
ALT. A : PW = - 170,000 + 44,000 x 6.14475
ALT. B : PW = - 260,000 + 49,000 x 6.14475
ALT. C : PW = - 300,000 + 66,000 x 6.14475
ALT. D : PW = - 330,000 + 68,000 x 6.14475
= 100,369
= 41,092
= 105,553
= 87,843
ALTERNATIVE C GIVES THE BIGGEST PRESENT WORTH SO IT

SHOULD BE CHOOSEN
ALTERNATIVES
2. ANALYSIS OF INDEPENDENT ALTERNATIVES
FOR INDEPENDENT ALTERNATIVES THE CAPITAL AVAILABLE MAY
BE THE LIMITING FACTOR. WITH THIS LIMIT IN MIND, THE BEST
ALTERNATIVE OR ALTERNATIVES MAY BE CHOSEN AFTER
FINDING PW OR IRR VALUES FOR EACH ALTERNTIVE. SINCE THEY
ARE NOT EXCLUSIVE, WE CAN CHOOSE MORE THAN ONE.
ONE USEFULL METHOD TO HANDLE INDEPENDENT ALTERNATIVES
IS TO CONVERT THEM TO MUTUALLY EXCLUSIVE GROUPS.
EXAMPLE: YOU HAVE THE FOLLOWING 4 INDEPENDENT PROPOSALS
PROPOSAL INVESTMENT END OF EACH YEAR
IRR%
PW
CASH FLOW
(i = 0.10)
1
2
3
1
$300
$130
130
130
14.4
23.29
2
500
210
210
210
12.5
22.24
3
600
250
250
250
12.0
21.71
4
1500
628
628
628
12.3
61.74
YOU CAN CONVERT THIS TO 16 MUTUALLY EXCLUSIVE ALTERNATIVES
ALTERNATIVES
GROUP
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
PROPOSALS
1
2
3
4
0
0
0
0
1
0
0
0
0
1
0
0
1
1
0
0
0
0
1
0
1
0
1
0
0
1
1
0
1
1
1
0
0
0
0
1
1
0
0
1
0
1
0
1
1
1
0
1
0
0
1
1
1
0
1
1
0
1
1
1
1
1
1
1
INVESTMENT
0
$300
500
800
600
900
1100
1400
1500
1800
2000
2300
2100
2400
2600
2900
ANNUAL RECEIPT
FOR 3 YEARS
0
$130
210
340
250
380
460
590
628
758
838
968
878
1008
1088
1218
PW
0
$23.29
22.24
43.53
21.71
45.00
43.95
67.24
61.74
85.03
83.98
107.27
83.45
106.74
105.69
128.98
ALTERNATIVES
PRESENT WORTHS CAN BE CALCULATED BY ADDING THE PRESENT
WORTHS OF THE GROUP MEMBERS OR BY
R {(1.13 1) / 0.1(1.1)3} PINV
IF THERE IS NO CAPITAL LIMITATION, WE SHOULD CHOOSE GROUP 16
COVERING ALL PROPOSALS SINCE IT HAS THE BIGGEST PW. IF
THERE IS A LIMIT OF $2400 WE SHOULD CHOOSE GROUP 12,
IF
THERE IS A LIMIT OF $1000 WE SHOULD CHOOSE GROUP 6.
IN ANY ANAYLSIS DO NOTHING ALTERNATIVE SHOULD BE
CONSIDERED. WHEN ALL IRRS ARE < MARR OR PWS ARE
NEGATIVE, THIS ALTERNATIVE SHOULD BE CHOSEN (IF THE
INVESTMENT IS NOT A MUST). THEN THE INVESTOR OR THE
COMPANY WILL DO NOTHING ABOUT THE PROJECTS BEING
CONSIDERED AND THE AVAILABLE FUNDS WILL BE USED IN
OTHER PROJECTS OR INVESTMENT TOOLS.
ALTERNATIVES
WE MAY HAVE TWO INDEPENDENT SETS OF MUTUALLY EXCLUSIVE
PROPOSALS. THAT IS, PROPOSALS A1 AND A2 ARE MUTUALLY
EXCLUSIVE AND B1 AND B2 ARE ALSO MUTUALLY EXCLUSIVE BUT
AS AND BS ARE INDEPENDENT (TWO KINDS OF COMPUTERS AND
TWO KINDS OF FORKLIFTS).
THAN WE HAVE :
GROUP
1
2
3
4
5
6
7
8
9
A1
0
1
0
0
0
1
1
0
0
A2
0
0
1
0
0
0
0
1
1
B1
0
0
0
1
0
1
0
1
0
B2
0
0
0
0
1
0
1
0
1
ALTERNATIVES
IT IS QUITE POSSIBLE TO COMPARE A SERIES OF ALTERNATIVE

INVESTMENTS BY EACH OF THE DIFFERENT PROFITABILITY
METHODS AND FIND DIFFERENT RESULTS DEPENDING ON THE
EVALUATION TECHNIQUE USED.
IF THERE IS ANY QUESTION AS TO WHICH METHOD SHOULD BE USED
FOR A FINAL DETERMINATION, NET PRESENT WORTH SHOULD BE
CHOSEN.
ALTERNATIVES
EXAMPLE:
INVESTMENTS A ($160,000) AND B ($150,000) HAVE THE CASH FLOWS SHOWN
BELOW. DETERMINE WHICH INVESTMENT SHOULD BE UNDERTAKEN IF
THE SOLE CRITERION IS a) THE PAYBACK PERIOD, b) THE PRESENT
WORTH.
ALT
1
2
3
4
5
6 YEARS
A
$100,000 80,000 20,000 10,000 10,000 10,000
B
$ 25,000
25,000 25,000 100,000 150,000 80,000
a)
PAYBACK FOR A: 2 YEARS, PAYBACK FOR B: 4 YEARS
b)
PWA : 100,000 / 1.1 + 80,000 / 1.12 + 20,000/ 1.13 + 10,000/ 1.14 +

10,000/ 1.15 + 10,000 / 1.16 160,000 = 30,742
PWB :
25,000 / 1.1 + 25,000 / 1.12 + 25,000/ 1.13 + 100,000/ 1.14 +

150,000/ 1.15 + 80,000 / 1.16 150,000 = 118,838
ALTERNATIVE B IS MUCH BETTER, BUT PAYBACK METHOD MAY MISLEAD
ALTERNATIVES
REVENUE
: TOTAL INCOME (OR TOTAL SAVINGS)
NET PROFITS
: REVENUE ALL EXPENSES INCOME TAX
ALL EXPENSES : CASH EXPENSES + DEPRECIATION

INCOME TAX
: (REVENUE ALL EXPENSES) (TAX RATE)
CASH FLOW
: NET PROFIT + DEPRECIATION
IX. ANALYSIS OF REPLACEMENTS
REPLACEMENTS
REPLACEMENT : AN ALTERNATIVE CASE IN WHICH FACILITIES ARE
CURRENTLY IN EXISTENCE AND IT MAY BE DESIRABLE TO
REPLACE THESE FACILITIES WITH DIFFERENT ONES
THE REASONS FOR REPLACEMENTS CAN BE DIVIDED INTO TWO
GENERAL CLASSES:
1. AN EXISTING PROPERTY MUST BE REPLACED TO CONTINUE A
SATISFACTORY OPERATION BECAUSE
a) PROPERTY IS WORN OUT
b) CAPACITY IS NOT SUFFICIENT
C) ECONOMICALLY NOT FEASIBLE ANYMORE
2. DUE TO TECHNOLOGICAL IMPROVEMENTS, BETTER OR MORE
ECONOMICAL EQUIPMENT IS AVAILABLE
REPLACEMENTS
FOR THE FIRST CLASS OF REASONS, YOU SHOULD EITHER MAKE
THE REPLACEMENT OR GO OUT OF BUSINESS. SO ECONOMIC
ANALYSIS IS MADE BETWEEN THE NEW ALTERNATIVES. FOR THE
SECOND CLASS OF REASONS, ANALYSIS IS MADE BETWEEN THE
EXISTING FACILITY AND NEW ALTERNATIVE. IN THIS CASE, IN
ORDER TO DECIDE, THE OPERATING EXPENSES OF THE PRESENT
EQUIPMENT MUST BE COMPARED WITH THOSE THAT WOULD
EXIST IF THE CHANGE WERE MADE.
THE DIFFERENCE BETWEEN THE TOTAL COST OF THE NEW
PROPERTY AND THE NET RELIZABLE VALUE OF THE EXISTING
PROPERTY EQUALS THE NECESSARY INVESTMENT FOR THE
REPLACEMENT. IN THESE ANALYSIS, THE NET RELIZABLE VALUE
OF AN EXISTING PROPERTY SHOULD BE ASSUMED TO BE THE
MARKET VALUE. ALTHOUGH THIS MAY BE LESS THAN THE
ACTUAL VALUE OF THE PROPERTY AS FAR AS THE OWNER IS
CONCERNED OR LESS THAN THE BOOK VALUE (UNAMORTIZED
VALUE), IT STILL REPRESENTS THE AMOUNT OF CAPITAL WHICH
CAN BE OBTAINED FROM THE OLD EQUIPMENT. ANY ATTEMP TO
ASSIGN A VALUE GREATER THAN THIS TENDS TO FAVOR
REPLACEMENTS WHICH ARE UNECONOMICAL.
REPLACEMENTS
SUPPOSE YOU BOUGHT AN EQUIPMENT FOR $100,000 WITH 10 YEARS
ECONOMIC LIFE AND DEPRECIATE IT WITH STRAIGHT LINE
METHOD. AFTER 8 YEARS IT HAS A BOOK VALUE OF $20,000.
BUT IF YOU TRY TO SELL IT, ITS VALUE MAY BE LOWER OR HIGHER
THAN $20,000 DEPENDING ON MANY FACTORS. SO FOR
REPLACEMENT ANALYSIS YOU SHOULD FORGET $20,000 AND TRY
TO FIND OUT THE MARKET VALUE.
DURING REPLACEMENT, ADDITIONAL EXPENSES OCCUR SUCH AS
FREIGHT, CONSTRUCTION OF FOUNDATIONS, NEW CONNECTIONS
OF WIRING OR PIPING, TEST AND ADJUSTMENT EXPENSES,
REMOVAL OF OLD EQUIPMENT, REPLACING OF FLOORS OR OTHER
STRUCTURAL ELEMENTS AND THE SHUT- DOWN TIME DURING THE
REPLACEMENT. THESE COSTS WHICH MAY BE AS BIG AS THE
PRICE OF THE NEW EQUIPMENT OR EVEN BIGGER SHOULD
ALLWAYS BE CONSIDERED WHEN ANALYSING THE REPLACEMENT.
REPLACEMENT
REPLACEMENT ANALYSIS:
ALL KINDS OF EQUIPMENT USED IN PLANTS GETS OLD AND SHOULD
BE REPLACED ONE DAY. SO THE QUESTION IS NOT IF THE
EXISTING EQUIPMENT WILL BE REPLACED, BUT WHEN IT WILL BE
REPLACED.
THIS LEADS US TO THE DECISION:
SHALL WE REPLACE THE EXISTING EQUIPMENT NOW, OR SHALL
WE KEEP IT FOR ONE OR MORE ADDITIONALYEARS.
THE ECONOMIC EVALUATION MADE FOR THE ABOVE DECISION IS
CALLED REPLACEMENT ANALYSIS
REPLACEMENT
WE CALL THE EXISTING EQUIPMENT DEFENDER, AND THE BEST
AVAILABLE REPLACEMENT EQUIPMENT CHALLENGER.
1. FIND THE MARGINAL COST DATA OF THE DEFENDER
2. FIND THE EAC (EQUIVALENT ANNUAL COST) OF THE
CHALLENGER
3. MAINTAIN THE DEFENDER AS LONG AS THE MARGINAL COST OF
OWNERSHIP FOR ONE MORE YEAR IS LESS THAN THE MINIMUM
EAC OF THE CHALLENGER. WHEN THE MARGINAL COST OF THE
DEFENDER BECOMES GREATER THAN THE MINIMUM EAC OF THE
CHALLENGER, THAN REPLACE THE DEFENDER WITH THE
CHALLENGER
MARGINAL COST OF AN ASSET FOR ANY YEAR IS THE COST OF
KEEPING THE ASSET AND INCLUDE LOSS IN MARKET VALUE AND
YEARLY OPERATING AND MAINTENANCE EXPENSES
REPLACEMENT
EXAMPLE:
AN ASSET PURCHASED 5 YEARS AGO CAN BE SOLD TODAY FOR $15,000.
OPERATING AND MAINTENANCE EXPENSES FOR THE FIRST YEAR IS
$10,000 BUT THESE ARE ESTIMATED TO INCREASE IN THE FUTURE BY
$1,500 PER YEAR EACH YEAR. IT IS ESTIMATED THAT THE MARKET VALUE
OF THE ASSET WILL DECREASE BY $1,000 PER YEAR.
A NEW PIECE OF EQUIPMENT THAT MAY REPLACE THE EXISTING ONE,
WILL COST $25,000 INCLUDING ALL KIND OF REPLACEMENT COSTS.
ANNUAL OPERATING AND MAINTENANCE COSTS OF THIS NEW MACHINE
IS $7,000 THE FIRST YEAR AND INCREASING AT $1,000 PER YEAR
THEREAFTER. USEFUL LIFE OF THIS EQUIPMENT IS 5 YEARS ANDTHE
SALVAGE VALUE IS $4,000.
IF MARR = %15, DETERMINE WHEN, IF AT ALL, A REPLACEMENT DECISION
SHOULD BE MADE
REPLACEMENT
MARGINAL COST OF THE DEFENDER
1. YEAR: 10,000 + [(15,000)1.15 (14,000)] = 13,250
2. YEAR: 11,500 + [(14,000)1.15 (13,000)] = 14,600
3. YEAR: 13,000 + [(13,000)1.15 (12,000)] = 15,950
4. YEAR: 14,500 + [(12,000)1.15 (11,000)] = 17,300
5. YEAR: 16,000 + [(11,000)1.15 (10,000)] = 18,650
EAC OF THE CHALLENGER
[(25,000)1.155 4,000 + 11,000 + (10,000)1.15 + (9,000)1.152 + (8,000)1.153 +
(7,000)1.154] .15 / (1.155 1) = 15,606
AT THE BEGINNING OF THE THIRD YEAR YOU SHOULD REPLACE YOUR
EQUIPMENT SINCE MARGINAL COST IS BIGGER THAN THE EAC OF THE
NEW EQUIPMENT: 15,950 > 15,606
ALTERNATIVES - PROBLEMS
*ALTER INVESTMENT SALVAGE VALUE LIFE ANNUAL NET CASH FLOW
X
$11,000
$0
6 YR
$2,600
Y
12,000
3000
6
2,500
Z
18,000
0
6
4,000
IF MARR = 0.1, WHICH ALTERNATIVE(S) SHOULD BE SELECTED ?
a) WHEN ALTERNATIVES ARE MUTUALLY EXCLUSIVE
b) WHEN ALTERNATIVES ARE INDEPENDENT
PWX = R[{(1+i)n 1} / i(1+i)n ] PINV = 2600[{ (1.1)6 1} / 0.1(1.1)6] 11,000 = 323.68
PWY = R[{(1+i)n 1} / i(1+i)n ] PINV + 3000 / 1.16 = 581.60
PWZ = R[{(1+i)n 1} / i(1+i)n ] PINV = 578.96
a)
ALTERNATIVE Y IS BEST
b)
ALTERNATIVE Y + X IS BEST
ALTERNATIVE PROBLEMS
A MANUFACTURING FIRM HAS A CHOICE BETWEEN TO MACHINES TO
PRODUCE A STANDART COMMODITY. IF i = %13.6, WHAT ANNUAL
PRODUCTION IS REQUIRED TO JUSTIFY PURCHASE OF MACHINE B?
MACHINE A
MACHINE B
FIRST COST,$
30,000
46,000
SALVAGE,$
2,000
0
FIXED ANNUAL PRODUCTION COST,$
4,800
5,000
VARIABLE PRODUCTION COST, $ / UNIT
5
2
LIFE, YEARS
10
6
LET X BE THE NUMBER OF UNITS PRODUCED ANNUALLY.
EACA = 30,000[ .136 (1.136)10 / (1.13610 1)] 2000[.136 / (1.13610 1)] + 4,800 + 5X
= 10,356 + 5X
EACB = 46,000[ .136 (1.136)6 / (1.1366 1)] + 5,000 + 2X
= 16,700 + 2X
EACA = EACB
10,356 + 5X = 16,700 + 2X
X = 2115 UNITS / YEAR
MACHINE B IS ECONOMIC WHEN YEARLY PRODUCTION IS > 2115 UNITS
ALTERNATIVES PROBLEMS
A SPECIAL EQUIPMENT IS REQUIRED FOR A R&D PROJECT THAT
WILL LAST FOR 3 YEARS. FIRST ALTERNATIVE IS A $50,000
EQUIPMENT WITH A SALVAGE VALUE OF $25,000 AND YEARLY
OPERATING COST OF $15,000. A SIMPLER EQUIPMENT WILL COST
$30,000 WHICH WILL HAVE A SALVAGE VALUE OF $10,000 AND
YEARLY OPERATING COST OF $20,000. FIND THE BETTER
ALTERNATIVE USING EQUIVALENT ANNUAL COSTS IF i = 0.1.
RA = P[ i(1 + i)n / {(1 + i)n 1}]
= (50,000 25,000/1.13) { .1x1.13/ (1.13 1)} = 12,553
EACA = 12,553 + 15,000 = $ 27,553
RB = (30,000 10,000/1.13) { .1x1.13/ (1.13 1)} = 9,042
EACA = 9,042 + 20,000 = $ 29,042
ALTERNATIVE A IS BETTER
ALTERNATIVES - PROBLEM
A COMPANY MAY BUY A MACHINE THAT COSTS $10,000 WITH A SALVAGE

VALUE OF $4,000 AT THE END OF 6 YEARS LIFE. THE ANNUAL OPERATING
DISBURSEMENTS ARE $5,000 A YEAR FOR THE FIRST 3 YEARS AND $6,000
A YEAR FOR THE LAST 3 YEARS. THERE IS AN AUTOMATIC VERSION
WHICH COSTS $20,000 WITH A SALVAGE VALUE OF $6,000 AT THE END OF
THE 6th YEAR AND YEARLY OPERATING DISBURSEMENTS OF $3,000 A
YEAR. FIND THE BETTER ALTERNATIVE USING EQUIVALENT ANNUAL
COSTS IF i = 0.15.
RA = P [ i(1 + i)n / {(1 + i)n 1}]
SINCE $5,000 IS SPEND EVERY YEAR, $1,000 FOR THE LAST 3 YEARS WILL BE
CONSIDERED
RA =(10,000 4000/1.156 +1000/1.154 +1000/1.155 +1000/1.156){.15x1.156/(1.156-1)}
RA = $2582
EACA = 2582 + 5000 = $7582
RB = (20,000 6000/1.156) {.15x1.156/(1.156-1)} = $4599
EACB = 4599 + 3000 = $7599

ALTERNATIVE A IS BETTER
* 5 INVESTMENT PROPOSALS WITH 5 YEARS LIFE ARE AS FOLLOWS :
A
B
C
D
E
INVESTMENT $
30,000
60,000
20,000
40,000
30,000
SALVAGE VALUE $
0
10,000
0
10,000
5,000
NET ANNUAL CASH FLOW $ 7,500
13,755
5,000
10,000
7,500
MARR = 9%
a) WHICH PROPOSAL IS PREFERRED IF ONLY ONE CAN BE SELECTED?
b) HOW MUCH SHOULD BE INVESTED IF THE PROPOSALS ARE INDEPENDENT
AND UNLIMITED CAPITAL IS AVAILABLE?
PWA=R[{(1+i)n 1)} / i(1+i)n] PINV =7500{(1.095 1) / 0.9x1.095} 30,000 = 827.66
PWB = 13,755 {(1.095 1) / 0.9x1.095} +(10,000 / 1.095) 60,000 = 0
PWC = 5,000{(1.095 1) / 0.9x1.095} 20,000 = 552
PWD = 10,000{(1.095 1) / 0.9x1.095} +(10,000 / 1.095) 40,000 = 5,395.31
PWE = 7,500{(1.095 1) / 0.9x1.095} +( 5,000 / 1.095) 30,000 = 2,421.66
a)
b)
ALTERNATIVE D IS SELECTED SINCE IT HAS THE BIGGEST PW

ALT B + ALT D + ALT E = $130,000
* A COMPANY PLANS TO BUY A FACTORY BUILDING FOR A TEN YEAR
PROJECT AND SELL IT AT THE END. THE LOCATION OF THE
BUILDING EFFECTS THE COSTS, SO DIFFERENT CASH FLOWS
OCCUR. IF MARR = 15%, WHICH BUILDING IS BEST ?
SITE 1
SITE 2
SITE 3
PURCHASE PRICE : $140,000
190,000
220,000
RESALE VALUE
: $125,000
155,000
175,000
CASH FLOW
: $ 24,000
31,000
41,000
PW1 = 24,000{(1.1510 1)/0.15x1.1510} + 125,000/1.1510 140,000 = 11,349
PW2 = 31,000{(1.1510 1)/0.15x1.1510} + 155,000/1.1510 190,000 = 3,896
PW3 = 41,000{(1.1510 1)/0.15x1.1510} + 175,000/1.1510 220,000 = 29,027
HIGHEST PW IS SITE 3, SO CHOOSE SITE 3
* A FIRM FINDS THAT AIRCONDITIONING IS NECESSARY FOR A ROOM AND AS
MONEY SPEND ON INSULATING THE WALLS GETS LARGER, INVESTMENT
FOR AIRCONDITIONING GETS SMALLER :
ALTERNATIVES
1
2
3
4
FIRST COST OF INS.
$ 35,000
45,000
60,000 80,000
FIRST COST OF AC
$ 52,000
45,000
38,000 32,000
ANNUAL POWER COST $ 6,500
5,100
4,100
3,500
INSULATION HAS 20 YEARS, AC HAS 10 YEARS LIFE WITH 0 SALVAGE VALUE.
WHICH ALT. IS BEST IF i = 15%, AND REPLACEMENT COST IS CONSTANT ?
CR (AC) = C / 1.1510 = 0.2472 x C
PW = C(INS) + C(AC) + CR(AC) + R {(1.1520 1) / 0.15 x 1.1520}
PW1 = 35,000 + 52,000 + 12,854 + 6,500 {(1.1520 1) / 0.15 x 1.1520} = $140,538
PW2 = 45,000 + 45,000 + 11,124 + 5,100 {(1.1520 1) / 0.15 x 1.1520} = $133,045
PW3 = 60,000 + 38,000 + 9,394 + 4,100 {(1.1520 1) / 0.15 x 1.1520} =$133,056
PW4 = 80,000 + 32,000 + 7,910 + 3,500 {(1.1520 1) / 0.15 x 1.1520} =$141,817
CHOOSE THE MINIMUM PW : ALTERNATIVE 2
* TWO MUTUALLY EXCLUSIVE PROPOSALS HAVE THE FOLLOWING CASH FLOW :
INVESTMENT
1
2
3
4
5YEARS
A
$ 100,000
60,000 50,000 40,000 30,000
0
B
100,000
60,000 15,000 60,000 40,000
0
ALL RECEIPTS FROM PROPOSALS A AND B CAN BE REINVESTED AT 20% FOR
A AND 25% FOR B. THE REINVESTMENT RATES ARE EXPECTED TO
CONTINUE THROUGHOUT THE 5-YEAR COMPARISON PERIOD. MARR = 15%
a) WHICH IS BETTER WHEN REINVESTMENT OPPURTUNITY IS IGNORED?
PW = S/(1+i)n
PWA = 60,000/1.15 + 50,000/1.152 + 40,000/1.153 + 30,000/1.154 100,000 = 33,434
PWB = 60,000/1.15 + 15,000/1.152 + 60,000/1.153 + 40,000/1.154 100,000 = 25,837
ALT. A IS BETTER
b) WHICH IS BETTER WHEN RECEIPTS ARE INVESTED AT GIVEN RATES ?
S = P (1+i)N
PW = P(1+i)N / (1+i)n WHERE N : RECEIPT INVESTING TIME
PWA =(60,000x1.24 + 50,000x1.23 + 40,000x1.22 + 30,000x1.2)/1.155- 100,000=51,348
PWB =(60,000x1.254 + 15,000x1.253 + 60,000x1.252 + 40,000x1.25)/1.155- 100,000
=58864
58,864 ALT B IS BETTER
* CASH FLOWS FOR 5 ALTERNATIVES ARE BELOW : (i = 0.15)
ALT
INVESTMENT
1
2
3
4
5
A
$15,000
4,500
4,500
4,500
4,500
4,500
B
25,000
12,000 10,000
8,000
6,000
4,000
C
20,000
2,000
4,000
6,000
8,000
10,000
D
30,000
0
0
15,000
15,000 15,000
E
10,000
4,500
4,500
-2,500
4,500
7,500
a) IF ALTERNATIVES ARE MUTUALLY EXCLUSIVE , WHICH IS THE BEST ?
PWA = R[ {(1+i)n 1} / i(1+i)n] PINV = 4,500 {(1.155 1) / 0.15x1.155} 15,000 = 84
PWB =12,000/1.15+10,000/1.152+8,000/1.153+6,000/1.154+4,000/1.155- 25,000 =3,675
PWC =2,000/1.15+4,000/1.152+6,000/1.153+8,000/1.154+10,000/1.155- 20,000 =-1,754
PWD =15,000/1.153+15,000/1.154+15,000/1.155- 30,000 =- 4,103
PWE =4,500/1.15+4,500/1.152-2,500/1.153+4,500/1.154+7,500/1.155- 10,000 =1,974
ALT B IS THE BEST
b) IF INVESTMENT CAPITAL IS LIMITED WITH $30,000 AND THE PROPOSALS
ARE INDEPENDENT, WHICH PROPOSALS SHOULD BE EXPECTED ?
ALT B WILL BE EXPECTED
* PROPOSAL A REQUIRES AN INVESTMENT OF $250,000 WHICH WILL
BRING AN ANNUAL INCOME OF $100,000 FROM ANNUAL
DISBURSEMENTS OF $40,000. THE LIFE OF THE PROJECT IS
EXPECTED TO BE 20 YEARS WITH $75,000 SALVAGE AT THAT
DATE. PROPOSAL B REQUIRES $175,000 INVESTMENT WITH
ANNUAL INCOME OF $90,000 AND DISBURSEMENTS 0F $50,000.
AT THE END OF 20 YEARS ITS SALVAGE WILL BE $60,000.
THE PROPOSALS ARE MUTUALLY EXCLUSIVE ALTHOUGH THE
COMPANY MAY TURN DOWN BOTH IF NEITHER IS ACCEPTABLE.
THE MARR IS 20%.
PWA = 250,000 + 75,000/1.220 + 60,000 [(1.220 1)/ (.2 x 1.220)] = $44,131
PWB = 175,000 + 60,000/1.220 + 40,000 [(1.220 1)/ (.2 x 1.220)] = $21,348
BOTH ALTERNATIVES ARE ACCEPTABLE, BUT SINCE THEY ARE
EXCLUSIVE, ALTERNATIVE A SHOULD BE CHOOSEN
* A DAM COSTING $100,000 TO CONSTRUCT WILL COST $15,000 A
YEAR TO OPERATE AND MAINTAIN. ANOTHER DESIGN COSTING
$150,000 TO BUILD WILL COST $10,000 A YEAR TO OPERATE AND
MAINTAIN. BOTH INSTALLATIONS ARE FELT TO BE PERMENANT.
THE MINIMUM REQUIRED RATE OF RETURN IS 5%.
a) WHICH ALTERNATIVE IS BETTER ?
b) AT WHAT TIME THEY ARE EQUAL ?
a) WHEN n P = R / i
PWA = 100,000 + 15,000 / 0.05 = $400,000
PWB = 150,000 + 10,000 / 0.05 = $350,000
ALTERNATIVE B IS BETTER
b) 100,000 + 15,000 [ (1.05n 1) / 0.05 x 1.05n] =
150,000 + 10,000 [ (1.05n 1) / 0.05 x 1.05n]
1.05n 1 = 0.5 x 1.05n 1.05n = 2
n = 14.2 YEARS
* AN AUTOMATIC MACHINE COSTS $20,000 AND IS EXPECTED TO
HAVE AN ANNUAL OPERATING COST OF $900 AT THE END OF
EACH YEAR OF ITS 10-YEAR LIFE. A SEMIAUTOMATIC MACHINE
WHICH COSTS $10,000 WILL HAVE ANNUAL OPERATING COSTS OF
$2,000 OVER ITS 10-YEAR LIFE. IF SALVAGE VALUES ARE 0,
WHICH ONE COSTS LESS a) WHEN i = 0 AND b) WHEN i = 0.10 ?
a) CA = 20,000 + 10 x 900 = $29,000
CS = 10,000 + 10 x 2,000 = $30,000
AUTOMATIC COSTS LESS
b) PW = PINV + R [{(1+i)n 1} / i(1+i)n]
PWA = 20,000 + 900 {(1.110 1) / 0.1x1.110} = $25,529
PWS = 10,000 + 2,000 {(1.110 1) / 0.1x1.110} = $22,288
SEMIAUTOMATIC COSTS LESS
A FIRM INSTALLED A FACILITY WITH A FIRST COST OF $80.000, WHICH HAS A
LIFE OF 9 YEARS AND A SALVAGE VALUE OF $4,000. YEARLY
MAINTENANCE COST IS $6,800. AFTER THE FACILITY HAD BEEN IN
OPERATION FOR 5 YEARS AN IMPROVEMENT WAS PROPOSED TO
INCREASE ITS LIFE TO 11 YEARS, REDUCE YEARLY MAINTENANCE TO
$5,000 FOR THE REMAINING LIFE, AND INCREASE THE SALVAGE VALUE TO
$7,500. IF MONEY IS WORTH %10.5, WHAT IS THE MAXIMIM AMOUNT THE
FIRM SHOULD EXPEND FOR THIS IMPROVEMENT?
FIND THE ORIGINAL EAC:
EAC1 = 80,000[.105 (1.1O5)9 / (1.1O59 1)] 4,000 [.105 / (1.1O59 1)] + 6,800
= 20,681
FIND THE IMPROVED EAC ( LET X BE THE EXPENSE OF IMPROVEMENT):
P = 80,000 + X / 1.1O55 7,500 / 1.1O511 + 6,800 [ (1.1O55 1) / .105 (1.1O5)5 ]
+ 5,000 [ (1.1O56 1) / .105 (1.1O5)6 ] ( 1 / 1.1O55 ) = 115,985 + .607 X
EAC2 = (115,985 + .607 X) [.105 (1.1O5)11 / (1.1O511 1)] = 18,268 + .0956 X
EAC1 = EAC2
20,681 = 18,268 + .0956 X
X = $25,240
A FIRM IS CONSIDERING BUYING EQUIPMENT THAT WILL REDUCE ANNUAL
LABOR COSTS BY $10,500. THE EQUIPMENT COSTS $51,000 AND HAS A
SALVAGE VALUE OF $5,000 AND LIFE OF 7 YEARS. ANNUAL MAINTENANCE
WILL BE $1,200. IF THE MARR IS %10,IS THE FIRM JUSTIFIED IN
PURCHASING THE EQUIPMENT?
BY PRESENT WORTH
P = 51,000 + 5,000 / 1.17 + (10,500 1,200) [ (1.17 1) / .1(1.17) ] = 3,128
SINCE P IS NEGATIVE, IT IS NOT ECONOMIC
BY EAC
EAC = 51,000 [ .1(1.17) / (1.17 1) ] 5,000 [ .1 / (1.17 1) ] + 1,200 = 11,142
SINCE EAC > ANNUAL SAVING (10,500), IT IS NOT ECONOMIC
BY IRR
51,000 + 5,000 / (1+i)7 + (10,500 1200) [ (1+i)7 1) / i(1+i)7 ] = 0
BY TRIAL- ERROR i = %8.2 WHICH IS LESS THAN MARR, NOT ECONOMIC
X. INFLATION
INFLATION
INFLATION CAUSES PRICES TO RISE AND DECREASES THE
PURCHASING POWER OF MONEY. INFLATION RATES ARE USUALLY
MEASURED BY WHOLESALE PRICE INDEX AND CONSUMER PRICE
INDEX.
WHEN INFLATION IS MODEST, 2 TO 4 PERCENT PER YEAR, IT IS
GENERALLY IGNORED IN ECONOMIC EVALUATIONS OF
PROPOSALS. IT IS ARGUED THAT ALL PROPOSALS ARE
AFFECTED SIMILARLY BY PRICE CHANGES AND THAT THERE IS
TOO LITTLE DIFFERENCE BETWEEN CURRENT AND FUTURE
COSTS TO INFLUENCE THE ORDER OF PREFERENCE. THESE
ARGUMENTS LOSE SUBSTANCE WHEN INFLATION IS HIGH AND
SOME GOODS ESCALATE MORE RAPIDLY THAN OTHERS.
INFLATION
THERE ARE TWO ALTERNATIVE METHODS OF TREATING INFLATION IN
FINANCIAL ANALYSIS :
1. CONVERT ALL CASH FLOWS TO CONSTANT- WORTH (REAL OR
TODAYS DOLLAR) AMOUNTS TO ELIMINATE THE EFFECT OF
INFLATION. THEN USE THE REGULAR INTEREST RATES. THIS IS
APPROPRIATE WHEN ALL COMPONENTS INFLATE AT UNIFORM
RATE.
2. EXPRESS THE FUTURE CASH FLOWS IN THEN- CURRENT OR
ACTUAL DOLLARS AND USE AN INTEREST RATE THAT INCLUDES
INFLATION.
IN ANALYSIS THAT CONSIDERS INFLATION, MARKET INTEREST RATE
(if) SHOULD BE USED. if INCLUDES THE COMBINED EFFECT OF THE
EARNING VALUE OF CAPITAL AND EXPECTED INFLATION. MARKET
INTEREST RATES ARE ALSO REFERRED TO AS COMPOSITE OR
INFLATION ADJUSTED INTEREST RATES.
INFLATION
THE INTEREST RATE if IS DEFINED AS
if = (1 + i)(1 + f) 1
WHERE f IS THE AVERAGE INFLATION RATE.
IF i = 0.12 AND f = 0.1 THEN if = (1.12)(1.1) 1 = 0.232
CONSTANT (REAL) DOLLARS IN ANY FUTURE YEAR N CAN BE
INFLATED TO CURRENT DOLLARS BY:
CURRENT DOLLARS = (CONSTANT DOLLARS)(1 + f) N
WHEN f IS DIFFERENT FOR EACH YEAR :
(1+ f)N (1 + f1)(1 + f2) .. (1 + fN)
INFLATION
EXAMPLE : AN INVESTMENT IS MADE FOR $4000. IT WILL BRING
$1500 (REAL DOLLARS) EVERY YEAR FOR 4 YEARS. IF i = 0.12
AND f = 0.06 (CONSTANT FOR 4 YEARS), WHAT IS THE PW ?
a) IN REAL DOLLARS WE DO NOT CONSIDER INFLATION
PW = 4000 + 1500 [{ (1.12)4 1} / 0.12(1.12)4]
= $556
b) WHEN WE FIND CURRENT DOLLARS
N1 : R = 1500 (1.06) = 1590
N2 : R = 1500 (1.06)2 = 1685
N3 : R = 1500 (1.06)3 = 1787
N4 : R = 1500 (1.06)4 = 1894
if = (1.12)(1.06) 1 = 0.1872
PW = 4000 + (1590 / 1.1872) + (1685 / 1.18722) + (1787 / 1.18723) +
(1894 / 1.18724) = $556
INFLATION
EXAMPLE : A MACHINE CAN BE PURCHASED FOR $100,000. IT WILL
NO SALVAGE VALUE AT THE END OF 5 YEAR USEFULL LIFE.
OPERATING COSTS WILL BE $12,000 PER YEAR, WHILE IT
PROVIDES A REVENUE OF $40,000 ANNUALLY. ESTIMATES ARE
BASED ON CURRENT ECONOMIC CONDITIONS WITHOUT
CONSIDERATION OF INFLATION. EVALUATE THE PROPOSAL
ACCORDING TO REAL- DOLLAR DATA AND ACTUAL- DOLLAR CASH
FLOW WHEN INFLATION RATE IS 8%. THE MARR IS 10% WITHOUT
ANY ADJUSTMENT FOR INFLATION.
a) REAL- DOLLARS : 40,000 12,000 = 28,000 / YEAR
PW = 100,000 + 28,000 [(1.15 1) / 0.1(1.1)5] = $6142
b) CONVERT $28,000 TO CURRENT DOLLARS FOR f = 0.08
N1 : R = 28,000 x 1.08 = 30,240
N2 : R = 32,659
N3 : R = 35,272
N4 : R = 38,094
N5 : R = 41,141
if = (1.1 x 1.08) 1 = 0.188
PW = 100,000 + 30,240/1.188 + 32,659/1.1882 + 35,272/1.1883 +
38,094/1.1884 + 41,141/1.1885 = $6142
INFLATION
OFTEN ONE OR MORE COMPONENTS IN A CASH FLOW STREAM HAVE
ESCALATION RATES DIFFERENT FROM THE GENERAL INFLATION
RATE.
EXAMPLE : PREVIOUS PROBLEM BUT REVENUE ($40,000) WILL
ESCALATE AT 5% WHILE INFLATION IS 8% AND EXPENSES
INCREASE AT 8%
REVENUE
EXPENSES
NET RECEIPT
N1
$42,000
$12,960
$29,040
N2
44,100
13,997
30,103
N3
46,305
15,116
31,189
N4
48,620
16,326
32,294
N5
51,051
17,632
33,419
PW = 100,000 + 29,040/1.188 + 30,103/1.1882 + 31,189/1.1883 +

32,294/1.1884 + 33,419/1.1885
= $5,289
XI.OPTIMIZATION
OPTIMIZATION
THE OPTIMUM FOR A PROCESS DESIGN IS THE MOST COST-EFFECTIVE
SELECTION, ARRANGEMENT, SEQUENCING OF PROCESSING EQUIPMENT
AND OPERATING CONDITIONS FOR THE DESIGN.
HOW OPTIMIZATION IS MADE:

1. OPTIMIZATION CRITERIA IS ESTABLISHED: SELECTION OF AN ECONOMIC
CRITERION THAT IS TO BE THE OBJECTIVE FUNCTION
(total cost, profit, production rate)
2. PROBLEM IS DEFINED: EXAMINATION OF PROCESS TO DETERMINE
VARIABLES AND CONSTRAINTS THAT EFFECT THE OBJECTIVE FUNCTION
AND ESTABLISHMENT OF MATHEMATICAL RELATIONS (temperature,
pressure, flow rate, equipment specifications)
3. PROBLEM IS SOLVED FOR THE OPTIMAL VALUES
OPTIMIZATION
WHEN A DESIGN VARIABLE IS CHANGED, OFTEN SOME COSTS INCREASE
AND OTHERS DECREASE. THE TOTAL COST MAY GO THROUGH A MINIMUM
AT ONE VALUE OF THAT VARIABLE AND THIS VALUE IS THE OPTIMUM
VALUE OF THAT VARIABLE.
EXAMPLE: Optimum Insulation Thickness for a steam pipe
Cost per
Year, $
total cost (fixed+heat loss)
fixed costs
cost of heat loss
optimum insulation thickness
Insulation thickness,cm
OPTIMIZATION
IN PROCESS DESIGN YOU SHOULD OPTIMIZE IN TWO FIELDS:
STRUCTURAL OPTIMIZATION: TO FIND THE BEST FLOWHEET, YOU SHOULD
CONSIDER SELECTING EQUIPMENT, ARRANGEMENT AND SEQUENCING OF
EQUIPMENT
PARAMETRIC OPTIMIZATION: TO FIND THE BEST CONDITIONS, YOU SHOULD
CONSIDER YOU EQUIPMENT DESIGN PARAMETERS AND OPERATING
VARIABLES
TYPICALLY, A FEW NEAR OPTIMAL FLOWSHEETS ARE OBTAINED BY
ESTABLISHING SEVERAL FEASIBLE FLOWSHEETS AND THEN COMPARING
THEIR NET PRESENT WORTHS OR ANNULAIZED COSTS. ONE OR MORE OF
THESE IS THEN SUBJECTED TO PARAMETRIC OPTIMIZATION, AND THE
MOST ECONOMICALLY ATTRACTIVE ONE IS SELECTED.
OPTIMIZATION
WHEN THE FACTOR TO BE OPTIMIZED (MINIMIZED OR MAXIMIZED), IS AN
ANALYTICAL FUNCTION OF A SINGLE VARIABLE, SOLVING THE PROBLEM
IS SIMPLE.
EXAMPLE: SUPPOSE WE HAVE A COST FOR AN OPERATION BEING A
FUNCTION OF ONE VARIABLE:
C = ax + b + c / x + d
WHERE a, b, c, d ARE CONSTANTS, x IS THE VARIABLE AND C IS THE
OBJECTIVE FUNCTION TO BE MINIMIZED.
WE SET THE DERIVATIVE OF C WITH RESPECT TO X EQUAL TO 0:
dC / dx = a c / x2 = 0
x = (c / a)1/2
TO CHECK IF THE VALUE IS MINIMUM OR MAXIMUM YOU CAN TAKE THE
SECOND DERIVATIVE (IF IT IS POSITIVE, THE VALUE IS MINIMUM), OR
CALCULATE C FOR A SLIGHTLY DIFFERENT VALUE OF x.
OPTIMIZATION
EXAMPLE:
A BATCH OPERATION IN A PRODUCTION PLANT HAS ANNUAL OPERATION
COST EQUAL TO $2,000 Q0.8 WHERE Q IS THE KG OF PRODUCTION FOR
BATCH. THE PREPARATION COST FOR BATCH IS $60. WHAT IS THE
OPTIMUM BATCH SIZE IF THE YEARLY PRODUCTION IS 50,000 KG.
TOTAL COST C = 2,000 Q0.8 + 60(50,000/Q)
dC / dQ = 0.8(2,000 Q-0.2 ) 3,000,000 / Q2 = 0
Q1.8 = 1875
Q = 65.8 KG / BATCH
OPTIMIZATION
WHEN TWO OR MORE INDEPENDENT VARIABLES AFFECT THE OBJECTIVE
FUNCTION, WE USE A SIMILAR PROCEDURE
EXAMPLE: SUPPOSE YOU HAVE A TOTAL COST TO BE MINIMIZED WHICH IS A
FUNCTION OF TWO VARIABLES x AND y
C = ax + b / xy + cy + d
C / x = a b / x2y
C / y = c b / xy2
IF WE SET BOTH EQUATIONS EQUAL TO ZERO AND SOLVE FOR x AND y,
WE CAN FIND THE CORRECT VALUES OF BOTH VARIABLES OPTIMIZING
THE COST.
OPTIMIZATION
EXAMPLE: FOR AN OPERATION, THE TOTAL COST IS FOUND TO BE:
C = 2.33x + 11,900 / xy + 1.8y + 10
FIND THE x AND y VALUES GIVING THE MINIMUM TOTAL COST.
C / x = 2.33 11,900 / x2y = 0
C / y = 1.86 11,900 / xy2 = 0
2.33 x2y = 11,900
1.86 xy2 = 11,900
x ( 11,900 / 2.33x2)2 = 11,900
x = 16,
y = 20, C = 121.7
XII. PROJECT MANAGEMENT
PROJECT MANAGEMENT
PROJECT : A MAJOR UNDERTAKING THAT IS UNLIKELY TO BE
REPEATED IN EXACTLY THE SAME WAY AT FUTURE
PRODUCTION MANAGEMENT IS REPETITIVE IN NATURE,
PROJECT MANAGEMENT IS MORE OF A SINGLE, MAJOR JOB.
PROJECT ACTIVITIES HAVE PRECEDENCE RELATIONSHIPS.
IN PROJECT MANAGEMENT WE PLAN AND CONROL:
* BUDGET
* TIME
AIM IS TO MINIMIZE BUDGET AND TIME
PROJECT LIFE CYCLE

CONCEPT
- INITIATE BROAD DISCUSSION OF PROJECT
PROJECT DEFINITION
- DEVELOP PROJECT DESCRIPTION
- DESCRIBE HOW TO ACCOMPLISH THE WORK
- DETERMINE TENTATIVE TIMING
- IDENTIFY BROAD BUDGET, PERSONNEL, RESOURCE
REQUIREMENTS
PLANNING
- DEVELOP DETAILED PLANS IDENTIFYING TASKS, TIMING,
BUDGETS AND RESOURCES
- CREATE ORGANIZATION TO MANAGE THE PROJECT
PROJECT LIFE CYCLE

PRELIMINARY STUDIES
- VALIDATE THE ASSUMPTIONS MADE IN THE PROJECT PLAN BY
DATA COLLECTION, LITERATURE SEARCH
PERFORMANCE
- EXECUTE THE PROCECT PLAN AND PERFORM WORK
- USE PROJECT CONTROL TOOLS AND TECHNIQUES
POSTCOMPLETION
- CONFIRM PROJECT RESULTS
- REASSIGN PERSONNEL AND EQUIPMENT
- DOCUMENT PROJECT FILES FOR FUTURE REFERENCE
GANTT CHART
ONE OF THE OLDEST TECHNIQUES USED IS GANNT
CHART. IT SHOWS PLANNED ACTIVITIES VERSUS ACTUAL
ACCOMPLISMENTS ON THE SAME TIME SCALE.
IT IS NOT SUITED FOR MANAGEMENT OF LARGE

PROJECTS. INTERRELATIONS OF ACTIVITIES ARE NOT
SHOWN. IT IS DIFFICULT TO SEE HOW PROJECT IS
EFFECTED IF YOU DELAY AN ACTIVITY. RESCHEDULING,
WHEN THERE ARE DEVIATIONS, IS HARD TO MAKE.
GANTT CHART
8
12
12A
ACTIVITY
START OPERATION
16
18
END OPERATION
18B
PLANNED PROCESS TIME
22
ACTUAL TIME EXPANDED

0
10
NOW
15
WEEKS
ACTIVITY 16 IS EXACTLY ON SCHEDULE. ACT 12 IS 2 WEEKS AHEAD

OF SCHEDULE, ACT 18B IS 1/2 WEEK BEHIND SCHEDULE
THE GANTT CHART MUST BE UPDATED VERY FREQUENTLY TO
REFLECT THE CHANGING SITUATION SINCE CERTAIN ACTIVITIES
WILL TAKE LONGER OR SHORTER THEN EXPECTED
PROJECT PLANNING NETWORKS

TO OVERCOME SOME SHORTCOMINGS OF GANTT CHART, CPM
AND PERT METHODS WERE DEVELOPED, IN LATE 1950 s. CRITICAL
PATH METHOD (CPM) WAS DEVELOPED BY DUPONT COMPANY
DURING PLANNING FOR MAINTENANCE OF A CHEMICAL PLANT.
PERFORMANCE EVALUATION AND REVIEW TECHNIQUE (PERT)
WAS DEVELOPED DURING PLANNING POLARIS PROJECT.
USING CPM, DUPONT DECREASED THE DOWNTIME OF ITS PLANT
FOR MAINTENANCE FROM 125 TO 78 HOURS.
BY PERT, THE ORIGINAL PROGRAM OF POLARIS DEVELOPMENT
PROJECT WAS DECREASED BY 2 YEARS.
PERT AND CPM HAVE SIMILARITIES. THEY BOTH ALLOW US TO
DETERMINE THE MOST CRITICAL ACTIVITIES.
CRITICAL PATH METHOD (CPM)

CPM UTILIZE A NETWORK REPRESANTATION TO SHOW EACH TASK
TO BE PERFORMED, ITS PREDECESSOR AND ITS SUCCESSORS.
CPM REQUIRES THAT WE BEGIN BY IDENTIFYING ALL PROJECT
ACTIVITIES, PRESEDENCE RELATIONSHIPS AND TIMES.
ACTIVITY PREDECESSOR DURATION ACTIVITY PREDECESSOR DURATION
None
None
20
10
None
33
18
E,F
20

8
17
8
A,
17
2
17 D, 18 35
81
26
9
8
E,
2
0
1
0
10 B, 20 30
0
20
C,
20 30
3
30
20
F, 9
33
35
H,
39
29
29 39
6
0
G, 1
33
26
39
28
26 35
33
33 33
34
39
29
I, 4
43
43
43
43
33
43 43
7
LATEST ALLOWABLE EVENT
OCCURANCE TIME
33
33
LATEST ALLOWABLE ACTIVITY

START TIME
LATEST ALLOWABLE ACTIVITY

FINISH TIME
EARLIEST EVENT
OCCURANCE TIME
20 30
3
EARLIEST TIME ACTIVITY
CAN START
30
20
F, 9
ACTIVITY
DURATION
39
29
29 39
6
NODE
NUMBER
EARLIEST TIME
ACTIVITY ENDS

FORWARD PASS : CALCULATE THE EARLIEST TIME AN
ACTIVITY CAN START.
BACKWARD PASS : CALCULATE LATEST TIME AT WHICH
EVENTS CAN BE COMPLETED.
TOTAL ACTIVITY SLACK : LATEST ALLOWABLE OCCURANCE
TIME OF AN ACTIVITY'S SUCCESSOR EVENT, LESS THE
EARLIEST FINISH TIME OF THE ACTIVITY. TELLS AMOUNT
OF DELAY WE CAN HAVE WITHOUT AFFECTING THE
EARLIEST START OF AN ACTIVITY ON CP.
CRITICAL PATH : SEQUENCE OF ACTIVITIES HAVING NO
SLACK.

OFFERS A SYSTEMATIC PROCEDURE FOR SELECTING THE
CRITICAL PATH.
AMOUNT OF SLACK OR FREE TIME ON NONCRITICAL
PATHS MAY BE DETERMINED. THIS PERMITS US TO TRADE
OFF MANPOWER AND EQUIPMENT RESOURCES FROM
NONCRITICAL ACTIVITIES TO CONCENTRATE ON AND
SHORTEN THE CRITICAL PATH.
MANAGEMENT FOCUS MORE ATTENTION TO SMALL
PERCENTAGE OF CRITICAL ACTIVITIES.
EFFECTS OF CHANGES CAN BE SEEN EASILY.
PERT
PROGRAM EVALUATION AND REVIEW TECHNIQUE (PERT) IS
SIMILAR TO CPM. DIFFERENCE IS CPM REQUIRES SINGLE
ESTIMATE FOR EACH ACTIVITY, PERT REQUIRES 3 :
MOST LIKELY TIME, MINIMUM TIME, MAXIMUM TIME.
PERT IS USED WHERE GREAT DEAL OF UNCERTANITY EXISTS
FOR DURATIONS OF ACTIVITIES, LIKE RESEARCH PROGRAMS
OR APPLICATION OF NEW TECHNOLOGIES.
to : OPTIMISTIC TIME, tm : MOST LIKELY TIME,
tp : PESSIMISTIC TIME,
to
4 tm
te : EXPECTED TIME, (AVERAGE)

tp
6
VARIANCE OF DISTRIBUTION
6
te
=
Vt
=
tp - to 2
PERT
EXAMPLE : ACTIVITY t o t m
C 21 33 45 33 16
2.778
tpteVt
G
7 9 17 10
SINCE THE CRITICAL PATH IS C AND G

TE =
Vt =
te
Vt
= 33 + 10 = 43
C. G
= 16 +
2.788
= 18.778
C. G
STANDARD DEVIATION :
St =
18.778
St = Vt
=
4.333
THE PROJECT MOST PROBABLY WILL FINISH LATEST

43 + 4 = 47 DAYS
TIME-COST TRADE-OFFS
IN CPM AND PERT WE USE NORMAL WORKING CONDITIONS SUCH
AS REGULAR WORK DAY AND STANDARD EQUIPMENT. ALL JOBS
CAN BE SHORTENED BY USING NEW MACHINES, EXTRA MANPOWER, OVER TIME WORK ETC. THESE INCREASE THE DIRECT
COSTS. BUT INDIRECT COST LIKE PENALTIES FOR TIME
OVERRUNS, EARLY COMPLETION REWARDS MAY HAVE POSITIVE
EFFECT TO COST BY SHORTENING PROJECT DURATION.
WE CALCULATE DIRECT COSTS FOR EACH ACTIVITY FOR NORMAL
TIME AND CRASH TIME (MINIMUM TIME) AND INDIRECT OUTCOME
AS TOTAL TIME DECREASE
DURATION (TOTAL) :
REWARD (1000$)
43
42 41 40
39
38
37 36
35
34
10 18
31 36
40
43
45 46
25
TIME-COST TRADE-OFFS
x 1000 $
ACTIVITY
A B C D E F G H I
NORMAL TIME 8
CRASH TIME 6
NORMAL COST
CRASH COST 15
SLOPE (Cost/Day)
20
16
10
38
33
21
22
42
2.5
18
14
30
26
4
20 9
17 7
20 6
7.5
1
10
7
4
8
1.5
8
8
9
18
4
3
3
3
.5
PROJECT DURATION
ACTIVITY
CHANGE
RESULT
43
110
C: 33 TO 32
111
10
+9
C: 32 TO 31
112
18
+16
C: 31 TO 30
113
25
+22
6
9.5
2 3
3.5
COST
40
REWARD
42
41
KEEP LOWERING ACTIVITY TIMES ON CP AS LONG AS TOTAL COST

DECREASES TILL TO CRASH TIMES. THERE MAY BE A NEW CP.
WBS
WORK BREAKDOWN STRUCTURE (WBS)
THE PURPOSE OF WBS IS TO SUB-DIVIDE THE SCOPE OF
WORK INTO MANAGEABLE WORK PACKAGES WHICH
CAN BE ESTIMATED, PLANNED AND ASSIGNED TO A
RESPONSIBLE PERSON OR DEPARTMENT FOR
COMPLETION
IT IS A NICE TOOL USED FREQUENTLY IN PROJECT
MANAGEMENT BREAKING COMPLEXITY INTO SIMPLE,
MANAGEABLE COMPONENTS
BY USING WBS, ESTIMATING THE DURATION AND THE
COST OF THE PROJECT AND CONTROLLING IS EASIER
THERE ARE MANY METHODS (SYSTEM BREAKDOWN,
PRODUCT BREAKDOWN, CONTRACTOR BREAKDOWN..)
OF SUBDIVIDING THE WORK AND THE BEST METHOD IS
THE ONE THAT WORKS WELL FOR THAT PROJECT
WBS
AN EXAMPLE FOR WBS
HOUSE
CIVIL
FOUNDATIONS
ELECTRICAL
PLUMBING
WALLS / ROOF
PIPING
SEWERAGE
WIRING
APPLIANCES
DECISION TREE ANALYSIS

THE DECISION TREE TECHNIQUE FACILITATES PROJECT EVALUATION
BY ENABLING THE FIRM TO WRITE DOWN THE POSSIBLE FUTURE
EVENTS AS WELL AS THEIR MONETARY OUTCOMES, IN A
SYSTEMATIC MANNER.
IN MAKING THE DECISION TREE WE START WITH DECISION NODE.
THE DECISION ALTERNATIVES ARE REPRESENTED AS BRANCHES
FROM THE DECISION NODE. GENERALLY, TRAVERSING EACH
BRANCH ON THE DECISION TREE WILL BRING SOME REWARD,
POSITIVE OR NEGATIVE, TO THE DECISION MAKER. THIS REWARD
WILL BE CASH FLOW IN INDUSTRY.
alternative 1
alternative 2
alternative 3

FOR EACH ALTERNATIVE SHOULD PREDICT AN OUTCOME FOR GOOD,
MODERATE AND BAD CONDITIONS. THAN, FOR EACH CONDITION
YOU SHOULD ESTIMATE THE PROBABILITY OF OCCURANCE.
WITH THIS INFORMATION, YOU CAN CALCULATE EMV, EXPECTED
MONETARY VALUE, BY MULTIPLYING THE PRESENT VALUES OF
EACH CONDITION BY THE PROBABILITY OF THAT CONDITION AND
SUMMING THESE FOR EACH ALTERNATIVE. THE ALTERNATIVE
WITH THE LARGEST EMV IS THE BEST ALTERNATIVE.

EXAMPLE: YOUR COMPANY IS DISCUSSING AN EXPANSION PROJECT. THERE
ARE 3 ALTERNATIVES; LARGE EXPANSION, SMALL EXPANSION AND NO
EXPANSION. IN THE LARGE EXPANSION THE NEW MACHINERY
INVESTMENT IS $140,000, WORKING CAPITAL IS $20,000, THE SALVAGE
VALUE AFTER 5 YEARS IS ASSUMED TO BE 0. IN THIS ALTERNATIVE
YEARLY INCREASE IN EXPENSES WILL BE $20,000. IN THE SMALL
EXPANSION THE INVESTMENT REQUIRED IS $60,000, WORKING CAPITAL IS
$10,000 AND NO SALVAGE VALUE AFTER 5 YEARS. THE INCREASE IN THE
YEARLY EXPENSES IS $10,000. THE ESTIMATED INCREASE IN THE SALES
REVENUES AND THE PROBABILITIES ARE AS FOLLOWS:
LARGE EXPANSION
SMALL EXPANSION
REV. INCREASE PROBABILITY
REV. INCREASE PROBABILITY
GOOD
$100,000
0.25
$50,000
0.25
MODERATE $ 80,000
0.60
$35,000
0.60
POOR
$ 50,000
0.15
$24,000
0.15
FIND THE BEST ALTERNATIVE IF TAX RATE IS 30%, MAAR 15% USING
STRAIGHT LINE DEPRECIATION.

LARGE EXPANSION:
REVENUE INCREASE
EXPENSE INCREASE
DEPRECIATION
TAX
NET INCOME
WOR. CAP.
CASH FLOW
1
2
3
4
5
100,000 100,000 100,000 100,000 100,000
20,000 20,000 20,000 20,000 20,000
28,000 28,000 28,000 28,000 28,000
15,600 15,600 15,600 15,600 15,600
36,400 36,400 36,400 36,400 36,400
20,000
64,400 64,400 64,400 64,400 84,400
PVGOOD = 64,400 [ {(1.15)4 1} / .15(1.15)4] + 84,400 /(1.15)5 160,000 = 65,852

PVMOD = 18,917
PVPOOR = 51,486

SMALL EXPANSION:
REVENUE INCREASE
EXPENSE INCREASE
DEPRECIATION
TAX
NET INCOME
WOR. CAP.
CASH FLOW
1
2
50,000 50,000
10,000 10,000
12,000 12,000
8,400
8,400
19,600 19,600
31,600 31,600
3
4
50,000 50,000
10,000 10,000
12,000 12,000
8,400
8,400
19,600 19,600
31,600 31,600
5
50,000
10,000
12,000
8,400
19,600
10,000
41,600
PVGOOD = 31,600 [ {(1.15)4 1} / .15(1.15)4] + 41,600 /(1.15)5 70,000 = 40,915

PVMOD = 5,428
PVPOOR = 20,101
EMVLARGE EXPANSION= (65,852)(0.25) + (18,915)(0.60) (51,486)(0.15) = 20,089

EMVSMALL EXPANSION= (40,915)(0.25) + (5,428)(0.60 (20,101)/0.15) = 10,471
XIII. BASIC ACCOUNTING
ACCOUNTING
FINANCE DEPARTMENTS HAVE TWO PRIMARY FUNCTIONS IN COMPANIES:
1. RECORDING, MONITORING AND CONTROLLING OF FINANCIAL
CONSEQUENCES OF PAST AND CURRENT OPERATIONS.
2. ACQUIRING FUNDS TO MEET CURRENT AND FUTURE NEEDS.
THE FIRST ACTIVITY IS CALLED ACCOUNTING.
ALTHOUGH IT IS NOT NECESSARY TO KNOW THE DETAILS INVOLVED IN
ACCOUNTING, A KNOWLEDGE OF BASIC PRINCIPLES IS AN INVALUABLE
AID TO THE ENGINEERS.
ACCOUNTING
BUSINESS TRANSACTIONS
JOURNAL
LEDGER
BALANCE SHEET
INCOME STATEMENT
JOURNAL IS A BOOK IN WHICH THE ORIGINAL RECORD OF

TRANSACTIONS ARE LISTED DAILY.
LEDGER IS A GROUP OF ACCOUNTS GIVING CONDENSED AND
CLASSIFIED INFORMATION FROM THE JOURNAL
ACCOUNTING
BALANCE SHEET AND INCOME STATEMENT ARE TWO KEY
DOCUMENTS OF FINANCIAL ACCOUNTING.
BALANCE SHEET : SHOWS THE WEALTH IN MONETORY (DOLLARS,
TL) OR OTHER FORMS (BUILDING, LAND, ACCOUNTS RECEIVABLE)
AVAILABLE TO THE OWNERS AND OBLIGATIONS DUE TO OWNERS
AT A GIVEN TIME.
INCOME STATEMENT : SHOWS THE FLOW OF WEALTH, THAT IS
RECEIPT OR DISBURSEMENT OF WEALTH OCCURING BETWEEN
TWO POINTS IN TIME.
ACCOUNTING
BALANCE SHEET
AS OF 1 APRIL 2004
BALANCE SHEET
AS OF 31 MAY 2004
INCOME STATEMENT
FOR THE PERIOD 1 APRIL - 31 MAY 2004
BALANCE SHEET :
THE FORMAT OF BALANCE SHEET CONSIST OF A T , WITH THE
ASSETS ON LEFT HAND SIDE, LIABILITIES AND OWNERSHIP AT RIGHT
ASSETS
LIABILITIES
OWNERSHIP
ASSETS ARE CASH ON HAND, ACCOUNTS RECEIVABLE, INVENTORIES,

INVESTMENTS, LAND, MACHINERY ETC. TO WHICH ENTITY HAS
PRIMARY CLAIM.
THE RIGHT HAND SIDE CONTAINS OUTSIDERS' (LENDERS + OWNERS)
CLAIMS ON THE ASSETS OF THE ENTITY.
ACCOUNTING
ASSETS = LIABILITIES +
EQUITY
ASSETS : CURRENT ASSETS CONSISTS OF CASH OR CLAIMS ON

OUTSIDERS THAT CAN BE CONVERTED TO CASH IN
LESS THAN ONE YEAR. FIXED ASSETS ARE THINGS
LIKE
LAND, BUILDING, MACHINERY.
LIABILITIES : CURRENT LIABILITIES ARE ACCOUNTS PAYABLE AND
SHORT TERM CREDITS THAT ARE EXPECTED TO BE
DISCHARGED IN LESS THAN A YEAR. LONG TERM
LIABILITIES ARE CREDITS OR BONDS NOT DUE
WITHIN
THE NEXT FISCAL YEAR.
EQUITY :
CAPITAL, RETAINED INCOME.
ACCOUNTING
ASSUME COMPANY X FORMED IN JANUARY 1, 2004 WITH
5 MILLION DOLLAR PAID CAPITAL.
BALANCE SHEET, COMPANY X
AS OF JANUARY 1, 2004
CASH : . . . . . . . .
$ 5.000.000
CAPITAL : . . . . . . . . .$ 5.000.000
TOTAL ASSETS :
$ 5.000.000
TOTAL EQUITIES . . . $ 5.000.000
ASSUME FOLLOWING HAPPENED IN JANUARY FOR COMPANY X :

1. A BUILDING WAS BOUGHT FOR $ 7 MILLION, $ 2 MILLION BY
CASH, $ 5 MILLION BY BANK CREDIT.
2. EQUIPMENT WORTH $ 300.000 ACQUIRED BY CASH.
3. RAW MATERIAL WORTH $ 200.000 BOUGHT BY CREDIT.
ACCOUNTING
AS OF JANUARY 31, 2004
CASH :
INVENTORIES
$ 2.700.000
:
200.000
CURRENT ASSETS :
2.900.000
EQUIPMENT
BUILDING :
ACCOUNT PAYABLE :
CREDIT
:
$
300.000
7.000.000
FIXED ASSETS :
7.300.000
TOTAL ASSETS :
LIABILITES
$ 200.000
5.000.000
$ 5.200.000
CAPITAL
5.000.000
EQUITIES
$ 5.000.000
TOTAL LIABILITES
AND EQUITIES
$ 10.200.000
$
$ 10.200.000
ACCOUNTING
INCOME STATEMENT : TRANSACTIONS (REVENUES AND EXPENSES)
IN A COMPANY DURING A PERIOD.
IT IS ALSO CALLED PROFIT AND LOSS STATEMENT.
REVENUE: CAN BE FROM THE SALE OF PRODUCTS OR SERVICES, OR
FROM OTHER SOURCES. OTHER SOURCES INCLUDE THE SALE OF
OLD, USED EQUIPMENT, THE SALE OF SCRAP, PROFIT FROM
OTHER FIRMS AND INTEREST GAINED.
EXPENSES: BOTH CASH (PURCHASES OF RAW MATERIAL, LABOR
COSTS, ADMINISTRATIVE COSTS ETC.) AND NONCASH
(DEPRECIATION) EXPENSES ARE SHOWN.
TAX: INCOME TAX, CERTAIN PERCENT OF PROFIT
DIVIDENDS: PAYMENT TO THE SHAREHOLDERS
RETAINED INCOME: STAYS IN THE COMPANY AS A FUND
ACCOUNTING
INCOME STATEMENT
REVENUE .A
SALES, OTHER INCOME
EXPENSES B
OPERATING EXPENSES, ADM.COSTS, DEPRECIATION
INCOME BEFORE TAXC = (A-B)
TAXD
NET INCOME OR NET PROFIT AFTER TAXE = (C-D)
DIVIDENDS..F (CERTAIN % OF E)
RETAINED INCOME..E-F
ACCOUNTING
ASSUME FOLLOWING HAPPENED IN COMPANY X IN FEBRUARY :
1. RECEIPT FROM SALES
114.000
3. SALARIES PAID
:
$ 380.000
$ 208.000
2. RAW MATERIAL USED :
4. INTEREST ON MORTGAGE:
$ 40.000
INCOME STATEMENT (1-28 FEBRUARY 2004)

REVENUE :
SALES
...
EXPENSES :
:
$ 114.000
INTEREST
INCOME
:
$ 362.000
$ 380.000
SALARIES
40.000
$ 18.000
COST OF GOODS SOLD

:
208.000
ACCOUNTING
SO CASH IS :
2.700.000
+ [ 380.000 - ( 208.000 + 40.000 ) ] = $ 2.832.000
INVENTORIES IS:
200.000 - 114.000 = $ 86.000
NEW BALANCE SHEET IS :
AS OF FEBRUARY 28, 2004
CASH
INVENTORIES
:
:
$ 2.832.000
86.000
$ 2.918.000
:
:
300.000
7.000.000
FIXED ASSETS
$ 7.300.000
TOTAL ASSETS
: $ 10.218.000
CURRENT ASSETS
EQUIPMENT
BUILDING
ACCOUNTS PAYABLE
CREDIT
:
:
$ 200.000
5.000.000
$ 5.200.000
:
:
5.000.000
18.000
EQUITIES
$ 5.018.000
TOTAL LIAB.+ EQU.
: $ 10.218.000
LIABILITES
CAPITAL
RETAINED INCOME
FINANCIAL RATIOS
SOME OF THE RELATIONSHIPS FROM THE BALANCE SHEET AND
INCOME STATEMENT WERE JUDGED TO HAVE PARTICULAR
SIGNIFICANCE AS INDICATORS OF FINANCIAL HEALTH AND GOOD
MANAGEMENT. THEY ARE KNOWN AS FINANCIAL RATIOS.
MOSTLY USED RATIOS ARE AS FOLLOWS :
LIQUIDITY RATIOS :
CURRENT ASSETS
CURRENT RATIO :
CURRENT LIABILITES
CURRENT ASSETS - INVENTORIES
QUICK RATIO (ACID TEST)
:
CURRENT LIABILITIES
FINANCIAL RATIOS
PROFITABILITY RATIO
NET PROFIT
ON SALES :
SALES
PROFIT AFTER TAXES
ON EQUITY
:
EQUITY
ACTIVITY RATIOS
SALES
ASSETS TURNOVER
:
TOTAL ASSETS
SALES
INVENTORY TURNOVER :
INVENTORY
LEVERAGE RATIOS
ASSETS
TOTAL DEBT
DEBT TO TOTAL
TOTAL ASSETS
FINANCIAL MANAGEMENT
SHORT TERM FINANCING :
- TRADE CREDITS: THE USE OF MATERIALS WITHOUT
IMMEDIATELY PAYING FOR THEM
- NOTES : WRITTEN PROMISE TO PAY LATER
- BANK CREDITS : BORROWING FROM BANKS AND PAYING AN
INTEREST
- FACTORING
: TO SELL THE ACCOUNTS RECEIVABLE AT A
DISCOUNT IN EXCHANGE FOR IMMEDIATE MONEY
LONG TERM FINANCING :
- LONG TERM BANK CREDITS
- STOCKS : SELLING STOCKS. OWNERS GET SHARE
FROM PROFIT
- BONDS : YOU SELL BONDS AND AGREE TO PAY A
CHARGE ANNUALLY OR BUY WITH A HIGHER PRICE AT
THE MATURITY DATE
- PROFIT INVESTED IN CURRENT ASSETS
- SALES OF FIXED ASSETS
BORROWED FUNDS: COMPANIES MAY REQUIRE OUTSIDE
FUNDS FOR THEIR INVESTMENTS OR PRODUCTION
EXPENSES. THEY CAN SELL BONDS OR GET CREDITS
FROM BANKS OR OTHER ORGANIZATIONS. THEY PAY
INTEREST FOR THESE LOANS.
THE BORROWED FUNDS ARE NOT CONSIDERED AS
INCOME (SO ARE NOT TAXED); WHEN THEY ARE
REPAID, THIS IS NOT CONSIDERED AS AN EXPENSE
(NOT INCLUDED IN YOUR COSTS). BUT THE INTERESTS
PAID ARE CONSIDERED AS EXPENSE. SO THE REAL
COST OF BORROWING FUNDS CAN BE FOUND BY
DEDUCTING THE TAX AMOUNT.
EXAMPLE:
IF YOU PAY 30% INCOME TAX, WHAT IS THE COST OF
BORROWING $1,000,000 WITH 10% INTEREST RATE?
INTEREST/ YEAR = 0.1 x 1,000,000 = $100,000 / YEAR
YOU CAN INCLUDE THIS $100,000 INTO YOUR
EXPENSES, SO YOUR TAX WILL DECREASE
0.30 x 100,000 = $30,000 / YEAR
COST OF THE FUND = 100,000 30,000 = $70,000 / YEAR
OR 7%
LOAN REPAYMENT: THE BORROWED FUNDS CAN BE REPAID BY
DIFFERENT METHODS. THE MOST COMMON TYPE IS BY CONSTANT
PERIODIC PAYMENTS. EACH PAYMENT COVERS THE INTEREST
DUE ( INTEREST FOR THE REMAINING PORTION OF THE
PRINCIPLE) AND SOME OF THE REMAINING PRINCIPLE.
THE TOTAL PERIODIC PAYMENT IS CONSTANT; BUT SINCE THE
PRINCIPLE BALANCE DECREASES, THE INTEREST PORTION OF
EACH PAYMENT IS SMALLER THAN THE PREVIOUS ONE AND THE
PRINCIPLE PORTION OF EACH PAYMENT IS LARGER THAN THE
PREVIOUS ONE.
L = Ij + p j
WHERE L IS THE CONSTANT PAYMENT
EACH PERIOD; Ij IS THE jth PERIOD INTEREST PAYMENT;
pj
IS THE jth PERIOD PRINCIPLE PAYMENT.
YOU CAN DRIVE AND USE THE FOLLOWING FORMULA TO
CALCULATE THE CONSTANT PERIODIC REPAYMENT OF LOANS
N
L = P0 [ 1 + i 1 (1 + i) j-1 ] / 1 (1 + i) j-1
WHERE P0 IS THE INITIAL AMOUNT OF LOAN.
EXAMPLE:
A LOAN OF $100,000 AT AN INTEREST RATE OF 10% PER
YEAR IS MADE FOR A REPAYMENT PERIOD OF 10
YEARS. DETERMINE THE CONSTANT PAYMENT PER
PERIOD FOR ANNUAL, END-OF-THE-YEAR PAYMENTS.
N
L = P0 [ 1 + i 1 (1 + i)
j-1
] / 1 (1 + i) j-1
= 100,000 [ 1+ 0.1 1 (1.1) j-1 ] / 1 (1.1) j-1

= 100,000 [ 1 + 1.59374] / 15.9374
= $16,274.54 per year
XIV. COST CONTROL
COST CONTROL
CONTROLLING THE COSTS IS ONE OF THE MOST IMPORTANT
FUNCTIONS IN ANY COMPANY.
SINCE THE SELLING PRICE IS LIMITED BY THE MARKET, THE
COMPETING POWER AND THE PROFIT MARGIN OF A COMPANY
DEPENDS ON THE PRODUCT COST.
INCREASING GLOBAL COMPETITION DEMANDS EFFECTIVE METHODS
FOR IMPROVED OPERATIONAL PERFORMANCE AND EFFICIENCY
AIMING LOWER COSTS. THE PRODUCT COSTS ARE BECOMING
INCREASINGLY CRITICAL, AND IN SOME CASES, MAY MAKE THE
DIFFERENCE BETWEEN SURVIVAL AND EXTINCTION.
COST CONTROL IS THE JOB OF EVERYONE IN THE ORGANIZATION
AND IT CAN BE DONE EFFECTIVELLY BY GOOD ENGINEERING AND
MANAGEMENT PRACTICES.
COST CONTROL SHOULD BE DONE IN TWO STEPS:
1. CONTROLLING THE COSTS TO AVOID ANY INCREASE
2. REDUCING THE COSTS
COST CONTROL
1. CONTROLLING THE COSTS TO AVOID ANY INCREASE
A MANAGEMENT INFORMATION SYSTEM (MIS) IS REQUIRED TO
MONITOR ALL COST ITEMS IN THE COMPANY. COST STANDARDS
FOR ALL ITEMS SHOULD BE SET UP AND CONSTANTLY UPDATED.
PURCHASING AND RELATED COSTS FOR ALL MATERIAL, LABOR
COSTS, RAW MATERIAL USAGE, PRODUCTION EFFICIENCY,
UTILITY COSTS, ALL OVERHEAD COSTS SHOULD HAVE
STANDARDS AND SHOULD BE RECORDED. THE COMPARISON OF
ACTUAL COSTS WITH STANDARDS WILL GIVE YOU THE
MEASUREMENT OF PERFORMANCE AND ALARM YOU WHEN
GOING IN THE WRONG DIRECTION.
VARIANCES (OR VARIATIONS FROM STANDARD) AND THE COST
PERFORMANCE INDEX (OR PERCENT EFFECTIVENESS; RATIO OF
ACTUAL TO STANDARD) CONSTITUDE THE MOST VALUABLE
TOOLS OF COST MANAGEMENT.
COST CONTROL
A GOOD MANAGEMENT PRACTICE FOR COST CONTROL IS TO
DECENTRALIZE THE SYSTEM SO DEPARTMENTS HAVE THEIR OWN
COST DATA AND ARE RESPONSIBLE FOR THE COST
PERFORMANCE. THIS WILL BRING A CONSCIOUSNESS OF PROFIT
RESPONSIBILITY AND WILL RESULT WITH THE CONTROL OF MINOR
COST ELEMENTS EFFECTIVELY.
THE RULE IS THE BEST PLACE TO CONTROL COSTS IS AS CLOSE
TO THE SOURCE AS POSSIBLE. SO DEFINING COST CENTERS AS
SMALL AS POSSIBLE AND GIVING THE RESPONSIBILITY TO A
SMALL GROUP OF MEN WILL IMPROVE THE COST CONTROL
SYSTEM CONSIDERABLY.
COST CONTROL
THERE ARE 3 MAJOR TYPES OF STANDARDS THAT CAN BE USED
FOR COST CONTROL SYSTEMS:
a) BUDGET STANDARD:
MOST COMMONLY USED STANDARD; BASED ON THE PAST
HISTORY. DETERMINED BY MATHEMATICAL AND STATISTICAL
AVERAGES
b) ENGINEERING STANDARD:
DETERMINED BY ENGINEERING STUDIES AND BENCHMARKING
c) COST REDUCTION STANDARD:
DETERMINED BY ENGINEERING STUDIES INVOLVING
IMPROVEMENT OR CHANGE OF PROCESS, MATERIAL OR
EQUIPMENT
COST CONTROL
2. REDUCING THE COSTS
THE PRIMARY GOAL OF ALL COMPANIES IS TO INCREASE PROFIT
WHICH IS POSSIBLE BY COST REDUCTION. THERE ARE THREE
MAIN METHODS USED IN INDUSTRY FOR THIS PURPOSE:
- DAILY INCREMENTAL IMPROVEMENTS
USING THE EXISTING TECHOLOGY AND FACILITIES, SMALL
IMPROVEMENTS IN ALL PROCESSES CAN BE MADE TO REDUCE
COSTS
- TECHNOLOGICAL CHANGES
REDUCING THE COSTS BY CHANGING THE PROCESS OR
EQUIPMENT
- PRODUCT CHANGES
DESIGNING NEW PRODUCTS WHICH CAN BE PRODUCED WITH
LESS COST
COST CONTROL
THERE ARE MANY POSSIBILITIES OF COST REDUCTION.
BASIC PRINCIPLE IS TO INCREASE EFFICIENCY BY DECREASING
THE INPUTS (MATERIAL, LABOR, OVERHEAD COSTS) WITHOUT
DECREASING THE QUALITY OF YOUR PRODUCTS.
IT IS HARD TO NAME ALL POSSIBILITIES BUT SOME FREQUENTLY
USED METHODS ARE:
- BUY MATERIAL CHEAPER
- DECREASE THE COSTS OF PURCHASING, TRANSPORTATION
- DECREASE YOUR INVENTORY (INVENTORY IS MONEY KEPT WITH
ZERO INTEREST; IDEAL IS ZERO INVENTORY)
- IMPROVE YIELD SO USE LESS MATERIAL
- SUBSTITUDE LESS EXPENSIVE MATERIAL
- DECREASE THE LEAD-TIMES
- DECREASE LOSS AND SCRAP (TRY TO WORK ZERO-DEFECT)
- IMPROVE QUALITY ASSURANCE SYSTEMS, INCREASE TRAINING
COST CONTROL
- IMPROVE ALL PROCESSES
- WORK WITH MINIMUM NUMBER OF PEOPLE IN ALL KIND OF JOBS
- USE AUTOMATION
- MINIMIZE SUPERVISION AND CONTROL ACTIVITIES
- MINIMIZE MATERIAL FLOW
- MINIMIZE PAPER WORK AND BUREAUCRACY
- ELIMINATE UNUSED BUSINESS REPORTS AND DUPLICATIONS
- MINIMIZE SET-UP PERIODS, DECREASE CYCLE TIME
- INCREASE RATES OF FLOW IN PROCESSES
- ANALYZE JOBS, FIND BEST METHODS
- MINIMIZE UTULITY COSTS (AMOUNT AND UNIT COSTS)
- CHECK AND MINIMIZE ALL OVERHEAD COSTS
- MINIMIZE DISTRIBUTION COSTS
- MINIMIZE BREAK-DOWNS BY EFFECTIVE MAINTENANCE
- DO MAKE-OR-BUY ANALYSIS REGULARLY
- LOOK FOR IDLE TIMES OF PEOPLE AND FILL THEM

CHE 423-Ayhan Gerceker

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ENGINEERING ECONOMICS

CHEMICAL ENGINEERING ECONOMICS

PLANT DESIGN PROCESS

PRODUCT COST ECONOMIC PRODUCTION

TIME VALUE OF MONEY

VIII. ANALYSIS OF ALTERNATIVES

XIII. BASIC ACCOUNTING

ENGINEERS SHOULD BE ABLE FIND THE CORRECT ANSWERS TO

II. PLANT DESIGN PROCESS

PLANT DESIGN PROCESS

PLANT DESIGN PROCESS

AFTER EACH PHASE OF THE DESIGN, AN EVALUATION SHOULD BE

PLANT DESIGN PROCESS

PLANT DESIGN PROCESS

ORGANIZATION AND LABOR REQUIREMENTS

III. GENERAL CONSIDERATIONS

IV. CAPITAL INVESTMENT

NET PROFIT + DEPRECIATION

THE BOX OPERATIONS IS THE PRODUCTION, ENGINEERING, MARKETING

Index value for year m

EQUIPMENT COST INDEX IS PUBLISHED MONTHLY IN

THE COSTS FOUND THROUGH QUOTATIONS OR LITERATURE

A MUCH MORE RELEVANT METHOD OF ESTIMATING WORKING

WC = (ANNUAL PRODUCTION COST / 12) (TOTAL LEAD TIME IN

PLANT OVERHEAD COSTS

IN AVERAGE YOU CAN USE THE FOLLOWING FIGURES:

2 X (ORIGINAL COST PREVIOUS DEPRE. SALVAGE VALUE)

DEP: (900,000).02 + (700,000) .2 = 158,000

DEP: 2 x (900,000).02 + 2 x (700,000) .2 = 316,000

VARIABLE TOTAL COST AVERAGE

AS LONG AS MARGINAL COST IS BELOW AVERAGE COST,

FACTORY PRICE TO WHOLESALER

DUMPING OCCURS WHEN A COMPANY SELLS A PORTION OF HIS

TONS / YEAR, x1000

CAPITAL INVESTMENT - PROBLEM

PRODUCT COST - PROBLEM

PRODUCT COST - PROBLEM

ECONOMIC PRODUCTION - PROBLEM

ECONOMIC PRODUCTION - PROBLEM

ECONOMIC PRODUCTION - PROBLEM

ECONOMIC PRODUCTION - PROBLEM

V = 100 TL, F = 0.3FCI

PROFIT = 2,000,000 = 0.5FCI 100 x 50,000 0.3FCI

NEW PROFIT = 35,000,000 x 0.5 x 1.1 4,400,000 35,000,000 x 0.3 x 1.2

VI. TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

IF P = $1000 AND i = 10%

COMPOUND INTEREST IS THE MOST USED TYPE OF INTEREST AND IF

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TO USE ieff WHICH IS (1+r/m)m 1 = (1+r/m)m/r x r- 1

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY