ENGINEERING ECONOMICS ISE460 SESSION 16 June 23, 2015 Geza P. Bottlik Page 1 OUTLINE Questions? News? Recommendation New homework IRR Depreciation

ENGINEERING ECONOMICS ISE460SESSION 16

June 23, 2015

Geza P. Bottlik Page 1

OUTLINE

• Questions?

• News?

• Recommendation

• New homework

• IRR

• Depreciation


June 23, 2015


Recommendation

• National Gallery , Sainsbury wing– at Trafalgar Square

– Free

– Great impressionists (although there is a lot else there

such as medieval and renaissance paintings)

– Slide show at break


June 23, 2015


Practice Problem

You are considering

four types of

engineering designs.

The project lasts 10

years with the

following estimated

cash flows. The

interest rate (MARR) is

15%. Which of the four

is more attractive?

Project

A B C D

Initial cost $150 $220 $300 $340

Revenues/Year

$115 $125 $160 $185

Expenses/Year

$70 $65 $60 $80

IRR (%) 27.32 24.13 31.11 28.33


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Items CMS Option FMS Option

Annual O&M costs:

Annual labor cost $1,169,600 $707,200

Annual material cost 832,320 598,400

Annual overhead cost

3,150,000 1,950,000

Annual tooling cost 470,000 300,000

Annual inventory cost

141,000 31,500

Annual income taxes 1,650,000 1,917,000

Total annual costs $7,412,920 $5,504,100

Investment $4,500,000 $12,500,000

Net salvage value $500,000 $1,000,000

Example 7.13 Incremental Analysis for Cost-Only Projects


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n CMS Option FMS Option

Incremental

(FMS-CMS)

0 -$4,500,000 -$12,500,000 -$8,000,000

1 -7,412,920 -5,504,100 1,908,820

2 -7,412,920 -5,504,100 1,908,820

3 -7,412,920 -5,504,100 1,908,820

4 -7,412,920 -5,504,100 1,908,820

5 -7,412,920 -5,504,100 1,908,820

6 -7,412,920 -5,504,100

$2,408,820Salvage + $500,000 + $1,000,000

Incremental Cash Flow (FMS – CMS)


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Solution:

PW i

P A i

P F i

IRR

FMS CMS

FMS CMS

( ) $8, ,

$1,908, ( / , , )

$2, , ( / , , )

.43%

000 000

820 5

408 820 6

0

12 15%,

select CMS.


June 23, 2015


Summary Rate of return (ROR) is the interest rate earned on

unrecovered project balances such that an investment’s cash receipts make the terminal project balance equal to zero.

Rate of return is an intuitively familiar and understandable measure of project profitability that many managers prefer to NPW or other equivalence measures.

Mathematically we can determine the rate of return for a given project cash flow series by locating an interest rate that equates the net present worth of its cash flows to zero. This break-even interest rate is denoted by the symbol i*.


June 23, 2015


Internal rate of return (IRR) is another term for ROR that stresses the fact that we are concerned with the interest earned on the portion of the project that is internally invested, not those portions that are released by (borrowed from) the project.

To apply rate of return analysis correctly, we need to classify an investment into either a simple or a nonsimple investment.

A simple investment is defined as one in which the initial cash flows are negative and only one sign change occurs in the net cash flow, whereas a nonsimple investment is one for which more than one sign change occurs in the net cash flow series.

Multiple i*s occur only in nonsimple investments. However, not all nonsimple investments will have multiple i*s either.


June 23, 2015


• For a pure investment, the solving rate of return (i*) is the rate of return internal to the project; so the decision rule is:

If IRR > MARR, accept the project.

If IRR = MARR, remain indifferent.

If IRR < MARR, reject the project.

IRR analysis yields results consistent with NPW and other equivalence methods.

• For a mixed investment, we need to calculate the true IRR, or known as the “return on invested capital.” However, if your objective is simply to make an accept or reject decision, it is recommended that either the NPW or AE analysis be used to make an accept/reject decision.

• To compare mutually exclusive alternatives by the IRR analysis, the incremental analysis must be adopted.


June 23, 2015


• Despite a strong academic preference for NPV, surveys

indicate that executives prefer IRR over NPV.[6] Apparently,

managers find it easier to compare investments of different

sizes in terms of percentage rates of return than by dollars of

NPV. However, NPV remains the "more accurate" reflection

of value to the business. IRR, as a measure of investment

efficiency may give better insights in capital constrained

situations. However, when comparing mutually exclusive

projects, NPV is the appropriate measure.


June 23, 2015


• Under Italian law, anyone who works at the same job for

more than 36 months is considered an employee, entitled by

law to four weeks of annual vacation, 11 paid holidays,

maternity leave, state pension contributions and severance

pay if dismissed.


June 23, 2015



June 23, 2015


DEPRECIATION

• FIXED ASSETS LOOSE THEIR VALUE - BEST EXEMPLIFIED

BY PERSONAL AUTOMOBILES

• THIS LOSS IS CALLED DEPRECIATION

• ECONOMIC DEPRECIATION - GRADUAL LOSS OF UTILITY

WITH TIME = PURCHASE PRICE - MARKET VALUE

• ACCOUNTING (OR ASSET) DEPRECIATION -- ALLOCATING

THE COST OF THE ASSET OVER ITS DEPRECIABLE LIFE.

TRIES TO MATCH ECONOMIC DEPRECIATION


June 23, 2015


WHAT IS DEPRECIABLE?

ITEMS THAT ARE:

1. USED IN BUSINESS AND HELD FOR THE PRODUCTION

OF INCOME

2. HAVE A DEFINITE SERVICE LIFE LONGER THAN A

YEAR

3. MUST WEAR OUT, DECAY, BE USED UP, BECOME

OBSOLETE

4. MUST COST MORE THAN $1000


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WHO CAN DEPRECIATE ASSETS?

• ANYONE WHO USES THE ASSET FOR BUSINESS

PURPOSES AND MEETS THE RULES ON THE PREVIOUS

SLIDE


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COST BASIS

• COST BASIS IS:

• THE TOTAL COST OF THE ASSET OVER ITS LIFE

– INITIAL INVESTMENT

– FREIGHT

– SITE PREPARATION

– INSTALLATION

– TRADE-IN ALLOWANCE OF THE PREVIOUS EQUIPMENT

• IT DOES NOT INCLUDE OPERATING EXPENSES


June 23, 2015


OTHER DEFINITIONS

• THE BOOK VALUE EQUALS THE COST BASIS LESS THE ACCUMULATED TOTAL DEPRECIATION

• SALVAGE VALUE - ESTIMATED VALUE AT THE END OF AN ASSET’S LIFE

• DEPRECIABLE LIFE - NUMBER OF YEARS THAT THE ASSET CAN BE USED

• ASSET DEPRECIATION RANGE (ADR) - PRESCRIBED GUIDELINES BY THE IRS FOR DEPRECIABLE LIFE

• IRS - INTERNAL REVENUE SERVICE -- ENFORCES TAX RULES CREATED BY CONGRESS AND COLLECTS THE TAXES


June 23, 2015


DEPRECIATION METHODS• DEPRECIATION IS CALCULATED TWO WAYS, EACH WITH ITS OWN

PURPOSES

• BOOK DEPRECIATION

– FINANCIAL REPORTS

– INCOME STATEMENTS

– REFLECTS ACTUAL LOSS IN VALUE

– STATE TAXES AND FEDERAL TAXES BEFORE 1981

• TAX DEPRECIATION

– TO CALCULATE TAXES FOR THE IRS

– TAKES ADVANTAGE OF TAX RULES

– USUALLY LEADS TO BETTER CASH POSITION IN EARLIER YEARS


June 23, 2015


BOOK DEPRECIATION METHODS

• STRAIGHT LINE (SL)

• ACCELERATED

– DECLINING BALANCE (DB)

– DECLINING BALANCE WITH CONVERSION TO SL

• UNIT OF PRODUCTION

• DEPLETION

).......(

)(

21 nn

N

DDDIBN

SID


June 23, 2015


DECLINING BALANCE METHOD

• USES A FIXED FRACTION (alpha) OF THE BEGINNING BOOK

BALANCE EACH YEAR:

• MULTIPLIERS:

– 1.5 OR 150% DB

– 2.0 OR 200% OR DOUBLE DECLINING METHOD (DDB)

)(/1 multiplierN

nn

n

NN

IB

DDDTotalDB

ID

)1(

....

)1(

21

1


June 23, 2015


DECLINING BALANCE WITH CONVERSION TO STRAIGHT LINE

• WHAT DO WE DO IF THE DB METHOD DOES NOT RESULT

IN THE ESTIMATED SALVAGE VALUE?

1. IF BN > S

– WE HAVE NOT DEPRECIATED THE ASSET FULLY

– SWITCH TO STRAIGHT LINE THE FIRST YEAR THAT THE

STRAIGHT LINE DEPRECIATION IS GREATER THAN THE

DB METHOD

2. BN < S

– STOP DEPRECIATING WHEN YOU GET TO S

EXAMPLES 9.3 AND 9.4


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Example 9.3

• Cost basis of the asset I = $10,000

• Useful life N = 5 years

• Estimated salvage value S = $2,000


June 23, 2015


Example 9.4 –Declining Balance

• Cost basis of the asset I = $10,000

• Useful life N = 5 years

• Estimated salvage value, S = $778

• D1 =


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Changing to straight line

WE DID NOT DEPRECIATE THE ASSET FULLY AND MUST

SWITCH TO STRAIGHT LINE


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UNITS - OF - PRODUCTION METHOD

• ALLOCATES THE DEPRECIATION IN PROPORTION TO THE

UNITS PRODUCED AS A FRACTION OF THE TOTAL UNITS

EXAMPLE 9.7


June 23, 2015


HISTORY OF DEPRECIATION METHODS

• UNTIL 1954 - STRAIGHT LINE ONLY

• 1954 - 1981 --ADDED ACCELERATED METHODS:

– DECLINING BALANCE (DB)

– DOUBLE DECLINING METHOD (DDB)

– SUM OF THE YEARS’ DIGITS (SOYD) (WE DID NOT COVER)

• 1981

– REPLACED BY ACCELERATED COST RECOVERY SYSTEM (ACRS)

– 1986 MODIFIED ACRS = MACRS


June 23, 2015


MODIFIED ACCELERATED RECOVERY SYSTEM (MACRS)

• SALVAGE VALUE ALWAYS ZERO

• RECOVERY PERIOD -- ARBITRARY LIFE FOR THE

INVESTMENT, NOT NECESSARILY EQUAL TO ACTUAL LIFE

– EIGHT CATEGORIES: 3, 5, 7, 10, 15, 20, 27.5, 39 YEARS

• 3, 5, 7 AND 10 YEARS - USE 200%DDB, SWITCH TO SL

• 15 AND 20 YEARS -- USE 150%DDB AND SWITCH TO SL

• 27.5 YEARS RESIDENTIAL RENTAL -- SL

• 39 YEARS COMMERCIAL BUILDINGS -- SL

• USE TABLE 9.3 ON PAGE 448


June 23, 2015


MACRS TABLE


June 23, 2015


HALF YEAR CONVENTION

• FOR EQUIPMENT PLACED IN SERVICE USING MACRS:

• ALL ASSETS ARE ASSUMED TO BE PLACED IN SERVICE IN

THE MIDDLE OF THE YEAR

• ALL SALVAGE VALUE IS ZERO

• ONLY A HALF YEARS’ DEPRECIATION IS ALLOWED THE

FIRST YEAR

• THE REMAINING HALF YEAR IS ALLOWED FOLLOWING THE

END OF THE RECOVERY PERIOD

• FOR REAL PROPERTY, USE MID - MONTH INSTEAD OF

HALF YEAR


June 23, 2015


EXAMPLE 9.8

• ASSET = $10,000 MACRS CLASS 5 YEARS


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DEPLETION

• APPLIES TO NATURAL RESOURCES

• OBJECTIVE IS THE SAME AS DEPRECIATION

• COST DEPLETION WORKS JUST LIKE UNITS OF PRODUCTION - EQUATION 9.9:

COST DEPLETION =(ADJUSTED BASIS OF MINERAL PROPERTY)x(NUMBER OF UNITS SOLD) / (TOTAL NUMBER OF RECOVERABLE UNITS)

EXAMPLE 9.10

• PERCENTAGE DEPLETION - PORTION OF GROSS INCOME, LIMITED BY 50% OF THE TAXABLE INCOME WITHOUT THE DEPLETION

• ALLOWABLE PERCENTAGES ARE GIVEN IN TABLE 9.5. THESE RANGE FROM 5% TO 22%

EXAMPLE 9.11


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Cost depletion vs. percentage depletion


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REPAIRS OR IMPROVEMENTS

• For tax depreciation purposes, repairs or improvements made to

any property are treated as separate property items.

• The recovery period for a repair or improvement to the initial

property normally begins on the date the repaired or improved

property is placed in service.

• The recovery class of the repair or improvement is the recovery

class that would apply to the property if it were placed in service

at the same time as the repair or improvement.

• Example 9.12 (modified)


June 23, 2015


EXAMPLE 9.12

• In January 2004, Kendall Manufacturing Company purchased a

new numerical control machine at a cost of $60,000. The machine

had an expected life of 10 years at the time of purchase and a

zero expected salvage value at the end of the 10 years.

• For book depreciation purposes, no major overhauls had been

planned over the 10-year period, and the machine was being

depreciated toward a zero salvage value, or $6,000 per year, with

the straight-line method.

• For tax purposes, the machine was classified as a 7-year MACRS

property.


June 23, 2015


EXAMPLE 9.12 CONTINUED


June 23, 2015



• In December 2006, however, the machine was thoroughly

overhauled and rebuilt at a cost of $15,000. It was estimated that

the overhaul would extend the machine’s useful life by 5 years.


June 23, 2015



Documents

ENGINEERING ECONOMICS ISE460 SESSION 16 June 23, 2015 Geza P. Bottlik Page 1 OUTLINE Questions? News? Recommendation New homework IRR Depreciation