ENG 402.

1: ENGINEERING
ECONOMICS
Part Two (2)

Course Lecturers:
Prof. S. S. Ikiensikimama
Dr. J. C. Ofodu
Dr. A. Joseph
Dr. V. J. Aimikhe
Engr. S. Erimiatoe
1
METHODS FOR EVALUATING
INVESTMENTS

2
 REFERENCES FOR THIS SECTION
• www.osbornebooksshop.co.uk/files/asa2.pdf
(Accessed 13/01/2018)

• Leland Blank , P. E & Anthony Tarquin , P. E.

“Engineering Economy” Published by McGraw-
Hill, Seventh Edition, 2015.

• M. A Mian (2010): Project Economics and

Decision Analysis
3
 COURSE OUTLINE PART 2 OF 3
• Depreciation

• Taxes

• Cost of capital

• Replacement Analysis

• Budget and budget control

• Evaluation of Public Projects

4
Depreciation

5
 Depreciation
• Depreciation is a deductible non-cash expense
for income tax purposes.

• The higher the depreciation allowance being

deducted in any given year,

• the lower the taxable income and the cash

disbursements (cash outflow) in the form of
income tax.
6
 Depreciation Cont’d
• Depreciation is not an actual cash outflow and
therefore is not subtracted from the annual
cash flow as an expense.

• However, the tax deductibility of depreciation

decreases the firm’s tax liability.

• Depreciation is defined as a loss in the value of

an asset over the time it is being used.
7
 Depreciation Cont’d
• Events that can cause property to depreciate
include wear and tear, age, deterioration, and
obsolescence.

• The asset subject to depreciation can be

either tangible property or intangible
property.

8
 Depreciation Cont’d
• Depreciation of a property begins at the time
the property is placed in service for use in
trade/business or for the production of
income.

• Depreciation of a property ends when the cost

or other basis of the property is recovered or
when it is retired from service.

9
 Depreciation Cont’d
• The property is retired from service by selling
or exchanging it, abandoning it, or destroying
it.

• The cost of a property is fully recovered when

its depreciation deductions are equal to the
cost or investment in the project.

10
 Depreciation Cont’d
(Tangible property)
• Tangible property is that which can be seen or
touched.

• Tangible property includes two main types: real

property and personal property.

• Real property is land and buildings and,

generally, anything built or constructed on land
or anything growing on or attached to the land.
11
 Depreciation Cont’d
(Tangible property)
• Land by itself can never be depreciated because
it does not wear out or become obsolete and it
cannot be used up.

• Personal property includes cars, trucks,

machinery, furniture, equipment, and anything
that is tangible except real property.

12
 Depreciation Cont’d
(Intangible property)
• Intangible property is generally any personal
property that has a value but cannot be seen or
touched.

• It includes items such as copyright, franchises,

patents, trademarks, and trade names.

• Intangible property must either be amortized

(repayment over time) or depreciated using the
straight-line method.
13
 Depreciation Cont’d
(Intangible property)

• Unless the costs of patents or copyrights are

amortized, the costs can be recovered through
depreciation.

• The useful life of a copyright or patent is the life

granted to it by the government.

• If it becomes valueless in any year before its

useful life expires, the remaining cost can be
deducted in full for that year. 14
 Depreciation Cont’d
(Intangible property)
• For property to be depreciable, it must first
meet all of the following basic requirements:

1. The property must be used in business or

held to produce income.

2.The property must have a determinable useful

life longer than one year.
15
 Depreciation Cont’d
(Intangible property)
3.The property must be something that is subject
to wearing out, decaying, being used up,
becoming obsolete, or losing its value from
natural causes.

4.If a repair or replacement increases the value of

a property, makes it more useful, or lengthens
its life, the repairs or replacement cost must be
capitalized and depreciated
16
 Depreciation Cont’d
(Intangible property)

OR
• If the repair or replacement does not increase
the value of a property, make it more useful,
or lengthen its life, the cost of the repair or
replacement is deductible in the same way as
any other business expense.

17
 Depreciation Cont’d
(Depreciation Methods)

• Straight-Line Depreciation
• Declining Balance Depreciation
• Sum-of-years’-digits depreciation
• Units of production depreciation

18
 Depreciation Cont’d
(Straight-Line Depreciation)
• In this method of depreciation, the
depreciable cost or cost basis of the property
is equally distributed over the useful life of the
asset.

• The following equation is used

C  Sv
Dn  (2.1)
n
19
 Depreciation Cont’d
(Straight-Line Depreciation)

• Dn is the depreciation in nth year,

• C is the total cost of the depreciable asset,

• Sv is the salvage value, and n is the useful life of

the asset.

• Book value BVt, is the original price less

accumulated depreciation at that time 20
 Depreciation Cont’d
(Straight-Line Depreciation)

• Since the asset is depreciated by the same

amount each year,

• the book value after t years of service, denoted

by BVt , will be equal to the first cost B minus the
annual depreciation times t.

BVt B  tDt ( 2 .2 )
21
 Depreciation Cont’d
(Straight-Line Depreciation
• Salvage value, also referred to as residual value,
terminal value, or scrap value, is the estimated
value of property at the end of its useful life.

• It is what one would expect to get for the property

if it is sold after it can no longer be used
productively.

• The difference between the total acquisition cost of

the asset and its predicted salvage value is
sometimes called depreciable value. 22
 Depreciation Cont’d
(Straight-Line Depreciation

• if a depreciable asset is expected to have any salvage

value at the end of the project’s economic life,

• and this value exceeds the equipment’s book value,

• a corporate tax liability would be incurred on the profit

(net of abandonment costs) from the sale of such
equipment.

23
 Depreciation Cont’d
(Straight-Line Depreciation)

Example 2.1
(a)Compute the straight-line depreciation for a
pumping unit acquired at a cost of $35,000
with a salvage value of $5,000 at the end of its
useful life of five years.

(b) calculate and plot the book value of the asset

after each year, using straight line
depreciation.
24
 Depreciation Cont’d
(Straight-Line Depreciation)
(a) Straight-Line Depreciation
$35,000  $5,000
Dn  $6,000 per year
5

(b) Book Value

BV1 35,000  1(6,000) $29,000

BV2 35,000  2(6,000) $23,000

25
 Depreciation Cont’d
(Straight-Line Depreciation)

BV3 35,000  3(6,000) $17,000

BV4 35,000  4(6,000) $11,000

BV5 35,000  5(6,000) $5,000 Salvage Value

26
 Depreciation Cont’d
(Straight-Line Depreciation)

27
 Depreciation Cont’d
(Declining Balance Depreciation)
• This method is also referred to as the accelerated
depreciation method.

• The method is appropriate when it can be

reasonably estimated that the benefits derived
from an asset will decline with time.

• A fixed value of percentage is applied to the book

value (total value of asset less accumulated
depreciation of previous years) of the asset each
year. 28
 Depreciation Cont’d
(Declining Balance Depreciation)

• The declining balance depreciation is further

divided into different percentages,

• such as the 200% declining balance method (also

referred to as the double declining balance
depreciation),

• 175% declining balance, 150% declining balance,

and 125% declining balance.
29
 Depreciation Cont’d
(Declining Balance Depreciation)

• The fixed percentage is calculated by dividing

the previously mentioned percentages by the
recovery period assigned to the asset.

• Under this method, the salvage value is not

subtracted when figuring yearly deductions.

30
 Depreciation Cont’d
(Declining Balance Depreciation)
• However, the property may not be
depreciated below its reasonable salvage
value.

• In addition, it is allowed to switch to the

straight-line depreciation in the year when this
method provides greater deduction over the
declining balance method.

31
 Depreciation Cont’d
(Declining Balance Depreciation)

Example 2.2
• For the pumping unit in Example (2.1),
calculate 200% declining balance depreciation
and switch to straight-line when feasible.
Assume zero salvage value at the end of five
years.

32
 Depreciation Cont’d
(Declining Balance Depreciation)
Solution

200%
Fixed percentage  40% or 0.40
5

• The depreciation schedule is shown in Table

2.1.

33
 Depreciation Cont’d
(Declining Balance Depreciation)

• The book value at the beginning of the second

year (adjusted basis) is $21,000 (i.e., $35,000 –
$14,000 (35,000 x 0.40) = $21,000), and so on.

• The straight-line depreciation is calculated by

dividing the book value at the beginning of the
year by the remaining life of the asset.

34
 Depreciation Cont’d
(Declining Balance Depreciation)

Table 2.1: 200% declining balance with switch

to straight-line depreciation
Year Book Value of Rate Dn Dn Deduction
Asset Declining Straight Taken
at Beginning of Balance Line
Year

1 $35,000 0.40 $14,000 $7,000 $14,000

2 $21,000 0.40 $8,400 $5,250 $8,400
3 $12,600 0.40 $5,040 $4,280 $5,040
4 $7,560 0.40 $3,024 $3,780 $3,780
5 $3,780 0.40 $3,780 $3,780
Total $35,000
35
 Depreciation Cont’d
(Sum-of-years’-digits depreciation)

• This method produces a declining depreciation

charge each year by applying a declining charge
to the total cost of the asset (depreciation base).

• The declining charge is determined each year by

dividing the remaining life of the asset by the
sum of the years’ digits.

36
 Depreciation Cont’d
(Sum-of-years’-digits depreciation)

• For an asset with a five-year life, the sum of

years’ digits is 5 + 4 + 3 + 2 + 1 = 15,

• and the declining charge for the first year is

5/15, and so on.

• The following equations is used to calculate the

sum of years’ digits:
nn  1
SYD  (2.3)
2 37
 Depreciation Cont’d
(Sum-of-years’-digits depreciation)

Number of Remaining Years of Life

Dn  C  Sv  2.4
SYD

• Where SYD is the sum of years’ digits, and n is

the useful life of the asset to be depreciated.

38
 Depreciation Cont’d
(Sum-of-years’-digits depreciation)
• In this method of depreciation, the
depreciation rate is equal to the years
remaining divided by the sum of the years’
digits.

• Clearly, the annual depreciation is higher

toward the beginning of the project because
this is when the remaining life is longer.

39
 Depreciation Cont’d
(Sum-of-years’-digits depreciation)
Example 2.3
(a) Compute the sum-of-years’-digits depreciation
for a pumping unit acquired at a cost of
$35,000. Assume zero salvage value at the end
of five years.

(b) Calculate the book value of the asset after

each year, using sum-of-years’ digits
depreciation.
40
 Depreciation Cont’d
(Sum-of-years’-digits depreciation)

Solution
55  1
SYD  15
2
Table 2.2 Depreciation schedule
Year Depreciation Fraction Dn Book Value of
Base Depreciation Year End
Charge
1 $35,000 5/15 $11,667 $23,333
2 $35,000 4/15 $9,333 $14,000
3 $35,000 3/15 $7,000 $7,000
4 $35,000 2/15 $4,667 $2,333
5 $35,000 1/15 $2,333 0
TOTAL $35,000
41
 Depreciation Cont’d
(Units of production depreciation)

• When physical wear and tear is the dominating

factor in the useful life of the asset,

• depreciation may be based on units of service

rather than on the units of time.

• This method is used when it is determined that

the life of the asset is dependent on how much
the asset is used or it produces, rather than the
passage of time.
42
 Depreciation Cont’d
(Units of production depreciation)

• The activity may be measured in hours, days,

months, years, the number of items produced,
etc.

• The depreciation charge for each year is

calculated by multiplying the activity per
period by the depreciation rate.
Cost  Salvage Value
Depreciati on Rate  (2.5)
Total Lifetime Activity
43
 Depreciation Cont’d
(Units of production depreciation)
Example 2.4
A drilling rig is purchased for $1,300,000. It is
estimated that the rig will be able to drill a total
of 10,000,000 feet. After drilling that many
feet, the rig can be sold for $150,000. In the
first year of service, the rig drills 155,000 feet,
and in the second year, it drills 100,000 feet.
What is the depreciation deduction for the two
years?
44
 Depreciation Cont’d
(Units of production depreciation)
Solution
$1,300,000  $150,000
Depreciati on Rate  $0.115 per foot
10,000,000

Depreciati on for Year 1 $155,000 0.115 $17,825

Depreciati on for Year 2 $100,000 0.115 $11,500

45
Taxes

46
 Taxes
• There are many types of taxes levied upon
corporations and individuals in all countries.

• Some are sales tax, valued-added tax, import

tax, income tax, highway tax, gasoline tax, and
property (real estate) tax.

• Federal governments rely on income taxes for

a significant portion of their annual revenue.
47
 Taxes Cont’d
• States, provinces, and municipal-level governments
rely on sales, value-added, and property taxes to
maintain services, schools, etc. for the citizenry.

• Income tax is the amount of the payment (taxes) on

income or profit that must be delivered to a federal
(or lower-level) government unit.

• Taxes are real cash flows; however, for corporations

tax computation requires some noncash elements,
such as depreciation.
48
 Taxes Cont’d
• Corporate income taxes are usually submitted
quarterly, and the last payment of the year is
submitted with the annual tax return.

• The Internal Revenue Service (IRS), collects the

taxes and enforces tax laws.

• Though the formulas are much more complex when

applied to a specific situation, two fundamental
relations form the basis for income tax
computations. 49
 Taxes Cont’d
• The first involves only actual cash flows:

Net Operating Income ( NOI ) Revenue  Operating Expenses

• The second involves actual cash flows and noncash

deductibles, such as depreciation.
Taxable Income (TI ) Revenue  Operating Expenses  Depreciati on

• Operating revenue R , also commonly called gross

income GI, is the total income realized from all
revenue-producing sources.
50
 Taxes Cont’d
• Other, non-operating revenues such as sale of
assets, license fee income, and royalties are
considered separately for tax purposes.

• Operating expenses OE include all costs

incurred in the transaction of business.

• These expenses are tax-deductible for

corporations.
51
 Taxes Cont’d
• Net operating income NOI, often called EBIT
(earnings Before Interest and Income Taxes), is
the difference between gross income and
operating expenses.

NOI EBIT GI  OE ( 2.6)

52
 Taxes Cont’d
• Taxable income TI is the amount of income
upon which taxes are based.

• A corporation is allowed to remove

depreciation, depletion and amortization,

• and some other deductibles from net

operating income in determining the taxable
income for a year.
53
 Taxes Cont’d
• We define taxable income as:

TI Gross Income  Operating Expenses  Depreciati on

GI  OE  D (2.7)

• The differences in NOI and TI are tax-law-allowed

deductibles, such as depreciation.

54
 Taxes Cont’d
• Tax rate T is a percentage, or decimal
equivalent, of TI that is owed in taxes.

• The tax rates in many countries are graduated

(or progressive) by level of TI; that is, higher
rates apply as the TI increases.

• The marginal tax rate is the percentage paid on

the last dollar/naira of income.
55
 Taxes Cont’d
• The general tax computation relation is:
Income Taxes  Applicable Tax Rate Taxable Income
T TI  ( 2.8)

• Net operating profit after taxes NOPAT is the

amount remaining each year after taxes are
subtracted from taxable income.
NOPAT TI  Taxes TI  T TI 
TI 1  T  (2.9)
56
 Taxes Cont’d
• Basically, NOPAT represents the money
remaining in the corporation as a result of the
capital invested during the year.

• It is also called net profit after taxes (NPAT).

• The graduated tax rate schedule for

corporations is presented in Table 2.3 as taken
from IRS Publication 542, Corporations .
57
 Taxes Cont’d
TABLE 2.3: U.S. Corporate Income Tax Rate Schedule (2010)

58
 Taxes Cont’d
• These are rates for the entire corporation, not for
an individual project, though they are often
applied in the after-tax analysis of a single
project.

• The rates can change annually based upon

government legislation;

• However, the corporate tax rate schedule has

remained the same for some years.
59
 Taxes Cont’d
• To illustrate the use of the graduated tax rate,
assume a company is expected to generate a
taxable income of $500,000 in 1 year.

• From Table 2.3, the marginal tax rate for the

last dollar of TI is 34%,

• but the graduated rates become progressively

larger as TI increases.
60
 Taxes Cont’d

• In this case, for TI $500,000,

Taxes 113,900  0.34500,000  335,00 

113,900  56,000
$170,000

61
 Taxes Cont’d
• Alternatively, the rates for each TI level can be
used to calculate taxes the longer way.

Taxes 0.1550,000  0.2575,000  50,000  0.34100,000  75,000 

0.39335,000  100,000  0.34500,000  335,000 
7,500  6,250  8,500  91,650  56,100
$170,000

62
 Taxes Cont’d
• Smaller businesses (with TI < $335,000)
receive a slight tax advantage compared to
large corporations.

• Once the TI exceeds $335,000, an effective

federal tax rate of 34% applies,

• and when TI < $18.33 million, there is a flat tax

rate of 35%.
63
 Taxes Cont’d
• Because the marginal tax rates change with TI,
it is not possible to quote directly the percent
of TI paid in income taxes.

• Alternatively, a single-value number, the

average tax rate, is calculated as:
Total Taxes Paid Taxes
Average Tax Rate   (2.10)
Taxable Income TI
64
 Taxes Cont’d
• Referring to Table 2.3 , for a small business
with TI=$100,000, the federal income tax
burden averages $22,250/100,000= 22.25%.

• If TI=$15 million, the average tax rate is $5.15

million/15 million= 34.33%.

65
 Taxes Cont’d
• As mentioned earlier, there are federal, state,
and local taxes imposed.

• For the sake of simplicity, the tax rate used in

an economy study is often a single-figure
effective tax rate Te, which accounts for all
taxes.

• Effective tax rates are in the range of 35% to

50%.
66
 Taxes Cont’d
• One reason to use the effective tax rate is that
state taxes are deductible for federal tax
computation.

• The effective tax rate and taxes are calculated as:

Te State Rate  1  State Rate Federal Rate  (2.11)

Taxes Te TI  ( 2.12)

67
 Taxes Cont’d
Example 2.5
REI (Recreational Equipment Incorporated) sells outdoor equipment and
sporting goods through retail outlets, the Internet, and catalogs. Assume
that for 1 year REI has the following financial results in the state of Kentucky,
which has a flat tax rate of 6% on corporate taxable income.

Total revenue $19.9 million

Operating expenses $8.6 million

Depreciation and other allowed deductions $1.8 million

(a) Determine the state taxes and federal taxes due using Table 2.3 rates.

68
 Taxes Cont’d
(b) Find the average federal tax rate paid for the year.

(c) Determine a single-value tax rate useful in economic

evaluations using the average federal tax rate
determined in part (b).

(d) Estimate federal and state taxes using the single-value

rate, and compare their total with the total in part (a).

69
 Taxes Cont’d
Solution
(a) Calculate TI by Eqtn (2.7) and use Table 2.3
rates for federal taxes due.
Kentucky StateTI GI  OE  D 19.9million  8.6million  1.8million
$9.5million

Kentucky State Taxes T TI  0.06 9,500,000 

$570,000

Fedral TI GI  OE  D  StateTaxes

9,500,000  570,000
$8,930,000
70
 Taxes Cont’d

FederalTaxes 113,900  0.348,930,000  335,000

$3,036,200

Total Federal Taxes and State Taxes 3,036,200  570,000

$3,606,200

71
 Taxes Cont’d
(b) From Eqtn (2.10), the average tax rate paid is
approximately 32% of TI.

3,036,200
Average Federal Tax Rate  0.3196
9,500,000

(c) By Eqtn (2.11) , Te is slightly over 36% per

year for combined state and federal taxes.

Te 0.06  1  0.06 0.3196  0.3604(36.04%)

72
 Taxes Cont’d
(d) Use the effective tax rate and TI $9.5 million
from part (a) in Eqtn (2.12) to approximate
total taxes.

Taxes 0.36049,500,000  $3,423,800

Compared to Total Federal Taxes and State
Taxes, this approximation is $182,400 low, a
5.06% underestimate.

73
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)

• Net cash flow (NCF) is identified as the best estimate of

actual cash flow each year.

• The NCF is calculated as cash inflows minus cash outflows.

• Cash Flow Before Taxes (CFBT) and Cash Flow After Taxes
(CFAT) are actual cash flows;

• That is, they represent the estimated actual flow of

money into and out of the corporation that will result
from the alternative chosen.
74
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)

• The annual CFBT estimate must include the

initial capital investment and salvage value for
the years in which they occur.

• Incorporating the definitions of gross income

and operating expenses from NOI, CFBT for any
year is defined as:
CFBT Gross Income  Operating Expenses
 Initial Investment  Salvage Value
GI  OE  P  S (2.13)
75
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)

• P is the initial investment (year 0) and S is the

estimated salvage value in year n.

• Therefore, only in year 0 will the CFBT include P,

and only in year n will a S value be present.

• Once all taxes are estimated, the annual after-tax

cash flow is simply:
CFAT CFBT  Taxes ( 2.14)
76
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)

• Taxes are estimated using the relation (T)(TI) or

( Te)(TI).

• Eqtns (2.13) and (2.14) are now combined

• Suggested table column headings for CFBT and

CFAT calculations by hand or by spreadsheet are
shown in Table (2.4).

77
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)
• The eqtns are shown in column numbers, with the
effective tax rate Te used for income tax estimation.

• Expenses OE and initial investment P carry negative

signs in all tables and spreadsheets.

• A negative TI value may occur in some years due to

a depreciation amount that is larger than (GI − OE).

78
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)
• TABLE 2.4: Suggested Column Headings for Calculation
of CFAT

79
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)
Example 2.6:
Uniport Security has received a contract to provide additional
security for students and members of staff. Uniport plans to
purchase listening and detection equipment for use in the 6-
year contract. The equipment is expected to cost N550,000
and have a resale value of N150,000 after 6 years. Based on
the incentive clause in the contract, Uniport estimates that
the equipment will increase contract revenue by N200,000
per year and require an additional maintenance & operations
expense of N90,000 per year. Straight line depreciation allows
recovery in 6 years, and the effective corporate tax rate is
35% per year. Tabulate and plot the CFBT and CFAT series.
80
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)
YEAR GROSS OPERATING INVESTMENT CFBT DEPRECIATION TAXABLE TAXES CFAT
INCOME EXPENSES AND INCOME
SALVAGE (D)
(GI) (OE) (P&S) (TI)

0
-550,000 -550,000

1 200,000 -90,000 110,000 66,667 43,333 15166.55 -550,000

2 200,000 -90,000 110,000 66,667 43,333 15166.55 94,833

3 200,000 -90,000 110,000 66,667 43,333 15166.55 94,833

4 200,000 -90,000 110,000 66,667 43,333 15166.55 94,833

5 200,000 -90,000 110,000 66,667 43,333 15166.55 94,833

6 200,000 -90,000 150,000 260,000 66,667 43,333 15166.55 94,833

81
 Taxes Cont’d
(Calculation of Cash Flow after Taxes)

82
Cost of Capital

83
 Cost of Capital
• Most companies today use discounted cash
flow (DCF) techniques for project evaluation.

• The method involves forecasting the future

cash flows, choosing the appropriate cost of
capital (also referred to as the discount rate),

• and finding the present value of the forecasted

net cash flows.
84
 Cost of Capital Cont’d
• The Net Present Value (NPV) is defined as the
present value of receipts less the present
value of disbursements.

• If the NPV at the project’s cost of capital is

positive, then accepting the project adds value
to the firm and vice versa.

85
 Cost of Capital Cont’d
• Assume that estimates on the future cash flows
of a proposed project are sound.

• The success of the discounted cash flow

technique then depends on how well the
analysts choose the discount rate.

• If a picked rate is too high, projects that add

value to the firm will be unnecessarily rejected.
86
 Cost of Capital Cont’d
• On the other hand, if the discount rate is too
low, projects that do not add value to the firm
will be accepted.

• Therefore, choosing the appropriate discount

rate is as important as the estimation of
appropriate future cash flows.

87
 Cost of Capital Cont’d
• There are several different types of discounted
cash flow approaches,

• and each has a different specification of cash

flows and a different appropriate discount rate.

• The weighted average cost of capital approach

is highly recommended by some expert.

88
 Cost of Capital Cont’d
• To implement this approach, one has to first
estimate the costs of the various sources of
financing (including equity).

• In general, these costs are a function of the

riskiness of the project being financed and the
amount of debt used to finance the project.

89
 Cost of Capital Cont’d
• The technique involves:
1. Estimating the current cost of each source of
funds.
• This is not the historical cost of the capital raised,
but the marginal cost of the incremental funds
required for the project.

2. Finding the weighted average of the costs.

• These separate sources of capital are based on the
market values of the sources of financing.
• The result is the weighted average cost of capital. 90
 Cost of Capital Cont’d
• The different sources of financing include the
cost of:
1. Common Equity (i.e., the return the shareholders
expect the project to earn on their money).

2. Preferred Stock

3. Debt.

4. Other elements in the capital structure.

91
 Cost of Capital Cont’d
• The mixture of these elements is known as
Capital Structure.

• The ratio of borrowed funds to either total funds

or shareholders’ equity is known as the Gearing
Ratio.

• A firm is highly geared when it has a larger

proportion of funds borrowed from
intermediaries in relation to its share capital. 92
 Cost of Capital Cont’d
• Alternatively, low gearing occurs when a large
bulk of the borrowed funds is in the form of
share capital.

• The higher the level of capital gearing, the

greater the risk associated with the project.

• It is important to differentiate between two

types of risks: project risk and financial risk.
93
 Cost of Capital Cont’d
• Project Risk is the inherent uncertainty
surrounding the level of pre-tax profits that will
be generated by the project.

• It arises because it is usually impossible to

accurately forecast several variables that form
the project cash flow.

• Financial Risk is the additional risk introduced

because of gearing in the capital structure. 94
 Cost of Capital Cont’d
• The level of fixed interest financing in the capital
structure determines the financial risk.

• The probability of cash insolvency increases with

the level of gearing used by the firm, as does the
variability of the earnings available for ordinary
shareholders.

• The fixed interest loans have to be paid regardless

of whether the company is making profit,
95
 Cost of Capital Cont’d
• but paying dividends to the providers of share
capital can be avoided in poor years.

• The finance department or the corporate

planning department of the firm normally
specifies the appropriate discount rate.

• In the oil and gas industry, the general trend is

to use a discount rate of 10% – 12%.
96
 Cost of Capital Cont’d
Net Present Value (NPV)

• The net present value (NPV), also referred to as the

Present Value (PV) of cash surplus or Present Worth
(PW).

• NPV is obtained by subtracting the present value of

periodic cash outflows from the present value of
periodic cash inflows.

• The present value is calculated using the weighted

average cost of capital of the investor, also referred to as
the discount rate or minimum acceptable rate of return.
97
 Cost of Capital Cont’d
Net Present Value (NPV)

• The discount rate should reflect the value of the

alternative use of funds.

• What is an alternative use of funds? Money has

value regardless of how it is utilized.

• If it is kept in a bank savings account, it earns

interest;
98
 Cost of Capital Cont’d
Net Present Value (NPV)
• if it is kept in a mattress, it loses real value with time
because of the missed opportunity of earning
interest.

• For example, if N100,000 invested in a bank earning

5% interest is withdrawn for investing it in another
project,

• the 5% becomes the cost of capital or the

opportunity cost of the N100,000 that is forgone by
investing it in another project. 99
 Cost of Capital Cont’d
Net Present Value (NPV)

• The bank account is the alternative use of funds.

• Therefore, when evaluating the project it must

generate at least 5% to break even with the
returns from the bank account.

• The risk factor also comes into play (if return

from the project is riskier than the return on the
bank account, then some risk premium more
than the 5% return is desired). 100
 Cost of Capital Cont’d
Net Present Value (NPV)

• When the NPV of an investment at a certain

discount rate is positive, it pays for the cost of
financing the investment or the cost of the
alternative use of funds.

• The investment generates revenue that is equal

to the positive present value.

• It also implies the rate of return on the

investment is at least equal to the discount rate.
101
 Cost of Capital Cont’d
Net Present Value (NPV)

• A negative NPV indicates the investment is not

generating earnings equivalent to those expected
from the alternative use of funds, thus causing
opportunity loss.

• The net present value method of evaluating the

desirability of investments is mathematically
represented by the following equation
S1 S2 S3 Sn
NPV     ...  Io (2.15)
1  id  1  id  1  id 
1 2 3
1  id n

102
 Cost of Capital Cont’d
Net Present Value (NPV)

OR
n
St
NPV   Io (2.16)
i 1 1  id 
t

Where
• St = the expected net cash flow (gross revenue – LOE – taxes) at the
end of year t
• LOE= Lease Operating Expenditure
• Io = the initial investment outlay at time zero, i.e., 1/1/2011
• id = the discount rate, i.e., the required minimum annual rate of
return on new investment

103
• n = the project’s economic life in years
 Cost of Capital Cont’d
Net Present Value (NPV)
• Since the capital outlay may stretch longer than
one period, a more general formulation would be
to define Io as the present value of the capital
outlays.

• Eqtn (2.16) is modified as:

n
NCFt
NPV  ( 2.17)
i 1 1  id 
t

• NCF= Net Cash Flow 104

 Cost of Capital Cont’d
Net Present Value (NPV)

Example 2.7:
• Calculate the NPV of the NCF stream in Table
2.5 using a 10% discount rate and mid-year
cash flow assumption.

105
 Cost of Capital Cont’d
Net Present Value (NPV)
• Table 2.5: Net Cash Flow Stream
YEAR NCF (MN)
2011 (750.00)
2012 417.85
2013 192.45
2014 136.20
2015 81.77
2016 60.74
2017 46.67
2018 36.60
2019 30.87

106
 Cost of Capital Cont’d
Net Present Value (NPV)

Solution
Year NCF (MN) t 1/(1+0.10)t-0.5 Cum.NPV
@10%
MN

2011 (750.00) 0.5 0.9535 (715.13)

2012 417.85 1.5 0.8668 362.19
2013 192.45 2.5 0.7880 151.65
2014 136.20 3.5 0.7164 97.57
2015 81.77 4.5 0.6512 53.25
2016 60.74 5.5 0.5920 35.96
2017 46.67 6.5 0.5382 25.12
2018 36.60 7.5 0.4893 17.91
2019 30.87 8.5 0.4448 13.73
Total 253.15 42.25
107
 Cost of Capital Cont’d
Net Present Value (NPV)
• Once the NPV of the investment alternative is
calculated, the following decision rules apply:

• If the NPV is positive, accept the proposal.

• If the NPV is negative, reject the proposal.

• If the NPV is zero, the analyst will be indifferent,

108
 Cost of Capital Cont’d
Net Present Value (NPV)
• because the proposal is generating the same
return as the alternative use of funds will
generate (assuming both alternatives have the
same risk).

• The NPV decision criterion follows directly

from the assumption that the analyst is
required to maximize the worth of the firm.

109
 Cost of Capital Cont’d
Net Present Value (NPV)

• This criterion results in optimal choice of

projects.

• The size of a project’s NPV depends, among

other things, on the discount factor.

110
 Cost of Capital Cont’d
Net Present Value (NPV)

Take Home:
• Calculate the NPV of the NCF stream in Table
2.5 using a 10 and 15 % discount rates and
end of year cash flow assumption.

111
Comparing Alternative Investment

112
 Replacement Alternatives
• One of the most common and important issues
in industrial practice is that of replacement or
retention of an asset, process, or system that is
currently installed.

• A replacement study is usually designed to first

make the economic decision to retain or replace
now .

113
 Replacement Alternatives Cont’d
• If the decision is to replace, the study is
complete.

• If the decision is to retain, the cost estimates

and decision can be revisited each year to
ensure that the decision to retain is still
economically correct.

114
 Replacement Alternatives Cont’d
• The need for a replacement study can develop from
several sources:
1. Reduced Performance.

• Because of physical deterioration, the ability to perform at

an expected level of reliability or productivity is not
present.

• This usually results in increased costs of operation, higher

scrap and rework costs, lost sales, reduced quality,
diminished safety, and larger maintenance expenses.
115
 Replacement Alternatives Cont’d
2. Altered Requirements.

• New requirements of accuracy, speed, or other

specifications cannot be met by the existing
equipment or system.

• Often the choice is between complete

replacement or enhancement through
retrofitting or augmentation.
116
 Replacement Alternatives Cont’d
3. Obsolescence
• International competition and rapidly changing
technology make currently used systems and assets
perform acceptably but less productively than
equipment coming available.

• The ever-decreasing development cycle time to bring

new products to market is often the reason for
premature replacement studies,

• that is, studies performed before the estimated useful or

economic life is reached. 117
 Replacement Alternatives Cont’d
• Defender and challenger are the names for two
mutually exclusive alternatives.

• The defender is the currently installed asset, and the

challenger is the potential replacement.

• A replacement study compares these two alternatives.

• The challenger is the “best” challenger because it has

been selected as the best one to possibly replace the
defender.
118
 Replacement Alternatives Cont’d
• Market value is the current value of the installed asset if it
were sold or traded on the open market.

• Also called trade-in value , this estimate is obtained from

professional appraisers, resellers, or liquidators familiar
with the industry.

• Salvage value is the estimated value at the end of the

expected life.

• In replacement analysis, the salvage value at the end of

one year is used as the market value at the beginning of the
next year. 119
Replacement Alternatives Cont’d
Example 2.8:

Three years ago Port Harcourt International Airport

purchased a new fire truck. Because of flight
increases, new fire-fighting capacity is needed once
again. An additional truck of the same capacity can
be purchased now, or a double-capacity truck can
replace the current fire truck. Estimates are
presented on the table (next slide). Compare the
options at 12% per year using a 12-year study period

120
 Replacement Alternatives Cont’d
Presently Owned New Purchase Double Capacity

First Cost P, N -151,000(3years ago) -175,000 -190,000

Annual Operating -1,500 -1,500 -2,500

Cost, AOC, N

Market Value, N 70,000 - -

Salvage Value, N 10% of P 12% of P 10% of P

Life, Years 12 12 12

121
 Replacement Alternatives Cont’d
Solution
Identify option 1 as retention of the presently
owned truck and augmentation with a new
same capacity vehicle. Define option 2 as
replacement with the double-capacity truck.
Option 1 Option 2
Presently Augmentation Double Capacity
Owned
First Cost P, N -70,000 -175,000 -190,000
Annual Operating Cost, -1,500 -1,500 -2,500
AOC, N
Salvage Value, N 15,100 21,000 19,000
Life, Years 9 12 12
122
 Replacement Alternatives Cont’d
Solution
For a full-life 12-year study period of option 1
AW1 AW of presently owned  AW of augmentati on 

Where, AW=Annual Worth

 70,000A / P,12%,9  15,100A / F ,12%,9  1500
  175,000A / P,12%,12  21,000A / F ,12%,12  1500

 13,616  28,882
 N 42,496 123
 Replacement Alternatives Cont’d
This computation assumes the equivalent services
provided by the current fire truck can be purchased at −
N13,616 per year for years 10 through 12.

• For a full-life 12-year study period of option 2

AW 2  190,000A / P,12%,12  19,000A / F ,12%,12  2500

 N 32,386

Replace now with the double-capacity truck (option 2) at

an advantage of N10,112 per year.
124
Budget and Budget Control

125
 Budget and Budget Control
• Budgeting is used by businesses as a method of financial planning for
the future.

• Budgets are prepared for main areas of the business – purchases,

sales (revenue), production, labour, trade receivables, trade payables,
cash,

• and provide detailed plans of the business for the next three, six or
twelve months.

• Businesses need to plan for the future.

• In large businesses such planning is very formal while, for smaller

businesses, it will be less formal. 126
Budget and Budget Control Cont’d
• Planning for the future falls into three time
scales:

1. long-term: from about three years up to,

sometimes, as far as twenty years ahead

2. medium-term: one to three years ahead

3. short-term: for the next year

127
 Budget and Budget Control Cont’d
• Clearly, planning for these different time scales
needs different approaches: the further on in
time, the less detailed are the plans.

• In the medium and longer term, a business will

establish broad business objectives.

• Such objectives do not have to be formally

written down, although in a large business they
are likely to be. 128
 Budget and Budget Control Cont’d
• In smaller businesses, objectives will certainly
be considered and discussed by the owners or
managers.

• Planning takes note of these broader business

objectives and sets out how these are to be
achieved in the form of detailed plans known as
budgets.

129
 Budget and Budget Control Cont’d
What is a Budget?
• A budget may be set in money terms, e.g a sales
budget of N500,000,

• or it can be expressed in terms of units, e.g. a

“purchases” budget of 5,000 units (to be bought).

• Budgets can be income budgets for money

received, e.g. a sales budget, or expenditure
budgets for money spent, e.g. a purchases budget.
130
 Budget and Budget Control Cont’d
What is Budget Control?
• Most budgets are prepared for the next financial year
(the budget period),

• and are usually broken down into shorter time periods,

commonly four-weekly, monthly or quarterly.

• This enables budgetary control to be exercised over

the budget: the actual results can be monitored
against the budget, and discrepancies between the
two can be investigated and corrective action taken
where appropriate.
131
 Budget and Budget Control Cont’d
Benefits of Budgets and Budgetary Control
• Budgets provide benefits both for the business, and
also for its managers and other staff:

 The budget assists planning

• By formalizing objectives through a budget, a
business can achieve the plans set out for it.

• It bring to bear what is needed to produce the output

of goods and services, and to make sure that
everything will be available at the right time. 132
 Budget and Budget Control Cont’d
Benefits of Budgets and Budgetary Control

 The budget communicates and co-ordinates

• Because a budget is agreed on the business, all the
relevant managers and staff will be working towards the
same end.

• When the budget is being set, any anticipated problems

should be resolved and any areas of potential confusion
clarified.

• All departments should be in a position to play their part

in achieving the overall goals. 133
 Budget and Budget Control Cont’d
Benefits of Budgets and Budgetary Control
 The budget helps with decision-making
• By planning ahead through budgets, a business
(owners) can make decisions on how much
output in the form of goods or services can be
achieved.

• At the same time, the cost of the output can be

planned and changes can be made where
appropriate.
134
 Budget and Budget Control Cont’d
Benefits of Budgets and Budgetary Control
 The budget can be used to monitor and control

• An important reason for producing a budget is that

management is able to use budgetary control to
monitor and compare the actual results.

• This is so that action can be taken to modify the

operation of the business as time passes, or
possibly to change the budget if it becomes
unachievable. 135
 Budget and Budget Control Cont’d
Benefits of Budgets and Budgetary Control
 The budget can be used to motivate
• A budget can be part of the techniques for motivating
managers and other staff to achieve the objectives of the
business.

• The extent to which this happens will depend on how the

budget is agreed and set,

• and whether it is thought to be fair and achievable.

• The budget may also be linked to rewards (for example,

bonuses) where targets are met or exceeded. 136
 Budget and Budget Control Cont’d
Limitations of Budgets and Budgetary Control
• Whilst most businesses will benefit from the use of budgets,
there are a number of limitations of budgets to be aware of:

 The benefit of the budget must exceed the cost

• Budgeting is a fairly complex process and some businesses –
particularly small ones may find that the task is too much of
a burden in terms of time and other resources, with only
limited benefits.

• As a general rule, the benefit of producing the budget must

exceed its cost.
137
 Budget and Budget Control Cont’d
Limitations of Budgets and Budgetary Control
 Budget information may not be accurate

• It is essential that the information going into

budgets should be as accurate as possible.

• Anybody can produce a budget, but the more

inaccurate it is, the less useful it is to the
business as a planning and control mechanism.

138
 Budget and Budget Control Cont’d
Limitations of Budgets and Budgetary Control

• Great care needs to be taken with estimates of

sales – often the starting point of the budgeting
process – and costs.

• Budgetary control is used to compare the budget

against what actually happened – the budget
may need to be changed if it becomes
unachievable
139
 Budget and Budget Control Cont’d
Limitations of Budgets and Budgetary Control
 The budget may demotivate.
• Employees who have had no part in agreeing and
setting a budget which is imposed upon them, will feel
that they do not own it.

• As a consequence, the staff may be demotivated.

• Another limitation is that employees may see budgets

as either a ‘carrot’ or a ‘stick’, i.e. as a form of
encouragement to achieve the targets set, or as a form
of punishment if targets are missed. 140
 Budget and Budget Control Cont’d
Limitations of Budgets and Budgetary Control
 Budgets may lead to disfunctional management
• A limitation that can occur is that employees in one
department of the business may over-achieve against their
budget and create problems elsewhere.

• For example, a production department might achieve extra

output that the sales department finds difficult to sell.

• To avoid such disfunctional management, budgets need to

be set at realistic levels and linked and co-ordinated across
all departments within the business.
141
 Budget and Budget Control Cont’d
Limitations of Budgets and Budgetary Control
 Budgets may be set at too low a level

• Where the budget is too easy to achieve it will be of

no benefit to the business

• and may, in fact, lead to lower levels of output and

higher costs than before the budget was established.

• Budgets should be set at realistic levels, which make

the best use of the resources available. 142
 Budget and Budget Control Cont’d
What Budgets are Prepared?
• Budgets are planned for specific sections of
the business:

• these budgets can then be controlled by a

budget holder, who may be the manager or
supervisor of the specific section

143
 Budget and Budget Control Cont’d
What Budgets are Prepared?
• Types of budgets include:
• Purchases budget – what the business needs to
buy to make/supply the goods it expects to sell

• Sales (revenue) budget – what the business

expects to sell

• Production budget – how the business will

make/supply the goods it expects to sell
144
 Budget and Budget Control Cont’d
What Budgets are Prepared?
• Labour budget – the cost of employing the people
who will make/supply the goods

• Trade receivable budget – how much the business will

receive from credit sales

• Trade payable budget – how much the business will

pay for credit purchases

• Cash budget – how much money will be flowing in and

out of the bank account 145
 Budget and Budget Control Cont’d
What Budgets are Prepared?

• The end result of the budgeting process is

often the production of a master budget,

• which takes the form of forecast operating

statements – forecast income statement –
and forecast balance sheet.

• The master budget is the ‘master plan’ which

shows how all the other budgets ‘work
together’. 146
 Budget and Budget Control Cont’d
Budgetary Planning

Many large businesses take a highly formal view of

planning the budget and make use of:

• a budget manual, which provides a set of guidelines as to

who is involved with the budgetary planning and control
process, and how the process is to be conducted

• a budget committee, which organizes the process of

budgetary planning and control;

147
 Budget and Budget Control Cont’d
Budgetary Planning
• this committee brings together representatives
from the main functions of the business. e.g.
production, sales, administration

• and is headed by a Budget Co-ordinator whose

job is to administer and oversee the activities
of the committee

148
 Budget and Budget Control Cont’d
Budgetary Planning
• In smaller businesses, the process of planning the budget
may be rather more informal, with the owner or manager
overseeing and budgeting for all the business functions.

• Whatever the size of the business it is important, though,

that the planning process begins well before the start of
the budget period;

• this then gives time for budgets to be prepared, reviewed,

redrafted, and reviewed again before being finally agreed
and submitted to the directors or owners for approval
149
 Budget and Budget Control Cont’d
Budgetary Planning

For example, the planning process for a budget which is to

start on 1 January might commence in the previous June,
as follows:

• June Budget committee meets to plan next year’s budgets

• July First draft of budgets prepared

• August Review of draft budgets

• September Draft budgets amended in light of review 150

 Budget and Budget Control Cont’d
Budgetary Planning
• October Further review and redrafting to final
version

• November Budgets submitted to directors or

owners for approval

• December Budgets for next year circulated to

managers

• January Budget period commences 151

 Budget and Budget Control Cont’d
Cash Budget

• A cash budget sets out the expected cash/bank receipts and

payments,

• usually on a month by-month basis, for the next three, six or

twelve months, in order to show the estimated bank balance at
the end of each month throughout the period.

• From the cash budget, the managers of a business can decide

what action to take when a surplus of cash is shown to be
available

• or, as is more likely, when a bank overdraft needs to be

arranged. 152
 Budget and Budget Control Cont’d
layout of a cash budget

• A suitable format for a cash budget, with

sample figures, is shown below

153
 Budget and Budget Control Cont’d
sections of a cash budget

A cash budget consists of three main sections:

• receipts for the month

• payments for the month

• summary of bank account

154
 Budget and Budget Control Cont’d
Sections of a Cash Budget

• Receipts are analyzed to show the amount of money that

is expected to be received from cash sales, trade
receivables, sale of non-current assets, capital
introduced/issue of shares, loans received etc.

• Payments show how much money is expected to be paid

in respect of cash purchases, trade payables, expenses,
purchases of noncurrent assets, repayment of
capital/shares and loans.

Note that non-cash expenses (such as depreciation and

doubtful debts) are not shown in the cash budget. 155
 Budget and Budget Control Cont’d
Sections of a Cash Budget

• The summary of the bank account at the bottom

of the cash budget shows net cash flow added to
the bank balance at the beginning of the month,

• and resulting in the estimated closing bank

balance at the end of the month.

• An overdrawn bank balance is shown in brackets.

156
 Budget and Budget Control Cont’d
Sections of a Cash Budget

• The main difficulty in the preparation of cash budgets

lies in the timing of receipts and payments

• for example, trade receivables may pay two months

after date of sale,

• or trade payables may be paid by the business one

month after date of purchase

• it is important to ensure that such receipts and

payments are recorded in the correct month column.157
 Budget and Budget Control Cont’d
Advantages of a Cash Budget

The use of a cash budget enables a business to:

• Identify any possible bank overdraft in advance
and take steps to minimize the borrowing (so
saving interest payable)

• Consider rescheduling payments to avoid bank

borrowing, e.g. delay purchase of non-current
assets, agreement to pay rises, payment of
drawings/dividends
158
 Budget and Budget Control Cont’d
Advantages of a Cash Budget

• Arrange any possible bank finance well in

advance

• Identify any possible cash surpluses in

advance and take steps to invest the surplus
on a short term basis (so earning interest)

159
Evaluation of Public Projects

160
 Evaluation of Public Projects
• A public sector project is a product, service, or
system used, financed, and owned by the citizens
of any government level.

• The primary purpose is to provide service to the

citizenry for the public good at no profit.

• Areas such as public health, criminal justice,

safety, transportation, welfare, and utilities are
publicly owned and require economic evaluation.
161
Evaluation of Public Projects Cont’d
These are some public sector examples:
• Hospitals and clinics
• Parks and recreation
• Utilities: water, electricity, gas, sewer,
sanitation
• Schools: primary, secondary, community
colleges, universities
• Economic development projects
• Convention centers
• etc 162
 Evaluation of Public Projects Cont’d
• There are significant differences in the characteristics of
private and public sector alternatives.

• Often alternatives developed to serve public needs require

large initial investments, possibly distributed over several
years.

• Modern highways, public transportation systems, universities,

airports, and flood control systems are examples.
163
Evaluation of Public Projects Cont’d

• The long lives of public projects often prompt

the use of the capitalized cost method, where
infinity is used for n and annual costs are
calculated as A=P(i).

164
 Evaluation of Public Projects Cont’d

• As n gets larger, especially over 30 years, the

differences in calculated A values become small.

• For example, at i=7%, there will be a very small

difference in 30 and 50 years, because
(A/P ,7%,30)= 0.08059 and ( A/P ,7%,50)=
0.07246.

165
Evaluation of Public Projects Cont’d

• Public sector projects (also called publicly

owned) do not have profits;

• they do have costs that are paid by the

appropriate government unit; and they benefit
the citizenry.
166
Evaluation of Public Projects Cont’d
• Public sector projects often have undesirable
consequences, as interpreted by some sectors
of the public.

• It is these consequences that can cause public

controversy about the projects.

• The economic analysis should consider these

consequences in monetary terms to the degree
estimable.
167
 Evaluation of Public Projects Cont’d

• The capital used to finance public sector projects is

commonly acquired from taxes, bonds, and fees.

• Taxes are collected from those who are the owners—the

citizens.

• This is also the case for fees, such as toll road fees for
drivers. 168
Evaluation of Public Projects Cont’d

• Because many of the financing methods for public

sector projects are classified as low-interest,

• the interest rate is virtually always lower than for

private sector alternatives.

• Government agencies are exempt from taxes

levied by higher-level units.
169
Evaluation of Public Projects Cont’d

• Multiple categories of users, economic as well as

noneconomic interests,

• and special-interest political and citizen groups make the

selection of one alternative over another much more
difficult in public sector economics.

• Seldom is it possible to select an alternative on the sole

basis of a criterion such as PW or ROR. 170
 Evaluation of Public Projects Cont’d

• There are often public meetings and debates associated with

public sector projects to accommodate the various interests of
citizens (owners).

• Elected officials commonly assist with the selection, especially

when pressure is brought to bear by voters, developers,
environmentalists, and others.

• The selection process is not as “clean” as in private sector

evaluation. 171