Ministry of Higher Education

And Scientific Research

University of Technology

Dep. of Production Engineering And

Metallurgy

TECHNICAL REPORT 2019-2020

Branch : Industrial
Subject : Engineering economy and Value engineering

Capital cost method

‫ صبا صالح داود سلمان‬: ‫اسم الطالب‬

‫ الصناعية‬: ‫الفرع العلمي‬
‫ الرابعة‬: ‫المرحلة‬
‫ اقتصاد هندسي وهندسة القيمة‬: ‫اسم المادة‬

‫التوقيع‬ ‫اسم التدريسي‬ ‫درجة التقرير‬

‫كتابة‬ ‫رقما‬
 Capital cost method
Introduction
Capitalized cost represents the present worth of an alternative for a project that is going to
serve for a longer period of time i.e. for an infinite period of time. As the name indicates, it
refers to the present worth of mainly cost or expenditures (cash outflows) of the alternative
over infinite period of time. Capitalized worth refers to present worth of expenditures and
revenues of an alternative over infinite period of time. The capitalized cost method is used
for comparison of mutually exclusive alternatives which have perpetual service life (assumed
to serve forever). The examples of this kind of projects are bridges, dams, irrigation projects,
water supply systems for cities, pipeline projects etc. This method an also be used for finding
out the capitalized cost of permanent fellowship/scholarship endowment in educational
institutes and other organizations. This term is use in case where comparisons of costs are
assumed to be incurred on a perpetual basis. The cost of the renewal of long life assets can
be converted into a uniform perpetual series of payment as between renewals using the
aforementioned expression [ P=R/i]. The capitalized cost is the present sum, which will
.finance an annual cost at a fixed rate of interest in perpetuity

The capitalized cost can also be used for comparison of two or more mutually exclusive
alternatives which are assumed to serve perpetually. In this case the comparison of the
alternatives is made over same time period i.e. infinite period of time. The alternative that
shows lowest capitalized cost is selected as the best alternative. In the following examples,
the calculation of capitalized cost of an alternative and the comparison of mutually exclusive
.alternatives on the basis of capitalized cost are illustrated

Define
Capitalized cost is defined as the present worth of a constant annual cost over
an infinite analysis period. It can be shown that the factor (P/A,i%, n = infinity) is
equal to (1 / i ), with the interest rate i in decimal form.[1]

Methodology
1. For non-recurring costs, calculate PV using timevalue equivalence (find P)
2. For recurring costs (that last forever),
a) Convert recurring costs into annualized equivalent amount, A. [Using (A/F, i%, n)]
b) Use CC = A/i to find the capitalized cost.
3. Add PV of (1) and (2) together to find the total PV.

Procedure to Calculate Capitalized Cost

1. Draw a cash-flow diagram showing all nonrecurring costs and at least two cycles
of all recurring (periodic) costs and receipts.
2. Find the present worth of all nonrecurring amounts.
3. Find the equivalent annual worth through one life cycle of all recurring amounts
and add this to all other uniform amounts occurring in years 1 through infinity. This
results in a total equivalent uniform annual worth (AW).
4. Divide AW obtained in step 3 by the interest rate i to get its capitalized cost.
5. Add the CC values obtained in steps 2 and 4. [3]

Advantages and Disadvantages

When high dollar value items are capitalized, expenses are effectively smoothed out
over multiple periods. This allows a company to not present large jumps in expense
in any one period from an expensive purchase of property, plant, or equipment. The
company will initially show higher profits than it would have if the cost was expensed
in full. However, this also means that it will have to pay more in taxes initially.

Capitalizing costs inappropriately can lead investors to believe that a

company’s profit margins are higher than they really are. Surprising or unrealistic
profit margins combined with sudden drops in free cash flow (FCF), increases
in capital expenditures, and rapidly growing fixed or intangible assets recorded on
the books are all warning signs that a company may be capitalizing costs
inappropriately. [2]
: Example
-1

A public project has an initial cost of Rs.11000000 and annual operating and -2
maintenance cost of Rs.700000. Further the project will have one time major repair
work of Rs.2000000 at the end of 15 year. Find out the capitalized cost of the
.alternative if interest rate is 12% per year
Solution: The capitalized cost of the alternative is equal to sum of the initial cost,
present worth of one time major repair cost and capitalized cost of the annual
.operating and maintenance cost
;The total capitalized cost of the alternative is given by

Capitalized Cost  11000000  2000000 ( P/ F, I, n) -700000/i

Capitalized Cost  11000000  2000000 ( P/ F, 12%, 15) -700000/0.12

Capitalized cost = -Rs.17198733

Therefore the capitalized cost of the alternative for the public project is found to be
.Rs.17198733
: Referances
-1
https://global.oup.com/us/companion.websites/9780190296902/sr/interactive/worth/s
. /ec4

https://www.investopedia.com/terms/c/capitalizedcost.asp#:~:text=When%20high -2
.%20dollar%20value%20items,property%2C%20plant%2C%20or%20equipment

Chiu, C.Y., Park, C.S.: Fuzzy cash flow analysis using present worth criterion. -3
.The Engineering Economist 39(2), 113–138 (1994)