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Unit IV
Unit IV
Economic concepts
Computation of economic aspects
calculation of simple payback method
The time value of money concept.
Cash flow models,
payback analysis,
depreciation,
taxes and tax credit
Numerical problems.
Objectives
• To understand the time value of money concept
• To study the different cash flow models
• To develop a cash flow model for uniform series
compound amount factor & single compound
amount factor
• To learn about payback analysis
• To understand about depreciation
• To explain the meaning of life cycle cost analysis
• To learn about tax & credits
2
Common Terminology In Energy Economics
1. Fixed capital
• Cost spent for purchase land, plant & equipment
• Capital cost of generating equipment
• Capital cost of transmission system
• Capital cost of distribution system
2.Running capital
• Capital for purchase of raw material
• Payment of salary
• Wages
• Fuel cost
• Maintaing and repairing cost
• Cost of water
• Cost of lubricating oil
Common Terminology In Energy Economics
3. Taxes
• Property of taxes levied on generating station building and substation
building.
• Tax should be paid to municipal corporation for the use of street
road
• Income tax from employees
4. Insurance charges
• To cover the risk of fire to the building
• To cover accidental breakdown
• Workers compensation
5.Depreciation & sinking fund
• After a certain time the equipment is to be replaced because of
physical & functional reasons
• Eg. Plant has worn out & become unfit for further use (physical
reason) , capacity of the plant become inadequate due to load
growth (functional reason)
Interest
• Interest is the earning power of money.
• It represents the growth of capital per unit period.
• The period may be a month, a qurter, semi annual or a year.
• Interest is the income produced by money that is lent or loaned.
• Simple interest & Compound interest are the type of interest.
• Simple interest
F= Total sum realized after n years
n= no. of periods
i= Interest, i= PnR
F=P(1+ni)
• Compound interest
Fn= P*(1+i)^n
Capital budgeting Techniques:
The capital budgeting appraisal methods are techniques of
evaluation of investment proposal will help the company to
decide upon the desirability of an investment proposal depending
upon their;
Relative income generating capacity and
Rank them in order of their desirability.
These methods provide the company a set of norms on the basis
of which either it has to accept or reject the investment proposal.
The most widely accepted techniques used in estimating the cost-
returns of investment projects can be grouped under two
categories.
,
1. Traditional methods
2. Discounted Cash flow methods
Capital budgeting Techniques:
1. Traditional methods
• Pay-back period method: - even cash flow
• Average rate of return method (ARR):-uneven cash flow
2. Discounted Cash flow methods
The traditional method does not take into consideration the time
value of money.
They give equal weight age to the present and future flow of
incomes. The DCF methods are based on the concept that a rupee
earned today is more worth than a rupee earned tomorrow.
These methods take into consideration the profitability and also
time value of money.
Time value of money (TVM) is a financial principle that asserts that
money available in the present is worth more than the same amount
of money in the future because of its potential earning capacity so
long as the money earned in the present is able to earn interest.
Usually a percentage of the principal amount borrowed for interest can
be either simple or compound.
Traditional methods
These methods are based on the principles to
determine the desirability of an investment
project on the basis of its useful life and
expected returns.
These methods depend upon the accounting
information available from the books of
accounts of the company.
These will not take into account the concept of
‘time value of money’, which is a significant
factor to determine the desirability of a
project in terms of present value.
Pay-back period method: - Even cash flow
It is the most popular and widely recognized traditional method of
evaluating the investment proposals.
It can be defined, as ‘the number of years required to recover the
original cash out lay invested in a project’.
The pay back period is also called payout or payoff period.
This period is calculated by dividing the cost of the project by the
annual earnings after tax but before depreciation.
Under this method the projects are ranked on the basis of the
length of the payback period.
A project with the shortest payback period will be given the
highest rank and taken as the best investment.
The shorter the payback period, the less risky the investment is
the formula for payback period is
On the basis of this method, the company can select projects, who’s
ARR is higher than the minimum rate established by the company.
It can reject the projects with an ARR lower than the expected rate of
return.
This method can also help the management to rank the proposal on the basis of
ARR.
Merits
1. It is very simple to understand and calculate.
2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
Example 1:
Julie Miller is evaluating a new project for her firm, Basket Wonders
(BW). She has determined that the after-tax cash flows for the
project will be $10,000; $12,000; $15,000; $10,000; and $7,000,
respectively, for each of the Years 1 through 5. The initial cash outlay
will be $40,000.
Capital budgeting Techniques:
1. Traditional methods
• Pay-back period method: - even cash flow
• Average rate of return method (ARR):-uneven cash flow
2. Discounted Cash flow methods
The traditional method does not take into consideration the time
value of money.
They give equal weight age to the present and future flow of
incomes. The DCF methods are based on the concept that a rupee
earned today is more worth than a rupee earned tomorrow.
These methods take into consideration the profitability and also
time value of money.
Time value of money (TVM) is a financial principle that asserts that
money available in the present is worth more than the same amount
of money in the future because of its potential earning capacity so
long as the money earned in the present is able to earn interest.
Usually a percentage of the principal amount borrowed for interest can
be either simple or compound.
Discounted payback method of capital budgeting is a financial
measure which is used to measure the profitability of a project based upon
the inflows and outflows of cash for that project.
Under this method, all cash flows related to the project are discounted to
their present values using a certain discount rate set by the management.
The discounted payback method takes into account the time value of
money and is therefore an upgraded version of the simple payback period
method.
Companies use this method to assess the potential benefit of undertaking a
particular business project.
The discounted payback method tells companies about the time period in
which the initially invested funds to start a project would be recovered by
the discounted value of total cash inflow.
Additionally, it indicates towards the potential profitability of a certain
business venture.
For example, if a project indicates that the funds or initial investment will
never be recovered by the discounted value of related cash inflow, it means
the project would not be profitable and the company should refrain from
investing in it.
Example
The following example illustrates how a discounted payback method
differs from a traditional or simple payback method.
Years before full recovery + (Unrecovered cost at start of the year/Cash flow during the year)
= 2 + *150,000/300,000
= 2.5 years
= $800,000 – $650,000
We see that in year 3, the investment is not just recovered but the remaining cash inflow is
surplus. The initial investment of the company would be recovered in 2.5 years. So the project is
acceptable according to simple payback period method because the recovery period under this
method (2.5 years) is less than the maximum desired payback period of the
management (3 years).
Discounted payback period
The discounted payback method takes into account the present value of cash flows.
where,
FV = Future value of money,
PV = Present value of money,
i = Rate of interest or current yield on similar investment,
t = Number of years and
n = Number of compounding periods of interest per year
Time Value of Money Calculation (Step by Step)
Step 1: Firstly, try to figure out the rate of interest or the rate of return
expected from a similar kind of investment based on the market
situation. Please note that the rate of interest mentioned here is not
the effective rate of interest but the annualized rate of interest. It is
denoted by ‘i’.
Step 2: Now, the tenure of the investment in terms of number years
has to be determined i.e. for how long the money is going to remain
invested. The number of years is denoted by ‘t’.
Step 3: Now, the number of compounding periods of interest per year
has to be determined i.e. how many times in a year the interest will be
charged. The interest compounding can be quarterly, half-yearly,
annually, etc. The number of compounding periods of interest per
year is denoted by ‘n’.
Step 4: Finally, if the present value of money (PV) is available, then
the future value of money (FV) after ‘t’ number of year can be
calculated using the following formula as,
Time value of money concept
• The change in the amount of money over a given
time period is called time value of money
• Money can “make” money if invested.
• Money made depends upon interest rate
• Money has a time value
• Money can be spent, money to be borrowed,
money to be kept as a depreciation
Time value of money
• To compare the various option or alternatives it is necessary to
convert all cash flows for each measures or scheme into equivalent
base.
• This is based on the guiding principle that money in hand today is
more valuable than money received at some time in future.
• To convert cash from one time into another different techniques are
to be used.
Different techniques for time value of money are
1. Single Payment Compound Amount (SPCA)
2. Single Payment Present Worth (SPPW)
3. Uniform Series Compound Amount (USCA)
4. Sinking Fund Payment (SFP)
5. Uniform Series Present Worth (USPW)
6. Capital Recovery (CR)
7. Gradient Present Worth (GPW)
1. Single Payment Compound Amount (SPCA)
• This formula simply gives the future value (S) of an amount
of money with present value (P) after n periods at an
interest rate i.
S= P* SPCA at i,n Where SPCA= (1+i)n
given data :
n 3 i 20 % P 100 doller
SPCA ( 1 i ) n ( 1 0 . 2 ) 3 1 . 728
Where
7.Gradient Present Worth (GPW)
• This will determine the present amount P that can
be paid by annual amounts R which escalates at e%
at i interest for n years
1. Traditional methods
• Pay-back period method: - even cash flow
• Average rate of return method (ARR):-uneven cash flow
• The sum of all the present value is known as the Net Present Value (NPV). The
higher the net present value, the more attractive the proposed project.
• The cash flows of different years and are valued differently and made
comparable in terms of present values for this the net cash inflows of
various period are discounted using required rate of return which is
predetermined.
Co- investment
CF1, CF2, CF3… CFn= cash flows in different years.
k= Discounting rate
n= Years, ICO= Cashinflow
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has
determined that the after-tax cash flows for the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The
initial cash outlay will be $40,000. Basket Wonders has determined that the
appropriate discount rate (k) for this project is 13%.
Net present value method (NPV)
Merits:
1. It recognizes the time value of money.
2.It is based on the entire cash flows generated during the useful life of
the asset.
3.It is consistent with the objective of maximization of wealth of the
owners.
4. The ranking of projects is independent of the discount rate used for
determining the present value.
Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But
the concept of cost of capital. If self is difficult to understood and
determine.
3. It does not give solutions when the comparable projects are involved
in different amounts of investment.
4. It does not give correct answer to a question whether alternative
projects or limited funds are available with unequal lines.
PI(Profitability index method)
• PI is the ratio of the present value of a project’s future net cash flows to
the project’s initial cash outflow.
• The method is also called benefit cost ration.
• This method is obtained from NPV with slight modification.
• In case of NPV the present value of cash out flows are profitability index
(PI), the present value of cash inflows are divide by the present value of
cash out flows, while NPV is a absolute measure, the PI is a relative
measure.
• It the PI is more than one (>1), the proposal is accepted else rejected.
• If there are more than one investment proposal with the more than one
PI the one with the highest PI will be selected.
• This method is more useful incase of projects with different cash outlays
and hence is superior to the NPV method.
The formula for PI is
The formula for PI
Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period.
4. It is one of the widely used methods in small scale industry sector
Demerits
1. This method fails to take into account the cash flows received by the company
after the pay back period.
2. It does not take into account the interest factor involved in an investment
outlay.
3. It is not consistent with the objective of maximizing the market value of the
company’s share.
4. It fails to consider the pattern of cash inflows due to the magnitude and timing
of cash in flows.
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has
determined that the after-tax cash flows for the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The
initial cash outlay will be $40,000. Determined the PI for that the required rate is
13% for project.
Cash PV Factors PV of Cash PV Factors PV of Cash PV Factors PV of Cash
Year
Flows ($) @15% Flows ($) @13% Flows ($) @10% Flows ($)
1 10,000 .870 8,700 .884 8849 .909 9,090
2 12,000 .756 9,072 .783 9397 .826 9,912
3 15,000 .658 9,870 0.693 10395 .751 11,265
4 10,000 .572 5,720 0.613 6133 .683 6,830
5 7,000 .497 3,479 .542 3799 .621 4,347
Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.
IRR Solution (Try 10%)
Merits:
1.It consider the time value of money
2.It takes into account the cash flows over the entire useful life of the
asset.
3.It has a psychological appear to the user because when the highest rate
of return projects are selected, it satisfies the investors in terms of the
rate of return an capital
4.It always suggests accepting to projects with maximum rate of return.
5.It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:
1. It is very difficult to understand and use.
2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
IRR Solution (Try 15%)
Causes of Depreciation …
• Wear and Tear
• Disuse and Maintenance
• Change in production
• Restriction of production
• Reduced demand.
Bath tub curve
Depreciation methods
9 methods are present
1. Straight line depreciation
2. Sum of years digits depreciation
3. Declining balance depreciation
4. Diminishing value method
5. Sinking fund depreciation
6. Production units method
7. Machine hour method
8. Annuity method
9. Depletion method
1.Straight line depreciation
• There is reduction in value of equipment & other property of the
plant every year due to depreciation.
• A constant depreciation charge is made every year on the basis of
total depreciation and the useful life of the property.
• The annual depreciation charge equals to the total depreciation
divided by the useful life of the property.
1. Formulate Alternatives
2. PW of equal-life alternatives
3.PW of different-life alternatives
4. Future Worth analysis
For this reason, present worth values are often referred to as Discounted
Cash Flows (DCF), Similarly, the interest rate may be referred to as the
discount rate. Besides PW, equivalent terms frequently used are present
value (PV) and net present value (NPV).
The goal of this PRESENT WORTH ANALYSIS is to continue the introduction of
some basic concepts of engineering economics. The concepts that will be
discussed include:
Minimum Attractive Rate of Return (MARR).
Present Worth Method or Present Value.
Capitalized Worth Method or Capitalized Equivalency.
Where:
i = effective interest rate, or MARR, per compounding period
k = index for each compounding period (0≤k≤N)
Fk = future cash flow at end of period k
n = number of compounding periods in the study period
This equation assumes there is a constant
interest rate throughout the life of the project.
This would have to be adjusted if the interest rate
varied throughout the course of the project.
To apply the present worth method to determine
a project’s economic worthiness,
use the following:
EVALUATION
• For one project, if PW > 0, it is justified
• For mutually exclusive alternatives, select one with
numerically largest PW
• For independent projects, select all with PW >0
Selection of Alternatives by PW
Select alternative Y
Example: PW Evaluation of Equal-Life
Example: PW Evaluation of Equal-Life
Taxes & Tax credits
What is tax?
• A compulsory contribution to state revenue,
levied by the government on workers' income
and business profits, or added to the cost of
some goods, services, and transactions is
termed as tax.
• A fee charged ("levied") by a government on a
product, income, or activity.
• Two types of taxes- direct tax & indirect tax
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Taxes & Tax credits
What is tax?
• If tax is levied directly on personal or
corporate income, then it is a direct tax.
• If tax is levied on the price of a good or
service, then it is called an indirect tax.
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Taxes & Tax credits
What is tax?
• A tax is a financial charge
• Tax imposed upon a taxpayer by a state or the
functional equivalent of a state to fund
various public expenditures.
• A failure to pay is usually punishable by law.
• Taxes are also imposed by many
administrative divisions.
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Taxes & Tax credits
Why Tax?
• The purpose of taxation is to finance
government expenditure.
• One of the most important uses of taxes is to
finance public goods and services, such as
street lighting and street cleaning.
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Taxes & Tax credits
Why Tax?
• Tax deductable expenses such as maintenance ,
energy, operating cost, insurance & property
taxes reduce the income subject to taxes.
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Taxes & Tax credits
Tax credit
• A credit directly reduces tax bills, unlike tax
deductions and tax exemptions , which indirectly
reduce tax bills by reducing the size of the base.
• Most tax credits are nonrefundable tax credits.
Meaning that they can only be used to the point
at which no more taxes are owed (liable).
• Some tax credits are refundable tax credits.
Meaning if the credit exceeds the amount of
taxes owed, the excess is given to the taxpayer.
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4
Numerical Problems
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5
Q1. Calculate the depreciation rate using the i)straight line & ii) sum of year’s digit for
the data given below: Salvage value L is Rs 0, Life of equipment , n=5 years, Initial
expenditure ,
P=Rs 1,50,000, for a declining balance method use a 200% rate.
Sol:
1
3
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Numerical Problems
Q2. The equipment in a power station costs Rs
15,60,000/- and has a salvage value of Rs
60,000/- at the end of 25 years. Determine
the depreciation value of equipment at the
end of 20years by the following methods.
i)straight line method
ii) Diminishing value method
iii)Sinking fund method at 5% compounded
annually.
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Numerical Problems
Q2. Solution
P= 15,60,000/- Salvage value (S )= 60,000/-
N= 25 years, n=20
i) Straight line method
(total investment salvage value )
Annual depreciati on
no . of years
15 ,60 ,000 60 ,000
60 ,000 /
25
Depreciati on value at the end of 20 years
total investment ( P ) ( annual depreciati on * 20 )
15 ,60 ,000 ( 20 * 60 ,000 ) Rs 3,60 ,000 /
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Numerical Problems
Q2. Solution
ii) Diminishing value method
1
L (N)
D 1[ ] where L S Salvage value
P
1
60 ,000 ( 25 )
D 1[ ] 0.122
1560000
Depreciati on after 20 years P * (1 D ) n
1560000 * (1 0.122 ) 20
Rs 1,15,615 /
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Numerical Problems
Q2. Solution
iii) Sinking fund
rate of int rest 5%
r
Sinking fund ( q ) ( P L ) * ( N 1
)
[1 r ]
0.05
(15,60,000 60,000 ) * ( 25 1
)
[1 0.05]
q 31,433 /
P (1 r ) n 1
Sinking fund after 20 years Rs 10,39,362 /
r
(USCA Time Value money calculatio n)
The value of the plant after 20 years is
Rs (15,60,000 10,39,362 )
Rs 5,20,638 / 14
0
Numerical Problems
Q3. A transformer costing Rs 90,000 has an
useful life of 20 years .Determine the annual
depreciation charge using straight line
method. Assume the salvage value of the
equipment to be Rs 10,000/-.
P= 90,000/-
S= 10,000/-
N= 20 years
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Numerical Problems
Q3. Solution
Annual depreciation charge =( P – S) /n
= (90,000 – 10,000)/20
= Rs.4000/-
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Numerical Problems
Q4. A distribution transformer costs Rs 2,00,000
and has a useful life of 20 years. If the salvage
value is Rs 10,000 & the rate of annual
compound interest is 8%, calculate the
amount to be saved annually for replacement
of the transformer after the end of 20 years
by sinking fund method.
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Numerical Problems
Q4. Solution
P= 2,00,000/-
n= 20 years
S= 10,000/-
r = 8%
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Numerical Problems
Q4. Solution
q = (P – S) ( r/ (1+r)^n -1)
Rs 4153/-
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Numerical Problems
Q5. You have accumulated Rs 5000/- in credit
card debit. The credit card company charges
18% nominal annual interest compounded
monthly. You can offered to pay only Rs 100
per month. How many months will it take you
to pay off debit?
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Numerical Problems
Q5. Solution
P= 5000/-
A or R= 100
i or r = 0.18
c = 12
n =?
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Thank you