EECon 1- Engineering Economy

Module 4:
(Depreciation, Capitalized Cost, Depletion Cost, Annual
Cost and Bond)

Prepared by: Engr. Adrian L. Pillano

 Module Rationale
 This module contains depreciation (types and methods),
capitalized cost, annual cost, bonds (life cycle and value of the
bond).
 Module Outcomes

 At the end of the module, you are expected to:

1. Know the types and methods of computing depreciation
2. Analyze the different formulas of methods of computing depreciation,
capitalized cost and bonds.
3. Understand and appreciate different cases of capitalized cost
4. Familiarize and understand the life cycle of bond.
 Lesson 1: DEPRECIATION
 Depreciation is the decrease in the value of physical property due
to passage of time. (Quiseo-Baluran Book)

 Depreciation is the reduction of fall in the value of an asset or

physical property during the course of its working life and due to
the passage of time. (The EE Handbook, ESAS, Excel Academic Council
2008)
 Lesson 1: DEPRECIATION
 TYPES OF DEPRECIATION
A. Physical Depreciation- is due to the reduction in the demand for
the function that the equipment or asset to produce results.

B. Functional Depreciation- due to the reduction in the demand

for the function that the equipment or asset was designed to
render. This type of depreciation is often called obsolescence.
 Lesson 1: DEPRECIATION
 Symbols used and their meaning:
 Lesson 1: DEPRECIATION
 Terms to be remember:

1. First Cost / Original Cost (FC)- is the purchase price of the

asset.
2. Salvage Value (SV)- is the value of the asset at the end of its
useful life
3. Depreciable Life of Property (Useful Life-L)- represents the
number of periods/years in which the asset is expected to be
used by company/business company.
 Lesson 1: DEPRECIATION
3. Cost- is the initial acquisition or construction costs related to the
asset as well as any subsequent capital expenditure.
4. Book Value- is the original cost basis of the property including
any adjustments, less all allowable depreciation deductions.
5. Asset-
 Lesson 1: DEPRECIATION
A. STRAIGHT LINE METHOD – a method of calculating the
depreciation which assumes that asset will lose an equal amount
of value each year.

 Annual depreciation:

 Depreciation after “n” years:

 Book value after “n” years:

 Lesson 1: DEPRECIATION
 Example 1:
 Lesson 1: DEPRECIATION
 Example 2:

 Solution:
 Lesson 1: DEPRECIATION
B. SINKING FUND METHOD
-a method of depreciation which
assumes that there is a savings
account set up to replace an asset
at the end of its life.
 Lesson 1: DEPRECIATION
 Example:
 Lesson 1: DEPRECIATION
3. DECLINING BALANCE
METHOD
- a method of depreciation which
assumes that annual depreciation is a
fixed percentage of the BOOK
VALUE of the property per year.
 Lesson 1: DEPRECIATION
3. DECLINING BALANCE
METHOD
- in declining method, we have
Double Declining Balance Method
(DDBM) which has annual
depreciation, salvage value and book
value.
 Lesson 1: DEPRECIATION
 Example:
 Lesson 1: DEPRECIATION

4. SUM-OF-THE-YEAR’S-
DIGITS (SYD) METHOD
- method takes the asset’s
expected life and adds together
the digits for each year. Also, an
accelerated method for
determining an asset’s expected
depreciation over time.
 Lesson 1: DEPRECIATION

 Example:

 Solution:
 Try This: (In a piece of paper, write your computation. Submit
and send your solution in my 2nd FB account)
1. An asset is purchased for P500,000.00. The salvage value in 25 years is P100,000.00. What
is the total depreciation in the first three years using straight-line method? (Ans. P48,000.00)
2. An equipment costs P10,000 with a salvage value of P500 at the end of 10 years. Calculate
the annual depreciation cost by sinking-fund method at 4% interest. (Ans. P791.26)
3. A machine costing P720,000 is estimated to have a book value of P40,545.73 when retired
at the end of 10 years. Depreciation cost is computed using a constant percentage of the
declining book value. What is the annual rate of depreciation in %?(Ans. 25%)
4. ABC Corporation makes it a policy that for any new equipment purchased, the annual
depreciation cost should not exceed 20% of the first cost at any time with no salvage value.
Determine the length of service life necessary if the depreciation used is the SYD method.
(Ans. 9 years)
4. A company purchases an asset for P10,000.00 and plans to keep it for 20 years. If the salvage
value is zero at the end of the 20th year, what is the depreciation in the third year? Use SYD
method. (Ans. P857.14)
5. An asset is purchased for P9,000.00. Its estimated life is 10 years after which it will be sold for
P1,000.00. Find the book value during the first year if sum-of-year’s digit (SYD) depreciation is
used. (Ans. P7,545.45)
6. A machine costing P45,000 is estimated to have a book value of P4,350 when retired at the end
of 6 years. Depreciation cost is computed using a constant percentage of the declining book
value. What is the annual rate of depreciation in %? (Ans. 32.25%)
7. A machine has an initial cost of P50,000 and a salvage value of P10,000 after 10 years. What is
the book value after 5 years using straight line depreciation? (Ans.  P30,000.00)
 Lesson 2: Bonds
 Bond is financial security note issued by business or corporation
and by government as a means of borrowing long-term fund.
 It may also be defined as a long-term note issued by the lender
by the borrower stipulating the terms of repayment and other
conditions.
 Bonds do not represent ownership of a business or corporation
and therefore not entitled to share of the profits.
 Lesson 2: Bonds
 Bonds are issued in certain amounts known as the face value or
par value of the bond.
 When the face value has been repaid, normally at maturity, the
bond is said to be redeemed or retired.
 Bond Rate is the interest rate quoted in the bond.
 Lesson 2: Bonds
Life Cycle of a Bond
 Bonds are originated in the primary market through a bond issuance
process that offers the issue to the public for the first time. During
this process, issuers receive capital, and in return, provide investors
with bond certificates that outline the issuer’s obligations.
 Once the bonds are issued and in circulation, they are traded among
investors and dealers in the secondary market. At the maturity date,
bondholders receive a final coupon payment and are repaid the
principal amount. Issuers have the option to refinance the debt
obligations through the issuance of new bonds in the primary market.
Lesson 2: Bonds
 Lesson 2: Bonds
The Market
 The market is commonly used to refer to the primary and secondary markets
collectively. In the debt capital markets, the primary market is the market where
new bonds are created and the secondary market is the market where existing bonds
are traded. The market provides an exchange for capital and is strictly regulated.

Bond Origination – Primary Market

 The primary market is where corporations and government entities raise funds from
investors. This is done through issuing new fixed income securities to investors in
exchange for capital. In other words, fixed income securities are “originated” in the
primary bond market. Bond originations are facilitated by dealers who act as an
intermediary between issuers and investors.
 Lesson 2: Bonds
Bond Trading – Secondary Market
 The secondary bond market is where existing bonds are traded among holders of fixed
income securities (i.e. investors). Fixed income securities are generally traded over-the-
counter through a decentralized dealer network. This contrasts with the equity markets,
where securities can be readily traded on centralized exchanges. In particular, sales and
trading desks at investment banks (dealers) facilitate transactions between buyers and
sellers. Electronic trading platforms, usually in the form of interdealer networks
provide an alternative marketplace to trade fixed income securities.
Bond Redemption & Maturity
 Fixed income securities have a set maturity date, at which, principal amount is repaid
to investors. Alternatively, issuers may redeem bonds prior to maturity through
exercising early redemption features such as call provisions. Issuers may refinance
bond maturities by issuing new bonds at or near the maturity date.
 Lesson 2: Bonds

PRIMARY MARKET
 Corporate Bond Market
 The corporate bond market is used by corporations and financial
institutions to raise medium to long term debt financing. Funds can
be raised in a variety of forms:
1. Domestic or international
2. Underwritten or agency transaction offered to the public market
3. Public placements (e.g. Medium Term Notes)
4. Private placements
 Lesson 2: Bonds
Primary Bond Market
 The primary market is the marketplace where corporations and governments offer
their bonds to investors. New bond issues are underwritten by one or more lead
managers and a syndicate of co-managers. The underwriting process involves the
following:
 Lesson 2: Bonds
What Is Bond Valuation?
 Bond valuation is a technique for determining the theoretical fair
value of a particular bond. Bond valuation includes calculating
the present value of a bond’s future interest payments, also
known as its cash flow, and the bond's value upon maturity, also
known as its face value or par value. Because a bond's par value
and interest payments are fixed, an investor uses bond valuation
to determine what rate of return is required for a bond investment
to be worthwhile.
 Lesson 2: Bonds
 Bond valuation is a way to determine the theoretical fair value (or
par value) of a particular bond.
 It involves calculating the present value of a bond's expected
future coupon payments, or cash flow, and the bond's value upon
maturity, or face value.
 As a bond's par value and interest payments are set, bond
valuation helps investors figure out what rate of return would
make a bond investment worth the cost.
 Lesson 2: Bonds
Understanding Bond Valuation
 A bond is a debt instrument that provides a steady income stream
to the investor in the form of coupon payments. At the maturity
date, the full face value of the bond is repaid to the bondholder.
The characteristics of a regular bond include:

Coupon rate: Some bonds have an interest rate, also known as the

coupon rate, which is paid to bondholders semi-annually. The
coupon rate is the fixed return that an investor earns periodically
until it matures.
 Lesson 2: Bonds
 Maturity date: All bonds have maturity dates, some short-term, others
long-term. When a bond matures, the bond issuer repays the investor the
full face value of the bond. For corporate bonds, the face value of a bond is
usually $1,000 and for government bonds, the face value is $10,000. The
face value is not necessarily the invested principal or purchase price of the
bond.

 Current Price: Depending on the level of interest rate in the environment,

the investor may purchase a bond at par, below par, or above par. For
example, if interest rates increase, the value of a bond will decrease since
the coupon rate will be lower than the interest rate in the economy.
 Lesson 2: Bonds
Bond Valuation in Practice
 Since bonds are an essential part of the capital markets, investors
and analysts seek to understand how the different features of a
bond interact in order to determine its intrinsic value. Like a stock,
the value of a bond determines whether it is a suitable investment
for a portfolio and hence, is an integral step in bond investing.
 Bond valuation, in effect, is calculating the present value of a
bond’s expected future coupon payments. The theoretical fair
value of a bond is calculated by discounting the present value of its
coupon payments by an appropriate discount rate. 
 Lesson 2: Bonds
FORMULA FOR THE VALUE OF BOND:
 Lesson 2: Bonds
 Example:
A P1,000,000 issue of 3%, 15 year bond was
sold at 95%. What is the rate of interest of
this investment?
 Lesson 3: Cost
 DEPLETION COST- is the reduction of the value of certain natural
resources such as mines, oil, timber, quarries, etc. due to the gradual
extraction of its contents.

 Methods of Computing Depletion Charge for a year:

 A. Unit or Factor Method – this method dependent on the initial cost of
the property and the number of units in the property.
 Lesson 3: Cost
 B. Percentage or Depletion Allowance Method – the depletion
charge under this method, is computed as follows:

 Note: Use the smaller depletion charge; d:

 Lesson 3: Cost
 CAPITALIZED COST – of any structure or property is the sum
of its first cost and the present worth of all costs for replacement,
operation, and maintenance for a long time or forever,
 Lesson 3: Cost
 ANNUAL COST (Infinite Analysis Period) – any structure of
property is the sum of the annual depreciation cost, interest of the
first cost and the annual operating and maintenance costs,
 Try This! (In a piece of paper, write your computation.
Submit and send your solution in my 2nd FB account)
 A company must relocate one of its factories in three years. Equipment for the loading dock is
being considered for purchase. The original cost is P20,000, the salvage value of the equipment
after three years is P8,0000. The company’s rate of return on the money is 10%. Determine the
capital recovery rate per year. (ANS. P5,625)
 A corporation uses a type of motor truck which costs P5,000 with life of 2 years and final salvage
value of P800. How much could the corporation afford to pay for another type of truck of the
same purpose whose life is 3 years with a final salvage value of P1,000. Money is worth 4%.
(ANS. P7,164.3)
 At 6%, find the capitalized cost of a bridge whose cost is P250M and life is 20 years, if the bridge
must be partially rebuilt at a cost of P100M at the end of each 20 years. (ANS. P295.3M)
END OF DISCUSSION!

Thank you.