Chapter Four
Depreciation and Inflation
1.Introduction to valuation
2.depreciation
3.Inflation
 Introduction
Valuation in general is defined as the art of estimating
the fair monetary measures of the desirability of
ownership of specific property for specific purpose.
 For each property the value must be expressed in
terms of some recognized medium of exchange.
 In most uses of the term “value” as applied to
property is a sense of worth, a desirability of
ownership or possession or the exchangeability of
property as it can be measured in terms of money .
 Method of Valuation
Valuation from life
 This method is generally used for equipment but
also used for buildings in general.
 Depreciation. Whenever any machine, equipment or
a building performs useful work its wear and tear
is bound to occur. This can be minimized up to
some extent by proper care and maintenance but
can’t be totally prevented.
 Book Value. It is value of an asset as shown in
accounts book. This is value on that particular day
arrived by deducting total depreciation till date from
its value on the date of its purchase.
 Method of Valuation
 Obsolescence. is the depreciation of existing
machinery or asset due to new and better invention,
design of equipment of processes etc.
Methods of Depreciation Calculation: The following
are the methods for calculating depreciation.
i. Straight line Methods
ii. Declining Balance Method
iii. Sum of year Digits Method
iv. Sinking fund Method
v. Annuity Charging method
vi. The Insurance policy method
vii. The Revaluation or Regular Valuation method etc.
 Straight Line Method
 This method assumes that the loss of value of
machine is directly proportional to its age. It means
one should deduct the scrap value from the
original value and divide the remaining value by the
number of years of useful life.
Let C be the Initial cost of a machine.
S be the scrap value.
N be the Number of years of life of machine. and
D be the depreciation amount per year .
Then, D=(C-S)/N Birr
TDn=n*D and BVn=C-TDn
 Declining Balance
Method
 This is also called “Reducing Balance” Method. The
diminishing value of machine is greater in the early
years. It depreciates rapidly in the early and later-on
slowly. So under this method, the book value of
the machine goes on decreasing as its existence
continues.
 In this, let x be the fixed percentage taken to
calculate the yearly depreciation on the book value.
X=2/N, Dn=X*C(1-X)n-1,
TDn=C(1-(1-X)n), BVn=C-TDn=C(1-X)n
Where, C = initial cost, S = Scrap Value, N=No. of the
years of life.
 Depreciation
Example
The initial cost of a piece of construction
equipment is 3500000ETB. It has useful life of 10
years. The estimated salvage value of the
equipment at the end of useful life is
500000ETB. Calculate the annual depreciation
and book value of the construction equipment
using straight-line method and double-declining
balance method.
 Depreciation
For straight-line method, the constant annual
depreciation rate ‘Dn’ is given by;
Dn=D1=D2………..=(3,500,000-500,000)/10
=300,000ETB/Year
BV1=3,500,000-300,000=3,200,000ETB
BV2=3,200,000-300,000=2,900,000ETB
.
.
BV10=S=C-TDN=3,500,000-10*300,000=500,000ETB
 Depreciation
For double-declining balance method, the depreciation
amount for a given year is calculated using the above
equation.
X=2/10=0.2
D1=X*C(1-X)n-1=0.2*3,500,000(1-0.2)1-1=700,000
D2=X*C(1-X)n-1=0.2*3,500,000(1-0.2)2-1=560,000
,

D10=X*C(1-X)n-1=0.2*3,500,000(1-0.2)10-1= 93952.41
 Depreciation
BV1=C(1-X)n=C-D1=3,500,000(1-0.2)1=3,500,000-
700,000=2,800,000 ETB
BV2=3,500,000(1-0.2)2=2,800,000-560,000=2,240,000ETB
,

BV9=3,500,000(1-0.2)9=469762.05<S(500,000ETB)
BV10=3,500,000(1-0.2)10=375809.64<S(500,000ETB)
 Thus to match the book value with the estimated
salvage value, the depreciation in 9th year will be
87202.56 (587202.56 – 500000) and that in 10th year
will be zero. This will lead to a book value of 500000
(equal to salvage value) at the end of 9thyear and
10thyear.
Depreciation
 Home Assignment
 The construction company were purchased for use an
equipment or machine. The equipment will be DDB
depreciated over an expected life of 12 years. There is a first
cost of $25,000 and an estimated salvage of $2500.
( a ) Calculate the depreciation and book value for years 1 and
4. Write the spreadsheet functions to display depreciation for
years 1 and 4.
( b ) Calculate the implied salvage value after 12 years.
 Sum-of-years-digits
(SOYD) method
 In this method the annual depreciation rate for any
year is calculated by dividing the number of years left
(from the beginning of that year for which the
depreciation is calculated) in the useful life of the asset
by the sum of years over the useful life.
 The depreciation rate ‘dn’ for any year ‘n’ is given by;
Dn=dn*TD=dn*(C-S)
dn=(N-n+1)/SOY
SOY=N(N+1)/2
BVn=C-TDn
 SOYD method
Example:
Compute the SOYD depreciation schedule for the situation
below
 Cost of the asset=900ETB
 Depreciable life, in years=5
 Salvage value, S=70ETB
Solution: SOY=(5*6)/2=15
D1=(5-1+1)(900-70)/15=277
D2=(5-2+1)(900-70)/15=221
D3=(5-3+1)(900-70)/15=166
D4=(5-4+1)(900-70)/15=111
D5=(5-5+1)(900-70)/15=55
 SOYD method

Year Dn TDn BVn=C-TDn

1 277 277 623
2 221 498 402
3 166 664 236
4 111 775 125
5 55 830 70=S
 3. INFLATION
 Inflation is defined as an increase in the amount of
money required to purchase or acquire the same
amount of products and services that was acquired
without its effect.
 Inflation results in a reduction in the purchasing power
of the monetary unit.
 The inflation rate (f) is measured as the rate of increase
(per time period) in the amount of money required to
obtain same amount of products and services.
 Till now, the interest rate ‘i’ was assumed to be
inflation-free.
 3. INFLATION
 This interest rate ‘i’ is also known as also real interest
rate or inflation-free interest rate.
 The interest rate that includes the effect of price
inflation which is occurring in general economy is
known as the market interest rate (ic).
 Market interest rate is also known as inflated
interest rate or combined interest rate as it combines
the effect of both real interest rate and the inflation.
 3. INFLATION
Equivalent worth calculation including the effect of
inflation:

P = present worth (at base period ‘0’)

Fc = future worth in constant value monetary units
(inflation-free)

Fa is the future worth in actual monetary units (inflated)

and ‘f’ is the inflation rate as stated earlier.
 3. INFLATION

• (ic) = combined interest rate or market interest rate

 The above equation can also be written in functional
representation as follows
 3. INFLATION
Example:
A person has now invested 500000 ETB at a market
interest rate of 14% per year for a period of 8 years.
The inflation rate is 6% per year.
i) What is the future worth of the investment at the end
of 8 years?
ii) What is the accumulated amount at the end of 8
years in constant value monetary unit?
Solution:
ic=14% if=6%
i. FW=P(F/P,ic,n)=500,000(F/P,14%,8)=1426300ETB
 3. INFLATION
FW in constant value monetary units (inflation-free)=
future worth in actual monetary units (inflated) /(1+f)n

FW=1426300ETB/(1+0.06)8
=894861 ETB
Example 2:
The cash flow of an alternative consists of payment of
100000ETB per year for 6 years (uniform annual series).
The real interest rate is 9% per year. The inflation rate per
year is 5%. Find out the present worth of the uniform
series when the annual payments are in actual monetary
units (inflated).
 3. INFLATION
Solution:

=(0.09+0.05+0.05*0.09)=0.1445=14.45%
P=A(P/A,ic,n)=500,000(P/A,14.45%,6)=384,120ETB