Unit IV: Economic Appraisal Techniques

Net Present Value (NPV), Internal Rate of Return (IRR), Cost Benefit analysis. Depreciation
calculation; Meaning and Definition, Methods.

N.B. Exclude the pay-back period criteria for this examination

Economic Appraisal Techniques-Pay-Back Period criteria, Net Present Value (NPV),

Internal Rate of Return (IRR) comparison with MARR, Cost- Benefit analysis,
Numerical Examples
DEPRECIATION CALCULATION: Meaning and Definition

Methods: Straight Line Method, Declining Balance method, Sum-of-years digit method
and Sinking Fund Method (Methods to be explained with illustrations)

1. Payback period criteria

Payback period is the time in which the initial outlay of an investment is expected to be
recovered through the cash inflows generated by the investment.

The formula to calculate the payback period of an investment depends on whether the periodic
cash inflows from the project are even or uneven.

Case 1: Even cash inflows

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑝𝑝𝑝𝑝𝑝𝑝 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

Example 1:

Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year in net cash flows for 7 years. Calculate the
payback period of the project.

Solution:
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years

Example 2:

The Delta company is planning to purchase a machine which would cost $25,000 and have a
useful life of 10 years with zero salvage value. The expected annual cash inflow of the machine
is $10,000. Find the viability in acquiring this machine.

Payback period = $25,000/$10,000 = 2.5 years

The purchase of this machine is desirable because its payback period is 2.5 years which is
shorter than the maximum payback period of the company.
Case 2: Uneven cash inflows

𝐵𝐵
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐴𝐴 +
𝐶𝐶

Where:
A is the last period number with a negative cumulative cash flow; B is the absolute value (i.e.
value without negative sign) of cumulative net cash flow at the end of the period A; and C is
the total cash inflow during the period following period A

Years before full recovery

Unrecovered cost at start of the year
Cash flow during the year

Example 2:

An investment of $200,000 is expected to generate the following cash inflows in six years:

Year 1: $70,000 Year 2: $60,000 Year 3: $55,000

Year 4: $40,000 Year 5: $30,000 Year 6: $25,000

Required: Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?

Solution:

Initial investment = $200000

Year 1 2 3 4 5 6
Cash Inflow $70000 $60000 $55000 $40000 $30000 $25000
Cumulative cash inflow $70000 $130000 $185000 $225000 $255000 $280000

Payback period = 3 + (15,000*/40,000) = 3 + 0.375 = 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the end of 3rd year = $200000 – $185000 = $15000

The payback period for this project is 3.375 years which is longer than the maximum desired
payback period of the management (3 years). The investment in this project is therefore not
desirable.
2. Net Present Value (NPV)

Net Present Value = Present Value – Initial Cost

Project A Project B
Year Net Cash Discount PV Net Cash Discount PV (Rs.)
Income (Rs.) factor (@7%) (Rs.) Income (Rs.) factor (@7%)
1 4000 =
4000 3,740 8000 =
8000 7,480
(1.07)1 (1.07)1
2 4000 =
4000 3,492 6000 =
6000 5,238
(1.07)2 (1.07)2
3 4000 =
4000 3,264 2000 =
2000 1,632
(1.07)3 (1.07)3
4 8000 =
8000 6,104 2000 =
2000 1,526
(1.07)4 (1.07)4
5 2000 =
2000 1,426 2000 =
2000 1,426
(1.07)5 (1.07)5
6 2000 =
2000 1,332
(1.07)6
7 2000 =
2000 1,246
(1.07)7
8 2000 =
2000 1,164
(1.07)8

Total Present Value (Rs.) 18,026 21,044

Initial Cost (Rs.) 20,000 20,000
Net Present Value (Rs.) -1,974 1,044

3. Internal Rate of Return (IRR)

A company is trying to diversify its business in a new product line. The life of the project is 10
years with no salvage value at the end of its life. The initial outlay of the project is
Rs.2,000,000. The annual net profit is Rs.350,000. Find the rate of return for the new business.

Solution
𝑛𝑛
�1+𝑖𝑖 ̇� −1
Life of the product line(n) = 10 years (P/A, i, n) = � �
𝑖𝑖(1+𝑖𝑖)𝑛𝑛
Initial outlay = Rs.2,000,000
Annual net profit = Rs.350,000
Scrap value after 10 years = 0

If i = 8% PW (8%) = -2,000,000 + 350,000 (P/A, 8%, 10)

= -2,000,000 + 350,000 (6.710) = Rs. 3,48,500
If i = 10% PW (10%) = -2,000,000 + 350,000 (P/A, 10%, 10)
= -2,000,000 + 350,000 (6.1446) = Rs.150,610
If i = 12% PW (12%) = -2,000,000 + 350,000 (P/A, 12%, 10)
= -2,000,000 + 350,000 (5.6502) = Rs. –22,430

IRR = 10% + [150,610 – 0 / 150,610 – (–22,430)] * 2% = 11.74%

IRR ≥ MARR => Accept the proposal or else reject

4. Cost Benefit analysis or Benefit Cost analysis

Equivalent benefits
BC ratio =
Equivalent costs

or

BP = present worth of the total benefits

BF = future worth of the total benefits
BA = annual equivalent of the total benefits
P = initial investment
PF = future worth of the initial investment
PA = annual equivalent of the initial investment
C = yearly cost of operation and maintenance
CP = present worth of yearly cost of operation and maintenance
CF = future worth of yearly cost of operation and maintenance

Example 1:

In a particular locality of a state, the vehicle users take a roundabout route to reach certain
places because of the presence of a river. This results in excessive travel time and increased
fuel cost. So, the state government is planning to construct a bridge across the river. The
estimated initial investment for constructing the bridge is Rs.40,00,000. The estimated life of
the bridge is 15 years. The annual operation and maintenance cost is Rs.1,50,000. The value of
fuel savings due to the construction of the bridge is Rs.6,00,000 in the first year and it increases
by Rs.50,000 every year thereafter till the end of the life of the bridge. Check whether the
project is justified based on BC ratio by assuming an interest rate of 12%, compounded
annually.

Solution 1:

Initial investment = Rs. 40,00,000

Annual operation and maintenance = Rs. 1,50,000
Annual fuel savings during the first year = Rs. 6,00,000
Equal increment in fuel savings in the following years =
Rs. 50,000
Life of the project = 15 years
Interest rate = 12%

Total present worth of costs (or Equivalent costs) = Initial investment (P) + Present worth of
annual operating and maintenance cost (CP) = P + CP
= Rs. 40,00,000 + 1,50,000 × (P/A, 12%, 15) (1 + 𝑖𝑖)𝑛𝑛 − 1
= Rs. 40,00,000 + 1,50,000 × 6.8109 (𝑃𝑃/𝐴𝐴, 12%, 15) =
𝑖𝑖 (1 + 𝑖𝑖)𝑛𝑛
= Rs. 50,21,635
Total present worth of fuel savings (BP):
A1 = Rs. 6,00,000
G = Rs. 50,000
n = 15 years
i = 12%
Annual equivalent fuel savings (A) = A1 + G (A/G, 12%, 15) (1 + 𝑖𝑖)𝑛𝑛 − 𝑖𝑖𝑖𝑖 − 1
= 6,00,000 + 50,000 (4.9803) (𝐴𝐴/𝐺𝐺, 12%, 15) =
𝑖𝑖 (1 + 𝑖𝑖)𝑛𝑛 − 𝑖𝑖
= Rs. 8,49,015

Present worth of the fuel savings (BP) (or Equivalent benefits) = A (P/A, 12%, 15)
= 8,49,015 (6.8109)
= Rs. 57,82,556
𝐵𝐵𝑝𝑝 57,82,556
BC ratio = = = 1.1515
𝑃𝑃+𝐶𝐶𝑝𝑝 50,21,635

Since the BC ratio is more than 1, the project is economically reasonable.

Example 2:

Two mutually exclusive projects are being considered for investment. Project A1 requires an
initial outlay of Rs.30,00,000 with net receipts estimated as Rs.9,00,000 per year for the next
five years. The initial outlay for the project A2 is Rs.60,00,000, and net receipts have been
estimated at Rs.15,00,000 per year for the next seven years. There is no salvage value
associated with either of the projects. Using the benefit cost ratio, which project would you
select? Assume an interest rate of 10%.

Solution 2:
Project A1
Initial cost (P) = Rs. 30,00,000
Net benefits/year (B) = Rs. 9,00,000
Life (n) = 5 years
Annual equivalent of initial cost = P × (A/P, 10%, 5) 𝑖𝑖 (1 + 𝑖𝑖)𝑛𝑛
= 30,00,000 × (0.2638) (𝐴𝐴/𝑃𝑃, 10%, 5) =
(1 + 𝑖𝑖)𝑛𝑛 − 1
= Rs.7,91,400
Benefit-Cost ratio = Annual equivalent benefit / Annual equivalent cost
= 9,00,000/7,91,400 = 1.137
Project A2
Initial cost (P) = Rs. 60,00,000
Net benefits/year (B) = Rs. 15,00,000
Life (n) = 7 years
Annual equivalent of initial cost = P × (A/P, 10%, 7)
= 60,00,000 × (0.2054)
= Rs. 12,32,400
BC ratio = Annual equivalent benefit / Annual equivalent cost
= 15,00,000/12,32,400 = 1.217

Since, 1.217 > 1.137 Project A2 will be selected.

Depreciation calculation: See the slides

Meaning and Methods of
Accounting Depreciation
Meaning
Depreciation is the decrease in the value of physical
properties with the passage of time and use.

• It can be defined in three senses:

– Physical Depreciation: Due to physical decay

– Economic Depreciation: Loss of value of an asset
based on technology, ownership, rights, etc.
– Accounting Depreciation: Estimated value of fall in
the worth of an asset
Causes of Depreciation
1. Physical depreciation
2. Functional depreciation
3. Technological depreciation
4. Accident (Calamities, Fire, Water)
5. Depletion
6. Monetary depreciation
7. Time factor
8. Deferred maintenance
Methods of Accounting Depreciation
1. Straight line method of depreciation
2. Declining balance method of depreciation
3. Sum of the years-digits method of depreciation
4. Sinking-fund method of depreciation

5. Service output method of depreciation (N/A)

 Straight Line Method of Depreciation
In this method of depreciation, a fixed sum is charged as the
depreciation amount throughout the lifetime of an asset such that the
accumulated sum at the end of the life of the asset is exactly equal to
the purchase value of the asset.

Formula:
Dt = (P-S)/n
Bt = Bt-1 – Dt = P – t[(P-S)/n]

Dt = Depreciation amount for the period t.

Bt = Book Value of the asset at the end of the period t.
P = Purchase Price or First Cost of the Asset
S = Salvage Value of the asset
n = Life of the asset
Example-1 (Straight Line Method of Depreciation)
Company has purchased an equipment whose cost is Rs.1,00,000 with an
estimated life of 8 years. The salvage value is Rs.20,000. Determine the
depreciation charge and book value at the end of various years using the
straight line method of depreciation.

P = Rs. 1,00,000 , S= Rs. 20,000 , n = 8 years

Dt = (P – S)/n = (1,00,000 – 20,000)/8 = Rs. 10,000
Bt = Bt-1 – Dt = P – t[(P-S)/n]

The value of Dt is same for all the years but, Bt is different for each year.

Year (t) 0 1 2 3 4 5 6 7 8
Dt 0 10000 10000 10000 10000 10000 10000 10000 10000
Bt 100000 90000 80000 70000 60000 50000 40000 30000 20000

Exercise 1:
Consider Last Example and compute the depreciation and the book value for period 5.
Declining Balance Method of Depreciation
Constant percentage of the book value of the previous period of the
asset will be charged as the depreciation amount for the current period.

Formula:

Dt = K × Bt-1
Bt = Bt-1 – Dt = Bt-1 – K × Bt-1 = (1-K) × Bt-1

The Formula for depreciation and book value in terms of P are as follows:
Dt = K(1-K)t-1 × P
Bt = (1-K)t × P

Where;
K = a fixed percentage
Example -2 (Declining Balance Method)
Ref. Example-1: First cost is Rs.100000; Estimated life is 8 years. The
salvage value is Rs.20000. Compute the depreciation by if K is 0.2.
P = Rs. 1,00,000 ; S = Rs. 20,000 ; n = 8 years ; K = 0.2
Dt = K × Bt-1
Bt = Bt-1 – Dt = Bt-1 – K × Bt-1 = (1-K) × Bt-1
Dt = K(1-K)t-1 × P
Bt = (1-K)t × P
t 0 1 2 3 4 5 6 7 8
Dt 0 20000 16000 12800 10240 8192 6553.6 5242.88 4194.3
Bt 100000 80000 64000 51200 40960 32768 26214.4 20971.5 16777.2

Exercise 2: Ref. Example-1 calculate the depreciation and book value for period 5.
Sum-of-the-Years-Digits Method of Depreciation
The book value decreases at a decreasing rate. Asset has a life of 8
years hence, the sum of years = n (n + 1) / 2 = 36
The rate of depreciation charged in first year is maximum & it
decreases thereafter as follows: 8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36,
and 1/36.

Formula:
For any year, depreciation is calculated by multiplying the
corresponding rate of depreciation with (P – S).
Dt = Rate (P – S)
Bt = Bt–1 – Dt

The formulae for Dt and Bt for a specific year t are as follows:

𝑛−𝑡+1
𝐷𝑡 = (𝑃 − 𝑆)
𝑛(𝑛+1)/2
𝑛−𝑡 𝑛−𝑡+1
𝐵𝑡 = (𝑃 − 𝑆) + 𝑆
𝑛 𝑛+1
Example-3 (Sum-of-the-years-digits Method )
Ref. Example-1: First cost is Rs.100000; Estimated life is 8 years. The
salvage value is Rs.20000.
P = Rs. 1,00,000 ; S = Rs. 20,000 ; n = 8 years ; K = 0.2
t 0 1 2 3 4 5 6 7 8
Dt 0 17777.78 15555.56 13333.33 11111.11 8888.889 6666.667 4444.444 2222.222
Bt 100000 82222.22 66666.67 53333.33 42222.22 33333.33 26666.67 22222.22 20000

Exercise 2: Ref. Example-1 calculate the depreciation and book value

for period 5.
𝑛−𝑡+1
𝐷𝑡 = (𝑃 − 𝑆)
𝑛(𝑛 + 1)/2

𝑛−𝑡 𝑛−𝑡+1
𝐵𝑡 = 𝑃 − 𝑆 × +𝑆
𝑛 𝑛+1
Sinking Fund Method of Depreciation
Book value decreases at increasing rates with respect to life of the
asset.

 The loss in value of the asset (P – S) is made available in the form

of cumulative depreciation amount at the end of the life of the
asset by setting up an equal depreciation amount (A) at the end of
each period during the lifetime of the asset.
Annual Equivalent Amount (A) = (P – S) [A/F, i, n]
 The fixed sum depreciated at the end of every time period earns an
interest at the rate of i% compounded annually, and hence the
actual depreciation amount will be in the increasing manner with
respect to the time period.
Dt = (P – S) (A/F, i, n) (F/P, i, t – 1)
Formula
Dt = (P – S) × (A/F, i, n) × (F/P, i, t – 1)
Bt = P – (P – S) × (A/F, i, n) × (F/A, i, t)
ⅈ 1+ⅈ 𝑡 −1
Where; (A/F, i, n) = ; (F/A, i, t) =
1+ⅈ 𝑛 −1 ⅈ
and (F/P, i, t-1) = (1 + i)t-1

Example 4: Ref. Example 1 calculate the depreciation with an interest

rate of 12%, compounded annually.
P = Rs. 1,00,000; S = Rs. 20,000; n = 8 years; i = 12%
ⅈ
A = (P – S) = (1,00,000 – 20,000) 0.0813 = Rs. 6,504
1+ⅈ 𝑛 −1

a fixed amount of Rs. 6,504 is depreciated at the end of every year from the
earning of the asset. The depreciated amount will earn interest for the
remaining period of life of the asset at an interest rate of 12%, compounded
annually.
Depreciation at the end of year 1 (D1) = Rs. 6,504.
Depreciation at the end of year 2 (D2) = 6,504 + 6,504 x 0.12 = Rs. 7,284.48
Depreciation at the end of the year 3 (D3)
= 6,504 + (6,504 + 7,284.48) x 0.12 = Rs. 8,158.62
Depreciation at the end of year 4 (D4)
= 6,504 + (6,504 + 7,284.48 + 8,158.62) x 0.12 = Rs. 9,137.65
Exercise 3:
Ref. Example 1: Compute D5 and B7 using the sinking fund
method of depreciation with an interest rate of 12%, compounded
annually.
ⅈ
Dt = (P – S) × (1 + i)t-1
1+ⅈ 𝑛 −1
D5 = (1,00,000 – 20,000) x 0.0813 x 1.574 = Rs. 10,237.30

ⅈ 1+ⅈ 𝑡 −1
Bt = P – (P – S) × ×
1+ⅈ 𝑛 −1 ⅈ
B7 = 1,00,000 – (1,00,000 – 20,000) × 0.0813 × 10.089
= 34,381.10