INTERNATIONAL ISLAMIC UNIVERSITY

MALAYSIA
MME 4272 Engineering Management Part II
1

INVESTMENT ANALYSIS 1

Category of Projects
2

To help formulate alternatives, a

project is categorized as one of the

following:

Mutually exclusive: Only one of the viable

projects can be selected by the economic
analysis
Independent: More than one viable project may
be selected by the economic analysis

Tools for Evaluating Alternatives

3

Various

tools/methods to evaluate
alternatives economically (economic
equivalence) using the factors learned
Purpose:

Compare mutually exclusive alternatives

Basis:

present worth, future worth &

annual worth analysis

Tools for Evaluating alternatives

4

Present Worth Analysis

Formulating

Mutually Exclusive

Alternatives
Present Worth Analysis of Equal-life
Alternatives
Present worth Analysis of Different
Life Alternatives
Future Worth Analysis
Payback Period Analysis
Annual Worth Analysis
Rate of Return Analysis
Benefit/Cost Ratio Analysis

PW Analysis of Equal-Life Alternatives

5

One alternative: Calculate PW at the

MARR
PW 0, the requested MARR is met or
exceeded (alternative is financially
viable)

If

Two or more alternatives: Calculate the

PW of each alternative
Select

alternative with largest PW value

(alternative with less negative or more
positive)

PW Analysis of Equal-Life Alternatives

6

If the projects are independent, the

selection guideline is as follows:

For one or more independent projects,

select all projects with PW 0 at the

MARR

PW1

PW2

$ -1500

$ -500

Selected
alternative
2

-500

+1000

+2500

-500

+2500

+1500

PW Analysis of Equal-Life Alternatives

7

Perform a present worth analysis of

equal-service machine with costs shown

below, if the MARR is 10% per year.
Revenue for all the alternatives are
expected to be the same

First cost, $
Annual operating cost (AOC), $
Salvage value S, $
Life, years

Electric
powered

Gas powered

Solar
powered

- 2500
- 900
200
5

- 1500
- 700
350
5

- 6000
- 50
100
5

PW Analysis of Equal-Life Alternatives

8

These are service alternatives:

The PW of each machine is calculated at

i = 10% for n = 5 years

PWE = -2500 - 900(P/A,10%,5) + 200(P/F,10%,5)= $-5788
PWG = -3500 - 700(P/A,10%,5) + 350(P/F,10%,5)= $-5936
PWS = -6000 - 50(P/A,10%,5) + 100(P/F,10%,5)= $-6127

[See the calculations in excel file]

The electric-powered machine is selected

since the PW of its costs is the lowest

(has numerically the largest PW value)

PW Analysis of Different-Life Alternatives

9

A project engineer with EnvironCare is

assigned to start up a new office in a

city where a 6-year contract has been
finalized to take and to analyze ozonelevel readings. Two lease options are
available, each with a first cost, annual
lease cost, and deposit-return estimates
as shown below:
First cost, $
Annual lease cost, $ per year
Deposit return, $
Lease term, years

Location A

Location B

- 15,000
-3,500
1,000
6

- 18,000
-3,100
2,000
9

PW Analysis of Different-Life Alternatives

10

a. Determine which lease option should be

selected on the basis of a PW comparison,

if MARR is 15% per year
b. EnvironCare has a standard practice of
evaluating all projects over a 5-year
period. If a study period of 5 years is
used & the deposit returns are not
expected to change, which location should
be used?
c. Determine location over a 6-year study
period if deposit return at location B is
estimated to be $6000 after 6 years

Break-Even Point
11

Breakeven Analysis
Single-product Case
Multi-product Case

Assumptions
Graphical and Algebraic Approach

Determining BEP for single and multi-product cases

[Reference: Operations Management, Heizer & Render, 8 th ed (p-287)]

Break-Even Analysis
12

A critical tool for determining capacity a facility must

have to achieve profitability

Objective is to find the point in dollars or ringgits &
units at which, cost equals revenue
Requires estimation of fixed costs, variable costs, &
revenue
Fixed costs are costs that continue even if no units are
produced (depreciation, taxes, debt, mortgage
payments)
Variable costs are costs that vary with the volume of
units produced (labor, materials, portion of utilities)

Break-Even Analysis
13

Variable costs are costs that vary with the volume of

units produced (labor, materials, portion of utilities)

Contribution is the difference between selling price
and variable cost
Assumptions:
Costs and revenue are linear functions (In reality, the
case is not so)
There is no time value of money

Break-Even Analysis

Total revenue line

900
800

Cost in dollars

700
600

Break-even point
Total cost = Total revenue

o
Pr

co
t
i
f

r
o
d
rri

Total cost line

500
400

Variable cost

300
200
100

ss or
o
L rid
r
co
|

Fixed cost
|

0 100 200 300 400 500 600 700 800 900 10001100
Volume 14
(units per period)

Break-Even Analysis
BEPx =
Breakeven point in units
BEP$ =
Breakeven point in dollars
P
=
Price per
unit (after all
discounts)
Break-even point occurs when

x=
Number of units
produced
TR
=
Total
revenue = Px
F=
Fixed costs
V
=
Variable
costs per unit
TC
=
Total
costs = F + Vx

BEP$ = BEPx P
TR = TC
Profit =
or
= F
.P
=
Px = F + Vx
P-V
=
F
=
=
(P - V)/P
F
BEPx =
F
P-V
=
1 - V/P
15

TR - TC
Px - (F + Vx)
Px - F - Vx
(P - V)x - F

Break-Even Analysis
Fixed costs = $10,000
Direct labor = $1.50/unit

BEP$ =

F
1 - (V/P)

Material = $0.75/unit
Selling price = $4.00 per unit

$10,000
1 - [(1.50 + 0.75)/(4.00)]
$10,000
F
1 - (V/P) 1 - [(1.50 + 0.75)/(4.00)]
$10,000
=
= $22,857.14
.4375

BEPx = F
=
$10,000
4.00 - (1.50 + 0.75)
P-V
= 5,714
16

Break-Even Example
50,000

Revenue

40,000

Break-even
point

Dollars

30,000

Total
costs

20,000
10,000

Fixed costs

2,000

4,000

6,000
Units
17

8,000

10,000

Break-Even Example
Multi-product Case
where

V
P
F
W
i

=
=
=
=
=

BEP$ =

Vi

1 - Pi x
variable cost per unit
price per unit
(Wi)
fixed costs
percent each product is of total dollar sales
each product

Fixed costs = $3,500 per month

Forecasted
Item
Sandwich
Soft drink
Baked potato
Tea
Salad bar

Annual
Price
$2.95
.80
1.55
.75
2.85

Cost
$1.25
.30
.47
.25
18 1.00

Sales Units
7,000
7,000
5,000
5,000
3,000

Multiproduct BEP Example

Item (i)

Annual
Selling Variable
Forecasted
Price (P) Cost (V) (V/P) 1 - (V/P) Sales $

Sandwich $2.95
Soft drink
.80
Baked
1.55
potato
Tea
.75
Salad bar
2.85

Weighted
% of Contribution
Sales (col 5 x col 7)

$1.25
.30
.47

.42
.38
.30

.58
.62
.70

$20,650
5,600
7,750

.446
.121
.167

.259
.075
.117

.25
1.00

.33
.35

.67
.65

3,750 .081
8,550 .185
$46,300 1.000

.054
.120
.625

19

Multiproduct Example

BEP$ =

Vi
1Pi

x (Wi)

$3,500 x 12
.625

Daily = $67,200
sales 312 days

= $67,200
= $215.38

.446 x $215.38
= 32.6 33
$2.95
sandwiches
per day

20

Problems for practice (to be solved in the class)

(1) Given the following data, calculate BEP(x), BEP ($), and the
profit at 100,000 units:
P= $8/unit, V = $4/unit and F =$50,000.
(2) A prolific author is considering starting her own publishing
company. She will call it DSI Publishing, Inc. DSIs estimated
costs are
------------------------------------------------------------------Fixed
$250,000.00
Variable cost per book
$20.00
Selling price per book
$30.00
How many books must DSI sell to break even? What is its breakeven point in dollars?

21

Depreciation - Terminology
22

Depreciation - reduction in value of an asset

(usually annual depreciation is tax

deductible - it is subtracted from income
when calculating amount of taxes due each
year
First cost (or unadjusted basis) - the
delivered & installed cost of the asset
including purchase price
Book value (BV)represents the remaining
(undepreciated) capital investment in the
books after total amount of depreciation
charges to date have been subtracted from the
basis

Depreciation - Terminology
23

Book value (BV) - usually determined at the end

of each year; consistent with the end-of-year

convention
Recovery period (n)- the depreciable life, n
of the asset in years
Salvage value (S)- the estimated trade-in or
market value at the end of the assets useful
life
Depreciation rate or recovery rate (dt)- the
fraction of first cost removed by depreciation
each year (may be same for straight line
method or different for each year of the
recovery period)

Depreciation Methods
24

Straight Line (SL) Depreciation

Book value decreases linearly with time

Depreciation rate (dt = 1/n = d)is the same
each year of the recovery period, n
Considered the standard against which any
depreciation model is compared
The annual SL depreciation is determined by
multiplying the first cost minus salvage
value by d

Straight Line (SL) Depreciation

In equation form,
Dt ( B S ) d

BS
n

where,
t = year (t=1,2,n)
Dt= annual depreciation charge
B = first cost or unadjusted basis
S = estimated salvage value
n = recovery period
d = depreciation rate = 1/n

B
o
o
k
v
a
l
u
e

t
time

25

Straight Line (SL) Depreciation

Since the asset is depreciated by the same
amount each year, the book value after t
years of service (BVt) will be equal to the
first cost B minus the annual depreciation
times t
BVt = B tDt
Earlier we defined dt as a depreciation
rate for a specific year t. However, the SL
model has the same rate for all years, that
is
d = dt = 1/n
Excel function is SLN(B,S,n)
26

Straight Line (SL) Depreciation

If an asset has a first cost of $50,000 with
a $10,000 estimated salvage value after 5
years, (a) calculate the annual depreciation
and (b) compute and plot the book value of
the asset after each year, using straight
line (SL) depreciation
Solution
(a) The depreciation each year for 5 years
can be found by
Dt ( B S ) d

BS
n

= (50,000 10,000)/5 = $8000

Enter SLN(50000,10000,5) in any cell to get Dt of $8000
27

Straight Line (SL) Depreciation

(b) The book value after each year t is computed by using equation
BVt = B tDt.
BV1 = 50,000 1(8,000) = $42,000
BV5 = 50,000 5(8,000) = $10,000 = S

The BVt values are plotted for years 1 and 5

as
50

B
V
,
x
$
1
0
0
0

Dt=$8,000

40
30
20
10

S=$10,000
0

Year t

28
3

Declining Balance (DB) Depreciation

29

Declining balance method is commonly

applied (also known as the fixed

percentage or uniform percentage method)
Accelerates write-off of asset value
because annual depreciation is determined
by multiplying the book value at the
beginning of a year by a fixed (uniform)
percentage, d
If d = 0.1 then 10% of the book value is
removed each year so, the depreciation
amount decreases each year

Double Declining Balance (DDB)

Depreciation
30

Maximum annual depreciation rate for DB

method can be twice the straight line

rate, that is dmax = 2/n
A special title called double declining

balance (DDB) method

If n = 10 years, the DDB rate is 2/10 =
0.2 of the book value is removed each
year
The depreciation for year, t is the
fixed rate d times the book value at the
end of the previous year, Dt = (d)BVt-1

DB and DDB Depreciation

31

The actual depreciation rate for each year

t, relative to the first cost B, is dt =

d(1-d)t-1
If BVt-1 is not known, the depreciation in
year t can be calculated using B and d,
i.e Dt = dB(1-d)t-1
Book value in year t is determined in one

of two ways:
1.
2.

by using the rate d and the first cost B or

by subtracting current depreciation charge
from the previous book value

DB and DDB Depreciation

32

The equations are

BVt = B(1-d)t and BVt = BVt-1 Dt

Note that the book value for DB method

never goes to zero. Why?

The implied salvage value after n years is
BVn amount. Thus, implied salvage value =
Implied S = BVn = B(1-d)n
If a salvage value is estimated for the

asset, this estimated S value is not used

in the DB or DDB method to calculate
annual depreciation

DB and DDB Depreciation

33

However, if the implied S < estimated S,

it is correct to stop charging further

depreciation
So stop depreciating when the book value
is at or below the estimated salvage value
In most cases, the estimated S is in the
range of zero to the implied S value
If the fixed percentage d is not stated,
it is possible to determine the implied
fixed rate using the estimated S value, if
S > 0

DB and DDB Depreciation

34

The range for d is 0 < d < 2/n

Implied d = 1- (S/B)1/n [as we know, Implied

S = BVn = B(1-d)n]

A fiber optics testing device is to be DDB

depreciated. It has a first cost of $25,000
and an estimated salvage value of $2500
after 12 years
(a)Calculate

the depreciation and book value for

years 1 and 4
(b)Calculate the implied salvage value after 12
years

Declining Balance (DB) and Double

Declining Balance (DDB) Depreciation
Solution
(a)The DDB fixed depreciation rate is d = 2/n
= 2/12 = 0.1667 per year.
So, for year 1,
D1 = dB(1-d)1-1 =(0.1667)(25000)(1-0.1667)1-1
= $4167
BV1 = B(1-d)1 = 25,000(1-0.1667)1 = $20,833
For year 4,
D4 = dB(1-d)4-1 =(0.1667)(25000)(1-0.1667)4-1
= $2411
BV4 = B(1-d)4 = 25,000(1- 0.1667)4 = $12,054
35

Declining Balance (DB) and Double

Declining Balance (DDB) Depreciation
Solution (contd)
(a)DDB function for D1 and D4 are
respectively, DDB(25000,2500,12,1) and
DDB(25000,2500,12,4)
Assignment: Check with Excel
(b)The implied salvage value after 12 years
is
Implied S = B(1-d)n = 25,000(1-0.1667)12
= $2803

36

Another Example
A mining company has purchased a
computer-controlled gold ore grading
unit for $80,000, with an anticipated
life of 10 years & a salvage value of
$10,000. Use DB & DDB methods to
compare the schedule of depreciation &
book values for each year.
An implied DB depreciation rate is
d = 1 (S/B)1/n = 1 (10,000/80,000)1/10
= 0.1877
Note: 0.1877 < 2/n = 0.2. So the DB model
does not exceed twice the straight line
rate
37

Example 16.3:Schedule of Depreciation

& Book values
Declining Balance
Year t
0

Dt

BVt
--

$80,000

Double Declining
Dt
--

BVt
$80,000

$15,016

64,084

$16,000

64,000

12,197

52,787

12,800

51,200

9,908

42,879

10,240

40,960

8,048

34,831

8,192

32,768

6,538

28,293

6,554

26,214

5,311

22,982

5,243

20,972

4,314

18,668

4,194

16,777

3,504

15,164

3,355

13,422

2,846

12,318

2,684

10,737

10

2,318

38
10,000

737

10,000

Another problem
Equipment for immersion cooling of electronic components
has an installed value of $182,000 with an estimated tradein value of $50,000 after 18 yrs. Determine annual
depreciation charge using DDB & DB for years 2 &18.
Ans:
We need to determine the implied salvage value
to verify whether the implied S is less than the
estimated S (50,000)
For DDB, d = 2/n = 2/18 = 0.1111
Implied S = Book value after useful life = B(1- d)n
= 182,000(1- 0.1111)18 = $21,848
39

Using DDB
It is found that implied S (21,848) < estimated
S (50,000)
It will be correct to stop charging depreciation
beyond $50,000
For DDB, depreciation charge, Dt = dB(1-d)t-1
For this case, d = 2/n = 2/18 = 0.1111
Depreciation charge for year 2, D2=(0.1111)
(182,000)(1-0.1111)2-1 =$17,973.74
For year 18, D18=(0.1111)(182,000)(10.1111)18-1 =$2,730.77
So since after 18 years the implied salvage
value is lower than the estimated salvage
40
value, D should not be
charged

Using DB
For DB, d = 1/n = 1/18 = 0.05555 or
We can also use d = 1- (S/B)1/n
= 1- (50000/182000)1/18 = 0.0693
Implied S = B(1-d)n = 182,000(1-0.05555)18
= $65,057
Since the implied S (65,057) > estimated S
(50,000), it will be correct to continue
charging further depreciation
41

Using DB
Given, B=182,000
S=50,000
For DB, we know Dt = dB(1-d)t-1
Now d = 1/n = 1/18 = 0.055555
Depreciation charge for year 2,
D2=(0.05555)(182,000)(1-0.05555)2-1
=$9,549
Similarly, D18=(0.05555)(182,000)(10.05555)18-1 =$3,827
It should also be correct if someone
answers by using implied d = 0.0693
42

Example
A copy machine is purchased for $4,217.75.
The expected life is 5 years. Use double
declining balance to calculate the depreciation.
The salvage value of the copy machine is
$500.00.

43

Bibliography
44

1.

Chang, C. M. (2005). Engineering Management

Challenges in the New Millennium, Upper Saddle River,
NJ: Prentice Hall

The End
45

IQ + EQ + SQ = TQ