ENGINEERING

ECONOMY
DEPRECIATION &
VALUATION
DEFINITION OF TERMS AND
METHODS
TOPIC OBJECTIVES:
 Today’s topic – DEPRECIATION & VALUATION
◦ Learn some definition of terms used in calculating
depreciation
◦ Why do we depreciate assets?
◦ Learn the different types of Depreciation
◦ Know the types of asset life
◦ Know the requirements of a Depreciation Method
◦ Familiarize with the different Depreciation Methods
◦ Solve sample problems on these Depreciation
Methods
DEPRECIATION – An introduction
 Depreciation is a bothersome fact that must be dealt
with in business and economy studies. It is the
decrease in the value of physical property with the
passage of time.
 There are some exceptions – notably rare antiques,
good works of art, some musical instruments and
liquors, and, in most instances, land.
DEPRECIATION – An introduction
 The actual amount of depreciation can never be
determined until the asset is retired from service.
But because depreciation is a cost and thus must be
considered properly in economy studies, it is clear
that the analyst encounters some problems in
dealing with it.
 At the same time, it is equally evident that the cost
of depreciation, as contained in an economy study,
will be an estimate, and it most likely will not be
entirely accurate.
DEPRECIATION – An introduction
 Basically, from a business viewpoint, a physical asset
has value because one expects to receive future
monetary benefits through the possession and use
of it.
 These benefits are in the form of future cash flows
resulting from
a) the use of the asset to produce saleable goods or
services, or
b) the ultimate sale of the asset
DEPRECIATION – An introduction
 It is because of these anticipated cash flows that
the asset has commercial value.
 Depreciation, then, represents a decrease in value
because the ability of the asset to produce these
future cash flows decreases, due to one or more of
several causes, with the passage of time.
DEFINITIONS OF VALUE
Because depreciation is defined as decrease in value, it
is necessary to give some consideration to the
meaning of the term.
 Value, in a commercial sense, is the present worth
of all future profits that are to be received through
ownership of a particular property. This excellent
definition is, however, difficult to apply in actual
practice, inasmuch as we can seldom determine
profits far in advance.
DEFINITIONS OF VALUE
 The most commonly encountered measure of value
is market value.
 The market value of a property is the amount which
a willing buyer will pay to a willing seller for the
property where each has equal advantage and is
under no compulsion to buy or sell.
 The buyer is willing to pay the market price
because he believes it approximates the present
value of what he will receive through ownership
with some rate of interest or profit included.
DEFINITIONS OF VALUE
 Next to market value, probably the most important
kind of value is use value or utility value. This is what
the property is worth to the owner as an operating
unit.
 A property may be worth more to the person who
possesses it and has it in operation than it would be
to someone else, who, if purchased it, might have to
spend additional funds to move it and get it into
operation.
 Fair value is the value which is usually determined
by a disinterested third party in order to establish a
price that is fair to both seller and buyer.
DEFINITIONS OF VALUE
 Book value, sometimes called depreciated book
value, is the worth of a property as shown on the
accounting records of an enterprise.
 It is ordinarily taken to mean the original cost of
the property less the amounts that have been
charged as depreciation expense.
 It thus represents the amount of capital that
remains invested in the property and must be
recovered in the future through the depreciation
accounting process.
DEFINITIONS OF VALUE
 Salvage, or resale, value is the price that can be obtained
from the sale of the property second-hand.
 Salvage value implies that the property has further
utility.
 It is affected by several factors namely:
1) The reason of the present owner for selling may
influence the salvage value. If the owner is selling
because there is very little commercial need for the
property, this will affect the resale value; change of
ownership will probably not increase the
commercial utility of the article.
DEFINITIONS OF VALUE
2) Salvage value will also be affected by the present
cost of reproducing the property; price levels may
either increase or decrease the resale value.
3) A third factor that may affect salvage value is the
location of the property. This is particularly true in
the use of structures that must be moved in order
to be of further use.
4) The physical condition of a property will also have a
great influence upon the resale price that can be
obtained. A structure that has been well maintained
and is in good condition will obviously be of greater
value than one that has been neglected and would
require considerable repair before it could be used.
DEFINITIONS OF VALUE
 Scrap value is the amount the property would sell
for if disposed off as junk. The utility of the article is
zero.
 Because for most materials, except the precious
metals, the scrap price usually fluctuates
considerably over a period of time, the fact that
there is an existing scrap value does not assume
that a property will have more than a minimum
scrap value at a future date.
 Unless it is certain that a stated scrap value will
always exist in most economy studies, the future
scrap value should be assumed to be zero.
PURPOSES OF DEPRECIATION
 Because property decreases in value, it is desirable to
consider the effect that this depreciation has on
engineering projects.
 Primarily, it is necessary to consider depreciation for
two reasons:
1. To provide for the recovery of capital that has been
invested in physical property.
2. To enable the cost of depreciation to be charged to
the cost of producing products or services that
result from the use of the property. Depreciation
cost is real, as are labour and material costs, and it is
deductible in computing profits on which income
taxes are paid.
TYPES OF DEPRECIATION
 Another bothersome feature of depreciation is the fact
that the decrease in value has several causes, some of
which are very difficult to predict or anticipate.
 Decreases in value with the passage of time may be
classified as follows:
1. Normal depreciation
a) Physical
b) Functional
2. Depreciation due to changes in price level
3. Depletion
TYPES OF DEPRECIATION
 Physical depreciation is due to the lessening of the
physical ability of a property to produce results.
 Its common causes are wear and deterioration.
 These cause operation and maintenance costs to
increase and output to decrease. As a result, the
profits decrease.
 Physical depreciation is mainly a function of time
and use. It will be affected greatly by the
maintenance policy of the owner.
TYPES OF DEPRECIATION
 Some people contend that it is possible to maintain a
property so that it remains “good as new.” However, it
is doubtful if anything that is subject to depreciation can
ever be as good as new, regardless of maintenance.
 A property might be improved so that it is more
valuable than when it was new, but it is then not the
same as it was originally. Improvement has been
confused with maintenance.
Examples: Plant rehabilitation, equipment refurbishment,
vehicle body repair, etc.
TYPES OF DEPRECIATION
 Functional depreciation is due to the lessening in demand
for the function which the property was designed to
render.
 Functional depreciation is more difficult to determine
than physical depreciation.
 Its common causes are:
1. Inadequacy; increased demand – existing machine is
already incapable of producing the required volume. The
engineer does much to bring about these changed
conditions that cause functional depreciation.
2. Changes in styles – the product or services are already
outmoded.
TYPES OF DEPRECIATION
3. Saturation of markets – too many products in the market;
and
4. More efficient machines are produced – automation

 Depreciation due to changes in price levels is almost

impossible to predict and therefore is not considered in
economy studies.
 Depletion refers to the decrease in the value of a
property due to the gradual extraction of its contents.
TYPES OF DEPRECIATION
 When natural resources are being consumed in
producing products or services, the term depletion is
used to indicate the decrease in value that has
occurred.
◦ The term is commonly used in connection with mining
properties, oil and gas wells, timber lands, and so on.
◦ In any given parcel of mineral property, for example, there
is a definite quantity of ore, oil, or gas available. As some
of the mineral is mined and sold, the reserve decreases
and the value of the property normally diminishes.
TYPES OF DEPRECIATION
 Appreciation is the opposite of depreciation wherein the
price levels have decreased paving the way for the
property to appreciate. However, the long term
historical trend has been one of continued inflation.
 Any attempt to determine depreciation should consider
such factors as follows:
◦ Life of the property
◦ Future expenses for maintenance, operation and taxes
◦ Future technological changes that may cause obsolescence
TYPES OF DEPRECIATION
 Future conditions cannot be determined accurately.
However, it is necessary that depreciation be
determined as closely as is reasonably possible.
 Not only must provision be made for replacement of
equipment as it wears, but the correct depreciation
charge must be made before the true net profit can be
found.
PHYSICAL & ECONOMIC LIFE
 Physical life of a property is the length of time during
which it is capable of performing the function for which
it was designed and manufactured.
 Economic life is the length of time during which the
property may be operated at a profit. The entire amount
of depreciation should be written off during the
economic life. In this manner, equipment that is
unsatisfactory from the viewpoint of economy may be
replaced without causing a capital loss, even though it
may be in fair physical condition.
REQUIREMENTS OF A
DEPRECIATION METHOD
 From the standpoint of management, the depreciation
method should
1. provide the recovery of invested capital as is consistent
with the economic facts involved; known and computed
salvage values should agree, if possible;
2. be simple;
3. assure that the book value will not be greater than actual
value at any time; and
4. be accepted by the Bureau of Internal Revenue.
REQUIREMENTS OF A
DEPRECIATION METHOD
 Obviously, the requirement should provide for the
recovery of capital and the proper assignment of
depreciation cost over the estimated life of the asset.
 But equally important, it should account properly for
the flow of capital funds that are recovered, and which
thereby reduce the amount of capital remaining
invested in the project. These funds thus are available
for other use or investment.
 Finally, the method used must permit the proper
evaluation of the potential of an investment being
considered in an economy study.
DEPRECIATION METHODS
 The following symbols shall be used for the different
depreciation methods:

L = useful life of the property in years

C₀ = the original cost
CL = the value at the end of life, the scrap value
(including gain or loss due to removal)
d = the annual cost of depreciation
C n = the book value at the end of n years
Dn = depreciation up to age n years
DEPRECIATION METHODS – The
Straight Line Method
 The straight line method assumes that the loss in value is
directly proportional to the age of the property. This
straight line relationship gives rise to the name of the
method.
C₀ – C L
d = --------------- (3-1)
L

n (C₀ – C L )
Dn = ----------------- (3-2)
L

Cn = C₀ – Dn (3-3)
DEPRECIATION METHODS – The
Straight Line Method
 PROBLEM 3-1:
An electronic balance costs PHP90,000 and has an estimated
salvage value of PHP8,000 at the end of its 10 years life time. What
would be the book value after three years, using straight line
method in solving for the depreciation?
Solution:
C₀ = P90,000 C L = P8,000 L = 10 n=3

C₀ – CL P90,000 – P8,000
d = -------------- = ------------------------- = P8,200
L 10

D3 = (n) (d) = (3) (P8,200) = P24,600

C3 = C₀ – D3 = P90,000 – P24,600 = PHP65,400

DEPRECIATION METHODS – The
Sinking Fund Formula Method
 This method assumes that a sinking fund is established in
which funds will accumulate for replacement.
 The total depreciation that has taken place up to any
given time is assumed to be equal to the accumulated
amount in the sinking fund at that time.

D n C₀ – C L

0 1 2 3

d d d d d
DEPRECIATION METHODS – The
Sinking Fund Formula Method
 Formulas:

C₀ – CL
d = -------------- (3-4)
F/A, i%, L

Dn = d (F/A, ni%, n) (3-5)

Cn = C₀ – D (3-6)
DEPRECIATION METHODS – The
Sinking Fund Formula Method
 PROBLEM 3-2:
A broadcasting corporation purchased an equipment for
PHP53,000 and paid PHP1,500 for freight and delivery
charges to the job site. The equipment has a normal life
of 10 years with a trade-in value of PHP5,000 against
the purchase of a new equipment at the end of the life.
a) Determine the annual depreciation cost by the
straight line method.
b) Determine the annual depreciation cost by the
sinking fund method. Assume interest at 6 ½ %
compounded annually.
DEPRECIATION METHODS – The
Sinking Fund Formula Method
Solution:
C₀ = P53,000 + P1,500 = P54,500
C L = P5,000

C₀ – CL P54,500 – P5,000
(a) d = ------------ = ------------------------ = P4,950
L 10
C₀ – CL P54,500 – P5,000 P49,500
(b) d = -------------- = ------------------------ = -------------
F/A, i%, n F/A, 6.5%, 10 13.3846

= P3,668
DEPRECIATION METHODS – The
Sinking Fund Formula Method
 PROBLEM 3-3:
A firm bought an equipment for PHP56,000. Other
expenses including installation amounted to PHP4,000.
The equipment is expected to have a life of 16 years
with a salvage value of 10% of the original cost.
Determine the book value at the end of 12 years by (a)
the straight line method and (b) sinking fund method at
12% interest.
Solution:
C₀ = P56,000 + P4,000 = P60,000
CL = P60,000 (0.10) = P6,000
DEPRECIATION METHODS – The
Sinking Fund Formula Method
 PROBLEM 3-3 cont’d:
L = 16 n = 12 i = 12%
(a) Straight line method

C₀ – C L P60,000 – P6,000
d = ------------- = ------------------------- = P3,375
L 16
D12 = (d) (n) = P3,375 (12) = P40,500
C12 = C₀ – D12 = P60,000 – P40,500 = P19,500
DEPRECIATION METHODS – The
Sinking Fund Formula Method
 PROBLEM 3-3 cont’d:

(b) Sinking Fund method

C₀ – CL P60,000 – P6,000
d = ----------------- = ------------------------- = P1,263
F/A, 12%, 16 42.7533

D12 = (d) (F/A, 12%, 12) = P1,263 (24.1331)

= P30,480

C12 = C₀ – D12 = P60,000 – P30,480 = P29,520