Engineering Economics

(23EB6309)
Module: 5

Faculty Name: Dr. Jignesh Thaker

Type of Course: Engineering Economics
Teaching Scheme: Lecture (02), Tutorial (00), Practical (00)
Credit: 2
 Depreciation
In engineering economics, depreciation refers to the allocation of the
cost of a physical asset over its useful life.
This allocation reflects the gradual reduction in the asset's value
due to factors such as wear and tear, obsolescence, and aging.
Depreciation is a crucial concept because it allows businesses to
accurately reflect the true cost of using an asset to generate revenue
over its lifespan.
Depreciation is a fundamental concept in engineering economics
that reflects the gradual consumption of the economic benefits
associated with an asset over its useful life.
Properly accounting for depreciation is essential for financial
reporting, tax compliance, and strategic decision making within
organizations.
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 Depreciation
There are several methods used to calculate depreciation, including:
Straight-Line Method of Depreciation: This method evenly distributes the
cost of the asset over its useful life.
Declining Balance Method of Depreciation: This method involves applying
a constant depreciation rate to the remaining book value of the asset each
period.
Sum-of-the-Years'-Digits Method of Depreciation: This method accelerates
depreciation by allocating more depreciation expense to earlier years of the
asset's life.
Sinking-fund Method of Depreciation: This method is a way of setting
aside money regularly to replace an asset at the end of its useful life. It's
similar to saving up for a future expense.
Service Output Method of Depreciation: This method focuses on the
output or service provided by an asset rather than its physical deterioration.

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 Straight Line Method of Depreciation
In this method, 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.
The formulae for depreciation and book value are:
𝐷𝑡 = (𝑃 − 𝐹)/𝑛
𝐵𝑡 = 𝐵𝑡−1 − 𝐷𝑡

𝐵𝑡 = 𝑃 − 𝑡 ∗ (𝑃 − 𝐹)/𝑛
where, P = First cost of the asset
F = Salvage value of the asset
n = Life of the asset
Bt = Book value of the asset at the end of the period t
Dt = Depreciation amount of asset for the period t

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 Straight Line Method of Depreciation
Problem Statement 1: A company has purchased an equipment whose
first cost is Rs. 100000 with an estimated life of eight years. The
estimated salvage value of the equipment at the end of its lifetime is Rs.
20000. Determine the depreciation charge and book value at the end of
various years using the straight line method of depreciation.

Sol.: P = Rs. 100000

F = Rs. 20000
n = 8 years
Bt = Book value of the asset at the end of the period t
Dt = Depreciation amount of asset for the period t
𝐷𝑡 = (𝑃 − 𝐹)/𝑛
𝐷𝑡 = (100000 − 20000)/8
𝐷𝑡 = 10000
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 Straight Line Method of Depreciation
End of the Year Depreciation Book Value
(t) (Dt) (Bt)
0 100000
1 10000 90000
2 10000 80000
3 10000 70000
4 10000 60000
5 10000 50000
6 10000 40000
7 10000 30000
8 10000 20000

Computing the depreciation and book value for period 5

𝐷𝑡 = (𝑃 − 𝐹)/𝑛 𝐵𝑡 = 𝑃 − 𝑡 ∗ (𝑃 − 𝐹)/𝑛
𝐷𝑡 = (100000 − 20000)/8 𝐵𝑡 = 100000 − 5 ∗ (80000)/8
𝐷𝑡 = 𝑅𝑠. 10000 𝐵𝑡 = 𝑅𝑠. 50000

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 Declining Balance Method of Depreciation
In this method, a constant percentage of the book value of the
previous period of the asset will be charged as the depreciation
amount for the current period. This approach is realistic approach.
The book value at the end of the life of the asset may not be exactly
equal to the salvage value of the asset.
The formulae for depreciation and book value are: 𝐷𝑡 = 𝐾𝐵𝑡−1
𝐵𝑡 = 𝐵𝑡−1 − 𝐷𝑡
where, P = First cost of the asset 𝐵𝑡 = (1 − 𝐾)𝐵𝑡−1
F = Salvage value of the asset 𝐷𝑡 = 𝐾(1 − 𝐾)𝑡−1 𝑃
n = Life of the asset 𝐵𝑡 = (1 − 𝐾)𝑡 𝑃
Bt = Book value of the asset at the end of the period t
Dt = Depreciation amount of asset for the period t
K = fixed percentage

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 Declining Balance Method of Depreciation
Problem Statement 2: A company has purchased an equipment whose
first cost is Rs. 100000 with an estimated life of eight years. The
estimated salvage value of the equipment at the end of its lifetime is Rs.
20000. Determine the depreciation charge and book value at the end of
various years using the declining balance method of depreciation by
assuming 0.2 for K.
Sol.: P = Rs. 100000 𝐷𝑡 = 𝐾𝐵𝑡−1
𝐷𝑡 = 𝐾(1 − 𝐾)𝑡−1 𝑃
F = Rs. 20000
𝐵𝑡 = (1 − 𝐾)𝐵𝑡−1
n = 8 years
𝐵𝑡 = (1 − 𝐾)𝑡 𝑃
K = 0.2
Bt = Book value of the asset at the end of the period t
Dt = Depreciation amount of asset for the period t

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 Declining Balance Method of Depreciation
End of the Year Depreciation Book Value
(t) (Dt) (Bt)
0 100000
1 20000 80000
2 16000 64000
3 12800 51200
4 10240 40960
5 8192 32768
6 6554 26214
7 5243 20971
8 4194 16777

Computing the depreciation and book value for period 5

𝐷𝑡 = 𝐾(1 − 𝐾)𝑡−1 𝑃 𝐵𝑡 = (1 − 𝐾)𝑡 𝑃
𝐷𝑡 = 0.2(1 − 0.2)4 × 100000 𝐵𝑡 = (1 − 0.2)4 × 100000
𝐷𝑡 = 𝑅𝑠. 8192 𝐵𝑡 = 𝑅𝑠. 32768

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 Sum-of-the-Years'-Digits Method of Depreciation
In this method, it is assumed that the book value of the asset
decreases at a decreasing rate.
The rate of depreciation charge for the first year is assumed as the
highest and then it decreases.
For any year, the depreciation is calculated by multiplying the
corresponding rate of depreciation with (P-F):
𝐷𝑡 = 𝑅𝑎𝑡𝑒 × (𝑃 − 𝐹)
𝐵𝑡 = 𝐵𝑡−1 − 𝐷𝑡
The formulae for Dt and Bt for a specific year t are as follows:
𝑛−𝑡+1
𝐷𝑡 = (𝑃 − 𝐹)
𝑛(𝑛 + 1)/2
𝑛−𝑡 𝑛−𝑡+1
𝐵𝑡 = 𝑃 − 𝐹 × +𝐹
𝑛 (𝑛 + 1)

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 Sum-of-the-Years'-Digits Method of Depreciation
Problem Statement 3: A company has purchased an equipment whose
first cost is Rs. 100000 with an estimated life of eight years. The
estimated salvage value of the equipment at the end of its lifetime is Rs.
20000. Determine the depreciation charge and book value at the end of
various years using the Sum-of-the-Years'-Digits method of
depreciation.
Sol.: P = Rs. 100000
F = Rs. 20000
n = 8 years
Bt = Book value of the asset at the end of the period t
Dt = Depreciation amount of asset for the period t

𝑛 𝑛+1 𝐷𝑡 = 𝑅𝑎𝑡𝑒 × (𝑃 − 𝐹)
𝑆𝑢𝑚 = = 36
2 𝐵𝑡 = 𝐵𝑡−1 − 𝐷𝑡

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 Sum-of-the-Years'-Digits Method of Depreciation
End of the Year Depreciation Book Value
(t) (Dt) (Bt)
0 100000
1 17777.77 82222.23
2 15555.55 66666.68
3 13333.33 53333.35
4 11111.11 42222.24
5 8888.88 33333.36
6 6666.66 26666.70
7 4444.44 22222.26
8 2222.22 20000.04

Computing the depreciation value for period 5

𝑛−𝑡+1 8−5+1
𝐷𝑡 = (𝑃 − 𝐹) 𝐷𝑡 = (100000 − 20000)
𝑛(𝑛 + 1)/2 8(8 + 1)/2
𝐷𝑡 = 𝑅𝑠. 8888.88

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 Sum-of-the-Years'-Digits Method of Depreciation
End of the Year Depreciation Book Value
(t) (Dt) (Bt)
0 100000
1 17777.77 82222.23
2 15555.55 66666.68
3 13333.33 53333.35
4 11111.11 42222.24
5 8888.88 33333.36
6 6666.66 26666.70
7 4444.44 22222.26
8 2222.22 20000.04

Computing the book value for period 5

𝑛−𝑡 𝑛−𝑡+1
𝐵𝑡 = 𝑃 − 𝐹 × +𝐹
𝑛 (𝑛 + 1)
8−5 8−5+1
𝐵𝑡 = 100000 − 20000 × + 20000 𝐵𝑡 = 33333.33
8 (8 + 1)
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 Sinking Fund Method of Depreciation
In this method, the book value decreases at increasing rates with respect to
the life of the asset.
The loss in value of the asset (P-F) 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 at the end of each period during the
lifetime of the asset.
𝐴
𝐴 = (𝑃 − 𝐹) × , 𝑖, 𝑛
𝐹
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.
𝐴 𝐹
𝐷𝑡 = 𝑃 − 𝐹 × , 𝑖, 𝑛 × , 𝑖, 𝑡 − 1
𝐹 𝑃
𝐴 𝐹
𝐵𝑡 = 𝑃 − 𝑃 − 𝐹 × , 𝑖, 𝑛 × , 𝑖, 𝑡
𝐹 𝐴

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 Sinking Fund Method of Depreciation
Problem Statement 4: A company has purchased an equipment whose
first cost is Rs. 100000 with an estimated life of eight years. The
estimated salvage value of the equipment at the end of its lifetime is Rs.
20000. Determine the depreciation charge and book value at the end of
various years using the Sinking method of depreciation with an interest
rate of 12%, compounded annually.
Sol.: P = Rs. 100000
F = Rs. 20000
n = 8 years
i = 12%
Bt = Book value of the asset at the end of the period t
Dt = Depreciation amount of asset for the period t

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 Sinking Fund Method of Depreciation
𝐴
𝐴 = (𝑃 − 𝐹) × , 𝑖, 𝑛
𝐹

𝐴
𝐴 = (𝑃 − 𝐹) × , 12%, 8
𝐹

𝐴 = (100000 − 20000) × 0.0813

𝐴 = 𝑅𝑠. 6504

The fixed amount of Rs.6504 will be 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. 6504
Depreciation at the end of year 2 (D2) = 6504 + (6504×0.12) = 7284.48
Depreciation at the end of year 3 (D3) = 6504 + ((6504+7284.48)×0.12) = 8158.62

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 Sinking Fund Method of Depreciation
End of the Year Fixed Depreciation Fixed Depreciation Book Value
(t) (Dt) (Bt)
0 6504 100000
1 6504 6504 93496
2 6504 7248.48 86211.52
3 6504 8158.62 78052.90
4 6504 9137.65 68915.25
5 6504 10234.17 58681.08
6 6504 11462.27 47218.81
7 6504 12837.74 34381.07
8 6504 14378.27 20002.80

Computing the depreciation value for period 5

𝐴 𝐹 𝐴 𝐹
𝐷𝑡 = 𝑃 − 𝐹 × , 𝑖, 𝑛 × , 𝑖, 𝑡 − 1 𝐷𝑡 = 𝑃 − 𝐹 × , 12%, 8 × , 12%, 5
𝐹 𝑃 𝐹 𝑃
𝐷𝑡 = 𝑅𝑠. 10237.30

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 Sinking Fund Method of Depreciation
End of the Year Fixed Depreciation Fixed Depreciation Book Value
(t) (Dt) (Bt)
0 6504 100000
1 6504 6504 93496
2 6504 7248.48 86211.52
3 6504 8158.62 78052.90
4 6504 9137.65 68915.25
5 6504 10234.17 58681.08
6 6504 11462.27 47218.81
7 6504 12837.74 34381.07
8 6504 14378.27 20002.80

Computing the book value for period 7

𝐴 𝐹
𝐵𝑡 = 𝑃 − 𝑃 − 𝐹 × , 𝑖, 𝑛 × , 𝑖, 𝑡
𝐹 𝐴 𝐵𝑡 = 𝑅𝑠. 34381.07
𝐴 𝐹
𝐵𝑡 = 𝑃 − 𝑃 − 𝐹 × , 12%, 8 × , 12%, 7
𝐹 𝐴
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 Service Output Method of Depreciation
In some situation, it may not be realistic to compute depreciation
based on time period. In such cases, the depreciation is computed
based on service rendered by an asset.
The depreciation is defined per unit of service rendered:

𝑃−𝐹
Depreciation/unit of service =
𝑋
where X is maximum capacity of service of the asset during its
lifetime
𝑃−𝐹
Depreciation for x units of service in a period = (𝑥)
𝑋
where x is the quantity of service rendered in a period

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 Service Output Method of Depreciation
Problem Statement 5: The first coat of a road laying machine is Rs.
8000000. Its salvage value after five years is Rs. 50000. The length of
road that can be laid by the machine during its lifetime is 75000km. In
its third year of operation, the length of road laid is 2000 km. Find the
depreciation of the equipment for that year.
Sol.: P = Rs. 8000000
F = Rs. 50000
X = 75000 km
x = 2000 km
𝑃−𝐹
Depreciation for x units of service in a period = (𝑥)
𝑋
8000000 − 50000
Depreciation for year 3 = (2000)
75000
= 𝑅𝑠. 212000

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 Capital Allowance
Capital allowance refers to the tax deduction that businesses can
claim on certain types of capital expenditure. These allowances are
typically provided by governments to encourage investment in
specific types of assets, such as machinery, equipment, or buildings,
which are essential for business operations.
Capital allowances serve to reduce a company's taxable income,
thereby lowering its tax liability. This, in turn, can incentivize
businesses to invest in new equipment or infrastructure by providing
them with a financial benefit in the form of tax savings.
Understanding capital allowances is crucial in engineering
economics because it affects the financial analysis of investment
projects.

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 Types of Capital Allowances
Initial Allowances: These are deductions that businesses can claim in
the year that the capital asset is purchased. Initial allowances provide
upfront tax relief, allowing companies to offset a portion of the asset's
cost against their taxable income immediately.
Annual Investment Allowances (AIA): AIAs enable businesses to claim
a deduction on a specified portion of their capital expenditure each year.
Unlike initial allowances, AIAs apply to a broader range of capital assets
and are often subject to annual limits set by tax authorities.
Writing Down Allowances (WDAs): WDAs represent the ongoing
depreciation of capital assets over their useful lives. Businesses can
claim WDAs annually based on the remaining value of the asset,
allowing them to gradually write off the cost of the asset against their
taxable income.

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 Items which Quality for Capital Allowances
The specific items that qualify for capital allowances can vary
depending on the tax laws and regulations of a particular
jurisdiction. However, generally, the following types of assets
commonly qualify for capital allowances:
Plant and Machinery
Fixtures and Fittings
Business Premises
Renewable Energy Assets
Research and Development (R&D) Assets
Intangible Assets
Environmental Assets

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