Lecture Notes

Unit 3: Asset Depreciation and Project Evaluation

Dr. Kapil Lakhera

I have tried to make sure that these notes are clear and correct but there is always room for
improvement. Please email corrections or suggested improvements at
[email protected].
Depreciation
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It
represents the portion of the asset's cost that has expired or been consumed due to usage, wear
and tear, passage of time, or obsolescence. By allocating depreciation each year, businesses ensure
that the asset's cost is spread across the accounting periods that benefit from its use. Depreciation
ensures that the cost of a long-term asset is gradually charged to the Profit and Loss Account each
year. This allocation reflects the asset’s decreasing value and aligns with the principle of matching
expenses with revenues.
Any asset which is purchased today will not work forever. This may be due to wear and tear of the
asset or obsolence of technology. Hence, it is to be replaced at the proper time for continuance of
any business. The replacement of the asset at the end of its life involves money. This must be
internally generated from the earnings of the asset. The recovery of money from the earnings of
an asset for its replacement purpose is called depreciation fund since we make an assumption that
the value of the asset decreases with the passage of time. Thus, the word depreciation means
decrease in value of any physical asset with the passage of time.

Related Concepts:

• Depreciation vs. Depletion

Depreciation is a broad term that applies to tangible assets such as machinery, furniture
and buildings.
Depletion is specific to the reduction of natural resources from assets like mines, oil wells
or quarries. It represents the diminishing availability of a resource and is a method of
calculating depreciation on these “wasting assets.”

• Depreciation vs. Amortization

Depreciation applies to tangible assets such as asset, buildings, and machinery.
Amortization applies to intangible assets such as patents, copyrights and goodwill,
systematically writing off the cost over time.

• Depreciation vs. Obsolescence

Obsolescence is a decrease in an asset’s usefulness due to technological advancements or
changes in style making the asset outdated or less effective.
Depreciation includes functional loss from regular wear and tear. Obsolescence is a
specific cause of depreciation, as it reduces an asset’s usability and value.

• Depreciation vs. Fluctuation

Fluctuation is a temporary change in an asset’s market price which can either increase or
decrease.
Depreciation is a permanent, systematic reduction in value. It reflects only decreases and
relates to the book value of an asset rather than market conditions.
Causes of Depreciation
1. Wear and Tear: Assets lose value due to regular use over time. This physical deterioration
results in a reduction of the asset's operational efficiency.
2. Passage of Time: The value of some assets decreases as they age. For instance, assets like
patents or leases lose value as they approach the end of their legal or useful life.
3. Obsolescence: Newer models or technologies may render older asset less useful or even
redundant. This reduction in utility results in a decline in the asset’s value.
4. Depletion: Some assets, such as natural resources (e.g., coal mines, oil reserves) reduced
in quantity due to continuous extraction. Depletion accounts for the reduction in available
resources.

Methods of Depreciation
There are several methods of accounting depreciation fund.
These are as follows:
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

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.
Here, we make an important assumption that inflation is absent.
Let
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 for the period t.
The formulae for depreciation and book value are as follows:
Dt = (P – F)/n
Bt = Bt–1 – Dt
 = P – t [(P – F)/n]

Example 1
A company has purchased an asset whose first cost is ₹ 1,00,000 with an estimated life of eight
years. The estimated salvage value of the asset at the end of its lifetime is ₹ 20,000. Determine the
depreciation charge and book value at the end of various years using the straight line method of
depreciation.
P = ₹ 1,00,000
F = ₹ 20,000
n = 8 years
Dt = (P – F)/n = (1,00,000 – 20,000)/8
= ₹ 10,000
In this method of depreciation, the value of Dt is the same for all the years. The calculations
pertaining to Bt for different values of t are summarized in Table.
Table Dt and Bt Values under Straight line Method of Depreciation
End of year Depreciation Book Value
(t) (Dt) (Bt = Bt–1 – Dt)
0 1,00,000
1 10,000 90,000
2 10,000 80,000
3 10,000 70,000
4 10,000 60,000
5 10,000 50,000
6 10,000 40,000
7 10,000 30,000
8 10,000 20,000

If we are interested in computing Dt and Bt for a specific period (t), the formulae can be used. In
this approach, it should be noted that the depreciation is the same for all the periods.
Example 2
Consider Example and compute the depreciation and the book value for period 5.
P = Rs. 1,00,000
F = Rs. 20,000 n = 8 years
D5 = (P – F)/n = (1,00,000 – 20,000)/8
= Rs. 10,000 (This is independent of the time period.)
Bt = P – t (P – F)/n
B5 = 1,00,000 – 5 (1,00,000 – 20,000)/8
 = Rs. 50,000
Declining Balance Method of Depreciation
In this method of depreciation, 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 a more realistic approach, since the depreciation charge decreases with the life of
the asset which matches with the earning potential of the asset.
The book value at the end of the life of the asset may not be exactly equal to the salvage value of
the asset. This is a major limitation of this approach.
Let
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,
K = a fixed percentage, and
Dt = depreciation amount at the end of the period t.
The formulae for depreciation and book value are as follows:
Dt = K Bt-1
Bt = Bt–1 – Dt
= Bt–1 – K Bt–1
= (1 – K) Bt–1
The formulae for depreciation and book value in terms of P are as follows:
Dt = K (1 – K) t–1
P Bt = (1 – K) t P
While availing income-tax exception for the depreciation amount paid in each year, the rate K is
limited to at the most 2/n. If this rate is used, then the corresponding approach is called the double
declining balance method of depreciation.
EXAMPLE 3
Consider Example 1 and demonstrate the calculations of the declining balance method of
depreciation by assuming 0.2 for K.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
K = 0.2
The calculations pertaining to Dt and Bt for different values of t are summarized in Table 9.2 using
the following formulae:
Dt = K Bt-1
Bt = Bt–1 – Dt
Table Dt and Bt according to Declining Balance Method of Depreciation
End of year Depreciation Book Value
(n) (Dt) (Bt = Bt–1 – Dt)
0 1,00,000.00
1 20,000.00 80,000.00
2 16,000.00 64,000.00
3 12,800.00 51,200.00
4 10,240.00 40,960.00
5 8,192.00 32,768.00
6 6,553.60 26,214.40
7 5,242.88 20,971.52
8 4,194.30 16,777.22

If we are interested in computing Dt and Bt for a specific period t, the respective formulae can be
used.
EXAMPLE 4
Consider Example 9.1 and calculate the depreciation and the book value for period 5 using the
declining balance method of depreciation by assuming 0.2 for K.
Solution
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
K = 0.2
Dt = K (1 – K) t–1 P
D5 = 0.2(1 – 0.2)4 1,00,000
= Rs. 8,192
Bt = Bt–1 – Dt P
B5 = = (1 – 0.2) 5 1,00,000
= Rs. 32,768
Project Evaluation Techniques: Present Worth Method, Future Worth Method
Present Worth Method
When evaluating investment projects or asset, selecting the best option requires comparing their
financial benefits or costs. The Present Worth (PW) Comparison Method provides a consistent
basis for this decision-making by translating future cash flows to a single reference point in time
known as “present worth” for a clear comparison. These comparisons are particularly essential
when the alternatives are mutually exclusive, meaning only one project can be selected.
Use of Present Worth

• Consistent Valuation: Currency values fluctuate over time, meaning that cash flows from
different periods aren’t directly comparable. For example, an investment of ₹1,000,000 in
2014 does not hold the same value as an equivalent amount in 2024 due to inflation and
time value differences.
• Decision Standardization: By converting all cash flows to a common point in time,
projects can be evaluated based on their economic value today, enabling standardized and
accurate comparisons across alternatives.
The Present Worth Method translates future cash flows of a project back to “time zero” (typically
the base period or current year) using a discount rate (rate of interest). By comparing these present
values, one can identify the project with the least cost or the highest return.
Key Decision Factors in Present Worth Comparisons:
1. Minimization of Costs: If the goal is to choose the most cost-effective option, select the
alternative with the lowest present worth.
2. Maximization of Profit: If the aim is to maximize returns, choose the project with the
highest present worth.
Assumptions in Present Worth Comparisons:
All cash flows (both inflows and outflows) are known.
• The period and rate of interest are given.
• The value of money remains constant over the time period.
• Calculations are based on pre-tax cash flows.
• Intangible factors are not considered in the decision.
• Fund availability is not a limiting factor in project selection.

Basis of Cash Flows in Present Worth Calculations

Cash flow calculations vary based on the nature of the project:
• Revenue-Dominated Cash Flow Streams: Cash inflows (such as revenues) dominate
marked with positive signs while outflows (costs) are negative.
 • Cost-Dominated Cash Flow Streams: Cash outflows dominate typically representing
project costs with revenues taking a negative sign.
Example of Present Worth Calculation:
Consider Project X, the cash flows of X are given, P is the initial investment, R1, R2, R3, R4
and R6 are the cash inflows for respective years and C5 is the additional investment amount in
year 5. Project X is revenue-dominated, represented as:
Year 0 1 2 3 4 5 6
Project X P R1 R2 R3 R4 C5 R6
𝑅1 𝑅2 𝑅3 𝑅4 𝑐5 𝑅6
𝑃𝑤(𝑥) = −𝑃 + + + + − +
(1 + ⅈ)1 (1 + ⅈ)2 (1 + ⅈ)3 (1 + ⅈ)4 (1 + ⅈ)5 (1 + ⅈ)6
Here:
• P = Initial investment
• R1, R2, R3, R4, R6 = Cash inflows in respective years
• C5 = Additional Investment in year 5
• i = Discount rate
• (1+i) n = Factor for converting future cash flows to present worth
Applications of the Present Worth Comparison Method
The Present Worth Method applies in different scenarios:
Case 1: Comparison of Assets/Projects with Equal Lives (Co-Terminated Assets)
When two projects, say X and Y have equal lifespans, the Present Worth method compares them.
For equal-life projects, an equal payment series present worth factor (P/A, i, n) can simplify
the calculation:
• If Pw (X) > Pw (Y), Project X is preferable.

Case 2: Comparison of Assets/Projects with Unequal Lives

For projects with different lifespans, two approaches apply:
1. Common Multiple Method (Repeated Project Method):
o Find the Least Common Multiple (LCM) of project lifespans, effectively simulating
the length of time over which both projects can repeat.
o This approach calculates the number of replacements each project would need
to reach the LCM period.
2. Study Period Method:
o Choose a fixed analysis period that ignores each project’s individual life.
 o Salvage Value: If a project extends beyond the study period, its residual or salvage
value at the end of the period is included in the calculation.
Case 3: Comparison of Assets/Projects with Infinite Lives
Some projects like dams, tunnels and rail infrastructure, provide utility over extended or “infinite”
periods. In these cases, use capitalized cost, which represents the initial investment plus the
present worth of all perpetual disbursements.
Formula:
𝑃 (1 + ⅈ)𝑛 − 1
=[ ]
𝐴, ⅈ, 𝑛 ⅈ(1 + ⅈ)𝑛
Case 4: Comparison of Deferred Investments
Deferred investments: projects postponed to a future date can also be evaluated with present worth
comparison. By discounting future cash flows to today’s value, this method assesses whether the
deferred investment offers advantages over immediate alternatives.

Future Worth Method

In contrast to present worth, the Future Worth Method calculates each cash flow’s future value
using a discount rate, aggregating them to find the total worth at a later date. The project with the
highest future worth value is typically the preferred option. FW method is also based on the same
conditions on which the Present Worth method is based.
Formula:
𝐹
𝐹𝑊 = 𝑃𝑤 ( )
𝑃, ⅈ, 𝑛
= 𝑃𝑤 (1 + ⅈ)𝑛
where:
• Fw = Future worth
• Pw = Present worth of the project
(F/P, i, n)
Cost Benefit Analysis: Concepts and Application in Economics
A Cost Benefit Analysis (CBA) (or benefit cost analysis) is a decision-making tool that attempts
to balance the components of a project in order to maximize its net benefits and/or minimize its
costs. In this analysis, costs of project factors are quantified that do not truly have monetary costs;
for example, loss of life is often assigned a monetary value. These values are then incorporated
into the analysis along with other financial costs.
Using CBA, decision makers try to either maximize benefits for a set cost, minimize costs for a set
level of benefit, or find the most beneficial compromise when both costs and benefits are variable.
For any project to be worthwhile, the benefits must exceed the costs.

Difference between Service Projects and Revenue Projects

A revenue project is one that will generate both costs and revenues over its project life. When
choosing between multiple revenue projects, the alternative with the highest NPV is chosen.
Nearly every example we have discussed so far in this text fits the definition of a revenue project.
A service project is one that will generate costs, but not revenues, over its project life, or whose
revenues are constant regardless of the project alternative chosen. When choosing between
multiple service projects, the alternative that performs the service at the lowest cost is chosen.
For example, a city contracts a company for residential garbage collection. Since the program
generates no revenue for the city, when contracting a company to run the collection program, it
should choose the business that will run the program at the lowest cost, or do it themselves.
Framework for Benefit-Cost Analysis
Step 1: Evaluating User Benefits
The first step in performing a CBA is to identify the impacts that a project will have on its users
or stakeholders. We identify these impacts as benefits if they are positive, and costs if they are
negative.
It can be useful to rank these benefits and Costs as primary or secondary, in order to understand
their relative importance. Primary impacts are those that have a direct impact, while secondary
impacts might have an indirect impact. For example, the primary benefit of having a mountain
rescue service is that lost skiers are rescued. A secondary benefit is that knowing such a service
exists makes people feel safer about going skiing, and thus encourages tourism. When the benefits
and Costs of a project are directly quantifiable, we find the total value of the benefits for a project
with the following equation:
Total Benefits (B) = Σ(Benefits) – Σ(Costs)
To ensure a complete evaluation of benefits, it is necessary to be diligent when identifying all users
or stakeholders of a project, and the full range of effects they will experience. For example,
consider a city which plans to construct a new athletics stadium. The benefits would include
improved facilities for local sports teams (and their fans), a new space for civic, educational, and
corporate events, the opportunity to boost tourism and local industry by hosting larger events,
new jobs created in constructing and operating the stadium, and potentially many other positive
effects. Costs could include traffic delays surrounding the new stadium, or higher ticket prices for
events than at the existing facility. In order to properly assess any large project like this, the process
of identifying and ranking user benefits must be thorough and deliberate (and can be quite time
consuming).
Step 2: Evaluating Costs
After evaluating the benefits of a project, the costs are considered, which make up the other half
of our benefit-cost analysis. Since these costs are often strictly financial, they can be more tangible
to calculate than the benefits. It is important to realize that the total costs for a project also
incorporate any revenue generated by the project. We find the value of the costs for a project using
the following equation:
Total Costs (C) = (Capital Cost) + (Operating & Maintenance Cost)
With our example of a new athletics stadium, the costs would be fairly straightforward to
determine. There would be capital costs for the land acquisition and construction of the new
building, operating and maintenance costs for its upkeep and revenue produced from event ticket
sales or rental fees of the facility
Step 3: Quantifying Benefits and Costs
While the equations listed above may make this process look uncomplicated, they gloss over the
most difficult aspect of benefit-cost analysis: quantifying the benefits and Costs. In the example
of a new stadium, which would (among other impacts) create new employment opportunities and
cause traffic delays. These benefits and Costs are easy to list off, but difficult to assign monetary
amounts to.
How much is the creation of a new job in the maintenance and operation of the stadium worth to
the city? What is the equivalent cost of an added 20-minute delay per commuter during a peak
traffic time for the stadium? How will the increased tourism from the stadium translate into
increased business for local hotels, restaurants, etc.? These questions do not have straightforward
answers. However, since CBA requires us to quantify these kinds of abstract impacts, we need to
determine an approach that suits our scenario.
The two basic approaches to quantifying benefits/Costs are

• to determine the willingness to pay of consumers, or

• to set performance metrics for certain impacts of the project.
1. Willingness to pay
Willingness to pay is the highest price that the average consumer would be willing to pay to
obtain a product or service, or to avoid a negative outcome. For instance, imagine an open-air
Youth festival where one vendor is selling umbrellas. On one day, the vendor might find they can
only charge ₹150 per umbrella, and that their sales decline sharply if they raise their prices any
higher. However, if a sudden rainstorm strikes the festival, they might be able to raise their prices
to ₹250 per umbrella, because the willingness to pay of their consumers has been affected by their
circumstances.
In this case, we would say that the value of the umbrellas was found using the revealed preference
technique. This means that the customers of the umbrella vendor were revealing the value of the
umbrellas through their purchasing habits. If the price were too high, and the average festival-goer
would prefer to save their money and get rained on, then the umbrella would not be worth that
amount. If most consumers would gladly exchange the listed price for an umbrella, then the price
is acceptable or could be increased.
The alternative to the revealed preference technique is the stated preference technique. This
approach relies on surveying consumers directly about their willingness to pay. The advantage of
this technique is that it gives straightforward answers that can be directly applicable to the situation
at hand. Would you change laundry detergent brands if there was an alternative ₹2 cheaper? How
much more would you be willing to pay for internet if your provider upgraded to a high-speed,
fiber-optic network? Would a new tax on cigarettes impact your decision to quit (or begin)
smoking? Would increased ticket prices for speeding cause you to change your driving habits?
The drawback of this approach is that consumers stated preferences do not always line up well
with their actual preferences. For the examples above, a consumer might say they’d switch to a
cheaper detergent, but in practice stay with their usual brand out of habit. They might also
underestimate their preference for faster internet, overestimate their ability to quit smoking, and
quickly forget about the increased speeding fines (until they get written their first ticket). In short,
the stated preference technique can be useful for determining willingness to pay, but is not a
foolproof option.
2. Performance Metrics
Another commonly used approach for determining the value of a cost or benefit is to set
performance metrics for the impacts of a project. For example, when transportation engineers
compare alternative roadway designs, they calculate the expected number of crashes for each
design and the severity of those crashes. Most often, the crashes are classified as either “fatal”
crashes, “injury” crashes, or “property damage only (PDO)” crashes and a certain monetary value
is assigned to each type of crash based on the severity of the damage done (e.g., a “PDO” crash
might be valued around ₹1000, and a fatal crash might be valued around ₹1,000,000). Then, by
multiplying these values by the expected number of crashes, the relative cost savings (also
representing human safety) can be compared to the price to inform whether a project is
worthwhile.
For a project with environmental impacts, there are many possible routes for evaluation. If a
project generates some kind of pollutant, the metric could be based on the cost of removing that
pollutant from the ecosystem or on the contributing cost to the healthcare system for any negative
health outcomes it encourages (e.g., more air pollution might lead to increased respiratory
problems). Carbon pricing methods like a carbon tax or a cap-and-trade system are examples of a
government attaching a cost metric to an environmental impact (in this case, CO2 emissions) in
order to have businesses consider their environmental effects as a tangible cost.
Assigning performance metrics to determine the value of a cost or benefit is not an exact science,
and for any given benefit there are likely to be many different ways of quantifying it. The important
factor is to quantify the effect on the basis of a logically related cost and to arrive at a performance
metric that scales appropriately with the importance of the impact.
Step 4: Determining Social Discount Rate
Many financial evaluation methods are very sensitive to the discount rate applied during analysis.
Setting an appropriate interest rate is a vital step in determining the value of any project. Cost
benefit analysis is no different. When performing analysis for a services project, we refer to the
discount rate as a social discount rate.
The social discount rate is set slightly differently than other discount rates we have discussed
previously. There are two basic approaches to setting the rate, depending on whether the project
has private sector involvement:
1. For a fully public sector project, the social discount rate should reflect only the
prevailing government borrowing rate.
2. For a project with private counterparts, the social discount rate should reflect the rate
that could have been earned had the funds not been removed from the private
sector.
Once the social discount rate has been set, it is used in the same way as the discount rate for any
other project: to discount cash flows from different points in the project to a common time frame.
Step 5: Evaluating Results
Once the benefits and costs of a project have been determined, there are two commonly used
indicators for evaluating the project: the cost benefit ratio and the profitability index.
1. Cost Benefit Ratio
The cost benefit ratio or benefit cost ratio for a project is the present value of the project’s
benefits divided by the present value of its costs ensuring all costs and benefits are compared
during the same time scale is an important consideration of this process. Any future amounts can
be converted to present values using the determined social discount rate.

If the benefit cost ratio is greater than 1 (i.e., the benefits are greater than the costs), then the
project should be accepted. If it is less than 1, then the project should be rejected.
2. Profitability Index
The profitability index (PI) for a project is slightly different from the cost benefit ratio, since it
considers costs and benefits on an annual basis and incorporates the capital investment cost of
project separately. Again, the costs and benefits associated with the project must all be considered
at their present values.
As with the benefit cost ratio, if the PI is greater than 1, the project should be accepted. Otherwise,
the project should be rejected.
Comparing Multiple Projects
In case of performing cost benefit analyses to find the best alternative for the expansion of an
existing airport. Five alternatives were considered, which returned benefit cost ratios of 1.2, 0.8,
1.15, 1.3, and 0.95. One might assume that the alternative with the 1.3 benefit-cost ratio is the best
alternative, since it has the highest ratio. However, the best approach in this situation is to use an
incremental analysis technique, consisting of the following steps:
1. Eliminate any alternatives with benefit-cost ratios less than 1.
2. Arrange the remaining alternatives from lowest cost to highest cost.
3. Compute the incremental differences from the paired alternatives.
4. Compute the benefit cost ratio again based on the incremental benefits and costs.
5. Compare the chosen alternative to the next alternative.
This technique is best demonstrated using an example. Let’s look at the airport expansion example
from above, but in greater detail. Using the data provided below, let’s walk through the steps of
this analysis.
Initial Benefit/Cost
Alternative Benefits Costs
Investment Ratio
A ₹10,00,000 ₹48,000 ₹40,000 1.2
B ₹15,00,000 ₹48,000 ₹60,000 0.8
C ₹8,00,000 ₹40,250 ₹35,000 1.15
D ₹12,50,000 ₹58,500 ₹45,000 1.3
E ₹7,50,000 ₹33,250 ₹35,000 0.95

1. Eliminate any alternatives with benefit-cost ratios less than 1.

This leaves us with alternatives A, C, and D.
2. Arrange the remaining alternatives from lowest cost to highest cost.
This leaves us with the following table of results:
Initial Benefit/Cost
Alternative Benefits Costs
Investment Ratio
C ₹800,000 ₹40,250 ₹35,000 1.15
A ₹1,000,000 ₹48,000 ₹40,000 1.2

D ₹1,250,000 ₹58,500 ₹45,000 1.3

3. Compute the incremental differences from the paired alternatives.

4. Compute the benefit cost ratio again based on the incremental benefits and costs.
5.Compare the chosen alternative to the next alternative.