Project Financial Appraisal

School of Civil and Environmental
Engineering
COTM 5104: CONSTRUCTION MANAGEMENT
Chapter 3
Project Financial Appraisal
Contents
Project Financial Appraisal
1. General
2. Time Value of Money
3. Financial Appraisal Methods
4. Depreciation
1. General
1.1 Basic Definitions
1.1.1 Asset
Assets represents how much a company owns at a given
time of reporting usually, it is within the budget year.
Assets are divided into:
Current assets: include cash at hand other assets which

can easily be converted into cash in less than a year (e.g.
cash at hand, accounts receivable).
Fixed assets: permanent properties which cant be easily

converted into cash within a year (e.g. land, equipment,
buildings).
Other assets: include other investments and good will.
1. General
1.1 Basic Definitions
1.1.2 Liabilities
Liabilities represents what the company owes like loans,
debts etc.
Liabilities are divided into:
Current liabilities: debts to be settled in a short period of

time.
Other liabilities: includes long term loans, performance

bonds, wages, etc.
1.1.3 Stakeholders Equity
Stakeholders equity (capital) represents the capital
provided by owners of the company.
1. General
1.2 Basic Finance Notes
1.2.1 Balance Sheet
The balance sheet is a statement which shows the
financial position of a company at the end of a certain
reporting period, which is the fiscal year.
It mainly shows the assets, liabilities and stockholders
equity, based on the accounting equations:
Assets = Liabilities + Owners equity
1.2.2 Profit
Profit is an earning of a given period concerned whether
or not they have been received minus the expenses of the
same period whether or not they have been paid.
1. General
1.2.3 Income Statement
This is a form of financial statement that shows whether
the company has made or lost money during that
reporting period.
Income statements can be prepared monthly, quarterly,
etc. However, usual accounting periods extend to one
year, which is the fiscal year.
In the income statement one shows or itemizes:
Revenues and net sales;
Production costs and gross margin;
Gross profit and net profit; and
Earning per share.

6
1. General
1.2.4 Cash Flow Statement
The income statement shows how much the company has
lost or gained, but does not indicate financing and
investment activities during the period.
Cash flow statement show how the company generated
the cash and how it has spent or utilized it.
1.2.5 Retained Earnings
This is money which is retained from the net profit to be
used for expansion purposes or saved as security for
risks. The remaining balance, which is net profit minus
retained earnings, will be given as dividend to owners.

2.1 Basic Concepts and Terminologies
2.1.1 Basic Concepts
The concept of the time value of money is as old as money
itself money costs money.
Because money has both earning power and purchasing power
over time
Money has a time value because its purchasing power changes
over time (inflation).
Time value of money is measured in terms of interest rate.
Interest is the cost of money i.e. a cost to the borrower and an
earning to the lender.
Example : to buy refrigerator= $100 , if u invest it at annual interest rate

=6% and if Inflation rate =8% , inf. rate =4%. Analyze it .
8

2.1 Basic Concepts and Terminologies
2.1.2 Terminologies
P (Principal): Initial amount of money invested or borrowed.
i (Interest rate): expressed as a percentage per period of
time.
n (Interest period): determines how frequently interest is
calculated.
N (Number of interest periods): duration of transaction.
An (a plan for receipts or disbursements): a particular cash
flow pattern.
F (Future Amount): cumulative effects of the interest.

2.2 Cash Flow Diagrams
The graphic presentation of the costs and benefits over the
time is called the cash flow diagram. It is a presentation of
what costs have to be incurred and what benefits are received
at all points in time.
The following conventions are used in the construction of the
cash flow diagram:
The horizontal axis represents time;
The vertical axis represents costs and benefits;
Costs are shown by downward arrows; and
Benefits are shown by upward arrows.

All the benefits and/or costs incurred during a period are
assumed to have been incurred at the end of that period. Since
the period is normally a year, this is called the ''end of the
year" rule.
10

2.2 Cash Flow Diagrams
cash flows with in a given period of time .
Cash Flow
Receipt
Time
Disbursements
The two computational schemes for calculating this earned interest yield
either simple interest or compound interest.
11

2.3 Methods of Calculating Interest
2.3.1 Simple Interest
Simple interest is the practice of charging an interest rate
only to an initial sum (principal amount).
Fn = P+ (iP) N = P(1+i N)
Example: calculate the future value of ETB 1,500 at the end
of three years with an interest rate of 9%.
Table 1: Simple Interest Calculation.
End of
Year
Beginning
Balance (P)
Interest
(I = 9%)
Ending
Balance (F)
1, 500
1, 500
135
1, 635
1, 635
135
1, 770
1, 770
135
1, 905
12

2.3.2 Compound Interest
Compound interest is the practice of charging an interest rate to an

initial sum and to any previously accumulated interest that has not
been withdrawn.
the entire amount (principal and interest) will be compounded. the
factor (1 + i)N is known as the compound-amount factor.
P(l + i)(l + i) = P(l + i)2.
End of Year
Beginning
Balance (P)
Interest
(I = 9%)
Ending
Balance (F)
1, 500
1, 500
135
1, 635
1, 635
147.15
1, 782.15
1, 782.15
160.40
1, 942.55
13

Compounding Process of compound interest is shown below.
F = $1,500(1+0.09)3
= $1,942.54
$1,942.54
$1,500
14

Compound interest compounding Process equation
derivation.
n 0: P
n 1: F1 P (1 i )
n 2 : F2 F1 (1 i ) P (1 i ) 2
M
n N : F P (1 i )
15

2.3.3 Equivalence Calculation
Equivalence calculations are usually made to compare
alternatives.
Equivalence:-Interest formulas allow us to place different cash
flows received at different times in the same time frame and to
compare them.
There are certain rules that one should follow to make these
calculations.
They need to have a common time basis;
Equivalence is dependent on interest rate; and.
16

2.4 Interest Formula in Different Cash Flow Categories
2.4.1 Single Cash Flows
2.4.1.1 Future (Compound) Sum
F = P(1+i)n (1+i)n Single Payment Compound (Growth)
Amount Factor
= P(F/P, i, n)
Example: If you had $2,000 now and invested it at 10%,
how much would it be worth in 8 years?
F=?
i = 10%
0
$2,000
8
17

2.4.1.1 Future (Compound) Sum
F
Given: P = $2,000
I = 10%
F P(1 i ) N
N = 8 Years
F P( F / P, i, N )
Reqd :-F
0
Solution: F = $2,000(1+0.10)8
F = $2,000 (P/F, 10%, 8)
N
F = $4,287.18
Using compound-interest tables: page 510,The interest tables can be used to locate the
compound-amount factor for i = 10% and N = 8.P
F = P(F/P, i, N).
F= P(F/P, 10%, 8)
18
Contd
#1. Suppose you buy a share of stock for $10 and sell it for $20; If your
investment takes five years, what would be the rate of return on your
investment?
Given: P = $10, F = $20, and N = 5. Find: i.

Method 1: Go through a trial-and-error process in which you insert
different values of i = 14.87%.
Method 2: You can solve the problem by using the interest tables
F = P(1+i)n
,20= 10(1+i)5
Now look across the N = 5 row under the (F/P, i, 5) column until
you can locate the value of 2.This value is approximated in the 15%
interest table at (F/P, 15%, 5) = 2.0114.
19
Contd
#2.
You have just purchased 100 shares of General Electric stock at

$30 per share. You will sell the stock when its market price doubles.
If you expect the stock price to increase 12% per year, how long
do you expect to wait before selling the stock ?
#2. Given: P = $3,000, F = $6,000, and i = 12% per year.
Find: N (years).
Tables ?
calculator ? N=6
20

2.4.1.2 Present Worth (Discount) Sum
P = F(1+i)-n (1+i)-n Single payment Present Worth
(Discount) Factor
F
= F(P/F, i, n)
Given: F = $1,000
P F(1 i ) N
i = 12%
P F( P / F, i, N )
N = 5 Years
0
Reqd: P
N
Solution: P = $1,000(1+0.12)-5
P = $1,000 (F/P, 12%, 5)
P
P = $567.40
21

2.4.2 Multiple Payments
2.4.2.1 Uneven Payment Series
Example: how much do you need to deposit today (P) to
withdraw $25,000 at n =1, $3,000 at n = 2, and $5,000 at
n =4, if your account earns 10% annual interest?
$25,000
$3,000
0
1
$5,000
P
22

2.4.2.1 Uneven Payment Series
$25,000
$5,000
$3,000
0
$25,000
$5,000
$3,000
0
1
0
1
P2
$22, 727
P4
P1
P1 $25, 000( P / F ,10%,1)
P2 $3, 000( P / F ,10%, 2)

$2, 479
P P1 P2 P3 $28, 622
P4 $5, 000( P / F ,10%, 4)

$3, 415
23

2.4.2.2 Uniform (Equal) Payment Series
F
P
0
N
24

A. Compound Amount Factor (Future Value/Annuity)
F
A(1+i)N-2
A
A
A(1+i)N-1
F A(1 i ) N 1 A(1 i ) N 2 L A
25

Example:
Given: A = $5,000, N = 5 years, and i = 6%
Reqd: F
Solution: F = $5,000(F/A,6%,5) = $28,185.46
F
0
(1 i ) N 1
F A
i
A( F / A, i , N )
26

$5,000(1 0.06) 4 $6,312.38

$5,000(1 0.06)3 $5,955.08
$5,000(1 0.06) 2 $5,618.00
$5,000(1 0.06)1 $5,300.00
$5,000(1 0.06)0 $5,000.00
$28.185.46
27

B. Sinking Fund Factor
Example: College Savings Plan
Given: F = $100,000, N = 8 years, and i = 7%
Reqd: A
Solution: A = $100,000(A/F,7%,8) = $9,746.78
F
0
AF
3
N
1 i
1
F ( A / F , i, N )
28

C. Capital Recovery Factor
Example: Paying Off Education Loan
Given: P = $21,061.82, N = 5 years, and i = 6%
Reqd: A
Solution: A = $21,061.82(A/P,6%,5) = $5,000
P
1
3
N
A=?
i (1 i ) N
A P
(1 i ) N 1
P( A / P, i , N )
29

D. Present Worth Factor
Example: Powerball Lottery
Given: A = $7.92M, N = 25 years, and i = 8%
Reqd: P
Solution: P = $7.92M(P/A,8%,25) = $84.54M
P=?
1
3
N
1 i 1
PA
N
i 1 i
A( P / A, i, N )
30

E. Present Worth of Perpetuities
Perpetuity: A stream of cash flows that continues
forever.
P=?
1
A
P
i
A
31
Contd
2.4.2.3
Gradient Series
1. Linear Gradient Series .
2. Geometric Gradient Series

Linear Gradient Series
Sometimes cash flows will vary linearly, that is, they increase or decrease
by a set amount, G, the gradient amount. This type of series is known as a
strict gradient series.
Note that each payment is An = (n - 1)G.
the series begins with a zero cash flow at the end of period zero.
If G > 0. the series is referred to as an increasing gradient series. If G < 0, it

is referred to as a decreasing gradient series.
as a composite series, or a set of two cash flows. Two types of linear

gradient series as composites of a uniform series of N payments of A, and
a gradient series of increments of a constant amount G.
32

2.4.2.3 Gradient Series
A. Linear Gradient Series
(1 i) N iN 1
P G
2
N
i (1 i)
G ( P / G , i, N )
P
33

A. Linear Gradient Series
Example: Present value calculation for a gradient series
How much do you have to deposit now in a savings
account that earns a 12% annual interest, if you want to
withdraw the annual series as shown in the figure? $2,000
$1,750
$1,250 $1,500
$1,000
0
P =?
5
34

B. Gradient Series as a Composite Series
35
Contd
Geometric Gradient Series
Another
kind of gradient series is formed when the series in a

cash flow is determined not by some fixed amount like $250, but
by some fixed rate expressed as a percentage.
involve cash flows that increase or decrease over time by a constant
percentage (geometric), a process that is called compound growth.
Price changes caused by inflation are a good example of such a
geometric series.
An = A1(1 + g)^(n-1)
The g can take either a positive or a negative sign, depending on the
type of cash flow.
If g > 0. the series will increase: if g < 0, the series will decrease.
36

2.4.2.3 Gradient Series C. Geometric Gradient Series
Given: Al = $50.000, g = 5%. i = 7%, and N = 25 years, Find: P ?

37

2.4.2.3 Gradient Series Geometric Gradient Series
Present Worth Factor,
1 (1 g ) N (1 i ) N
A1
N
A1
1 i
if i g
if i g
38
Contd
Suppose
that your retirement benefits during your first year of

retirement are $50.000. However, your cost of living is
expected to increase at an annual rate of 5%, due to inflation.
Suppose you expect to receive cost-of-living adjustment in
your retirement pension., If your savings account earns 7%
interest a year, how much should you set aside before
hand(now )in order to get this payments both the cost of living
adjustment and the constant money of your penstion for the
over 25 years?
Given: Al = $50.000, g = 5%. i = 7%, and N = 25 years,.
Find: P.?
P=$940,696
39

2.5 Standard Factors for Economic Analysis
40

.
proper planning is now vital. It serves as a guideline, which is

flexible enough to accommodate the changes and be used for
checking planned against the actual executed work.
The amount of detailing in planning is likely to be the

function of the size of the firm, the complexity of the project
and the expertise of the management.
41

3.1 Investment Alternatives
There are two categories of investment alternatives while
dealing with multiple alternatives.
Independent Investment: This means that a decision on
one investment does not affect the other.
Mutually Exclusive Investment: In this case acceptance
of one automatically eliminates the others.
In this section only mutually exclusive alternatives are
considered for subsequent discussions.
42

3.2 Financial (Investment) Appraisal Methods
The common methods used for financial appraisal of
projects are:
Straight cost Method;
Pay back Method;
Rate of return Method;
Benefit - Cost Ratio;
Present worth or Net Present Value Method;
Future Value Method;
Annual Equivalent Cost Method; and
Internal Rate of Return Method.
43

2.1 Straight Cost Method
Compares the initial investment/immediate costs only.
E.g. Loader A ETB 4,500,000
Loader B ETB 5,000,000
Loader A
2.2 Payback Method
A simple crude method for getting a quick evaluation of the
alternatives is to calculate how long it takes to recover the
initial investment.
The time in any unit that it takes to recover the initial
investment is called the payback period.
It is obvious that the payback period neglects the time value of
money and is only accurate when the interest rate is zero.
Even with this shortcoming, many analysts consider this
method to be a useful quick way of comparison.
44

2.2 Payback Method
This method uses the number of years it takes to pay back
the initial investments from profits of the investment.
In computing the pay back period one can either consider
time value of money or disregard it.
When one considers time value of money, it is called
discounted payback method, otherwise it is conventional.
45

2.2 Payback Method
Example: For a dozer purchased at a cost of ETB 3.5 million,
determine the pay back period if the hourly rental rate is
900birr/hr and the cost for fuel, operator and maintains is
150birr/hr with 5 years of economic life.
Solution:
Yearly profit = (900-150) 8312 = ETB 1,872,000
Year
0
1
2
3
4
5
Cash Flow
-3,500,000
1,872,000
1,872,000Pay Back Period = 2yrs
1,872,000
1.872,000
1,872,000
46

2.3 Rate of Return Method
This method uses percentage of the average annual return
to the initial investment as:Rate of return =
Average. Annual. Re turn

100
Capital .Invested
Example: If the dozer given in the pay back problem can

have a life span of four years, determine the rate of
return.
Solution:
Rate of
1 / 4(1,872,000 1,872,000 1,872,000 1.872,000)

100
return=
3,500,000
=53.5%
47

2.4 Benefit Cost Ratio
Another method of assessing the viability of a system or
comparing several systems is to calculate the net present
value of the costs and the benefits and obtain the benefitcost ratio (B/C).
If this ratio is greater than one, then the project is
profitable.
B/C > 1 Accept;
B/C = 1 Indifferent; and
B/C < 1 Reject.
48

2.5 Present Worth (Net Present Value) Method
In this case all disbursements and receipts are brought to
their net present worth and the comparison of their
present worth is made.
In the present value method, the present time (time zero or
start of year 1) equivalent value of all the costs and
benefits incurred during the life of the system or the
project is calculated using a specific interest rate.
In this method all cash inflows and outflows of a given
project (having a given project life) are brought to time 0.
If the difference between the inflows minus the outflows
is positive then the project is acceptable.
If it is to compare among various projects, the one having
more positive value is economically the best alternative.
49

In order to evaluate projects one need to use discounted
cash flow techniques (DCF). One of these is the method of
net present worth (NPW) or net present value (NPV).
In
Ci
CSn
PW costs = Ci + CSn(P/A, i ,n)

PW incomes = In (P/A, i, n) + S (P/F, i, n)
NPW(NPV) = PW incomes - PW costs
50

Example 1
A construction company wants to introduce a new system of
billing/preparing invoices for payment certificates for the next 5yrs
after which the company will consider other new options shown
below. Two alternatives with identical capacities and job are
available.
Model A: It is semi-automatic that costs ETB 112,500 which lasts 3yrs
with annual operation and maintenance cost of 45,000 having a
salvage value of 18,000.
Model B: It is a complete automatic that costs ETB 135,000 which lasts
4yrs with annual operation and maintenance cost of 36,000 having
a salvage value of 13,500.
if a yearly revenue of ETB 54,000 is obtained for both models.
Which model is acceptable if the interest rate is 15%?

51

2.6 Future Worth (Net Future Value) Method
A corollary to the present value and net present worth is the
future value and the net future worth (NFW).
In this method all cash inflows and outflows of a given project
(having a given project life) are brought to time n. If the
difference between the inflows minus the outflows is positive
then the project is acceptable.
If it is to compare among various projects, the one having
more positive value is economically the best alternative.
52

2.7 Annual Equivalent Worth Method
In this case all the cash flow is converted to an equal
uniform series of cost or income.
Then for mutual exclusive alternatives, the one with higher
annual income or lower annual cost will be opted.
This helps to determine an investments worth in terms of
equal annual basis.
The main benefits of this method are:
Report format;
Need for unit cost/benefit analysis; and
Ease of analysis for mutually exclusive projects with

unequal project lives, as long as identical repetition is to be
made.
Example 3: Compute the AE of Example 1
53
Contd
Contd
54

2.8 Internal Rate of Return (IRR) Method
The internal rate of return, IRR is that interest rate at
which future cash flows when discounted will equate to
the initial investment i.e. their present value will be zero.
If IRR is Internal Rate of Return and MARR is the
Minimum Attractive Rate of Return (Market Interest
Rate), then if :
IRR > MARR Accept;
IRR = MARR Indifferent; and
IRR < MARR Reject.
55
4. Depreciation
IRR is the interest which makes the summation of present
worth value to be zero.
A
A
0 1 .... An
n
0 1
1 i
1 i
1 i
n An
n
PW
0;i IRR
n
i
0 1 i
0
PW i
This expression only works for cash flows with 3yrs of

life. Cash flow projecting beyond three years involve
complex polynomial functions.
56

Computation of IRR
Plot the PW cash flow against interest (horizontal axis).
A. Simple Investment
Pw
B. Non-simple Investment
57

Computation of IRR
2.8.1 Direct Solution Method
This applies when either there is only two flow
transaction of cash flow series or when the projects
service life doesnt exceed 2 yrs.
Example: consider the following cash flow and compute
the IRR for both options.
n
-8,000
-16,000
10,400
12,000
12,000
58

Computation of IRR
2.8.1 Direct Solution Method
Solution:
Project A:
PW (i) = -8000 + 12,000 (P/F, i, 4) = 0
- 8000 +12000/(1+i)4 = 0 (1+i)4 = i= 10.6681%
Project B:
PW (i) = -16,000 + 10000/ (1+i)1 + 12000/ (1+i)2 = 0
-16,000 (1+i)2 + 10,000 (1+i) + 12,000 = 0
16i2 21.62 6.4 = 0
i = -1.6 = -160%; not feasible
i = 0.25 = 25%; therefore, i =25%
59

Computation of IRR
2.8.2 Trial and Error Approach
In this method, assume a certain value for i and compute
PW(i) = 0.
PW(i) PWi > 0-increase i
PWi < 0- decrease i

The computation process proceeds until PW(i) = 0.
60

Computation of IRR
2.8.3 Incremental Analysis: two alternatives
IRR method cant give a clue on the best alternative
when used for investment analysis.
Thus it is recommended to use the incremental analysis.
It is done in such a way that by projecting a cash flow
which is the difference of cash flows of the alternatives
presented for comparative analysis.
61

Computation of IRR
2.8.3 Incremental Analysis
Example: Select a better option if MARR = 10%.
Yr
B-A
-3,000
-12,000
-9,000
1,350
4,200
2,800
1,800
6,225
4,425
1,500
6,330
4,830
25%
17.43%
15%
IRR
Alternative B is selected
Selection Criterion:IRR (B-A) > MARR - select B
IRR (B-A) < MARR - select A
IRR (B-A) = MARR - select either
62

Computation of IRR
2.8.3 Incremental Analysis: alternatives more than two
Considering two at a time, the selection can be easily carried
out.
YrA
B-A C-B
-1,000
-1,000
-2,000
900
600
900
-300
300
500
500
900
400
100
500
900
400
400
50
900
50
IRR
100
21% 26.3%
0 -1,000
800
First Comparison:- Alternative B is better, reject A

Second Comparison:- Alternative C is better; therefore
Alternative C is acceptable.
63

2.9 Source of Finance
Collateral base of the domestic construction industry is
very weak.
There are two broad choices for financing construction
projects where as a combination of the two is also
possible:
Equity Financing;
Debt Financing; and
Hybrid of equity and debt.
64

2.9.1 Equity Financing
Share company:- retained earnings.
Private company:- re-investment of profits.
Issuance of Stocks:- Eg. Ayat Real Estate a couple of
years ago.
2.9.2 Debt Financing
It can be grouped in to three main categories:
Short term (up to one year);
Medium term ( 1-5 years); and
Long term (>5 years).
65

A. Short Term Financing
It requires more working capital (operating cost).
The current asset need to be much greater than current
liability to come up with a positive working capital.
When negative working capital encountered; the
following measures usually taken:
Delay wage payments and salaries;
Delay credit payment; and
Selling some fixed assets.
AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.
66

Short term financing schemes:
Bank overdraft;
Trade credit; and
Factoring.
i. Bank Overdraft
It has high interest rate.
If not paid, the company will be liquidated and declare
bankruptcy where the client will be sued.
67

ii. Trade Credit
Acquire supply of materials on a credit basis.
Depends on the credibility of the company.
It has no interest.
iii. Factoring
Delegating another company to fix the credit and collect
the revenues of the company; and finally share the profit
as per the agreement.
68

B. Medium Term Financing
Bank loans.
Sale and lease back.
C. Long Term Financing
Bank loans (International Bank loans).
Bond Financing.
Joint Venture Financing: due to size of the project and its
associated risk where:
Risk shared;
Good opportunity to knowledge;
Capital and material combined; and
Reduces competition.
69
4. Depreciation
4.1 Definition and Requirements
4.1.1 Depreciation: Definition
The number of years over which a machine is depreciated
is called its depreciable life.
Depreciation is a business expense the government
allows to offset the loss in value of business assets.
Depreciation deductions reduce the taxable income of
businesses and thus reduce the amount of tax paid.
Accountants define depreciation as follows:
the systematic allocation of the cost of an asset over
its useful, or depreciable life.
The latter definition is used for determining taxable
income hence, income taxes.
70
4. Depreciation
4.1 Definition and Requirements
4.1.2 Depreciation Requirements
In general business assets can only be depreciated if they
meet the following basic requirements:
The property must have a useful life that can be

determined, and this life must be longer than one year.
The property must be an asset that decays, gets used up,

wears out, becomes obsolete, or loses value to the owner
due to natural causes.
71
4. Depreciation
4.2 Depreciation Causes
Due to use and obsolescence every equipment loses its
value. This loss is accounted for by depreciating the
equipment every year. Depreciation is a decrease in
value of an asset each year.
Depreciation: whenever any machine or equipment
performs useful work its wear and tear is bound to occur.
This can be minimized up to some extent by proper care
and maintenance but cant be totally prevented.
Obsolescence: is the depreciation of existing machinery
or asset due to new and better invention, design of
equipment of processes etc.
72
4. Depreciation
4.3 Classification of Depreciation
73
4. Depreciation
4.4 Depreciation Calculation Fundamentals and Methods
4.4.1 Depreciation Calculation Fundamentals
The following are the methods for calculating
depreciation.
BVt = cost basis (d1 + d2 + + dt)
This equation is used to compute the book value of an
asset at the end of any time t.
Book value can be viewed as the remaining unallocated
cost of an asset:
Book value = Cost Depreciation charges made to date
Note:
If the item has a salvage value then the final book value
will be the salvage value.
74
4. Depreciation
4.4 Depreciation Calculation Fundamentals and Methods
4.4.2 Depreciation Calculation Methods
The following are the methods for calculating
depreciation.
Straight line Methods,
Declining Balance Method (esp. DDB),
The Sum Of the Years Digits (SOYD) Method,
Sinking fund Method,
Annuity Charging method,
The Insurance policy method,
The Revaluation or Regular Valuation method, and
Machine Hour Basis method.

75
4. Depreciation
4.5 Calculation of Depreciation
4.5.1 Straight Line Method
This method assumes that the loss of value of machine is
directly proportional to its age. It means one should
deduct the scrap value from the original value and divide
the remaining value by the number of years of useful life.
D = (C-S)/N
Where: D = Depreciation amount per year.
C = Initial cost of a machine.
S = Scrap/Salvage value.
N = Number of years of life of machine.
76
4. Depreciation
4.5.2 [Double] Declining Balance Method
For straight line depreciation with N years, the rate of
decrease each year is 1/N.
Declining balance depreciation uses a rate of either 150%
or 200% of the straight-line rate.
Since 200% is twice the straight-line rate, it is called
double declining balance (DDB).
The DDB equation for any year is
DDB depreciation dt = (2/N) ( Book value)
Book value = Initial cost total charges to date,
So,
DDB deprec. dt = (2/N) (Initial cost total charges to date)
77
4. Depreciation
4.5.2 [Double] Declining Balance Method
It can be shown for DDB, that the depreciation schedule
in year t is given by:
DDB depreciation in year t = (2B/N)(1 2/N)t-1
For
150% declining balance depreciation, the
depreciation in year t is given by:
DB depreciation in year t =(1.5 B/N)(1 1.5/N)t-1.
Where:
B = Book Value
It is common usually to use DDB in many depreciation
computations.
78
4. Depreciation
4.5.3 Sum of Years Digits (SOYD) Method
SOYD depreciation causes larger decreases in book value
in earlier years than in later years.
dt= [(N+1-t)/SOYD](B-S) = [2(N+1-t)/(N(N+1))](B-S)
Where: 2(N+1-t)/N(N+1) = multiplier

B = Book Value
S = Scrap/Salvage value.
The product of the multiplier and B-S for the year is the
depreciation charge for the year. Note the multipliers add
to 1. i.e. (N+1-t)/SOYD = 2(N+1-t)/N(N+1) = 1
79
4. Depreciation
Example: Depreciation
An excavator costs Birr 5, 000,000.00 with a scrap value
of Birr 200,000 after its useful life of 5 years in the
taxpayers hand. Calculate the depreciation value in the
useful life of this machine using:
Straight line method,
SOYD method, and
DDB method.
Show your result in the entire useful life of the excavator.
Compare and comment on both results by the help of a
graph.
80
THANK YOU!
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