Plant design and economics

1. Interest ,Taxes , insurance and Deprecation

2. Objective
• Identify types of interest and determine it
• Identify types of taxes
• Define ,Identify and determine depreciation

3. INTEREST AND INVESTMENT COSTS
Engineers define interest as the compensation paid for the use
of borrowed capital. The rate at which interest will be paid is
usually fixed at the time the capital is borrowed, and a
guarantee is made to return the capital at some set time in the
future or on an agreed-upon pay-off schedule.
TYPES OF INTEREST
1. Simple Interest : In economic terminology, the amount of
capital on which interest is paid is designated as the principal,
and rate of interest is defined as the amount of interest earned
by a unit of principal in a unit of time. The time unit is usually
taken as one year. For example, if $100 were the compensation
demanded for giving someone the use of $1000 for a period of
one year, the principal would be $1000, and the rate of interest
would be lOO/lOOO = 0.1 or 10 percent/year.

4. The simplest form of interest requires compensation
payment at a constant interest rate based only on the
original principal.
Thus, if $1000 were loaned for a total time of 4 years at
a constant interest rate of 10 percent/year, the simple
interest earned would be $1000 x 0.1 x 4 = $400
If P represents the principal, n the number of time units
or interest periods, and i the interest rate based on the
length of one interest period, the amount of simple
interest Z during n interest periods is
The principal must be repaid eventually; therefore, the
entire amount S of principal plus simple interest due
after n interest periods is

5. 2. Compound Interest
• In the payment of simple interest, it makes no difference
whether the interest is paid at the end of each time unit or
after any number of time units. The same total amount of
money is paid during a given length of time, no matter
which method is used. Under these conditions, there is no
incentive to pay the interest until the end of the total loan
period.
• If the interest were paid at the end of each time unit, the
receiver could put this money to use for earning additional
returns. Compound interest takes this factor into account
by stipulating that interest is due regularly at the end of
each interest period.

6. • If payment is not made, the amount due is added to the
principal, and interest is charged on this converted principal
during the following time unit.
• Thus, an initial loan of $1000 at an annual interest rate of
10 percent would require payment of $100 as interest at the
end of the first year.
• If this payment were not made, the interest for the second
year would be ($1000 + $100X0.10) = $110, and the total
compound amount due after 2 years would be $1000 +
$100 + $110 = $1210
• The compound amount due after any discrete number of
interest periods can be determined as follows

8. 3. NOMINAL AND EFFECTIVE INTEREST RATES
• Consider an example in which the interest rate is 3% per
period and the interest is compounded at half-year periods.
A rate of this type would be referred to as “6 % compounded
semiannually.” Interest rates stated in this form are known
as nominal interest rates.
• The actual annual return on the principal would not be
exactly 6 % but would be somewhat larger because of the
compounding effect at the end of the semiannual period.
• It is desirable to express the exact interest rate based on the
original principal and the convenient time unit of 1 year. A
rate of this type is known as the effective interest rate.

9. • In this equation, S represents the total amount of principal plus
interest due after n periods at the periodic interest rate i. Let r be
the nominal interest rate under conditions where there are m
conversions or interest periods per year.
• Then the interest rate based on the length of one interest period
is r/m, and the amount S after 1 year is
• Designating the effective interest rate as ief, the amount S after
1 year can be expressed in an alternate form as

10. CONTINUOUS INTEREST
• A form of interest in which the payments are charged at
periodic and discrete intervals, where the intervals represent
a finite length of time with interest accumulating in a discrete
amount at the end of each interest period. Although in
practice the basic time interval for interest accumulation is
usually taken as one year, shorter time periods can be used
as, for example, one month, one day, one hour, or one
second. The extreme case, of course, is when the time
interval becomes infinitesimally small so that the interest is
compounded continuously.
• The concept of continuous interest is that the cost or income
due to interest flows regularly, and this is just as reasonable
an assumption for most cases as the concept of interest
accumulating only at discrete intervals.

11. • S = P ern

12. Present Worth / Present Value
• It is often necessary to determine the amount of money which must be
available at the present time in order to have a certain amount
accumulated at some definite time in the future. Because the element of
time is involved, interest must be taken into consideration. The present
worth (or present value) of a future amount is the present principal which
must be deposited at a given interest rate to yield the desired amount at
some future date.
• S represents the amount available after n interest periods if the initial
principal is P and the discrete compound-interest rate is i.

13. Home work ( 6 marks ) to be submitted on coming Friday
1.Define what an annuity mean , how we can determine ,where
we can apply it ( real example )
2.Define what an perpetuities and capitalized costs mean how
we can determine , where we can apply it ( real two examples
for each )

14. Taxes and Insurance
• Expenses for taxes and insurance play an important part in
determining the economic situation for any industrial process.
• Insurance costs ordinarily are only a small part of the total
expenditure involved in an industrial operation; however,
adequate insurance coverage is necessary before any
operation can be carried out on a sound economic basis.
• Taxes are collected to supply funds to meet the public needs
of a government .
• Insurance is required for protection against certain types
of emergencies or catastrophic occurrences.
• Insurance rates and tax rates can vary considerably for
business concerns as compared to the rates for individual
persons.

15. TYPES OF TAXES
• Taxes may be classified into three types:
1. Property taxes,
2. Excise taxes, and
3. Income taxes.
These taxes may be leveled by the governments.
• Property taxes : Local governments usually have jurisdiction over
property taxes, which are commonly charged on a county basis.
• Property taxes vary widely from one locality to another, but the
average annual amount of these charges is 1 to 4 % of the assessed
valuation.
• Taxes of this type are referred to as direct since they must be paid
directly by the particular concern and cannot be passed on as such
to the consumer.

16. • Excise Taxes : are levied by the governments. excise taxes
include charges for import customs duties, transfer of stocks
and bonds, and a large number of other similar items.
• Taxes of this type are often referred to as indirect since they
can be passed on to the consumer. Many business concerns
must also pay excise taxes for the privilege of carrying on a
business or manufacturing enterprise in their particular
localities.
• Income Taxes : are based on gross earnings, which are
defined as the difference between total income & total
product cost.
• Many industries have special tax exemptions because of the
type of product, market, or service involved in their business,
or because the government wishes to offer particular support
and incentive to concerns producing essential materials.

17. INSURANCE
The annual insurance cost for ordinary industrial concerns is
approximately up to max of 2 % of the capital investment. The major
insurance requirements for manufacturing concerns can be classified as
follows:
1. Fire insurance and similar emergency coverage on buildings,
equipment, and all other owned, used, or stored property. Included in this
category would be losses caused by lightning, wind- or hailstorms, floods,
automobile accidents, explosions, earthquakes, and similar occurrences.
2. Public-liability insurance, including bodily injury and property loss or
damage, on all operations such as those involving automobiles, elevators,
attractive nuisances, bailee’s charges, aviation products, or any company
function carried on at a location away from the plant premises.

18. 3. Business-interruption insurance. The loss of income due to
a business interruption caused by a fire or other emergency
may far exceed any loss in property. Consequently, insurance
against a business interruption of this type should be given
careful consideration.
4. Power-plant, machinery, and special-operations hazards.
5. Workmen’s-compensation insurance.
6. Marine and transportation insurance on all property in
transit.
7. Comprehensive crime coverage.
8. Employee-benefit insurance, including life, hospitalization,
accident, health, personal property, and pension plans.

19. Purpose of Depreciation as a Cost
• Consideration of depreciation as a cost permits realistic evaluation of
profits earned by a company and, therefore, provides a basis for
determination of income taxes. Simultaneously, the consideration of
depreciation as a cost provides a means whereby funds are set aside
regularly to provide recovery of the invested capital.
TYPES OF DEPRECIATION
• Physical depreciation is the term given to the measure of the
decrease in value due to changes in the physical aspects of the
property. Wear and tear, corrosion, accidents, and deterioration
due to age or the elements are all causes of physical
depreciation. With this type of depreciation, the serviceability of the
property is reduced because of physical changes.
• Depreciation due to all other causes is known as functional
depreciation. One common type of functional depreciation is
obsolescence. This is caused by technological advances or
developments which make an existing property obsolete.

20. • Even though the property has suffered no physical change, its economic
serviceability is reduced because it is inferior to improved types of
similar assets that have been made available through advancements in
technology. Other causes of functional depreciation could be ;
• change in demand for the service rendered by the property, such as a
decrease in the demand for the product involved because of saturation of
the market,
• shift of population center,
• changes in requirements of public authority,
• inadequacy or insufficient capacity for the service required,
• termination of the need for the type of service rendered, and
• Abandonment of the enterprise.
• Because depreciation is measured by decrease in value, it is necessary
to
consider all possible causes when determining depreciation. Physical
losses are easier to evaluate than functional losses, but both of these
must be taken into account in order to make fair allowances for
depreciation.

21. • In engineering design practice, the total depreciation period
is ordinarily assumed to be the length of the property’s
useful life, and the value at the end of the useful life is
assumed to be the probable scrap or salvage value of the
components making up the particular property.
• In estimating property life, the various factors which may
affect the useful-life period, such as wear and tear,
economic changes, or possible technological advances,
should be taken into consideration.

22. • Depletion : Capacity loss due to materials actually consumed is
measured as depletion.
Depletion cost equals the initial cost times the ratio of amount of
material used to original amount of material purchased. This type
of depreciation is particularly applicable to natural resources, such as
stands of timber or mineral and oil deposits.
Costs for Maintenance and Repairs
• The term maintenance conveys the idea of constantly keeping a
property in good condition;
• Repairs connotes the replacing or mending of broken or worn parts of
a property.
• The costs for maintenance and repairs are direct operating expenses
which must be paid from income, and these costs should not be
confused with depreciation costs.
• The extent of maintenance and repairs may have an effect on
depreciation cost, because the useful life of any property ought to be
increased if it is kept in good condition.

23. SERVICE LIFE : The period during which the use of a property is
economically feasible is known as the service life of the property.
Both physical and functional depreciation are taken into consideration in
determining service life, and, as used in this book, the term is synonymous
with economic or useful life. In estimating the probable service life, it is
assumed that a reasonable amount of maintenance and repairs will be
carried out at the expense of the property owner.
SALVAGE VALUE : is the net amount of money obtainable from the sale
of used property over and above any charges involved in removal and
sale.
•If the property cannot be disposed of as a useful unit, it can often be
dismantled and sold as junk to be used again as a manufacturing raw
material. The profit obtainable from this type of disposal is known as the
scrap, or junk, value

24. PRESENT VALUE : an asset may be defined as the value of
the asset in its condition at the time of valuation.
Book Value, or Unamortized Cost : The difference between
the original cost of a property, and all the depreciation charges
made to date is defined as the book value (sometimes called
unamortized cost). It represents the worth of the property as
shown on the owner’s accounting records.
Market Value : The price which could be obtained for an asset
if it were placed on sale in the open market is designated as
the market value. The use of this term conveys the
idea that the asset is in good condition and that a buyer is
readily available.
Replacement Value : The cost necessary to replace an
existing property at any given time with one at least equally
capable of rendering the same service.

25. METHODS FOR DETERMINING DEPRECIATION
•Straight-line, declining-balance, and sum-of-the-years-
digits methods are included in the first class, while the
second class includes the sinking-fund and the present-
worth methods.
•Straight-Line Method it is assumed that the value of the
property decreases linearly with time. Equal amounts are
charged for depreciation each year throughout the entire
service life of the property.

27. Declining-Balance (or Fixed Percentage) Method
•When the declining-balance method is used, the annual
depreciation cost is a fixed percentage of the property value at
the beginning of the particular year.
•The fixed-percentage (or declining-balance) factor remains
constant throughout the entire service life of the property, while
the annual cost for depreciation is different each year. Under
these conditions, the depreciation cost for the first year of the
property’s life is Vf, where f represents the fixed-percentage
factor.

28. Comparison with the straight-line method shows that declining-
balance depreciation permits the investment to be paid off more
rapidly during the early years of life. The increased depreciation
costs in the early years are very attractive to concerns just starting
in business, because the income-tax load is reduced at the time
when it is most necessary to keep all pay-out costs at a minimum.

29. • The sum-of-the-years digits method is an arbitrary
process for determining depreciation which gives results
similar to those obtained by the declining-balance method.
Larger costs for depreciation are allotted during the early-life
years than during the later years. This method has the
advantage of permitting the asset value to decrease to zero
or a given salvage value at the end of the service life. In the
application of the sum-of-the-years-digits method, the
annual depreciation is based on the number of service-life
years remaining and the sum of the arithmetic series of
numbers from 1 to n, where n represents the total service
life. The yearly depreciation factor is the number of useful
service-life years remaining divided by the sum of the
arithmetic series. This factor times the total depreciable
value at the start of the service life gives the annual
depreciation cost.

30. • As an example, consider the case of a piece of equipment
costing $20,000 when new.
• The service life is estimated to be 5 years and the scrap
value $2000. The sum of the arithmetic series of numbers
from 1 to n is 1 + 2 + 3 + 4 + 5 = 15.
• The total depreciable value at the start of the service life is
$20,000 - $2000 = $18,000.
• Therefore, the depreciation cost for the first year is
$l8,OOOX( 5/15) = $6000, and the asset value at the end of
the first year is $14,000.
• The depreciation cost for the second year is ($18,OOOX
(4/15) = $4800. Similarly, the depreciation costs for the
third, fourth, and fifth years, respectively, would be $3600,
$2400, and $12OO.

31. Sinking-Fund Method
• It uses compound interest.
• It is assumed that the basic purpose of depreciation
allowances is to accumulate a sufficient fund to provide for
the recovery of the original capital invested in the property.
• i =annual interest rate expressed as a fraction
• R = uniform annual payments made at end of each year
(this is the annual depreciation cost), dollars
• V-Vs, = total amount of the annuity accumulated in an
estimated service life of n years (original value of property
minus salvage value at end of service life), dollars.