Notes for Engineering Economy final

examination
First of all, I would like to apologize for some misleading in teaching assistant class about
depreciation and tax. Hence, after revising the terminologies, I decided to outline this note for you
guys.
Second, you must cover all the materials taught in class by Mr. Thanh. There is no exclusion for
the final examination. Cashflow is a must
In the final exam, we will have 3 types of depreciation which are SL, DDB, and GDS Recovery.
The fastest way to access this concept should be learning through examples.
✓ I have witnessed that there are 2 additional sections in chapter 6 which are Sensitivity
Analysis and Decision Tree. Hence, for these 2 parts, I recommend students should have
a look in chapter 12, section 12.4.1 Probability Trees; chapter 11, section 11.3
Sensitivity Analysis. These problems are detailed enough for the reviewing of final
examination.
Clarification: Initially at T.A classes, I said that if the recovery period is less than useful life, the
market value will be taxed, and otherwise. This statement is wrong and I would clarify it following:
If the questions state that you sold the machine at the end of useful life, your MV will be
taxed. If not any assumptions of selling an asset at the end of useful life, your MV won’t be
taxed.
How to use this note: this note is provided together with an Excel, I recommend you should
read this document and check Excel file parallelly. The Excel file would support you on
how to figure out these numbers accurately.

I. Tax and Depreciation

1. Example 1:
Q1: Your company is contemplating the purchase of a large stamping machine. The machine will
cost $130,000. With additional transportation and installation costs of $5,000 and $10,000,
respectively, the cost basis for depreciation purposes is $145,000. Its market value at the end
of five years is estimated at $25,000. The machine has a 3-year class recovery period, using
straight-line method. The justifications for this machine include $20,000 savings per year in labor
and $30,000 savings per year in reduced materials. The before-tax MARR is 20% per year, and
the effective income tax rate is 40% (assuming you sell the machine at the end of year five).
Calculate the PW of the after-tax cash flow from the machine is most nearly (using the after-tax
MARR).
Years BTCF Depreciation Taxible income Income taxes ATCF
0 $ -145.000,00 $ -145.000,00
1 $ 50.000,00 $ 40.000,00 $ 10.000,00 $ -4.000,00 $ 46.000,00
2 $ 50.000,00 $ 40.000,00 $ 10.000,00 $ -4.000,00 $ 46.000,00
3 $ 50.000,00 $ 40.000,00 $ 10.000,00 $ -4.000,00 $ 46.000,00
4 $ 50.000,00 $ 50.000,00 $ -20.000,00 $ 30.000,00
5 $ 50.000,00 $ 50.000,00 $ -20.000,00 $ 30.000,00 45.000,00 ₫
5 $ 25.000,00 $ 25.000,00 $ -10.000,00 $ 15.000,00
PW(12%) $ 10.083,99

145000−25000
• SL depreciation = = 40000, with 3 here is the recovery period
3
mentioned in the question.
• After-tax MARR = Before-tax MARR x (1-tax-rate) = 0.2x0.6=0.12 (12%).
• Here, we see that the question assumes this asset will be sold at the end of five years,
therefore, our MV is taxed

Q2:

a) Calculate the after-tax PW using the SL depreciation method with a 10-year recovery
period.
b) Calculate the after-tax PW using GDS depreciation with a 5-year recovery period. Assume
the machines will be retained for 10 years, the sold at the estimated values.
First, we solve part a.
Notice that, our SV won’t be taxed because there is no assumption of selling an asset at the
end of life. Moreover, ATCF from year 1 to year 10 is equal because depreciation and BTCF of
each year are the same for all 10 years.
 • Using equation (1 − 𝑡)(𝑅𝑘 − 𝐸𝑘 ) + 𝑡(𝑑𝑘 ) to calculate ATCF.
15000 − 3000
𝑑𝑘 = = 1200
10
• ATCF for each year = −3000 ∙ 0.5 + 1200 ∙ 0.5 = −900
• PW(7%) of A = -15000 – 900(P/A,7%,10) + 3000(P/F,7%,10) = -19,796.18, or
PW(7%) of A = -15000 – 900(P/A,7%,9) + 2100(P/F,7%,10)
A BTCF D ATCF
0 $ -15.000,00 $ -15.000,00
1 $ -3.000,00 $ 1.200,00 $ -900,00
2 $ -3.000,00 $ 1.200,00 $ -900,00
3 $ -3.000,00 $ 1.200,00 $ -900,00
4 $ -3.000,00 $ 1.200,00 $ -900,00
5 $ -3.000,00 $ 1.200,00 $ -900,00
6 $ -3.000,00 $ 1.200,00 $ -900,00
7 $ -3.000,00 $ 1.200,00 $ -900,00
8 $ -3.000,00 $ 1.200,00 $ -900,00
9 $ -3.000,00 $ 1.200,00 $ -900,00
10 $ -3.000,00 $ 1.200,00 $ -900,00 $ 2.100,00
10 $ 3.000,00 $ 3.000,00
PW(7%) $ -19.796,18

Second, for part b

Years BTCF D rate Depreciation Taxible income
Income taxesATCF
0 $ -15.000,00 $ -15.000,00
1 $ -3.000,00 $ 0,20 $ 3.000,00 $ -6.000,00 $ 3.000,00 $ -
2 $ -3.000,00 $ 0,32 $ 4.800,00 $ -7.800,00 $ 3.900,00 $ 900,00
3 $ -3.000,00 $ 0,19 $ 2.880,00 $ -5.880,00 $ 2.940,00 $ -60,00
4 $ -3.000,00 $ 0,12 $ 1.728,00 $ -4.728,00 $ 2.364,00 $ -636,00
5 $ -3.000,00 $ 0,12 $ 1.728,00 $ -4.728,00 $ 2.364,00 $ -636,00
6 $ -3.000,00 $ 0,06 $ 864,00 $ -3.864,00 $ 1.932,00 $ -1.068,00
7 $ -3.000,00 $ - $ -3.000,00 $ 1.500,00 $ -1.500,00
8 $ -3.000,00 $ - $ -3.000,00 $ 1.500,00 $ -1.500,00
9 $ -3.000,00 $ - $ -3.000,00 $ 1.500,00 $ -1.500,00
10 $ -3.000,00 $ - $ -3.000,00 $ 1.500,00 $ -1.500,00 0
10 $ 3.000,00 $ - $ 3.000,00 $ -1.500,00 $ 1.500,00
Total 15000

In this question, it is useful that we should use a table for performing ATCF.
• The orange column is the GDS rate which could be found in the textbook.
Total depreciation at the end of useful life is 15000, which points out that our asset totally
depreciated. It is seldom that your asset could completely depreciate. Later, we may encounter
the more general concept which is so-called Gain(loss) on disposal asset.
Similarly, using the same approach you will have the appropriate result for B
 2. Example 2
It is seldom that your asset could fully depreciate and when a depreciable asset (tangible or real
property) is sold, the MV is seldom equal to its BV. In this section, we will meet the new
terminology which is Gain(loss) on disposal asset. Generally, it equals to the fair maker value
minus its book value at that time.
𝐺𝑎𝑖𝑛(𝑙𝑜𝑠𝑠) = 𝑀𝑉𝑛 − 𝐵𝑉𝑛
The below example would illustrate how this concept is applied in economic evaluation.
A corporation uses the following: after-tax MARR of 7% per year, and an effective tax rate of 50%.
Two new machines have the following estimates

Machine A Machine B

First cost 45000 55000

Salvage value at the
0 0
end of year 7
Annual cost 3000 2500
Life. Years 7 7

The machine is retained in use for a total of 7 years, the sold for the estimated salvage
value. Conduct after-tax PW analysis, using Double Declining Balance with 7 years
recovery period for both machines.
We first conduct the depreciation for machine A using DDB with a 7-year recovery period.
2
Here, DDB rate is 5.

Taxable
Year BTCF BV D Income Tax (50%) ATCF PW(7%)
0 $-45.000,00 $45.000,00 $-45.000,00 $-45.000,00
1 $ -3.000,00 $27.000,00 $18.000,00 $-21.000,00 $10.500,00 $ 7.500,00 $ 7.009,35
2 $ -3.000,00 $16.200,00 $10.800,00 $-13.800,00 $ 6.900,00 $ 3.900,00 $ 3.406,41
3 $ -3.000,00 $ 9.720,00 $ 6.480,00 $ -9.480,00 $ 4.740,00 $ 1.740,00 $ 1.420,36
4 $ -3.000,00 $ 5.832,00 $ 3.888,00 $ -6.888,00 $ 3.444,00 $ 444,00 $ 338,73
5 $ -3.000,00 $ 3.499,20 $ 2.332,80 $ -5.332,80 $ 2.666,40 $ -333,60 $ -237,85
6 $ -3.000,00 $ 2.099,52 $ 1.399,68 $ -4.399,68 $ 2.199,84 $ -800,16 $ -533,18
7 $ -3.000,00 $ 1.259,71 $ 839,81 $ -3.839,81 $ 1.919,90 $ -1.080,10 $ -672,63
7 $ - $ -1.259,71 $ 629,86 $ 629,86 $ 392,24
Total $43.740,29 -$33.876,58

Here, the yellow area is the depreciation of this asset for over 7 years. The total of column
D is the cumulative depreciation value after 7 years which shows that our asset is not fully
depreciated. The remaining BV of this asset at year 7 is 45000-43740.29 = 1259.71
Assuming that our asset is sold at the end of useful life, we have 𝑀𝑉7 = 0, 𝐵𝑉7 = 1259.71,
the loss on disposal asset would be
𝐿𝑜𝑠𝑠 = 𝑀𝑉7 − 𝐵𝑉7 = −1259.71
And this value has to be taxed (the blue row on the table).
The last column of the table denotes for the after-tax present worth of each year. The total
value of these columns is the required PW mentioned in the questions.
A similar approach for machine B, you may have a suitable result.

Example 3
The AutoChess gaming company is attempting to evaluate the profitability of adding
another integrated complex to its present operations. The company would need to
purchase two or more acre of land for $275,000 (total). The facility could cost $60,000,000
and have $5,000,000 net MV at the end of five years. The facility could be depreciated
over 5 years. An increment of working capital would be required, and its estimated
amount is $10,000,000. Gross income is expected to increase by $40,000,000 per year
for five years, and the operating expenses are estimated to be $8,000,000 per year for five
years. The firm's effective income tax rate is 40%. After-tax MARR is 10%
a) Calculate the present worth ATCF of this facility using DDB.
b) Calculate the present worth ATCF of this facility using MACRS-GDS recovery.
Part a

k BTCF BV D Taxable income Cash Flow for income taxes ATCF

-60
0 -10 -70,275
-0,275 60
1 32 36,00 ₫ 24,00 ₫ 8,00 -3,20 28,80
2 32 21,60 ₫ 14,40 ₫ 17,60 -7,04 24,96
3 32 12,96 ₫ 8,64 ₫ 23,36 -9,34 22,66
4 32 7,78 ₫ 5,18 ₫ 26,82 -10,73 21,27
5 32 4,67 ₫ 3,11 ₫ 28,89 -11,56 20,44
5 0,00 ₫ 0,33 -0,13 -0,13
5 10,275 10,28
PW(10%) 27,08
BV(5) 4,67 ₫

• The yellow cell denotes for the MV of working capital and purchasing land. Note that
working capital and purchasing land is not depreciable.
• As usual, the 𝐵𝑉5 is calculated by taking the basis cost ofthe asset minus total
depreciation over 5 years, which is the 4.67.
• We calculate the gain(loss) on disposal asset
 𝐿𝑜𝑠𝑠 = 𝑀𝑉5 − 𝐵𝑉5 = 5 − 4.67 = 0.33
𝑀𝑉5 here is five million dollars due to the given information. Remember that, the facility
asset here is personal property.
Ending up with ATCF, we calculate the PW at 10% with 40% tax, $28320000.
Part b

k BTCF GDS rate D Taxible income Cash Flow for income taxes ATCF
-60
0 -10 -70,275
-0,275 60
1 32 0,2 12,00 20,00 -8,00 24,00
2 32 0,32 19,20 12,80 -5,12 26,88
3 32 0,192 11,52 20,48 -8,19 23,81
4 32 0,1152 6,91 25,09 -10,04 21,96
5 32 0,0576 3,46 28,54 -11,42 20,58
5 0,00 -1,91 0,76 0,76
5 10,275 10,28
PW(10%) 26,28

Part b could be processed easily following the same as part a. However, the red cell here
is the half-year convention.
• If the asset is disposed of before the full recovery period is used, then only half of
the normal depreciation deduction can be taken for that year.
Clarification:
You should notice the GDS recovery rate (table 7-3 in the textbook). The half-year
convention is applied if and only if your asset depreciates shorter than the GDS recovery
period. For example, in this question, the facility just operates for 5 years while the 5- year
GDS recovery period is 6 years (table 7-3).

II. Select among alternatives

In this chapter, you already heard about two assumptions called: repeatability and
coterminated.
Repeatability assumption:
• Simply compare the AW (PW, FW) amounts of each alternative over its own useful
life
• Select the alternative with the larger value
Coterminated assumption:
 • Bring all cash flows to time N, the end of the life of the longest lived-alternative
without repeating any cash flows (use FW).
• Select the alternative with a larger value.
For more information about these concepts, I recommend you guys read example 6-7 and
6-8 which are very thoughtful and detailed.
This section would focus on the Incremental IRR method which is, somehow,
confused students (including me at the time I was studying…). I also notice that many
students forget the summary diagram described in detail about the procedure of this
method. Therefore, to not waste your study time, I would summary it below (this summary
was created by our former marvelous lecturers Mrs. Mai and Mr. Vu)

Step 1: Arrange the Alternatives by ascending order of capital investment

Step 2: Establishing a base Alternative
• Cost Alternatives: choose the 1st one (least capital investment) as base
• Investment Alternatives: justify the 1st alternative
o If 1st Alternative is justified: IRR > MARR, PW/AW/FW > 0 at MARR,
choose it as base
o If not, discard and move to the 2nd one and do the same
Step 3: Check if ∆(𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒𝑠 − 𝐵𝑎𝑠𝑒) is justified
• Yes: Alternatives being compared becomes the new base
• No: retain Base
Step 4: Repeat until all Alternatives are compared

Example:
As the supervisor of a facilities engineering department, you consider mobile cranes to be critical
equipment. The purchase of a new medium-sized, truck-mounted crane is being evaluated. The
economic estimates for the two best alternatives are shown in the following table. You have
selected the longest useful life (nine years) for the study period and would lease a crane
for the final three years under Alternative A. On the basis of previous experience, the
estimated annual leasing cost at that time will be $66,000 per year (plus the annual expenses of
$28,800 per year). The MARR is 15% per year. Show that the same selection is made with
a) PW method
b) IRR method
Part a
PW(15%) of A = -$272,000 - $28,800(P/A,15%,9) + $25,000(P/F,15%,6) -
$66,000(P/A,15%,3)(P/F,15%,6) = -$463,758.
PW(15%) of B = -$346,000 -$19,300(P/A, 15%, 9) + $40,000(P/F, 15%, 9)
= -$426,000
Select B to minimize the equivalent cost.
Note: this question followed the coterminated assumptions. That is the reason why you see in
alternative A, we have to compute it to the longest live which is 9 years. This information already
mentioned in the question (bold part).
Part b
Alternative A is the base alternative due to it has the least capital investment.

Year Machine A Machine B delta(B-A)

0 -272 -346 -74
1 -28,8 -19,3 9,5
2 -28,8 -19,3 9,5
3 -28,8 -19,3 9,5
4 -28,8 -19,3 9,5
5 -28,8 -19,3 9,5
6 -3,8 -19,3 -15,5
7 -94,8 -19,3 75,5
8 -94,8 -19,3 75,5
9 -94,8 20,7 115,5
Here is a table illustrated the cashflow we need. Two yellow cells are already plus the market
value. After computing the difference between B and A (A is baseline), we aim to determine the
Increment IRR.
PW(i%) of delta(B-A) = -$74,000 + $9,500(P/A, i%, 5) - $15,500(P/F, i%,6)
+ $75,500(P/A, i%, 2)(P/F, i%, 6) + $115,500(P/F, i%, 9) =0
There are various ways to calculate this equation, you could use the Shift Solve of your calculator,
or Linear Interpolation.
With 𝑖% = 15%, PW of delta(B-A) = 37.04
with unknown i%, PW of delta(B-A) = 0
And 0With 𝑖% = 25%, PW of delta(B-A) = −8.51. Therefore, we have:

15% − 𝑖% 37.04 − 0
=
15% − 25% 37.04 + 8.51
As a result, we have I % = 23.1% which is larger than the MARR. Hence, the incremental
investment is justified and Alternative B should be selected.
Example 2:
A firm is considering three mutually exclusive alternatives as part of an upgrade to an existing
transportation network.

At EOY 10, alternative III would be replaced with another alternative III having the same installed
cost and net annual revenues. If MARR is 10% per year, which alternative (if any) should be
chosen? Use the incremental IRR procedure.
First, we rank these alternatives, III-II-I by the order of installed cost. Then, we select III as
our baseline. Moreover, all these plans are justified since these calculated IRR larger than the
MARR 10%.
Next,

III II I
0 -20 -30 -40
From 1 to 20 5,25 5,65 6,4
Remember that the III will be reinstalled and the end of year 10 with the same installed
cost.
Delta(II-III) = -$10,000 + $400(P/A, i′, 20) + $20,000(P/F, i′, 10) => i’ = 11.3%, > MARR; select II.
Delta(I-II) = -$10,000 + $750(P/A, i′, 20) => i’ = 4% < MARR, reject I, keep II.
Final decision: select alternative II