UNIT-III

Depreciation: Introduction, Straight Line Method of Depreciation, Declining Balance Method of

Depreciation, Sum-of-the-Years-Digits Method of Depreciation, Sinking Fund Method of
Depreciation/Annuity Method of Depreciation, Service Output Method of Depreciation, Evaluation of
Public Alternatives- Introduction, Examples, Inflation Adjusted Decisions – Procedure to Adjust
Inflation, Examples on comparison of alternatives and Determination of Economics. Life of asset.

3.1 DEPRECIATION

Any equipment which is purchased today will not work for ever. This may bedue to wear and tear of the
equipment or obsolescence of technology. Hence, itis to be replaced at the proper time for continuance of
any business. Thereplacement of the equipment at the end of its life involves money. This mustbe
internally generated from the earnings of the equipment. The recovery of money from the earnings of an
equipment for its replacement purpose is calleddepreciation fund since we make an assumption that the
value of the equipment decreases with the passage of time. Thus, the word “depreciation” means decrease
in value of any physical asset with the passage of time.

There are several methods of accounting depreciation fund. These are asfollows:

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

3.2. 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

Bt = P – t [(P – F)/n]
EXAMPLE 3.1 A company has purchased an equipment whose first cost is Rs. 1,00,000 with an
estimated life of eight years. The estimated salvage value of the equipment at the end of its lifetime is Rs.
20,000. Determine the depreciation charge and book value at the end of various years using the straight
line method of depreciation.

Solution P = Rs. 1,00,000; F = Rs. 20,000; n = 8 years;

Dt = = (P – F)/n
Dt = (1,00,000 – 20,000)/8
Dt = Rs. 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 3.1.

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.

3.3. 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

Dt =Bt–1 – Dt

Dt = Bt–1 – K Bt–1

Dt = (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 3.2 Consider Example 3.1 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

3.4. SUM-OF-THE-YEARS-DIGITS METHOD OF DEPRECIATION .

In this method of depreciation also, it is assumed that the book value of the asset decreases at a decreasing
rate. If the asset has a life of eight years, first the sum of the years is computed as :
Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 = n(n + 1)/2
The rate of depreciation charge for the first year is assumed as the highest and then it decreases.
The rates of depreciation for the years 1–8, respectively are as follows:
8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.
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:
Dt = n + 1 ( + 1) / 2 − t n n (P – F)
Bt = (P – F) (n t n ) − (n t n + ) ( + ) − 1 1 + F
EXAMPLE 3.3 Consider Example 3.1 and demonstrate the calculations of the sum-of-the-years-digits
method of depreciation.
Solution
P = Rs. 1,00,000; F = Rs. 20,000; n = 8 years;
Sum = n(n + 1)/2 = 8   9/2 = 36
3.5. SINKING FUND METHOD OF DEPRECIATION.

In this method of depreciation, the book value decreases at increasing rates with respect to the life of the
asset.

Let P = first cost of the asset,

F = salvage value of the asset,

n = life of the asset,

i = rate of return compounded annually,

A = the annual equivalent amount,

Bt = the book value of the asset at the end of the period t, and

Dt = the depreciation amount at the end of the period t.

The loss in value of the asset (P – F) is made available and the form of cumulative depreciation amount at
the end of the life of the asset by setting up an equal depreciation amount (A) at the end of each period
during the lifetime of the asset.

A = (P – F) [A/F, i, n] 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 generalized formula for Dt is

Dt = (P – F) (A/F, i, n) (F/P, i, t – 1)

The formula to calculate the book value at the end of period t is

Bt = P – (P – F) (A/F, i, n) (F/A, i, t)

The above two formulae are very useful if we have to calculate Dt and Bt for any specific period. If we
calculate Dt and Bt for all the periods, then the tabular approach would be better.

EXAMPLE 3.4 Consider Example 9.1 and give the calculations regarding thesinking fund method of
depreciation with an interest rate of 12%, compounded annually.
Solution
P = Rs. 1,00,000; F = Rs. 20,000 n = 8 years i = 12%
A = (P – F)   [A/F, 12%, 8] = (1,00,000 – 20,000)   0.0813 = Rs. 6,504

In this method of depreciation, a fixed amount of Rs. 6,504 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. For example, the calculations of net
depreciation for some periods are as follows:
Depreciation at the end of year 1 (D) = Rs. 6,504.
Depreciation at the end of year 2 (D2) = 6,504 + 6,504  * 0.12 = Rs. 7,284.48

3.6. SERVICE OUTPUT METHOD OF DEPRECIATION.

In some situations, 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.

Let P = first cost of the asset

F = salvage value of the asset

X = maximum capacity of service of the asset during its lifetime

x = quantity of service rendered in a period.

Then, the depreciation is defined per unit of service rendered: Depreciation/unit of service = (P – F)/X
Depreciation for x units of service in a period = P F X − (x)
EXAMPLE 3.5 Consider Example 3.1 and compute D andB using the sinking fund method of
depreciation with an interest rate of 12%, compounded annually.
Solution
P = Rs. 1,00,000; F = Rs. 20,000 n = 8 years i = 12%

3.7 ALTERNATIVES OF PRIVATE ORGANIZATIONS.

In evaluating alternatives of private organizations, the criterion is to select the alternative with the
maximum profit. The profit maximization is the main goal of private organizations while providing
goods/services as per specifications to their customers. But the same criterion cannot be used while
evaluating public alternatives. Examples of some public alternatives are constructing bridges, roads,
dams, establishing public utilities, etc. The main objective of any public alternative is to provide
goods/services to the public at the minimum cost. In this process, one should see whether the benefits of
the public activity are at least equal to its costs. If yes, then the public activity can be undertaken for
implementation. Otherwise, it can be cancelled. This is nothing but taking a decision based on Benefit-
Cost ratio (BC) given by BC ratio = Equivalent benefits Equivalent costs. The benefits may occur at
different time periods of the public activity. For the purpose of comparison, these are to be converted into
a common time base (present worth or future worth or annual equivalent). Similarly, the costs consist of
initial investment and yearly operation and maintenance cost. These are to be converted to a common
time base as done in the equivalent benefits. Now the ratio between the equivalent benefits and equivalent
costs is known as the “Benefit-Cost ratio”. If this ratio is at least one, the public activity is justified;
otherwise, it is not justified.

Let BP = present worth of the total benefits

BF = future worth of the total benefits

BA = annual equivalent of the total benefits

P = initial investment

PF = future worth of the initial investment

PA = annual equivalent of the initial investment

C = yearly cost of operation and maintenance

CP = present worth of yearly cost of operation and maintenance

CF = future worth of yearly cost of operation and maintenance

3.8 INFLATION MANAGEMENT

A general inflationary trend in the cost of goods is common everywhere due to various interacting factors.
If the rate of inflation is very high, it will produce extremely serious consequences for both individuals
and institutions. Inflation is the rate of increase in the prices of goods per period. So, it has a
compounding effect. Thus, prices that are inflated at a rate of 7% per year will increase 7% in the first
year, and for the next year the expected increase will be 7% of these new prices. The same is true for
succeeding years and hence the rate of inflation is compounded in the same manner that an interest rate is
compounded. If the average inflation over six years period is 7%, then the prices at the beginning of the
seventh year would be 150% that of the first year by assuming 100% for the prices at the beginning of the
first year of the six-year period. If economic decisions are taken without considering the effect of inflation
into account, most of them would become meaningless and as a result the organizations would end up
with unpredictable return. But there is always difficulty in determining the rate of inflation. The
worldwide trend/wish is to curtail inflation. But due to various reasons, it is very difficult to have zero
inflation. For practical decision making, an average estimate may be assumed depending on the period of
the proposals under consideration. Hence, we need a procedure which will combine the effects of
inflation rate and interest rate to take realistic economic decision.

Procedure to Adjust Inflation .

A procedure to deal with this situation is summarized now. 1. Estimate all the costs/returns associated
with an investment proposal in terms of today’s rupees. 2. Modify the costs/returns estimated in step 1
using an assumed inflation rate so that at each future date they represent the costs/returns at that date in
terms of the rupees that must be expended/received at that time, respectively. 3. As per our requirement,
calculate either the annual equivalent amount or future amount or present amount of the cash flow.

3.9. INFLATION ADJUSTED ECONOMIC LIFE OF MACHINE

In any industrial/service organization, equipment/machinery forms an important element. The

productivity of any organization is a function of many factors. It is largely affected by efficient and
effective use of machinery and equipment. So, operations and maintenance of these equipments are very
important to the organization. A machine which is purchased today cannot be used forever. It has a
definite economic lifetime. After the economic life, the machine should be replaced with a substitute
machine with similar operational capabilities. This kind of analysis is called replacement analysis. The
elements of costs involved in the replacement analysis are as follows: 1. Purchase cost (initial cost) 2.
Annual operation and maintenance cost 3. Salvage value at the end of every year, if it is significant

Limitation of Existing Model In the case where the machine is replaced due to wear and tear, the
following costs are considered :
1. Initial cost

2. Operation and maintenance cost

3. Salvage value

In the existing model to deal with this type of replacement analysis, the different cost elements are
estimated without taking the effect of inflation into account. The annual cost of operation and
maintenance of the machine will increase with the age of the machine due to decline in efficiency of the
machine. In the existing model, this increase in the operation and maintenance cost is taken into account.
But the increase in the operation and maintenance cost due to inflation is not considered. Similarly, in the
existing model, the salvage value is estimated without taking into account the effect of inflation. To
highlight this particular fact on salvage value, an example is now given. The internal combustion engines
(R.A. Lister) which were made in England during pre-independence of India are still functioning well.
Their resale value is going up year after year. This may be partly due to inflation and partly due to good
quality of the engine parts. So, consideration of the effect of the inflation on the economic life of the
machine is a realistic approach. In replacement analysis, a discount rate is usually assumed to reflect the
time value of money. First the concept of replacement analysis is demonstrated without taking the
inflation into account. Then, the same is demonstrated by taking the effect of inflation into account. At
the end, a comparison between the two models is presented.

3.10. ECONOMIC LIFE DETERMINATION WITHOUT/ WITH INFLATIONARY EFFECT

The determination of economic life of a machine without considering the effect of inflation is
demonstrated using the following example.

EXAMPLE A machine costs Rs. 5,00,000. Its annual operation cost during the first year is Rs. 40,000
and it increases by Rs. 5,000 every year thereafter. The maintenance cost during the first year is Rs.
60,000 and it increases by Rs. 6,000 every year thereafter. The resale value of the machine is Rs. 4,00,000
at the end of the first year and it decreases by Rs. 50,000 every year thereafter. Assume an interest rate
(discounting factor) of 20%. The method of finding the economic life of the machine with a discounting
factor of 20% at zero inflation rate is summarized in Table . From the table it is clear that the total annual
equivalent cost is minimum if the machine is used for 14 years. Hence, the economic life of the machine
is 14 years. From the discussions, it is clear that the total annual equivalent cost is minimum if the
machine is used for three years. Thus, the economic life of the machine is three years.

Results of two approaches