Chapter 3

Depreciation is the decrease in the value of physical property with the passage of time.

Definitions Of Value

Value, in a commercial sense, is the present worth of all future profits that are to be received through
ownership of a particular property.

The market value of a property is the amount which a willing buyer will pay to a willing seller for the
property where each has equal advantage and is under no compulsion to buy or sell.

The utility or use value of a property is what the property is worth to the owner as an operating unit.
Fair value is the value which is usually determined by a disin terested third party in order to establish a
price that is fair to both seller and buyer.

Book value, sometimes called depreciated book value, is the worth

of a property as shown on the accounting records of an enterprise.

Salvage, or resale, value is the price that can be obtained from the sale of the property after it has been
used.

Scrap value is the amount the property would sell for if disposed

off as junk?

Purposes Of Depreciation

1. To provide for the recovery of capital which has been invested in physical property
2. To enable the cost of depreciation to be charged to the cost of producing products or services
that results from the use of the property.

Types Of Depreciation
 1. Normal depreciation

(a) Physical

(b) Functional

2. Depreciation due to changes in price levels

3. Depletion

Physical depreciation is due to the lessening of the physical ability of a property to produce results. Its
common causes are wear and deterioration. Functional depreciation is due to the lessening in the
demand for the function which the property was designed to render. Its common causes are
inadequacy, changes in styles, population centers shift, saturation of markets or more efficient machines
are produced.

Depreciation due to changes in price levels is almost impossible to predict and therefore is not
considered in economy studies.

Depletion refers to the decrease in the value of a property due to the gradual extraction of its contents.

Physical And Economic Life

Physical life of a property is the length of time during which it is capable of performing the function for
which it was designed and manufactured.

Economic life is the length of time during which the property may Be operated at a profit.

Requirements Of A Depreciation Method

1. It should be simple.
2. It should recover capital.
 3. The book value will be reasonably close to the market value at any time.

4. 4. The method should be accepted by the Bureau of InternalRevenue.

Depreciation Methods

We shall use the following symbols for the different depreciation

Methods.

L useful life of the property in years Co the original cost

C the value at the end of the life, the scrap value (including gain or loss due to removal)

D the annual cost of depreciation C, the book value at the end of n years

D = depreciation up to age n years

The Straight Line Method

This method assumes that the loss in value is directly propor. Tional to the age of the property.

The Sinking Fund Formula

This method assumes that a sinking fund is established in which funds will accumulate for replacement.
The total depreciation that has taken place up to any given time is assumed to be equal to the
accumulated amount in the sinking fund at that time,

Declining Balance Method

In this method, sometimes called the constant percentage method or the Matheson Formula, it is
assumed that the annual cost of depreciation. Is a fixed percentage of the salvage value at the begin
ning of the year. The ratio of the depreciation in any year to the book value at the beginning of that year
is constant throughout the life of the property and is designated by k, the rate of depreciation

This method does not apply, if the salvage value is zero, because k will be equal to one and d_{1} will be
equal to C_{0}

Double Declining Balance (DDB) Method

This method is very similar to the declining balance method except that the rate of depreciation k is
replaced by 2/L.

When the DDB method is used, the salvage value should not be subtracted from the first cost when
calculating the depreciation charge.

The Sum-of-the-Years’-Digits (SYD) Method

Let d

Depreciation charge during the nth year

= (depreciation factor) (total depreciation)

Chapter 4

Capital Financing

Equity and Borrowed Capital

Equity capital or ownership funds are those supplied and used by the owners of an enterprise in the
expectation that a profit will be earned.

Borrowed funds or capital are those supplied by others on which A fixed rate of interest must be paid
and the debt must be repaid at a Specified time.

Types of Business Organizations

A. Individual Ownership. The individual ownership or sole pre prietorship is the simplest
form of business organization, wherein a person uses his or her own capital to establish
a business and is the sole owner.

Advantages of the Individual Ownership

1. It is easy to organize.

2.The owner has full control of the enterprise.

3. The owner is entitled to whatever benefits and profits that Accrue from the business.

4. It is easy to dissolve.

Disadvantages of the Individual Ownership

1. The amount of equity capital which can be accumulated is limited

2. The organization ceases upon the death of the owner..
3. 3. It is difficult to obtain borrowed capital, owing to the uncerTainty of the life of the
organization.
4. The liability of the owner for his debts is unlimited.

B. The Partnership. A partnership is an association of two or more persons for the purpose
of engaging in a business for profit.

Advantages of the Partnership

1. More capital may be obtained by the partners pooling their resources together.

2.It is bound by few legal requirements as to its accounts, procedures, tax forms and other items of
operation.

3. Dissolution of the partnership may take place at any time by

Mere agreement of the partners.

 4. It provides an easy method whereby two or more persons of differing talents may enter into
business, each carrying those burdens that he can best handle.

Disadvantages of the Partnerships

1. The amount of capital that can be accumulated is definitely limited.

2. The life of the partnership is determined by the life of the individual partners. When any partner
dies, the partnership automatically ends.
3. There may be serious disagreement among the individual partners.
4. Each partner is liable for the debts of the partnership.

C. The Corporation. A corporation is a distinct legal entity, separate from the individuals who own it, and
which can engage in almost any type of business transaction in which a real person could occupy himself
or herself.

Advantages of the Corporation

1. It enjoys perpetual life without regard to any change in the person of its owners, the
stockholders.
2. The stockholders of the corporation are not liable for the debts of the corporation.
3. It is relatively easier to obtain large amounts of money for Expansion, due to its perpetual life.
4. The ownership in the corporation is readily transferred.
5. Authority is easily delegated by the hiring of managers.

Disadvantages of the Corporation

1. The activities of a corporation are limited to those stated in its Charter.

2.It is relatively complicated in formation and administration.

3.There is a greater degree of governmental control as com pared to other types of business
organizations.

Capitalization of A Corporation
The capital of a corporation is acquired through the sale of stock. There are two principal types of capital
stock: common stock and preferred stock.

Common Stock

Common stock represents ordinary ownership without special guarantees of return. Common
stockholders have certain legal rights, among which are the following:

1. Vote at stockholders’ meetings.

2. 2. Elect directors and delegates to them power to conduct the Affairs of the business.

3. Sell or dissolve the corporation.

4. Make and amend the by laws of the corporation.

5. 5. Subject to government approval, amend, or change the char

Ter or capital structure.

6. Participate in the profits.

7. Inspect the books of the corporation.

Preferred Stock

Preferred stockholders are guaranteed a definite dividend on their stocks. In case the corporation is
dissolved, the assets must be used to satisfy the claims of the preferred stockholders before those of the
holders of the common stock. Preferred stockholders usually have the right to vote in meetings, but not
always.

Financing With Bonds

A bond is a certificate of indebtedness of a corporation usually for a period not less than ten years and
guaranteed by a mortgage on certain assets of the corporation or its subsidiaries. Bonds are issued when
there is need for more capital such as for expansion of the plant or the services rendered by the
corporation.

The face or par velue of a bond is the amount stated on the bond.

When the face value has been repaid, the bond is said to have been retired or redeemed. The bond rate
is the interest rate quoted on the bond.

Classification of Bonds

1. Registered bonds. The name of the owner of this bond is recorded on the record books of the
corporation and interest payments are sent to the owner periodically without any action on his
part.

2. Coupon bonds. Coupon bond have coupon attached to the bond for each interest payment that
will come due during the life of the bond. The owner of the bond can collect the interest due by
surren dering the coupon to the offices of the corporation or at specified banks.

Methods of Bond Retirement

1. The corporation may issue another set of bonds equal to the amount of bonds due for
redemption.
2. 2. The corporation may set up a sinking fund into which periodic deposits of equal amount are
made. The accumulated amount in the

Sinking fund is equal to the amount needed to retire the bonds at the Time they are due.
Bond Value

The value of a bond is the present worth of all future amounts that are expected to be received through
ownership of the bond.

Chapter 6

Basic Methods for Making Economy Studies

BASIC METHODS OR PATTERNS FOR MAKING ECONOMY STUDIES

THE RATE OF RETURN (ROR) METHOD

The rate of return on the capital invested is given by the formula,

Rate of return= net annual profit /capital invested

(6-1)

Rate of return is a measure of the effectiveness of an investment of capital. It is a financial efficiency.

When this method is used, it is necessary to decide whether the computed rate of return is sufficient to
justify the investment. The advantage of this method is that it is easily understood by management and
investors. The applications of the rate of return method is controlled by the following conditions. A
single investment of capital at the beginning of the first year of the project life and identical revenue and
cost data for each year. The capital invested is the total amount of capital investment required to
finance the project, whether equity or borrowed.

THE ANNUAL WORTH (AW) METHOD

In this method, interest on the original investment (sometimes called minimum required profit) is
included as a cost. If the excess of annual cash inflows over annual cash outflows is not less than zero
the proposed investment is justified – is valid. This method is covered by
The same limitations as the rate of return pattern a single initial investment of capital and uniform
revenue and cost throughout the life of the investment.

THE PRESENT WORTH (PW) METHOD

This pattern for economy studies is based on the concept of present worth. If the present worth of the
net cash flows is equal to, or greater than, zero, the project is justified economically. The present worth
method is flexible and can be used for any type of economy study. It is used extensively in making
economy studies in the public works field, where long-lived structures are involved.

THE FUTURE WORTH (FW) METHOD

The future worth method for economy studies is exactly compa rable to the present worth method
except that all cash inflows and outflows are compounded forward to a reference point in time called
the future. If the future worth of the net cash flows is equal to, or greater than, zero, the project is
justified economically.

THE PAYBACK (PAYOUT) PERIOD METHOD

The payback period is commonly defined as the length of time required to recover the first cost of an
investment from the net cash flow produced by that investment for an interest rate of zero.