c) Interest cost or cost of capital investment

It is the annual cost of interest charged on the borrowed money or that of capital investment to acquire the ownership of the equipment. If the equipment is purchased by borrowing money from a lender, then interest cost is the interest charged (at interest rate charged by lender) on the borrowed amount. On the other hand if the equipment is purchased using construction firm's own funds, then cost of capital investment is the interest charged on capital investment at interest rate equal to construction firm's rate of return. Even though the construction firm uses its own funds to purchase the equipment, cost of capital investment is charged as part of the ownership cost because the construction firm could have invested the funds elsewhere to earn the return instead of purchasing the equipment.

The interest cost on borrowed money or cost of capital investment can be exactly calculated by considering time value of money and using appropriate compound interest factors. However the interest cost or cost of capital investment can also be calculated approximately as percentage of constant average annual investment (cost) over the useful life of the equipment. The annual interest rate or the rate of return is multiplied to the average annual investment to find out the annual interest cost or cost of capital investment. The average annual investment can be calculated by finding out the average value of the equipment over the useful life of the equipment. It may be noted here that the value of the equipment depreciates with time. By considering straight-line depreciation, the average annual investment can be found out by calculating average of the book value at the beginning of 1^st year and that at beginning of last year of useful life i.e. at the beginning of ‘ n ' year.

From module 3, the expression for constant annual depreciation from straight-line method (equation (3.1)) is given as follows;

Where, P is the initial cost of equipment, n is the useful life and SV is the estimated salvage value of the equipment.

The book value at the beginning 1^st year is equal to the initial cost i.e. ‘P'. Now the book value at beginning of last year (i.e. ‘n'), which is equal to book value at the end of ‘ (n-1)' year, can be calculated by using equation (3.7) from module 3.

Now the average annual investment ( AAI ) is calculated by taking the average of the book value at the beginning of 1^st year and that at beginning of last year of useful life i.e. BV_n-1 .

------------------------------------------------(4.1)