CE 215 – ENGINEERING ECONOMICS

MODULE 2

Chapter 2- Interest and Money- Time relationship

Introduction

The majority of engineering economy studies involve commitment of capital for

extended periods of time, so effect of time must be considered. It is recognized that a unit of
principal today is worth more than a unit of principal one or more years from now because of
interest (or profits) it can earn. Therefore, money has a time value.

Objectives:

At the end of this chapter, students are expected to be able to:

1. Understand the relationship of interest and money with respect to time.

2. Solve problems involving interest and money.
3. Learn to create cash flow diagrams.

Discussion

ANNUITY
An annuity is a series of equal payments made at equal intervals of time. Financial
activities like installment payments, monthly rentals, life-insurance premium, monthly
retirement benefits, are familiar examples of annuity.
Annuity can be certain or uncertain. In annuity certain, the specific amount of payments
are set to begin and end at a specific length of time. A good example of annuity certain is the
monthly payments of a car loan where the amount and number of payments are known. In
annuity uncertain, the annuitant may be paid according to certain event. Example of annuity
uncertain is life and accident insurance. In this example, the start of payment is not known and
the amount of payment is dependent to which event.
Annuity certain can be classified into two, simple annuity and general annuity. In simple
annuity, the payment period is the same as the interest period, which means that if the
payment is made monthly the conversion of money also occurs monthly. In general annuity,
the payment period is not the same as the interest period. There are many situations where
the payment for example is made quarterly but the money compounds in another period, say
monthly. To deal with general annuity, we can convert it to simple annuity by making the
payment period the same as the compounding periods by the concept of effective rates.
Types of Annuities
In engineering economy, annuities are classified into four categories. These
are (1) ordinary annuity, (2) annuity due, (3) deferred annuity, and (4) perpetuity.

An annuity is a series of equal payments occurring at equal periods of time.

Symbol and their meaning

P = Value or sum of money at present
F = Value or sum of money at some future time
A = A series I periodic, equal amounts of money
n = Number of interest periods
I = Interest rate per interest period
Ordinary Annuity
An ordinary annuity is a series of uniform cash flows where the first amount
of the series occurs at the end of the first period and every succeeding cash flow
occurs at the end of each period.

An ordinary annuity is one where the payments are made at the end of each
period.

Cash Flow Diagram

P F
𝑖%
0 1 2 3 4 5 6 𝑛−5 𝑛−4 𝑛−3 𝑛−2 𝑛−1 𝑛

A A A A A A A A A A A A A

To find F, use n as a focal date.

𝐹 = 𝐴 + 𝐴(1 + 𝑖)1 + 𝐴(1 + 𝑖)2 + 𝐴(1 + 𝑖)3 + ⋯ + 𝐴(1 + 𝑖)𝑛−2 + 𝐴(1 + 𝑖)𝑛−1

𝐹 = 𝐴[1 + (1 + 𝑖)1 + (1 + 𝑖)2 + (1 + 𝑖)3 + ⋯ + (1 + 𝑖)𝑛−2 + (1 + 𝑖)𝑛−1 ]

This is a geometric series

𝑟𝑛 − 1
𝑆𝐺 = 𝑎1 [ ]
𝑟−1

Where:

𝑆𝐺 = sum of geometric gradient

𝑎1 = first term
𝑟 = common ratio
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑒𝑟𝑚𝑠
∴ 𝑎1 = 1 r = (1 + i) 𝑛 = 𝑛
 (1 + 𝑖)𝑛 − 1
𝑆𝐺 = (1)[ ]
(1 + 𝑖) − 1

(1 + 𝑖)𝑛 − 1
𝑆𝐺 =
𝑖

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴𝑆𝐺 = 𝐴 [ ]
𝑖

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖

𝑟
As consequence, 𝑖 =
𝑚

𝑟 𝑛𝑚
(1 + ) −1
𝐹 = 𝐴[ 𝑚 ]
𝑟
𝑚

To find P, use 0 as a focal date.

𝑃 = 𝐴(1 + 𝑖)−1 + 𝐴(1 + 𝑖)−2 + 𝐴(1 + 𝑖)−3 + ⋯ + 𝐴(1 + 𝑖)−(𝑛−1) + 𝐴(1 + 𝑖)−𝑛

𝑃 = 𝐴(1 + 𝑖)−1 [𝐴(1 + 𝑖)−1 + 𝐴(1 + 𝑖)−2 + ⋯ + 𝐴(1 + 𝑖)−(𝑛−2) + 𝐴(1 + 𝑖)−(𝑛+1)

This is a geometric series

𝑟𝑛 −1
𝑆𝐺 = 𝑎1 [ ]
𝑟−1

∴ 𝑎1 = 1 r = (1 + i)−1 𝑛=𝑛

(1 + 𝑖)−𝑛 − 1
𝑆𝐺 = (1)[ ]
(1 + 𝑖)−1 − 1

(1 + 𝑖)−𝑛 − 1
𝑆𝐺 =
(1 + 𝑖)−1 − 1

(1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴(1 + 𝑖)−1 𝑆𝐺 = 𝐴(1 + 𝑖)−1 [ ]
(1 + 𝑖)−1 − 1

(1 + 𝑖)
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑦 𝑏𝑜𝑡ℎ 𝑏𝑦
(1 + 𝑖)

(1 + 𝑖)−𝑛 − 1 (1 + 𝑖)
𝑃 = 𝐴(1 + 𝑖)−1 [ ]∙
(1 + 𝑖)−1 − 1 (1 + 𝑖)

(1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴[ ]
1 − (1 + 𝑖)
 (1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴[ ]
−𝑖

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

𝑟
As consequence, 𝑖 =
𝑚

𝑟 −𝑚𝑛
1 − (1 + )
𝑃 = 𝐴[ 𝑚 ]
𝑟
𝑚

(1+𝑖)𝑛 −1 (1+𝑖)𝑛 −1
In 𝐹 = 𝐴 [ ], the factor is called “uniform series compound factor”
𝑖 𝑖
(𝐹/𝐴, 𝑖%, 𝑛) → F given A at i% in n interest periods.

∴ 𝐹 = 𝐴(𝐹/𝐴, 𝑖%, 𝑛)

1−(1+𝑖)−𝑛 1−(1+𝑖)−𝑛
In 𝑃 = 𝐴 [ ], the factor is called “uniform series present worth factor”
𝑖 𝑖
(𝑃/𝐴, 𝑖%, 𝑛) → P given A at i% in n interest periods.

∴ 𝑃 = 𝐴(𝑃/𝐴, 𝑖%, 𝑛)

𝑖 𝑖
Also, in 𝐴 = 𝐹 [(1+𝑖)𝑛 ] the factor (1+𝑖)𝑛 is called “sinking fund factor” (𝐴/𝐹, 𝑖%, 𝑛) →
−1 −1

A given F at i% in n interest periods.

∴ 𝐴 = 𝐹(𝐴/𝐹, 𝑖%, 𝑛)

𝑖 𝑖
And in Also, in 𝐴 = 𝑃 [ ] the factor is called “capital recovery factor”
1−(1+𝑖)−𝑛 1−(1+𝑖)−𝑛

(𝐴/𝑃, 𝑖%, 𝑛) → A given P at i% in n interest periods.

∴ 𝐴 = 𝑃(𝐴/𝑃, 𝑖%, 𝑛)

Relationship between capital recovery factor and sinking fund factor:

𝑖 𝑖 + 𝑖(1 + 𝑖)𝑛 − 𝑖
+ 𝑖 =
(1 + 𝑖)𝑛 − 1 (1 + 𝑖)𝑛 − 1

𝑖(1 + 𝑖)𝑛 (1 + 𝑖)−𝑛

= ∙
(1 + 𝑖)𝑛 − 1 (1 + 𝑖)−𝑛

𝑖 𝑖
+ 𝑖 =
(1 + 𝑖)𝑛 − 1 1 − (1 + 𝑖)−𝑛

∴ 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑 𝑓𝑎𝑐𝑡𝑜𝑟 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑓𝑎𝑐𝑡𝑜𝑟

(𝐴/𝐹, 𝑖%, 𝑛) + 𝑖 = (𝐴/𝑃, 𝑖%, 𝑛)

Example:
What are the present worth and the accumulated amount of a 10-year annuity
paying ₱10000 at the end of each year, with interest at 15% compounded annually?

Solution:
𝐴 = ₱10000
𝑛 = 10
𝑖 = 15%

P F

0 1 2 3 9 10

₱10000 ₱10000 ₱10000 ₱10000 ₱10000

𝑃 10000(𝑃/𝐴, 15%, 10) 𝑃 10000(𝐹/𝐴, 15%, 10)

𝑃 = 𝐴(𝑃/𝐴, 𝑖%, 𝑛) = 10000(𝑃/𝐴, 15%, 10)

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

1 − (1 + 0.15)−10
= 10000 [ ] = ₱𝟓𝟎, 𝟏𝟖𝟖
0.15

𝐹 = 𝐴(𝐹/𝐴, 𝑖%, 𝑛) = 10000(𝐹/𝐴, 15%, 10)

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖

(1 + 0.15)10 − 1
= 10000 [ ] = ₱𝟐𝟎𝟑, 𝟎𝟑𝟕
0.15
Example:

What is the present worth of ₱500 deposited at the end of every three months for
6years if the interest rate is 12% compounded semiannually?

Solution:
Solving for the interest rate per quarter,

0.12 2
(1 + 𝑖)4 − 1 = (1 + ) −1
2
1 + 𝑖 = (1.06)0.5

𝑖 = 0.0296 𝑜𝑟 2.96% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟

𝑃 = 𝐴(𝑃/𝐴, 2.96%, 24)
1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

1 − (1 + 0.0296)−24
𝑃 = 500 [ ]
0.0296

𝑃 = 500[17.0087]
𝑷 = ₱𝟖𝟓𝟎𝟒. 𝟑𝟕

Example:

The purchase of an equipment of ₱100000 has been made available through a loan
which earns 12% per annum. It has been agreed that the loan be payable in 10 equal
payments. How much then is the yearly due?
Given:

P=₱100000
i = 12%
n = 10 years
A=?
Solution:
1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

1 − (1 + 0.12)−10
10000 = 𝐴 [ ]
0.12

𝐴 = ₱17698.42
Example:
What is the future worth of ₱600 deposited at the end of every month for 4 years if the
interest rate is 12% compounded quarterly?
Given:
A = ₱600
r = 12%
m=4
n = 4 years
F=?
Solution:
Convert 12% compounded quarterly to r% compounded monthly:
(Effective rate must be equal)

𝑟 12 0.12 4
(1 + ) − 1 = (1 + ) −1
12 4
𝑟 = 0.1188 𝑜𝑟 11.88 % (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑚𝑜𝑛𝑡ℎ𝑙𝑦)
𝑟 𝑛𝑚
(1 + ) −1
𝐹 = 𝐴[ 𝑚 ]
𝑟
𝑚

0.1188 4(12)
(1 + ) −1
𝐹 = 600 [ 12 ]
0.1188
12
𝐹 = ₱36,641.32

Deferred Annuity
A deferred annuity is one where the first payment is made several periods after
the beginning of the annuity (first cash flow of the series is not at the end of the lot period
or it is deferred for some time).
Finding P when A is given

P Cash flow diagram

P’

k-1 k
0 1 2 0 1 n
2 n-1

A A A A
𝐴(𝑃/𝐴, 𝑖%, 𝑛)(𝑃/𝐹, 𝑖%, 𝑘 − 1) 𝐴(𝑃/𝐴, 𝑖%, 𝑛)
 1 − (1 + 𝑖)−𝑛
𝑃′ = 𝐴 [ ]
𝑖

𝑃 = 𝑃′(1 + 𝑖)−(𝑘−1) where k = deferment period

1−(1+𝑖)−𝑛
𝑃 = 𝐴[ ] (1 + 𝑖)−(𝑘−1)
𝑖

(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ]
𝑖

Example:
A man loans ₱187,400 from a bank with interest at 5% compounded annually. He
agrees to pay his obligations by paying 8 equal annual payments the first being due at the
end of 10 years. Find the annual payments.
Given:
P = ₱187,400
i = 5%
n=8
k = 10
A=?
Solution:

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

A A A A A A A A

P’

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ] (1 + 𝑖)−(𝑘−1)
𝑖

1 − (1 + 0.05)−𝑛
₱187,400 = 𝐴 [ ] (1 + 0.05)−(10−1)
0.05

𝐴 = ₱44,980.56
Annuity Due
An annuity due is one where the payments are made at the beginning of each period

Finding F When A is given

𝑃 𝐹’ 𝐹

0 1 2 3 𝑛−3 𝑛−2 𝑛−1 𝑛

𝐴 𝐴 𝐴 𝐴 𝐴 𝐴 𝐴

Cash flow diagram given A to find F

(1 + 𝑖)𝑛 − 1
𝐹′ = 𝐴 [ ]
𝑖

𝐹 = 𝐹′(1 + 𝑖)
(1 + 𝑖)𝑛 − 1
𝐹 = 𝐴[ ] (1 + 𝑖)
𝑖

(1 + 𝑖)𝑛+1 − (1 + 𝑖)
𝐹 = 𝐴[ ]
𝑖

(1 + 𝑖)𝑛+1 − 1 𝑖
𝐹 = 𝐴[ − ]
𝑖 𝑖

(1 + 𝑖)𝑛+1 − 1
𝐹 = 𝐴[ − 1]
𝑖

1 − (1 + 𝑖)−(𝑛−1)
𝑃 = 𝐴+ 𝐴[ ]
𝑖

1 − (1 + 𝑖)−(𝑛−1)
𝑃 = 𝐴 [1 + ]
𝑖
Example:
A man bought an equipment costing P60, 000 payable in 12 quarterly payments, each
installment payable at the beginning of each period. The rate of interest is 24%
compounded quarterly. What is the amount of each payment?
Given:
P = ₱60000
r = 24%
m=4
n = 12
A=?
Solution:

0.24 −(12−1)
1 − (1 + )
₱60000 = 𝐴 [1 + 4 ]
0.24
4
𝐴 = ₱6751.53

Perpetuity
The type of annuity similar to ordinary annuity except that the payments continue
infinitely.
𝑃

0 1 2 3 ∞

𝐴 𝐴 𝐴 𝐴 𝐴 𝐴

Cash flow diagram given A to find F

1 − (1 + 𝑖)−𝑛
𝑃 = 𝐴[ ]
𝑖

But since n approaches infinity, (1 + 𝑖)−𝑛 ≈ 0

1−0
𝑃 = 𝐴[ ]
𝑖
𝐴
𝑃= 𝐹 𝑐𝑎𝑛𝑛𝑜𝑡 𝑏𝑒 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑
𝑖
Example:
What amount of money invested today at 15% interest can provide the following
scholarships: ₱30,000 at the end of each year for 6 years: ₱40,000 for the next 6 years and
₱50,000 thereafter?
Solution:

𝑖 = 15%

∞
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
P
P P P P P P P P PP P P P P P P

A1=₱30000 A2=₱40000 A3=₱50000

P
P
1 − (1 + 𝑖)−𝑛 1 − (1 + 𝑖)−𝑛 𝐴
𝑃 = 𝐴1 [ ] + 𝐴2 [ ] (1 + 𝑖)−𝑛 + (1 + 𝑖)−𝑛
𝑖 𝑖 𝑖

1 − (1 + 0.15)−6 1 − (1 + 0.15)−6
𝑃 = 30000 [ ] + 40000 [ ] (1 + 0.15)−6
0.15 0.15
50000
+ (1 + 0.15)−12
0.15
𝑃 = ₱241,282.32

Uniform Arithmetic Gradient Payment

A series of payments with common difference.

For Ascending Payments

An
An-1
An-2
An-3
A2
A1
G G G
G
0 1 2 n-3 n-2 n-1 n

P Cash Flow Diagram F

𝐴2 −𝐴1 = 𝐺 ← 𝑐𝑜𝑚𝑚𝑜𝑛 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒

 A1 A A1 A1 A1 A1
1

0 1 2 n-3 n-2 n-1 n

P F

(n-1)G

(n-2)G
(n-3)G
(n-4)G
G

0 1 2 n-3 n-2 n-1 n

P F

∴ 𝑃 = 𝑃𝐴 + 𝑃𝐺
1 − (1 + 𝑖)−𝑛
𝑃𝐴 = 𝐴1 [ ]
𝑖
𝐺 (1 + 𝑖)−𝑛 − 1
𝑃𝐺 = [ − 𝑛](1 + 𝑖)−𝑛
𝑖 𝑖
1 − (1 + 𝑖)−𝑛 𝐺 (1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴1 [ ]+ [ − 𝑛](1 + 𝑖)−𝑛
𝑖 𝑖 𝑖

To get the equivalent annuity for this uniform arithmetic gradient payment:

𝐺 𝑛𝑖
𝐴 𝑇 = 𝐴1 + [1 − ]
𝑖 (1 + 𝑖)𝑛 − 1

To find F:
𝐹 = 𝐹𝐴 + 𝐹𝐺
(1 + 𝑖)𝑛 − 1
𝐹𝐴 = 𝐴1 [ ]
𝑖

𝐺 (1 + 𝑖)𝑛 − 1
𝐹𝐺 = [ − 𝑛]
𝑖 𝑖

(1 + 𝑖)𝑛 − 1 𝐺 (1 + 𝑖)𝑛 − 1
𝐹 = 𝐴1 [ + [ − 𝑛]]
𝑖 𝑖 𝑖
For Descending Payments

A1

A2
A3
An-1
An
G G

0 1 2 3 n-1 n

P F

∴ 𝑃 = 𝑃𝐴 − 𝑃𝐺

1 − (1 + 𝑖)−𝑛 𝐺 (1 + 𝑖)−𝑛 − 1
𝑃 = 𝐴1 [ ]− [ − 𝑛](1 + 𝑖)−𝑛
𝑖 𝑖 𝑖

𝐹 = 𝐹𝐴 − 𝐹𝐺

(1 + 𝑖)𝑛 − 1 𝐺 (1 + 𝑖)𝑛 − 1
𝐹 = 𝐴1 [ − [ − 𝑛]]
𝑖 𝑖 𝑖

𝐺 𝑛𝑖
𝐴 𝑇 = 𝐴1 − [1 − ]
𝑖 (1 + 𝑖)𝑛 − 1

Example:
Find the equivalent annual payment of the following obligations at 20% interest.
End of Year Payment
1 ₱ 8,000
2 ₱ 7,000
3 ₱ 6,000
4 ₱ 5,000
Solution:
Given: 𝐴1 = ₱8,000

𝑛=4
𝑖 = 20%
Since this is a descending payment, we will use the formula:
𝐺 𝑛𝑖
𝐴 𝑇 = 𝐴1 − [1 − ]
𝑖 (1 + 𝑖)𝑛 − 1
₱1000 4(0.20)
𝐴 𝑇 = ₱8,000 − [1 − ]
0.2 (1 + 0.20)4 − 1
𝐴 𝑇 = ₱6725.78
Geometric Gradient

P F
Cash Flow Diagram

i%

A1
A2
A3
An-3
An-2
An-1
An
Where,
𝐴𝑛 = 𝐴1 (1 + 𝑔)𝑛−1
𝑔 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒

Using 0 as focal date:

𝑃 = 𝐴1 (1 + 𝑔)−1 + 𝐴2 (1 + 𝑔)−2 + 𝐴3 (1 + 𝑔)−3 + ⋯ + 𝐴𝑛 (1 + 𝑔)−𝑛

𝐴𝑛 = 𝐴1 (1 + 𝑔)𝑛−1

𝐴1 1 − (1 + 𝑖𝑐𝑟 )−𝑛
𝑃= [ ]
1+𝑔 𝑖𝑐𝑟

1+𝑖
𝑖𝑐𝑟 = −1
1+𝑔

Example:
A ₱1M debt is to be paid in 4 installments, the next payment being 20% larger than
the preceding. If money is worth 10% and the first payment is made 3 years after the debt
has been granted. Compute the first payment during the third year.

Solution:
P F
Given:
P = ₱1M
n=4
g= 20%

A1
1.2A1
1.22 A1
1.23 A1
From the cash flow diagram, setting 0 as focal date:
𝐴1 1 − (1 + 𝑖𝑐𝑟 )−𝑛
𝑃= [ ](1 + 𝑖)−2
1+𝑔 𝑖𝑐𝑟
1+𝑖
𝑖𝑐𝑟 = −1
1+𝑔
−𝑛
1 + 0.1
𝐴1 1 − (1 + − 1)
1,000,000 = [ 1 + 0.2 ](1 + 0.1)−2
1 + 0.2 1 + 0.1
−1
1 + 0.2
𝐴1 = ₱290,658.08

Continuous Compounding and Continuous Cash Flow

𝑛→∞
𝑚→∞

𝑒 𝑟𝑛 − 1
𝐹 = 𝐴[ ]
𝑟
𝑟
𝐴 = 𝐹[ 𝑟𝑛 ]
𝑒 −1

1 − 𝑒 𝑟𝑛 𝑒 𝑟𝑛 − 1
𝑃 = 𝐴[ ]=[ ]
𝑟 𝑟𝑒 𝑟𝑛

𝑃𝑟 𝑃𝑟𝑒 𝑟𝑛
𝐴= =
1 − 𝑒 𝑟𝑛 𝑒 𝑟𝑛 − 1

Capitalized Cost
One of the most important applications of perpetuity is in capitalized cost. The
capitalized cost of any property is the sum of the first cost and the present worth of all
costs of replacement, operation and maintenance for a long time or forever.
Capitalized cost is an application for perpetuity. It is one method used in
comparing alternatives. It is defined as the sum of the first cost (FC) and the present
worth of all perpetual maintenance and replacement cost.

Case 1. No replacement, only maintenance and or operation every period.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑𝑜𝑟 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
Example:
Determine the capitalized cost of a structure that requires an initial investment of
₱1,500,000 and an annual maintenance of ₱150,000. Interest is 15%.

Solution:

₱150,000 ₱150,000

0 1 2

𝐴 150,000
𝑃= = = 1,000,000
𝐼 0.15
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝑃
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱1,500,000 + ₱1,000,000
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱2,500,000

Case 2.Replacement only, no maintenance and/ or operation.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡

Let S = amount needed to replace a property every k period
X = amount of principal invested at rate i% the interest on which will amount
to S every k periods

Xi = interest on X every period, the periodic deposit towards accumulation of S

0 1 2 3 k-1 k

Xi Xi Xi Xi Xi
Cash Flow diagram to find X given S

𝑆 = 𝑋𝑖 (𝐹/𝐴, 𝑖%, 𝑘)
𝑆 1 𝑆 𝑖
𝑋= [ ]= [ ]
𝑖 (𝐹/𝐴, 𝑖%, 𝑘) 𝑖 (1 + 𝑖)𝑘 − 1
𝑆
𝑋=
(1 + 𝑖)𝑘 − 1
 Difference between p and X in a perpetuity

A A A S S S

0 1 2 3 0 k 2k 3k

P X
𝐴
𝑃= 𝑆
𝑖 𝑋=
𝑘
(1 + 𝑖) − 1

P is the amount invested now at i% per period whose interest at the end of
every period forever is A while X is the amount invested now at i% per period whose
interest at the end of every k periods forever is S. If k = 1, then X = P.

Example:
A new engine was installed by a textile plant at a cost of ₱300,000 and projected to
have a useful life of 15 years. At the end of its useful life, it is estimated to have a salvage
value of ₱30,000. Determine its capitalized cost if interest is 18% compounded annually.
Solution:

₱30000 ₱30000 ₱30000

0 15 30 45

₱300000 ₱300000
₱300000 ₱300000

₱270000 ₱270000 ₱270000

0 15 30 45

X
𝑆 270000
𝑋=
𝑘
= 15
= ₱24,604
(1 + 𝑖) − 1 (1 + 0.18) −1
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝑋
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱300,000 + ₱24,604
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = ₱324,604
 Case 3. Replacement, maintenance and/or operation every period

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡
= 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡
+ 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑/ 𝑜𝑟 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
+ 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡.
Example:
Determine the capitalized cost of a research laboratory which requires
P5,000,000 for original construction; P100,000 at the end of every year for the first 6
years and then P120,000 each year thereafter for operating expenses, and P500,000
every 5 years for replacement of equipment with interest at 12% per annum?

₱120,000 ₱120,000
Solution 0.12
(𝑃/𝐴, 12%, 6)
0.12

₱100,000 (𝑃/𝐴, 12%, 6)

₱120,000 ₱120,000 ₱120,000

₱100,000 ₱100,000 ₱100,000 ₱100,000 ₱100,000 ₱100,000

∞
1 2 3 4 5 6 7 8 9

Let Q be the present worth of cost of perpetual operation

1 − (1 + 0.12)−6 ₱120,000
𝑄 = ₱100,000 [ ]+ (1.012)−6
0.12 0.12

𝑄 = ₱917,721.85
Replacement:
₱500000 ₱500000 ₱500000

0 5 10 15

Let X = the present worth of cost of perpetual replacement

𝑆 500000
𝑋=
𝑘
= 5
= ₱655,873.88
(1 + 𝑖) − 1 (1 + 0.12) − 1
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑄 + 𝑋
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = ₱5,000,000 + ₱917,721, .85 + ₱655,873.88
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = ₱6,573,645.73
Amortization
Amortization is any method of repaying a debt, the principal and interest included,
usually by a series of equal payments at equal intervals of time.
Amortization is any mode of paying debt, the principal and interest included, usually
by a series of uniform amount every period.

Amortization Schedule
-is a table showing the payments throughout the total interest period.

Example:
A debt of ₱5,000 with interest at 12% compounded semiannually is to be
amortized by equal semiannual payments over the next 3 years, the first due in 6
months. Find the semiannual payment and construct an amortization schedule.

₱5,000

0 1 2 3 4 5 6

A A A A A A

𝑃 ₱5,000
𝐴= = = ₱1,016.82
𝑃/𝐴, 6%, 6 4.9173
Amortization Schedule

Period Outstanding Interest due Payment Principal repaid

principal at at end pf at end of period
beginning of period period
1 ₱5,000.00 ₱300.00 ₱1,016.82 ₱716.82
2 4,283.18 256.99 1,016.82 759.83
3 3,523.35 211.40 1,016.82 805.42
4 2,717.93 163.08 1,016.82 853.74
5 1,864.19 111.85 1,016.82 904.97
6 959.22 57.55 1,016.82 959.27
Totals ₱1,100.87 ₱6,100.92 ₱5,000.05