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Teaching Module

2.1

Introduction

The objective of this chapter is to examine those procedures

which used to answer questions associated with major financial
transactions involving the interest problem, annuity and depreciation.
These procedures are part of what is usually financial mathematics.
Most important financial transactions, such as repaying housing loan,
involve a series of repayments.
In section 2.2 and 2.3, both simple and compound interest will
be discussed. Next, we will define the effective interest rate and
present value. To allows customers greater flexibility in the way in
which they repay loans, financial institutions use a procedure called
continuous compounding to calculate interest payments.
In section 2.4 we have a series of regular payments made at the
end of each period and whose compounding and payment periods
coincide, this called an ordinary annuity. In this section, the formulas
for the future and present value of an ordinary annuity have been
discussed.
Section 2.5 examines the three methods commonly used to
calculate the depreciation on particular capital assets.

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2.2

Simple Interest

The study of interest is very important and fundamental to the

understanding of the economy of a country.
Interest is money earned when money is invested or interest is
charge incurred when a loan or credit is obtained.
If you deposit a sum of money P in a savings account or if you
borrow a sum of money P from a lending agent such as financial
agency or bank, then P is call principal. Usually we have to repay this
amount P plus an extra amount. These extra amounts, which pay to
the lender for the convenience of using lender money is called
interest.
Simple interest formula is given by the following formula:
Simple Interest
Where

I Pr t

I = simple interest
P = principal
r = rate of simple interest
t = time in years

In general, if the principal P is borrowed at a rate r after t years,

the borrower will owe the lender an amount A that will include the
principal P plus interest I. Since P is the amount that is borrowed now
and A is the amount that must be paid back in the future, P is
often referred to as the present value and A as the future value. The
formula relating A and P is as follows:

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Amount Simple Interest/Simple Amount/ Future Value

A P Pr t
P 1 rt
Where
A = amount or future value
P = principal or present value
r = rate of simple interest
t = time in years
Example 2.2.1
RM1000 is invested for two years in a bank, earning a simple
interest rate of 8% per annum. Find the simple interest earned
Solution
P RM 1000
r 0.08
t2
I Pr t
1000 0.08 2
RM 160

Exercise 1
RM5000 is invested for 6 years in a bank, earning a simple interest
rate of 5.7 % per annum. Find the simple interest earned
I=RM 1710
Example 2.2.2
RM10000 is invested for 4 years 9 month in a bank earning a
simple interest rate of 10% per annum. Find the simple amount at
the end of the investment period.
Solution

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P RM 10000
r 0.1
t 4 years9month 4.75 years
A P 1 rt

10000 1 0.1 4.75

RM 14750

Exercise 2
If Bank A offers a simple interest rate of 8 % per annum, Ahmad
invested RM 9000 for 4 years 6 months in a bank earning. Find the
future value obtain by Ahmad at the end of the investment period.
Anwer
A RM 12240

Example 3.2.3
Find the present value at 8% simple interest of a debt amount
RM3000 due in ten months.
Solution
A RM 3000
r 0.08
10
t years
12
P ??
P A 1 rt

10
3000 1 0.08
12

RM 2812.50

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Example 3
Find the present value at 6% simple interest with total amount of
debt RM 40000 due in 15 years.
Anwer
P RM 21052.63

2.3

Compound Interest

Compound interest is based on the principal which interest

changes from time to time. Interest that is earned is compounded or
converted into principal and earns thereafter. Hence the principal
increases from time to time. The formula to compute the amount of
compound interest is given below

Amount: Compound Interest/Future Value

A P1 i

Where i r m and n mt
A = amount or future value at the end of n periods
P = principal or present value
r = annual nominal rate
m = number of compounding periods per year
i = rate per compounding period
n = total number of compounding periods
t= time in year
Some important terms are best explained with the following
example.

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Suppose RM9000 is invested for 7 years at 12% compounded

quarterly
Principal, P
The original principal, denoted by P is the original amount
invested. Here the principal is P = RM 9000
Annual nominal rate, r
Annual nominal rate denoted by r is the interest rate for a year
together with the frequency in which interest is calculated in a
year. Thus the annual nominal rate is given by r = 12%
compounded quarterly, that is four times a year.
Frequency of conversions/ number of compounding periods per
year, m
Frequency of conversion denoted by m is the number of times
interest is calculated in a year. The annual nominal rate is given
by r = 12% compounded quarterly, that is four times a year. In
this case, m=4
Interest period
Interest period is the length of time in which interest is
calculated. Thus, the interest period is three month.
Periodic interest rate, i
Periodic interest rate denoted by i is the interest rate for each
interest period. Thus, the periodic interest rate in this case is given
r 12%
3%
by i
m
4
Number of interest periods in the investment period/ total number
of compounding periods, n
The number of interest periods during the investment period
denoted by n is the number of times interest is calculated. The
number of interest periods is given by n mt . Thus, n 4 7 28 .

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Example 2.3.1
Find the accumulated amount after 3 years if RM1000 is invested at
8% per year compounded
a) Annually
b) Semi-annually
c) Quarterly
d) Monthly
e) Daily
Solution
a Annually
P 1000,r 0.08,m 1,n 3
A P 1 i

thus i

r
0.08
m

1000 1 0.08

1259.71

b semi annually
P 1000,r 0.08,m 2,n mt 2 3 =6
A P 1 i

thus i

r 0.08

0.04
m
2

1000 1 0.04

1265.32

c quarterly
P 1000,r 0.08,m 4,n mt 4 3 =12
A P 1 i

thus i

r 0.08

0.02
m
4

1000 1 0.02

12

1268.24

d monthly
A 1270.24

e daily
A 1271.22
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Example 2.3.2
RM9000 is invested for 7 years 3 months. This investment is
offered 12% compounded monthly for the first 4 years and 12%
compounded quarterly for the rest of the period. Calculate the future
value of this investment.
Solution
amount of investment at the end of 4 years
P 9000
A 14510.03
amount of investment at the end of 7 years 3 month(3years3months)
r 0.12
P 14510.03,r 0.12,m 4 ,n mt 3.25 4 =13 thus i
m
4
A P 1 i

0.12

14510.03 1

21308.48

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Example 3.3.3
What is the annual nominal rate compounded monthly that will
make RM1000 become RM2000 in five years?
Solution
P 1000, A 2000,r ??,m 12,n mt 5 12 =60
A P 1 i

r
A P 1
m

thus i

r
r

m 12

mt

r 13.94%

Example 4
Determine the annual nominal rate compounded quarterly that will
make RM10000 increase to RM25000 in 10 years?
r=9.27%
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2.3.1 Effective Rate of Interest

Interest actually earned on an investment depends on the
frequency with which the interest is compounded. One such way of
comparing interest rates is provided by the use of the effective rate.
The effective rate is the simple interest rate that would produce same
accumulated amount in 1 year as the nominal rate compounded m
times a year. The effective rate also called the effective annual yield.
The formula for computing the effective rate of interest is given below

Effective Rate of Interest

r
reff 1 1
m

Where
reff = effective rate of interest
r = annual nominal interest rate
m = number of compounding periods per year

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Example 2.3.4
Find the effective rate of interest corresponding to a nominal rate of
8% per year compounded
a) Annually
b) Semi-annually
c) Quarterly
d) Monthly
e) Daily
Solution
a Annually
r 0.08,m 1

r
reff 1 1
m

1 0.08 1
0.08
the effective rate is 8 % per year
b semi annually
r 0.08,m 2
m

reff 1 1
m

0.08
1
1
2

0.0816
the effective rate is 8.16% per year

c quarterly
The effective rate is 8.243% per year

d monthly
The effective rate is 8.3% per year

e daily
The effective rate is 8.328% per year

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Example 2.3.5 (Application Effective rate of Interest)

Kamal wishes to borrow some money to finance some business
expansion. He has received two different quotes:
Bank A: charges 15.2% compounded annually
Bank B: charges 14.5% compounded monthly
Which bank provides a better deal?
Solution
r 15.2%,m 1
effective rate of bank A is

r
reff 1 1
m

15.2%
1
1
1

15.2%
effective rate is 15.2% per year
r 14.5%,m 12
effective rate of bank B is
m

reff 1 1
m

BANK
A
B

15.2%
14.5%

Effective rate
15.2%
15.5%

Hence bank A provides better deal as it charges a lower effective rate

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2.3.2 Present Value

Recall:
Amount: Compound Interest/Future Value

Where i r m and n mt

A P1 i

Present Value of Compound Interest

P A 1 i

Where i r m and n mt
A = amount or future value at the end of n periods
P = principal or present value
r = annual nominal rate
m = number of compounding periods per year
i = rate per compounding period
n = total number of compounding periods

The process for finding the present value is called discounting.

Example 3.3.6
How much money should be deposited in a bank paying interest at
the rate of 6% per year compounded monthly so that, at the end of 3
years, the accumulated amount will be RM20000?
Solution
P ??, A 20000,r 0.06,m 12,n mt 3 12 =36 thus i
P A 1 i

r 0.06

m 12

0.06

20000 1

12

16713

36

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RM 16713 should be invested so that we get accumulated RM 20000

after 3 years
Exercise 5
Find the present value of RM 56 500 due in 7 years at an interest of
8% per year compounded semi-annually.
P= RM 32, 627.34
Example 2.3.7
Find the present value of RM49, 158.60 due in 5 years at an interest
of 10% per year compounded quarterly.
Solution
P ??, A 49158.60,r 0.1,m 4,n mt 5 4 =20
P A1 i

thus i

r 0.1

m 4

0.1
49158.60 1
4

30000.07

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Example 2.3.8 (HOMEWORK1)

A debt of RM3000 will mature in three years time. Find
a) The present value of this debt
b) The value of this debt at the end of the first year
c) The value of this debt after four years
Assuming money is worth 14% compounded semi-annually
Solution
a P 1999.03

b P 2288.69
c A 3434.70

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2.3.3 Continuous Compounding of Interest

Thus far, we have been discussing compounding of interest on
discrete time intervals (daily, monthly, etc). If compounding of
interest is done on a continuous basis the formula is
Amount: Compound Interest
A Peit
A = amount or future value at the end of n periods
P = principal or present value
e = 2.718282
i = rate per compounding period
t = time in years

Example 2.3.9
Find the accumulated value of RM1000 for six months at 10%
compounded continuously.
Solution
P 1000, A ??,i 0.10,t

6
0.5 year
12

A Peit
1000e0.1 0.5
1051.27

Exercise 6
Find the accumulated value of RM8000 in 1 year 4 months at 8%
compounded continuously.
A=8900.51
Example 2.3.10 (HOMEWORK2)
Find the amount to be deposited now so as to accumulate RM1000
in eighteen months at 10% compounded continuously.
Solution
A Peit
P 860.71
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2.4

Annuities

Annuity is a sequence of equal payments made at equal

intervals of time. Examples of annuity are shop rentals, insurance
policy premiums, instalment payment, etc. In this section we shall
discuss ordinary annuity certain. An annuity in which the payments
are made at the end of each payment period is call ordinary
annuity certain.
2.4.1 Future Value of Ordinary Annuity Certain
Future value of an ordinary annuity certain is the sum of all the
future values of the periodic payments. Formula for calculate the
future value of ordinary annuity certain is

Future Value of Ordinary Annuity Certain

1 i n 1
S R

Where i r m and n mt

S = future value of annuity at the end of n periods

R = periodic payments
i = interest rate per interest period
n = term of investment
Example 2.4.1
Find the amount of an ordinary annuity consisting of 12 monthly
payments of RM100 that earn interest at 12% per year compounded
monthly.
Solution

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R 100,S ??,i

r 0.12

0.01,n mt 12 1 12
m 12

1 i n 1
S R

1 0.01 12 1
100

0.01

1268.25

sum of all the future values

Example 2.4.2 (D)
RM 100 is deposited every month for 2 years 7 month at 12%
compounded monthly. What is the future value of this annuity at the
end of the investment period?
Solution
R 100,S ??,i

r 0.12
31

0.01,n mt 12 31
m 12
12

1 i n 1
S R

1 0.01 31 1
100

0.01

3613.27

Example 2.4.3 (Try verify given answer)

RM100 was invested every month in an account that pays 12%
compounded monthly for two years. After the two years, no more
deposit was made. Determine the future value of this annuity at the
end of the investment period?
Anwser
S=2697.35

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Example 2.4.4 (D)

Lily invested RM100 every month for five years in an investment
scheme. She was offered 5% compounded monthly for the first three
years and 9% compounded monthly for the rest of the period.
Determine the future value of this annuity at the end of five years
and total amount money after 5 years.
Solution
amount just after the 3rd year
S 3875.33
amount at the end of 5 years

24

0.09
A 3875.33 1

12

4636.50
amount at the end of 5years
r 0.09
R 100,S ??,i
,n mt 12 2 24
m 12
1 i n 1
S R

24

0.09

1
1

12

100
0.09

12

2618.85
hence, the amount in the account at the end of 5 years is
RM4636.50 RM2618.85 RM 7255.35

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2.4.2 Present Value of Ordinary Annuity Certain

In certain instances, we may try to determine the current value
P of a sequence of equal periodic payment that will be made over a
certain period of time. After each payment is made, the new balance
continues to earn interest at some nominal rate. The amount P is
referred to as the present value of ordinary annuity certain. Formula to
calculate this present value is given below.

1 1 i n
P R

Where

P = present value of annuity at the end of n periods

R = periodic payments
i = interest rate per interest period
n = term of investment
Example 2.4.5
After making a down payment of RM4000 for an automobile,
Maidin paid RM400 per month for 36 month with interest charged
at 12% per year compounded monthly on the unpaid balance. What
was the original cost of the car?
Solution
0.12
,n mt 12 3 36
12
1 1 i n
P R

1 1 0.01 36
400

0.01

12043
R 400,i

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Example 2.4.6
As a savings program toward Alfian college education, his parents
decide to deposit RM100 at the end of every month into a bank
account paying interest at the rate of 6% per year compounded
monthly. If the saving program began when Alfian was 6 years old,
how much money would have accumulated by the time he turn 18?
P= RM 10247.47

Example 2.4.7 (HOMEWORK3)

Ray has to pay RM300 every month for twenty-four months to settle
loan at 12% compounded monthly.
a) What is the original value of the loan?
b) What is the total interest that he has to pay?
a P 6373.02

b total interest RM 826.98

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2.4.3 Amortization
An interest bearing debt is said to be amortized when all the
principal and interest are discharged by a sequence of equal payments
at equal intervals of time.

Amortization
R

Pi
n
1 1 i

Where
P = present value of annuity at the end of n periods
R = periodic payments
i = interest rate per interest period
n = term of investment

Example 2.4.8
A sum of RM50000 is to be repaid over a 5 year period through
equal instalments made at the end of each year. If an interest rate of
8% per year is charged on the unpaid balance and interest
calculations are made at the end of each year, determine the size of
each instalment so that the loan is amortized at the end of 5 years.
Solution
P 50000 ,i
R

0.08
,n mt 1 5 5
1

Pi
1 1 i

50000 0.08

1 1 0.08

12522.82

Have to pay RM 12522.82 per year within 5 years

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Example 2.4.9
Andy borrowed RM120, 000 from a bank to help finance the
purchase of a house. The bank charges interest at a rate 9% per year
in the unpaid balance, with interest computations made at the end
of each month. Andy has agreed to repay the loan in equal monthly
instalments over 30 years. How much should each payment be if
the loan is to be amortized at the end of the term?
Solution
P 120000,i

0.09
0.0075,n mt 12 30 360
12

R 965.55

Have to pay RM 965.55 per month within 30 years

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2.4.4 Sinking Fund

Sinking funds are another important application of the annuity
formula. Simply stated, a sinking fund is an account that is set up
for a specific purpose at some future date. For example, an
individual might establish a sinking fund for the purpose of
discharging a debt at a future date. A corporation might establish a
sinking fund in order to accumulate sufficient capital to replace
equipment that is expected to be obsolete at some future date. The
formula for finding the sinking fund is given below
Sinking Fund
R

iS
n
1 i 1

Where
S = future value of annuity at the end of n periods
R = periodic payments
i = interest rate per interest period
n = term of investment

Example 2.4.10 D
A debt of RM1000 bearing interest at 10% compounded annually is to
be discharged by the sinking fund method. If five annual deposits
are made into a fund which pays 8% compounded annually,
a) Find the annual interest payment
b) Find the size of the annual deposit into the sinking fund
c) What is the annual cost of this debt?
Solution
a annual interest payment RM 1000 0.10 RM 100

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b S 1000,i 0.08,n 5
R

iS

1 i 1
0.08 1000

5
1 0.08 1
n

170.46
c annual cost annual interest payment + annual deposit
RM 100 RM 170.46
RM 270.46
Pay RM 270.46 annually for 5 years

Example 2.4.11
The proprietor of Carling Hardware has decided to set up a sinking
fund for the purpose of purchasing a truck in 2 years time. It is
expected that the truck will cost RM 30000. If the fund earns 10%
interest per year compounded quarterly, determine the size of each
instalment the proprietor should pay.
Solution
R 3434.02 per month for 2 years

Example 2.4.12
Harris, a self employed individual who is 46 years old, is setting up a
defined benefit retirement plan. If he wishes to have RM250000 in
this retirement account by age 65, what is the size of each yearly
instalment he will be required to make into a saving account earning
1
interest at 8 % yr?
4
m=1
Solution
R 5313.59

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2.5

Depreciation

Depreciation is an accounting procedure for allocating the cost

of capital assets, such as buildings, machinery tools and vehicles over
their useful life. It is important to note that depreciation amount are
estimates and no one can estimate such amounts with certainty.
Depreciation expenses allow firms to recapture the amount of money
to provide for replacement of the assets and to recover the original
investments. Depreciation can also be viewed as decline in value of
assets because of age, wear or decreasing efficiency. Many properties
such as buildings, machinery, vehicles and equipment depreciate in
value as they get older.
Several terms are commonly used in calculation relating to
depreciation. The terms are
Original cost
The original cost of an asset is the amount of money paid for an asset
plus any sales taxes, delivery charges, installation charges and other
cost.
Salvage value
The salvage value (scrap value or trade in value) is the value of an
asset at the end of its useful life. If a company purchases a new
machine and sells it for RM600 at the end of its useful life, then the
salvage value is RM600. The salvage value of an asset is an estimate
that is usually based on previous salvage value of a similar asset.
Useful life
The useful life an asset is the life expectancy of the asset or the
number of years the asset is expected to last. For example, if a
company expects to use machinery for 10 years, then its useful life is
10 years.
Total depreciation
The total depreciation or the wearing value of an asset is the
difference between cost and scrap value.
Annual depreciation
The annual depreciation is the amount of depreciation in a year. It
may or may not be equal from year to year.

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Accumulated depreciation
The accumulated depreciation is the total depreciation to date. If the
depreciation for the first year is RM2000 and for the second year
RM1000 then the accumulated depreciation at the end of the second
year is RM3000
Book value
The book value or carrying value of an asset is the value of the asset
as shown in the accounting record. It is the difference between the
original cost and the accumulated depreciation charged to that date.
For example a car which was purchased for RM40000 two years ago,
will have a book value of RM34000 if its accumulated depreciation
for two years is RM6000.
Three method of depreciation are commonly used. These methods are
1. Straight line method
2. Declining balance method
3. Sum of years digits method
2.5.1 Straight Line Method
The straight line method of computing depreciation is the
simplest of the three methods and probably the most common method
used. Under the straight line method, the total amount of depreciation
is spread evenly to each accounting period through the useful life of
the asset. The formula for finding the annual depreciation, annual rate
of depreciation and book value are given below
Straight Line Method

cost salvage value

useful life
total depreciation

useful life
annual depreciation
annual rate of depreciation
100% or
total depreciation
1

100%
useful life
book value
cost accumulated depreciation 25
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Example 2.5.1
The book values of an asset after the third year and fifth year using the
straight line method are RM7000 and RM5000 respectively. What is
the annual depreciation of the asset?
Solution
Decline in value from third year to fifth year = RM7000-RM5000
=RM2000
this decline occurs within two years. hence
RM 2000
annual depreciation

2
RM 1000

Example 2.5.2
John Company bought a lorry for RM38000. The lorry is expected to
last 5 years and its salvage value at the end of 5 years is RM8000.
Using the straight line method to;
a) Calculate the annual depreciation
b) Calculate the annual rate of depreciation
c) Calculate the book value of the lorry at the end of third year
d) Prepare a depreciation schedule
Solution
a Cost RM 38000
Salvage value RM 8000
Total Depreciation RM 38000 RM 8000 RM 30000
Useful life 5 years
cost salvage value
annual depreciation

useful life
RM 38000 RM 8000

5
RM 6000
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annual depreciation
100%
total depreciation
6000

100%
30000
20%
c book value cost accumulated depreciation

b annual rate of depreciation

RM 38000 3 RM 6000
RM 20000
(d)
End of
Year
0
1
2
3
4
5

Annual
Depreciation(RM)
0
6000
6000
6000
6000
6000

Accumulated
Depreciation (RM)
0
6000
12000
18000
24000
30000

Book value at end

Of year(RM)
38000
32000
26000
20000
14000
8000

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2.5.2 Declining Balance Method

Declining balance method is an accelerated method in which
higher depreciation charged are deducted in the early life of the asset.
Formula for finding book values, annual rate of depreciation and
accumulated depreciation is given below
Declining Balance Method
n
BV
C 1 r
where BV Book Value
C cost of asset
r annual rate of depreciation
n number of years
S
C
where r
S
C
n

r 1 n

salvage value
cost of asset
number of years

Da C C 1 r

where Da accumulated depreciation

C cost of asset
r annual rate of depreciation
n number of years
Example 2.5.3
The cost of fishing boats is RM150000. Declining balance method is
used for computing the depreciation. If the depreciation rate is 15%,
compute the book value and accumulated depreciation of the boat at
the end of 5 years.
Solution
BV=RM 66555.80
Da RM 83444.20
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Example 2.5.4
Given
Cost of the asset = RM15000
Useful life = 4 years
Scrap value = RM3000
a) Find the annual rate of depreciation
b) Construct the depreciation schedule
Using the declining balance method
Solution
a C RM 15000
S RM 3000
n 4 years
r 1 n

S
C

3000
15000
33.13%
b Depreciation
1 4

for the first year = 33.13% RM15000 =RM 4969.50

Year
Annual
Accumulated
Depreciation(RM)
Depreciation (RM)
0
0
0
1
4969.50
4969.50
2
3323.10
8292.60
3
2222.16
10514.76
4
1485.24
12000

Book Value (RM)

15000
10030.50
6707.40
4485.24
3000

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2.5.3 Sum of Years Digits Method

The sum of years digits method is another accelerated method.
In this method, the rate of depreciation is based on the sum of the
digits representing the number of years of useful life of the asset. If an
asset has a useful life of 3 years, the sum of digits is S = 1+2+3=6,
while for an asset with a useful life of 5 years, the sum of digits is S =
1+2+3+4+5=15. Since S is an arithmetic progression, S can be
calculated with the formula
Sum of Years Digits Method
n n 1
S
2
where S sum of years digits
n number of years

The depreciation in the first year is

the asset,
Depreciation in the the second is
the asset,
Depreciation in the the third is

n
X the depreciable value of
s

n 1
X the depreciable value of
s

n2
X the depreciable value of the
s

asset and so on

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Universiti Malaysia Perlis 2013

Example 2.5.5
A machine is purchased for RM45000. Its life expectancy is 5 years
with a zero trade in value. Prepare a depreciation schedule using the
sum of the years digits method.
Solution
useful life,n 5
sum of years digits, S 1 2 3 4 5 15
or
n n 1 5 6

15
2
2
Amount of depreciation for each year is calculated as follows
S

Year
1
2
3
4
5

Annual Depreciation
5
RM 45000 RM 15000
15
4
RM 45000 RM 12000
15
3
RM 45000 RM 9000
15
2
RM 45000 RM 6000
15
1
RM 45000 RM 3000
15

The depreciation schedule is as follows

Year
Annual
Accumulated
Depreciation(RM)
Depreciation (RM)
0
0
0
1
15000
15000
2
12000
27000
3
9000
36000
4
6000
42000
5
3000
45000

Book Value (RM)

45000
30000
18000
9000
3000
0

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Universiti Malaysia Perlis 2013

Example 2.5.6
A computer is purchased for RM3600. It is estimated that its salvage
value at the end of 8 years will be RM600. Find the depreciation and
the book value of the computer for third year using the sum of the
years digits method.
S 36
C RM 3600
S RM 600
Depreciable value =RM3000
Depreciation for the third year =RM500
Accumulated depreciation for the first 3years =RM1750
Book Value = RM 1850
Solution
n n 1 8 9
S

36
2
2
C RM 3600
S RM 600
Depreciable value = Original Cost Salvage Value
=RM3600 RM600
=RM3000
6
Depreciation for the third year =
3000
36
=RM500
7
6
8
RM 3000
36 36 36
=RM1750

Accumulated depreciation for the first 3years =

Book Value = RM3600 RM1750
= RM 1850

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