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Teaching Module

2.1

Introduction

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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Universiti Malaysia Perlis 2013

2.2

Simple Interest

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

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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Universiti Malaysia Perlis 2013

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

Answer

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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Universiti Malaysia Perlis 2013

P RM 10000

r 0.1

t 4 years9month 4.75 years

A P 1 rt

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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Universiti Malaysia Perlis 2013

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

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

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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Universiti Malaysia Perlis 2013

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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Universiti Malaysia Perlis 2013

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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Universiti Malaysia Perlis 2013

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

13

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?

Answer

r=9.27%

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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

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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Universiti Malaysia Perlis 2013

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

10

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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%

11

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Recall:

Amount: Compound Interest/Future Value

Where i r m and n mt

A P1 i

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

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

12

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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.

Answer

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

20

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

13

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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.

Answer

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

14

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2.4

Annuities

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

1 i n 1

S R

Where i r m and n mt

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

15

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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

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

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

16

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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

17

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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

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

18

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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?

Answer

P= RM 10247.47

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?

Answer

a P 6373.02

19

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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

20

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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

21

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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

22

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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

23

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2.5

Depreciation

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.

24

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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

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

__________________________________________________________________

annual depreciation

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

26

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annual depreciation

100%

total depreciation

6000

100%

30000

20%

c book value cost accumulated 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

Of year(RM)

38000

32000

26000

20000

14000

8000

27

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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

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

28

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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

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

15000

10030.50

6707.40

4485.24

3000

29

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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 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

30

__________________________________________________________________

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

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

45000

30000

18000

9000

3000

0

31

__________________________________________________________________

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.

Answer

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

Book Value = RM3600 RM1750

= RM 1850

32

__________________________________________________________________

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