REVIEW QUESTIONS:

1. What is a sinking fund? When does a sinking fund situation occur?

A sinking fund is a fund established by an economic entity by setting aside revenue
over a period of time to fund a future capital expense, or repayment of a long-term
debt.Sinking fund situation occurs when the future value of an annuity is known, and the
payment required each period to accumulate to that future value is the unknown. Sinking
funds are accounts used to set aside equal amounts of money at the end of each period,
at compound interest, for the purpose of saving for a future obligation. It is also a long-
term debt with a large amount suggest that the debtor periodically deposit a sum of money
in a sinking fund in order to retire the principal on the maturity date. The periodic deposit
may or may not be equal amounts nor be at equal intervals. However, in this chapter only
illustrations of periodic deposits made at equal intervals and in equal amounts are
considered. Since the deposits may be made either at the end of or the beginning of each
period, the deposits thus from an annuity problem.

2. Give some purposes for which a sinking fund may be or use.

Businesses use sinking funds to accumulate money for purposes such as
acquiring a new equipment, facility expansion, and retiring financial obligations such as
bond issues that come due at a future date. Likewise, individuals can use sinking funds
to save for a college education, a car, down payment on a house, or a vacation.

3. How is sinking fund payment computed using table?

In a sinking fund, the future value is known; therefore, the future value of an annuity
table or table 3 is used to compute the amount of the payment. Sinking fund payment is
found by dividing the future value of the sinking fund by the future value table factor, or
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑
Sinking fund payment =
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑎𝑏𝑙𝑒 𝑓𝑎𝑐𝑡𝑜𝑟

Example: What sinking fund payment is required at the end of each 6-month period, at
6% interest compounded semiannually, to amount to P120,000 in 4 years?
This sinking fund is for 8 periods (4 years x 2 periods per year) at 3% per period (6% ÷
2 periods per year). From table 3, the future value table factor is 8.892336
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑
Sinking fund payment = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑎𝑏𝑙𝑒 𝑓𝑎𝑐𝑡𝑜𝑟
 120,000
Sinking fund payment = 8.892336

Sinking fund payment = P13,494.77

4. State the sinking fund payment formula.
Sinking fund payment may be computed using the formula:
𝑖
Sinking fund payment = FV x ( 1+ 𝑖 )ⁿ −1

Where
FV = amount needed in the future
i = interest rate per period (nominal rate ÷ periods per year)
n = number of periods (years x periods per year)

Example : Calantha Corporation needs P1,000,000 in 5 years to pay off a bond issue.
What sinking fund payment is required at the end of each month, at 12% interest
compounded monthly, to meet this financial obligation?
𝑖
Sinking fund payment = FV x ( 1+ 𝑖 )ⁿ −1

Sinking fund payment = 1,000,000 x .01

(1+.01)60 – 1
.01
Sinking fund payment = 1,000,000 x .8166967

Sinking fund payment = 1,000,000 x .0122444

Sinking fund payment = P12,244.40

5. How does the interest rate on a debt differ from the interest rate on a sinking
fund investment.
Since the sinking fund is established for paying the principal of the debt at maturity,
the periodic interest on the debt should not be paid out of the fund. The interest rate on
the debt may or may not equal the rate used for the sinking fund investment. The interest
is called interest expense, whereas the interest from the sinking fund investment is called
sinking fund income. It is emphasized that the interest date is also regarded as the date
for making the periodic deposit to the fund. The debtor thus is making two payments on
each payment date – one for the interest on the debt and the other as a deposit to the
fund.
Example : A P40,000 debt is to be repaid at the end of 1 ½ years. Interest changed is
15% payable at the end of every 3 months. The debtor established a sinking fund that
earns 12% interest compounded quarterly. (a) find the interest payment on the debt for
each 3-month period. (b) Construct a sinking fund schedule.
(a) The quarterly interest payment for the debt is computed using I = PRT, or
I = 40,000 x 15% x ¼ = P1,500
(b) The size of each quarterly deposit in the sinking fund is found using table 3. This
sinking fund is for 6 periods (1 ½ years x 4 periods per year) at 3% per period (12%
÷ 4 periods per year).
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑
Sinking fund payment =
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑡𝑎𝑏𝑙𝑒 𝑓𝑎𝑐𝑡𝑜𝑟

40,000
Sinking fund payment = 6.468410

Sinking fund payment = P6,183.90

6. How is the interest on the debt computed?

Adjusted Periodic Deposits Schedule

(1) Principal at At End End of Each Principal

Period Beginning of Of Period Period Reduced by
(1-Month Each Period: (2) x 1% Each Payment
Interval) (2) – (5) (4) – (3)

1
2
3
4
5
6
7

The interest in column (3) is based on the following expression (see column (5) of
illustration 1):
 Actual interest income = Sinking fund accumulated x Interest rate

Thus, the interest for each period is computed as follows:

First period = 0 x 3% = 0
Second period = 6,183.90 x 3% = P185.52
Third period = 12,553.32 x 3 1/2% = P439.37
Fourth period = 19,113.82 x 3 1/2% = P668.98
Fifth period = 25,871.13 x 2 1/2% = P646.78
Sixth period = 32,831.16 x 2 1/2% = P820.72

Notice that the values in column (6), periodic increase in fund, of the above schedule
are the same as the values in column (4) of the sinking fund schedule of illustration 1.
The sum of the periodic increases in the fund equals the sum of the actual interest
income plus the sum of the adjusted (actual) deposits: 2,761.43 + 37, 238.57 =
P40,000.

7. What is amortization? Describe the situation where it could be applied.

Amortization is the opposite of a sinking fund. Amortization is a financial

arrangement whereby a lump-sum obligation measured at present value is incurred and
is paid off or liquidated by a series of equal periodic payments for a specified amount of
time at compound interest. With amortization the amount of the loan or obligation is
given, and the equal payments that will amortize or pay off the obligation must be
computed. Some business uses of amortization would be paying off real estate loans
and liquidating insurance. Long-term debts are normally in the form of long-term notes
or bonds with a maturity date that is more than one year. Long-term debts usually
involve large sums of money. A borrower many promise to discharge the debt by
making periodic partial payments under the amortization method.

The amortization method broadly refers to the discharging of a debt by means of a set
of regular or irregular and equal or unequal payments. In this chapter, only a debt
discharged by a sequence of equal payments at equal intervals of time is considered. In
order to discharge a debt, each payment must be greater than the periodic interest, so
that a part of payment applies to the interest and the remainder applies to the principal
until the principal becomes zero.

8. Using the table, how is amortization payment determined?

With amortization, the original amount of the loan or obligation is known (present
value). The present value of an annuity table or table 4 is used to compute the amount
of the payment. Amortization payment is found by dividing the present value of the
obligation by the present value table factor, or
 Amortization payment = Original amount of obligation
Present value table factor

EXAMPLE:
What amortization payments are required each month, at 12% interest, to pay off a
P10,000 loan in 2 years?

This amortization is for 24 periods (2 years x 12 period per year) at 1% per period (12%
÷ 12 periods per year). From Table 4, the present value table factor is 21.243387.

Amortization payment = 50,000 x __.015__

.4149103

Amortization payment = 50,000 x .0361524

Amortization payment = P1,807.62

Oftentimes both the creditor and the borrower must know the amount of the
outstanding principal or the unpaid balance on a certain date. The information may be
needed for various reasons: it may be necessary for accounting purpose; the creditor
may wang to sell the unpaid balance; the borrower may wish to know his or her equity
from an investment (such as house purchase price minus unpaid balance); or the
creditor and the borrower may agree to settle the balance on an earlier date.

The outstanding principal may be determined under two types of arrangements: (a) all
periodic payments are equal, or (b) all periodic payments, except the final payment, are
equal.

9. State the amortization formula.

When it is necessary for all the periodic payments to be the same, the method
given in illustration 2 (under amortization payment by table) should be used to find the
size of payments. The outstanding principal on certain date is the present value of an
annuity formed by the remaining unpaid payments, as shown below.

EXAMPLE:
Calvin purchased P1200000 worth of gym exercise and made a P200,000 down
payment He agreed to pay the balance by making equal ayments at the end of each
month for 15 years. If the interest charged is 12% compounded monthly, what is yhe
size of the monthly payment?
Find the outstanding principal after Calvin made the monthly payments for 10 years.
Here, Pmt = P12,001.68; i = 1% (12% ÷ 12); n = 60 (180 – 120). From Table 4, the table
factor is 44.955038.

Outstanding principal = 12,001.68 x 44.955038

Outstanding principal = P539,535.98

Instead of using the table as presented in the previous illustration, the outstanding
principal on a certain date may be obtained by constructing an amortization schedule
such as that shown in the next illustration.

EXAMPLE:

A debt of P40,000 is to be amortized by equal payments at the end of every quarter for
1 ½ years. If the interest charged is 12% compounded quarterly, find the outstanding
principal after each payment is made.

The outstanding principal is computed by first finding the size of the periodic payment
and then constructing and amortization schedule. Here, PV, = P40,000; i = 3% (12% ÷
4); n = 6 (1 ½ x 12). From the table 4, the table factor is 5.417191.

Amortization payment = Original amount of obligation

Present value table factor
Amortization payment = 40,000
5.417191
Amortization payment = P7,383.90

The amortization schedule is shown below:

(1) Principal at At End End of Each Principal

Period Beginning of Of Period Period Reduced by
(1-Month Each Period: (2) x 1% Each Payment
Interval) (2) – (5) (4) – (3)

1 60,000.00 600.00 10,000.00 9,400.00

2 50,600.00 506.00 10,000.00 9,494.00
3 41,106.00 411.06 10,000.00 9,588.94
4 31,517.06 315.17 10,000.00 9,684.83
5 21,832.23 218.32 10,000.00 9,781.68
6 12,050.55 120.51 10,000.00 9,879.49
7 2,171.06 21.71 2,192.77 2,171.06
 Total 2,192.77 62,192.77 60,000.00

Observe the amortization schedule of the illustration. Column (2) shows the outstanding
principal after each payment is made. For example, the outstanding principal after the
fourth payment is P14,128.87. The fourth payment is made at the end of the fourth
period. Thus, P14,128.87 is also the principal at the beginning of the fifth period. The
discharged portion of the original principal after the fourth period is P25,871.13 [40,000
– 14,128.87, or 6,183.90 + 6,369.42 + 6,560.50 + 6,757.31; see column (5) of the
schedule].

Each outstanding principal shown in column (2) may be checked. For example, the
outstanding principal after the fourth payment is made is the present value of an annuity
formed by two remaining unpaid payments. Here, Pmt = 7,383.90; i = 3% (12% ÷ 4); n =
2 (remaining quarterly payments). From Table 4, the present value of an annuity table
factor is 1.913470.
Outstanding principal=7,383.90 x 1.913470

Outstanding principal = P14,128.87

The last figures in Columns (2) and (5) should be the same. The total for Column (5)
should be equal to the original principal, P40,000. Theoretically, all the payments should
be equal. However, the schedule shows that the sixth payment is P7,383.91. the
discrepancy of one centavo results from rounding all computations to the nearest
centavos. For example, interest due at the end of the sixth period is computed as follows:

Interest = 7,168.84 x 3% = P215.0652 or P215.07

The size of the sixth payment, therefore, is 7,168.84 + 215.07 = P7,383.91. the final
payment covers the outstanding principal at the beginning of the last payment interval
and the interest due thereon.

Here, the interest for each period is computed by the simple interest method. It should
be observed that when a debtor makes each of the simple interest payments on the
interest date, the simple interest method is actually a compound interest method.

Also, note that as the principal is gradually reduced, the periodic interest becomes
smaller after each payment is made. Thus, a greater portion of each equal payment is
used in reducing the principal.

10. How is outstanding principal of amortization computed assuming all

amortization payments are equal?
 Sometimes, the size of each payment is not obtained by the method explained in
the previous section. Instead, it is specified by the agreement between the creditor and
the debtor, and a more convenient or rounded figures, such as P500 or P1,000, is
decided upon as the size of each payment. The exact size of the final payment is not
known. It may or may not equal size of other payments. The exact size of the final
payment may be known by constructing an amortization schedule.

EXAMPLE: A debt of P60,000 is to be discharged by payments of P10,000 at the end

of every month. Interest charged is 12% compounded monthly. Find (a) the number of
payments, (b) the outstanding principal after each payment is made, (c) the interest
included in each payment, (d) the principal included in each payment, and (e) the size of
the final payment and the total of the payments.

(1) Principal at At End End of Each Principal

Period Beginning of Of Period Period Reduced by
(1-Month Each Period: (2) x 1% Each Payment
Interval) (2) – (5) (4) – (3)

1 60,000.00 600.00 10,000.00 9,400.00

2 50,600.00 506.00 10,000.00 9,494.00
3 41,106.00 411.06 10,000.00 9,588.94
4 31,517.06 315.17 10,000.00 9,684.83
5 21,832.23 218.32 10,000.00 9,781.68
6 12,050.55 120.51 10,000.00 9,879.49
7 2,171.06 21.71 2,192.77 2,171.06
Total 2,192.77 62,192.77 60,000.00

The answers may be found in the respective columns of the amortization schedule.
 PROBLEM #1
SINKING FUND

FINDING THE SINKING FUND PAYMENT

SINKING PAYMENT TIME NOMINAL INTEREST FUTURE

FUND FREQUENCY PERIOD RATE COMPOUNDED VALUE
PAYMENT
P859.25 Every 3 months 4 years 16% Quarterly 187,500

WORD PROBLEMS
3. Caspar is planning a vacation in Bangkok in 4 years and will need P75,000 for the
trip. Caspar decides to set up a sinking fund savings account for the vacation. He
intends to make regular payments at the end of each 3 month period into the account
that pays 6% interest compounded quarterly. What periodic sinking funds payment will
allow him to achieve his vacation goal?
 PROBLEM #2
SINKING FUND
Finding the Unknown Values

In each of the following problems, find (a) the interest payment on the debt for each
interest period, (b) the size of deposit to the sinking fund, (c) the amount in the
sinking fund at the end of the nth period, (d) the book value of the debt at the end
of the nth period, and (e) the sinking fund interest income for the (n+1) th payment
period. Do not construct a sinking fund schedule in finding your answers.

Debt Interest Rate No. of Interest Rate nth Period

on the Debt Deposits in on Sinking
Sinking Fund Fund
1 P 6,000 24%, 20, monthly 18%, 6th
monthly monthly
2 10,000 6%, monthly 8, semi- 5%, semi- 5th
annually annually
3 450 7%, annually 5, annually 10%, 3rd
annually

PROBLEM #3
SINKING FUND
Constructing a Sinking Fund Schedule

3.
Problem #4

6. Construct a sinking fund schedule for the first 2 years for the previous problem

At the end of Interest Periodic Period increase Sinking fund Book value
period (6 income on deposit in fund in fund accumulated 10, 000, 000
months) sinking fund
4%
1 …. 178,300.9905 178,300.9905 178,300.9905 9,821,699. 0095
2 7132.03962 178,300.9905 185,433. 0301 363,734. 0206 9,636,265.9794
3 14549.36082 178,300.9905 192,850.3513 556,584.3719 9,443,415.628
4 22263.37488 178,300.9905 200,564.3654 757148.7373 9,242,851.26

Problem 5

Loan Payment Payment Term of Loan Nominal Rate Present Value

period
5 Every month 1.5years 12% 8,500

Amortization payment = Original amount of obligation / Present value table factor

Amortization payment = 8,500 / 16.398269

Amortization payment = 518.3473939

Word Problem

3. The Clintons bought a home for P12, 050, 000. After a 15% down payment, the balance is financed at
8% interest for 9 years. (a) What equal quarterly payments will be required to amortize this mortgage
loan? (b) What is the total amount of interest the Clintons will pay on the loan?
Solution

A
N = 9 x 4 = 36 periods
I = 8% / 2 = 2%

Amortization payment = Original amount of obligation / present value table factor

Amortization payment = 10 242500 / 25.488842

Amortization payment = 401842.5003