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Construction of Valuation Tables P10486
Construction of Valuation Tables P10486
valuation tables
2 Learning outcomes
After studying this paper you should be able to:
Make the various calculations using the given formulae.
Show the interrelationship of the tables.
Describe the function of each table and when to apply each table in
practice.
3 Introduction
The valuation tables merely express formulae, which could be found with a
financial or scientific calculator, and a knowledge of principles. However, you
will find tables more convenient to use for problem solving. This paper deals
primarily with the construction of the tables. At the heart of the matter is
compound interest, and this is considered first.
Throughout this paper, calculations are based on the assumption of income
being received yearly in arrear.
4 Compound interest
In most societies the payment of interest for the use of capital is an established
part of economic life. In financial practice, the term ‘interest’ may have various
meanings and that in any given circumstance it is obviously important to be
certain as to the meaning which is being attached to the term.
The assumption here is that if the investor had not purchased the land, he
would have had his capital invested elsewhere earning interest, and since he
has not been using that interest, even that might have been put back with the
capital to acquire still more interest. That is to say, the investor had had to give
up £5,000 in cash and £1,535 in loss of compound interest which he might
otherwise have enjoyed. At the end of five years the real cost of the land to the
investor is £6,535 if it is lying waste.
It may be argued that in order to purchase the land, the investor drew money
from his bank and so is losing compound interest at a lower rate than 5.5
percent if his bank does pay a rate lower than 5.5 percent. The answer to this is
that for five years he has had his money invested in property which he
considered, owing to the risks involved, should yield 5.5 percent, and he quite
correctly assesses the lost compound interest at that rate and not at the rate of
interest the bank or his previous investments were paying him.
In stating rules and formulae for the purpose of working out other tables of
compound interest, we shall assume that the amount of £1 at the given rate
percent, and for the given number of years, is already known, or can be worked
out, and we shall refer to this amount as ‘A’:
Amount of £1 = A =(1 + i)n
5.2.1 Formula
It will be seen that Example 2 is the reciprocal of Example 1, and it will follow
that the two tables are reciprocal also, that is to say:
1 1
Present value of £1 = or =V
Amount of £1 A
Substituting in the formula for A given above,
1
V = Present value of £1 = n
(1+ i)
Alternatively V + compound interest on V for n years @ i% = 1 where V is the
sum to be paid for a future income of £1 in n years.
1
∴ V(1 + i)n = 1; V =
(1+i)n
The sum to be paid now for £1,000 p.a. for three years = £2,486.84. But
using the tables at p.34 we have:
Income £1,000
YP 3 years @ 10%. 2.4869
£2,486.90
5.3.1 YP formula
The formula for the years’ purchase for a limited term may be found in one of
two ways:
from the summation of present values
from the sinking fund concept.
5.3.2 Years’ purchase (single rate) as the summation of present values
The present value of an income of £1 p.a. is the present value of £1 in one
year, plus the present value of £1 in two years and so on. To find, for example,
the present value of £1 p.a. in three years we have:
1 1 1
+ +
(1 + i) (1 + i) 2
(1 + i)3
5.3.3 Years’ purchase (single rate) from the sinking fund theory
The income is made up of two parts, i.e. interest on capital expended and
replacement of capital expended. It follows from this that:
1
Years’ purchase =
i+SF
where SF is the annual sinking fund to replace each £1 of expenditure over the
period of the income at i%.
There are therefore two alternative formulae in the case of YP single rate, each
of which gives the same result.
Example 4
Find the years’ purchase for three years at 10 percent
1-V
a YP =
i
=
1-
(1(1+i) )
3
i
1-0.7513
=
0.10
= 2.487
1
b YP =
i+SF
1
=
0.1+0.3021148*
1
=
0.4021148
Note: The instalments are taken for convenience from the end of the term
instead of from the beginning. As the payments are handed over to the bank at
the end of each year, the last instalment is paid in and drawn out again before it
has had time to earn any interest. The remainder of the calculation is simple
and is performed as for calculating (1 + i)n.
This table is valuable to landowners who have property entailing regular annual
expenditure for a period without any productive return until the end of the
period. Mining undertakings or timber plantations occasionally provide such
conditions.
Example 7
Owing to unfavourable conditions a small mining concern had to shut
down for five years. As a safeguard to the property, certain pumping
operations had to be carried out during the whole term at an annual cost
of £500. What is the cost of the pumping operation at the end of the 5
years, if compound interest is allowed for at 5 percent per annum?
Another use to which this table may be put is the checking of calculations
involving sinking funds as shown in Example 8.
5.6.1 Formula
The Annual Sinking Fund table is the reciprocal of the amount of £1 p.a.
1
Annual sinking fund =
Amount of £1 p.a.
Check
Annual sinking fund payment
Amount of £1 p.a. in 10 years @ 2.5% (see p.144)
Capital sum replaced in 10 years @ 2.5% £
Example 9
This example will introduce problems involved in deriving one table from
another; such are common in examinations.
Calculate the sinking fund necessary to produce £1 at the end of 21
years at 2.25 percent using:
a. the Amount of £1 p.a. table
b. the Amount of £1 table.
Answer (a)
1 1 ❑
Annual sinking fund = = =
Amount of £1 p.a. ❑ ❑
Answer (b)
1
Annual sinking fund = = = =
A-1