Financial Markets

Brennan John Rivera, CPA

124
 Table of Contents

Module 8 Bond and Bond Valuation 126

Introduction 126
Learning Outcomes 126
Lesson 1 Classification of bonds 127
Lesson 2 Bond valuation 128
Lesson 3 Premium or Discount equation 131
Lesson 4 Amortization of the premium 133
Lesson 5 Accumulation of discount 136
Lesson 6 Bond between dates 138
Lesson 7 The yield or investment rate 140
Assessment Questions 145
References 146

Module 9 Depreciation
Introduction 147
Learning Outcomes 148
Lesson 1 Straight Line Method 148
Lesson 2 Declining Balance Method 150
Lesson 3 Sum of Years Digits Method 151
Lesson 4 Unit Product Method 153
Lesson 5 Sinking Fund Method 156
Lesson 6 Annuity Method 158
Assessment Questions 160
References 161

125
 MODULE 8
BONDS AND BOND VALUATION

Introduction

A bond is a written promise to pay a specified sum of money called redemption value
at specified future date called redemption date
A bond should not be mistaken for a promissory note, for bond is usually a long-term
obligation. A bond is an acknowledgment of obligation, together with an agreement to make
periodic payments known as coupon payment at a stated rate and to repay the principal on
a certain date.
A bond is said to be redeemed" when it is bought back by the corporation which issued
it. (Capitulo et al 1990)

Learning Outcomes

At the end of this module, students should be able to:

1. define bond and explain how is bond valued

2. calculate the amortization of bond premium and bond discount, redemption
value, coupon payment
3. compute the price of bonds in between interest dates
4. estimate the yield of the bonds

Lesson 1. Classification of Bond to security provided for a

bond (Capitulo et al., 1990)

1. Registered Bonds - Bonds that can only be transferred from one owner to another by
proper endorsement and with the consent of the issuer. Thus, the owner is protected against
loss or theft.

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2. Unregistered Bonds - Bonds that can be transferred from one owner to another at will and
anytime the owner desires.
A bondholder can sell his bond to the highest bidder. A bond bought at its face value
or par value is said to be bought at a par, if the bond is bought at a premium it is bought at a
price higher than the par value, and if it is below the face or par value is said to be bought at
discount.
Although bonds are seldom sold at par, and if they are sold at par value, the bond rate
and yield are equal.

Important features of bonds

1. Par or face value - the value quoted on the bond.
2. Redemption Date - the date on which the bond will be redeemed
3. Coupon - the contract to pay a periodic payment on a specified date. The coupons can be
detached and cashed through the bank.
4. Bond rate - the interest rate on the par value for the periodic coupon payments
5. Redemption value - the amount which will be paid on the redemption date
6. Redemption rate - the rate on the principal; it is used to find the redemption

Rates associated with bonds

1. Bond Rate (Br) the rate at which the bond pays interest on its par value.
2. Yield Rate(Y) the true overall rate of return that an investor receives on the invested capital.

Notations:
FV = Par or face value of a bond.
RV = Redemption value of a bond.
Br = Bond rate
Y = Yield rate
Rr = Redemption rate
Ср = Coupon payment
m = conversion period per year
n = total number of interest periods for the whole term.
b = bond rate per interest period.(Br/m)
i = yield rate per interest period (Y/m)

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Pp = Purchase price or Value of the bond.
Вр = Bond premium
Bd = Bond discount
MQ= Market Price
BV = Book Value

Lesson 2. Bond Valuation (Capitulo et al., 1990)

The price an investor can pay for a bond to return the desired yield on the value of a
bond may be determined, and the process is called bond valuation.
In this section we shall discuss the procedures for finding the redemption value,
coupon payment, purchase price of a bond, bond premium and bond discount

Formulas:
RV=FV Rr
Cp = FV xb b=Br/m
Pp = RV (1 + i)⋀⁻ⁿ + Cp a
n i
Table 3 Table 6
Bp = Pp - RV
Bd = RV-Pp

Let us work on the following examples to illustrate the application of the above.

Illustrative Examples:
1. A 5,000, 6% bond with quarterly coupons is redeemed at 115% at the end of 10 years. Find
the coupon payment and redemption value.

Given:

FV = P5,000; Rr = 115%; Br = 6%, m=4

Solution:

128
b = Br/m Rr = 115%
= 6%/4 = 1.15
= 1 1/2% or .015
Cp = FV xb
= P5,000 x .015
= P75
RV = FV x Rr
= P5,000 x 1.15
=5,750

2. A 10,000, 4% bond with semiannual coupons is redeemed at 95% at the end of 15 years.
Find the coupon payment and the redemption value.
Given:
FV = P10,000; Rr = 95%; Br = 4%; m=2

Solution:
b=Br/m Rr =95%
=4%2 = 0.95
= 2% or.02
Cp =FV xb
= P10,000 x .02
= P200
RV = FV x Rr
= P10,000 x .95
=P9,500

3. A 4,000, 5 1/2% bond with quarterly coupons is redeemed at par at the end of 5 years. Find
the coupon payment and redemption value.
Given:
FV = P4,000; Br = 5 1/2%; m = 4; Rr = at par (100%)

Solution:

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b= Br/m Rr = 100%
= 5 1/2%/4 = 1.00
= 1 3/8% or .01375
Cp = FV xb
= P4,000 x .01375
= P55
RV = FV x Rr
= P4000 x 1.00
= P4,000

4. A 8,000 bond with interest at 5% converted semiannually is redeemable at 112% in 12

years. Find the coupon payment, redemption value, purchase price, and premium that yields
the purchaser 3 1/2% com- pounded semiannually.

Given:
FV = P8,000 Rr = 112% t = 12 yrs m=2
Br = 5% Y = 3 1/2%

Solution:
Rr =112% n=txm b = Br/m i= Y/m
= 1.12 = 12 x 2 = 5%/2 = 3 1/2%/2
= 24 = 2 ½% = 1 ¾%

Cp = FV xb RV = FV x Rr
= 8,000 x .025 = P8,000 x 1.12
= 200 = 8,960

Pp=RV (+1)⁻ⁿ + Cp a
n i
Table 3 Table 6
Pp=8,960 (1 + 1 3/4 %)^-24 + P200 a
24 1 3/4%
=P8,960 (0.659438) + P200 (19.460686)

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= 5,908.56 + P3,892.14
=9,800.70

Bp= Pp-RV
= 9,800.70 -P8,960
= 840.70

Lesson 3. Premium or Discount Equation

(Capitulo et al., 1990)

In the preceding topic we discussed the procedure in solving bond premium and bond
discount on a bond bought at par, premium or discount by computing first the purchase price.

This section will deal on the computation of bond premium or discount when a bond is
redeemable at par. It means that the face value is equal to the redemption value. As observed
in 5.1, if the yield rate is less than the bond rate, the purchase price is higher than its face
value, while if the yield rate is greater than the bond rate, the purchase price is lower than its
face value.

Formulas:
Bp = RV (b - 1) a Table 6
n i
Pp = RV + Bp

Bd = RV (i - b) a Table 6
n i
Pp = RV - Bd

Let us work on the following examples to illustrate the application of the above

Illustrative Examples:

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1. Find the bond premium and purchase price on a P3,000 bond with interest at 5%
compounded quarterly, redeemable at par for 7 years and 9 months, if it is to yield 4 1/2%
compounded quarterly.
Given:
RV = P3,000 Y = 4 1/2% t = 7 yrs. & 9 mos.
Br = 5% m=4

Solution:
b= Br + m i= Y + m n= t x m
= 5% /4 = 4 1/2% +4 = 79/12 x 4
= 1 1/4% = 1 1/8% = 31

Bp=RV (b-i) a Table 6

n i
= P3,000 (1 1/4% - 1 1/8%) a
31 1 1/8%
= P3,000 (1/8%) a
31 1 1/8%
= P3,000 (0.00125) (26.049362)
= P97.69
Pp = RV + Bp
= P3,000+ P97.69
P3,097.69

2. Find the purchase price and discount on a P5,000 bond with interest at 5% converted
semiannually, redeemable at par at the end of 15 years, to yield 6% compounded
semiannually.
Given:
Given:
RV = P5,000 Y = 6% t = 15 years
Br = 5% m=2

Solution:

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b= Br + m i= Y + m n= t x m
= 5% /2 = 6% +2 = 15 x 2
= 2 1/2% = 3% = 30

Bd=RV (i-b) a Table 6

n i
= 5,000 (3% - 2 1/2%) a
30 3%
= 5,000 (0.005) (19.600441)
= 490.01

Pp = RV - Bd
= 5,000 – 490.01
=4,509.99

Lesson 4. Amortization of the Premium (Capitulo et al., 1990)

When a bond is purchased at a value higher than the redemption value, it is said to be
bought at a premium. The premium is paid back in installments as part of the coupon
payments on the redemption date. Thus, amortization of premium decreases the value of the
bond at redemption date. A table of amortization of premium will show the gradual decrease
of the book value from the purchase price to redemption value. It shows also how a part of
the coupon payment is added as in interest and what part is used to amortize the premium.
The following examples will show how this is done.

Illustrative Examples
1. A 8,000 bond, redeemable at 105, pays interest at 6% to yield the buyer
5%, m=4 for 2 years. Determine the coupon payment, redemption value, purchase price, bond
premium and construct a schedule of amortization of premium.

Given:
FV= 8,000 Rr =105% Br=6%

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Y = 5% t = 2 years m= 4

Solution:
b = Br+m i=y+m n=txm
=6% /4 = 5%/4 =2 x 4
=1½ = 1 1/4% =8

a. Cp=FVxb
= 8,000 x 1 1/2%
= 120

b. RV=FV x Rr
=8,000 x 1.05
= P8,400

с Pp=RV (1+i)^⁻n + Cp a
n i
= 8,400 (1 + 1 1/4%)^ ⁻8 + 120 a-
8 1 1/4%
=8,400 (.905398) + 120 (7.568124)
= 7,605.34 + 908.17
= 8,513.51

d. Bp= Pp-RV
=8,513.51 - 8,400
= 113.51

e. Schedule of Amortization of Premium

End of Period Yield (BV x i) Coupon Payment Credit to Premium Book Value
0 0 0 0 8,513.51

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 1 106.42 120 13.58 8,499.93
2 106.25 120 13.75 8,486.18
3 106.08 120 13.92 8,472.26
4 105.98 120 14.10 8,458.16
5 105.73 120 14.27 8,443.89
6 105.55 120 14.45 8,429.44
7 105.37 120 14.63 8,414.81
8 105.19 120 14.81 8,400.00
846.49 960 113.51

Note: The difference of the total coupon payments and yield is equal to the total P113.51
credit to premium, and the final book value is equal to the redemption value.

2. A 5,000 bond with interest at 5 1/2% payable semiannually, redeemable at par at the end
of 3 years and is priced to yield 4 ½%, m = 2. Find the coupon payment, purchase price, bond
premium and construct a schedule of amortization of premium.
Given:
RV= 5,000 Br=5 1/2%
Y = 4 1/2% t = 3 years m= 2

Solution:
b = Br+m i=y/m n=txm
=5 1/2% /2 = 4 1/2%/2 =3 x 2
= 2 ¾% = 2 1/4% =6

a. Cp =FV x b
= 5,000 x 0.0275
= 137.50

b Bp=RV (b-i)a
n i
= 5,000 (2 3/4% - 2 ¼%) a
6 2 1/4%
=5,000 (.005) (5.554477)
= 138.86

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d. Pp = RV + Bp
=5,000 + 138.86
= 5,138.86

e. Schedule of Amortization of Premium

End of Period Yield (BV x i) Coupon Payment Credit to Premium Book Value
Cp - Y (BV – C to P)
0 0 0 0 5,138.86
1 115.62 137.50 21.88 5,116.98
2 115.13 137.50 22.37 5,094.61
3 114.63 137.50 22.87 5,071.74
4 114.11 137.50 23.39 5,048.35
5 113.59 137.50 23.91 5,024.44
6 113.05 137.50 24.45 4,999.99
686.13 825.00 138.87

Lesson 5. Accumulation of Discount (Capitulo et al., 1990)

When a bond is purchased at a value lower than the redemption value, it is said to be
bought at a discount. The bond discount is the difference between the redemption value and
purchase price. When the redemption value is larger than the purchase price, the holder gains
more than just the coupon payment. On any coupon date, the coupon payment is too small to
pay all the interest desired by the investor, so he may treat the unpaid interest as new or
additional investment which increase the book value of the bond.

The process of adding the unpaid interest to the value of the bond is called
accumulation of discount. The schedule of accumulation of discount is a table that shows the
gradual increase in the book value from the original purchase price to the redemption value
at the redemption date.

Let us work on the following to show how this is being done.

Illustrative Examples:

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1. A 4,000 bond with interest at 6% compounded quarterly is redeemable at 110 at the end of
2 years and priced to yield 7%. Find the bond discount, purchase price and make out a bond
schedule showing the accumulation of discount

Given:
FV = 4,000 Y= 7% Rr= 110%
Br = 69 m= 4 t = 2 yrs.
Solution:

Rr=110% = 1.10 i=Y+m n= t x m

b = Br+m =7% /4 =2x4
=6% /4 = 1 3/4% =8
=1 1/2%

RV=FV x Rr Cp = FV x b
=4,000 x 1.10 =4,000 x .015
=4.400 =60

Pp = RV (1 + i)^⁻n + Cp a
n i
=4,400 (1 + 1 3/4)^⁻8 + 60 a
8 1 ¾%
=4,400 (.870412) + 60 (7.405053)
=3,829.81 + 444.30
= 4,274.11

Bd= RV - Pp
=4,400 - 4,274.11
=125.89

Schedule showing the accumulation of discount

End of Period Yield (BV x i) Coupon Payment Accum of Discount Book Value
FV x b Col 2-3 Col 4 + BV
0 0 0 0 4,274.11

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 1 74.80 60 14.80 4,288.91
2 75.06 60 15.06 4,303.97
3 75.32 60 15.32 4,319.29
4 75.59 60 15.59 4,394.88
5 75.86 60 15.86 4,350.74
6 76.14 60 16.14 4,366.88
7 76.42 60 16.42 4,383.30
8 76.71 60 16.71 4,400.01
605.90 480.00 138.87

Lesson 6. Bonds between Dates (Capitulo et al., 1990)

We have been computing the purchase price of bonds on a coupon payment date in
the preceding topic but bonds can be bought between coupon dates.
There are many methods of computing the purchase price of a bond bought between
interest dates. In this text we shall consider the most common method by calculating the
purchase price of the bond at yield rate on the preceding coupon date, and accumulate this
value through time that has elapsed between the coupon date ad the purchase date using
simple interest at the given yield rate.
The above method follows the principle of approximate method of accumulation which
was discussed in chapter 2. Let us work on the following to illustrate the above.

Illustrative Examples.
1. A 7,000, 5 1/2% bond with interest payable on June 1 and December will matures on June
1, 1992. The bond was purchased on October 1, 1989 to yield 4 1/2% compounded
semiannually. Find the purchase price of the bond on October 1, 1989.
Given:
FV =7,000 Y= 4 1/2% Br = 5 1/29
t= 10-1-89 to 10-1-92 = 3 years. m =2

Solution:
b Br+ m i=Y+m n=t x
=5 1/2% /2 =4 1/2% /2 =3 x 2
= 2 ¾% = 2 ¼% =6

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Cp = FV xb
= 7,000 x .0275
=192.50 10 years
Pp = RV (1 + i)^⁻n +CP a
n i
= 7,000 (1 +2 1/4%)⁻6 + P192.50 a
6 2 ¼%
=7,000 (.875024) + P192.50 (5.554477)
=6,125.17+ 1,069.24
=7,194.41
t = June 1, 1989 to October 1, 1989
= 4 months
I = Prt (1 = Pp x Yxt)
=7,194.41 x .045 x 4/12
=P107.92
Pp on October 1, 1989
=7,194.41 +107.92
=P7,302.33

2. On May 1, 1988, what was the value of a P5,000, bond with 6% compounded semiannually
due on January 1, 1995, if money is worth 8%, m = 2 and interest dates January 1 and July
1.

Given:
FV = 5,000 Br = 6% Y = 8% m= 2
t= 1-1-88 to 1-1-95
= 7 years

Solution:
b= Br + m i=Y+m n=t x m
= 6% /2 = 8% +2 =7x2
=3% =4% = 14

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Cp = FV xb
=5,000 x .03
= 150
Pp = RV (1 + i)^⁻n + Cp a
n i
= 5,000 (1 +4%)^- 14 + 150 a
14 4%
=5,000 (.577475) + 150 (10.563123)
=2,887.38 +1,584.47
= 4,471.85

t = January 1, 1988 to May 1, 1988

= 4 months
I = Pp * Y x T
= 4.471.85 x .08 x 4/12
= P119.25
Pp on May 1, 1988
= 4,471.85 + 119.25
= 4,591.10

Lesson 7. The Yield or Investment Rate (Capitulo et al., 1990)

In the preceding section we determined the purchase price or value of a bond on the
redemption date and between dates to yield a certain rate of return on the investment. What
rate of retum or yield rate does an investor receive on a bond? It is necessary for us then to
determine the yield rate in order to know which of the several bonds gives the best investment,
because the yield or investment rate is the true overall rate of return that an investor receives
on the invested capital.
Since there is no direct formula or solution in finding the yield or investment rate, we
apply the approximate method, which is simple and usually leads to a fairly accurate yield
rate. And to illustrate this, let us work on the following.

Illustrative Examples

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1. A 5,000, 5% bond with semi-annual coupons is redeemable at par at the end of 18 years.
If the market or quoted price is 95%, what is the yield or investment rate, compounded
semiannually?

Given:
FV = P5,000 m=2 Rr= 100%
Br = 5% MQ = 95% t = 18 years

Solution:
b= Br + m n=t x m
= 5% /2 = 18 x 2
= 2 1/2% = 36

Steps:
1. Coupon payment = Face Value x Bond rate
Cp=FV x b
=5,000 x .025
=125

2. Redemption value = Face Value x Redemption rate

RV=FV Rr
=5,000 x 1.00
=5,000

3. Book Value = Face Value x Market Price

BV = FV x MQ
= 5,000 x.95
= 4,750
4. Total Befits = RV +(Cp x n)
Tb = 5,000 + (125 x 36)
=5,000+4,500
= 9,500

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5. Net Benefit = Tb - BV
Nb = 9,500 - 4,750
= 4,750

6. Average Benefit = Nb +n
Ab = 4,750 + 36
= 131.94

7. Average Invested Principal = (BV+RV) ÷2

AIP = (4,750 +5,000) ÷ 2
=9,750 ÷ 2
=4,875

8. Yield rate = (Ab + AIP) x m

Y = (131.94 +4,875) x2
= .02706 x 2
= 5.42%

2. A 50,000, 6% bond with coupons payable quarterly is redeemable at 112 at the end of 12
years. The market price is 125%. Find the yield rate.
Given:
FV =50,000 Br=6% m=4
MQ = 125% Rr=112% t = 12 years

Solution:
b= Br ÷ m n=t x m
= 6% ÷4 = 12 x 4
= 1 ½% = 48
Steps:
1. Cp=FV xb
=50,000 x 0.015
=750

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2. RV=FV XR
= 50,000 x 1.12
=56,000

3. BV = FV x MQ
=50,000 x 1.25 62,500

4. Tb = RV + (Cp x n)
=56,000 + (750 x 48)
= 56,000+36,000
=92,000

5. Nb = Tb - BV
= 92,000-62,500
= P29,500

6. Ab = Nb un
= 29,500 +48
= 614.58

7. AIP = (BV+RV) + 2
= (62,500 + 56,000) + 2
= 118,500 + 2
=59,250

8. Y = (Ab + AIP) x m
= (614.58 +59,250) x 4
= .0104 x 4
= .0416
= 4.16%

Summary of Formulas

143
1. Redemption Value (RV)
RV= FV x Rr

2. Coupon payment (Cp)

Cp= FV x b
B= Br ÷m

3. Purchase price (Pp) or Value of Bond (V)

Pp= RV (1+i)^⁻n + Cp a
n i
Table 3 Table 6
i= Y ÷ m n=txm

4. Bond premium (Bp) and purchase price

Bp = RV (b-i) a Table 6
n i
Pp= RV + Bp

5. Bond discount (Bd) and purchase price

Bd = RV (i-b) a Table 6
n i
Pp= RV - Bd

6. Yield rate or Investment rate (Y)

a. Cp= FV x b
b. RV= FV x Rr
c. BV= FV x MQ
d. Tb= RV + (Cp x n)
e. Nb= Tb –BV
f. Ab= Nb ÷ n
g. A/P= (BV + RV) ÷ 2
h. Y= (Ab ÷ A/P) x m

144
 Assessment

1. A 15,000, 5 ½% bonds with quarterly coupons is priced to yield 4 ½% converted quarterly.

If it is redeemable at 104% at the end of t20 years, find the coupon payment, redemption
value, purchase price and bond premium. (Bond Valuation)

2. A 12,000 bond redeemable at par in 20 years pays interest at 3 ½% compounded

quarterly. Find the purchase price to yield 4% m=4.(Bond Valuation)

3. What is the purchase price of a 9,000 bond with dividend rate at 7%, compounded semi-
annually on August 1 and February 1, redeemable at 109 on August 1, 1995 was
purchased on February 1, 1985 to yield 6% compounded semi-annually?(Bond Valuation)

4. Find the purchase price and discount of a 4% m=2, Php 20,000 bond maturing in 20 years
to yield the buyer 5 ½% compounded semi-annually and redeemable at par. (Premium or
Discount)

5.Find the bond premium and purchase price of a 7%, m=2, Php 15,000 bond redeemable at
par at the end of 13 years and is priced to yield 6% converted semi-annually? (Premium or
Discount)

6. A Php14,000 , 7% bond payable quarterly is priced to yield 8%, m=4 and redeemable at
par at the end of 14 years and 9 months. Find the purchase price and bond premium.
(Premium or Discount)
7. A 7,000, 5% bond with annual coupons, redeemable at 108 at the end of 5 years is priced
to yield 4%, m=1. Construct a table showing the amortization of premium. (Amortization of
Premium)

8. A 10,000 bond wit interest at 6% payable quarterly is bought to yield 4 ½% converted

quarterly. On a certain date, the book value of the bond is 11,000. Find the book value just
after the next coupon payment is made. (Amortization of Premium)

145
9. A 4,000, 8% bond with coupons payable quarterly on January 1, April 1, July 1, October 1
and will be redeemed on October 1, 1992.(Amortization of Premium)
a. Find the purchase price of the bond on April 1, 1990 to yield 7% m=4.
b. Construct a schedule of amortization of premium.

10. A 9,000 3 ½% bond with monthly coupon is priced to yield 5% and redeemable at par at
the end of 10 years. Find the purchase price and bond discount. (Accumulation of Discount)

11. Construct a bond schedule showing the accumulation of discount on a 6,000 4% bond
with quarterly coupon, redeemable at 102 at the end of 2 years and 3 months and priced to
yield 5 ½% m=4. (Accumulation of Discount)

12. A bond with interest at 5% with coupons payable on April 1 and October 1 is to mature at
par on October 1, 1994. If the bond is bought on April 1, 1992 to yield 6% m=2, construct a
bond schedule showing the accumulation of discount. (Accumulation of Discount)

13. Find the value on June 1, 1990 of 4,000 with interest at 4% compounded semi-annually,
redeemable at par on October 1, 1989 to yield 5 ½% m=2. (Bonds between dates)

14. On November 1, 1988, what is the purchase price of a 12,000 bond with 7% converted
semi-annually, due on October 1, 1997, if money is worth 6% m=2 with interest dates April
and November. (Bonds between dates)

15. A 25,000 4% bond with interest payable annually will mature on May 1, 1998. The date of
purchase is July 1, 1988 to yield 3 ½% m=1. Find the purchase price of the bond on July 1,
1988. (Bonds between dates)

16. A 25,000 5% bond with coupons payable semi-annually is redeemable at 97% at the end
of 10 years. If the market price is 102, what is the yield rate compounded semi-annually?
(Yield or Investment Rate)

17. Find the investment rate compounded quarterly for a 11,000, 5 1/2% m=4 redeemable at
110% at the end of 11 years and quoted price of 99. (Yield or Investment Rate)

146
 Summary

 A bond is a written promise to pay a specified sum of money called redemption value
at specified future date called redemption date
 Registered Bonds are bonds that can only be transferred from one owner to another
by proper endorsement and with the consent of the issuer. Thus, the owner is
protected against loss or theft.
 Unregistered Bonds are bonds that can be transferred from one owner to another at
will and anytime the owner desires.
 The price an investor can pay for a bond to return the desired yield on the value of a
bond may be determined, and the process is called bond valuation.

Reference

Capitulo, Florante & Cruz, Carmelita (1990) Mathematics of Investment 2 nd Edition. Manila,
Philippines National Bookstore Inc.

MODULE 9
DEPRECIATION

Introduction

147
 Depreciation is the loss or decline in value of an asset through use and passage of
time. Buildings, equipments, and other assets depreciate through age, obsolescence, decay,
decrease in efficiency, and inadequacy.

The basic principle of business is that the capital invested must be kept intact, and a
replacement or depreciation fund to provide for losses due to depreciation should be set up.
This fund is used to provide for the replacement of an asset when the asset can no longer be
used profitably. When an asset can no longer be used for the purpose for which it was
purchased, it is said to be worth scrap value or salvage or trade-in-value. The difference
between the original cost and the scrap value is called the wearing value or total depreciation
of the asset, while the difference between the original cost and amount of depreciation on a
given date is called the book value. As an asset depreciates, it is carried at a decreasing book
value (Capitulo et al., 1990).
The depreciation allowance each year offsets the decrease in book value and at all
times the book value plus the total accumulated depreciation should equal the cost of the
asset. In general, depreciation charges are on an annual basis (Capitulo et a.,l 1990).

The following notation will be used in our discussion of depreciation (Capitulo et al.,
1990):
O =original cost
S =Scrap or salvage value
W = wearing value
n = useful economic life of an asset in years
R =periodic depreciation
BV =Book value
T =rate of depreciation
There are many methods of determining the depreciation of various assets. Probably
the following are the most common and serviceable methods (Capitulo et al., 1990):

1. Straight-Line-Method or Age-Life Method (SLM)

2. Declining-Balance-Method or Constant-Percent Method (DBM)
3. Sum-of-the-Years-Digit Method or Age-Life Method or Reducing Fraction Method (SYD)
4 Unit Product-Method or Working Hour-Method. (UPM)

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5. Sinking-Fund-Method (SFM)
6. Annuity Method (AM)

Learning Outcomes

At the end of this module, students should be able to:

1. compute depreciation using different methods

2.
3. define depreciation and apply the use of it in business

Lesson 1. Straight-Line-Method or Age-Life-Method

(Capitulo et al., 1990)

This is the simplest method of allowing for depreciation and it is the most commonly
used method adequately accurate for practical purposes. It spread depreciation evenly over
the useful life of the asset. It assures that depreciation is in proportion to time.
The formula for the periodic depreciation is:
R=W W=O-S
n

Illustrative Examples
1. A steel cabinet which cost 8,500 is expected to last 12 years, and at that time will have a
trade-in-value of P500. Find the annual depreciation charge.
Given:
O = P8,500 S=P500 n = 12 Note:
Solution:
W=O-S
=8,500 - 500
= 8,000
R=W÷ n
= 8,000 ÷ 12

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=666.67
2. An item which cost Ps 200 and after 5 years has a scrap value of P400. What is the annual
depreciation? What percent of the cost is the yearly depreciation?
Given
O =5,200 S = P400 n=5
Solution:
W=0 - S R=W ÷ n T= R ÷ O
=5,200-400 =4,800 ÷ 5 =960 ÷ 4,800
= 4,800 =960 = 20%
3. A machine which costs 12,000 and after 6 years has a salvage value of 900. Determine the
yearly depreciation and prepare a depreciation schedule.
Given:
O = 12,000 S =900 n=6
Solution:
W=0-S R = W+n
= 12,000-900 = 11,100 ÷ 6
= 11,100 = P1,850
Depreciation Schedule:
Year Annual Depn Accum Depn. Book Value
0 0 0 12,000
1 1,850 1,850 10,150
2 1,850 3,700 8,300
3 1,850 5,550 6,450
4 1,850 7,400 4,600
5 1,850 9,250 2,750
6 1,850 11,100 900
Note: The accumulated depreciation charge plus the book value always equals the original
cost.

Lesson 2. Declining-Balance Method or Constant-Percent

Method (Capitulo et al., 1990)

This methods shows that an asset depreciates by the same percent of book value.
This means that every year the depreciation charge is a fi percentage of the preceding book

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value. This method has a property of bearing the largest peso depreciation during the early
years and the depreciation charge becomes progressively smaller as the number of years
increases.

Let us work on the following examples to show how this is done.

Illustrative Examples:
1. An item which costs 5,000 depreciates by 8% each year. Construct a depreciation table for
8 years.
Given: O = 5,000 r = 8% = .08

Depreciation Table Annual Depreciation

Year Annual Depn Total Depn Book Value
0 0 0 5,000
1 400 400 4,600
2 368 768 4,232
3 338.56 1,106.56 3,893.44
4 311.48 1,418.04 3,581.96
5 286.56 1,704.60 3,295.40
6 263.63 1,968.23 3,031.77
7 241.54 2,210.77 2,789.23
8 223.14 2,433.91 2,566.09
Note: The total depreciation plus the book value is equal to the original cost

2. Set up a depreciation schedule for a machine which costs 12,000 and depreciates 20% of
its value each year and find the book value at the end of 10 years.
Given:
O = 12,000 r = 20% = 20

Depreciation Schedule
Year Annual Depn Total Depn Book Value
0 0 0 12,000
1 2,400 2,400 9,600
2 1,920 4,320 7,680

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 3 1,536 5,856 6,144
4 1,228.80 7,084.80 4,915.20
5 983.04 8,067.84 3,932.16
6 786.43 8,854.27 3,145.73
7 629.15 9,483.42 2,516.58
8 503.32 9,986.74 2,013.26
9 402.65 10,389.39 1,610.61
10 322.12 10,711.51 1,288.49

Lesson 3. Sum of the Years-Digit Method (SYD)

(Capitulo et al., 1990)

The sum of the years digit method or reducing fraction method follows he same
principle as the declining balance method. That is, the depreciation allowances are larger
during the early years of the useful life of the asset and become progressively increases Most
of the cost is recovered early in the life of the asset.

The depreciation each year is a fraction of the wearing value. The common
denominator of the fraction is obtained by numbering the years of useful life and adding as
illustrated below.
Assuming that the economic life of an asset is 5 years, the denominator
1+2+3+4+5=15. The numerator for the first year is the bigger year and each year is reduced
by 1, and to find the total number of digits we apply:

Total = n (n+1)
2
= 5 (5+1)
2
= 15
Let us work on the following to illustrate the application of the above.

Illustrative Examples

152
1. A machine costing 5,000 has a scrap value of 500 after a useful life of 6 years. Find the
depreciation and construct a depreciation schedule.
Given
O=5,000 S=500 n=6 years
Solution
W =5,000-500
= 4,500
Total digits = 6 (6+1)
2
= 6 (7)
2
=21
Year Wearing Value Annual Depn
1 4,500 (6÷21)= 1,285.71
2 4,500 (5÷21)= 1,071.43
3 4,500 (4÷21)= 857.14
4 4,500 (3÷21)= 642.86
5 4,500 (2÷21)= 428.57
6 4,500 (1÷21)= 214.29

Year Annual Depn Total Depn Book Value

0 0 0 5,000
1 1,285.71 1,285.71 3,714.29
2 1,071.43 2,357.14 2,642.86
3 857.14 3,214.28 1,785.72
4 642.86 3,857.14 1,142.86
5 428.57 4,285.71 714.29
6 214.29 4,500 500.00

2. An asset valued at 7,500 with a trade-in-value of 900 has an estimated life of 8 years. Find
the yearly depreciation and make out a depreciation table.
Given:
O = 7,500 S=900 n= 8 years
Solution:

153
W=0-5
=7,500-2900
= 6,600
Total digits = n(n+1) /2
= 8 (8 + 1) /2
= 36
Year Wearing Value Annual Depn
1 6,600 (8÷36)= 1,466.67
2 6,600 (7÷36)= 1,283.33
3 6,600 (6÷36)= 1,100
4 6,600 (5÷36)= 916.67
5 6,600 (4÷36)= 733.33
6 6,600 (3÷36)= 550.00
7 6,600 (2÷36)= 366.67
8 6,600 (1÷36)= 183.33

Year Annual Depn Total Depn Book Value

0 0 0 7,500.00
1 1,466.67 1,466.67 6,033.33
2 1,283.33 2,750.00 4,750.00
3 1,100.00 3,850.00 3,650.00
4 916.67 4,766.67 2,733.33
5 733.33 5,500.00 2,000.00
6 550.00 6,050.00 1,450.00
7 366.67 6,416.67 1,083.33
8 183.3 6,600.00 900.00

Lesson 4. Unit Product Method or Working Hours-Method

(Capitulo et al., 1990)

This method is based on the number of hours an asset is used or the number of unit
it produces. This method allows for more depreciation during a busy period of an asset.
Except in rare cases this method is inapplicable because the total operating hours and
units produced cannot be estimated with any degree of accuracy.

154
 Let us work on the following to illustrate the above.

Illustrative Examples

1. A machine costs P7500 has a salvage value of P600. It is estimated that the machine can
produce 25,000 units. This machine has been run as follows:
1st year - 2,800 units
2nd year - 3,200 units
3rd year – 4,100 units
4th year - 5,500 units
5th year-2,500 units

Prepare a depreciation table.

Given: 0=27.500 S = P600 n = 25,000 hours

Solution:
W=0-S
=7,500-P600
= 6,900

Annual Depreciation
1st year 6,900 (2,800 ÷ 25,000) = 772.80
2nd year 6,900 (3,200 ÷ 25,000) = 883.20
3rd year 6,900 (4,100 ÷ 25,000) = 1,131.60
4th year 6,900 (5,500÷25,000) = 1,518.00
5th year 6,900 (2,500÷25,000) = 690.00
Depreciation Schedule

Year Yearly Depn Total Depn Book Value

0 0 0 7,500.00
1 772.80 772.80 6,727.20
2 883.20 1,656.00 5,844.00
3 1,131.60 2,787.60 4,712.40
4 1,518.00 4,305.60 3,194.40

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 5 690.00 4,995.60 2,504.40

Again, we note that the sum of the book value and total depreciation is equal

2. A certain machine costs 12,800 depreciates to 1,200. This type of machine has an
estimated operating life of 35,500 hours, and run as follows:
1st year 3,400 hours
2nd year 3,800 hours
3rd year 4,350 hours
4th year 5.160 hours
5th year 4,995 hours
6th year 7,200 hours
7th year 1,500 hours
Prepare a depreciation table.
Given:
O=12,800 S = 1,200 n=35,500

Solution:
W=O - S
= 12,800 - 1,200
= 11,600
Annual Depreciation
1st year 11,600 (3,400 + 35,500) = 1,110.99
2nd year 11,600 (3,800 + 35,500) = 1,241.69
3rd year 11,600 (4,350 +35,500) = 1,421.41
4th year 11,600 (5,160 +35,500) = 1,686.08
5th year 11,600 (4,995 +35,500) = 1,632.17
6th year 11,600 (7,200 + 35,500) = 2,352.68
7th year 11,600 (1,500 +35,500) = 490.14

Depreciation Schedule
Year Yearly Depn Total Depn Book Value
0 0 0 12,800.00

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 1 1,110.99 1,110.99 11,689.01
2 1,241.69 2,352.68 10,447.32
3 1,421.41 3,774.09 9,025.91
4 1,686.08 5,460.17 7,339.83
5 1,632.17 7,092.34 5,707.66
6 2352.68 9,445.02 3,354.98
7 490.14 9,935.16 2,864.84

Lesson 5. Sinking Fund (Capitulo et al., 1990)

This method consist of setting aside periodically equal amounts which with compound
interest, will produce a sum equal to the original cost or expected replacement cost of the
property at the end of its economic life.
To determine the annual depreciation, we apply this formula.
R = W Table 5
s
n i
Where:
R = the anoual depreciation or periodic payment
i = the periodic rate (r + m)
n= number of conversion periods for the whole term (lxm)
W = the wearing value (OS)
Under this method, the yearly depreciation charge varies from year to year, since it
equals the payment made at the end of the year plus the interest earned on the sinking fund
during the year.
Let us work on the following to illustrate the above.

Illustrative Examples:
1. An asset which cost 2,600 has a trade-in-value of P210 after an economic life of 12 years.
The depreciation charges under the sinking fund are invested at 4 1/2%. Find the yearly
depreciation.
Given:

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O = 2,600 S =210 n = 12 i = 4 1/2%
Solution:
W = O-S
= 2,600 - 210
= 2,390 00

Yearly Depreciation
R = W
s
n i
= 2,390
s 12 41/2%
= 2,390
15.464032
= 154.55

2. A machine costs 4,500 has a salvage value of 430 at the end of 7 years. If money is worth
5% compounded annually, find the periodic payment and construct a depreciation schedule.
Given:
O=4,500 S=430 n=7 i= 590
Solution:
W = O-S
= 4,500 - 430
= 4,070.00

Yearly Depreciation
R = W
s
n i
= 4,070
s
7 5%
= 4,070.00

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 8.142008
= 499.88

Year Periodic Payment Int. on Fund Yearly Dep Total Dep Book Value
0 0 0 0 0 4,500
1 499.88 0 499.88 499.88 4,000.12
2 499.88 24.99 524.87 1,024.75 3,475.25
3 499.88 51.24 551.12 1,575.87 2,924.13
4 499.88 78.79 578.67 2,154.54 2,345.46
5 499.88 107.73 607.61 2,762.15 1,737.85
6 499.88 138.11 637.99 3,400.14 1,099.86
7 499.88 170.01 669.89 4,070.03 429.97

Lesson 6. Annuity Method (Capitulo et al., 1990)

In this method the depreciation charge is composed of the amount credited to the fund
and the interest on the book value of the asset. The investment in the asset is regarded, first,
as the amount of the salvage value which earns interest, and second, an investment in an
annuity to be equal to the periodic payments.
The formula for finding the annual depreciation charge is:
R = W + Si Table 6
a
n i

Illustrative Examples

1. A machine worth 25,600 has an estimated lite of 18 years. Its trade-in value is 1,250. What
is the annual depreciation charge? If money is worth 6 ½% compounded annually.
Given:
O=25,600 S = 1,250 n= 18 i= 6 ½%
Solution:
W=O - S

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= 25,600 - 1,250
= 24,350
R = W + Si Table 6
a
n i
=24,350 + 1,250(0.065) Table 6
a
18 6 ½%
= 24,350 + 81.25
10.432466
= 2,334.06 + 81.25
= 2,415.31
2. An asset costing 6,500 has a scrap value of P180 after a useful life of 5 years. Find the
periodic payment if interest is calculated at 4 1/2%, compounded annually.
Given:
O = 6,500 S = 180 n=5 i = 4 1/2%
Solution:
W= O - S
= 6,500 - 180
= 6,320
R = W + Si Table 6
a
n i
=6,320 + 180(0.045) Table 6
a
5 4 ½%
= 6,320 + 8.10
4.389977
= 1,439.64 + 8.10
= 1,447.74

Year Periodic Payment Charge on Fund Int. on BV Book Value

0 0 0 0 6,500.00

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 1 1,447.74 1,155.24 292.50 5,344.76
2 1,447.74 1,207.23 240.51 4,137.53
3 1,447.74 1,261.55 186.19 2,875.98
4 1,447.74 1,318.32 129.42 1,557.66
5 1,447.74 1,377.65 70.09 180.01

Summary

 Methods of Depreciation

The objective of all depreciation is the eventual recovery of the capital invested, but
there are differences in the rate of recovery.
The following methods may be considered.
1. Straight line method- where the rate of recovery is uniform throughout the life of the
asset.
2. Declining Balance Method and Sum of the Years Digit Method which results in a quick
or early recovery of a large portion of the capital invested in an asset.
3. Working hours method where the rate of recovery is large when the asset is full force
or working time.
4. Sinking fund and annuity method where there is gradual recovery of the capital
invested.

Assessment
1. A ceiling fan costs 1,680 has an economic life of 3 years and has scrap value of 20.
What is the yearly depreciation? What percent of the cost is the yearly
depreciation?(Straight Line Method)

2. A stereo set which costs 14,800 is expected to last 8 years and at that time will have
a trade in value of 1,800. Find the yearly depreciation charge and prepare a
depreciation table. (Straight Line Method)

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 3. A machine depreciates by 12% each year. The original cost is 8,500. Make out a
schedule showing the annual depreciation, the total depreciation and book value at
the end of each year for 6 years. (Declining Balance Method)

4. A sala set which cost 9,250 depreciates by 25% of its value each year. Make out a
depreciation table for the first 3 years and find the book value at the end of 6 years.
(Declining Balance Method)

5. An asset valued at 5,750 has a scrap value of 310 with an estimated life of 7 years.
Make out a depreciation schedule. (Sum of years digits Method)

6. A filing cabinet valued at 4,750 depreciates to 410 after useful life of 9 years. Find the
5th and 8th year depreciation. (Sum of years digits method)

7. A machine costs 9,250 with a trade in value of 710. Th machine can produce 26,800 units
and the annual production has been:
1st year 3,600 units
2nd year 4,980 units
3rd year 8,755 units
4th year 6,000 units
Find the yearly depreciation (units of Production methods)
8. A lathe machine costing 53,000 has a scrap value of 5,000 at the end of useful life. This
machine has a working hour average life of 50,000 hours and will be run as follows:
1st year 5,675 hours
2nd year 7,300 hours
3rd year 6,600 hours
4th year 9,775 hours
5th year 8,260 hours
6th year 2,785 hours
Find the 3rd, 5th and 6th year depreciation charge respectively. (Units of production method)

162
9. An equipment depreciates from its purchase price of 7,200 to 400 at the end of 9 years. If
money is worth 5 ½%, find the periodic payments. (Sinking fund method)

10. Find the periodic payment into a depreciation fund, for a filing cabinet which cost 5,400
with a scrap value of 150 after a useful life of 10 years. If money is worth 6 ½%. (Sinking fund
method)

11. An airconditioner costing 14,760 depreciates to 600 at the end of 11 years. If interest on
the book value is 8%, find the periodic payment. (Annuity Method)

12. Find the annual depreciation for an equipment whose purchase value is 6,250 and loses
its value to 220 at the end of 9 years. Interest rate at 4 ½%(Annuity Method)

Reference

Capitulo, Florante & Cruz, Carmelita (1990) Mathematics of Investment 2nd Edition.
Manila, Philippines National Bookstore Inc.

163