CHAPTER II – MONEY-TIME RELATIONSHIPS AND EQUIVALENCE

I. LESSON TITLES

1. Interest and the Time Value of Money

2. The Concepts of Equivalence
3. Cash Flows

II. LESSON OVERVIEW

This lesson deals with the Interest and the Time Value of Money, Concepts of Equivalence and
Cash Flows.

III. DESIRED LEARNING OUTCOMES

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

1. Learn and Understand Interest and the Time Value of Money;

2. Learn and Understand the Concepts of Equivalence; and
3. Learn and Understand Cash Flows.

IV. LESSON CONTENT

1. INTEREST AND THE TIME OF VALUE OF MONEY

The Concept of Time Value of Money

“Money makes money”. This is true because if we invest money today, by tomorrow we will
have accumulated more money that what we had originally invested. And also if you borrow money
today you will have to pay in the future an amount that is larger on what you have originally owed.
This change in the amount of money over a given time period is called time value of money”

Interest is the amount of money paid for the use of borrowed capital or the income produced by
money which has been loaned. Interest is the increase between the original amount of money and
the final amount owed. Interest is the cost of using somebody else’s money. When you borrow money,
you pay interest. When you lend money, you earn interest. Interest maybe simple or compound.
When borrowing: To borrow money, you’ll need to repay what you borrow. In addition,
to compensate the lender for the risk of lending to you (and their inability to use the money
anywhere else while you use it), you need to repay more than you borrowed.
When lending: If you have extra money available, you can lend it out yourself or
deposit the funds in a savings account, effectively letting the bank lend it out or invest the
funds. In exchange, you’ll expect to earn interest. If you are not going to earn anything, you
might be tempted to spend the money instead, because there’s little benefit to waiting.

Capital is the wealth in the form of money or property that can be used to produce more wealth.

Interest rate is the percentage of the original amount per time unit.

Simple Interest
Simple interest is calculated using the principal only, ignoring any interest that had been
accrued in preceding periods. In practice, simple interest is paid on short-term loans in which the time
of the loan is measured in days.

I = Pni (1)

F = P + I = P + Pni
Page 1 of 24
 F = P (1 + ni) (2)

where : I = interest
P = principal or present worth
n = number of interest periods
i = rate of interest per interest period
F = accumulated amount or future worth

(a) Ordinary simple interest is computed on the basis of 12months of 30 days each or 360 days a year.
1 interest period = 360 days

(b) Exact simple interest is based on the exact number of days in a year, 365 days for an ordinary year
and 366 for a leap year.
1 interest period = 365 or 366 days

Example 1. Determine the ordinary simple interest on P800 for 9 months and 20 days if the rate of
interest is 6%.

Solution : no. of days = 9(30) + 20 = 290 days

n = 290/360 = 0.806
I = Pni = P800 x 290/360 x 0.06 = P38.688

or no. of months = 9 + (20/30) = 9.67 months

n = 9.67/12 = 0.806
I = Pni = P800 x (9.67/12) x 0.06 = 38.688

Example 2. Determine the exact simple interest on P1000 for the period from January 15, 2000 to
June 8, 2000 at 15% interest.

Solution : Jan 15-31 = 16 days (excluding Jan. 15)

Feb = 29 (leap year)
Mar = 31
Apr = 30
May = 31
Jun = 8
145 days

Exact simple interest = P500 x 145/366 x 0.15 = P29.71

Cash Flow Diagrams
A cash flow diagram is simply a graphical representation of as flows drawn on a time scale.
Cash flow diagram for economic analysis problems is analogous to that of free body diagram for
mechanics problems.
A cash flow diagram presents the flow of cash as arrows on a time line scaled to the magnitude
of the cash flow, where expenses are down arrows and receipts are up arrows.

Receipt (positive cash flow or cash inflow)

Disbursement (negative cash flow or cash outflow)

A loan of P100 at simple interest of 10% will become P150 after five years.

Page 2 of 24
 P150

0 1 2 3 4 5

P100
Viewpoint of the Lender

P100

0 1 2 3 4 5

P150
Viewpoint of the Borrower

Present and Future Worth

Present Worth of money is the original amount of money to be invested/lend or the capital
amount itself. While Future Worth is the incurred money after applying the interest including its capital.

Example 3. What will be the future worth of money after 20 months, if a sum of P20,000 is invested
today at a simple interest rate of 15% per year?

Solution : F = P(1 + ni) (From equation 2)

F = Future Worth
P = Present Worth
n = no. of period/s
i = interest rate

F = P(1 + ni) = P20000 (1 + (20/12) x 0.15) = P25,000

Compound Interest
In calculations of compound interest, the interest for an interest period is calculated on the
principal plus total amount of interest accumulated in previous periods. Thus, compound interest
means “interest on top of interest.”

0 1 2 3 n-1 n

F
Compound Interest (Borrower’s Viewpoint)

Interest Principal Interest Amount at end of

Period at earned period
Beginning during
period period
1 P Pi P+Pi=P(1+ni)
2 P(1+i) P(1+i)i P(1+i)+P(1+i)I =P(1+i)2
3 P(1+i)2 P(1+i)2i P(1+i)2+P(1+i)2i=P(1+i)3
… … … …
Page 3 of 24
 n P(1+i)n+1 P(1+i)n+1i P(1+i)n

F = P(1 + i)n (3)

The quantity (1+i)n is commonly called the “single payment compound amount factor” and is
designated by the functional symbol F/P, i%, n. Thus,

F = P(F/P,i%,n) (4)

The symbol F/P, i%, n is read as “F given P at i percent in n interest periods. From equation
(4),
P = F(1 + i)-n (5)

The quantity (1 + i)-n is called the “single payment present worth factor” and is designated by
the functional symbol P/F, i%, n. Thus

P = F(P/F,i%,n) (6)

The symbol P/F, i%, n is read as “P given F at i percent in n interest periods.

Rates of Interest

(a) Nominal rate of interest

The nominal rate of interest specifies the rate of interest and a number of interest periods in
one year.
i=r/m (7)

where: i = rate of interest per interest period

r = nominal rate of interest
m = number of compounding periods per year

If the nominal rate of interest is 10% compounded quarterly, then i=10%/4, the rate of interest
per interest period.

(b) Effective rate of interest

Effective rate of interest is the actual or exact rate of interest on the principal during one year.
If P1.00 is invested at a nominal rate of 15% compounded quarterly, after one year this will become,

P1 (1+0.15/4)4 = P1.1586

The actual interest earned is P0.1586, therefore, the rate of interest after one year is P15.86%.
Hence,
Effective rate = F1 – 1 = (1+i)m – 1 (8)

where: F1 = the amount P1.00 will be after one year.

F1

0 1 2 m

1 year
P1.00
Effective Rate of Interest

Page 4 of 24
 Example : Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?

Solution : Let r = the unknown nominal rate

For two or more nominal rates to be equivalent, their corresponding effective rates must be
equal.
Nominal rate Effective rate
𝑟
r% compounded quarterly (1 + )4 − 1
4

0.12 12
12% compounded monthly (1 + ) −1
12

𝑟
(1 + )4 − 1 = (1 + .01)12 − 1
4

𝑟
(1 + )4 = (1.01)3
4

r = 0.1212 or 12.12% compounded quarterly

Example : Find the amount at the end of two years and seven months if P1000 is invested at
8% compounded quarterly and using simple interest for anytime less than a year interest period.

Solution : For compound interest : i = 8% / 4 = 2%, n = 2 (4) = 8

For simple interest : i = 8%, n = 7/12

F2
F1

0 1 2 2 yrs 7 months

Compound interest Simple interest

P1000

F1 = P (1 + i)n = 1000 (1 + 0.02)8 = P1171.66

F2 = F1 (1 + ni) = 1171.66 (1 + (7/12) (.08)) = P1,226.34

Equation of Value

An equation of value is obtained by setting the sum of the values on a certain comparison or
focal date of one set of obligations equal to the sum of the values on the same date of another set of
obligations.

Example : A man bought a lot worth P1,000,000 if paid in cash. On the installment basis, he
paid a down payment of P200,000; P300,000 at the end of one year; P400,000 at the end of three
years and a final payment at the end of five years. What was the final payment if interest was 20%?
Solution : Let Q = the final payment

P1,000,000 – P200,000 = P800,000

Page 5 of 24
 P800,000

0 1 2 3 4 5

300,000
300,000(P/F,20%,1)
400,000
400,000(P/F,20%,3)

Q(P/F,20%,5)
Q
Using today as the focal date, the equation of value is

P800,000 = P300,000(P/F, 20%, 1) + P400,000 (P/F, 20%, 3) + Q (P/F, 20%, 5)

P800,000 = P300,000(1.20)-1 + P400,000(1.20)-3 + Q(1.20)-5

P800,000 = P300,000(0.8333) + P400,000(0.5787) + Q(0.4019)

Q = P792,560

Continuous Compounding and Discrete Payments

In discrete compounding, the interest is compounded at the end of each finite – length period,
such as month, a quarter or a year.
In continuous compounding, it is assumed that cash payments occur once per year, but the
compounding is continuous throughout the year.

0 1 2 mn

n years
P
Continuous Compounding (Lender’s Viewpoint)

r = nominal rate of interest per year

r/m = rate of interest per period
m = number of interest periods per year
mn = number of interest periods in n year
𝑟
F = P(1 + )𝑚𝑛 (9)
𝑚

Let m/r = k, then m = rk, as m increases so must k

𝑟 1 1
(1 + )𝑚𝑛 = (1 + )𝑟𝑘𝑛 = [ (1 + ) 𝑘 ] 𝑟𝑛
𝑚 𝑘 𝑘

𝑟
The limit of (1 + )𝑘 as k approaches infinite is e
𝑚

1
[ (1 + ) 𝑘 ] 𝑟𝑛 = 𝑒 𝑟𝑛
𝑘

Thus, F = P𝑒 𝑟𝑛 (10)

Page 6 of 24
 P = F𝑒 −𝑟𝑛 (11)

Discount
Discount on a negotiable paper is the difference between the present worth (the amount
received for the paper in cash) and the worth of the paper at some time in the future (the face value
of the paper or principal). Discount is interest paid in advance.

Discount = Future Worth – Present Worth (12)

The rate of discount is the discount on one unit of principal for one unit of time.

(1 + i)-1

0 1

P1.00
Rate of Discount

d = 1 – (1 + i)-1 (12)

𝑑
i= (13)
1−𝑑

where : d = rate of discount for the period involved

i = rate of interest for the same period

Example : A man borrowed P5,000 from a bank and agreed to pay the loan at the end of
9 months. The bank discounted the loan and gave him P4,000 in cash. (a) What was the rate of
discount? (b) What was the rate of interest? and (c) What was the rate of interest for one year?

Solution :

P4,000 P0.80

0 9 mo. 0 9 mo.

P5,000 P1.00

𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑃1,000
(a) d = = = 0.20 or 20%
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑃5,000

Another solution, using equation (12)

d = 1 – (1 + 0.20i)-1 = 1 – 0.80 = 0.20 or 20%

𝑑
(b) using equation (13) i=
1−𝑑

Page 7 of 24
 0.20
i= = 0.25 or 25%
1−0.20

Another solution,

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃1,000
i= = = 0.25 or 25%
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑃4,000

𝐼 𝑃1,000
(c) I = Pni i= = 9 = 0.3333 or 33.33%
𝑃𝑛 (𝑃4,000)(12)

Inflation
Inflation is the increase in the prices for goods and services from one year to another, thus
decreasing the purchasing power of money.

FC = PC (1 + f)n (14)

where : PC = present cost of a commodity

FC = future cost of the same commodity
f = annual inflation rate
n = number of years

Example : An item presently cost P1,000. If inflation is at the rate of 8% per year, what will
be the cost of the item in two years?

Solution : FC = PC (1 + f)n = P1000 (1 + 0.08)2 = P1166.40

In an inflation economy, the buying power of money decreases as costs increases. Thus,
𝑃
F = (1+𝑓) 𝑛 (15)

where F is the future worth, measured in today’s pesos, of a present amount P.

Example : An economy is experiencing inflation at an annual rate of 8%. If this continues, what
will P1000 be worth two years from now in terms of today’s pesos?
𝑃1000
Solution : F = (1+0.08) 2 = 857.34

If interest is being compounded at the same time that inflation is occurring, the future worth
will be

𝑃(1+𝑖)𝑛 1+ 𝑖 𝑛
F= =P( ) (16)
(1+𝑓)𝑛 1+𝑓

Example : A man invested P10,000 at an interest rate of 10% compounded annually. What
will be the final amount of his investment, in terms of today’s pesos, after five years, if inflation remains
the same at the rate of 8% per year?

1+ 𝑖 𝑛 1+ 0.10 5
Solution : F=P( ) = P10,000 P ( ) = P10,960.86
1+𝑓 1+0.08

Page 8 of 24
ANNUITIES

An annuity is a series of equal payments occurring at equal periods of time.

Symbols and their Meaning

P = value or sum of money at present

F = value or sum of money at some future time
A = a series of periodic, equal amounts of money
n = number of interest periods
i = interest rate per interest periods

Ordinary Annuity

An ordinary annuity is one where the payments are made at the end of each period.

Finding P when A is Given

P

0 1 2 3 n-1 n

A A A A A
A(P/F, i%, 1)

A(P/F, i%, 2)

A(P/F, i%, 3)

A(P/F, i%, n-1)

A(P/F, i%, n)

Cash Flow Diagram to find P given A

P = A (P/F, i%, 1) + A (P/F, i%, 2) + A (P/F, i%, 3) +. . .+ A (P/F, i%, n-1) + A (P/F, i%, n)

P = A (1 + i)-1 + A (1 + i)-2 + A (1 + i)-3 +. . .+ A (1 + i)-(n-1) + A (1 + i)n first equation

Multiplying this equation by (1 + i) results in

P + Pi = A + A (1 + i)-1 + A (1 + i)-2 +. . .+ A (1 + i)-n+2 + A (1 + i)-n+1 second equation

Subtracting the first equation from the second gives

Pi = A – A (1 + i)-n

Solving for P

1− (1+𝑖)−𝑛 (1+𝑖)𝑛 −1
P=A[ ] =A[ ] (17)
𝑖 𝑖 (1+𝑖)𝑛

The quantity in brackets is called the “uniform series present worth factor” and is designated
by the functional symbol P/A, i%, n, read as “P given A at i percent in n interest periods.” Hence
equation (17) can be expressed as

P = A (P/A, i%, n) (18)

Page 9 of 24
Finding F when A is Given F
0 1 2 3 n-1 n

A A A A A
A(P/F, i%, 1)
A(P/F, i%, n-3)
A(P/F, i%, n-2)
A(P/F, i%, n-1)

Cash Flow Diagram to find F given A

F = A + A (F/P, i%, 1) +. . .+ A (F/P, i%, n-3) + A (F/P, i%, n-2) + A (F/P, i%, n-1)

F = A + A (1 + i) +. . .+ A (1 + i)n-3 + A (1 + i)n-2 + A (1 + i)n-1 first equation

Multiplying this equation by (1 + i) results in

F + Fi = A (1 + i) + A (1 + i)2 +. . .+ A (1 + i)n-2 + A (1 + i)n-1 + A (1 + i)n second equation

Subtracting the first equation from the second gives

Fi = – A

Solving for F

(1−𝑖)𝑛 −1
F=A[ ] (19)
𝑖

The quantity in brackets is called the “uniform series compound amount factor” and is
designated by the functional symbol F/A, i%, n, read as “F given A at i percent in n interest periods.”
Hence equation (19) can be expressed as

F = A (F/A, i%, n) (20)

Finding A when P is Given

Taking Equation (17) and solving for A, we have

𝑖
A=P[ ] (21)
1− (1+𝑖)−𝑛

The quantity in brackets is called the “capital recovery factor”. It will be denoted by the
functional symbol A/P, i%, n which is read as “A given P at i percent in n interest periods.” Hence

A = P (A/P, i%, n) (22)

Finding A when F is Given

Taking Equation (19) and solving for A, we have

𝑖
A=F[ ] (23)
(1+𝑖)𝑛 −1

Page 10 of 24
 The quantity in brackets is called the “sinking fund factor”. It will be denoted by the functional
symbol A/F, i%, n which is read as “A given F at i percent in n interest periods.” Hence

A = F (A/F, i%, n) (24)

Relation between A/P, i%, n and A/F, i%, n

A/F, i%, n + i = A/P, i%, n (25)

Sinking Fund Factor + i = Capital Recovery Factor

Example : What are the present worth and the accumulated amount of a 10-year annuity paying
P10,000 at the end of each year, with interest at 15% compounded annually?

Solution : A = P10,000 n = 10 i = 15%

P F

0 1 2 3 9 10

10,000 10,000 10,000 10,000 10,000

10,000 (P/A, 15%, 10) P10,000 (F/A, 15%, 10)

P = A (P/A, i%, n) = P10,000 (P/A, 15%, 10)

1− (1+0.15)−10
= P10,000 [ ] = 50,188
0.15

F = A (F/A, i%, n) = P10,000 (F/A, 15%, 10)

(1+0.15)10 −1
= P10,000 [ ] = P203,037
0.15

Example : What is the present worth of P500 deposited at the end of every three months for 6 years
if the interest rate is 12% compounded semi-annually?

Solution :
Solving for the interest rate per quarter,

0.12 2
(1 + i)4 – 1 = (1 + ) −1
2
0.5
1 + i = (1.06)

i = 0.0296 or 2.96% per quarter

P = A (P/A, 2.96%, 24)

1−(1+0.0296)−24
= P500 [ ]
0.0296

= P500 (17.0087)
= P8,504

Page 11 of 24
Example : Today, you invest P100,000 into a fund that pays 25% interest compounded annually.
Three years later, you borrow P50,000 from a bank at 20% annual interest and invest in the fund.
Two years later, you withdraw enough money from the fund to repay the bank loan and interest due
on it. Three years from this withdrawal you start taking P20,000 per year out of the fund. After five
withdrawals, you withdraw the balance in the fund. How much was withdrawn?

Solution
Q
P50,000 (1.20)2 (F/P,25%,7)

P50,000 (1.20)2
P20,000 (F/A,25%,5)

P20,000 each

0 1 2 3 4 5 6 7 8 9 10 11 12

P50,000

P50,000 (F/P, 25%, 9)

P100,000
P100,000 (F/P, 25%, 12)

Let Q = the amount withdrawn after 12 years

Using 12 years from today as the focal date, the equation of value is

Q + P20,000(F/A,25%,5) + P50,000(1.20) 2 (F/P,25%,7) = P100,000(F/P,25%,12) + P50,000(F/P,25%,9)

Q + P20,000(8.2070) + P50,000(1.20) 2(4.7684) = P100,000(14.5519) + P50,000(7.4506)

Q = P1,320,255

Deferred Annuity

A deferred annuity is one where the first payment is made several periods after the beginning
of the annuity.

Finding P when A is given

P

m periods n periods

0 1 2 n-1 n
0 1 2 m

A A A A

A(P/A, i%, n) (P/F, i%, m) A(P/A, i%, n)

P = A (P/A, i%, n) (P/F, i%, m) (26)

1−(1+𝑖)−𝑛
P=A[ ] (1 + 𝑖)−𝑚 (27)
𝑖

Example : On the day grandson was born, a man deposited to a trust company a sufficient amount
of money so that the boy could receive five annual payments of P10,000 each for his college tuition
fees, starting with his 18th birthday. Interest at the rate of 12% per annum was to be paid on all

Page 12 of 24
amounts on deposit. There was also a provision that the grandson could elect to withdraw no annual
payments and receive a single lump amount on his 25 th birthday. The grandson chose this option.
(a) How much did the boy receive as the single payment?
(b) How much did the grandfather deposit?

Solution : Let P = the amount deposited

X = the amount withdrawn
X

10,000 10,000 10,000 10,000 10,000

0 18 19 20 21 22 23 24 25

P
The P10,000 suppose withdrawals are represented by broken lines since they did not actually
occur. Three separate cash flow diagrams can be drawn.

(a) X

P10,000(F/A,12%,5) P10,000(F/A,12%,5)(F/P,12%,3)

10,000 10,000 10,000 10,000 10,000

17 18 19 20 21 22 23 24 25

X and the P10,000 suppose withdrawals are equivalent. Using 25 years of age as the focal
date, the equation of value is

X = P10,000 (F/, 12%, 5) (F/P, 12%, 3)

= P10,000 (6.3528)(1.4049)

= P89,250

The other good focal dates are 17 and 22 years from today.

(b)

P10,000(P/A,12%,5)(P/F,12%,17) P10,000 (P/A,12%,5)

10,000 10,000 10,000 10,000 10,000

0 17 18 19 20 21 22

P
P and the P10,000 suppose withdrawals are equivalent.

Using today as the focal date, the equation of value is

P = P10,000 (P/A,12%,5)(P/F,12%,17)
= P10,000 (3.6047) (0.14565)
= P5,250

Page 13 of 24
The other good focal dates are 17 and 22 years from today.

Another solution :

P10,000 (P/A,12%,5)

0 25
P

This was what actually happened, P was deposited today and X was withdrawn 25 years later.
Using today as the focal date, the equation value is

P = X (P/F,12%,25)
= P89,250 (0.058821)
= P5,250

Annuity Due

An annuity Due is one where the payments are made at the beginning of each period.

Find P when A is Given

P

0 1 2 3 n-1 n

A A A A A

P = A + A (P/A, i%, n-1) (28)

P = A (1 + P/A, i%, n-1) (29)

Finding F when A is Given

F

0 1 2 3 n-1 n

A A A A A

F = A (F/A, i%, n+1) – A (30)

F = A [(F/A, i%,n+1) – 1] (31)

Example : A certain property is being sold and the owner received two bids.
The first bidder offered to pay P400,000 each year for 5 years, each payment is to be made
is to be made at the beginning of each year. The second bidder offered to pay P240,000 first year,
P360,000 the second year and P540,000 each year for the next 3 years, all payment will be made
at the beginning of each year.
If money is worth 20% compounded annually, which bid should the owner of the property
accept?

Page 14 of 24
Solution :
First Bid :
P1

0 1 2 3 4 5

400K 400K 400K 400K 400K

Let P1 = present worth of the first bidder

= A (1 + P/A, 20%, 4)
= P400,000 (1 + P/A, 20%, 4)
= P400,000 (1 + 2.5887)
= P1,435,480

Second Bid :
P2

0 1 2 3 4 5

240K 360K 540K 540K 540K

Let P1 = present worth of the second bidder

= 240,000 + 360,000 (P/F, 20%, 1) + 540,000 (P/A, 20%, 3)(P/F, 20%, 1)
= 240,000 + 360,000 (0.8333) + 540,000 (2.1065)(0.8333)
= P1,487,875
The owner of property should accept the second bid.

PERPETUITY

A perpetuity is an annuity in which the payments continue indefinitely.

0 1 2 3 n ∞

A A A

1− (1+𝑖)−𝑛 1− (1+𝑖)−∞
P =A[ ] =A[ ]
𝑖 𝑖
𝐴
P= (32)
𝑖

Example : What amount of money invested today at 15% interest can provide the following
scholarships : P30,000 at the end of each year for 6 years; P40,000 for the next 6 years and
P50,000 thereafter?

Page 15 of 24
Solution :
Using today as the focal date, the equation value is

𝑃50,000
P = P30,000 (P/A, 15%, 6) + P40,000 (P/A, 15%, 6) (P/F, 15%, 6) + (P/F, 15%, 12)
0.15

𝑃50,000
= P30,000 (3.7845) + P40,000 (3.7845) (0.4323) + (0.1869)
0.15

= P241,277

CAPITALIZED COST

On of the most important application of perpetuity is in capitalized cost. The capitalized cost
of any property is the sum of the first cost and the present worth of all costs of replacement,
operation and maintenance for a long time or forever.

Case 1. No replacement, only maintenance and/or operation every period.

Capitalized Cost = First Cost + Present Worth of perpetual operation or maintenance.

Example : Determine the capitalized cost of a structure that requires an initial investment of
P1,500,000 and an annual maintenance of P150,000. Interest is 15%.

Solution :
P150,000 P150,000

0 1 2

𝐴 𝑃150,000
P = = = P1,000,000
𝑖 0.15

Capitalized Cost = First Cost + P

= P1,500,000 + P1,000,000

= P 2,500,000

Case 2. Replacement only, no maintenance and/or operation every period.

Capitalized Cost = First Cost + Present Worth of Perpetual Replacement

Let S = amount needed to replace a property every k periods

X = amount of principal invested at a rate i% the interest on which will amount
to S every k periods
Xi = interest on X every period, the periodic deposit towards the accumulation of S

Page 16 of 24
 S

0 1 2 3 k-1 k

Xi Xi Xi Xi Xi

S = Xi (F/A, i%, k)

𝑆 1 𝑆 𝑖 𝑆
X= [ = [ ] = (33)
𝑖 ( 𝐹, 𝑖%, 𝑘) 𝑖 (1+𝑘)𝑘 −1 (1+𝑘)𝑘 −1
𝐴

Difference between P and X in a perpetuity.

A A A S S S

0 1 2 3 0 k 2k 3k

P X

𝐴 𝑆
P= X=
𝑖 (1+𝑘)𝑘 −1

P is the amount invested now at i% period whose interest at the end of every period
forever is A while X is the amount invested now at i% per period whose interest at the end of every k
periods forever is S. If k = 1, then, X = P.

Example : A new engine was installed by a textile plant a cost of P300,000 and projected to have a
useful life of 5 years. At the end of its useful life, it is estimated to have a salvage value of P30,000.
Determine its capitalized cost if interest is 18% compounded annually.

Solution : P30,000 P30,000 P30,000

0 15 30 45

300,000 300,000 300,000 300,000

P270,000 P270,000 P270,000

0 15 30 45

X
𝑆 𝑃270,000
X= = = P 24,604
(1+𝑘)𝑘 −1 (1+0.18)15 −1

Capitalized Cost = First Cost + X = P300,000 + P24,604 = P324,604

Case 3. Replacement, Maintenance and/or operation every period.

Capitalized Cost = First Cost + Present Worth of cost of perpetual operation and/or maintenance +
Present Worth of cost of perpetual replacement

Page 17 of 24
Example : Determine the capitalized cost of a research laboratory which requires P5,000,000 for
original construction; P100,000 at the end of every year for the first 6 years and then P120,000 each
year thereafter for operating expenses, and P500,000 every 5 years for replacement of equipment
with interest at 12% per annum.

Solution :

Operation :
𝑃120,000 𝑃120,000
(P/F, 12%, 6)
0.12 0.12

P100,000 (P/A, 12%, 6) 120,000 120,000 120,000

100,000 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5 6 7 8 9

Q
𝑃120,000
Let Q = P100,000 (P/A, 12%, 6) + (P/F, 12%, 6)
0.12

𝑃120,000
= P100,000 (4.1114) + (0.5066)
0.12

= P917,740

Replacement :
P500,000 P500,000 P500,000

0 5 10 15

X
Let X = the present worth of cost of perpetual replacement

𝑆 𝑃500,000
X= = = P655,910
(1+𝑖)𝑘 −1 (1+0.12)5 −1

Capitalized Cost = First Cost + Q + X

= P5,000,000 + P917,740 + P655,910

= P6,753,650

Page 18 of 24
AMORTIZATION

Amortization is any method of repaying a debt or loan, the principal and interest included,
usually by a series of equal payments at equal interval of time. This is often the common practice on
repaying a debt or loan.

Example : A debt of P5,000 with interest at 12% compounded semi-annually is to be amortized

by equal semi-annual payments over the next 3 year, the first due in 6 months. Find the semi-annual
payment and construct an amortization schedule/table.

Solution :
P5000

0 1 2 3 4 5 6

A A A A A A
𝑃 𝑃5,000
A= 𝑃 = = 1,016.82
(𝐴, 6%, 6) 4.9173
Amortization Schedule
Period Outstanding principal at Interest due at Payment Principal repaid
beginning of period end of period at end of period
1 5,000.00 300.00 1,016.82 716.82
2 4,283.18 256.99 1,016.82 759.83
3 3,5232.35 211.40 1,016.82 805.42
4 2,717.93 163.08 1,016.82 853.74
5 1,864.19 111.85 1,016.82 904.97
6 959.22 57.55 1,016.82 959.27
Totals 1,100.87 6,100.82 5,000.05

Example : A debt of P10,000 with interest at the rate of 20% compounded semiannually is to be
amortized by 5 equal payments at the end of each 6 months, the first payment is to be made after 3
years. Find the semiannual payment and construct an amortization schedule.

P10,000

0 1 2 3 4 5
0 1 2 3 4 5 6 7 8 9 10

A A A A A

P = A (P/A, 10%, 5) (P/F, 10%, 5)

A = P (A/P, 10%, 5) (F/P, 10%, 5)
= P10,000 (0.2638)(1.6105)
= P4,248.50

Amortization Schedule
Period Outstanding principal at Interest due at Payment Principal repaid
beginning of period end of period at end of period
1 10,000.00 1,000.00
2 11,000.00 1,100.00
3 12,100.00 1,210.00
Page 19 of 24
 4 13,310.00 1,331.00
5 14,641.00 1,464.10
6 16,105.10 1,610.51 4,248.50 2,637.99
7 13,467.11 1,346.71 4,248.50 2,901.79
8 10,565.32 1,056.53 4,248.50 3,191.97
9 7,373.35 737.34 4,248.50 3,511.16
10 3862.19 386.22 4,248.50 3,862.28
Totals 11,242.41 21,242.50 16,105.19

2. CONCEPTS OF EQUIVALENCE

Two sums of money at two different points in time can be made economically equivalent if:
• We consider an interest rate and,
• The number of time periods between the two sums

Economic equivalence is a combination of interest rate and time value of money to determine
the different amounts of money at different points in time that are equal in economic value.

Economic equivalence is a fundamental concept upon which engineering economy computations are
based. Before we delve into the economic aspects, think of the many types of equivalency we may
utilize daily by transferring from one scale to another. Some example transfers between scales are as
follows:

Often equivalency involves two or more scales. Consider the equivalency of a speed of 110
kilometers per hour (kph) into miles per minute using conversions between distance and time scales
with three-decimal accuracy.

However, those are with regards to equivalence of measurements, weights, distance, etc. in the
engineering terminologies.

Now we consider economic equivalency.

Economic equivalence is a combination of interest rate and time value of money to determine
the different amounts of money at different points in time that are equal in economic value.

As an illustration, if the interest rate is 6% per year, $100 today (present time) is equivalent to $106
one year from today.

Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106

If someone offered you a gift of $100 today or $106 one year from today, it would make no difference
which offer you accepted from an economic perspective. In either case you have $106 one year from
today. However, the two sums of money are equivalent to each other only when the interest rate is

Page 20 of 24
6% per year. At a higher or lower interest rate, $100 today is not equivalent to $106 one year from
today.

In addition to future equivalence, we can apply the same logic to determine equivalence for previous
years. A total of $100 now is equivalent to $94.34 one year ago at an interest rate of 6% per year.
From these illustrations, we can state the following: $94.34 last year, $100 now, and $106 one year
from now are equivalent at an interest rate of 6% per year. The fact that these sums are equivalent
can be verified by computing the two interest rates for 1-year interest periods.

EXAMPLE :

Manufacturers make backup batteries for computer systems available to Batteries + dealers through
privately owned distributorships. In general, batteries are stored throughout the year, and a 5% cost
increase is added each year to cover the inventory carrying charge for the distributorship owner.
Assume you own the City Center Batteries outlet.
Make the calculations necessary to show which of the following statements are true and which are
false about battery costs.

(a) The amount of $98 now is equivalent to a cost of $105.60 one year from now.
(b) A truck battery cost of $200 one year ago is equivalent to $205 now.
(c) A $38 cost now is equivalent to $39.90 one year from now.
(d) A $3000 cost now is equivalent to $2887.14 one year earlier.
(e) The carrying charge accumulated in 1 year on an investment of $20,000 worth of batteries is
$1000.

EXAMPLE

Howard owns a small electronics repair shop. He wants to borrow $10,000 now and repay it over the
next 1 or 2 years. He believes that new diagnostic test equipment will allow him to work on a wider
variety of electronic items and increase his annual revenue. Howard received 2-year repayment
options from banks A and B.

After reviewing these plans, Howard decided that he wants to repay the $10,000 after only 1 year
based on the expected increased revenue. During a family conversation, Howard’s brother-in-law
Page 21 of 24
offered to lend him the $10,000 now and take $10,600 after exactly 1 year. Now Howard has three
options and wonders which one to take. Which one is economically the best?

Solution

The repayment plans for both banks are economically equivalent at the interest rate of 5% per
year. (This is determined by using computations that you will learn in Time Value of Money.)
Therefore, Howard can choose either plan even though the bank B plan requires a slightly larger sum
of money over the 2 years.

The brother-in-law repayment plan requires a total of $600 in interest 1 year later plus
the principal of $10,000, which makes the interest rate 6% per year. Given the two 5% per
year options from the banks, this 6% plan should not be chosen as it is not economically better
than the other two. Even though the sum of money repaid is smaller, the timing of the cash flows and
the interest rate make it less desirable. The point here is that cash flows themselves, or their sums,
cannot be relied upon as the primary basis for an economic decision. The interest rate, timing, and
economic equivalence must be considered.

3. CASH FLOWS

Cash flow is the sum of money recorded as receipts or disbursements in a project’s financial
records.

Cash flow is the money that is moving (flowing) in and out of your business in a month. Although it
does seem sometimes that cash flow only goes one way - out of the business - it does flow both
ways.1

• Cash is coming in from customers or clients who are buying your products or services. If
customers don't pay at the time of purchase, some of your cash flow is coming from collections
of accounts receivable.
• Cash is going out of your business in the form of payments for expenses, like rent or a
mortgage, in monthly loan payments, and in payments for taxes and other accounts payable.

Cash vs. Real Cash

For some businesses, like restaurants and some retailers, cash is really cash – currency and
paper money. The business takes cash from customers and sometimes pays its bills in cash. Cash
businesses have a special issue with keeping track of cash flow, especially since they may not track
income unless there are invoices or other paperwork.

Think of 'cash flow' as a picture of your business checking account over time. If more money
is coming in than is going out, you are in a "positive cash flow" situation and you have enough to pay
your bills. If more cash is going out than coming in, you are in danger of being overdrawn, and you
will need to find money to cover your overdrafts.

As discussed cash flows can either be positive or negative. It is calculated by subtracting the
cash balance at the beginning of a period which is also known as opening balance, form the cash
balance at the end of the period (could be a month, quarter or a year) or the closing balance.

If the difference is positive, it means you have more cash at the end of a given period. If the
difference is negative it means that you have less amount of cash at the end of a given period when
compared with the opening balance at the starting of a period.

To analyse where the cash is coming from and going out, cash flow statements are prepared.
It has three main categories – operating cash flow which includes day-to-day transactions, investing
cash flow which includes transactions which are done for expansion purpose, and financing cash flow
which include transactions relating to the amount of dividend paid out to stockholders.
Page 22 of 24
 However, the level of cash flow is not an ideal metric to analyse a company when making an
investment decision. A Company’s balance sheet as well as income statements should be studied
carefully to come to a conclusion.

Cash level might be increasing for a company because it might have sold some of its assets,
but that doesn’t mean the liquidity is improving. If the company has sold off some of its assets to pay
off debt then this is a negative sign and should be investigated further for more clarification.

If the company is not reinvesting cash then this is also a negative sign because in that case it
is not using the opportunity to diversify or build business for expansion.

4. DEPRECIATION AND CAPITAL FINANCING

Depreciation is the decrease in the value of physical property with the passage of time.

Definition of Value

Value, in a commercial sense, is the present worth of all future profits that are to be received
through ownership of a particular property.

The market value of a property is the amount which a willing buyer will pay to a willing seller
for the property where each has equal advantage and in under no compulsion to buy or sell.

Fair value is the value which is usually determined by a disinterested third party in order to
establish a price that is fair to both seller and buyer.

Book value, sometimes called depreciated book value, is the worth of a property as shown on
the accounting records of an enterprise.

Salvage, or resale, value is the price that can be obtained from the sale of the property after it
has been used.

Scrap value is the amount of the property would sell for if disposed off as junk.

Purposes of Depreciation

1. To provide for the recovery capital which has been invested in physical property.
2. To enable the cost of depreciation to be charged to the cost of producing products or services
that results the use of the property.

Types of Depreciation

1. Normal depreciation (physical and functional)

2. Depreciation due to changes in price levels
3. Depletion

Physical depreciation is due to the lessening of the physical ability of a property to produce
results. Its common causes are wear and deterioration. Functional depreciation is due to the
lessening in the demand for the function which the property was designed to render. Its
common causes are inadequacy, changes in styles, population centers shift, saturation of
markets or more efficient machines are produced.
Depreciation due to changes in price levels is almost impossible to predict and therefore
is not considered in economic studies.
Depletion refers to the decrease in the value of the property due to the gradual extraction
of its content.

Page 23 of 24
Physical and Economic Life

Physical life of a property is the length of time during which it is capable of performing the
function for which it was designed and manufactured.
Economic life is the length of time during which the property may be operated at a profit.

Requirements of a Depreciation Method

1. It should be simple.
2. It should recover capital
3. The book value will be reasonable close to the market value at any time.
4. The method should be accepted by the Bureau of Internal Revenue.

Depreciation Methods
We shall use the following symbols for the different depreciation methods:

L = useful life of the property in years

Co = the original cost
CL = the value at the end of the life, the scrap value (including gain or loss)
d = the annual cost of depreciation
Cn = the book value at the end of n years
Dn = depreciation up to age n years

a. The Straight Line Method

This method assumes that the loss in value is directly proportional to the age of the
property.
Co −CL
d=
𝐿

n(Co −CL)
Dn =
𝐿

Cn = Co - Dn

b. The Sinking Fund Formula

This method assumes that a sinking fund is established in which funds will accumulate
for replacement. The total depreciation that has taken place up to any given time is assumed
to be equal to the accumulated amount in the sinking fund at that time.
Co −CL
d=𝐹
, 𝑖%, 𝐿
𝐴

Dn = d(F/A, i%, n)

Cn = Co - Dn

c. Declining Balance Method

In this method, sometimes called the constant percentage method or the Matheson
Formula, it is assumed that the annual cost of depreciation is a fixed percentage of the book
value at the beginning of the year. The ratio of the depreciation in any year to the book at the
beginning of that year is constant throughout the life of the property and is designated by k,
the rate of depreciation.
This method does not apply if the salvage value is zero because k will be equal to one
and d1 will be equal to Co.

dn = Co (1 – k)n-1 k
𝐶𝐿
Co = Co (1 – k)n = Co [ ]n/L
𝐶𝑜
Page 24 of 24