MATHEMATICS

INVESTMENT
 CHAPTER 5

TABLE OF CONTENTS

I. Amortization and Sinking Fund

1. Extinction of Debt
2. Computation of the Outstanding Balance
3. Amortization Method
4. Sinking Fund Method

DESIRED LEARNING OUTCOMES

At the end of the chapter, the students must have:
1. construct an amortization schedule;

2. solve the problems on amortization where present value, amount/future value, rate,
terms, or time is unknown.

3. Compute the outstanding liability for any desired time;

4. Determine the periodic expense and book value of a sinking fund.

Mathematics of Investment
CHAPTER 5

TOPIC 1 SINKING FUND

Sinking fund and amortization are two common applications of annuities. A 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.
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 the future date. Likewise, individuals can use sinking funds to save for a college education,
a car, down payment on a house, or a vacation.

SINKING FUND USING THE FORMULA

Sinking fund payments may be computed using the formula:

i
Sinking Fund Payment = FV 
(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 multiplied by periods per year)

Example 1: Coca-Cola Corporation needs Php 1,000,000 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?

Given: FV = Php 1,000,000

i = 1% or (0.01) that is 12% interest divided by 12 periods/year
n = 60 (5 years multiplied by 12 periods per year)

Unknown: Sinking fund payment

i
Solution: Sinking Fund Payment = FV 
(1 + i )
n
−1

.01
= 1, 000, 000 
(1 + .01)
60
−1
.01
= 1, 000, 000 
0.8166967
= 1,000,000  0.0122444
Conclusion: Therefore, the sinking fund payment required at the end of each month is
Php 12,244.40.
Mathematics of Investment
CHAPTER 5

SINKING FUND SCHEDULE

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
interest 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 interest on the debt and the other as a deposit to the fund.

Example 2: A Php 40,000 debt is to be repaid at the end of 2 and 1/2 years. Interest charged 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) Find the amount in the sinking fund at the end of
the fourth period; c) the sinking fund interest income for the fifth payment period; d)
the book value of the debt at the end of the fourth period.

a) The quarterly interest payment for the debt is computed using I=PRT
I = Php 40,000 x 15% x (0.25)
= Php 1,500

b) The amount in the sinking fund at the end of the fourth period is the future value of
an annuity of Php 6,183.90 payable quarterly at 12% compounded quarterly for four
periods. Hence, Pmt = 6,183.90 ; n = 4 ; i = 3%

Future value = Php 6183.90 x 4.183627

= Php 25,871.13

c) The sinking fund interest income for the fifth payment period. The principal at the
beginning of the fifth payment period is the amount in the sinking fund at the end of
the fourth period, Php 25,871.13

Interest Income = Php 25,871.13 x 0.03

= Php 776.13

d) The book of value of the debt at the end of the fourth period. The book value is the
net obligation, which equals the original debt less the accumulated amount in the
fund at that time.

Book Value = Php 40,000 - Php 25,871.13

= Php 14,128.87

Mathematics of Investment
CHAPTER 5

TOPIC 2 AMORTIZATION

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 businesses uses of
amortization would be paying off real estate loans and liquidating insurance.
Amortization method broadly refers to the discharging of a debt by means of a set of
regular or irregular and equal or unequal payments. Only debt discharged by a sequence of equal
payments at equal intervals of time will be discussed in this learning material. In order to
discharge a debt, each payment must be greater than the periodic interest, so that a part of the
payment applies to the interest and the remainder applies tot eh principal until the principal
becomes zero.

AMORTIZATION PAYMENT USING THE FORMULA

Amortization payments may be computed by using the formula:
i
Amortization Payment = PV 
1 − (1 + i )
−n

Example 3: What amortization payment is required each month at 18% interest, to pay off Php
50,000 in 3 years?

i = (18% ÷ 12 months) = 1.5% and n = (3 years x 12 periods) = 36

i
Amortization Payment = PV 
1 − (1 + i )
−n

0.015
= Php 50,000 x
1 − (1 + 0.015 )
−36

= Php 50,000 x 0.0361524

= Php 1,807.62

OUTSTANDING PRINCIPAL
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: like for accounting purposes; the creditor may want 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 agree to settle th
balance on an earlier date.
Mathematics of Investment
CHAPTER 5

Example 4: Calvin purchased a Php 1,200,000 house and made a down payment of php 200,000.
he agreed to pay the balance by making equal payments at the end of each month
for 15 years. With an interest of 12% compounded monthly, and a monthly payment
of Php 12,001.68, Find the outstanding principal after Calvin made the monthly
payments for 10 years.

Pmt = Php 12,001.68

i = 1% (that is 12% ÷ 12 months)
n = 60 (180 months - 120 months)

Using the Formula for Future Value of an Annuity, we have

Outstanding Principals = Php 12,001.68 x 44.955038

= Php 539,535.98

Mathematics of Investment