LESSON 4

engineering
ECONOMICS
EMPP
Instructor
 01 03
THE CONCEPT OF INFLATION
ECONOMIC
EQUIVALENCE
topics
02 04
ANNUITY discount
 objective

• Students should be able to learn about the concept of economic

equivalence, annuities, inflation, and discounts.

• Students should be able to calculate problems involving annuities,

inflation, and discounts.
 01.
THE CONCEPT OF
ECONOMIC
EQUIVALENCE
 THE CONCEPT OF ECONOMIC EQUIVALENCE

Economic equivalence is a fundamental concept upon which

engineering economy computations are based.

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.
 02.
Annuity

a series of equal payments made at equal intervals of time.
Certain annuity
the specific amount of payments is
set to begin and end at a specific
length of time.
Example: monthly payments of a car
loan where the amount and number
of payments are known.
annuity
uncertain annuity
the annuitant may be paid
according to certain event.
Example: life and accident insurance.
In this example, the start of payment
is not known and the amount of
payment is dependent to which
event.
 annuity

Two classification of annuity

simple annuity general annuity

the payment period is the same as
the interest period, which means
that if the payment is made monthly
the conversion of money also occurs
monthly
the payment period is not the same
as the interest period. To deal with
general annuity, convert it to simple
annuity by making the payment
period the same as the
compounding periods by the
concept of effective rates.
 annuity

Types of annuity

ordinary annuity Deferred annuity

Annuity due Perpetuity

 ordinary annuity
a series of uniform cash flows where the first amount of the series
occurs at the end of the first period and every succeeding cash
flow occurs at the end of each period.

CHARACTERISTICS OF ORDINARY ANNUITY

p f a
PRESENT EQUIVALENT FUTURE EQUIVALENT
ANNUAL EQUIVALENT
VALUE VALUE
VALUE
– Occurs one interest – Occurs at the same time
– Occurs at the end of
period before the first A as the last A and n
each period
(uniform amount) intervals after P
 ordinary annuity
Finding p, When A is given:

Where,
P = Present equivalent value of annuity
A = payment, annual equivalent value
i = interest rate
n = number of compounding period

The quantity in brackets is called the “uniform series present worth factor” and is designated by
the functional P/𝐴, 𝑖%, 𝑛, read as “P given A at I percent in the interest periods.”
 ordinary annuity

EXAMPLE
What is the present worth of a 10-year annuity paying P10,000 at the end of each year, with
interest at 15% compounded annually?

Given: Solution:
A = P10,000 1− 1 + 𝑖 −𝑛
i = 15% P=𝐴
𝑖
n = 10 years
1− 1 + 0.15 −10
= P10,000
Required: 0.15
P, present value of annuity
P = P50,187.69
 ordinary annuity
Finding F, When A is given:

Where,
F = Future equivalent value of annuity
A = payment, annual equivalent value
i = interest rate
n = number of compounding period

The quantity in brackets is called “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 period.”
 ordinary annuity

EXAMPLE
What is the future worth of a 10-year annuity paying P10,000 at the end of each year, with
interest at 15% compounded annually?

Given: Solution:
A = P10,000 1 + 𝑖 𝑛 −1
i = 15% F=𝐴
𝑖
n = 10 years
1 + 0.15 10 −1
= P10,000
0.15
Required:
F, future value of annuity F = P203,037.18
 ordinary annuity
Finding a, When p is given:

Where,
P = Present equivalent value of annuity
A = payment, annual equivalent value
i = interest rate
n = number of compounding period

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 an interest period.”
 ordinary annuity

EXAMPLE
If P25,000 is deposited now into a savings account that earns 6% per year, what uniform annual
amount could be withdrawn at the end of each year for ten years so that nothing would be left in
the account after the 10th withdrawal?
Given: Solution:
P = P25,000 𝑖
i = 6% A=𝑃
1− 1 + 𝑖 −𝑛
n = 10 years
0.06
Required: = P25,000
1− 1 + 0.06 −10
A, annual equivalent value
A = P3,396.70
 ordinary annuity
Finding a, When f is given:

Where,
F = Future equivalent value of annuity
A = payment, annual equivalent value
i = interest rate
n = number of compounding period

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 per n interest periods.”
 ordinary annuity

EXAMPLE
Sixty monthly deposits are made into an account paying 6% nominal interest compounded
monthly. If the subject of these deposits is to accumulate P100,000 by the end of the fifth year,
what is the amount of each deposit?
Given: Solution:
F = P100,000 𝑖
i = (6%)/12 = 0.005 A=𝐹
1 + 𝑖 𝑛 −1
n = 5 yrs x 12 = 60 months
0.005
Required: = P100,000
1 + 0.005 60 −1
A, annual equivalent value
A = P1,433.28
 Annuity due
it is one where the payments are made at the beginning of
each period.

Finding p, When A is given: Finding F, When A is given:

WHERE,
P = Present equivalent value of annuity A = payment, annual equivalent value
F = Future equivalent value of annuity i = interest rate
n = number of compounding period
 Annuity due

EXAMPLE 1
A man bought an equipment costing P60,000 payables in 12 quarterly payments, each installment
payable at the beginning of each period. The rate of interest is 8% compounded quarterly. What
is the amount of each payment?
Given: Solution:
P = P60,000 1−(1+𝑖)−(𝑛−1)
P=𝐴 +1
i = 8% 𝑖

n = 12 𝑃
A= 1−(1+𝑖)−(𝑛−1)
+1
𝑖
Required: 𝑃60,000
A, amount per payment A= 1−(1+0.08)−(12−1)
+1
0.08
A = P7,371.00
 Annuity due

EXAMPLE 2
Suppose that P400 is deposited each year into a bank account that pays 8% interest annually. If
12 payments are made into the account, how much would be accumulated in his fund by the end
of the 12 year? The first payment occurs at time zero (now).
Given: Solution:
A = P400 (1+𝑖)(𝑛+1) −1
i = 8% F=𝐴 − 1
𝑖
n = 12
(1+0.08)(12+1) −1
F = P400 − 1
Required: 0.08
F, future value
F = P8,198.12
 Deferred Annuity
it is one where the first payment is made several periods
after the beginning of the annuity.

where:
𝑚 = 𝑑𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑝𝑒𝑟𝑖𝑜𝑑
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑖𝑒𝑠
*Note that the counting of m is up to the period
before the first A.
 Deferred Annuity

EXAMPLE
David who deposited a certain amount of money today and is supposed to receive 30 annual
payments of P5,000 each. However, the annuity will start 4 years from today and the applicable
rate of interest is 5%. Calculate the amount of money deposited if the annuity payment is
supposed to be made at the end of each year.
Given: Solution:
A = P5,000 1− 1+𝑖 −𝑛
i = 5% P=𝐴 (1 + 𝑖)−𝑚
𝑖
n = 30 years
1− 1+0.05 −30
m = 4 years P = 𝑃5,000 (1 + 0.05)−4
0.05

Required: P = P63,234.77
P, present value
 Perpetuity
it is a security that pays for an infinite amount of time. It is
the payment period extends forever, which means that
the periodic payments continue indefinitely.

where:
A = payment per 𝑝𝑒𝑟𝑖𝑜𝑑
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑖𝑒𝑠
P = present value
 Perpetuity

EXAMPLE
If a trust fund has a rate of return of 8%, find out the endowment value that can support 1Million
pesos payment each year.

Given: Solution:
A = P1,000,000 𝐴 (1+𝑖)𝑛 −1
i = 8% P=
(1+𝑖)𝑛 𝑖
n=1
𝑃1,000,000 (1+0.08)1 −1
Required: P=
1+0.08 1 (0.08)
P, present value
P = P12,500,000
 03.
inflation
 inflation
the increase in the prices for goods and services from one
year to another, thus decreasing the purchasing power of
money.

WHERE,
𝑃𝐶 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
𝐹𝐶 = 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑎𝑚𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
𝑓 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
 inflation

EXAMPLE
An item presently costs P1,000. If Inflation is at the rate of 8% per year. What will be the cost of
the item in two years?

Given: Solution:
PC = P1,000
𝑓 = 8% FC = PC 1 + 𝑓 𝑛
n = 2 years
= P1,000 1 + 0.08 2
Required:
FC, future cost of item 𝐅𝐂 = P1,166.40
 Inflationary Economy
it means that the buying power of money decrease as cost
increase.

WHERE,
𝑃 = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 worth 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦
𝐹 = 𝑓𝑢𝑡𝑢𝑟𝑒 worth 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦
𝑓 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
 Inflationary Economy

EXAMPLE
An economy is experiencing inflation at the annual rate of 8%. If this is continuous, what will
P1,000 be worth two years from now, in terms of today’s peso?

Given: Solution:
P = P1,000 𝑃
𝑓 = 8% F=
1+𝑓 𝑛
n = 2 years
𝑃1,000
=
Required: 1 +0.08 2
F, future worth of money
𝐅 = P857.34
 04.
discount
 discount
it is defined as interest deducted in advance. In negotiable paper,
it is the difference between the present worth of the paper and
its value sometime in the future.

Where,
d = amount of discount for the given period
i = rate of interest for the same period
F = future value
P = preset value (principal amount)
 rate of discount
it is defined as the discount of one unit of principal for one
unit of time.

Where,
d = rate of discount for the given period
 discount

EXAMPLE
Mr. de la Cruz borrowed money from a bank. He received from the bank P1,342 and promised to
repay P1,500 at the end of 9 months. Determine the corresponding discount rate.

Given: Solution:
F = P1,500 Discount Amount = future worth – present worth
P = P1,342 = 𝑃1,500 − 𝑃1,342
Discount Amount = 𝑃158
Required: discount amount
d, discount rate d=
future worth
P158
d=
P1,500
d = 0.1053
d = 10.53%
THANKS

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“The study of economy usually shows us that
the best time for purchase was last year.”

— Woody Allen