I.

UNIT TITLE/CHAPTER TITLE: Money-Time Relationships and Equivalence

II. LESSON TITLE

2. The Concept of Equivalence

3. Cash Flows
3.1 Notation and Cash-Flow Diagrams and Tables
3.2 Relating Present and Future Equivalent Values of Single Cash Flows
3.3 Interest Formulas Relating a Uniform Series (Annuity) to Its Present and Future Equivalent
Value
3.4 Annuities
3.4.1 Ordinary Annuity
3.4.2 Deferred Annuity
3.4.3 Annuity Due
3.5 Perpetuity
3.6 Capitalized Cost
3.7 Amortization

III. LESSON OVERVIEW

This lesson provides the students an overview of the relationship between Money and Time, how our
money makes money over a specified period of time. This will help the students understand what a
capital is, and how this capital grows in the form of interest. This module discusses the different forms
of interest, and how to calculate interest. Moreover, this will help students calculate easily using cash
flow diagrams, this will help students understand more the concept of equivalence.

IV. DESIRED LEARNING OUTCOMES

1. Provide an understanding of the return to capital in the form of interest or profit.
2. Illustrate how basic equivalence calculation are made.
3. Respect the cost of capital n engineering economy studies.
4. Calculate interest.
5. Determine interest rate that vary with time.

V. LESSON CONTENT
2. The Concept of Equivalence (Sullivan, Wicks, & Koelling, 2015)
Alternatives should be compared when they produce similar results, serve the same purpose, or
accomplish the same function. This is not always possible in some types of economy studies (as
we shall see later), but now our attention is directed at answering the question: How can
alternatives for providing the same service or accomplishing the same function be compared when
interest is involved over extended periods of time? Thus, we should consider the comparison of
alternative options, or proposals, by reducing them to an equivalent basis that is dependent on (1)
the interest rate, (2) the amounts of money involved, and (3) the timing of the monetary receipts or
expenses.
To better understand the mechanics of interest and to explain the concept of equivalence,
suppose you have a $17,000 balance on your credit card. “This has got to stop!” you say to
yourself. So you decide to repay the $17,000 debt in four months. An unpaid credit card balance at
the beginning of a month will be charged interest at the rate of 1% by your credit card company.
For this situation, we have selected three plans to repay the $17,000 principal plus interest owed.
These three plans are illustrated in Table 4-1, and we will demonstrate that they are equivalent
(i.e., the same) when the interest rate is 1% per month on the unpaid balance of principal.

Page 1 of 33
 Plan 1 indicates that none of the principal is repaid until the end of the fourth month. The
monthly payment of interest is $170, and all of the principal is also repaid at the end of month four.
Because interest does not accumulate in Plan 1, compounding of interest is not present in this
situation. In Table 4-1, there are 68,000 dollar-months of borrowing ($17,000×4 months) and $680
total interest. Therefore, the monthly interest rate is ($680 ÷ 68,000 dollar-months) × 100% = 1%.

Plan 2 stipulates that we repay $4,357.10 per month. Later we will show how this number is
determined (Section 4.9). For our purposes here, you should observe that interest is being
compounded and that the $17,000 principal is completely repaid over the four months. From Table
4-1, you can see that the monthly interest rate is ($427.10 ÷ 42,709.5 dollar-months of borrowing)
×100% = 1%. There are fewer dollar-months of borrowing in Plan 2 (as compared with Plan 1)
because principal is being repaid every month and the total amount of interest paid ($427.10) is
less.

Finally, Plan 3 shows that no interest and no principal are repaid in the first three
months. Then at the end of month four, a single lump-sum amount of $17,690.27 is repaid. This
includes the original principal and the accumulated (compounded) interest of $690.27. The
dollar-months of borrowing are very large for Plan 3 (69,026.8) because none of the principal
and accumulated interest is repaid until the end of the fourth month. Again, the ratio of total
interest paid to dollar-months is 0.01.
This brings us back to the concept of economic equivalence. If the interest rate remains
at 1% per month, you should be indifferent as to which plan you use to repay the $17,000 to
your credit card company. This assumes that you are charged 1% of the outstanding principal
balance (which includes any unpaid interest) each month for the next four months. If interest
Page 2 of 33
 rates in the economy go up and increase your credit card rate to say, 11 4% per month, the
plans are no longer equivalent. What varies among the three plans is the rate at which principal
is repaid and how interest is repaid?
3. Cash flows
Cash flow is the net amount of cash and cash-equivalents being transferred into and out
of a business. At The most fundamental level, a company’s level, company’s ability to create
value for shareholders is determined by its ability to generate positive cash flows, or more
specifically, maximize long-term free cash flow. (Tuovila, 2020)
KEY TAKEAWAYS: (Tuovila, 2020)
 Positive cash flow indicates that a company is adding to its cash reserves, allowing it to
reinvest in the company, pay out money to shareholders, or settle future debt payments.
 Cash flow comes in three forms: operating, investing, and financing.
 Operating cash flow includes all cash generated by a company's main business activities.
 Investing cash flow includes all purchases of capital assets and investments in other
business ventures.
 Financing cash flow includes all proceeds gained from issuing debt and equity as well as
payments made by the company.
 Free cash flow, a measure commonly used by analysts to assess a company's profitability,
represents the cash a company generates after accounting for cash outflows to support
operations and maintain its capital assets.
3.1. Notation and Cash-Flow Diagrams and Tables (Sullivan, Wicks, & Koelling, 2015)
The following notation is utilized in formulas for compound interest calculations:
i = effective interest rate per interest period;
N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or more cash flows at a
reference point in time called the present;
F = future sum of money; the equivalent value of one or more cash flows at a reference
point in time called the future;
A = end-of-period cash flows (or equivalent end-of-period values) in a uniform series
continuing for a specified number of periods, starting at the end of the first period and
continuing through the last period.

The use of cash-flow (time) diagrams or tables is strongly recommended for situations in
which the analyst needs to clarify or visualize what is involved when flows of money occur at
various times. In addition, viewpoint (remember Principle 3?) is an essential feature of cash-flow
diagrams.

The difference between total cash inflows (receipts) and cash outflows (expenditures) for
a specified period of time (e.g., one year) is the net cash flow for the period. As discussed in
Chapters 2 and 3, cash flows are important in engineering economy because they form the
basis for evaluating alternatives. Indeed, the usefulness of a cash-flow diagram for economic
analysis problems is analogous to that of the free-body diagram for mechanics’ problems.

Figure 4-2 shows a cash-flow diagram for Plan 3 of Table 4-1, and Figure 4-3 depicts the
net cash flows of Plan 2. These two figures also illustrate the definition of the preceding symbols
and their placement on a cash-flow diagram. Notice that all cash flows have been placed at the
end of the month to correspond with the convention used in Table 4-1. In addition, a viewpoint
has been specified.

The cash-flow diagram employs several conventions:

1. The horizontal line is a time scale, with progression of time moving from left to right. The
period (e.g., year, quarter, month) labels can be applied to intervals of time rather than to
points on the time scale. Note, for example, that the end of Period 2 is coincident with the
Page 3 of 33
 beginning of Period 3. When the end-of-period cash-flow convention is used, period numbers
are placed at the end of each time interval, as illustrated in Figures 4-2 and 4-3.

2. The arrows signify cash flows and are placed at the end of the period. If a distinction needs to
be made, downward arrows represent expenses (negative cash flows or cash outflows) and
upward arrows represent receipts (positive cash flows or cash inflows).

3. The cash-flow diagram is dependent on the point of view. For example, the situations shown
in Figures 4-2 and 4-3 were based on cash flow as seen by the lender (the credit card
company). If the directions of all arrows had been reversed, the problem would have been
diagrammed from the borrower’s viewpoint.

EXAMPLE: (Sullivan, Wicks, & Koelling, 2015)

1. Before evaluating the economic merits of a proposed investment, the XYZ
Corporation insists that its engineers develop a cash-flow diagram of the proposal. An
investment of $10,000 can be made that will produce uniform annual revenue of $5,310
for five years and then have a market (recovery) value of $2,000 at the end of year
(EOY) five. Annual expenses will be $3,000 at the end of each year for operating and
maintaining the project. Draw a cash-flow diagram for the five-year life of the project.
Use the corporation’s viewpoint.
Solution:
As shown in the figure below, the initial investment of $10,000 and annual expenses of
$3,000 are cash outflows, while annual revenues and the market value are cash inflows.

Page 4 of 33
 Notice that the beginning of a given year is the end of the preceding year. For example,
the beginning of year two is the end of year one.

3.2. Relating Present and Future Equivalent Values of Single Cash Flows (Sullivan, Wicks, &
Koelling, 2015)

Finding F when Given P:

If an amount of P dollars is invested at a point in time and i% is the interest (profit or
growth) rate per period, the amount will grow to a future amount of P + Pi = P(1+i) by
the end of one period; by the end of two periods, the amount will grow to P(1 + i)(1 + i)
= P(1 + i)2; by the end of three periods, the amount will grow to P(1 + i)2(1 + i) = P(1 +
i)3; and by the end of N periods the amount will grow to F = P(1 + i)N.

EXAMPLE: (Sullivan, Wicks, & Koelling, 2015)

Suppose that you borrow $8,000 now, promising to repay the loan principal plus
accumulated interest in four years at i = 10% per year. How much would you repay
at the end of four years?
Solution:

Finding F when Given P:

From Equation (4-2), F = P(1 + i)N. Solving this for P gives the relationship

EXAMPLE: (Sullivan, Wicks, & Koelling, 2015)

An investor (owner) has an option to purchase a tract of land that will be
worth $10,000 in six years. If the value of the land increases at 8% each year,
how much should the investor be willing to pay now for this property?

Solution:
P= $10,000(1+0.08)-6
P= $6,302

Page 5 of 33
 General Cash-Flow Diagram Relating Present Equivalent and Future
Equivalent of Single-Payments

3.3. Interest Formulas Relating a Uniform Series (Annuity) to Its Present and Future
Equivalent Value (DeGarmo, Sullivan, & Bontadelli, 1993)
The figure below shows a general cash flow diagram involving a series of uniform
receipts, each amount A, occurring at the end of each period for N periods with interest at i%
per period. Such a uniform series is often called an annuity. It should be noted that the
formulas and tables to be presented are derived such that A occurs at the end of each
period, and thus:
1. P (present worth, PW) occurs one interest period before the first A (uniform payment).
2. F (future worth, FW) occurs at the same time as the last A, and N periods after P.
3.A (annual worth, AW) occurs at the end of periods 1 through N, inclusive.

General Cash-Flow Diagram Relating Uniform Series (Ordinary Annuity)

to its PW and FW

E
XAMPLES: (Discrete Cash Flow Examples Illustrating Equivalence)

Page 6 of 33
 3.4. Annuities
An annuity is a series of equal payments occurring at equal periods of time. When an
annuity has a fixed time span, it is known as annuity certain. (Tiong, Rojas, & Capote,
2004)
Symbols and their meaning:

P= value or sum of money at present

F= value or sum of money at some

A= a series of periodic, equal amounts of money

n= number of interest periods

i= interest rate per interest period

The following are annuity certain:

3.4.1. Ordinary Annuity
Ordinary Annuity is a type of annuity where the payments are made at the end of
each period beginning from the first period. (Tiong, Rojas, & Capote, 2004)

Annuity is based on the principles of compound interest. Hence computation of

the sum of annuity may be done using the formulas for geometric progression.

Solving for common ratio:

a2
r=
a1
A (1+i)
r=
A
r= 1+i

Solving for the sum:

n
a (r −1)
S= 1
r −1
A [(1+i)n−1 ]
S=
1+ i−1

Page 7 of 33
 A [(1+i)n−1 ]
S=
i

Finding F when A is given: (DeGarmo, Sullivan, & Bontadelli, 1993)

If a cash flow in the amount of A dollars occurs at the end of each period for N
periods and i% is the interest (profit or growth) rate per period, the future worth,
F, at the end of the Nth period is obtained by summing the worths of each of the
cash flows. Thus,

F= A(F/P, i%, N-1) + A(F/P, i%, N-2) + A(F/P, i%, N-3) + …+ A(F/P, i%, 1)
+ A(F/P, i%, 0)

F= A[(1+i)N-1 + (1+i)N-2 + (1+i)N-3 + … + (1+i)1 + (1+i)0]

The bracketed terms comprise a geometric sequence having a common ratio of

(1+i)-1. Recall that the sum of the first N terms SN of a geometric sequence is

a1−ba N
SN= (b≠ 1)
1−b

where a1 is the first term in the sequence, aN is the last term and b is the common
ratio. If we let b = (1+i)-1, a1 = (1 + i)N-1 , and aN= (1+i)0, then

F= A

[ ]
1
(1+i) N−1−
(1+i)
1
1−
which reduces to (1+i)
F= A

[ ]
N
(1+i) −1 (3-6)
i

The quantity {[(1+i)N-1-1]/i} 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 3-6 can be expressed as:

F= A(F/A, i%, N)

Page 8 of 33
 Cash flow diagram to find F given A

Finding A when F is given (Sta. Maria, 1993)

Taking the equation, A= F

[ i
N
(1+i) −1 ]
The quantity in brackets is called “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)

EXAMPLE:
1. A woman wishes to have $100,000 in her retirement savings plan after
working for 25 years. She will accomplish this by depositing A dollars each
year savings account that earns 6% per year. How much must she save each
year? (DeGarmo, Sullivan, & Bontadelli, 1993)
Solution:
The annual deposit required to accumulate $100,000 at 6% annual interest is:

[ ]
25
(1+6 %) −1
$100,000= A
6%
A= $1,822.67
2. If eight annual deposits of $187.45 each are placed in an account, how much
money has accumulated immediately after the last deposit, using an interest
rate of i= 10% compounded annually? (DeGarmo, Sullivan, & Bontadelli,
1993)
Solution:
What amount at the end of the eighth year is equivalent to eight end-of-year
payments of $187.45 each?

Page 9 of 33
 [ ]
N
(1+i) −1
F= A
i

[ ]
8
(1+10 %) −1
F= $187.45
10 %
F= $2,143.66

3. What uniform annual amount should be deposited each year in order to

accumulate $2,143.60 at the time of the eighth annual deposit, using an
interest rate of i= 10% compounded annually? (DeGarmo, Sullivan, &
Bontadelli, 1993)

Solution:
What uniform payment at the end of successive years is equivalent to $2,143.60
at the end of the eighth year?

A= F
[ i
N
(1+i) −1 ]
A= $2,143.60
[ 10 %
8
(1+10 %) −1 ]
A= $187.44

Finding P When Given A (DeGarmo, Sullivan, & Bontadelli, 1993)

[ ]
N
N (1+i) −1
From equation, F= P(1+i) . Substituting for F in equation F= A , one
i
determines that

[ ]
N
(1+i) −1
P(1+i)N= A
i
Dividing both sides by (1+i)N,

[ ]
N
(1+i) −1
A
P= i
N
( 1+ i )
(3-8)

[ ]
−N
1−( 1+i )
P= A
i
Thus, Equation 3-8 is the relation for finding the equivalent present worth (as of the
beginning of the first period) of a uniform series of end-of-period cash flows of amount A
for N periods. The quantity in brackets is called the uniform series present worth factor.
We shall use the functional symbol (P/A, i%, N) for this factor. Hence
P= A(P/A, i%,N) (3-9)

Page 10 of 33
 Cash flow diagram to find P Given A

Finding A When P is Given (DeGarmo, Sullivan, & Bontadelli, 1993)

[ ]
N
(1+i) −1
A
Taking Equation, P = i and solving for A, one finds that
N
( 1+ i )

A= P
[
i(1+ i) N
(1+i) N −1 ]
[ ]
N
i(1+ i)
where can be simplified as
(1+i) N −1

[ ]
N N −N
i(1+ i) i(1+i) (1+i)
= ·
(1+i) N −1 (1+i)N −1 (1+i)−N
i
= −N
1−(1+i)
Therefore,

A= P
[ i
1−(1+i)
−N
]
Thus, the equation is the relation for finding the amount, A, of a uniform series of cash
flows occurring at the end of each of N interest periods that would be equivalent to, or
could be traded for, the present worth, P, occurring at the beginning of the first period.
The quantity in brackets is called capital recovery factor. The capital recovery factor is
more conveniently expressed as i/[1-(1+i)-N] for computation with a hand-held calculator.
We shall use the functional symbol (A/P, i%, N) for this factor. Hence

A= P(A/P, i%, N)

Relationship between A/P, i%, N and A/F, i%, N

(subtract A/P, i%, N and A/F, i%, N)
N N
i(1+i) −i i(1+ i) −i
N =
(1+i)N −1 ( 1+ i ) −1 (1+i) N −1
i(1+i)
N
−i i [ (1+ i)N −1 ]
N =
(1+i)N −1 ( 1+ i ) −1 (1+i)N −1
N
i(1+i) −i
N =i
(1+i) −1 ( 1+ i ) −1
N

N
i(1+i) i
= N
+i
(1+i) −1 ( 1+ i ) −1
N

Page 11 of 33
 i i
−N =
+i
1−(1+i) ( 1+ i )N −1
Therefore,
capital recovery factor= sinking fund factor + i

Example:
1. If a certain machine undergoes a major overhaul, its output can be increased
by 20%- which translates into cash flow of $20,000 at the end of each year for
5 years. If i = 15% per year, how much can we afford to invest to overhaul this
machine? (DeGarmo, Sullivan, & Bontadelli, 1993)

Solution:
The increase in cash flow is $20,000 per year, and it continues for 5 years at
15% annual interest. The upper limit on what we can afford to spend is
P= $20,000(P/A, 15%, 5)

[ ]
5
(1+ 0.15) −1
$ 20,000
P= 0.15
5
( 1+0.15 )
P= $67,043.102

2. How much should be deposited in a fund now to provide for end-of-year

withdrawals of $187.45 each, use 10% interest rate compounded annually?
(DeGarmo, Sullivan, & Bontadelli, 1993)
Solution:
What is the equivalent present worth of eight end-of-year payments $187.45
each?
P= $187.45(P/A, 10%, 8)

[ ]
8
( 1+ 0.10) −1
$ 187.45
P= 0.10
8
( 1+0.10 )
P= $1,000

3. What are the present worth and the accumulated amount of a 10- year annuity
paying ₱10,000 at the end of each year, with interest at 15% compounded
annually? (Sta. Maria, 1993)

Solution:
A= ₱10,000 n=10 i=15%

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

[ ]
−10
1−(1.15)
= P10,000
0.15
= P50,188

Page 12 of 33
 F= A(F/A, i%, n)= P10,000 (F/A, 15%, 10)

[ ]
10
(1.15) −1
= P10,000
0.15
= P203,037

4. What is the present worth of ₱500 deposited every three months for 6 years if
the interest rate of 12% compounded semiannually? (Sta. Maria, 1993)
Solution:

( )
2
0.12
(1+i)4 -1 = 1+ −1
2
√
4
1 + i = ( 1.06 )2
i = 0.0296 or 2.96% per quarter

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

[ ]
−24
1−(1+0.0296)
= ₱500
0.0296
= ₱500(17.0087)
= ₱8,504.37
5. Using an interest rate of 10% compounded annually, what is the size of eight
equal annual payments to repay a loan of $1,000? The first payment is due 1
year after receiving the loan. (DeGarmo, Sullivan, & Bontadelli, 1993)
Solution:
What uniform payment at the end of 8 successive years is equivalent to $1,000
at the beginning of the first year?

A= P(A/P, 10%, 8)

A= $1,000
[ 0.10
1−(1+0.10)
−8
]
A=$187.44

6. A businessman needs ₱50,000 for his operations. One financial institution is

willing to lend him the money for one year at 12.5% interest per annum
(discounted). Another lender is charging 14%, with the principal and interest
payable at the end of year. A third financier is willing to lend him ₱50,000
payable in 12 equal monthly installments of ₱4,600. Which offer is best for
him? (Sta. Maria, 1993)

Solution:

Page 13 of 33
 Compare the effective rate of each offer and select the one with the
lowest effective rate.

First Offer:
Rate of discount, d= 12.5%
d 0.125
Rate of interest, i= = = 14.29% per year
1−d 1−0.125

Effective rate= 14.29%

Another solution:
Amount received= P50,000(0.875) = P43,750

P 50,000−P 43,750
Rate of interest= = 14.29%
P 43,750
Effective rate= 14.29%

Second offer:

Effective rate= 14%

Third offer:

P P 50,000
P/A, i%, 12 = =
A P 4,600

[ ]
−12
1−( 1+ i )
= 10.8696
i
Solving simultaneously,
i = 0.01556= 1.556%
Page 14 of 33
 Effective rate= (1+0.01556)12-1= 20.36%
Therefore, The second offer is the best.
7. An electrical engineer wishes to set up a special fund by making uniform
semiannual end-of-period deposits for 20 years. The fund is to provide
P100,000 at the end of each of the last five years of the 20-year period. If
interest is compounded semiannually, what is the required semiannual deposit
to be made?

Solution:

8%
For the deposits, i= = 4%
2
For the withdrawals, i= (1+0.04)2 – 1= 0.0816 or 8.16%
Using 20 years from today as the focal date, the equation

A(F/A, 4%, 40)= P100,000 (F/A, 8.16%,5)

[ ]
(1+0.04)2 (20)−1
[ ]
5
(1+0.0816) −1
A = P100,000
0.04 0.0816
A(95.0255)= P100,000 (5.8853)
A=P6,193.39
3.4.2. Deferred Annuity (Sta. Maria, 1993)
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

Page 15 of 33
 Cash flow diagram to find A Given P
P= A (P/A, i%, n) (P/F, i%, m)

[ ]
−n
1−( 1+ i )
P= A (1+i)-m
i
Note: review formulas in compound interest (P/F,i%,n)

Example:
1. On the day his 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 18 th birthday.
Interest at the rate of 12% per annum was to be paid on all amounts on
deposit. There was also a provision that the grandson could elect to withdraw
no annual payments and receive a single lump sum amount on his 25 th
birthday. The grandson chose this option. (Sta. Maria, 1993)
(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

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)

Page 16 of 33
 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/A, 12%, 5) (F/P, 12%, 3)

[ ]
5
(1+0.12) −1
X= P10,000 (1+0.12)3
0.12
X= P89,252.93

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

(b)

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)

[ ]
−5
1−( 1+ 0.12 )
= P10,000 (1+0.12)-17
0.12
= P10,000 (3.6047)(0.14565)
= P5,250.25

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

Another solution:

This was what actually happened, P was deposited today and X was withdrawn
25 years

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

P= X (P/F, 12%, 25)
Page 17 of 33
 = P89,250 (0.058821)
= P5,250

Note: review formulas in compound interest (P/F,i%,n)

2. If P10,000 is deposited each year for 9 years, how much annuity can a person
get annually from the bank every year for 8 years starting 1 year after the 9 th is
made Cost of money is 14%. (Sta. Maria, 1993)
Solution:

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

A (P/A, 14%, 8) (P/F, 14%, 9) = P10,000 (P/A, 14%, 9)

[ ] [ ]
−8 −9
1−( 1+ 0.14 ) 1−( 1+ 0.14 )
A (1+0.14)-9 = P10,000
0.14 0.14
A(4.63886)(0.30751) = P10,000 (4.94637)
A = P34,675

Another solution:

Using 9 years from today as the focal date, the equation of value is
A(P/A, 14%, 8) = P10,000 (F/A, 14%, 9)

[ ] [ ]
−8 9
1−( 1+ 0.14 ) (1+0.14) −1
A = P10,000
0.14 0.14
A(4.63886) = P10,000 (16.08535)
A = P34,675

Page 18 of 33
 Another solution:

Using 17 years from today as the focal date, the equation of value is

A(F/A, 14%, 8) = P10,000 (F/A, 14%, 9)(F/P, 14%,8)

[ ] [ ]
8 9
(1+0.14) −1 (1+0.14) −1
A = P10,000 (1+0.14)8
0.14 0.14
` A(13.23276) = P10,000 (16.8535)(2.85259)
A = P34, 675
Note: review formulas in compound interest (F/P,i%,n)

3. A debt of P40,000, whose interest rate is 15% compounded semiannually, is

to be discharged by a series of 10 semiannual payments, the first payment to
be made 6 months after consummation of the loan. The first 6 payments will
be P6,000 each, while the remaining 4 payments will be equal and of such
amount that the final payment will be liquidate the debt. What is the amount of
the last 4 payments? (Sta. Maria, 1993)

Solution:

PA

PB
P1

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

P40,000 = P6,000 (P/A, 7.5%, 6) + A(P/A,7.5%,4)(P/F, 7.5%, 6)
P40,000 = P6,000 (4.6938) + A(3.3493)(0.6480)
A= P5,454

Another Solution:
P= PA + PB
P= P40,000

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 Find PA, using the given annuity:

[ ]
−6
1−( 1+ 0.075 )
PA= P6,000 = P28,163.08
0.075
Find the equation for P1, using the annuity A:

[ ]
−n
1−( 1+ i )
P1= A
i

[ ]
−4
1−( 1+ 0.075 )
P1= A
0.075
Using compound interest, find the equation for PB, use P1 as your future value.
PB= P1 (1+0.075)-6

[ ]
−4
1−( 1+ 0.075 )
PB= A (1+0.075)-6
0.075
Finding A,
P= PA+PB

[ ]
−4
1−( 1+ 0.075 )
P40,000= P28,163.08 + A (1+0.075)-6
0.075
A= P5,454.2
3.4.3. Annuity Due (Sta. Maria, 1993)
An annuity due is one where the payments are made at the beginning of each
period.

Finding P when A is Given

Cash flow diagram given A to find P

P= A + A(P/A, i%, n-1) (2-28)

P= A(1 + P/A, i%, n-1) (2-29)
−(n−1)
1−( 1+i )
P= A(1 + )
i

Finding F when A is Given

Page 20 of 33
 Cash flow diagram given A to find F

F= A(F/A, i%, n+1)-A (2-30)

F= A[(F/A, i%, n+1)-1] (2-31)

[ ]
n +1
(1+i) −1
F= A −1
i

Example:
1. A man bought an equipment costing P60,000 payable in 12 quarterly
payments, each installment payable at the beginning of each period. The rate
of interest is 24% compounded quarterly. What is the amount of each
payment? (Sta. Maria, 1993)
Solution:
24 %
P= P60,000 n=12 i= = 6%
4

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

P60,000= A(1+ P/A, 6%, 11)

( )
−11
1−( 1+6 % )
P60,000= A 1+
6%
P60,000= A(7.8869)
A= P7,607.58

2. 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 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 three years, all payments will be made at the beginning of each year.
If money is compounded annually, which bid should the owner of the
property accept? (Sta. Maria, 1993)

Solution:
First bid:

Page 21 of 33
 Let P1= present worth of the first bid
P1= A(1 + P/A, 20%, 5-1)
= P400,000 (1+ P/A,20%,5-1)

[ ]
−(5−1)
1−( 1+ 0.2 )
= P400,000 1+
0.2
= P400,000 (1 + 2.5887)
= P1,435,493.83

Second bid:

Let P2= present worth of the second bid

P2= P240,000 + P360,000 (P/F,20%,1) + P540,000 (P/A,20%,3)(P/F,20%,1)
= P240,000 + P360,000 (0.8333) + P540,000 (2.1065)(0.8333)
= P1,487,875.08

The owner of the property should accept the second bid.

Note: review formulas in compound interest (P/F,i%,n)

3. Suppose you want to save money for your child’s college expenses. Suppose
you deposit $1,000 at the beginning of each year, for 18 years at an interest
rate of 5%. How much is available for your child when he/she starts school?

Solution:

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 F= A[(F/A, i%, n+1)-1]

[ ]
18+1
(1+0.05) −1
F= $1000 −1
0.05
F= $29,539.00

3.5. Perpetuity (Sta. Maria, 1993)

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

Cash flow diagram given to find P given A

[ ] [ ]
−n −∞
1−( 1+ i ) 1−( 1+ i )
P= A =A
i i
A
P= (2-32)
i
Example:
1. 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? (Sta. Maria, 1993)

PB

Page 23 of 33
 P1
PA
P2
PB

PC

Solution:
Using today as a focal date, the equation of value is

P= P30,000(P/A,15%,6) + P40,000(P/A,15%,6)(P/F,15%,6)
P 50,000
+ (P/F,15%,12)
0.15

[ ] [ ][
−6 −6
1−( 1+ 0.15 ) 1−( 1+ 0.15 )
=P30,000 + P40,000 ( 1+0.15 )−6 ]
0.15 0.15
P 50,000
+
0.15
[ ( 1+0.15 )−12 ]
P 50,000
=P30,000(3.7845) + P40,000(3.7845)(0.4323)+ (0.1869)
0.15
= P241, 282

Another Solution:
P= PA + PB + PC
Using perpetuity formula, find P1:
P 50,000
P1= = P333,333.33
0.15
Use compound interest formula to find PA, use P1 as Future value:
P 50,000
PA=
0.15
[ ( 1+0.15 )−12 ]= P62,302.38
Find P2, using the given annuity:

[ ]
−6
1−( 1+ 0.15 )
P2= P40,000 = P151,379.31
0.15
Using compound interest formula, find PB, use P2 as Future value:
PB= P151,379.31[ ( 1+0.15 )−6 ]= P65,445.45
Find PC, using the given annuity:

[ ]
−6
1−( 1+ 0.15 )
PC= P30,000 = P113,534.48
0.15
Therefore,
P= P62,302.38 + P65,445.45 + P113,534.48
P= P241,282.31

Note: review formulas in compound interest (P/F,i%,n)

Page 24 of 33
 2. Company ABC pays $3 dividends annually and estimates that they will pay the
dividends indefinitely. How much are investors willing to pay for the dividend
with a required rate of return of 5%?
A
P=
i
$3
P=
5%
P= $60

3.6. Capitalized Cost

One of the most important applications 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 and or
Maintenance

Example:
1. 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:

A P 150,000
P= = = P1,000,000
i 0.15
Capitalized cost= First cost + P
= P1,500,000 + P1,000,000
= P2,500,000

Case 2. Replacement only, no maintenance and or operation.

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 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 25 of 33
 Cash flow diagram given to find X given S
S= Xi
(F/A, i%, k)

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

A S
P= X=
i ( 1+ i )k −1

P is the amount invested now at i% per 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:
1. A new engine was installed by a textile plant at a cost of P300,000 and projected to
have a useful life of 15 years. At the end of its useful life of 15 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. (Sta. Maria, 1993)

Solution:

Page 26 of 33
 Cash flow diagram for the engine

S P 270 , 00
X= = = P24,604
( 1+ i ) −1 ( 1+ 0.18 )15−1
k

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

Example:
1. 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:
For Operation:

P1 P1

Q1

Q2

Page 27 of 33
 Let Q= the present worth of cost of perpetual operation
P 120,000
Q= P100,000(P/A, 12%,6) + ¿
0.12

[ ]
−6
1−( 1+ 0.12 ) P 120,000
= P100,000
0.12
+
0.12
[ ( 1+0.12 )−6 ]

P 120,000
= P100,000(4.1114) + (0.5066)
0.12
= P917,771.85

Another Solution:
Q= Q1 + Q2
Using perpetuity formula:
P 120,000
P1= =P1,000,000
0.12
Using compound interest formula, find Q1:
P 120,000
Q1= ( 1+ 0.12 )−6= P506,631.12
0.12
Find Q2 using the given annuity,

[ ]
−6
1−( 1+ 0.12 )
Q2= P100,000
0.12
Q2= P411,140.73
Therefore,
Q= P506,631.12 + P411,140.73
Q= P917,771.85

Replacement:

Let X= the present worth of cost of perpetual replacement

S P 500,000
X= = = P655,873.88
( 1+ i ) −1 ( 1+ 0.12 )5−1
k

Capitalized cost= First cost + Q + X

= P5,000,000 + P917,740 + P655,873.88
= P6,573,613.88

3.7. Amortization

Amortization is any method of repaying a debt, the principal and interest

included, usually by a series of equal payments at equal interval of time. (Sta. Maria,
1993)

Example:

1. A debt of P5,000 with interest at 12% compounded semiannually is to be

amortized by equal semiannual payments over the next 3 years, the first due in

Page 28 of 33
 6 months. Find the semiannual payment and construct an amortization
schedule. (Sta. Maria, 1993)

Solution:

P 5,000
P
A= = 1− ( 1+ 0.06 )−6
P / A ,6 % , 6
0.06
A= P1,016.82

Interest due at end of period(I)= Pin

= (P5,000)(0.12) ( 126 )
= P300

Principal repaid at end of period= Payment – Interest due at end of period

= P1,016.82 – P300
= P716.82

Outstanding principal at the beginning of period (at period n)

= Outstanding principal at the beginning of period (at period n-1)
– Principal repaid at end of period (at period n-1)
where: n= 2,3,4,5,6…

2. 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. (Sta. Maria, 1993)
Solution:

Page 29 of 33
 20 %
since it is compounded semiannually; i= = 10%
2

Using compound interest find the future value, P2:

P2= P10,000(F/P,10%,5)
= P10,000 (1+0.10)5
= P16,105.1
Using P2, find A:
A= P2(A/P, 10%,5)

A= P16,105.1
[ 0.10
1−(1+0.10)
−5
]
A= P4,248.50

VI. LEARNING ACTIVITIES

Note: Problems 11-15 will serve as PRACTICE PROBLEMS, those are not included as your recorded
Learning Activities.

1. Engineer Reyes plans to set aside $60 at the end of each month for his brother’s tertiary education.
If his brother were to be born today, assuming an interest rate of 6% compounded monthly, how
much will be available for its tertiary education we he turns 20 years old?

2. At the beginning of each month, $200 is deposited into a retirement fund. The fund earns 6%
annual interest, compounded annually, and paid into the account at the end of the month. How
much is in the account if deposits are made for 10 years? (Draw the cash flow diagram.)

3. Determine the capitalized cost of a structure that requires an initial investment of P2,000,000 and
an annual maintenance of P250,000. Interest is 15%.

4. What amount of money invested today at 20% interest can provide the following scholarships:
P40,000 at the end of each year for 7 years; P50,000 for the next 7 years and P60,000 thereafter?
(Draw the cash flow diagram)

Page 30 of 33
 5. A friend of yours asks a favor to you to help him determine the appropriate price to pay an annuity
offering a retirement income of P50,000 a month for 10 years. Use an interest rate of 6%
compounded monthly.

6. Using an interest rate of 12% compounded annually, what is the size of eight equal annual
payments to repay a loan of $2,000? The first payment is due 1 year after receiving the loan. (Draw
the cash flow diagram.

7. Mr. Lopez borrows $10,000 at 10% compounded annually, agreeing to repay the loan in fifteen
equal annual payments. How much of the original principal is still unpaid after he has made the 9 th
payment?

8. An asphalt road requires no upkeep until the end of 2 years when P60,000 will be needed for
repairs. After this P90,000 will be needed for repairs at the end of each year for the next five years
then P120,000 at the end of each year for the next 5 years. If money is worth 14% compounded
annually, what was the equivalent uniform annual cost for the 12-year period?

9. A businessman begins making quarterly payments of $1,000 (for his son’s future) into an account
paying 7% compounded quarterly. Payments begin on the 10 th birthday. How much will be available
on his son’s 15th birthday? and on his 21st birthday?

10. An Engineer wants to deposit P15,000 into a fund at the beginning of each month. How much
amount will be there in the fund at the end of 6 years, if he/she can earn 10% compounded
monthly?
11. A debt of P7,000 with interest at 10% compounded semiannually is to be amortized by equal
semiannual payments over the next 4 years, the first due in 6 months. Find the semiannual
payment and construct an amortization schedule.

12. If a certain money is worth 12% compounded annually, determine the present worth and the
accumulated amount of an annuity consisting of 5 payments of P110,000 each.

13. What is the future worth of of P500 at the end of every month for 4 years of the interest is 10%
compounded quarterly? (Draw the cash flow diagram)

14. A bank loans a family $90,000 at 4.5% annual interest rate to purchase a house. The family agrees
to pay the loan off by making monthly payments over a 15-year period. How much should the
monthly payment be in order to pay off the debt in 15 years.

15. A certain property is being sold and the owner received two bids. The first bidder offered to pay
P500,000 each year for 7 years each payment is to be made at the beginning of each year. The
second bidder offered to pay P500,000 first year. P120,000 the second year and P100,000 each
year for the next four years, all payments will be made at the beginning of each year.
If money is compounded annually, which bid should the owner of the property accept?

VII. ASSIGNMENT

1. Explain Uniform Arithmetic Gradient and site at least two examples, use cash flow diagrams if
necessary.

2. Explain in 3-5 sentences the differences between annuity and amortization.

3. The will of a wealthy businessman left P6,000,000 to establish a perpetual charitable foundation.
The foundation trustees decided to spend P1,200,000 to provide facilities immediately and to
provide P200,000 of capital replacement at the end of each 5-year period. If the invested funds
earned 12% per annum, what would be the year end amount available in perpetuity from the
endowment for charitable purposes.

4. Give a brief explanation on depreciation.

5. Site two examples of problem solving involving depreciation.

VIII. REFERENCES

Page 31 of 33
Sta. Maria, H. B. (1993). Engineering Economy Third Edition. Manila: National Bookstore.
Sullivan, W. G., Wicks, E. M., & Koelling, C. P. (2015). Engineering Economy Sixteenth Edition. United States of
America: Pearson Higher Education, Inc.
Tiong, J. R., Rojas, R. J., & Capote, R. S. (2004). 2001 Solved Problems in Engineering Sciences and Allied Subjects .
Cebu: Benchmark Publishing.

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