ENGINEERING

ECONOMY
INTEREST AND MONEY-
TIME RELATIONSHIPS
PERPETUITIES & CAPITALIZED
COST

Engr. Armando C. Emata

December 3, 2013
TOPIC OBJECTIVES:
 Board work on Nov 28 and Dec 3
assignments
 Familiarize with another form of annuity –
the Perpetuity
 Solve sample problem on Perpetuity
 Be introduced to a key learning in
succeeding Economy studies where
perpetuity is applied – the Capitalized Cost
 Learn the tree types of Capitalized Cost
 Solve sample problems on capitalized Cost
 Assignment for next meeting
PERPETUITY
 Another type of annuity of interest to the engineer, known as a
perpetuity, is a uniform series in which the payments continue
indefinitely. If there exists a present or principal amount P pesos and
this earns interest at the rate of i% per period, then the end of period
perpetual payment, A pesos, (like interest earned) which can be made
from this principal is

A=Pxi

One can then convert this equation to show that the present worth of
a perpetuity of payments of A can be found as

P =A / i

The P in this equation is often spoken of as the capitalized value or

capitalized cost of A.
PERPETUITY
 A perpetuity is an annuity in which the payments continue indefinitely.

0 n -> inf.
1 2 3

A A A

Cash flow diagram to find P given A

-n
P
1 – (1+i)
= A ---------------
1 – (1+i) - inf.
= A ------------------
i i

A
P = ---- (2-32)
i
PERPETUITY
 PROBLEM:
What amount of money invested today at 15% interest can provide
the following scholarships: PHP30,000 at the end of each year for 6
years, PHP40,000 for the next 6 years and PHP50,000 thereafter?
Solution:
P50,000 P50,000
------------------ (P/F, 15%, 12) ------------------
0.15 0.15

P30,000(P/A, 15%, 6)(P/F, 15%, 6)

P40,000(P/A, 15%, 6)

P50k P50k
P30,000(P/A, 15%, 6)
P40k P40k P40k
P30k P30k P30k

0 1 2 6 7 8 12 13 14

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

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

P50,000
+ ------------ (P/F, 15%, 12)
0.15

= P30,000(3.7845) + P40,000(3.7845)(0.4323)

P50,000
+ ----------- (0.1869)
0.15

P = PHP241,277
CAPITALIZED COST
 In providing for the perpetual care for some structure or the
maintenance of endowed foundations we often encounter a special
type of perpetuity. A certain amount S may be needed every k
periods to provide for replacement or maintenance. The owner or
founder wishes to provide a fund of sufficient size so that the
earnings from it will provide for this periodic demand.
To be available perpetually, S must be accumulated in k periods
from the interest I that is earned by some amount of principal X,
invested at rate i. Thus periodic deposit toward this accumulation
will be Xi. And X can be computed through the relationship

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

and
S 1 S
X = ----- x --------------- = ------ x (A/F, i%, k)
i (F/A, i%, k) i
CAPITALIZED COST
 Another rationale for computing X in this circumstance is to
reason as follows:

What principal amount X, when compounded at i% per period for

k periods, will at the end of the kth period equal the S needed plus
X to be available for accumulating interest to provide the next S
payments? Algebraically, this can be stated as

X(F/P, i%, k) = S + X

Thus,
S
X = ---------------------------
[(F/P, i%, k) – 1]
CAPITALIZED COST
If the first cost of the project is added to X, the sum is known as
the capitalized cost. Thus, the capitalized cost of an article is the
amount of sufficient size to purchase the article and also to provide
for its perpetual maintenance.

Specifically, it 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.

Examples:
 Permanent structures like parks, monuments an other landmarks (Luneta in
Manila, Central Park in NY, Statue of Liberty in NY, Burnham Park in Baguio)
 Buildings (Manila City Hall, Central Bank in Manila, Araneta Coliseum in Q.C.)
 Factories and similar facilities (Philippine Match Co, in Manila, Kimberly Clark in
Laguna) – most of these large facilities have already shutdown and left however.
CAPITALIZED COST
 CASE 1. No replacement, only maintenance and/or operation
every period.
Capitalized cost = First cost + Present worth of perpetual
operation and or maintenance
 CASE 1 SAMPLE PROBLEM:
Determine the capitalized cost of a structure that requires an initial
investment of PHP1,500,000 and an annual maintenance of
PHP150,000. Interest is 15%

P150,000 P150,000

0 1 2

P
CAPITALIZED COST
 CASE 1 SAMPLE PROBLEM cont’d:

A P150,000
P = ---- = --------------- = PHP1,000,000
i 0.15

Capitalized cost = First cost + P

= P1,500,000 + P1,000,000
= PHP2,500,000
CAPITALIZED COST
 CASE 2. Replacement only, no maintenance and/or operation.
Capitalized cost = First cost + Present worth of perpetual
replacements
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 period
Xi = interest on X every period, the periodic deposit towards
the accumulation of S S

0 1 2 3 k–1 k

Xi Xi Xi Xi Xi
Cash flow diagram to find X given S
CAPITALIZED COST
 CASE 2 cont’d...

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

S 1 S i
X = ---- --------------- = ---- ------------------
i F/A, i%, k i k
(1+i) – 1

S
X = ---------------- (2-33)
(1+i) k – 1
CAPITALIZED COST
 CASE 2 cont’d...
Difference between P and X in a perpetuity
A A A S S S

0 1 2 3 0 k 2k 3k

A S
P P = ---- X X = ----------------
k
i (1+i) – 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 period is
S. If k=1, then, X=P.
CAPITALIZED COST
 CASE 2 cont’d...
 CASE 2 SAMPLE PROBLEM:
A new engine was installed by a textile plant at a cost of
PHP300,000 and projected to have a useful life of 15 years. At the
end of its useful life, it is estimated to have a salvage value of
PHP30,000. Determine its capitalized cost if interest is 18%
compounded annually.
Solution:
P30,000 P30,000 P30,000

0 15 30 45

P300,000 P300,000 P300,000 P300,000

Cash flow diagram for the engine

CAPITALIZED COST
 CASE 2 SAMPLE PROBLEM cont’d...
P270,000 P270,000 P270,000

0 15 30 45

X
S P270,000
X = ---------------
k
= --------------------
15
= PHP24,604
(1+i) – 1 (1+0.18) – 1

Capitalized cost = First cost + X = P300,000 + P24,604

= PHP324,604
CAPITALIZED COST
 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

 CASE 3 SAMPLE PROBLEM:

Determine the capitalized cost of a research laboratory which
requires PHP5,000,000 for original construction; PHP100,000 at
the end of every year for the first 6 years and then PHP120,000
each year thereafter for operating expenses; and PHP500,000 every
5 years for replacement of equipment with interest at 12% per
annum.
 CAPITALIZED COST
 CASE 3 SAMPLE PROBLEM cont’d:
Solution:
Operation:

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

P100,000(P/A, 12%, 6) P120,000 P120,000 P120,000

P100,000 P100,000 P100,000 P100,000 P100,000 P100,000

0 1 2 3 4 5 6 7 8 9

Q
CAPITALIZED COST
 CASE 3 SAMPLE PROBLEM cont’d:

Let Q = the present worth of cost of perpetual operation

P120,000
Q = P100,000(P/A, 12%, 6) + -------------- (P/F, 12%, 6)
0.12
P120,000
= P100,000(4.1114) + ------------- (0.5066)
0.12

Q = PHP917,740
CAPITALIZED COST
 CASE 3 SAMPLE PROBLEM cont’d:
P500,000 P500,000 P500,000

0 5 10 15

Let X = the present worth of cost of perpetual replacement

X
S P500,000
X = --------------
k
= ------------------- = P655,910
(1+i) – 1 (1+0.12)⁵ – 1
Capitalized cost = First cost + Q + X
= P5,000,000 + P917,740 + P655,910
= PHP6,753,650
Assignment – Dec 5, 2013
 For next meeting, submit in one sheet of bond paper. Write your
name, subject/section, date and write the problem statement.
Please write legibly.
Non-compliance will mean non-acceptance of your assignment.

 Calculate the capitalized cost of an infrastructure project

that has an estimated initial cost of $14,000,000 and an
additional investment cost of $3,000,000 at the end of every
ten years. The annual operating cost will be $200,000 at the
end of every year for the first four years and $280,000
thereafter. In addition, there is expected to be a recurring
major rework cost of $450,000 every 13 years. Assume
interest at 15%.

Note: Correct diagram is worth 10 points.