MODULE 2

The Time Value of Money

Unit 3
Perpetuity, Capitalized Costs and Uniform Arithmetic Gradient
UNIT LEARNING OUTCOMES

❖ TLO 2.3: To solve problems that involve time value of money calculations and to
illustrate economic equivalence involving cash flows that last for a long time or
increase by a uniform amount.

Diagnostic Test : Please try answer the following questions

What comes into your mind when you hear the word
“Perpetuity”?

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 1. Perpetuity

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

P

0 1 2 3 4 n ∞

A A A A
Using “0” as focal point
= ∑

𝟏 − (𝟏+𝒊 )−𝒏 𝟏 − (𝟏+𝒊 )−∞

P=A[ 𝒊
] = A[ 𝒊
]
𝑨
P= 𝒊

2. 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

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

P = amount of principal invested at rate i% the

interest on which will amount to S every k periods

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 Example K = 3

0 1 2 3 4 5 6
∞

∞
S S

S S
∞

0 1 2 3 4 5 6
∞

A A A A A A

𝒊
A = S(A/F, i%, k) = S [(𝟏+𝒊 )𝒌 −𝟏]

𝑨 𝑺 𝒊
P= = [(𝟏+𝒊 )𝒌 −𝟏]
𝒊 𝒊

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

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 The above discussions are further clarified by the following examples. Examining the
solution to each example can give you deeper insights into the subject matter.

Example 1: What amount of money invested today at 15% interest can provide the following
scholarships: ₱30,000 at the end of each year for 6 years; ₱40,000 for the next 6 years and
₱50,000 thereafter?
Solution:

₱50,000
₱50,000
(P/F, 15%,12) 0.15
0.15

₱40,000 (P/A, 15%, 6)

(P/F, 15%,6) ₱40,000 (P/A, 15%, 6) ₱50,000 ₱50,000
∞
₱30,000 (P/A, 15%, 6) ₱40,000 ₱40,000 ₱40,000

₱30,000 ₱30,000 ₱30,000

0 1 2 6 7 8 12 13 14

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

₱50,000
P = ₱30,000 (P/A, 15%, 6) + ₱40,000 (P/A, 15%, 6) (P/F, 15%, 6) + 0.15
(P/F, 15%, 12)

𝟏 − (𝟏.𝟏𝟓 )−𝟔 𝟏 − (𝟏.𝟏𝟓 )−𝟔 ₱50,000

P = ₱30,000 [ .𝟏𝟓
]+ ₱40,000 [ .𝟏𝟓
] (1.15)-6 + 0.15
(1.15)-12
₱50,000
P = ₱30,000 (3.7845) + ₱40,000 (3.7845) (0.4323) + 0.15
(0.1869)

P = ₱241,277

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 Example 2: Determine the capitalized cost of a structure that requires an initial investment of
₱1,500,000 and an annual maintenance of ₱150,000. Interest is 15%.
Solution: 1.5M
A A
P P ∞

0 1 2

P = Capitalized Costs

𝐴 ₱150,000
𝑖
= 0.15
= ₱1,000,000

Capitalized Cost = First cost + A/i

= ₱1,500,000 + ₱1,000,000
Capitalized Cost = ₱2,500,000

Example 3: A new engine was installed by a textile plant at a cost of ₱300,000 and projected
to have a useful life of 15 years. At the end of this useful life, it is estimated to have a salvage
value of ₱30,000. Determine its capitalized cost if interest is 18% compounded annually.
Solution: X

(isolate the cash flow of the replacement)

₱30,000 ₱30,000 ₱30,000
∞

0 15 30 45 0 15 30 45

∞ ∞
₱300,000 ₱300,000 ₱300,000 ₱300,000
₱270,000 ₱270,000 ₱270,000
𝑆 ₱270,000
X = (𝟏+𝒊 )𝒌 −𝟏 = (𝟏+𝟎.𝟏𝟖 )𝟏𝟓−𝟏 = ₱24,604

Capitalized Cost = First cost + X

= ₱300,000 + ₱24,604
Capitalized Cost = ₱324,604

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 3. 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.

Example 4: A debt of ₱5,000 with interest at 12% compounded semi annually is to be

amortized by equal semi annual payments over the next 3 years, the first due in6 months.
Find the semi annual payment and construct an amortization schedule.
Given: P = P5,000 n=3 yrs x 2 SA/yr = 6 SA r = 12% CSA i = 12%/2 = 6%/SA
Required: A and amortization table
Solution:

₱5,000

0 1 2 3 4 5 6

A A A A A A

.𝟎𝟔
A = 5,000 [𝟏 − (𝟏.𝟎𝟔 )−𝟔 ]

A = ₱1,016.82

Amortization table

C1 C2 C3 C4

Period (n) Outstanding Interest due at Payment Principal

principal at end of period repaid at end
beginning of of period
period
1 ₱5,000 ₱300.00 ₱1,016.82 ₱716.82
2 4,283.18 256.99 ₱1,016.82 759.83
3 3,523.35 211.40 ₱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 ₱6,100.92 ₱5,000.05
C1= C1n-1 – C4n-1 C2= C1*.06 C3= A C4 = C3-C2

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 4. Uniform Arithmetic Gradient

In certain cases, economic analysis problems involve receipts or disbursements that

increase or decrease by a uniform amount each period.
(n-1) G
3G 4G
A A A A A A 2G
G
0
= +
0 1 2 3 4 5 6 0 1 2 3 4 5 6
0 1 2 3 4 5 6

P PA PG

P = PA + PG
𝟏 − (𝟏+𝒊 )−𝒏
PA = A(P/A, i%,n) = A[ 𝒊
]

𝑮 (𝟏+𝒊 )𝒏 −𝟏 𝟏
PG = 𝒊
[ 𝒊
− 𝒏] [(𝟏+𝒊 )𝒏 ]

𝟏 (𝟏+𝒊 )𝒏 −𝟏 𝟏
P/G, i%, n = 𝒊 [ 𝒊
− 𝒏] [(𝟏+𝒊 )𝒏 ]

P = A(P/A, i%,n) + G(P/G, i%, n)

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 Example 5: A loan was to be amortized by a group of four end-of-year payments forming an
ascending arithmetic progression. The initial payment was to be ₱5,000 and the difference
between successive payments was to ₱400. But the loan was renegotiated to provide for
the payment of equal rather than uniformly varying sums. If the interest rate of the loan was
15%, what was the annual payment?

Solution: let A’ = annual payment

₱1200
₱5,400₱5,800 ₱5,000 ₱5,000 ₱5,000 ₱5,000
₱800 A’ A’ A’ A’
₱5,000 ₱6,200 ₱400
= + 0
=
0 1 2 3 4 0 1 2 3 4 0 1 2 3 4 0 1 2 3 4

P PA P P

Let A’ = the annual payment

A= ₱5,400 G = ₱400 n= 4 i = 15%

𝟏−(𝟏.𝟏𝟓 )−𝟒
P/A, 15%, 4 = [ 𝟎.𝟏𝟓
] = 2.8550

𝟏 (𝟏.𝟏𝟓 )𝟒 −𝟏 𝟏
P/G, 15%, 4 = 𝟎.𝟏𝟓 [ 𝟎.𝟏𝟓
− 𝟒] [(𝟏.𝟏𝟓 )𝟒] = 3.7865

P = A (P/A, 15%, 4) + G (P/G, 15%, 4)

= (₱5,400) (2.8550) + (₱400)(3.7865)

= ₱15,789.60

A’(P/A, 15%, 4) = ₱15,789.60

A’ = ₱5,530.51

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 Work on the following exercise. This is an opportunity for you to practice your knowledge
and skills you acquired in this unit.
1. Calculate the capitalized cost of a project that has an initial cost of ₱3,000,000 and
an additional investment cost of ₱1,000,000 at the end of every ten years. The annual
operating cost will be ₱100,000 at the end of every year for the first four years and
₱160,000 thereafter. In addition, there is expected to be a recurring major rework cost
of ₱300,000 every 13 years. Assume i = 15%. Ans: ₱4,281,990

2. The will of a wealthy philanthropist left ₱5,000,000 to establish a perpetual charitable

foundation. The foundation trustees decided to spend ₱1,200,000 to provide facilities
immediately and to provide ₱100,000 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 purpose?
Ans: ₱440,259

3. A contract has been signed to lease a building at ₱200,000 per year with an annual
increase of ₱1,500 for 8 years. Payments are to be made at the end of each year,
starting one year from now. The prevailing interest rate is 7%. What lump sum paid
today would be equivalent to the 8-year lease-payment plan? Ans: ₱147,609

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 Work on the following problems as your exercise.

1. Find the uniform annual amount that is equivalent to a uniform gradient series in
which first year’s payment is $500, the second year’s payment is $600, the thirds year’s
payment is $700, and so on, and there are total of 20 payments. The annual interest
rate is 8%.

2. Mr. Alhambra has instructed his bank to establish a trust fund that will provide P10,000
per year for the first five years then P8000 per year for the next 10 years and then will
provide P7,000 per year thereafter to help pay for the upkeep on a memorial garden.
The first of these payments would begin on Jan1, 2009, He also wishes to provide
P100,000 every 8 years for replacement to start Jan 1, 2015. Suppose it is now Jan 1,
2004, how much should be in the trust fund today if interest rate is 5% compounded
annually?

3. Calculate the future equivalent at the end of 2012 at 8% per year, of the following
series of cash flows in the figure: [Use a uniform gradient amount (G) in your solution]

4. A debt of ₱10,000 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 amortization
schedule.

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