ENS191

Time Value of Money

Lecture 3

Rosal Jane G. Ruda-Bayor

 content
1 Cash Flow Diagrams

2 Time Value of Money

3 Applications of Time Value of Money

Part/ 01
Cash Flow Diagram
Definition of Terms

Cash Inflow – are the receipts, revenues, incomes, and savings

generated by project and business activity. A plus sign indicates a
cash inflow.

Cash Outflow – are costs, disbursements, expenses, and taxes

caused by projects and business Cash flow activity. A negative or
minus sign indicates a cash outfl ow. When a project involves only
costs, the minus sign may be omitted for some techniques, such as
benefit/cost analysis.

Net Cash Flow = Receipts – Disbursements

Cash Flow Diagram

• very important tool in an economic analysis, especially when

the cash flow series is complex
• a graphical representation of cash fl ows drawn on the y axis
with a time scale on the x axis. The diagram includes what is
known, what is estimated, and what is needed.
• Identify on whose viewpoint (lender or borrower)
 Cash Flow Diagram
Receipt
Cash inflow
Number of
Beginning
of time End of time time
Time scale period 1
(months, years,
period 1 periods
weeks, etc.

0 1 2 3 4 5 6 ............ n

i=1% per period

Disbursement
Cash outflow

Interest
rate per
time period
Example

Each year Exxon-Mobil expends large amounts of funds for

mechanical safety features throughout its worldwide
operations. Carla Ramos, a lead engineer for Mexico and
Central American operations, plans expenditures of $1 million
now and each of the next 4 years just for the improvement of
field-based pressure-release valves. Construct the cash flow
diagram to find the equivalent value of these expenditures at
the end of year 4, using a cost of capital estimate
for safety-related funds of 12% per year.
Example

0 1 2 3 4
Part/ 02
Time Value of Money
Simple Interest

❖ Total interest earned or charged is linearly proportional to

the initial amount loaned (principal)
❖ Calculated using the principal only, ignoring any interest
accrued in preceding interest periods.
❖ Infrequently used in modern practice

𝐼 = 𝑃𝑛𝑖

I= total interest
n= number of interest periods
i= interest rate per period

𝐹 = 𝑃 + 𝐼 = 𝑃(1 + 𝑛𝑖)
Example

GreenTree Financing lent an engineering company $100,000 to retrofit

an environmentally unfriendly building. The loan is for 3 years at 10%
per year simple interest. How much money will the firm repay at the
end of 3 years?
Example
Year Principal Interest Earned Amount Due at the end of Year

1 100,000 100,000(0.10)=10,000 110,000

Given:
i=10% 2 110,000 100,000(0.10)=10,000 120,000

P=$100,000 3 120,000 100,000(0.10)=10,000 130,000

n=3 years

Asked:
F= future amount to be paid at the end of 3 years.

Substitute:
𝐹 = 𝑃 1 + 𝑛𝑖 = 100,000 1 + 0.10 × 3 =
Consequently, the total interest paid is
𝐼 = $130,000.00 − $100,000.00 =
Activity

A business takes out a simple interest loan of $10,000 at a rate of 7.5%.

What is the total amount the business will repay if the loan is for 8
years?
Compound Interest

❖ reflects both the remaining principal and any accumulated interest

❖ commonly used in personal and professional financial transactions
Period Principal at the beginning of the Interest Earned Amount at the End of
period During period Period
1 P Pi P+Pi=P(1+i)
2 P(1+i) [P(1+i)]i 𝑃 1+𝑖 + 𝑃 1+𝑖 𝑖
=𝑃 1+𝑖 2
…. … … …
N 𝑃 1+𝑖 𝑛−1 𝑃 1+𝑖 𝑛−1 𝑖 𝑃 1+𝑖 𝑛

𝑛
𝐹 =𝑃 1+𝑖

F= future amount
n= number of interest Periods
i=interest rate per period
Example
GreenTree Financing lent an engineering company $100,000 to retrofit
an environmentally unfriendly building. The loan is for 3 years 10%
per year compound interest and will pay the principal and all the
interest after 3 years. Compute the annual interest and total amount
due after 3 years.
Example
Year Principal Interest Earned Amount Due
at the end of
Given: Year
i=10% 1 100,000 100,000(0.10)= 10,000 110,000
P=$100,000
n=3 years 2 110,000 110,000(0.10)= 11,000 121,000
3 121,000 121,000(0.10)=12,100 133,100
Asked:
Annual interest for Y1, Y2, and Y3.
F= future amount to be paid at the end of 3 years.

𝐹 = 100000 1 + 0.10 3 =
Economic Equivalence

❖ 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.

For Example:

If the interest rate is 6% per year, $100 today (present time) is

equivalent to $106 one year from today.
Nominal and Effective Interest Rate

Nominal Interest Rate, r

❖ Specifies the rate of interest and a number of interest periods
❖ Also defined as stated interest rate
❖ It works like a simple interest and does not take into account
the compounding periods

For example, if the interest rate per month is i=8%

𝑟 = 0.08 × 12 = 0.096 = 9.6% 𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Nominal and Effective Interest Rate

Effective Interest Rate, 𝑖𝑒

❖ The actual or exact rate of interest on the principal
❖ Take the compounding period into account and thus is a more
accurate measure of interest charges.
❖ Effective interest rates are generally higher than the stated
nominal interest rate.

𝑟 𝑚
𝑖𝑒 = 1 + −1= 1+𝑖 𝑚−1
𝑚
m= number of compounding periods
i=interest rate per period
Nominal and Effective Interest Rate

Effective Interest Rate, 𝑖𝑒

❖ If there is more compounding in a time period, the bigger is the
difference between the nominal and effective interest. For
example, for i=6% per year.
Compounding Number of Nominal interest Effective interest rate
Frequency compounding per rate
year
1
Annually 1 0.06 0.06
1+ − 1 = 0.06
1
2
Semi-Annually 2 0.06 0.06
1+ − 1 = 0.0609
2
12
Monthly 12 0.06 0.06
1+ − 1 = 0.0617
12
Nominal and Effective Interest Rate

Effective Interest Rate, 𝑖𝑒

❖ The actual or exact rate of interest on the principal
❖ Take the compounding period into account and thus is a more
accurate measure of interest charges.
❖ Effective interest rates are generally higher than the stated
nominal interest rate.

𝑟 𝑚
𝑖𝑒 = 1 + −1= 1+𝑖 𝑚−1
𝑚
m= number of compounding periods
i=interest rate per period
Example

A credit card company charges an interest rate of 1.375% per month on

the unpaid balance of all accounts. What is the effective rate of interest
per year being charged by the company?
Example

Find the nominal rate which if converted quarterly could be used

instead of 12% compounded monthly. What is the corresponding
effective rate?
Discrete Compounding

In discrete compounding interest is compounded at the end of

each finite length period, such as a month, a quarter or a year
𝑛
𝐹 =𝑃 1+𝑖

Where
i=interest rate per period
n=number of periods
When using nominal rate of interest, r.
𝑚 𝑛 𝒎𝒏
𝑟 𝒓
𝐹 =𝑃 1+[ 1+ −1] =𝑃 𝟏+
𝑚 𝒎
Where,
r=nominal rate of interest (usually expressed as the % rate compounded)
n=number of periods
m=number of compounding per period
Discrete Compounding

Finding F when P is given

𝑛
𝐹 =𝑃 1+𝑖 = 𝑃(𝐹/𝑃, 𝑖%, 𝑛)
Where
1 + 𝑖 𝑛 =single payment compound amount factor
• Designated by (F/P,i%,n)

Finding P when F is given

P= 𝐹 1 + 𝑖 −𝑛
= 𝑃(𝑃/𝐹, 𝑖%, 𝑛)
Where
1 + 𝑖 −𝑛 =single payment present worth factor
• Designed by (P/F,i%,n)
Continuous Compounding

In continuous compounding, it is assumed that each cash payment

occurs once per year, but the compounding is continuous
throughout the year.
𝐹 = 𝑃𝑒 −𝑟𝑛

Where
r= nominal rate of interest
n=number of periods
Example

Compare the accumulated amounts after 5 years of P 1 000

invested at the rate of 10% per year compounded a) annually b)
semiannually c) quarterly d) monthly, e) daily and f) Continuously
Example
Compounded Equation Amount
Annually 𝐹 = 1000 1 + 0.10 5 Php 1,610.51
Semi-annually 0.10
5×2 Php 1,628.89
𝐹 = 1000 1 +
2
Quarterly 0.10
5×4
Php 1, 638.62
𝐹 = 1000 1 +
4

Monthly 0.10
5×12
Php 1,645.31
𝐹 = 1000 1 +
12

Daily 0.10
5×365
Php 1,648.61
𝐹 = 1000 1 +
365

Continuously 𝐹 = 1000𝑒 0.10×5 Php 1,648.72

Example

A man wants to invest a certain amount P so that after 10 years, he can

withdraw an amount of P100,000.00. How much should he invest if the
interest rate is 10% compounded quarterly?
 (𝑃/𝐹, 𝑖%, 𝑛)

Cash
0 1 2 3 4 5 6 7 8 9 10 Flow
Diagram
𝑟 = 10% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦
Annuity

A series of equal payments occurring at equal periods of time

Common application is in insurance payments, home mortgage
payments

Common Symbols and Their Meanings

P: value or sum of money at present
F: value or sum of money at the future
A: A series of periodic, equal amounts of money
n: number of interest periods
i: interest rate per interest period
Ordinary Annuity

one where the payments are made at the end of each period
• Examples of ordinary annuities are interest payments from bonds,
which are generally made semiannually, and quarterly dividends
from a stock

0 1 2 3 n-1 n

𝐴(𝑃/𝐴, 𝑖%, 1)

𝐴(𝑃/𝐴, 𝑖%, 2)
𝐴(𝑃/𝐴, 𝑖%, 3)
𝐴(𝑃/𝐴, 𝑖%, 𝑛 − 1)
𝐴(𝑃/𝐴, 𝑖%, 𝑛)
Ordinary Annuity
Finding P when A is given
1 − 1 + 𝑖 −𝑛
𝑃=𝐴 = 𝐴(𝑃/𝐴, 𝑖%, 𝑛)
𝑖
Where (P/A,i%,n)=uniform series present worth factor

0 1 2 3 n-1 n

𝐴(𝑃/𝐴, 𝑖%, 1)

𝐴(𝑃/𝐴, 𝑖%, 2)
𝐴(𝑃/𝐴, 𝑖%, 3)
𝐴(𝑃/𝐴, 𝑖%, 𝑛 − 1)
𝐴(𝑃/𝐴, 𝑖%, 𝑛)
Ordinary Annuity
Finding A when P is given
𝑖
𝐴=𝑃 −𝑛
= 𝑃(𝐴/𝑃, 𝑖%, 𝑛)
1− 1+𝑖
Where (A/P,i%,n)=capital recovery factor

0 1 2 3 n-1 n

𝑃(𝐴/𝑃, 𝑖%, 1)

𝑃(𝐴/𝑃, 𝑖%, 2)
𝑃(𝐴/𝑃, 𝑖%, 3)
𝑃(𝐴/𝑃, 𝑖%, 𝑛 − 1) 𝑃(𝐴/𝑃, 𝑖%, 𝑛)
Ordinary Annuity
Finding A when F is given
𝑖
𝐴=𝐹 𝑛
= 𝐹(𝐴/𝐹, 𝑖%, 𝑛)
1+𝑖 −1
Where (A/F,i%,n)=sinking fund factor

0 1 2 3 n-1 n

𝐴(𝐹/𝐴, 𝑖%, 1)
𝐴(𝐹/𝐴, 𝑖%, 𝑛 − 3)
𝐴(𝐹/𝐴, 𝑖%, 𝑛 − 2)
𝐴(𝐹/𝐴, 𝑖%, 𝑛 − 1)
Ordinary Annuity
Finding F when A is given
1+𝑖 𝑛−1
𝐹=𝐴 = 𝐴(𝐹/𝐴, 𝑖%, 𝑛)
𝑖
Where (F/A,i%,n)=uniform series compound amount factor

0 1 2 3 n-1 n

𝐹(𝐴/𝐹, 𝑖%, 1)
𝐹(𝐴/𝐹, 𝑖%, 𝑛 − 3)
𝐹(𝐴/𝐹, 𝑖%, 𝑛 − 2)
𝐹(𝐴/𝐹, 𝑖%, 𝑛 − 1)
Example

What are the present worth and the accumulated amount of a 10-year
annuity paying P10,000 at the end of each year, with interest of 15%
compounded annually?
 Cash
0 1 2 3 4 5 6 7 8 9 10 Flow
Diagram
𝑟 = 15% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦
Solution

Given:
r=15% compounded annually
A=P10,000 at the end of year for 10 years

Find: P
𝑃 = 𝐴 𝑃Τ𝐴 , 10%, 10
−1(10)
0.15
1− 1+ 1
𝑃 = 10000 = 50,187.69
0.15
1
 Cash
0 1 2 3 4 5 6 7 8 9 10 Flow
Diagram
𝑟 = 15% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦
Solution

Given:
r=15% compounded annually
A=P10,000 at the end of year for 10 years

Find: F
𝐹 = 𝐴 𝐹 Τ𝐴 , 15%, 10
0.15 1(10)
1+ 1 −1
𝐹 = 10000 = 203,037.18
0.15
1
 𝑟 = 15% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦

Cash
0 1 2 3 4 5 6 7 8 9 10 Flow
Diagram
We can also check to see if
your calculated values will
match if we use the single
value formula.
Solution

From our calculations, we know that

P=50,187.69
r=15% compounded annually
A=P10,000 at the end of year for 10 years

Find: F
𝐹 = 𝑃 𝐹 Τ𝑃 , 15%, 10
1(10)
0.15
𝐹 = 50,187.69 1 + = 203,037.20
1

We can see that this is approximately the value of F we calculated in the

previous slides.
Deferred Annuity

are uniform series that do not begin until some time in the future

0 1 2 m 1 2 n-1 n

𝑃 𝑃
𝐴 , 𝑖%, 𝑛 𝑃( , %, 𝑚) 𝐴(𝑃/𝐴, 𝑖%, 𝑛)
𝐴 𝐹
Example

Suppose that a father, on the day his son is born, wishes to determine
what lump amount would have to be paid into an account bearing
interest of 12 per year to provide withdrawals of P200,000 on each of
the son’s 18th, 19th, 20th, and 21st birthdays?
 𝑃17

𝐴(𝑃Τ𝐴 , 𝑖%, 𝑛)
𝑃(𝑃Τ𝐹 , 𝑖%, 𝑚)

Cash
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Flow
𝑖 = 12% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
Diagram
Solution

Given
m=17
i=12% per year
A=P200,000 for n years
n=4

Find: P
𝑃 = 𝐴 𝑃Τ𝐴 , 𝑖%, 𝑛 𝑃Τ𝐹 , 𝑖%, 𝑚
0.12 −1(4)
1− 1+ 1 0.12
−1(17)
𝑃 = 200,000 1+ = 88,474.55
0.12 1
1
Activity
A chemical engineer wishes to set up a special fund by making
uniform semi-annual 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 the interest rate is 8% compounded semi-annually, what
is the required semi-annual deposit to be made?
 𝐹𝐴2

𝐹𝑜𝑐𝑎𝑙 𝐷𝑎𝑡𝑒: 𝟐𝟎 𝒚𝒆𝒂𝒓𝒔 𝒇𝒓𝒐𝒎 𝒏 = 𝟎

A2 (𝐹 Τ𝐴 , 𝑖%, 𝑛)

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Period

A1 (𝐹 Τ𝐴 , 𝑖%, 𝑛)
𝑟 = 8% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑠𝑒𝑚𝑖 − 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦
𝐹𝐴1
Solution
Find: 𝑨𝟏 such that 𝐹𝐴1 = 𝐹𝐴2
Given:
r=8% compounded semiannually

Since

𝑨𝟐 = 𝟏𝟎𝟎, 𝟎𝟎𝟎

Since r=8%, we can solve for the effective interest rate per period.
2
0.08
𝑖𝑒 = 1 + − 1 = 0.0816 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
2
Where 1 period=1 year

We can solve for 𝐹𝐴2 = 100,000(𝐹 Τ𝐴 , 8,16%, 5)

1 + 0.0816 (5) − 1
𝐹𝐴2 = 100000 = 588,534.66
0.0816
Solution
Find: 𝑨𝟏 such that 𝐹𝐴1 = 𝐹𝐴2
Given:
r=8% compounded semiannually

For the deposits, our interest rate is just

𝑟 0.08
𝑖= = = 0.04 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
𝑚 2
Where 1 period=1 half year

We equate this to 𝐹𝐴1 = 588,534.66 where we have n=40 periods

𝐹𝐴1 = A1 (𝐹 Τ𝐴 , 4%, 40)

We can solve for

1 + 0.04 (40) − 1
588,534.66 = 𝐴1
0.04
Solving for 𝐴1
𝑨𝟏 = 𝑷𝟔, 𝟏𝟗𝟑. 𝟒𝟒
Annuity Due

one where the payments are made at the beginning of each period

Ordinary Annuity Annuity Due

0 1 2 3 n-1 n 0 1 2 3 n-1 n
Annuity Due
Finding P when A is given
−(𝑛−1)
1− 1+𝑖
𝑃 =𝐴+𝐴 = 𝐴(1 + 𝑃/𝐴, 𝑖%, 𝑛 − 1)
𝑖

0 1 2 3 n-1 n
Annuity Due
Finding F when A is given
1 + 𝑖 𝑛+1 − 1 𝐹
𝐹=𝐴 −𝐴=𝐴 , 𝑖%, 𝑛 + 1 − 1
𝑖 𝐴

0 1 2 3 n-1 n

𝐹(𝐴/𝐹, 𝑖%, 1)
𝐹(𝐴/𝐹, 𝑖%, 𝑛 − 3)
𝐹(𝐴/𝐹, 𝑖%, 𝑛 − 2)
𝐹(𝐴/𝐹, 𝑖%, 𝑛 − 1)
𝐹(𝐴/𝐹, 𝑖%, 𝑛)
Example

A certain property is to be sold and the owner received two offers. The
first bidder offered to pay P400,000 each year for 5 years. Each
payment is to be made at the beginning of the year. The second bidder
offered to pay P240,000.00 first year, P360,000 second year, and
P540,000 each year for the next 3 years, all payments will be made at
the beginning of each year.
If money is worth 20% compounded annually, which bid should the
owner of the property accept?
𝐹𝑜𝑐𝑎𝑙 𝐷𝑎𝑡𝑒: 𝑭 𝒚𝒆𝒂𝒓𝒔 𝒇𝒓𝒐𝒎 𝒏 = 𝟓 𝑭𝟏

Cash
Flow
Diagram
𝑟 = 20% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦
Solution
Problem: Find the offer with the higher value.
F𝐢𝐫𝐬𝐭 𝐁𝐢𝐝𝐝𝐞𝐫: 𝑭𝟏
Given:
r=20% compounded annually
Using Annuity Due formula:
𝑭
𝐹1 = 400,000 , 𝒊%, 𝒏 + 𝟏 − 𝟏
𝑨
0.20 5+1
1+ 1 −1
𝐹1 = 400,000 − 1 = 𝑃3,571,968.00
0.20
1
𝐹𝑜𝑐𝑎𝑙 𝐷𝑎𝑡𝑒: 𝑭 𝒚𝒆𝒂𝒓𝒔 𝒇𝒓𝒐𝒎 𝒏 = 𝟓

𝑟 = 20% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦

Cash
Flow
Diagram
Solution
Problem: Find the offer with the higher value.
𝐒𝐞𝐜𝐨𝐧𝐝 𝐁𝐢𝐝𝐝𝐞𝐫: 𝑭𝟐
Given:
r=20% compounded annually
Using Annuity Due formula:
𝑭 𝑭 𝑭
𝐹2 = 540k , 𝒊%, 𝟑 + 𝟏 − 𝟏 + 360k , 𝒊%, 𝟒 + 240k , 𝒊%, 𝟓
𝑨 𝑷 𝑷

𝐹2 = 3,702,412.80
Solution

Since
𝐹2 = 3,702,412.80 > 𝐹1 = 3,571,968.00

Choose the second bidder.

Try using the focal point to be n=0.

Perpetuity
An annuity wherein the payments continue indefinitely

𝑛→∞
0 1 2 3 4 5

Finding P when A is given

1− 1+𝑖 −𝑛 1− 1+𝑖 −∞ 𝑨
𝑃=𝐴 =𝐴 =
𝑖 𝑖 𝒊
Example

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 P
40,000 for the next 6 years and P 50,000 thereafter?
Example

𝟓𝟎𝟎𝟎𝟎 𝑷 𝟓𝟎𝟎𝟎𝟎
( ൗ𝑭 , 𝟏𝟓%, 𝟏𝟐)
𝟎. 𝟏𝟓 𝟎. 𝟏𝟓

𝟒𝟎𝟎𝟎𝟎(𝑷ൗ𝑨 , 𝟏𝟓%, 𝟔)(𝑷ൗ𝑭 , 𝟏𝟓%, 𝟔) 𝟒𝟎𝟎𝟎𝟎(𝑷ൗ𝑨 , 𝟏𝟓%, 𝟔)

𝑷 = 𝟑𝟎𝟎𝟎𝟎(𝑷ൗ𝑨 , 𝟏𝟓%, 𝟔)

𝑛→∞

0 1 2 6 7 8 12
Activity

Today, you invest P100,000 into a fund that pays 25% interest
compounded annually. Three years later, you borrow P50,000 from a
bank at 20% annual interest and invest into the fund. Two years later,
you withdraw enough money from the fund to repay the bank loan
and all interest due on it. Three years from this withdrawal, you start
taking P20,000 per year out of the fund. After five withdrawals, you
withdraw the balance in the fund. How much is the balance?
Discount

Discount on a negotiable paper is the difference between the

present worth (the amount received for the paper in cash) and the
worth of the paper some time in the future (the face value or the
principal). Discount is interest paid in advance.
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ − 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ

Discount Rate:
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑑=
𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ/𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

Discount and Interest Rate

𝑑
𝑖=
1−𝑑
Example

A man borrowed P5,000 from a bank and agreed to pay the loan
at the end of 9 months. The bank discounted the loan and gave
him P4000 in cash.
a) What was the rate of discount?
b) What was the rate of interest for 9 months?
c) What was the interest rate for one year?
Inflation

Inflation is the increase in the prices for goods and services from
one year to another, thus decreasing the purchasing power of
money.

𝑛
𝐹𝐶 = 𝑃𝐶 1 + 𝑓

Where
FC= future cost of a commodity
PC=present cost of a commodity
f= actual inflation rate
n= number of years
Inflation and Compounding

If interest is being compounded the same time inflation occurs, the

future worth will be:
𝑛
1+𝑖
𝐹 =𝑃× 𝑛
1+𝑓

Where
F= future cost of a commodity
P=present cost of a commodity
f= actual inflation rate
n= number of years
Uniform Arithmetic Gradient
Applies when cash flow (receipt or disbursement) increase
or decrease by a uniform amount each period.

0 1 2 3 4 n
Uniform Arithmetic Gradient
Therefore,
𝑃 = 𝑃𝐴 + 𝑃𝐺

Where:
𝑃𝐴 = 𝐴 𝑃Τ𝐴 , 𝑖%, 𝑛

And
𝑃𝐺 = 𝐺 𝑃Τ𝐴 , 𝑖%, 𝑛
𝐺 1+𝑖 𝑛−1 1
𝑃𝐺 = −𝑛 𝑛
𝑖 𝑖 1+𝑖
 Cash
0 1 2 3 4 5 6 7 8 9 10 Flow
Example: The maintenance of a machine is initially P1000
Diagram
per year and increases at a rate of P500 per year for the
next 9 years. Find the Present Value given that i=10% per
year.
Solution
Given:
G=500
A=1000
n=10
Using Ordinary Annuity, 𝑷𝑨
𝑃𝐴 = 𝐴 𝑃Τ𝐴 , 𝑖%, 𝑛
−10
1 − 1 + 0.10
𝑃𝐴 = 1000
0.10
And
𝑃𝐺 = 𝐺 𝑃Τ𝐴 , 𝑖%, 𝑛
500 1 + 0.10 10 − 1 1
𝑃𝐺 = − 10 10
0.10 0.10 1 + 0.10

Therefore,
𝑃 = 𝑃𝐴 + 𝑃𝐺
Part/ 03
Applications
Capitalized Cost
• One of the most important applications of perpetuity
• The sum of first cost and the present worth of all costs of replacement,
operation, and maintenance for a long time or forever
• Used for projects with infinite life and repeating expenses

Case 1 No Replacement, only maintenance and/or operation every period

• 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝑪𝒐𝒔𝒕 = 𝑭𝒊𝒓𝒔𝒕 𝑪𝒐𝒔𝒕 + 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒘𝒐𝒓𝒕𝒉 𝒐𝒇 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒂𝒍 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏 𝒂𝒏𝒅 Τ𝒐𝒓 𝒎𝒂𝒊𝒏𝒕𝒆𝒏𝒂𝒏𝒄𝒆

Case 2 Replacement only, no maintenance and/or operation

• 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝑪𝒐𝒔𝒕 = 𝑭𝒊𝒓𝒔𝒕 𝑪𝒐𝒔𝒕 + 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒘𝒐𝒓𝒕𝒉 𝒐𝒇 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒂𝒍 𝒓𝒆𝒑𝒍𝒂𝒄𝒆𝒎𝒆𝒏𝒕

Case 3 Replacement, maintenance and/or operation every period

• 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝒄𝒐𝒔𝒕 = 𝑭𝒊𝒓𝒔𝒕 𝒄𝒐𝒔𝒕 + 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒘𝒐𝒓𝒕𝒉 𝒐𝒇 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒂𝒍 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏 𝒂𝒏𝒅 Τ𝒐𝒓 𝒎𝒂𝒊𝒏𝒕𝒆𝒏𝒂𝒏𝒄𝒆 +
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒘𝒐𝒓𝒕𝒉 𝒐𝒇 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒂𝒍 𝒓𝒆𝒑𝒍𝒂𝒄𝒆𝒎𝒆𝒏𝒕
Case 1: No replacement, only maintenance and/or operation
Determine the capitalized cost of a public works project that will cost P
25,000,000.00 now and will require P2,000,000.00 in maintenance
annually? Interest rate is 12%.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 𝐹𝐶 + 𝑃𝑊 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒

Solution
𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝑪𝒐𝒔𝒕 = 𝑭𝑪 +
𝑷𝑾 𝒐𝒇 𝒑𝒆𝒓𝒑𝒆𝒕𝒖𝒂𝒍 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏 𝒂𝒏𝒅 Τ𝒐𝒓 𝒎𝒂𝒊𝒏𝒕𝒆𝒏𝒂𝒏𝒄𝒆

𝐶𝐶 = 25 + 2 𝑃Τ𝐴 , 12%, ∞
2
𝐶𝐶 = 25 + = 41.67𝑀
0.12
Capitalized cost is P41, 666,666. 67 million.
Case 2: Replacement only, no maintenance and/or operation
If there is replacement cost every k years, the present value of all
replacement

𝑆
𝑋=
1+𝑖 𝑘−1
X=amount of principal needed to
replace a property every k years
Case 2: No replacement, only maintenance and/or operation
A new engine was installed by a textile plant at a cost of P300,000.00 and
projected to have a useful life of 15 years. At the end of the 15 years, it is
estimated to have a salvage value of P30,000.00. Determine its capitalized
cost if interest is 18% compounded annually.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 𝐹𝐶 + 𝑃𝑊 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡

Case 3: Replacement, maintenance and operation
Calculate the capitalized cost of a project that has an initial cost of
P300,000.00. An additional investment cost of P1,000,000 after ten
years. The annual operating cost will be P10,000.00 for the first four
years and P16,000 after that. It is expected that the recurring major
rework costs of P30,000 every 13 years with interest rate of 5% per
year.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡
= 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 𝐹𝐶 + 𝑃𝑊 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡
+ 𝑃𝑊 𝑜𝑓 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
Amortization
• Any method of repaying a debt, the principal and interest included,
usually by a series of equal payments at equal interval of time
• Direct application of Annuity
Example
A debt of P 5 000 with interest at 12% compounded semiannually is to
be amortized by equal semiannual payments over the next 3 years,
the first due in 6 months. Find the semiannual payment and construct
an amortization schedule
Amortization Schedule

Period Principal Interest Earned Payment Balance

1 5000 5000(0.12/2)=
2
3
4
5
6