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CAPITALIZED COST

CASE #1 : NO REPLACEMENT BUT W/ MAINTENANCE OR OPERATION COST EVERY PERIOD

CC = FC = PW WHERE : CC = CAPITALIZED COST FC = FIRST COST PW = PRESENT WORTH OF PERPETUAL OPERATION OR MAINTENACE COST OF
PROPERTY

EX. DETERMINE THE CC OF A BLDG. THAT NEED AN INITIAL CAPITAL OF 1.5 M & A YEARLY MAINTENANCE COST OF 150 K @ 15 % INT.

1 2
SOLN. :

150 150

P P = A / i = 150K / 0.15 = 1 M CC = FC = PW = 1.5M + 1M = 2.5 M

CASE # 2 : REPLACEMENT ONLY NO MAINTENANCE OR OPERATION COST .

CC = FC + PW LET : S = AMT. NEEDED TO REPLACE A PROPERTY EVERY K PERIODS. X = AMT. OF P INVESTED @ i RATE . THE INT. W/C WILL AMT. TO S EVERY
Xi = INT. ON X EVERY PERIOD THE PERIODIC DEPOSIT TOWARDS K PERIODS.
THE ACCUMULATION OF S S

0 1 2 3 K-1 K

Xi Xi Xi Xi Xi

X = ( S/i ) [ 1 ] = ( S/i ) [ i ]
k k
{ (1+i ) 1 } (1+i) -1
i
AMORTIZATION
AMORTIZATION = is the gradual extinguishment of any amt. over a period of time . That is the extinction of a debt., principal & interest by means of a sequence of equal
periodic payments or installment payment due @ the end of equal intervals of time.

AMORTIZATION OF A DEBT = when a debt is amortized by equal payments @ equal intervals the debt becomes the present value of an ordinary annuity.

FOR PERSENT VALUE :

P = A [ 1 (1+i ) n ] ------ present value A = P[ 1 -i ] ------- periodic payment


i -n
1-(1+i ) /i

EX. A LOAN OF 4K IS TO BE AMORTIZED BY EQUAL PAMENTS @ THE END OF EACH QUARTR FOR 1 YR. & 6 MOS. IF INT. IS 5 % COMPOUNDED QUARTERLY FIND
THE PERIODIC
PAYMENTS & CONSTRUCT AN AMORTIZATION SCHEDULE.

SOLN. GIVEN : P = 4K i = 5% = 5%/4 = 0.05/4 = 0.0125 m = 4 n = 1YR & 6 MOS. = 1.5 X 4 = 6

A = P = 4K = 696.14
-n
[ 1-( 1+i ) ] [ 1 ( 1.0125 )-6 ]
i 0.0125

AMORTIZATION SCHEDULE : Payment # Unpaid bal. Int. paid Periodic payment Principal repaid

OUTSTANDING PRINCIPAL : ( OP )
NOTE : Both the borrower & the lender must be updated on the status of any obligation . They should know the remaining liabilities or OP before or after any given
no. of payments.
PROSPECTIVE METHOD & RETROSPECTIVE METHOD

PROSPECTIVE METHOD OP = A [ 1 ( 1+i )-(n-k) ] WHERE : OP = OUTSTANDING PRINCIPAL A = PERIODIC PAYMENT i = PERIODIC RATE
i n = TOTAL NO. OF PAYMENTS k = NO. OF PAST PAYMENT n-k = NO. OF FUTURE
PAYMENTS THAT REMAINS TO BE MADE
EX. A LOAN IS TO BE AMORTIZED BY EQUAL PAYMENTS OF 500 EACH @ THE END OF EACH 6 MOS. FOR 10 YRS. IF THE INT. RATE IS BASED ON 7 % COMPOUNDED SEMI-
ANNUALLY .
FIND : A. THE PRESENT VALUE OF LOAN B. THE OP JUST AFTER THE 8th PAYMENT. C. THE REMAINING LIABILITY AFTER 8 YRS.

GIVEN : A = 500 i = 7 % = 7%/2 = 3.5% m = 2 n = 10 YRS. = 10 X 2 20

BOND

BOND = A written promise to pay a specified sum of money called REDEMPTION VALUE @ an specified future date called REDEMPTIONDATE . Usually a long
Term obligation.
= An acknowledgement of obligation together w/ an agreement to make periodic payments known as COUPON PAYMENT @ an stated rate & to repay the
Principal on a certain date.
= A bond is said to be REDEEMED when it is bought back by the corporation w/c issued it.

CLASSIFICATION OF BOND :

1. REGISTERED BONDS = Bonds that can only be transferred from one owner to another by proper endorsement & w/ the consent of the issuer. Thus
the owner is protected against loss or theft.
2. UNREGISTERED BONDS = Bonds that can be transferred from one owner to another at will & anytime the owner desires.

NOTE : A bondholder can sell his bond to the highest bidder


A bond bought at its face or par value is said to be bought at par .
If the bond is bought at a premium it is bought at a price higher than the par value
If the bond is bought at a price below the par value it is bought at a discount
If the bond is sold at par value . The bond rate & yield rate are equal.
FEATURES OF A BOND :

1. PAR OR FACE VALUE ( FV ) --- the value quoted on the bond


2. REDEMPTION DATE --- the date on w/c the bond will be redeemed
3. COUPON --- the contract to pay a periodic payment on an specified date. The coupon can be detached &
cashed through the bank
4. BOND RATE ( BR ) --- the interest rate on the par value for the periodic coupon payments
5. REDEMPTION VALUE ( RV ) --- the amt. w/c will be paid on the redemption date
6. REDEMPTION RATE --- the rate on the principal it is used to find the redemption value
NOTATIONS :

FV = PAR OR FACE VALUE OF A BOND RV = REDEMPTION VALUE OF A BOND Br = BOND RATE


YR = YIELD RATE Rr = REDEMPTION RATE Cp = COUPON PAYMENT
m = CONVERSION PERIOD/YR n = TOTAL NO. OF INT. PERIOD FOR THE b = BOND RATE/INT. PERIOD
i = YIELD RATE / INT. PERIOD WHOLE TERM = BR / m
= Y/m Pp = PURCHASE PRICE OR VALUE OF THE BOND Bp = BOND PREMIUM
Bd = BOND DISCOUNT MQ = MARKET PRICE BV = BOOK VALUE

FORMULAS :

RV = FV X Rr Cp = FV X b b = Br / m Pp = RV ( 1+i)-n + Cp [ 1- ( 1+i )-n ]


i

EXAMPLE : 1. A 5,000 . 6 % BOND W/ QUARTERLY COUPONS IS REDEEMED AT 115% AT THE END OF 10 YRS. FIND THE COUPON PAYMENT & REDEMPTION VALUE.

GIVEN : FV = 5,000 Rr = 115 % Br = 6 % m = 4

2. A 10K . 4 % BOND W/ SEMI-ANNUAL COUPON IS REDEEMED @ 95 % AT THE END OF 15 YRS. FIND THE COUPON PAYMENT & THE REDEMPTION
VALUE

GIVEN : FV = 10K Rr = 95 % Br = 4 % m = 2

3. A 4K 5.5 % BOND W/ QUARTERLY COUPON IS REDEEMED AT PAR AT THE END OF 5 YRS. FIND THE COUPON PAYMENT & REDEMPTION VALUE

GIVEN : FV = 4K Br = 5.5 % m = 4 Rr = AT PAR ( 100 % )

4. FIND THE PURCHASE PRICE OF A BOND VALUED AT 10K W/ INT. AT 5.5 % PAYABLE QUARTERLY & REDEEMABLE AT 96 % IN 15 YRS. IF THE BOND YIELDS
6 % COMPOUNDED QUATERLY ON INVESTMENT.

GIVEN : FV = 10K n = 15 YRS Br = 5.5 % Rr = 96 % m = 4 y = 6%


INFLATION

INFLATION = Increase in amount of money needed to purchase same amount of goods or services. Inflation results in a decrease in purchasing power, i.e., one unit of
money buys less goods or services.

Two ways to work problems when considering inflation:


1. Convert to constant value (CV) , then use real rate i. If f = inflation rate (% per year), the equation is: Constant-value = F = P
n n
(1+ f) (1+ f)
2. Leave money amounts as is and use interest rate adjusted for inflation, i i = i + f + (i)(f)
f f

EXAMPLE : How much would be required today to purchase an item that increased in cost by exactly the inflation rate? The cost 30 years ago was 1000 and
inflation has consistently averaged 4% per year.

Deflation: Opposite of inflation; purchasing power of money is greater in future than at present; however, money, credit, jobs are tighter

Three Different Rates


Real or inflation rate i Rate at which interest is earned when effects of inflation are removed; i represents the real increase in purchasing
power
Market or inflation-adjusted rate if Rate that takes inflation into account. Commonly stated rate everyday
Inflation rate f Rate of change in value of currency
Relation between three rates is derived using the relation :

= F ( 1 + if )-n

Market rate is: i = i + f + (i)(f)


f
EXAMPLE : MARKET vs REAL RATE

Money in a medium-risk investment makes a guaranteed 8% per year. Inflation rate has averaged 5.5% per year. What is the real rate of return on the investment?
Solution: Solve for the real rate i in relation for i
f

i = i + f + (i)(f) i = ( i f )/( 1 + f ) = ( 0.08 0.055 ) / ( 1 + 0.055 ) = 0.024


f f
Investment pays only 2.4% per year in real terms vs. the stated 8%

PW Calculations with Inflation : Two ways to account for inflation in PW calculations

(1) Convert cash flow into constant-value (CV) and use regular i
n n
where: CV = future amt. / (1 + f) = present amt. / (1 + f)
f = inflation rate
(2) Express cash flow in future (then-current ) and use inflated interest rate where : if = i + f + ( i )( f )

EXAMPLE : Present Worth w/ inflation


A honing machine will have a cost of 25,000 (future cost) six years from now. Find the PW of the machine, if the real interest rate is 10% per
year and the inflation rate is 5% per year using (a) constant-value , and (b) future amount.

6
Solution : a) Determine constant-value and use i in PW equation CV = 25,000 / (1 + 0.05) = 18,655 PW = 18,655 [(1+i f )-n ] = 10,530
if = 10 %
b)Leave as future dollars and use if in PW equation if = 0.10 + 0.05 + (0.10)(0.05) = 15.5% PW = 25,000 [(1+ i f )-n ] = 10,530
i f = 15.5 %

FW Calculations with Inflation : FW values can have four different interpretations ( FW = future worth )

The actual amount accumulated: Use if in FW equation -------- FW = PW( 1 + if )n


n
The purchasing power in terms of CV of the future amount : Use if in FW equation and divide by (1+f) or use real i where real i = (if f)/(1 + f)
-------- FW = PW( 1 + i )n
The number of future dollars required to have the same purchasing power as a dollar today with no time value of money considered
Use f instead of i in F/P factor FW = PW( 1 + f )n
The amount required to maintain the purchasing power of the present sum and earn a stated real rate of return
Use if in FW equation FW = PW( 1 + if )n
EXAMPLE : FW with inflation

An engineer invests 15,000 in a savings account that pays interest at a real 8% per year. If the inflation rate is 5% per year, determine :
(a) the amount of money that will be accumulated in 10 years,
(b) the purchasing power of the accumulated amount (in terms of todays dollars),
(c) the number of future dollars that will have the same purchasing power as the 15,000 today, and
(d) the amount to maintain purchasing power and earn a real 8% per year return.

SOLUTION : a. ) The amount accumulated is a function of the market interest rate, if if = 0.08 + 0.05 + (0.08)(0.05) = 13.4%
Amount Accumulated = 15,000 ( 1+ 0.134 )10 = 52,750
b.) To find the purchasing power of the accumulated amount deflate the inflated dollars
10
Purchasing power = 15,000( 1+ 0.134 )10 / (1 + 0.05) = 32,384
c.) The number of future dollars required to purchase goods that cost 15,000 now is the inflated cost of the goods
Number of future dollars = 15,000 ( 1+ 0.05 )10 = 24,434

d.) In order to maintain purchasing power and earn a real return, money must grow by the inflation rate and the interest rate, or if = 13.4%, as in
part (a ) FW = 15,000( 1+ 0.134 )10 = 52,750

Capital Recovery with Inflation :

EXAMPLE : If a small company invests 150,000 in a new production line machine, how much must it receive each year to recover the investment in 5
years? The real interest rate is 10% and the inflation rate is 4% per year.

Solution: Capital recovery (CR) is the AW value


if = 0.10 + 0.04 + (0.10)(0.04) = 14.4% CR = AW = 150,000(A/P,14.4%,5) = 150,000 [ i / 1 (1 + i )-n ] = 150,000 [ 0.144 / 1-(1.144 )-5 ]
= 44,115 per year
COMPARING ALTERNATIVES

ECONOMY STUDIES METHODS

RATE OF RETURN METHOD ( ROR ) = a measure of the effectiveness of an investment of capital.


= a financial effy.

ROR = net annual profit


capital invested

ANNUAL WORTH METHOD ( AW ) = the excess of annual cash inflows over annual cash outflows is not less than 0 the
proposed investment is justified.
PRESENT WORTH METHOD ( PW ) = the PW of the net cash flows is equal to, or greater than, 0, the project is justified
economically.
FUTURE WORTH ( FW ) = exactly comparable to the present worth method except that all cash inflows & outflows are
compounded forward to a reference point n time called the future. If the FW of the net cash flows is
equal to, or greater than, 0 the project is justified economically.
PAYBACK/PAY-OUT PERIOD ( PPP ) = the length of time reqd. to recover the first cost of an investment from the net cash flow
produced by that investment for an int. rate of zero.

PPP ( yrs. ) = investment - salvage value


net annual cash flow

EXAMPLE : LUCIO TAN invested an amt worth 300M for a housing proj. in Palawan that will give him a yearly revenue of 190M for 5 yrs. &
depreciated cost of 10% on his investment. The operation & maint. Cost amounted to 81M annually. Insurances & taxes is @ 4% of its first
cost per year. He expects his investment to earn not less 25 % before income taxes. Det. whether the investment is desirable ? What is the
payback period ?