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IE 307 Engineering Economy 2015-2016; Summer

Annuity & Capitalized Cost


Engr. Justiniano B. Menes Jr.

Annuity (A)
Series of equal payments made at equal intervals of time. Instances where annuities occur:
i. Payment of a debt by a series of equal payments at equal intervals of time.
ii. Accumulation of certain amount by setting equal amoun periodically.
iii. Substitution of a series of equal amounts periodically in lieu of a lump sum.

Classifications of Annuity:
i. Simple annuity – payment period is the same as the interest period. If the payment is made
monthly then the conversion of money also occurs monthly.
ii. General Annuity – Payment period is not the same as the interest period however it can be
converted to simple annuity by making the payment period the same as the compounding
period by concept of effective rates.

Types of Annuities:
i. Ordinary annuity – one where the equal paymentd are made at the end of each payment
period starting from the first period.
ii. Deferred Annuity – is one where the payment of the first amount is deferred a certain
number of periods after the first.
iii. Annuity Due – one where the payments are made at the start of each period, beginning
from the first period.
iv. Perpetuity – annuity where the payment periods extend to forever or in which the priodic
payments continue indefinitely.

ORDINARY ANNUITY
In ordinary annuity, the equal payments are made at the end of each compounding period
starting from the first compounding period. Four essential elements of ordinary annuity:
1. Amounts of all paymnts are equal
2. Payments are made at equal intervals of time.
3. First payment is made at the end of the first periodand all payments thereafter are made at
the end of the corresponding period.
4. Compound interest is paid on all amounts in the annuity.

Characteristics of ordinary annuity:


1. P – present equivalent value, occurs one interest period before the first A (uniform amount)
2. F – future equivalent value, oocurs at the same time as the last A and n intervals after P
3. A – annual equivalent value, occurs at the end of each period.

Annuity is based on the principles of compound interest. Hence, computation of the sum of
annuity may be done using the formula of geomtric progression. Solving for the common ratio (r):
r = a2/a1 = A(1+i)/A = (1 + i)
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

Finding F when A is given:


a1 (r n − 1) A((1 + i)n − 1) 𝐀((𝟏 + 𝐢)𝐧 − 𝟏)
S= = = =𝐅
r−1 (1 + i) − 1 𝐢

(𝟏+𝐢)𝐧 −𝟏
where: 𝐢
is called uniform series compound amount factor (F/A, i%, n)

Finding P when A is given:

P = A(1+i)-1 + A(1+i)-2 + A(1+i)-3 + ... + A(1+i)-n


P = A[(1+i)-1 + (1+i)-2 + (1+i)-3 + ... + (1+i)-n]

a1 −ban
S= where: a1 = first term = (1+i)-1
1−b
an = last term = (1+i)-n
b = common rate = (1 + i)-1

(1 + 𝑖)−1 − (1 + 𝑖)−1 (1 + 𝑖)𝑛 1 − (1 + 𝑖)−𝑛


S= =
1 − (1 + 𝑖)−1 i

𝟏 − (𝟏 + 𝐢)−𝐧
𝐏 = 𝐀[ ]
𝐢
𝟏−(𝟏+𝐢) −𝐧
where: 𝐢
is called uniform series present worth factor (P/A, i%, n)

Finding A when P or F is given:

𝒊 𝒊
𝐀 = 𝐏[ ] 𝐀 = 𝐅[ ]
𝟏 − (𝟏 + 𝐢)−𝐧 (𝟏 + 𝐢)𝐧 − 𝟏

𝒊
where: 𝟏−(𝟏+𝐢)−𝐧
is called capital recovery factor (A/P, i%, n)
𝒊
(𝟏+𝐢)𝐧 −𝟏
is called sinking fund factor (A/F, i%, n)

Exercises:
1. Determine the present equivalent value of Php 5,000 paid every 3 months for a period of seven
years and rate of interest is 12% compounded quarterly? Php 93,820.40

1 − 1.03−28
𝑃 = 5000 ( ) = 93, 820.40
. 03

2. If Php 25,000 is deposited now into a savings account that earns 6% per year, what uniform
annual amount could be withdrawn at the end of each year for ten years so that nothing would
be left in the account after the 10th withdrawal? Php 3725.74

𝐹𝑢𝑡𝑢𝑟𝑒
1.0610 − 1
25,000(1.06)10 = 𝐴 ( )
. 06
𝑨 = 𝟑𝟑𝟗𝟔. 𝟕𝟎
𝑃𝑟𝑒𝑠𝑒𝑛𝑡
1 − 1.06−10
25000 = 𝐴( )
. 06
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

3. An engineer wants to start a business which requires purchase of a Php 100,000 worth machine
which will produce a net income of Php 11,000 per year after deducting operating expenses. The
engineer plans to put the machine on sale after 4 years, what must be the resale price to justify
the investment if the engineer should make 12% annual return on the investment. Php
104,779.33

4. If you’re planning to franchise a certain food cart business worth Php 150,000, two years from
now but you’re current capital does not meet this requirement. Instead, you’ll make twenty-
four monthly deposits into an account paying 8% nominal interest rate compounded monthly,
how much should the deposit be so that after two years you will be able to avail the franchise?
Php 5784.09

1.0064724 − 1
150,000 = 𝐴 ( )
0.0067
𝑨 = 𝟓𝟕𝟖𝟒. 𝟎𝟗

5. How much money would you have to deposit for five consecutive years starting one year from
now if you want to be able to withdraw Php 50,000 ten years from now? Assume i = 14%
compounded annually. Php 3,928.60

1.145 − 1
50,000 = 𝐴 ( ) (1.14)5
. 14
𝑨 = 𝟑𝟗𝟐𝟖. 𝟔𝟎

6. A corporation will make the following disbursements:


a. Php 50, 000 on December 31, 1991
b. Php 100,000 on December 31, 1992
c. Php 200,000 one December 31, 1993
To accumulate these sums, a singking fund is established by making equal year-end deposits
starting December 31, 1986 up to the end of 1993. If the fund earns 9% interest compounded
annually, what is the required amount of the annual deposit? Php 33, 404.89

1.098 − 1
200𝐾 + 100𝐾(1.09)1 + 50𝐾(1.09)2 = 𝐴 ( )
. 09
𝑨 = 𝟑𝟑, 𝟒𝟎𝟒. 𝟖𝟗
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

DEFERRED ANNUITY
An ordinary annuity where the first cash flow of the series is not at the end of the first period or
it is deferred for sometime.

𝟏 − (𝟏 + 𝐢)−𝐧
𝐏 = 𝐀[ ] [(𝟏 + 𝐢)−𝐤 ]
𝐢

Where: n – number of annuities


k – deferred period (some books used ‘m’ for symbol)
NOTE: In counting the number of deferred period (k or m), count up to the period before the
first A.

Exercises:
1. What lump sum of money must be deposited in a bank account at present time so that Php 500
per monthly can be withdrawn for five years with the first withdrawal scheduled six years from
today? Interest rate is 9% compounded quarterly. Php 14,170.27

. 09 4
(1 + ) − 1 = (1 + 𝑖)12 − 1
4
𝑖 = 7.444442749𝑥10−3
1 − (1 + 𝑖)−60
𝑃 = 500 ( ) (1 + 𝑖)72 = 𝟏𝟒, 𝟏𝟒𝟐. 𝟕𝟕𝟒𝟔𝟕
𝑖

2. A man invested Php 10,000 now for the college education of his three-year old son. If the fund
earns 14% effective, how much will the son get each year starting from 19th to 22nd birthday?

1.144 − 1
10𝑘(1.14)20 = 𝐴 ( )
. 14
𝑨 = 𝟐𝟕, 𝟗𝟐𝟕. 𝟒𝟑

3. During the first ten years of the life of a certain machine, the following were spent for its
maintenance:
During the first 5 years, Php 3,000 was spent each year; during the second five years, Php 5,000
each year was spent. In addition, Php 8,000 was spent for overhauling at the end of the fourth
year and Php 10,000 also for averhauling at the end of the ninth year.
If money is worth 9% compounded annually, what was the equivalent uniform annual cost for
the ten-year period? Php 5388.36
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

ANNUITY DUE
Series of uniform cash flows that occur at the beginning of each period.

𝟏 − (𝟏 + 𝐢)−(𝐧−𝟏) 𝟏 − (𝟏 + 𝐢)−(𝐧−𝟏)
𝐏 = 𝐀[ ] + 𝐀𝟎 = 𝐀 [ + 𝟏]
𝐢 𝐢

(𝟏 + 𝐢)𝐧+𝟏 − 𝟏
𝐅 = 𝐀[ − 𝟏]
𝐢

Exercises:
1. A farmer bought a tractor costing Php 25,000 payable in ten semi-annual payments, each
installment payable at the beginning of each period. If the rate of interest is 26% compounded
semi-annually, determine the amount of each installment. Php 4077.20

1 − 1.13−10
25,000 = 𝐴 ( ) (1.13)
. 13
𝑨 = 𝟒𝟎𝟕𝟕. 𝟐

2. A certain manufacturing plant is being sold and was submitted for bidding. Two bids were
submitted by intrsted buyrs. The first bid offered to pay Php 200,000 each year for 5 years, each
payment being made at the beginning of each year. The second bidder offered to pay Php
120,000 the first year, Php 180,000 the second year and Php 270,000 each year for the next 3
years, all payments being made at the beginning of each year. If money is 12% compounded
annually, which bid should the owner consider?
𝑓𝑖𝑟𝑠𝑡 𝑏𝑖𝑑:
1 − 1.12−5
𝑃 = 200𝐾 ( ) = 807 469.87
. 12
𝑠𝑒𝑐𝑜𝑛𝑑 𝑏𝑖𝑑:
1 − 1.12−2
𝑃 = 120 + 180(1.12)−1 + 270( )
. 12
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

3. As rental for a building, the owner received two offers:


a. Php 50,000 a year for eight years, the rental for each year being paid at the start of each
year.
b. Php 30,000 the first year, Php 40,000 the second year, Php 50,000 the third year and
Php 60,000 for the next five years with rentals paid at the beginning of ach year
If money is worth 12% effective, which is better offer?
Better offer A, P=278 187.83

4. 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 5
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?
Php 79, 245

5. A man wishes to provide a fund for his retirement such that from his 60th to 70th birthdays he
will be able to withdraw equal sums of P18, 000 for his yearly expenses. He invests equal
amount for his 41st to 59th birthdays in a fund earning 10% compounded annually. How much
should each of these amounts be? Php 2285

PERPETUITY
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

It is a series of uniform cash flows where they extend for a long time or forever.

From the formula of present worth of an ordinary annuity,


𝟏 − (𝟏 + 𝐢)−𝐧
𝐏 = 𝐀[ ]
𝐢
The expression (1 + i)-n approaches to zero when n approaches to infinity. Thus, the present
worth of a perpetuity becomes:
𝐀
𝐏= [ ]
𝐢

Capitalized Cost (CC)


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 allcosts of replacement, operation
and maintenane for along time or forever.
Cases of capitalized cost:
CASE 1: No replacement, only costs of maintenance and/or operation every period
CC = FC + PO&M
Where: CC = capitalized Cost
FC = forst cost (initial investment)
PO&M = Present worth of all perpetual operation and maintenance costs
PO&M = A/i
A = periodic operation and maintenance costs

Example:
1. Determine the capitalized cost of a structure that requires an initial investment of Php 1,500,000
and an annual maintenance of php 150,000. Interest is 15%. Php. 2,500,000.00

2. To maintain a bridge, Php 5,000 will be required at the end of 3 years and annually thereafter. If
money is worth 8%, determine the capitalized cost of all future maintenance. Php 53,583.68

CASE 2: Replacement only, no maintenance and/or replacement costs


IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

CC = FC + PR
Where: PR = Present worth of perpetual replacement costs
Let: S = amount needed to replace a property every k period
S = FC – SV
SV – Salvage value (worth of property at the end of its useful life);
Scrap value (worth of the property if disposed-off as a junk)
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

k-1 k

Xi Xi Xi Xi Xi Xi
(1+i)k −1 S i
S = Xi [ i
] X= i
[(1+i)k−1]

𝐒
𝐗 = 𝐏𝐑 = [ ]
(𝟏 + 𝐢)𝐤 − 𝟏

Examples:
1. A manufacturing plant installed a new boiler at a total cost of Php 150,000 and is estimated to
have a useful life of 10 years. It is estimated to have a scrap value at the end of the useful life
Php 5,000. If interest is 12% compounded annually, determine its capitalized cost. Php
218,855.87

2. A new engine was installed by a textile plant at a cost of Php 300,000 and projected to have a
useful life of 15 years. At the end of its ueful life, it is estimated to have a salvage value of Php
30,000. Determine its capitalized cost if interest rate is 18% compounded annually. Php 324,604

CASE 3: Replacement, Maintenance and/or operation every period


IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

CC = FC + PO&M + PR

Examples:
1. Determine the capitalized cost of a research laboratory which requires Php 5,000,000
for original construction, Php 100,000 at the end of every year for the first 6 years and
then Php 120,000 each year thereafter for operating expenses and Php 500, 000 every 5
years for replacement of equipment with interest at 12% per annum? Php 6,753,650

2. Calculate the capitalized cost of a project that has an initial cost of P3, 000,000 and an
additional cost of P100, 000 at the end of every 10 yrs. The annual operating costs will
be P100, 000 at the end of every year for the first 4 years and P160, 000 thereafter. In
addition, there is expected to be recurring major rework cost of P300, 000 every 13 yrs.
Assume i =15%. Php 4,281,934.994

Problem Set:
IE 307 Engineering Economy 2015-2016; Summer
Annuity & Capitalized Cost
Engr. Justiniano B. Menes Jr.

1. Mr. J. de la Cruz borrowed money from a bank. He received from the bank P1, 342 and promises
to repay P1, 500 at the end of 9 months. Determine the simple interest rate and the
corresponding discount rate or often referred to as the “Banker’s discount. 10.53%, 11.77%
2. A man deposits P50, 000 in a bank account at 6% compounded monthly for 5 years. If the
inflation rate of 6.5% per year continues for this period, will this effectively protect the
purchasing power of the original principal? P49, 225.00
3. What is the future worth of P600 deposited at the end of every month for 4 years if the interest
is 12% compounded quarterly? P36, 641.32
4. A man planned to build a house. The cost of property and construction is Php 2,000,000 with the
salvage value of Php 400,000 after the life of 10 years. The cost of maintenance is Php 50,000
per year. If the interest rate is 6%, what is the capitalized cost of the house?
5. Choose from the two machines, which is more economical, if money is worth at least 16%.

6. A house and lot was offered for Php87,000 with a 10% down payment and a monthly payment
of Php500 per month for 25 years. What is the monthly interest rate and effective rate?
7. A father wishes to provide Php400,000 for his son’s 21st birthday. How much should he deposit
every 6 months in a savings bank which pays 3% compounded semi-annually, if first deposit is
made when the son is 3½ years old?

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