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 answer the following questions and

write your answers on the space provided and submit your
work in our Google Classroom Under Diagnostic Test M2.3

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[ ] = A[ ]
𝒊 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 ]
𝒊 𝒊 −𝟏

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) + (P/F, 15%, 12)
0.15

𝟏 − (𝟏.𝟏𝟓 )−𝟔 𝟏 − (𝟏.𝟏𝟓 )−𝟔 ₱50,000

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

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
= = ₱1,000,000
𝑖 0.15

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+𝟎.𝟏𝟖 )𝟏𝟓 = ₱24,604
−𝟏 −𝟏

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

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

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

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 = [ ] = 2.8550
𝟎.𝟏𝟓

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

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. Final answers are provided at the end of each problem to
serve as your guide. Submit your work in our Google Classroom under classwork Assignment
M2.3
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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 Write your answers in a short bond paper and submit your work in our Google Classroom
under classwork Quiz Assignment M2.

1. You borrow $5000 from a family member and agree to pay it back in 5 months.
Because you are part of the family, you are only being charged an interest at the rate
of 0.5% per month. How much will you owe after 6 months? How much is the interest?
What is the effective interest rate? What is the corresponding nominal rate?

2. What lump sum amount of interest will be paid on a P100,000 loan that was made on
August 1, 1993, and repaid on November 1, 1999, with ordinary simple interest at 12%
per year?

3. A woman arranges to repay a P10,000 bank loan in 10 equal payments at a 10%

effective annual interest rate. Immediately after her third payment she borrows
another P5000, also at 10%. When she borrows the P5,000, she talks the banker into
letting her repay the remaining debt of the first loan and the entire amount of the
second loan in 12 equal annual payments. The first of these 12 payments would be
made 1 year after she receives the P5,000. Compute the amount of each of the 12
payments.

4. Your rich uncle has just offered you to make you wealthy! For every amount you save
in an insured bank account during the next 10 years, he will give you the total amount
(excluding interest) that you saved to match it. Because your modest income permits
you to save P2,000 per month for the next 10 years, your uncle will be willing to give
you 240,000 at the end of the 10th year. If you desire a total of P1,00,000 10 years from
now, what effective interest rate would you have to earn on your insured bank
account to make your goal possible?

5. 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?
6. 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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