ANNUITIES AND

CAPITALIZED COST

Learning Objectives:

At the end of this chapter, students should be able to understand the

following:
- Annuity and Amortization

- Types of Annuities

- Arithmetic and Geometric Gradients

4
- Bond Value and Capitalized Cost
TABLE OF CONTENTS
Table of Contents .................................................................................... 2
1 Definitions ........................................................................................ 3
2 Types of Annuity ................................................................................ 3
2.1 Ordinary Annuity ......................................................................... 3
2.2 Deferred Annuity ......................................................................... 4
2.3 Annuity Due ............................................................................... 4
2.4 Perpetuity .................................................................................. 5
2.5 Sample Problems......................................................................... 5
3 Capitalized Cost ................................................................................. 6
3.1 Sample Problems......................................................................... 6
4 Gradients ......................................................................................... 7
4.1 Arithmetic Gradient...................................................................... 7
4.2 Geometric Gradient...................................................................... 7
4.3 Sample Problems......................................................................... 7
1 DEFINITIONS
annuity – it is a series of equal payments occurring at equal interval of time.

amortization – a method of paying debt including the principal and interest which
is done in a series of equal payments occurring at equal interval of time.

2 TYPES OF ANNUITY
In engineering economy, annuities help analyze financial decisions involving
recurring costs or revenues.

Engineers use annuities in project evaluation, equipment purchases, loan

repayment, and investment analysis.

2.1 ORDINARY ANNUITY

An annuity when payments or amortization are made at the end of each period.

Consider the CFD,

To find , use as the focal date:

= + (1 + ) + + (1 + ) + + (1 + ) + + (1 + ) + ⋯ + (1 + ) + (1 + )

= [1 + (1 + ) + (1 + ) + (1 + ) + ⋯ + (1 + ) + (1 + ) ]

The part inside the brackets is a geometric series, therefore, to get the sum:
−1
=
−1
where:

= sum of geometric series

= first term

= common ration
 = number of terms
∴ = 1, = (1 + ), −
(1 + ) − 1
=1
1+ −1
(1 + ) − 1
=

= ×
( + ) −
=

and for , from

= (1 + )
(1 + ) − 1
= (1 + )

( + ) −
=
( + )
( ) ( )
In = , the factor is called “uniform series compound factor”
( / , %, ) → F given A at % in interest periods.

= ( / , %, )
( ) ( )
In = ( )
, the factor ( )
is called the “uniform series present worth
factor” ( / , %, ) → P given A at i% in interest periods
= ( / , %, )

Also, in = ( )
, the factor ( )
is called the “sinking fund factor”
( / , %, ) → A given F at i% in interest periods
= ( / , %, )
( ) ( )
And in = ( )
, the factor ( )
is called the “capital recovery factor”
( / , %, ) → A given P at i& in interest periods
= ( / , %, )

2.2 DEFERRED ANNUITY

A type of annuity where payments are made several periods after the annuity
has started

2.3 ANNUITY DUE

A type of annuity where payments started at the beginning of the annuity
periods
2.4 PERPETUITY
A type of annuity where payments are made indefinitely or forever.

2.5 SAMPLE PROBLEMS

1. What is the accumulated amount of the five-year annuity paying ₱6,000 at
the end of each year, with interest at 15% compounded annually?
Solution:
Given:
= ₱6,000
=?
= 15% Annually

(1 + ) − 1 (1 + 0.15) − 1
= = 6000
0.15
= ₱4 , .

2. A businessman borrowed ₱10,000.00 with interest at the rate of 5%

payable annually. The debt will be paid, principal and interest included by
equal installment at the end of each year for 3 years. Compute the annual
payment.

Solution:
Given:
= 10,000
= 5%
=?
= ( / , %, )
( + ) 0.05(1.05)
= = 10000
(1 + ) − 1 (1.05) − 1
=₱ , .

3. An investment of ₱350,000 is made to be followed by revenue of ₱200,000

each year for 3 years. What is most nearly the annual rate of return on
investment for this project?
Solution:
= 350000
(1 + ) − 1
= 350000
(1 + )
(1 + ) − 1
200000 = 350000
(1 + )
= 0.32675160636 ≈ 32.6752%
 4. A man loans ₱187,400 from a bank with interest at 5% compounded
annually. He agrees to pay his obligations by paying 8 equal payments, the
first being due at the end of 10 years. Find the annual payments.
5. What present sum would be needed to provide for annual end of year
payments of ₱150,000 each forever at an interest of 8%?
6. What amount of money deposited 50 years ago at 8% interest would now
provide a perpetual payment of ₱10,000 per year?
7. A man borrows ₱100,000 at 10% effective annual interest. He must pay
back the loan over 30 years with uniform monthly payments due on the
first day of each month. What amount does the man pay each month?
8. A student needs ₱4,000 per year for four years to attend college. Her father
invested ₱5,000 in a 7% account for her education when she was born. If
the student withdraws ₱4,000 at the end of her 17th, 18th, 19th and 20th
years, how much money will be left in the account at the end of her 21st
year?
9. A farmer buys a tractor. There will be no maintenance cost the 1st year as
the tractor is sold with one-year free maintenance. The 2nd year the
maintenance is estimated at ₱2000. In the subsequent years, the
maintenance cost will increase by ₱2000 per year. How much would need
to be set aside now at 5% interest to pay the maintenance cost on the
tractor for the first 6 years of ownership.

3 CAPITALIZED COST
It is the sum of the first cost (FC or Co) and the present worth of perpetual annual
maintenance and operational cost (MC), cost of repair (CR) at interval yrs, and
renewal cost (RC) at the end-of-life yrs.

= + + +
( + ) − ( + ) −

3.1 SAMPLE PROBLEMS

1. A machine costs ₱80,000 and with a salvage value of ₱20,000 at the end
of useful life of 20 years. The annual operating costs is ₱18,000. Find the
capitalized cost of the machine at an interest rate of 10% per annum.
2. A dam was constructed for ₱200,000. The annual maintenance cost is
₱5,000. Find the capitalized cost of the dam at an interest rate of 5% per
annum.
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 its useful life, it is
estimated to have a salvage value of ₱30,000. Determine its capitalized
cost if interest is 18% compounded annually?
4 GRADIENTS

4.1 ARITHMETIC GRADIENT

A series of payment with common difference and occurring at equal interval of time

= +
(1 + ) − 1
=

(1 + ) − 1
= −

(1 + ) − 1 (1 + ) − 1
F= + −

4.2 GEOMETRIC GRADIENT

series of payment with common ratio and occurring at equal interval of time
1−
=
1+ 1−
1+
=
1+
= % change in payments

1 + = common ratio

If =

=
1+

4.3 SAMPLE PROBLEMS

1. A farmer buys a tractor. There will be no maintenance cost the 1st year as the tractor is sold
with one-year free maintenance. The 2nd year maintenance is estimated at ₱2000. In the
subsequent years, the maintenance cost will increase by ₱2000 per year. How much would
need to be set aside now at 5% interest to pay the maintenance cost on the tractor for the
first 6 years of ownership?
2. Find the equivalent annual payment of the following obligations at 20% interest.

End of Year Payment

1 ₱ 8,000
2 ₱ 7,000
3 ₱ 6,000
 4 ₱ 5,000

3. A young man has decided to go into business at age 40. He wishes to accumulate ₱200,000 at
that age. On his 25th birthday, he deposits a certain amount and will increase the deposit by
10% each year until the 40th year. If the fund can be invested at 9.6% compounded annually,
how much should his financial investment be?
4. A ₱1 million debt is to be paid in 4 installments, the next payment being 20% larger than the
preceding. If money is worth 10% and the first payment is made 3 years after the debt has
been granted, compute the first payment during the third year.