ENGINEERING ECONOMICS 2020

LESSON 05: PERPETUITY, CAPITALIZED COST,

AMORTIZATION, UNIFORM ARITHMETIC
GRADIENT

PERPETUITY

A perpetuity is a security that pays for an infinite amount of time. In finance,

perpetuity is a constant stream of identical cash flows with no end. The formula to
calculate the present value of a perpetuity, or security with perpetual cash flows, is as
follows:

1 − (1 + 𝑖) 1 − (1 + 𝑖)
𝑃=𝐴 =𝐴
𝑖 𝑖

𝑨
𝑷=
𝒊
ILLUSTRATIVE PROBLEM

What amount of money invested today at 15% interest can provide the
following scholarships: Php 30, 000 at the end of each year for 6 years; Php 40, 000 for
the next 6 years and Php 50, 000 thereafter?

(1 + 𝑖) − 1
𝑃=𝐴
𝑖(1 + 𝑖)

(1 + 𝑖) − 1
𝑃=𝐴 (1 + 𝑖)
𝑖(1 + 𝑖)

𝐴
𝑃=
𝑖

(1 + 0.15) − 1 (1 + 0.15) − 1 50, 000

𝑃 = 30, 000 + 40, 000 (1 + 0.15) + (1 + 0.15)
0.15(1 + 0.15) 0.15(1 + 0.15) 0.15

𝑷 = 𝑷𝒉𝒑 𝟐𝟒𝟏, 𝟐𝟖𝟐. 𝟑𝟏𝟔

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.

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Capitalized cost = First cost + Present worth of perpetual operation and/or

maintenance.

ILLUSTRATIVE PROBLEM

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%.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑃

150, 000
𝑃=
0.15

𝑃 = 𝑃ℎ𝑝 1, 000, 000

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑃ℎ𝑝 1, 500, 000 + 𝑃ℎ𝑝 1, 000, 000

𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝒄𝒐𝒔𝒕 = 𝑷𝒉𝒑 𝟐, 𝟓𝟎𝟎, 𝟎𝟎𝟎. 𝟎𝟎

Case 2. Replacement only, no maintenance or operation.

Capitalized cost = First cost + Present worth of perpetual replacement.

Let S = amount needed to replace a property every k period

X = amount of principal invested at rate i% the interest on which will
amount to S every k periods
Xi = interest on X every period, the periodic deposit towards the
accumulation of S

𝑆
𝑋=
(1 + 𝑖) − 1

Difference between P and X in a perpetuity.

P is the amount invested now at i% per period whose interest at the end of
every period forever is A while X is the amount invested now at i% per period whose
interest at the end of every k periods forever is S. if k=1, then, X=P.

ILLUSTRATIVE PROBLEM

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 useful life, it is estimated to
have a salvage of Php 30, 000. Determine its capitalized cost if interest is 18%
compounded annually.

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Cash flow for diagram for the engine

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑋

𝑆
𝑋=
(1 + 𝑖) − 1

270 000
𝑋=
(1 + 0.18) − 1

𝑋 = 𝑃ℎ𝑝 24, 604.173

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 300 000 + 24, 604.173

𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝒄𝒐𝒔𝒕 = 𝑷𝒉𝒑 𝟑𝟐𝟒, 𝟔𝟎𝟒. 𝟏𝟕𝟑

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Case 3. Replacement, maintenance, and/or operation every period.

Capitalized cost = First cost + Present worth of perpetual operation and/or

maintenance + Present worth of cost of perpetual replacement.

ILLUSTRATIVE PROBLEM

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?

Let Q be the present worth of perpetual operation and X the present worth of
perpetual replacement.

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡 + 𝑄 + 𝑋

(1 + 𝑖) − 1
𝑃=𝐴
𝑖(1 + 𝑖)

𝐴
𝑃= (1 + 𝑖)
𝑖

𝑆
𝑋=
(1 + 𝑖) − 1

(1 + 𝑖) − 1 𝐴
𝑄=𝐴 + (1 + 𝑖)
𝑖(1 + 𝑖) 𝑖

(1 + 0.12) − 1 120 000

𝑄 = 100 000 + (1 + 0.12)
0.12(1 + 0.12) 0.12

𝑄 = 𝑃ℎ𝑝 917, 771.8535

500 000
𝑋=
(1 + 0.12) − 1

𝑋 = 𝑃ℎ𝑝 655, 873.8831

𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 = 5, 000, 000 + 655, 873.8831 + 917, 771.8535

𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝒄𝒐𝒔𝒕 = 𝑷𝒉𝒑 𝟔, 𝟓𝟕𝟑, 𝟔𝟒𝟓. 𝟕𝟑𝟕

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AMORTIZATION

Amortization refers to the act of paying off a debt through scheduled, pre-
determined smaller payments. In almost every area where the term amortization is
applicable, these payments are made in the form of principal and interest. The
payments are done usually by a series of equal payments at equal interval of time.

ILLUSTRATIVE PROBLEM

A debt of Php 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.

12
𝑖= = 6%
2

𝑖(1 + 𝑖)
𝐴=𝑃
(1 + 𝑖) − 1

0.06(1 + 0.06)
𝐴 = 5000
(1 + 0.06) − 1

𝑨 = 𝑷𝒉𝒑 𝟏, 𝟎𝟏𝟔. 𝟖𝟐

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Amortization Schedule

Period Outstanding principal Interest Due at Payment (Php) Principal

at the beginning of the end of repaid at end
period (Php) period (Php) of period
(Php)
1 5, 000.00 300.00 1, 016.82 716.82
2 4, 283. 18 265.99 1, 016.82 756.83
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
TOTAL 1, 100.87 6, 100.92 5, 000.05

UNIFORM ARITHMETIC GRADIENT

In certain cases, economic analysis problems involve receipts or

disbursements that increase or decrease by a uniform amount each period. For
example, maintenance and repair expenses on specific equipment or property may
increase by a relatively constant amount each period. This is known as a uniform
arithmetic gradient.

Suppose that the maintenance expense on a certain machine is Php 1000.00

at the end of the first year and increasing at a constant rate of Php 500 each year
for the next four years.

Cash flow for the given situation

The cash flow above can be resolved into two components

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G is known as the uniform gradient amount

𝑃 =𝑃 +𝑃

(𝟏 + 𝒊)𝒏 − 𝟏 𝑃
𝑷=𝑨 𝑜𝑟 𝐴 , 𝑖%, 𝑛
𝒊(𝟏 + 𝒊)𝒏 𝐴

( )
𝑃 = 𝐺(1 + 𝑖) + 2𝐺(1 + 𝑖) + 3𝐺(1 + 𝑖) + ⋯ + (𝑛 − 1)(1 + 𝑖)

𝑮 (𝟏 + 𝒊)𝒏 − 𝟏 𝟏 𝑃
𝑷𝑮 = −𝒏 𝒏
𝑜𝑟 𝐺 , 𝑖%, 𝑛
𝒊 𝒊 (𝟏 + 𝒊) 𝐺

𝑮 (𝟏 𝒊)𝒏 𝟏 𝟏
𝒊 𝒊
−𝒏 (𝟏 𝒊)𝒏
this factor is called the gradient to present worth conversion
factor, thus

(𝟏 + 𝒊)𝒏 − 𝟏 𝑮 (𝟏 + 𝒊)𝒏 − 𝟏 𝟏
𝑷=𝑨 𝒏
+ −𝒏
𝒊(𝟏 + 𝒊) 𝒊 𝒊 (𝟏 + 𝒊)𝒏
Or
𝑃 𝑃
𝑃 = 𝐴 , 𝑖%, 𝑛 + 𝐺 , 𝑖%, 𝑛
𝐴 𝐺

ILUSTRATIVE PROBLEM

1. 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 Php 5, 000.00 and the difference between successive payments
was to be Php 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?

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A = Php 5000
G = Php 400
n=4
i= 15%

(1 + 0.15) − 1 400 (1 + 0.15) − 1 1

𝑃 = 5 000 + −4
0.15(1 + 0.15) 0.15 0.15 (1 + 0.15)

𝑃 = 𝑃ℎ𝑝 15, 789.466

𝑖(1 + 𝑖)
𝐴=𝑃
(1 + 𝑖) − 1

0.15(1 + 0.15)
𝐴 = 15, 789.466
(1 + 0.15) − 1

𝑨 = 𝑷𝒉𝒑 𝟓, 𝟓𝟑𝟎. 𝟓𝟎𝟑

2. Find the equivalent annual payment of the following obligations at 20%

interest.
End of Payment (Php)
Year
1 8, 000
2 7, 000
3 6, 000
4 5, 000

Solution:

Cash flow diagram

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A = Php 8000
G = Php 1000
n=4
i= 20%

(1 + 𝑖) − 1 𝐺 (1 + 𝑖) − 1 1
𝑃=𝐴 + −𝑛
𝑖(1 + 𝑖) 𝑖 𝑖 (1 + 𝑖)

(1 + 0.2) − 1 1000 (1 + 0.2) − 1 1

𝑃 = 8 000 − −4
0.2(1 + 0.2) 0.2 0.2 (1 + 0.2)

𝑃 = 𝑃ℎ𝑝 17, 411.265

𝑖(1 + 𝑖)
𝐴=𝑃
(1 + 𝑖) − 1

0.2(1 + 0.2)
𝐴 = 17, 411.265
(1 + 0.2) − 1

𝑨 = 𝑷𝒉𝒑 𝟔, 𝟕𝟐𝟓. 𝟕𝟖𝟐

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EXERCISES 06
Direction: Solve the following problems. Show complete and neat solution. Show
illustrations (cash flow diagrams) if necessary.

1. Calculate the capitalized cost of a project that has an initial cost of Php 3,
000, 000 and an additional investment cost of Php 1, 000, 000 at the end of
every ten years. The annual operating cost will be Php 100, 000 at the end of
every year for the first four years and Php 160, 000 thereafter. In addition,
there is expected to be recurring major rework cost of Php 300, 000 every 13
years. Assume i = 15%. (Ans. Php 4, 281, 935.961)

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2. The COE Company is building a new plant, whose equipment maintenance

costs are expected to be Php 25, 000 the first year, Php 7, 500 the second
year, Php 10, 000 the third year, Php 12, 500 the fourth year, etc., increasing
by Php 2, 500 per year through the 10th year. Assuming the interest rate is 8%,
compounded annually, how much should the company plan to set aside
now in order to pay the maintenance? (Php 117, 011.00)

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