ENGINEERING ECONOMY

INTEREST AND MONEY-TIME RELATIONSHIPS

PERPETUITIES & CAPITALIZED COST

Engr. Armando C. Emata

December 3, 2013

TOPIC OBJECTIVES:
Board work on Nov 28 and Dec 3 assignments Familiarize with another form of annuity the Perpetuity Solve sample problem on Perpetuity Be introduced to a key learning in succeeding Economy studies where perpetuity is applied the Capitalized Cost Learn the tree types of Capitalized Cost Solve sample problems on capitalized Cost Assignment for next meeting

PERPETUITY

Another type of annuity of interest to the engineer, known as a perpetuity, is a uniform series in which the payments continue indefinitely. If there exists a present or principal amount P pesos and this earns interest at the rate of i% per period, then the end of period perpetual payment, A pesos, (like interest earned) which can be made from this principal is A=Pxi One can then convert this equation to show that the present worth of a perpetuity of payments of A can be found as P=A/i The P in this equation is often spoken of as the capitalized value or capitalized cost of A.

PERPETUITY

A perpetuity is an annuity in which the payments continue indefinitely.

P

n -> inf.

Cash flow diagram to find P given A

-n 1 (1+i) i = A ---------------

1 (1+i)- inf. i = A ------------------

A P i = ---(2-32)

PERPETUITY

PROBLEM: What amount of money invested today at 15% interest can provide the following scholarships: PHP30,000 at the end of each year for 6 years, PHP40,000 for the next 6 years and PHP50,000 thereafter? Solution: P50,000 P50,000
------------------ (P/F, 15%, 12) 0.15 -----------------0.15
P30,000(P/A, 15%, 6)(P/F, 15%, 6) P40,000(P/A, 15%, 6)

P50k
P30,000(P/A, 15%, 6)

P50k

P40k

P40k

P40k

P30k

P30k

P30k

12

13

14

PERPETUITY
Using today as the focal date, the equation of value is P = P30,000(P/A, 15%, 6) + P40,000(P/A, 15%, 6)(P/F, 15%, 6) P50,000 0.15 (P/F, 15%, 12) + -----------= P30,000(3.7845) + P40,000(3.7845)(0.4323) P50,000 0.15 (0.1869) + ----------P = PHP241,277

CAPITALIZED COST

In providing for the perpetual care for some structure or the maintenance of endowed foundations we often encounter a special type of perpetuity. A certain amount S may be needed every k periods to provide for replacement or maintenance. The owner or founder wishes to provide a fund of sufficient size so that the earnings from it will provide for this periodic demand. To be available perpetually, S must be accumulated in k periods from the interest I that is earned by some amount of principal X, invested at rate i. Thus periodic deposit toward this accumulation will be Xi. And X can be computed through the relationship S = IS (F/A, i%, 1 k) = Xi S (F/A, i%, k) i (F/A, i%, k) i X = ----- x --------------- = ------ x (A/F, i%, k)

and

CAPITALIZED COST

Another rationale for computing X in this circumstance is to reason as follows: What principal amount X, when compounded at i% per period for k periods, will at the end of the kth period equal the S needed plus X to be available for accumulating interest to provide the next S payments? Algebraically, this can be stated as X(F/P, i%, k) = S + X Thus, S [(F/P, i%, k) 1] X = ---------------------------

CAPITALIZED COST
If the first cost of the project is added to X, the sum is known as the capitalized cost. Thus, the capitalized cost of an article is the amount of sufficient size to purchase the article and also to provide for its perpetual maintenance. Specifically, it 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. Examples:
Permanent structures like parks, monuments an other landmarks (Luneta in Manila, Central Park in NY, Statue of Liberty in NY, Burnham Park in Baguio) Buildings (Manila City Hall, Central Bank in Manila, Araneta Coliseum in Q.C.) Factories and similar facilities (Philippine Match Co, in Manila, Kimberly Clark in Laguna) most of these large facilities have already shutdown and left however.

CAPITALIZED COST

CASE 1. No replacement, only maintenance and/or operation every period. Capitalized cost = First cost + Present worth of perpetual operation and or maintenance CASE 1 SAMPLE PROBLEM: Determine the capitalized cost of a structure that requires an initial investment of PHP1,500,000 and an annual maintenance of PHP150,000. Interest is 15%
P150,000 P150,000

CAPITALIZED COST

CASE 1 SAMPLE PROBLEM contd:

A P150,000 P = ---- = --------------- = PHP1,000,000 i 0.15

Capitalized cost = First cost + P = P1,500,000 + P1,000,000 = PHP2,500,000

CAPITALIZED COST

CASE 2. Replacement only, no maintenance and/or operation. Capitalized cost = First cost + Present worth of perpetual replacements Let S = amount needed to replace a property every k periods X = amount of principal invested at rate i% the interest S on which will amount to S every k period Xi = interest on X every period, the periodic deposit 0 1 2 3 k1 k towards the accumulation of S
Xi
Xi Xi Xi

Xi

Cash flow diagram to find X given S

CAPITALIZED COST

CASE 2 contd... S = Xi (F/A, i%, k) S 1 S i X = ---- --------------- = ---- -----------------k i F/A, i%, k i (1+i) 1 S X = ---------------k (1+i) 1

(2-33)

CAPITALIZED COST

CASE 2 contd... Difference between P and X in a perpetuity

A A A S S S

2k

3k

A P = ---i

S X = ---------------k (1+i) 1

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 period is S. If k=1, then, X=P.

CAPITALIZED COST

CASE 2 contd... CASE 2 SAMPLE PROBLEM: A new engine was installed by a textile plant at a cost of PHP300,000 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 PHP30,000. Determine its capitalized cost if interest is 18% compounded annually. Solution:
P30,000 P30,000 P30,000

15

30

45

P300,000

P300,000

P300,000

P300,000

Cash flow diagram for the engine

CAPITALIZED COST

CASE 2 SAMPLE PROBLEM contd...

P270,000 P270,000 P270,000

15

30

45

S P270,000 X = --------------= -------------------= PHP24,604 k 15 (1+i) 1 (1+0.18) 1 = First cost + X = P300,000 + = PHP324,604

Capitalized cost P24,604

CAPITALIZED COST

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 CASE 3 SAMPLE PROBLEM: Determine the capitalized cost of a research laboratory which requires PHP5,000,000 for original construction; PHP100,000 at the end of every year for the first 6 years and then PHP120,000 each year thereafter for operating expenses; and PHP500,000 every 5 years for replacement of equipment with interest at 12% per annum.

CAPITALIZED COST

CASE 3 SAMPLE PROBLEM contd: Solution: Operation:

P120,000 ----------------(P/F, 12%, 6) 0.12 P120,000 ---------------0.12

P100,000(P/A, 12%, 6) P100,00 0 P100,00 0 P100,00 0 P100,00 0 P100,00 0 P100,00 0

P120,00 0

P120,00 0

P120,00 0

CAPITALIZED COST

CASE 3 SAMPLE PROBLEM contd: Let Q = the present worth of cost of perpetual operation P120,000 Q = P100,000(P/A, 12%, 6) + -------------- (P/F, 0.12 12%, 6) P120,000 0.12 = P100,000(4.1114) + ------------(0.5066) Q = PHP917,740

CAPITALIZED COST

CASE 3 SAMPLE PROBLEM contd:

P500,00 0 P500,00 0 P500,00 0

10

15

Let X = the present worth of cost of perpetual replacement

X

S P500,000 X = -------------= ------------------= P655,910 k (1+i) 1 (1+0.12) 1

Capitalized cost = First cost + Q + X = P5,000,000 + P917,740 + P655,910 = PHP6,753,650

Assignment Dec 5, 2013

For next meeting, submit in one sheet of bond paper. Write your name, subject/section, date and write the problem statement. Please write legibly. Non-compliance will mean non-acceptance of your assignment.

Calculate the capitalized cost of an infrastructure project that has an estimated initial cost of $14,000,000 and an additional investment cost of $3,000,000 at the end of every ten years. The annual operating cost will be $200,000 at the end of every year for the first four years and $280,000 thereafter. In addition, there is expected to be a recurring major rework cost of $450,000 every 13 years. Assume interest at 15%. Note: Correct diagram is worth 10 points.