UNIT IV

Amortization and Sinking Funds

Objectives:

• Solve for the amount or present value of annuity, periodic payment/deposit

• Create an amortization or sinking fund schedule
• Compute for the outstanding principal after specified total number of payments
One of the most important and most common applications of annuities in business is the repayment of
interest-bearing debts: (1) Amortization; and (2) Sinking Funds.

AMORTIZATION

Amortization is an accounting technique used to periodically lower the book value of

a loan or intangible asset over a set period of time. The term "amortization" can refer to two situations.
First, amortization is used in the process of paying off debt through
regular principal and interest payments over time. An amortization schedule is used to reduce the current
balance on a loan, for example a mortgage or car loan, through installment payments. Second, amortization
can also refer to the spreading out of capital expenses related to intangible assets over a specific duration
– usually over the asset's useful life – for accounting and tax purposes. (Investopedia.com)

To Amortize means to pay off a debt by installment payments.

Computing the Present Value of an Amortization

With amortization, the original amount of the loan (present value or obligation) is known; therefore,
we use the present value formula for ordinary simple annuity.

1 − (1 + 𝑖)−𝑛
𝐴 = 𝑃𝑀𝑇 ∗ [ ]
𝑖

Where: A = the present value of an annuity or the amount of money you need now or owe now

PMT = the amount of the deposit or payment for each payment period

i = r/m the interest rate for the compound period is calculated by dividing the annual interest rate
by the number of compound periods in a year.

n = the number of deposits made for the duration of the annuity (m * t)

m= the number of compound periods in a year

t = length of the annuity in years

Example 1: A loan of 7 quarterly payments of P8,300.00 is to be made, to pay of a loan at 10% compounded
quarterly. Find the value of the loan and construct an amortization schedule.

Solution: By using the formula, solve for A. P= payment for each quarter = P8,300, i = .10/4=0.025, and n =
4*1.75 = 7.

1 − (1 + 𝑖)−𝑛
𝐴 = 𝑃𝑀𝑇 [ ]
𝑖

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 1 − (1 + 0.025)−7
𝐴 = 8,300 [ ]
0.025

1 − (1.025)−7
𝐴 = 8,300 [ ]
0.025

1 − 0.841265231
𝐴 = 8,300 [ ]
0.025
0.158734765
𝐴 = 8,300 [ ]
0.025

𝐴 = 8,300 (6.3493906)

𝐴 = 𝐏𝟓𝟐, 𝟔𝟗𝟗. 𝟗𝟒𝟐

Therefore, the present value of the loan is P52,699.942.

Steps in Creating an Amortization Schedule

Step 1: Build a strong familiarization of the following variables will be used in amortization schedule:

Definition of Terms:

• OPBI- Outstanding Principal at Beginning of Interval

• POP - Previous Outstanding Principal
• PRP - Previous Repayment of Principal
• IDEI- Interest Due at the End of Interval RII Rate of Interest per Interval
• TPEI - Total Payment of Principal at the End of Interval
• RPEI - Repayment of Principal at the End of Interval
Step 2: Construct an Amortization Schedule Table with heading such as:

• Column 1: Period
• Column 2: Outstanding Principal at the Beginning of Interval (OPBI)
• Column 3: Interest Due at the End of Interval (IDEI)
• Column 4: Total Payment at the End of the Interval (TPEI)
• Column 5: For Repayment of Principal at the End of Interval (RPEI)

The Amortization Schedule Table

Outstanding Interest at 2.5% For Repayment

Total Payment
Principal at the Due at the End of Principal at
Period at the End of the
Beginning of of Interval the End of
Interval (TPEI)
Interval (OPBI) (IDEI) Interval (RPEI)
1
2
3
4
5
6
7
TOTAL

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 Step 3: Determine the value of OPBI, IDEI, TPEI and RPEI for the first period using the following formula:

• Formula for computing the Outstanding Principal at the Beginning of Interval (OPBI):
𝑂𝑃𝐵𝐼 = 𝑃𝑂𝑃 − 𝑃𝑅𝑃
• Formula for computing the Interest Due at the End of Interval (IDEI):
𝐼𝐷𝐸𝐼 = 𝑅𝐼𝐼 𝑥 𝑂𝑃𝐵𝐼
• Formula for computing the Total Payment at the End of Interval (TPEI):
𝑇𝑃𝐸𝐼 = 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 (𝑅)
• Formula for computing the Repayment of Principal at the End of Interval (RPEI):
𝑅𝑃𝐸𝐼 = 𝑇𝑃𝐸𝐼 – 𝐼𝐷𝐸𝐼

The Amortization Schedule Table

Outstanding Interest at 2.5% For Repayment

Total Payment
Principal at the Due at the End of Principal at
Period at the End of the
Beginning of of Interval the End of
Interval (TPEI)
Interval (OPBI) (IDEI) Interval (RPEI)
1 P52,699.942 P1,317.936 P8,300.000 P6,982.501
2
3
4
5
6
7
TOTAL

Step 4: Compute for the OPBI, IDEI, TPEI, and RPEI for the next period up to the nth period.

The Amortization Schedule Table

Outstanding Interest at 2.5% For Repayment

Total Payment
Principal at the Due at the End of Principal at
Period at the End of the
Beginning of of Interval the End of
Interval (TPEI)
Interval (OPBI) (IDEI) Interval (RPEI)
1 P52,699.942 P1,317.936 P8,300.000 P6,982.501
2 P45,717.441 P1,142.936 P8,300.000 P7,157.064
3 P38,560.377 P964.009 P8,300.000 P7,335.991
4 P31,224.377 P780.610 P8,300.000 P7,519.390
5 P23,704.996 P592.625 P8,300.000 P7,707.375
6 P15,997.621 P399.941 P8,300.000 P7,900.059
7 P8,097.562 P202.439 P8,300.000 P8,097.561
TOTAL P5,400.059 P58,100.000 P52,699.941

Computing the Periodic Payment of an Amortization

Amortization Formula (Periodic Payment)

The periodic payment P on a loan of A (amount)to be amortized over n periods with interest charged
at the rate of i per period is

𝐴𝑖
𝑃𝑀𝑇 =
1 − (1 + 𝑖)−𝑛

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 This is known as the amortization equation and you use this equation when trying to calculate
required monthly payments to pay off loans such as car loans, mortgage payments, credit cards,
determining inheritance payments, and determining retirement income.

Example:

Shane and Andy want to buy their dream house. If they make a down payment of P75,000 on a house
that costs P650,000 and the mortgage rate is 7.5% with a term of 30 years, what will be their monthly
payment be?

Solution: By using the formula, solve for PMT. A= the amount of the loan = P650,000-75,000 = P575,000 , i
= .075/12=0.00625 , and n = 30*12 = 360.

𝐴𝑖
𝑃=
1 − (1 + 𝑖)−𝑛

(575,000)(0.00625)
𝑃=
1 − (1 + 0.00625)−360
3,593.75
𝑃=
1 − (1.00625)−360
3, 593.75
𝑃 = 1 − 0.1061398293
3, 593.75
𝑃 = 0.893860171
𝑷 = 𝟒, 𝟎𝟐𝟎. 𝟒𝟖

• What is the total amount of interest paid?

This is equal to what they pay over thirty years (n*A) minus the amount of the original loan (P): nA- P=
(360*4020.48) – 575000 = P872,372.80

If Shane and Andy decide to pay-off their mortgage after 10 years what amount do they owe? The balance
of the unpaid loan is equal to the PRESENT VALUE of the remaining payments. Each payment equals
P4,020.48 and after ten years of payments Shane and Andy still have to make 240 payments (20 years of
payments). To find the present value we use the Amortization Formula
𝑃𝑖 𝐴[1−(1+𝑖)−𝑛 ]
𝐴 = 1−(1+𝑖)−𝑛 = 𝑃 = 𝑖

𝐴[1 − (1 + 𝑖)−𝑛 ]
𝑃=
𝑖
4020.48[1 − (1 + 0.00625)−240 ]
=
0.00625
= 𝑷𝟒𝟗𝟗, 𝟎𝟕𝟏

Note: When the debt is paid on a series of equal payments, pay the interest outstanding at the time the
payments are made and also repay a part of the principal. As the principal gradually reduced by periodic
payments, the interest of the unpaid balance decreases

Example 3: A Php30,600.00 loan at 15% compounded semiannually is to be amortized every 6 months for
3 years. Find the quarterly payment and construct an amortization schedule.

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 The Amortization Schedule Table

Outstanding Interest at 7.5% For Repayment

Total Payment
Principal at the Due at the End of Principal at
Period at the End of the
Beginning of of Interval the End of
Interval (TPEI)
Interval (OPBI) (IDEI) Interval (RPEI)
1 P30,600.000 P2,295.000 P6,519.174 P4,224.174
2
3
4
5
6
TOTAL

Outstanding Interest at 2.5% For Repayment

Total Payment
Principal at the Due at the End of Principal at
Period at the End of the
Beginning of of Interval the End of
Interval (TPEI)
Interval (OPBI) (IDEI) Interval (RPEI)
1 P30,600.000 P2,295.000 P6,519.174 P4,224.174
2 P26,375.826 1,978.187 P6,519.174 4,540.987
3 21,834.839 1,637.613 P6,519.174 4,881.561
4 16,953.278 1,271.496 P6,519.174 5,247.678
5 11,705.600 877.920 P6,519.174 5,641.254
6 6,064.346 454.826 P6,519.174 6,064.348
TOTAL 8,515.044 39,115.044 30,600.000

SINKING FUNDS

A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. A company
that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship
of a large outlay of revenue. A sinking fund is established so the company can contribute to the fund in the
years leading up to the bond's maturity. It helps companies that have floated debt in the form bonds
gradually save money and avoid a large lump-sum payment at maturity. Some bonds are issued with the
attachment of a sinking fund feature. The prospectus for a bond of this type will identify the dates that the
issuer has the option to redeem the bond early using the sinking fund. While the sinking fund helps
companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use
the funds to repurchase preferred shares or outstanding bonds. (Investopedia.com)

Computing the Future Value of a Sinking Fund

To determine the future value of a sinking fund we will use the formula for computing the
future value of ordinary simple annuity.

(1 + 𝑖)𝑛 − 1
𝑆 = 𝑃𝑀𝑇 [ ]
𝑖

Where: S = the future value of sinking fund

PMT = periodic payment

i = r/m the interest rate for the compound period is calculated by dividing the annual interest rate
by the number of compound periods in a year.

n = the number of deposits made for the duration of the annuity (m * t)

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 m= the number of compound periods in a year

t = length of the annuity in years

Example 1: Ms. Eunica De Guzman invests Php5,400.00 every 3 months at 16% compounded quarterly to
accumulate a fund. How much must the fund be in 1 year and 3 months, just after the deposit due
then is made? Construct a sinking fund schedule.

Solution: Using the formula, solve for future value of sinking Fund (S). PMT = 5, 400; i = 0.16/4=0.04; n= 4
x 1.25.

(1 + 𝑖)𝑛 − 1
𝑆 = 𝑃𝑀𝑇 [ ]
𝑖

0.16 (4)(1.25)
(1 + 4 ) −1
𝑆 = 5,400 [ ]
0.16
4

(1 + 0.04)5 − 1
𝑆 = 5,400 [ ]
0.04

1.2166529024 − 1
𝑆 = 5,400 [ ]
0.04
0.2166529024
𝑆 = 5,400 [ ]
0.04
𝑆 = 5,400[5.41632256]

𝑆 = 𝑷𝟐𝟗, 𝟐𝟒𝟖. 𝟏𝟒

Therefore, the fund will accumulate to Php29,248.140.

Steps in Constructing a Sinking Fund Schedule

STEP 1: Build a strong familiarization of the following variables will be used in sinking fund
schedule:
• FBI - Fund at the Beginning of Interval
• PBFEI - Previous Balance in Fund at the End of Interval
• IRFEI - Interest Received of Fund at the End of Interval
• RII - Rate of Interest per Interval
• PFEI - Payment of Fund at the End of Interval
• FEI - Fund at the End of Interval

STEP 2: Construct a Sinking Fund Schedule Table with the following column headings:
• Column 1: Payment Interval
• Column 2: In Fund at the Beginning of Interval (FBI)
• Column 3: Interest Received of Fund at the End of Interval (IRFEI)
• Column 4: Payment to Fund at the End of Interval (PFEI)
• Column 5: In Fund at the End of the Interval (FEI)

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 The Sinking Fund Schedule Table

In Fund at the Interest at 4% Payment to In Fund at the

Beginning of Received of Fund Fund at the End End of the
PAYMENT Interval (FBI) at the End of of Interval Interval (FEI)
Interval (IRFEI) (PFEI)

1
2
3
4
5
TOTAL

STEP 3: Determine the value of FBI, IRFEI, PFEI, and FEI for the first period using the following
formula:
• Formula for computing the Fund at the Beginning of Interval (FBI):
𝐹𝐵𝐼 = 𝑃𝐵𝐹𝐸𝐼
• Formula for computing the Interest Received of Fund at the End of Interval (IRFEI):
𝐼𝑅𝐹𝐸𝐼 = 𝑅𝑅𝐼 𝑥 𝐹𝐵𝐼
• Formula for computing the Payment to Fund at the End of Interval (PFEI):
𝑃𝐹𝐸𝐼 = 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑎𝑦𝑚𝑒𝑛𝑡
• Formula for computing the In Fund at the End of Interval (FEI):
𝐹𝐸𝐼 = 𝐹𝐵𝐼 + 𝐼𝑅𝐹𝐸𝐼 + 𝑃𝐹𝐸𝐼

The Sinking Fund Schedule Table

In Fund at the Interest at 4% Payment to In Fund at the

Beginning of Received of Fund Fund at the End End of the
PAYMENT Interval (FBI) at the End of of Interval Interval (FEI)
Interval (IRFEI) (PFEI)

1 0.000 0.000 P5,400.000 P5,400.000

2
3
4
TOTAL

STEP 4: Compute for the FBI, IRFEI, PFEI, and FEI for the next period up to the nth payment
interval.

The Sinking Fund Schedule Table

In Fund at the Interest at 4% Payment to In Fund at the

Beginning of Received of Fund Fund at the End End of the
PAYMENT Interval (FBI) at the End of of Interval Interval (FEI)
Interval (IRFEI) (PFEI)

1 0.000 0.000 P5,400.000 P5,400.000

2 P5,400.000 P216.000 P5,400.000 P11,016.000
3 P11,016.000 P440.640 P5,400.000 P16,856.640
4 P16,856.640 P674.266 P5,400.000 P22,930.906
5 P22,930.906 P917.236 P5,400.000 P29,248.140
TOTAL P2,248.142 P27,000.00

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Computing The Periodic Payment Of A Sinking Fund

To calculate the value of the periodic payment of a sinking fund we will do the same
method for finding the value of periodic payment of an ordinary simple annuity. The periodic payment E
required to accumulate a sum of S (amount) over n periods with interest charged at the rate of i per period
is

𝑆𝑖
𝑃𝑀𝑇 =
(1 + 𝑖)𝑛 − 1

Example 1:

A friend borrows P100,000 to purchase a boat and agrees to pay the full amount back in one
payment, ten years from now. In the meantime, he agrees to pay interest monthly on the P10,000 at an
annual rate of 12%. He also sets up a sinking fund to accumulate the lump-sum payment. The sinking fund
earns 9% interest, compounded monthly. How much does he pay monthly? The monthly amount is both
the interest to the lender and a deposit into the sinking fund.

Solution: First find the interest to the lender that is based on an annual rate of 12%. Using the simple
interest formula, I = Prt, you have I = 100,000(0.12)(1) = 12,000 per year. Because he plans to make
monthly payments, you divide by 12 so P1000 per month goes for the interest payments. Next, By using
the sinking fund formula, solve for E. F= the amount of the loan = P100,000, i = .09/12=0.0075 , and n =
30*12 = 360.

𝐹𝑖
𝐸=
(1 + 𝑖)𝑛 − 1

(100,000)(0.0075)
𝐸=
(1 + 0.0075)120 − 1
750
𝐸=
(1.0075)120 − 1
750
𝐸=
2.451357078 − 1
750
𝐸=
1.451357078
𝑬 = 𝟓𝟏𝟔. 𝟕𝟔
Therefore, the monthly payment into the sinking fund is about P516.76. Add that to the interest
payments, and the monthly commitment is P1,516.76. In ten years, the monthly payments will end.

Example 2: The sum of Php14,000.00 will be needed at the end of 1 1/2 years. If money can be invested
at 12% quarterly, find the periodic payment and construct a sinking fund schedule.

The Sinking Fund Schedule Table

In Fund at the Interest at 4% Payment to In Fund at the

Beginning of Received of Fund Fund at the End End of the
PAYMENT Interval (FBI) at the End of of Interval Interval (FEI)
Interval (IRFEI) (PFEI)

1 0.000 0.000 P2,164.365 P2,164.365

2
3
4
5
6
TOTAL

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 In Fund at the Interest at 4% Payment to In Fund at the
Beginning of Received of Fund Fund at the End End of the
PAYMENT Interval (FBI) at the End of of Interval Interval (FEI)
Interval (IRFEI) (PFEI)

1 0.000 0.000 P2,164.365 P2,164.365

2 P2,164.365 P64.931 P2,164.365 P4,393.661
3 P4,393.661 P131.810 P2,164.365 P6,689.836
4 P6,689.831 P200.695 P2,164.365 P9,054.896
5 P9,054.896 P271.647 P2,164.365 P1,149.908
6 P11,490.908 P394.727 P2,164.365 P14,000.000
TOTAL 1,013.810 12,986.190

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