v) Equation of Value

Sometimes there is a need to replace a set of debts by another set of differen

amounts due at different times. For example, a single payment on the 6 th yea
settle these two debts:
a) 500 due in 3 years
b) 800 due in 7 years
In order to find the single payment, an equation of value should be set up.

In an equation of value, the sum of the values of one set of debts on a compa
date equals the sum of the values of another set of debts on the same date.
sum on the comparison date is obtained by either accumulating or discountin
depending on when the obligation and the comparison dates fall.

Example 1: Francis owes 500, due in 3 years, and 800, due in 7 years. He
allowed to settle these obligations by a single payment on the 6 th year. Find
much he has to pay on the 6th year if money is worth 14% (m = 2).

Example 1: Francis owes 500, due in 3 years, and 800, due in 7 years. He
allowed to settle these obligations by a single payment on the 6 th year. Find
much he has to pay on the 6th year if money is worth 14% (m = 2).
Solution:
Step 1: Make a time diagram:
Debts

Rate: (14%, m=2)

500

CD
4

6
x

800
7

(years)

Payment
Step 2: Choose a comparison date (usually the payment date, to simplify
computation). Here, the 6th year is used as comparison date (CD).

Step 3: Bring all values to the comparison date by either accumulating or

discounting. Write down the equation of value, which can be briefly stated a
all payments = all debts

Debts:
Accumulate 500 for 3 years: P = 500 = 750.36518
Discount 800 for one year: F = 800 = 698.75098
Payment:
x remains the same: x = x
The equation of value is therefor
payment = All debts
x = 500+ 800
= 1,449.12

Thus, payment of 1,449.12 on the 6th year will equitably replace the two d
Note: Any time can be used as the comparison date. For instance, if 5 years
the CD in example above, the equation of value would be:
x = 500+ 800
x = = 1,449.12

Example 2: Marian owes 2,500 due in 2 years and 4,000 due in 5 years.
settle these obligations, she agrees to pay 1,000 on the first year and ano
payment on the 4th year. How much is the payment on the 4th year if money
worth 16% compounded quarterly?

Example 3: What two equal payments at the end of 2 years and 5 years will
equitably replace the following interest-bearing debts?
a) 2000 due in 3 years with accumulated interest from today at 10%
compounded quarterly.
b) 1000 due in 7 years with accumulated interest from today at 9%
compounded semi-annually.
Money is worth 8% effective rate.

Example 2: Marian owes 2,500 due in 2 years and 4,000 due in 5 years.
settle these obligations, she agrees to pay 1,000 on the first year and ano
payment on the 4th year. How much is the payment on the 4th year if money
worth 16% compounded quarterly?
Solution:
Let x be the payment on the 4th year.
Choose 4 years as CD.
Debts
0

1
1,000
Payments

Rate: (16%, m=4)

2,500
2
3

CD
4
x

4,000
5
6 (years)

Bring the values to CD.

Debts: Accumulate 2,500 for 2 years : 2,500 = 3421.4225
Discount 4,000 for 1 year: 4,000 = 3419.2168

Payments:

Accumulate 1,000 for 3 years: 1,000 = 1601.0322

x remains the same:
x=x
The equation of value is
All payments = All debts
1,000 + x = 2,500 + 4,000
1601.0322 + x = 3421.4225 + 3419.2168
x = 5,239.61

Example
3: What two equal payments at the end of 2 years and 5 years wil
equitably replace the following interest-bearing debts?
a) 2000 due in 3 years with accumulated interest from today at 10%
compounded quarterly.
b) 1000 due in 7 years with accumulated interest from today at 9%
compounded semi-annually.
Money is worth 8% effective rate.

Solution:
Let x be the equal payment on the 2nd and 5th years. If a debt bears interes
first compute for the maturity value on the due date.
The maturity value of the first debt is: 2000 = 2689.7776
The maturity value of the second debt is: 1000 = 1851.9449
Choose 5 years as CD
Debts
0
Payments

Rate: (8%, m=1)

2689.7776
CD
1851.9449
1

2
x

5
x

8 (years)

Bring

the values to CD using 8% effective rate.

Debts:
Accumulate 2,689.7776 for 2 years: 2,689.7776 = 3137.3566
Discount 1,851.9449 for 2 years: 1,851.9449 = 1587.7443
Payments:
Accumulate x on the 2nd year for 3 years: x
x on the 5th year remains the same:
x =x
The equation of value is
All payments = All debts
x + x = 2,689.7776 + 1,851.9449
x + 1.259712x = 3137.3566 + 1587.7443
2.259712x = 4725.1009
x = 2,091.02
Assignment:
Page 51
Items: 2 and 6
Book: Mathematics of Investment by Victoria C. Naval, et., al.

vi) Varying Interest:

If the interest rate changes during an investment term, the amount at the
previous rate is first obtained before applying the new rate.

Example 1: Find the amount in 15 years if 500 is invested at 18% compound

semi-annually in the first 5 years, 15% compounded semi-annually in the ne
years and 18% compounded quarterly in the last 6 years.
Solution:

5
(18%, m=2)
10 periods

9
(15%, m=2)
8 periods

(18%, m=4)
24 periods

15

500

The principal

of 500 at an interest rate of 18% (m=2) will on the 5th yea

amount to:
Accumulate this amount at 15% (m=2) in 4 years:
= the amount at the of 9 years

The final amount on the 15th year is therefore obtained by accumulating t

above amount at 18% (m=4).
= 500(2.3673637)(1.7834778)(2.870138)
= 6,071.47

Example 2: 2,000 is invested for 10 years in a savings bank that gives 9%

compounded quarterly in the first 6 years and 10% compounded quarterly
last 4 years. What is the amount at the end of 10 years?

Example 3: On March 14, 1999, Nyang deposited 15,320 in a bank. How

did she have after 10 years if the 9% interest payable quarterly was in effe
until September 14, 2002, and if 10% was payable semi-annually thereafte