Economic Life,Sinking Funds,Amortization and RDs
April 22, 2011 5 Comments
I first came across the concepts of economic life,sinking fund and amortization as an engineering student.Adapted to our personal finances and business these concepts help us to always have enough money at the right time.
Economic life , a.k.a useful life is the period of actual usefulness of an asset.Beyond this period it is cheaper to replace or scrap the asset than to continue maintaining it.
A sinking fund is a reserve created by periodically setting aside certain sums in an account to replace an asset in future or to repay a liability.
Amortization refers to spreading an asset’s replacement cost over it’s economic/useful life.
Every asset we own will need to be replaced , majorly overhauled , renovated or rebuilt after some time.So vehicles, household and office appliances,etc. need to be replaced,houses and business premises renovated or rebuilt and major investments and upgradations become inevitable in farms over a period of time.So every asset has an economic life.Moreover we often know the approximate time in which such expenses are likely to become due.So the way to ensure that there is enough money to undertake a capital expense when it becomes due,is to establish a sinking fund into which we periodically pay money into to raise the required amount i.e we amortize the sinking fund amount.
To determine the sinking fund amount first consider how much an asset costs today.Then decide how inflation might affect the price of a similar asset in future.If you think that inflation will increase the price of replacement then increase the sinking fund value appropriately.You can use the calculator here to figure out the inflation-adjusted sinking fund amount http://www.yetanothersite.com/inflation-calculator-for-india.htm#resultsA .Remember that many appliances are likely to actually be cheaper in future.So don’t panic and over allow for inflation unless you are looking for some major upgrade say from a basic to some designer model.However, wherever there is a wage/labour content do err on the side of caution especially if you live in some emerging economy.Otherwise you might have to do a bit of DIY when the time comes.Likewise if the asset has a resale-value or trade in price or scrap value,estimate it and deduct it from the sinking fund value.It pays to be conservative while estimating the money you are likely to make from selling your old asset.In case you live in a place where you have to pay to have your trash carted off, add don’t subtract this value from the sinking fund.
Next to find out how much you need to lay aside periodically,use this amortization calculator: http://www.cecalc.com/Economics/UniformSeriesSF.aspx. The future value is the sinking fund value determined as per the previous paragraph.For the yearly interest rates use the recurring deposit rates offered by banks.They are usually a percentage below the FD rates offered.The following link will help you look for the best rates: http://www.ratekhoj.com/fixed-deposits/fixed-deposit-rates/index.php.In case the economic life is over 10 years determining the interest rate might be tricky.In that case why not assume the long-term post office rate of interest ?Post office Savings instruments are always a fall back option in case the interest rates fall drastically.
Now that RD rates are so high why not start creating your sinking funds now?
Of course sinking funds can be parked in any instrument which offers capital security and interest but RDs are really convenient in that they take out the hassles associated with guessing interest rates and the amounts required to be set aside given variable rates.In case you decide against RDs you will to work out how much you need to contribute each year depending on the interest rate you can secure in a given year and the rates your previous deposits are earning.I feel that the effort is not worth it unless the sinking fund in question is so huge that it becomes necessary to seek out instruments that are more tax-efficient.