A reserve fund is a sum of money reserved for some specific future event or some emergency. It is a specific amount intended to be accumulated through periodic savings assisted by the power of compound interest. This future sum can be used to replace a piece of aging equipment.
The central question is what sum saved now for a given period will amount to the reserve fund required?
There are four basic steps:-
Determine the rate of interest applicable to a specific time period compared to the yearly interest rate. This will not normally be the yearly rate divided by 12 to determine the monthly rate because interest is earned throughout the interval.
Formula :D=(1+R)1/12 -1 where R is the yearly rate of discount. This is used to determine the present value of the Reserve Fund ie. D multiplied by Reserve Fund.
Secondly, get the cumulative discount rate (CDR). The formula used is 1-(1+R)-n/R. This will be used to reflect the time value of periodic investments accumulated over the entire lifetime of the project.
Thirdly, multiply required funds (RF) by the discount figure (D) to determine the present value (PV) of the Reserve Fund.
Fourthly, divide the PV of the required Reserve Fund by the cumulative discount rate (CDR) to determine the periodic sum to invest to, in due course, amount to the Reserve Fund.