Chapter 3: The Time Value of Money

Annuity
Annuities: Definition

An annuity is a series of periodic payments, usually

made in equal amounts. The payments are computed by
the compound interest method and are made at equal
interval of times, such as annually, semiannually,
quarterly, or monthly.
 Annuities: Definition

Term of an annuity

Origin A = Uniform Amounts =Periodic Payments

A A A A A

0 1 2 3 N-1 N

Payment Interval
P= Present Equivalent F= Future Equivalent
Annuities: Definition

Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

End of year 1

End of year 2

End of year 3
End of year 4
Future Value of an Ordinary Annuity

To find the future

value of an ordinary
annuity, multiply the
amount of the
annuity by the future
value of an ordinary
annuity factor.
Annuities: Amount of an annuity –
Finding F Given A

How much will you have in 40 years if you

save $3,000 each year and your account
earns 8% interest each year?
Annuities: Present Value of an annuity –
Finding P Given A

How much money is needed today to provide

an annual amount of $50,000 each year for 20
years, at 9% interest each year?
9
Annuities: Present Value of an annuity –
Finding P Given A

How much money is needed today to provide

an annual amount of $50,000 each year for 20
years, at 9% interest each year?
 Annuities: Finding A Given F

How much would you need to set aside each

year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25
years?
 Annuities: Finding A Given F

How much would you need to set aside each

year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25
years?
 Annuities: Finding A Given F

If you had $500,000 today in an account

earning 10% each year, how much could you
withdraw each year for 25 years?
 Annuities: Example

You wish to withdraw $10,000 at the end of

each of the next 4 years from a bank
account that pays 10% interest
compounded annually.

How much do you need to invest today to

meet this goal?
 Present Value of an Annuity

Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

PV1
PV2
PV3
PV4
 Present Value of an Annuity
PV of $1 Present
Annuity Factor Value
PV1 $ 10,000 0.90909 $ 9,090.90
PV2 10,000 0.82645 8,264.50
PV3 10,000 0.75131 7,513.10
PV4 10,000 0.68301 6,830.10
Total 3.16986 $ 31,698.60

If you invest $31,698.60 today you will be able to

withdraw $10,000 at the end of each of the next
four years.
 Present Value of an Ordinary Annuity
PV of $1 Present
Annuity Factor Value
PV1 $ 10,000 0.90909 $ 9,090.90
PV2 10,000 0.82645 8,264.50
PV3 10,000 0.75131 7,513.10
PV4 10,000 0.68301 6,830.10
Total 3.16986 $ 31,698.60

Can you find this value in the Present Value of Ordinary

Annuity of $1 table?
More Efficient Computation
$10,000 × 3.16986 = $31,698.60
Present Value of an Ordinary Annuity

How much must a person 65 years old

invest today at 8% interest compounded
annually to provide for an annuity of
$20,000 at the end of each of the next 15
years?
a. $153,981
b. $171,190 PV of Ordinary Annuity $1
c. $167,324 Payment $ 20,000.00
PV Factor × 8.55948
d. $174,680
Amount $171,189.60
 Deferred Annuity

Deferred annuities are uniform series that

do not begin until some time in the
future.
 Deferred Annuity

If the annuity is deferred J periods then the

first payment (cash flow) begins at the end
of period J+1.
 Deferred Annuity-step 1

Finding the value at time 0 of a deferred annuity is a

two-step process.
Step 1:
Use (P/A, i%, N-J) find the value of the deferred
annuity at the end of period J (where there are
N-J cash flows in the annuity).

P j=A (P/A, I %, N-J)

 Deferred Annuity-step2

Finding the value at time 0 of a deferred annuity

is a two-step process.
Step 2:Use (P/F, i%, J) to find the value of the
deferred annuity at time zero.

P0=P j (P/F, i%, J)

 Deferred Annuity

Finding the value at time 0 of a deferred annuity is a

two-step process.

P j=A (P/A, I %, N-J)

P0=P j (P/F, i%, J)

 Deferred Annuity

Finding the value at time 0 of a deferred annuity

is a two-step process.
1. Use (P/A, i%, N-J) find the value of the
deferred annuity at the end of period J
(where there are N-J cash flows in the
annuity).
2. Use (P/F, i%, J) to find the value of the
deferred annuity at time zero.
 Deferred Annuity Exercise-part 1

Suppose that a father on the day his son is born

wishes to determine what amount would be paid
into an account bearing an interest of 12% per
year to provide withdrawals of $2000 on each of
the son’s 18th, 19th, 20th and 21st birthdays
 Solution

• N=21 , J=17
• P17= A(P/A,12%,4)=$2000(3.0373)

P0= P17(P/F,12%,17)=$2000(3.0373)(0.1456)
P0=$884.46
 Deferred Annuity Exercise-part 2

Extra exercise for you to think about:

• Suppose that the father wishes to determine
the equivalent worth of the four $2000
withdrawals as of the son’s 24th birthday.
• This could mean that the 4 amounts were
never withdrawn or re-deposited in an
account earning 12% per year