4.2.

Annuities
Annuity
An annuity is a series of equal payments made at equal intervals of time. Financial
activities like installment payments, monthly rentals, life-insurance premium, monthly
retirement benefits, are familiar examples of annuity. Annuity can be certain or
uncertain. In annuity certain, the specific amount of payments is set to begin and end at
a specific length of time. A good example of annuity certain is the monthly payments of
a car loan where the amount and number of payments are known. In annuity uncertain,
the annuitant may be paid according to certain event. Example of annuity uncertain is
life and accident insurance. In this example, the start of payment is not known and the
amount of payment is dependent to which event.
Annuity certain can be classified into two, simple annuity and general annuity.
In simple annuity, the payment period is the same as the interest period, which means
that if the payment is made monthly the conversion of money also occurs monthly.
In general annuity, the payment period is not the same as the interest period. There
are many situations where the payment for example is made quarterly but the money
compounds in another period, say monthly. To deal with general annuity, we can
convert it to simple annuity by making the payment period the same as the
compounding period by the concept of effective rates.

Elements of Annuity
A = amount of periodic payment
P = present amount of all periodic payments
F = future worth of all periodic payments after the last payment is made
i = interest rate per compounding period
n = total number of payments
m = nominal rate (see compounded interest)
t = number of years
 

Single-Payment, Compound-Amount Factor

Suppose that a given sum of money P earns interest at a rate i, compounded annually.
Since the total amount of money F which will have accumulated from an investment
of P dollars after n years is given by F = P(1+ i)n. The ratio F/P = (1+ i)n is called
the single-payment compound-amount factor.
Suppose a student deposits Php1000 in a savings account that pays interest at the rate
of 6% per year, compounded annually. If all of the money is allowed to accumulate, how
much money will the student have after 12 years?
We wish to solve for F, given P, i, and n. Hence,

F=P×(F/P,i%,n)
F=Php1000(F/P,6%,12)

F=P(1+i¿n
F=Php1000(1+0.06¿12
F=Php2012.196

Single-Payment, Present-Worth Factor

The single-payment present-worth factor is the reciprocal of the single-payment,
compound-amount factor: P/F = (F/P)-1 = (1+ i)-n
A certain sum of money will be deposited in a savings account that pays interest at the
rate of 6% per year, compounded annually. If all of the money is allowed to accumulate,
how much must be deposited initially so that Php5000 will have accumulated after 10
years?
We wish to solve for P, given F, i, and n. Hence,

P=F×(P/F,i%, n)
P=Php5000(P/F,6%,10)

P=F(1+i¿−n
 P=Php5000(1+0.06¿−10

P=Php2791.974

Types of Simple Annuities

Annuities are typically classified into four categories in engineering economy: (a)
ordinary annuity, (b) annuity due, (c) deferred annuity, and (d) perpetuity.

Ordinary Annuity
In ordinary annuity, the equal payments are made at the end of each compounding
period starting from the first compounding period.
From the cash flow diagram shown above, the future amount F is the sum of payments
starting from the end of the first period to the end of the nth period. Observe that the total
number of payments is n and the total number of compounding periods is also n. Thus,
in ordinary annuity, the number of payments and the number of compounding periods
are equal.
An engineer who is about to retire has accumulated Php50 000 in a savings account
that pays 6% per year, compounded annually. Suppose that the engineer wishes to
withdraw a fixed sum of money at the end of each year for 10 years. What is the
maximum amount that can be withdrawn?
Annuity Due
In annuity due, the equal payments are made at the beginning of each compounding
period starting from the first period. The diagram below shows the cash flow in annuity
due.

As indicated in the figure above, F1 is the sum of ordinary annuity of n payments. The
future amount F of annuity due at the end of nth period is one compounding period away
from F1. In symbol, F = F1(1 + i).
Deferred Annuity
In deferred annuity the first payment is deferred a certain number of compounding
periods after the first. In the diagram below, the first payment was made at the end of
the kth period and n number of payments was made. The n payments form an ordinary
annuity as indicated in the figure.

Perpetuity
Perpetuity is an annuity where the payment period extends forever, which means that the
periodic payments continue indefinitely.