Unit 3: Annuities

Accumulated value of an ordinary annuity: Ordinary annuity payments made at the end of the time
period.eg: end of 1st year, 2nd year etc. Applications: House loan, vehicle loan etc.

Accumulated value represents the accumulated value of money at the end of time period.

Example 1:
The same is represented inn the following formula:
In the given example: A = Rs. 3000, R =5% p.a, i=R/100 = 5/100 = 0.05, N= 4 years.

Substituting in formula:

V: accumulated value: 3000/.05 ( ( 1+.05)^4-1) : V= Rs. 12930.375 (same as elaborated example).

Present value: It is the amount of money invested now at a certain rate of interest so that the
payment due in future can be obtained. For ordinary annuity, payments are made at the end of the
period.

Example 2:
Explanation:

The same can be represented as: Present value (P) =

Practice:

1. A person is repaying a debt with payments of Rs.2,500 per month (means end of the month). If he
misses his payments for July, August, September and October, what payment will be required in
November to put him back on schedule, if interest is at 12.6% per annum? (Hint: find accumulated
value at the end of 5 months from July to November, convert annual interest to monthly and
substitute in formula).

Soln: The person has to pay four overdue payments with interest, along with November
payment. Considering only these five payments, we can find the accumulated value to be paid in
November, so that he is put back on schedule. Given: A = Rs. 2, 500; N = 5 months; R = 12.6%p.a.
=⇒ R = 12.06/12 months = 1.05% p.m. =⇒ i = 1.05/ 100 = 0.0105 Formula used: V = A/ i [(1 + i)^
N – 1]
V = 2, 500/ 0.0105 [(1 + 0.0105) ^5 – 1] = Rs.12, 765.2.

2. A machine costs Rs. 32,00,000 and its effective life is estimated 15 years. If the scrap value is
Rs.2,00,000. What amount should be retained out of profits at the end of each year to accumulate
compound interest at 8.5% per annum compounded annually?
 Soln: Given: Cost of the machine = Rs. 32,00,000 Scrap value = Rs. 2,00,000 The amount desired
at the end of 15 years = Rs. 32,00,000 – 2,00,000 = Rs. 30,00,000 ∴ V = Rs. 30, 00, 000; N = 15
years; R = 8.5%p.a. =⇒ i = 8.5 /100 = 0.085. Formula used: V = A/ i [(1 + i) N – 1]
30, 00, 000 = A/ 0.085 [(1.085) ^15 – 1] =⇒ A = Rs.1, 06, 261.

3. Find the present value and amount of an annuity of Rs. 500 payable once in two months for 2
years, if the money is worth 10% compounded once in two months.
Sol: Given: A = Rs. 500; N = 2 years = (2 × 6) two month periods = 12 t.m.p R = 10 % p.a.= 10/ 6 %
per t.m.p., implies i = 5 /300 = 0.016667. Therefore, the present value P = A /i (1 − (1 + i) ^−N)
P = 500/ 0.016667( 1 − (1 + 0.016667)^ −12)= Rs. 5, 397.5.

Extra practice problems:

1. Find the amount of an ordinary annuity of 15 monthly payments of Rs.2500 that earn interest
at 12% per annum compounded monthly.

2. What amount should be set-aside at the end of each year to amount to Rs.38,674.58 at the
end of 10 years at 14% per annum compounded annually?

3. Find the present value of an ordinary annuity of Rs. 1000 per annum for 10 years allowing
compound interest at 5% per annum.

4. Find the present worth of an ordinary annuity of Rs. 500 payable at the end of each month for
2 years, if the money is worth 8% compounded monthly.

Annuity due: When payments are made at the beginning of the payment intervals.
Here we find accumulated value where we find accumulated value at the end of term, where howvere
is due in the beginning of the payment term. eg: annuity payment made at the beginning of 2019,
beginning of 2020 etc.

Present value: where we find, present value of future payments to be made in the beginning of the
payment term.
Same thing can be represented with the formula:

Present value example:

Substituting in the formula:

Soln:

Practice:

1. A person is repaying a debt with payments of Rs.2,500 per month, at the beginning of every
month. If he misses his payments for July, August, September and October, what payment will
be required in November to put him back on schedule, if interest is at 12.6% per annum?

Sol: The person has to pay four overdue payments with interest, along with November
payment. Considering only these five payments, we can find the accumulated value to be paid
in November, so that he is put back on schedule.
Given: A = Rs. 2, 500; N = 5 months; R = 12.6%p.a. =⇒ R = 12.6/12 months: 1.05% p.m. =⇒ i =
1.05/ 100 = 0.0105.
Formula used: V = A/ i [(1 + i)^ N – 1] (1 + i)
V = 2, 500/ 0.0105 (1 + 0.0105)^ 5 – 1] (1 + 0.0105) = Rs. 12, 900.

2. A bank pays 8% per year interest, compounded quarterly. What equal deposits have to be made
at the beginning of each quarter for 10 years, to have Rs. 30,200 at the end of 10 years?

Sol: Given V = Rs. 30,200; N = 10 years = 40 quarter years; R = 8 % p.a.= 8/ 4 per quarter year = 2
p.q.y, =⇒ i = 2/ 100 = 0.02
Formula used: V = A/ i [(1 + i) ^N − 1 ] (1 + i)
30, 200 = A/ 0.02[ (1 + 0.02)^ 40 – 1] (1 + 0.02).
Hence the annuity A = Rs. 490.2.
 3. Find the present worth of an annuity due of Rs. 500 payable at the beginning of each month for
2 years, if the money is worth 8% p.a. compounded monthly.

Sol: Given: A = Rs. 500; N = 2 years = (2 × 12) months = 24 months R = 8 % p.a.= 8 /12 % p.m, implies
i = 2/ 300 = 0.00667.

Therefore, the present value P = A/ i [1 − (1 + i) −N] (1 + i)

P = 500/ 0.00667 [1 − (1 + 0.00667)^ −24] (1 + 0.00667) = Rs. 11, 128.5

Deferred annuity: Type of ordinary annuity where first payment is postponed until the expiry of certain
time period. (Theory only)

Perpetual annuity or Perpetuity: It is an annuity where payments begin on a fixed date and continues
forever. P= A/i, where is P is perpetuity, A is the amount of annuity and I is the rate of interest.

Perpetuity practice problems:

1. Find the Present value of an ordinary simple perpetuity paying Rs. 500 a month, if (a) R = 12%
per annum (b) R = 24% per annum.

Sol: (a) Given: A = Rs. 500; R = 12%p.a. =⇒ i = (12/ 12)/100 = 0.01

Formula used: P = A/ i ; P = 500 /0.01 = Rs. 50, 000.

Sol: (b) Given: A = Rs. 500; R = 24%p.a. =⇒ i = (24 /12) /100 = 0.02 P = 500/ 0.02 = Rs. 25, 000.

2. A scholarship fund is established by an endowment of Rs. 2,00,00,000 invested at 10% per

annum compound interest. What payment will this fund provide (a) at the end of each year,
forever? (b) at the end of every 2 years, forever?

Sol: Given: P = Rs. 2, 00, 00, 000; R = 10% p.a. =⇒ i = 10/ 100 = 0.1.

Formula used: P = A /i
(a) ∴ A = P × i =⇒ A = 2, 00, 00, 000 × 0.1 = Rs.20, 00, 000.

(b) ∴ A = P × 2i =⇒ A = 2, 00, 00, 000 × 0.2 = Rs. 40, 00, 000.

Practice: Sinking fund
1. A company sets aside a sum of Rs. 30,000 at the end of each year for 20 years in a sinking
fund, which earns 12% compound interest. The balance amount sufficient to replace
equipment. Find the expected value of the equipment at that time.

2. A company creates a sinking fund for the redemption of debentures of Rs. 16,00,000 at the
end of 16 years. If the company invests Rs. 60,000 at the end of each year in the sinking fund
and the fund accumulates 8% per annum, compounded annually. Find the extra money in
the fund after paying off the debentures.

Extra problems Sinking fund:

1. How much money is needed to establish a scholarship fund paying Rs. 10000 annually, if
the fund will earn interest at 12% per annum and the first payment be made at the end
of the first year?
2. What sum should be set aside biannually into an account paying 9% per annum interest
compounded half yearly, if it has to buy a machine expected to cost Rs. 2,00,000 at the
end of 8 years.
3. A company establishes a sinking fund for payment of Rs. 1,00,00,000 debt maturing in 8
years. How much should be deposited quarterly into sinking fund carrying 15% per
annum compounded quarterly to provide for the purpose.