Chapter 2.

TIME VALUE OF MONEY

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University
 Annuities
– a series of equal payments occurring at equal interval of time.

TYPES OFANNUITIES

ORDINARY ANNUITY – this type of annuity is one where the

payments are made at the end of each period beginning from the first
period.

Finding F when Ais given: Finding P when

−
A is given:
1+𝑖 𝑛−1 1−1+𝑖 𝑛
Where: F = future worth of an annuity
F =A 𝑖
P= A 𝑖 A = a series of periodic, equal amounts of
money
P = present worth of an annuity
i = interest rate per interest period
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n = number of interest periods
 Ordinary Annuity
P

Years 0 1 2 3 4... n
.

A F

Years 0 1 2 3 4... n
.

A
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 Ordinary Annuity
Properties of ordinary annuity:

The present sum P of the series occurs one period before the first cash
flow of the series.

The future sum F of the series occurs at the same time with the last cash
flow of the series

The annuity A is the amount of uniform cash flows and occur at regular
interval from period 1 through n, inclusive.

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 Ordinary Annuity
Properties of ordinary annuity:

The present sum P of the series occurs one period before the first cash
flow of the series.

The future sum F of the series occurs at the same time with the last cash
flow of the series

The annuity A is the amount of uniform cash flows and occur at regular
interval from period 1 through n, inclusive.

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 Ordinary Annuity

The annuity amount A, can be determine from these two formulas:

𝒊
𝑨= 𝑷
𝟏− (𝟏+𝒊)−𝒏

The factor in the bracket is called capital recovery factor and can be
designated by the symbol (A/P, i, n).
𝒊
𝑨= 𝑭
(𝟏+𝒊)𝒏 −𝟏

The factor in the bracket is called sinking fund factor and can be designated
by the symbol (A/P, I, n).
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 Ordinary Annuity
Example. What are the present worth
and the accumulated amount of a 10- Solution:
year annuity paying P10,000 at the end P = A{[1-(1+i)-n ] / i}
of each year, with interest at 15% = P10,000((1-(1+.15) -10/.15))
compounded annually? P = P50, 188
Given:
A= P10,000 F = A{[(1+i)n – 1] / i}
i = 15% = P10,000 ((1+.15) 10-1)/0.15))
n= 10 F= P203, 037
Required; P and F?

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 Ordinary Annuity
Example.
1. A 5- year ordinary annuity has a present value of $1,000. If the interest rate
is 8 percent, find the amount of each annuity payments and the accumulated
amount. Draw the cash flow diagram. Answer. A = $250.46, F = $1469.35
2. If P10,000 is deposited now, how much annuity at the end of each year can
a person get annually from the bank every year for 8 years. Cost of money
is 14%. Answer. P2155.70
3. A man bought car in installment basis. If he pays P10,000 per month at a
rate of 15% compounded monthly for 3 years, find the cash price and the
accumulated amount of money for the car.

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 Deferred Annuity
this type of annuity is one where the first payment is made several periods after
the beginning of the annuity.

P
n

Year 0 1 2 3 4... n
s .
m

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 Deferred Annuity
Finding P and F givenA

 1 1 i n 
PA 1 im

 i 

 1 i n 1 
F A 1 im

 i 
Where: m = deferred period
n= number of annuities

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 Deferred Annuity
Example 1 and 2. Suppose that a father, on the day his son is born, wishes to
determine what lump amount would have to be paid into an account bearing
interest of 12% per year provide withdrawals of $2,000 on each of the son’s
18th, 19th, 20th, and 21st birthdays. (Ans. 884.46)
 1 1 i n 
Use the formula 
P  A 1im

 i 
Where A = $2,000
n= 4 years (18th, 19th, 20th, and 21st)
m = 17 years (0-17th)
i = 0.12
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 Deferred Annuity
Example 1 continued
Suppose that the father wishes to determine the equivalent worth of the four
$2,000 withdrawals as of the son’s 24th birthday. (Ans. 13, 429.22)

Example 3. What lump sum of money must be deposited in a bank account

at present time so that P500 per month can be withdrawn for five years
with the first withdrawal scheduled for six years from today?. Let i=9%
compounded monthly. (Ans. P14,170.27)

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 Annuity Due
The annuity due is when payments are made at the beginning of the payment
period.

Find P and F givenA

 1 1 i (n1) 
P F P  A 1 
 i 
Year 0 1 2 3 ... n- n
s . 1
 1 i (n1) 1 
F  A 1
A i
 

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 Annuity Due
Example.
What are the present worth and the accumulated amount of a 10-year annuity
paying P10,000 at the beginning of each year, with interest at 15% compounded
annually? (Ans. P = P57,715.84, F = P233,492.76)

Given: A = P10,000 Solution: Direct substitution to the formula

n=10 years
i=0.15  1 1 i (n1) 
P  A 1 
 i 
Required: P and F
 1 i (n1) 1 
F  A 1
 i 
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 Annuity Due
Example.
2. A 5- year annuity due has a present value of $1,000. If the interest rate is 8
percent, find the amount of each annuity payments and the accumulated
amount. (Ans. A = $231.90)

Given: P=$1,000 Solution: Substitute to the formula:

i=0.08
n=5 years  1 1 i (n1) 
P  A 1 
 i 
Required: A=?

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 Annuity Due
Example.
3. A man bought car in installment basis. If he pays P100 at the beginning of
each month at a rate of 15% compounded monthly for 3 years, find the cash
price and the accumulated amount of money for the car.
(Ans. P = P2162.42, F = P6422.84)

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

P=A/i

Years 0 1 2 3 ...
.

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 Perpetuity
Example: Consider the perpetuity paying $100 a year. If the relevant interest
rate is 8%; what is the value of the consol? What is the value of the consol if
the interest rate goes down to 6%?

Given: A=$100
i=0.08 down to 0.06

Required: P=?

Solution:
P=A/i = $100/0.08 = $1250 , P=A/i = $100/0.06 = $1666.67

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 Annuity with Continuous Compounding
Finding P and F givenA.

 rn 
 1 e 
P  A r 
 e 1 
 

 rn 
 e 1 
F  A r 
 e 1 
 

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 Annuity with Continuous Compounding
Example.
1. A present loan of P12,000 is to repaid by equal payments every 6 months
over the next 8 years. If the interest rate is 7% compounded continuously,
what is the amount of each payment? (Ans. P996.84)

Given: P=P12,000
n=8x2 for the payment of semi-annual
i=0.07

Required: A=? Solution: Substitutetornthe formula:

 
 1 e 
P  A r 
 e 1 
11
1
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 
 Annuity with Continuous Compounding
Example.
2. What is the future worth of an equal-payment series of $5,000 per year for five
years if the interest rate is 8% compounded continuously? (Ans. $29525.87)

Given: A= $5,000 Solution: Substitute to the formula:

n=5 years
i=0.08  rn 
 e 1 
F  A r 
Required: F=?  e 1 
 

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 Gradient Series
series of cash flows where the amounts change every period.

Types of Gradient Series

1. Arithmetic Gradient Series

2. Geometric Gradient Series

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 Arithmetic Gradient Series
-An arithmetic gradient cash flow is one wherein the cash flow changes
(increase or decreases) by the same amount in each cash flow period. The
amount of increase or decrease is called gradient.

Year 0 1 2 3 ... n
.
s
A A+ A+2
G G A+(n-
1)G

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 Arithmetic Gradient Series
Finding P givenA

P= PA + PG
Where:
PA= the present worth of the first cash flow diagram which is an ordinary
annuity
PG= the present worth of the second cash flow diagram

 1 1 i n  G  1 1 i n n 

PA  A  PG    
i  n 
1i 
  i  i

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 Arithmetic Gradient Series
Example. Determine the present worth of the following series of cash flows
that occur at the end of each year at an interest rate of i=10% per year.

Given: A=100 Solution: Substitute to the formula:

n= 4 years P= PA + PG
i=0.10  1 1 i n  G  1 1 i n n 
G=50 PA  A  PG   
Required: P=?  i  i  i 1i 
n

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 Arithmetic Gradient Series
Finding F givenA

F= FA + FG
Where:
FA= the future worth of the first cash flow diagram which is an ordinary annuity
FG= the future worth of the second cash flow diagram

 1 i n 1  G  1 i n 1 
FA  A  FG    n 
 i  i  i 
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 Arithmetic Gradient Series
Example. Determine the future worth of the following series of cash flows that
occur at the end of each year at an interest rate of i=10% per year.

Given: A=100 Solution: Substitute to the formula:

n= 4 years F= FA + FG
 1 i n 1   
i=0.10
G 
 1 i n
1 
G=50 FA  A  FG   n
Required: P=?  i  i  i 
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 Arithmetic Gradient Series
Equivalent Uniform Amount (A’)

A’ is the equivalent uniform amount taking the equivalent of the series as

ordinary annuity.
A’= A + AG
A = first year’s payment
AG = uniform amount on the second year and so on
Where

1 n 
AG  G  

 i 
1 i n
1 
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 Arithmetic Gradient Series
Example. Determine equivalent uniform amount of the following series of cash
flows that occur at the end of each year at an interest rate of i=10% per year.

Given: A=100 Solution: Substitute to the formula:

n= 4 years A’= A + AG
i=0.10 1 n 
AG  G  

G=50
 i 
1 i n
1 
Required: P=?
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 Geometric Gradient Series
A geometric gradient is when the periodic payment increases or decreases by a
constant percentage.
P
Year 1= A
Year 2 = A(1+f) ...
Year 0 1 2 3 n
Year 3 = A(1+f)2 s .
Year 4 = A(1+f)3 A
Year n = A(1+f) n-1 A(1+f A(1+f)
2
A(1+f) n-
) 1

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 Geometric Gradient Series
Example:
If the first payment is $100 and the geometric gradient for successive payments
is 10%, find A in year 1 thru 4

Solution:
Year 1= A = 100
Year 2 = A(1+f) =100(1+.10) = 110
Year 3 = A(1+f)2=100(1+.10)2 = 121
Year 4 = A(1+f)3=100(1+.10)3 = 133.1

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 Geometric Gradient Series
When x ≠ 1 When x = 1
G 1 − Xn G
P= P=
1+i 1−x 1+i

1−Xn F = G(1 + i)n−1

F = G((1 + i)n−1 )
1−x
Where,
1+r
x=
1+i

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 Geometric Gradient Series
Example. Determine present amount of the following series of cash flows that
occur at the end of each year at an interest rate of i=20% and increase
percentage of r = 25% per year (Ans. P3013.07)
1000
1000
1000
1000

Given: n= 4 years i=0.20 r =0.25

Required: P=?

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 Geometric Gradient Series
Example:
Kathryn, believing that life begins at 40, decided to retire and start enjoying
life ar age of 40. She wishes to have upon her retirement a sum of P5M. On
her 21st birthday, she deposited and increased her deposit by 15% each year
until she will be 40. if the money is deposited in a super savings account
which earns 15% compounded annually, how much was her initial deposit?
(Ans. P17,566.33)

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 Capitalized Cost (CC)
-this is one of the most important applications of perpetuity. The capitalized
cost of any property is the sum of its first cost and the present worth of all costs
for replacement, operation, and maintenance for a long period or forever.

Case 1: No Replacement, maintenance and/or operation every period.

CC = FC + P

Where: CC = capitalized cost

FC = first cost
P = present worth of perpetual operation and maintenance

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 Capitalized Cost (CC)
Case 2: Replacement only, no operation and maintenance

CC = FC + X

X = S / (1+i)k-1
Where: X = present worth of perpetual replacement
S = amount needed to replace the property every k period
k = periodic replacement

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 Capitalized Cost (CC)
Example.
1.For its maintenance, a bridge in NLEX requires P250,000 at the end of 3
years and annually thereafter. If money is worth 8%, determine the capitalized
cost of all future maintenance.
(Ans. P2,679,183,81 )

2.API installed a new steam boiler at a total cost of P1.5M and is estimated to
have a useful life of 10 years. It is estimated to have a scrap value of P50,000 at
the end of its life. If interest is 8% compounded annually, determine its
capitalized cost.
Ans. P2,751,159.48

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 Amortization
-is any mode of paying debt, the principal and the interest included, usually by
a series of uniform amount every period.

Amortization schedule- a table showing the payments throughout the total

interest period.

Example. A loan of P100,000 must be repaid by a uniform amount every year

for 10 years at 10% interest per year. Determine the amount of periodic
payment and construct the amortization schedule.

Use the formula in ordinary annuity to find A.

(A= P16274.5395)
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 Amortization Schedule

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