ANNUITIES 3.1 Introduction and Information In our discussions in the last two chapters, we learned that an individual or business owner can invest a sum of money in a bank or financial institution over a period of time that will earn simple or compound interest. But, if the individual or business owner does not have a large sum of money to do that, he may invest over a period of time. This can be done by making a series of equal deposits or payments at regular intervals ata specific interest rate that will earn compound interest. This form of investing money is known as annuity. ies for several reasons taxes and retirement Individuals and business owners invest in ann such as to pay promissory notes, dividends, liabilities, benefits or accumulate funds to expand their businesses or procure modern facilities and equipment. Buying insurance policies from insurance companies is a common and simple form of investing in annuities. An annuity is a series of equal payments made at equal intervals of time. This means that each payment made is added to the amount already in the account and the new balance becomes the basis for calculating the compound interest. In other words, if a specific sum of money is deposited on a regular basis over a number of years, the compound interest on each new balance every compounding period will eventually attain the desired amount of money. For example, if 100,000.00 is deposited in an account at the end of each year for 5 years that earns interest rate at’ 10% compounded annually, then the accumulated amount or future value under annuity would be 610,510.00. But, if no interest was earned on the interest, the accumulated value would only be 600,000.00. In this chapter, we will discuss the two (2) types of annuities, commonly used in business. The types of annuities are the ordinary annuity, annuity due, deferred annuity and annuity perpetuity. 3.2 Ordinary Annuity The ordinary annuity is a series of equal and regular payments in which each payment is made at the end of the payment period. The amount of each payment is called the periodic rent or periodic payment. The periodic period is the length of time between two (2) successive payments. The length of time between the beginning of the first payment period and the end of the last payment period is called the term of the annuity. 1063.2.1 Amount of an Ordinary Annuity (5,) 0 The amount or final val ayments and th cash value, We s lue of an ordinary annuity is the sum of all Fae eres interests. This total amount is also called use S, to denote the amount of an ordinary annuity. The amount of an ordinary annuity is calculated using the following, formula: where: S, = amount of ordinary annuity R = amount of periodic payment i = rate of interest per conversion period n = number of payment periods Examples: 1. A man will deposit 25,000.00 each year for the next 5 years in an ordinary annuity account that pays 8% interest compounded annually. Find the amount of the annuity at the end of 5 years. Given: R = 25,000.00 n= 5 (5 years X 1 period per year) i = 8% or 0.08 Solution: Substituting the given values in the formula, we have: 1+i)'-1 " (‘ ? i (1+0.08)) Prse000| 5, = 146,665.02 (rounded to the nearest centavo) Using a scientific calculator, g, = 25,000 x (((1 + 08) A5— 1) + .08) = 146,665.02 or = + .08 = x 25,000 = 146,665.02 $,= 14.08 =A5=— Use y* or x if A is not available in the calculator.2. Find the amount of an ordinary annuity whose payment of F16,069, 0 is payable at the end of each quarter for 10 years and 6 mony, Money is worth:5.8% compounded quarterly. . Given: R = 16,000.00 n= 42 (104 years x4 periods per year) 5.8% j=5:8% (m =4)or i ie = 1.45% or 0.0145 Solution: Substituting the given values in the formula, we obtain: (1+0.0145)" -1 0.0145 S, =F 916,490.18 (rounded to the nearest centavo) A Pris. By using scientific calculator, we have: S, = 16,000 x (((1 + 0145) A 42 - 1) + .0145) = 916,490.18 or S, = 1+ .0145 = A 42 = - 1 = + .0145 = x 16,000 = 916,490.18 3.3 Annuity Due An annuity due involves a series of equal payments made at the beginning of each payment period. Hence, the term of an annuity due begins from the time the first periodic payment is made and ends one period after the last periodic payment. The amount of an annuity due is the value of the annuity at the end of the term. 3.3.1 Amount of an Annuity Due (S,,,) The amount of an annuity due is the sum of all payments from the beginning of the payment period plus the accumulated interest where the number of compounding periods is increased by 1. One compounding period is added since the payment is made at the beginning of the compounding period. We shall use S,,, to denote the amount of an annuity due. 108 ‘[IMatheriatics of investment)The amount - . int of an annuity due is determined by using the following formula: where: S.,,.. = amount of annuity due R = amount of periodic payment i = rate of interest per conversion period n = number of payment periods Examples: 1. Mr. R. dela Cruz has been investing #5,000.00 at the beginning of each quarter in a savings account for the past 5 years. If the bank is paying 8% compounded quarterly, how much is the balance in his savings account and the interest earned at the end of 5 years? Given: R= 5,000.00 n= 21 6 years x 4 periods per year + 1 period) = = 2% or 0.02 j = 8% (m = 4) or i Solutions: a. Solve the annuity due. Substitute the given values in the e formula, we obtain: (1+0.02)°"=1_| 7 00 0.02 Sas) =P 123; 916.59 (rounded to the nearest centavo) ave) =P AY : Using a scientific calculator, ) +.02)- 1) = F 123,916.59 Sun DAU ACOA D—T wae ope ABs —1e 4 022-1 = *5,000 = 123,916.59 Siew)nt of compound interest earned, as follows, b. Find the total amouw —Sum of Payments Le Stave = F123, 916.59 - (5,000.00 x 20) =F 123,916.59 -F*100, 000.00 1 =? 23,916.59 int of the a) annuity due and b) interest earned fo, 2. Find the amoui easoo00 a 6 years if the quarterly periodic payment is compounded quarterly. Given: R = ¥12,500.00 n = 25 (6 years x 4 periods per year + 1 period 8.4% 4 = 2.1% or 0.021 j = 8.4% (m = 4) or i= Solution: a. The amount of annuity due is obtained by substituting the given values in the formula, as follows: aA i Say 8H a) =F 12,500.00] (42.02 =1_ : 0.021 Save) =7°393, 031.89 (rounded to the nearest centavo) Using a scientific calculator, Saye) = 12,500 x ((((1 + .021) A (24 + 1)— 1) + .021) ~1) = 393,031.89 or See) = 1+ 021 = A25 = -1 = + 021 = 1 = x 12,500 = 393,031.89 b. Calculating the amount of compound interest earned, we shall have: I= S,,,. — Sum of Payments = 393,031.89 - (F 12,500.00 x 24) = F393, 031.89 - 300,000.00 I = 93,031.8934 Present Value of an Ordina : 7 ry Annuity (A,) e present val i ed a Spee of an annuity is the sum of money today which if _ stiat tha ‘Gnd e will amount to all the payments and the compound inter ier deposit gine, term of the annuity. This can also mean the eee ceanties be ad in order to receive a specified number of regular Be (00,00, at the oa if an individual would like to withdraw - aa eee’ of each month for the next 5 years, he may decide to dep P Sum of money today in an account earning compound interest every month. We shall use A. : ; te ordinary annuity, ‘> to denote the present value of an The present value of an o: din: ity i ing the following formula: lary annuity is calculated by using the where: A, = present value of ordinary annuity R = amount of periodic payment i = rate of interest per conversion period n = number of payment periods Examples: 1. Find the present value of an ordinary annuity whose periodic payment of 15,000.00 is payable at the end of each 6 months for 10 years at 8% compounded semi-annually. Given: R = 15,000.00 n = 20 (10 years x 2 periods per year) , 8% 8% (m = 2) or 1= >= 4% or 0.04 jSolution: We shall substitute = Ps n00| the given values in the formula, as follows, A, =?203,854.90 (rounded to the nearest centavo) Using a scientific calculator, A, = 15,000 x ((1 = (1 + .04) A 20 +/+) = + 0.04 = 208,854.90 A, = 1+.04= A204 = 41-41 = + 04 = * 15,000 = 208,854.90 2. Mr. R. Romero wants to deposit a sum of money today that will give an ordinary annuity paying 12,000.00 quarterly for the next 6 years. If the interest is 8.8% compounded quarterly and withdrawals will be done at the end of each quarter, find the present value of the ordinary annuity. Given: R= F 12,000 n= 24 (6 years x 4 periods per year) j = 8.8% (m = 4) ori = oe or 2.2% or 0.022 Solution: Substituting the given values in the formula, we have: A, -x{ 020") 1-(1+0.022)" 0.022 221,907.78 (rounded to the nearest centavo) = Prac Using a scientific calculator, A, = 12,000 x (((1 — (1 + .022) A.24 H-) = + .022) = 221,907.78 or A, = 14.022 = A24 4h = 4h +1 = + 022 = x 12,000 = 221,907.78. e and lot. Mr. Santos is offering of 250,000.00 icashy, while Mr. Reyes is offering a downpayment the end of each mang rthly Periodic payments of 725,000.00 at Romero accept if moat for 5 years. Which of the offers should Mrs. and find the differ, ‘oney can be invested at 9% compounded monthly eich walues ence between the offers in terms of their equivalent Solution: a. The cash offer of Mr. Santos is ¥1,400,000.00 cash. b. ihe equivalent cash offer of Mr. Reyes is the sum of the lownpayment and the present value of the annuity. Given: Downpayment = 250,000.00 R = 25,000.00 1 = 60 (5 years x 12 periods per year) j= 9% (m= 12) of i= Gem, Be'0.0075 - 12 4 The present value is calculated, as follows: -(1+i)” A,=R [Eo] 1-1 see") = on oo A, = P°1,204,334.34 (rounded to the nearest centavo) Using a scientific calculator, A, = 25000x((CL-(1+ 0079) 060 44) = +. 0075) = P,204 334.34 or A,= 14.0075 = AGO +E = H+ 1 = + 0075 x 25,000 = 1,204,334.34 Hence, the offer of Mr. Reyes is: Deposit + Present Value of the Annuity = Equivalent Cash Value 250,000.00 + ¥1,204,334.34 = P1454,334.34we say that Mrs. R. de Vera should accepy because the cash equivalent of his offer than the offer of Mr. Santos c. Comparing the offers, the offer of Mr. Reyes is 1,454,334.34 which is greater which is only *1,400,000.00. d. The difference between the equivalent cash values of the 2 offers is 54,334.34, calculated as follows: Mr. Reyes’ Offer ~ Mr. Santos’ Offer = F 1,454,334.34 — F1,400,000.00 = 54,334.34 Difference in Offer 3.5. Present Value of an Annuity Due The present value of an annuity due is the vali the annuity, including the initial payment. The term of an annuity due has one payment more than that of an ordinary annuity. We shall use A,,,, to denote the present value of an annuity due. jue at the beginning of The present value of an annuity due is calculated by using the following formula: A (due) . x te i where: Ajj. = present value of annuity due due) R = amount of periodic payment i = rate of interest per conversion period n = number of payment periods Examples: 1. Find the present value of an annuity due whose periodic : payment of 12,000.00 is payable per quarter at 8% compounded qlaterly for 5 years. Given: R = F 12,000.00 n = 20 (5 years x 4 periods per year) ; “) 3% j = 8% (m = 4) ori= a = 2% or 0.02 114Solution: Substitut : ubstituting the given values in the formula, we have: =Pi2,000,00| 1=@+ 0.02)" 0.02 Pra = Ee | A au) = 200,141.54 (rounded to the nearest centavo) Using a scientific calculator, A aun) = 12,000 x (((1 — (1 + 02) 0.19 +/+) + 02) + 1) = 200,141.54 or Maw = 1+.= A194 = 4-41 = + 02 = +1 = x 12,000 = 200,141.54 2. How much is the periodic payment payable twice a year of an annuity due whose present value is 150,000.00 for 5 years and 6 months if money is worth 8% compounded twice a year. Given: Aue = 150,000.00 ne n(55 years x2 periods per year) j = 8% (m = 2) ori= Se = 4% or 0.04 Solution: Step 1: From the formula on annuity due, we shall derive the formula for the periodic payment (R), as follows: 1-(1+i Aca) =f oer" 1 1sStep 2: Substituting the values in the formula above, we shai have: ____ 150,000.00 = (11-1) 1-(1 a = if ag _ 150,000.00 z 10 ee +1 R =? 16, 463.80 (rounded to the nearest centavo) Using a scientific calculator, we shall have: R = 150,000 + (((1 — (1 + .04) A 10 +/-) + .04) + 1) = 16,463.80