Time Value of Money

ANNUITY
Learning Goals
Find the present and future value of:
a. Ordinary annuity, and
b. Annuity due
Find the present value of perpetuity
ANNUITIES
DEFINITION OF TERMS
Annuity a stream of equal periodic cash flows, over a specified time
period. These cash flows can be inflows of returns earned on investment
or outflows of funds invested to earn future returns.

Ordinary annuity an annuity for which the cash flow occurs at the
end of each period.

Annuity Due an annuity for which the cash flow occurs at the
beginning of each period.

Perpetuity an annuity with an infinite life in other words, an annuity

that never stops providing its holders with a cash flow at the end of each
year.
ANNUITIES
Illustration:
Fran Abrams is choosing which of two annuities to receive. Both are 5-
year, $1,000 annuities; annuity A is an ordinary annuity, and the annuity
B is an annuity due. Note that the amount of each annuity totals $5,000.
The two annuities differ in timing of their cash flows: the cash flows are
received sooner with the annuity due than with the ordinary annuity.
ANNUITIES
Future Value of Ordinary Annuity
Fran Abrams wishes to determine how much money
she will have at the end of 5 years if she chooses
annuity A, the ordinary annuity. It represents
deposits of $1,000 annually, at the end of each of
the next 5 years, into savings account paying 7%
annual interest.
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Future Value of Ordinary Annuity
General Equation:
FVAn=PMT x {[(1+i)n-1]/i}
where:
FVAn = future value of an n-year annuity
PMT = amount to be deposited annually at the
end of each year
i = annual rate of interest paid
n = number of period that the money is left on
deposit
ANNUITIES
Future Value of Ordinary Annuity
Solution : Using the Timeline
ANNUITIES
Future Value of Ordinary Annuity
Solution : Using the formula
Required: Future value of Fran Abrams investment if she chooses annuity
A, the ordinary annuity.
Formula:
FVAn=PMT x {[(1+i)n-1]/i}
Given:
PMT = $1,000 .00
i = 7% or 0.07
n = 5 years
Solution:
FVAn=PMT x {[(1+i)n-1]/i}
FVAn=$1,000 x {[(1+0.07)5-1]/0.07}
FVAn =$1,000 x 5.75073901
FVAn =$5,750.71
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Present Value of Ordinary Annuity
Braden Company, a small producer of plastic toys,
wants to determine the most it should pay to
purchase a particular ordinary annuity. The annuity
consists of cash flows of $700 at the end of each
year for 5 years. The firm requires the annuity to
provide a minimum return of 8%.
ANNUITIES
Present Value of Ordinary Annuity
General Equation:
PVAn=PMT x {[1-(1+i)-n]/i}
where:
PVAn = Present value of an n-year annuity
PMT = amount to be deposited annually at the
end of each year
i = annual rate of interest paid
n = number of period that the money is left on
deposit
ANNUITIES
Present Value of Ordinary Annuity
Using the Timeline
ANNUITIES
Present Value of Ordinary Annuity
Solution : Using the formula
Required: The amount Braden Company should pay to purchase a
particular ordinary annuity. Formula:
PVAn=PMT x {[1-(1+i)-n]/i}
Given:
PMT = $700 .00
i = 8% or 0.08
n = 5 years
Solution:
PVAn=PMT x {[1-(1+i)-n]/i}
PVAn=$700 x {[1-(1+0.08) -5]/0.08}
PVAn =$700 x 3.9927100375
PVAn =$2,794.90
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Future Value of Annuity Due
Fran Abrams wishes to determine how much money
she will have at the end of 5 years if she chooses
annuity B, the annuity due. It represents deposits of
$1,000 annually, at the beginning of each of the
next 5 years, into savings account paying 7%
annual interest.
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Future Value of Annuity Due
General Equation:

where:
FVA(annuity due) = future value of an n-year annuity
PMT = amount to be deposited annually at the
beginning of each year
i = annual rate of interest paid
n = number of period that the money is left on
deposit
ANNUITIES
Future Value of Annuity Due
Solution : Using the formula
Required: Future value of Fran Abrams investment if she chooses annuity
B, the annuity due.
Formula:

Given:
PMT = $1,000 .00
i = 7% or 0.07
n = 5 years
Solution:
FVA (annuity due)=PMT x {[(1+i)n-1]/i} x (1+i)
FVAn=$1,000 x {[(1+0.07)5-1]/0.07} x (1+0.07)
FVAn =$1,000 x 6.1532907407
FVA =$6,153.29
 ANNUITIES
Comparison between Future Value of Ordinary
Annuity versus Future Value of Annuity Due
(Fran Abrams two annuities)
Future Value of Ordinary Annuity : $5,750.71
Future Value of Annuity Due : $6,153.29

Analysis:
The future value of an annuity due is greater than the future value of
an otherwise identical ordinary annuity. Because the cash flow of the
annuity due occurs at the beginning of the period rather than at the
end, its future value is greater. In the problem given, Fran would earn
about $400 more with annuity due.
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Present Value of Annuity Due
Braden Company, a small producer of plastic toys,
wants to determine the most it should pay to
purchase a particular ordinary annuity. Braden has
annual cash flows of $700 occurring at the
beginning of each year for 5 years. The firm requires
the annuity to provide a minimum return of 8%.
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Present Value of Annuity Due
General Equation:

where:
PVA(annuity due) = present value of an n-year annuity
PMT = amount to be deposited annually at the
beginning of each year
i = annual rate of interest paid
n = number of period that the money is left on
deposit
ANNUITIES
Present Value of Annuity Due
Solution : Using the formula
Required: The amount Braden Company should pay to purchase a
particular ordinary annuity. Formula:

Given:
PMT = $700 .00
i = 8% or 0.08
n = 5 years
Solution:
PVAn=PMT x {[1-(1+i)-n/i} x (1+i)
PVAn=$700 x {[1-(1+0.08) -5]/0.08} x (1+0.08)
PVAn =$700 x 4.3121268405
PVAn =$3,018.49
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Comparison between Present Value of
Ordinary Annuity versus Present Value of
Annuity Due (Branden Companys two
annuities)
Present Value of Ordinary Annuity : $2,794.90
Present Value of Annuity Due : $3,018.49

Analysis:
The present value of an annuity due is greater than the present
value of an otherwise identical ordinary annuity. Because the cash flow
of the annuity due occurs at the beginning of the period rather than at
the end, its present value is greater. In the problem given, Braden
Company would realize about $200 more with present value with annuity
due.
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Present Value of Perpetuity
An individual is offered a bond that pays coupon
payments of $10 per year and continues for an infinite
amount of time. Assuming a 5% discount rate, what is
the amount the individual is expected to pay for this
perpetuity?
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Present Value of Perpetuity
General Equation:
PVA = PMT x (1 / i )
where:
PVA = Present value of an annuity with an indefinite
life
PMT = amount to be deposited annually at the end
of each year
i = annual rate of interest paid
 An individual is offered a bond that pays co

ANNUITIES payments of $10 per year and continues fo

infinite amount of time. Assuming a 5% dis
rate, what is?
Present Value of Annuity Due
Solution : Using the formula
Required: The amount the individual is expected to pay for this perpetuity
Formula:
PVA = PMT x (1 / i )
Given:
PMT = $10 .00
i = 5% or 0.05
Solution:
PVA = $10 x (1 / 0.05 )
PVA = $10 x 20
PVA = $200
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Illustrative Problems:
1. Kimberly had just won $20 million lottery, which
will pay her $1 million at the end of each year for 20
years. An investor has offered her $10 million for
this annuity. She estimates she can earn 10 percent
interest, compounded annually, on any amounts she
invest. She askes your advice on whether to accept
or reject the offer. What will you tell her?
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Illustrative Problems:
2. Mr. Handyman has been awarded a bonus for his
outstanding work. His employer offers him a choice
of a lump-sum of $5,000 today or an annuity of
$1,250 a year for the next five years. Which option
should Mr. Handyman chooses if his opportunity
cost is 9 percent?
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Illustrative Problems:
3. In their meeting with their advisor, Mr. & Mrs.
Smith concluded that they would need $40,000 per
year during their retirement years in order to live
comfortably. They will retire 10 years from now and
expect a 20-year retirement period. How much
should Mr. & Mrs. Smith deposit now in a bank
account paying 9 percent to reach financial
happiness during retirement?
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Illustrative Problems:
4. Jay is 30 years old and will retire at age 65. He
will receive retirement benefits but the benefits are
not going to be enough to make a comfortable
retirement life for him. Jay has estimated that an
additional $25,000 a year over his retirement
benefits will allow him to have a satisfactory life.
How much should Jay deposit today in an account
paying 6 percent interest to meet his goal? Assume
Jay will have 15 years of retirement.