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Annuities

An annuity is a series of nominally equal payments equally spaced in time Annuities are very common:
Rent Mortgage payments Car payment Pension income

The timeline shows an example of a 5-year, $100 annuity


100 0 1 100 2 100 3 100 4 100 5

The Principle of Value Additivity


How do we find the value (PV or FV) of an annuity? First, you must understand the principle of value additivity: The value of any stream of cash flows is equal to the sum of the values of the components In other words, if we can move the cash flows to the same time period we can simply add them all together to get the total value

Present Value of an Annuity


We can use the principle of value additivity to find the present value of an annuity, by simply summing the present values of each of the components:
PVA !

1  i ! 1  i  1  i   1  i
Pmt t Pmt 1 Pmt 2
t 1 2 t !1

Pmt N
N

Present Value of an Annuity (cont.)


Using the example, and assuming a discount rate of 10% per year, we find that the present value is:
PVA ! 100
1

. . 110 110

100
2

100 . 110
3

100 . 110
4

100 . 110
5

! 379.08

62.09 68.30 75.13 82.64 90.91 379.08

100 0 1

100 2

100 3

100 4

100 5

Present Value of an Annuity (cont.)


Actually, there is no need to take the present value of each cash flow separately We can use a closed-form of the PVA equation instead:
PVA !

1  i
Pmt t
t !1

1  1 N 1  i ! Pmt i

Present Value of an Annuity (cont.)


We can use this equation to find the present value of our example annuity as follows:
1  1 5 . 110 ! 379.08 PVA ! Pmt 0.10


This equation works for all regular annuities, regardless of the number of payments

The Future Value of an Annuity


We can also use the principle of value additivity to find the future value of an annuity, by simply summing the future values of each of the components:
FVA !

Pmt 1  i
t t !1

Nt

! Pmt 1 1  i

N 1

 Pmt 2 1  i

N 2

  Pmt N

The Future Value of an Annuity (cont.)


Using the example, and assuming a discount rate of 10% per year, we find that the future value is:
FVA ! 100 110  100 110  100 110  100 110  100 ! 610.51 . . . .
146.41 133.10 121.00 110.00
4 3 2 1

100 0 1

100 2

100 3

100 4

100 5

= 610.51 at year 5

The Future Value of an Annuity (cont.)


Just as we did for the PVA equation, we could instead use a closed-form of the FVA equation:
FVA !


Pmt 1  i
t t !1

Nt

1  i N  1 ! Pmt i

This equation works for all regular annuities, regardless of the number of payments

Future Value of an Annuity


Annuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat and promise to make a series of payments over an agreed period, you have created an annuity.
(1  i ) n  1 Fn ! A i

The term within brackets is the compound value factor for an annuity of Re 1, which we shall refer as CVFA.
n

= v CVFA n, i

Example
Suppose that a firm deposits Rs 5,000 at the end of each year for four years at 6 per cent rate of interest. How much would this annuity accumulate at the end of the fourth year? We first find CVFA which is 4.3746. If we multiply 4.375 by Rs 5,000, we obtain a compound value of Rs 21,875:
F4 ! 5,000(CVFA 4, 0.06 ) ! 5,000 v 4.3746 ! Rs 21,873

Sinking Fund
Sinking fund is a fund, which is created out of fixed payments each period to accumulate to a future sum after a specified period. For example, companies generally create sinking funds to retire bonds (debentures) on maturity. The factor used to calculate the annuity for a given future sum is called the sinking fund factor (SFF). i A = Fn (1  i )n  1

Capital Recovery and Loan Amortisation


Capital recovery is the annuity of an investment made today for a specified period of time at a given rate of interest. Capital recovery factor helps in the preparation of a loan amortisation (loan repayment) schedule.
1 = P PVAFn ,i

The reciprocal of the present value annuity factor is called the capital recovery factor (CRF).
A= C Fn,i

Annuities Due
Thus far, the annuities that we have looked at begin their payments at the end of period 1; these are referred to as regular/ordinary annuities A annuity due is the same as a regular annuity, except that its cash flows occur at the beginning of the period rather than at the end
100 5-period Annuity Due 5-period Regular Annuity 0 100 100 1 100 100 2 100 100 3 100 100 4

100 5

Present Value of an Annuity Due


We can find the present value of an annuity due in the same way as we did for a regular annuity, with one exception Note from the timeline that, if we ignore the first cash flow, the annuity due looks just like a fourperiod regular annuity Therefore, we can value an annuity due with:
PVAD

1  1 N 1 1  i  Pmt ! Pmt i

Present Value of an Annuity Due (cont.)


Therefore, the present value of our example annuity due is:
1  1 51 . 110  100 ! 416.98 ! 100 0.10

PVAD

Note that this is higher than the PV of the, otherwise equivalent, regular annuity

Future Value of an Annuity Due


To calculate the FV of an annuity due, we can treat it as regular annuity, and then take it one more period forward:
FVAD 1  i N  1 1  i ! Pmt i
Pmt 2 Pmt 3 Pmt 4 5

Pmt 0

Pmt 1

Future Value of an Annuity Due (cont.)


The future value of our example annuity is:
110 5  1 . 110 ! 67156 . . ! 100 0.10

FVAD

Note that this is higher than the future value of the, otherwise equivalent, regular annuity

Value of an Annuity Due


Annuity due is a series of fixed receipts or payments starting at the beginning of each period for a specified number of periods. Future Value of an Annuity Due
Fn = A v CVFA n , i (1  i )

Present Value of an Annuity Due


= A PVFA n, i (1 + i)

Deferred Annuities
A deferred annuity is the same as any other annuity, except that its payments do not begin until some later period The timeline shows a five-period deferred annuity
100 0 1 2 3 100 4 100 5 100 6 100 7

PV of a Deferred Annuity
We can find the present value of a deferred annuity in the same way as any other annuity, with an extra step required Before we can do this however, there is an important rule to understand: When using the PVA equation, the resulting PV is always one period before the first payment occurs

PV of a Deferred Annuity (cont.)


To find the PV of a deferred annuity, we first find use the PVA equation, and then discount that result back to period 0 Here we are using a 10% discount rate
PV2 = 379.08 PV0 = 313.29
0 0 1 0 2 100 3 100 4 100 5 100 6 100 7

PV of a Deferred Annuity (cont.)


1  1 5 . 110 ! 379.08 PV2 ! 100 0.10

Step 1:

Step 2:

PV0 !

379.08 . 110
2

! 313.29

FV of a Deferred Annuity
The future value of a deferred annuity is calculated in exactly the same way as any other annuity There are no extra steps at all

Uneven Cash Flows


Very often an investment offers a stream of cash flows which are not either a lump sum or an annuity We can find the present or future value of such a stream by using the principle of value additivity

Uneven Cash Flows: An Example (1)


Assume that an investment offers the following cash flows. If your required return is 7%, what is the maximum price that you would pay for this investment?
100
0 1

200
2

300
3 4 5

PV !

100
1

1.07 1.07

200
2

300

1.07

! 513.04

Uneven Cash Flows: An Example (2)


Suppose that you were to deposit the following amounts in an account paying 5% per year. What would the balance of the account be at the end of the third year?
300
0 1
2

500
2

700
3
1

FV! 300 1.05  500 1.05  700 ! 1,555.75

Non-annual Compounding
So far we have assumed that the time period is equal to a year However, there is no reason that a time period cant be any other length of time We could assume that interest is earned semiannually, quarterly, monthly, daily, or any other length of time The only change that must be made is to make sure that the rate of interest is adjusted to the period length

Non-annual Compounding (cont.)


Suppose that you have $1,000 available for investment. After investigating the local banks, you have compiled the following table for comparison. In which bank should you deposit your funds?
Bank First National Second National Third National Interest Rate 10% 10% 10% Compounding Annual Monthly Daily

Non-annual Compounding (cont.)


To solve this problem, you need to determine which bank will pay you the most interest In other words, at which bank will you have the highest future value? To find out, lets change our basic FV equation slightly:
i FV ! PV 1  m In this version of the equation m is the number of compounding periods per year
Nm

Non-annual Compounding (cont.)


We can find the FV for each bank as follows:

First National Bank: Second National Bank:

FV ! 1,000 110 ! 1,100 . 0.10 FV ! 1,000 1  12 0.10 FV ! 1,000 1  365


12

! 1,104.71
365

Third National Bank:

! 1,10516 .

Obviously, you should choose the Third National Bank

Multi-Period Compounding
If compounding is done more than once a year, the actual annualised rate of interest would be higher than the nominal interest rate and it is called the effective interest rate.
i EIR = 1  m
nv m

Continuous Compounding
There is no reason why we need to stop increasing the compounding frequency at daily We could compound every hour, minute, or second We can also compound every instant (i.e., continuously): rt

F ! Pe

Here, F is the future value, P is the present value, r is the annual rate of interest, t is the total number of years, and e is a constant equal to about 2.718

Continuous Compounding (cont.)


Suppose that the Fourth National Bank is offering to pay 10% per year compounded continuously. What is the future value of your $1,000 investment?

F ! 1,000 e
 

0 .10 1

! 1,105.17

This is even better than daily compounding The basic rule of compounding is: The more frequently interest is compounded, the higher the future value

Continuous Compounding (cont.)


Suppose that the Fourth National Bank is offering to pay 10% per year compounded continuously. If you plan to leave the money in the account for 5 years, what is the future value of your $1,000 investment?

F ! 1,000e

0 .10 5

! 1,648.72

Present Value of Perpetuity


Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in financial decision-making:
Present value of a perpetuity ! Perpetuity Interest rate

Present Value of Growing Annuities


The present value of a constantly growing annuity is given below:
1  g n A = 1  i  g 1 i

Present value of a constantly growing perpetuity is given by a simple formula as follows:


A P= ig

Continuous Compounding
The continuous compounding function takes the form of the following formula:
Fn ! v eiv n ! v ex

Present value under continuous compounding:


Fn P ! i n ! Fn e e  i vn