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You are on page 1of 51

Ordinary

10

O

Ordinary A nnuities

Annuities

Chapter 10

McGraw-Hill

McGraw-HillRyerson

Ryerson

Ordinary

Learning Objectives

10

Annuities

LO-1

ordinary

general annuities

Calculate the

Future Value and Present Value of

ordinary simple annuities

LO-2

LO-3

fair market

McGraw-Hill Ryerson

that includes an annuity

10-2

Ordinary

Learning Objectives

10

Annuities

Calculate the

principal

immediately after any payment

LO-4

LO-5

LO-6

McGraw-Hill Ryerson

of a deferred annuity

ordinary general annuities

10-3

10-4

Ordinary

Terminology

10

Annuities

Annuity

LO-1

intervals

Term of the Annuity

- the time from the beginning of the first payment period

to the end of the last payment period

Present Value

the amount of money needed to

invest today in order to

receive a series of payments

for a given number of years

in the future

McGraw-Hill Ryerson

Future Value

the future dollar amount of a

series of payments plus interest

10-5

Ordinary

Terminology

10

Annuities

payment interval

successive payments in an annuity

are made

at the end of each payment interval

McGraw-Hill Ryerson

10-6

Ordinary

10

Terminology

Annuities

Suppose

you obtain

a personal

loan

to be

repaid by

48 equal monthly

payments

McGraw-Hill Ryerson

Term

48 months or 4years.

payment interval

1 month

ordinary annuities

first payment will be due 1 month after

you receive the loan,

i.e. at the end of the first payment interval

10-7

Ordinary

Terminology

10

Annuities

Payment interval

PMT

PMT

n-1

McGraw-Hill Ryerson

Interval

number

10-8

Ordinary

10

Ordinary Annuity

Annuities

Ordinary

Ordinary

Simple Annuities

General Annuities

differs from

Monthly payments,

Monthly payments,

and interest is

but interest is

compounded monthly

compounded semi-annually

McGraw-Hill Ryerson

Ordinary

10

Annuities

LO-2

10-9

Future Value

of an

Ordinary Simple Annuity

with interest at 4%

$1000

$1000

3

$1000

n=1

n=2

n=3

4 Interval

number

$1000

$1000 (1.04)1

$1000 (1.04)2

$1000 (1.04)3

Sum = FV of annuity

the sum of the future values of all the payments

McGraw-Hill Ryerson

Ordinary

Future Value

of an

Ordinary Simple Annuity

10

Annuities

10-10

with interest at 4%

1

$1000

4 Interval

number

$1000

$1000

$1000

n=1

$1000 (1.04)1

n=2

$1000 (1.04)2

n=3

$1000 (1.04)3

Sum = FV of annuity

= $1000 + $1040+ $1081.60 +$1124.86

= $4246.46

McGraw-Hill Ryerson

Ordinary

Future Value

of an

Ordinary Simple Annuity

10

Annuities

10-11

Suppose that you vow to save $500 a month for the next

four months, with your first deposit one month from today.

If your savings can earn 3% converted monthly, determine

the total in your account four months from now.

0

1

$500

2

$500

4 Month

3

$500

$500

$500(1+.03/12)

$500(1+.03/12)2

$500(1+.03/12)3

Sum = FV of annuity

McGraw-Hill Ryerson

Result

$ 500.00

501.25

502.50

503.76

$2,007.51

Ordinary

10

Annuities

Future Value

of an

Ordinary Simple Annuity

10-12

Now imagine that you save $500 every month for the

next three years. Although the same logic applies, I

certainly dont want to do it this way!

PV = 0

n = 3 yrs * 12 payments per year = 36 payments

Using the

McGraw-Hill Ryerson

Ordinary

10-13

Future Value

of an

Ordinary Simple Annuity

10

Annuities

You save $500 every month for the next three years.

Assume your savings can earn 3% converted monthly.

Determine the total in your account three years from now.

12

Note

Keys direction

FV

P/Y==

3

18810.28

120

36

500

McGraw-Hill Ryerson

Ordinary

10

Annuities

the

Formula

McGraw-Hill Ryerson

10-14

Future Value

of an

Ordinary Simple Annuity

FV

= PMT [

(1+ i)n - 1

Ordinary

Future Value

of an

Ordinary Simple Annuity

10

Annuities

10-15

You save $500 every month for the next three years.

Assume your savings can earn 3% converted monthly.

Determine the total in your account three years from now.

n -1

(1+

i)

FV = PMT

i

18810.28

37.6206

1.0025

0.0941

0.0025

1.0941

12

.03

1

1

500

McGraw-Hill Ryerson

]

36

Ordinary

10

using Annuities

10-16

Annuities

with your first deposit one month from today.

If your savings can earn 3% converted monthly, determine

the total in your account four months from now.

PV = 0

n = 4 payments

PMT = -500

McGraw-Hill Ryerson

10-17

Ordinary

10

Annuities

Cash Flows

..a term that refers to payments

that can be either

payments received

e.g. receipts

Positives

Treated as:

payments made

e.g. cheques

Negatives

Therefore

McGraw-Hill Ryerson

10-18

Ordinary

10

Annuities

Therefore

when you are making payments,

or even making deposits to savings,

these are cash

outflows,

Really

payments to

the bank!

and therefore

the values must be negative!

Using the

McGraw-Hill Ryerson

Ordinary

10-19

Future Value

of an

Ordinary Simple Annuity

10

Annuities

PV = 0

3

You vow to save

0

$500/month for the

12

FV =

next four months,

500

with your first

deposit one month

from today.

4

If your savings can

earn 3% converted

We already have

monthly, determine these from before, so

the total in your we dont have to enter

account four

them again!

months from now.

McGraw-Hill Ryerson

2007.51

Formula solution

Ordinary

10

Annuities

10-20

four months, with your first deposit

one month from today. If your savings can

earn 3% converted monthly, determine the

total in your account four months from now.

Formula FV = PMT

PMT = $500

n= 4

i = .03/12

= 0.0025

2007.51

4.0150

0.0100

1.0100

1.0025

0.0025

12

.03

1

1

500

McGraw-Hill Ryerson

(1+ i)n - 1

i

10-21

Ordinary

10

Annuities

calculators financial functions to

calculate an annuitys

Future Value,

the amount

each payment contributes to

the future value

is NOT apparent!

McGraw-Hill Ryerson

Ordinary

10-22

FV Contributions

10

Contribution

Annuities

FV

$10.00

14.64

$10.00

$10.00

13.31

$10.00

12.10

$10.00

11.00

10.00

0

McGraw-Hill Ryerson

3

Years

$61.05

Ordinary

10-23

Future Value

of an

Ordinary Simple Annuity

10

Annuities

If you invest all of these savings in an account which

will pay you 7% compounded monthly, determine:

a) the total in the account after 4 years

b) the amount you deposited

c) the amount of interest earned

PMT = - $75

=7

= 12 n = 4 * 12 = 48

PV = 0

FV = ?

Total Deposits = $75* 48 = $3,600

Solve

McGraw-Hill Ryerson

10-24

Ordinary

10

Annuities

$75/month for the

next four years.

If you invest all of

these savings in an

account which will

pay you 7%

compounded

monthly, determine:

a) the total in the

account after 4 years

b) the amount you

deposited

c) the amount of

interest earned

McGraw-Hill Ryerson

FV

P/Y==

7

12

4140.69

12

48

75

FV.. $4,140.69

Deposits... 3,600.00

Interest Earned = $ 540.69

Formula solution

10-25

Ordinary

10

Formula FV = PMT

Annuities

$75/month for the

next four years.

If you invest all of

these savings in an

account which will

pay you 7%

compounded

monthly, determine:

a) the total in the

account after 4 years

b) the amount you

deposited

c) the amount of

interest earned

McGraw-Hill Ryerson

(1+ i)n - 1

i

1.005833

0.005833

55.20924

0.32205

1.32205

4140.6927

12

.07

48

1

75

FV $4,140.69 - Deposits 3,600.00

= Interest Earned $540.69

Ordinary

10

Annuities

the

10-26

PresentValue

of an

Ordinary Simple Annuity

Formula

McGraw-Hill Ryerson

PV

= PMT [

1-(1+ i)-n

Ordinary

10-27

Present Value

of an

Ordinary Simple Annuity

10

Annuities

payments with interest at 4%

0

$1000 (1.04)-1

$1000

(1.04)-2

$1000

(1.04)-3

(1.04)-4

$1000

Sum = PV of annuity

McGraw-Hill Ryerson

1

$1000

n=1

2

$1000

3

$1000

4 Interval

Number

$1000

n=2

n=3

n=4

the sum of the present values of all the

payments

Ordinary

10-28

Present Value

of an

Ordinary Simple Annuity

10

Annuities

payments with interest at 4%

1

$1000

n=1

2

$1000

3

$1000

4 Interval

Number

$1000

$1000 (1.04)-1

n=2

$1000 (1.04)-2

n=3

$1000 (1.04)-3

n=4

$1000 (1.04)-4

PV of annuity

Sum = PV of annuity

= $1000(1.04)-1 + $1000(1.04)-2 + $1000(1.04)-3 + $1000 (1.04)-4

= $961.54 + $924.56 + $889.00 + $854.80

= $3629.90

McGraw-Hill Ryerson

Ordinary

10-29

Present Value

of an

Ordinary Simple Annuity

10

Annuities

loan at $450 every month for the next nine months.

The interest rate he has been charged is 12%

compounded monthly. Calculate the amount of the

loan, and the amount of interest involved.

Since you are making payments, not receiving them, PMT = -450

n = 9 payments

At the end of the loan, you dont owe any money, so FV

McGraw-Hill Ryerson

=0

Solve

10-30

Ordinary

10

Annuities

You

overhear your

friend saying the

he is repaying a

loan at $450 every

month for the next

nine months.

The interest rate he

has been charged is

8% compounded

monthly. Calculate

the amount of the

loan, and the

amount of interest

involved.

McGraw-Hill Ryerson

PV = 3,918.24

12

450

Repaid.. 4,050.00

Interest Paid = $

131.76

Formula solution

Ordinary

10

PV = PMT

Formula

Annuities

You

overhear your

friend saying the

he is repaying a

loan at $450 every

month for the next

nine months.

The interest rate he

has been charged is

8% compounded

monthly. Calculate

the amount of the

loan, and the

amount of interest

involved.

McGraw-Hill Ryerson

1-(1+ i)-n

i

10-31

-0.0580479

1.006667

0.006667

3,918.24

0.94195

12

.08

1

450

Repaid $4,050.00 - Borrowed $3,918.24

10-32

Ordinary

10

Annuities

Contribution of

Each Payment

to an

Annuitys Present Value

McGraw-Hill Ryerson

Ordinary

10

Annuities

PV Contributions

PV

9.09

8.20

$10.00

$10.00

7.51

$10.00

$10.00

6.83

$10.00

McGraw-Hill Ryerson

Contribution

$

$10.00

10-33

3

Years

6.21

5 $37.91

Ordinary

10-34

10

Annuities

LO-3

of a cash flow

McGraw-Hill Ryerson

10-35

Ordinary

10

Annuities

LO-3

building lot that you want to sell.

Ms. Armstrongs offer is

$25,000 down plus a

$100,000 lump sum payment

five years from now.

$5000 every quarter for five years.

Compare the economic values of the two offers

if money can earn 5% compounded annually.

McGraw-Hill Ryerson

Ordinary

10

Annuities

On what information

ocu

should we focus?

10-36

on a particular date (focal date)

refers to

a single amount

that is an

economic substitute for the payment stream

WE need to choose a focal date, and determine the

values of the two offers at that focal date.

offers, or the end of the term i.e. 5 years from now.)

Back to Offer Comparison

McGraw-Hill Ryerson

10-37

Ordinary

10

Annuities

you want to sell. Ms. Armstrongs offer is $25,000

down plus a $100,000 lump sum payment five

years from now. Mr. Belcher has offered $20,000

down plus $5000 every quarter for five years.

Compare the economic values of the two offers if

money can earn 5% compounded annually.

Mr. Belcher

Ms. Armstrong

$25,000 down

plus a $100,000 lump

sum payment

five years from now

$20,000 down

plus $5000 every quarter

for five years

McGraw-Hill Ryerson

Time Lines

Ordinary

10

Annuities

10-38

five years from now

$20,000 down plus $5,000 every quarter for five years

Years

$25,000

Ms. Armstrong

$20,000

Mr.Belcher

$5000 every quarter

$20,000

$20,000

$20,000

$20,000

$20,000

McGraw-Hill Ryerson

5

$100,000

10-39

Ordinary

10

Annuities

two offers on a

building lot that you

want to sell. Ms.

Armstrongs offer is

$25,000 down plus a

$100,000 lump sum

payment five years

from now. Mr. Belcher

has offered $20,000

down plus $5000 every

quarter for five years.

Compare the economic

values of the two offers

if money can earn 5%

compounded annually.

McGraw-Hill Ryerson

todays

todays

value

of

ofvalue

Ms. As

lump

sum

total offer

PV= 103,352.62

78352.692

100,000

1

25,000

Step 2

10-40

Ordinary

10

Annuities

two offers on a

building lot that you

want to sell. Ms.

Armstrongs offer is

$25,000 down plus a

$100,000 lump sum

payment five years

from now. Mr. Belcher

has offered $20,000

down plus $5000 every

quarter for five years.

Compare the economic

values of the two offers

if money can earn 5%

compounded annually.

McGraw-Hill Ryerson

todays

value

todays

of

Mr.of

Bs

value

lump

sum

total offer

P/Y

C/Y

PV == 79,376.93

99,376.93

410

5

4

4500

20

20000

10-41

Ordinary

10

Annuities

Total Value

of each offer

Ms. Armstrong

Mr.Belcher

$103,352.62

99,376.93

Difference in Offers $

3,975.69

McGraw-Hill Ryerson

Ordinary

10

Calculating the

Annuities

Original Loan

LO-4

10-42

a five-year loan, bearing 8% interest,

compounded monthly, is $249.10.

a) What was the original principal amount of the loan?

b) What is the balance owed just after the twentieth payment?

Since you are borrowing money, you are looking for PV

and FV = 0 once you have repaid the loan!

n = 5 yrs * 12 payments per year = 60 payments

McGraw-Hill Ryerson

10-43

Ordinary

10

Annuities

PMT = 249.10 FV = 0

The required

monthly payment

on a five-year loan,

bearing 8% interest,

compounded

monthly, is $249.10.

a) What was the

original principal

amount of the loan?

b) What is the

balance owed just

after the twentieth

payment?

McGraw-Hill Ryerson

n = 5*12 = 60 i = .08/12

Original loan

value

PV = 12,285.220

0

12

249.10

60

c=

= PV of 40 payments left

Ordinary

10

Annuities

The required

monthly payment

on a five-year loan,

bearing 8% interest,

compounded

monthly, is $249.10.

a) What was the

original principal

amount of the loan?

b) What is the

balance owed just

after the twentieth

payment?

McGraw-Hill Ryerson

10-44

PV =

8,720.75

New loan

balance

40

We will leave it to you to do

the algebraic solution!

10-45

Ordinary

10

Annuities

LO-5

A Deferred Annuity

may be viewed as an

ordinary annuity

that does not begin until a

time interval

(named the period of deferral)

has passed

McGraw-Hill Ryerson

10-46

Ordinary

10

Deferred Annuities

Annuities

A Deferred

Annuity

may be viewed as

an

ordinary annuity

that does not begin

until a time

interval

(named the period

of deferral)

has passed

McGraw-Hill Ryerson

Calculate the present value, PV1,

of the payments at the end of the

period of deferral this is just the

PV of an ordinary annuity

Calculate the present value,

PV2, of the STEP 1 amount

at the beginning of the period

of deferral

10-47

Ordinary

10

Annuities

month for four months. The interest rate he has been charged is

8% compounded monthly. Calculate the amount of the loan, and

the amount of interest involved.

for another 11 months, at a rate $500 every month

for four months. The interest rate is still 8%

compounded monthly. Determine the size of the loan.

McGraw-Hill Ryerson

Solve

Ordinary

10-48

Present Value

of a

Deferred Annuity

10

Annuities

10

11

$500

12

$500

13

$500

14 Months

$500

Step 2 - Discount for 10 months to get todays Loan Value

Hint: (Use Compound Discount)

McGraw-Hill Ryerson

10-49

Ordinary

10

Annuities

doesnt begin to

repay his loan

for another 11

months, at a rate

$500 every month

for four months.

The interest rate is

still 8%

compounded

monthly.

Determine the size

of the loan.

McGraw-Hill Ryerson

PV

PV =

FV

- 1967.11

1840.65

0

12

loan10value

value

months

today

from

now

8

500

4

0

10

10-50

Ordinary

10

Annuities

LO-6

differs from

Monthly payments,

but the interest is

compounded semi-annually

Using calculators

McGraw-Hill Ryerson

Ordinary

10-51

10

Annuities

McGraw-Hill Ryerson

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