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10-1

Ordinary

10

O
Ordinary A nnuities

Annuities

Chapter 10
McGraw-Hill
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Ryerson

Ordinary

Learning Objectives

10
Annuities

After completing this chapter, you will be able to:

Define and distinguish between


LO-1

ordinary

simple annuities and ordinary


general annuities

Calculate the
Future Value and Present Value of
ordinary simple annuities

LO-2

LO-3

fair market

McGraw-Hill Ryerson

value of a cash flow stream


that includes an annuity

10-2

Ordinary

Learning Objectives

10
Annuities

Calculate the
principal

balance owed on a loan


immediately after any payment

LO-4

LO-5

LO-6

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Present Value of and period of deferral


of a deferred annuity

Future Value and Present Value of


ordinary general annuities

10-3

10-4

Ordinary

Terminology

10
Annuities

Annuity

LO-1

- A series of equal payments at regular


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
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Future Value
the future dollar amount of a
series of payments plus interest

10-5

Ordinary

Terminology

10
Annuities

PMT is the amount of each payment in an annuity

is the number of payments in the annuity

payment interval

is the time between


successive payments in an annuity

ordinary annuities are ones in which payments


are made
at the end of each payment interval
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10-6

Ordinary

10

Terminology

Annuities

Suppose
you obtain
a personal
loan
to be
repaid by
48 equal monthly
payments

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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

for an n-payment Ordinary Annuity


Payment interval

PMT

PMT

n-1

PMT PMT PMT

Term of the annuity


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Interval
number

10-8

Ordinary

10

Ordinary Annuity

Annuities

Ordinary

Ordinary

Simple Annuities

General Annuities

The payment interval

The payment interval

differs from

the compounding interval

the compounding interval

Monthly payments,

Monthly payments,

and interest is

but interest is

compounded monthly

compounded semi-annually

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Ordinary

10
Annuities

LO-2

10-9

Future Value
of an
Ordinary Simple Annuity

Assume that there are four(4) annual $1000 payments


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
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Ordinary

Future Value
of an
Ordinary Simple Annuity

10
Annuities

10-10

Assume that there are four(4) annual $1000 payments


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

FV of annuity = $1000 + $1000(1.04) + $1000(1.04)2 + $1000(1.04)3


= $1000 + $1040+ $1081.60 +$1124.86
= $4246.46
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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!

Since your account was empty when you began


PV = 0
n = 3 yrs * 12 payments per year = 36 payments

Using the
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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

Using the formula


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Ordinary

10
Annuities

the

sum of the future values of all the payments

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
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]
36

Ordinary

10

Solving earlier Question


using Annuities

10-16

Annuities

You vow to save $500/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.

Since your account was empty when you began

PV = 0
n = 4 payments
PMT = -500

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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
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10-18

Ordinary

10

Cash Flow Sign Convention

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
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Ordinary

10-19

Future Value
of an
Ordinary Simple Annuity

10
Annuities

PV = 0

n = 4 payments PMT -500

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.
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2007.51

Formula solution

Ordinary

10
Annuities

10-20

You vow to save $500/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.
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

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(1+ i)n - 1
i

10-21

Ordinary

10

Not seeing the total picture!

Annuities

When you use formula or a


calculators financial functions to
calculate an annuitys
Future Value,

the amount
each payment contributes to
the future value
is NOT apparent!

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Ordinary

10-22

FV Contributions

10

Contribution

10% Compounded Annually

Annuities

FV

$10.00

14.64

$10.00

$10.00

13.31

$10.00

12.10

$10.00

11.00
10.00

0
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3
Years

$61.05

Ordinary

10-23

Future Value
of an
Ordinary Simple Annuity

10
Annuities

You decide to save $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

Extract necessary data...


PMT = - $75

=7

= 12 n = 4 * 12 = 48

PV = 0
FV = ?
Total Deposits = $75* 48 = $3,600

Solve
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10-24

Ordinary

10
Annuities

You decide to save


$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

You decide to save


$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

sum of the present values of all the payments

Formula

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PV

= PMT [

1-(1+ i)-n

Ordinary

10-27

Present Value
of an
Ordinary Simple Annuity

10
Annuities

Assume that there are four(4) annual $1000


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
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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

Assume that there are four(4) annual $1000


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
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Ordinary

10-29

Present Value
of an
Ordinary Simple Annuity

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 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

Repaid 9 payments at $450 = $4,050

Interest - use 12, not .12 when using financial calculator


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

Amount Borrowed (PV) $ 3,918.24


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

= Interest Charged $131.76

10-32

Ordinary

10
Annuities

Contribution of
Each Payment
to an
Annuitys Present Value

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Ordinary

10
Annuities

PV Contributions
PV

9.09
8.20

$10.00

$10.00

7.51

$10.00
$10.00

6.83
$10.00

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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

stream that includes an annuity

10-35

Ordinary

10
Annuities

LO-3

You have received 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.

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Ordinary

10
Annuities

On what information
ocu
should we focus?

10-36

The economic value of a payment stream


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.

(Obvious choices would be today, the date of the


offers, or the end of the term i.e. 5 years from now.)
Back to Offer Comparison
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10-37

Ordinary

10
Annuities

You have received 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.

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

Focal Date: Today


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Preparing Time Lines

Time Lines

Ordinary

10

Annuities

10-38

$25,000 down plus a $100,000 lump sum payment


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

Step 1Determine todays value of Ms. Armstrongs offer

You have received


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

Step 2 Determine todays value of Mr. Belchers offer.

You have received


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

Better off accepting Ms. Armstrongs offer!

McGraw-Hill Ryerson

Ordinary

10

Calculating the

Annuities

Original Loan

LO-4

and a Subsequent Balance

10-42

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?
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
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10-43

Ordinary

10
Annuities

Original Principal = PV of all 60 payments


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=

Balance after 20 payments


= PV of 40 payments left

Ordinary

10
Annuities

PMT = 249.10 FV = 0 n = 60 - 20 = 40 i = .08

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

d = Number of payment intervals


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

in the period of deferral

Two-step procedure to find PV:


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

your friend saying the he is repaying a loan at $450 every


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.

this same friend 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

Solve

Ordinary

10-48

Present Value
of a
Deferred Annuity

10
Annuities

Step 1 Determine PV of Annuity 10 months from now

10

11
$500

12
$500

13
$500

14 Months
$500

PVof the Annuity


Step 2 - Discount for 10 months to get todays Loan Value
Hint: (Use Compound Discount)

McGraw-Hill Ryerson

10-49

Ordinary

10
Annuities

this same friend


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

The payment interval


differs from

the compounding interval

e.g. A typical Canadian mortgage has


Monthly payments,
but the interest is
compounded semi-annually

Using calculators
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Ordinary

10-51

10
Annuities

This completes Chapter 10

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