Simple Annuities

Definition of Terms:

An annuity is a sequence of equal payments made at regular intervals of time.

Payments may be made annually, semi-annually, quarterly, or at other periods
Some examples of annuities are:
1) monthly payments of rent,
2) weekly wages,
3) annual premiums on a life insurance policy,
4) periodic pensions,
5) periodic payments on installment purchases, and
6) semi-annual interest payments on a bond.
Annuities are classified into annuity certain and contingent annuity:

1) An annuity certain is an annuity in which payments begin and end at fixed t

Installment payments are an annuity certain.
2) A contingent annuity is an annuity whose payments depend upon an event
cannot be foretold accurately. Life insurance premiums are an example of
contingent annuity, because the payments ends at the death of the insured.
an insured would die is uncertain.

Other terms are:

1) The payment interval is the time between successive payments of an ann
2) The term of an annuity is the time between the first payment interval and
last payment interval.
3) The periodic payment, denoted by R, is the amount of each payment.
4) Simple annuity is an annuity in which the payment interval is the same as
interest period.
There are 3 kinds of annuities certain, namely:
a) Ordinary Annuity
b) Annuity Due
c) Deferred Annuity

In an ordinary annuity, payments are made at the end of each payment inter
Diagram: (R = periodic or regular payment)

4
TERM

R
n1

n(periods)

In an annuity due, payments are made at the beginning of each payment int
Diagram: (R = periodic or regular payment)
R
0

R
n1

n(periods)

TERM
A deferred annuity is an annuity in which the first payment is made at some
time, as shown in this diagram:
no payments
for d periods
0

2
d-1
d
d+1 d+2
n +(d-1) n +d (per
payments for n periods
1. Amount of an Ordinary Annuity:
is the value at the end of the term
The amount of an ordinary is the value on the last payment date
is the sum of the accumulated payments
annuity, denoted by S,
at the end of term.

For instance,

to find the amount of a 1000 ordinary annuity, payable annua

for 4 years when money is worth 5%, accumulate the payment of each peri
to the end of 4 years, then add the accumulations.
TERM
1,000
1,000
0

1,000

1,000

2
3
4
1000
= 1000
1000(1+0.05) = 1,050
1000 = 1,102.5
1000 = 1,157.625
S = 4,310.125

Derivation of Ordinary Annuity Formulas:

Let: S = amount of an ordinary annuity at the end of n periods
R = periodic payment or periodic rent
n = number of periods or payments
i = rate per conversion period
TERM
0

R
1

R
2

R
n-2

R
n-1

R
n (periods)

R
R(1+i)
R
R
R
S = sum of the accumulated values of R at the end of the term
S = R + R(1+i) + R+ + R+ R (equation1)
Multiplying equation1 by (1 + i), we get
(1+ i)S = R(1+i) + R+ + R+ R
(equation 2)
Subtracting equation 1 from equation 2, we get
(1+i)S S = R - R
Solving for S: (SEE NEXT SLIDE)

Formula:

Present Value of an Ordinary Annuity

The present value of
an ordinary annuity,
denoted by A,

is the value at the beginning of the term,

is the value one period before the first paymen
is the sum of discounted payments at the
beginning of the term

For example, to find the present value of an annuity, discount each payment,
add the results, as shown in the diagram.
TERM
1,000
1,000
1,000 1,000
0
1
952.3809 = 1,000
905.0294 = 1,000
863.8376 = 1,000
822.7024 = 1,000
A = 3,545.9505

In deriving
the formula for the present value, we use the fact that A is the pre
value of S due in n periods.
n periods
S
A
0

n1

From the previous formulas, notice that A and S are related to the equations
S=A
A=S
Hence, A = S
=
=
=

The
formulas for the amount S and present value A

of
ordinary annuity:

A=
Note: These formulas are applicable only when the
payment interval is the same as the interest period.
Example 1: Find the amount and the present value
of an ordinary annuity of 250 each quarter
payable for 5 years and 9 months, if money is
worth 12% compounded quarterly.


Example
1: Find the amount and the present value of an ordinary
annuity of
250 each quarter payable for 5 years and 9 months, if money is
worth 12%
compounded quarterly.
Solution:
Given: R = 250
j = 0.12
t = 5 years
m=4
i = j/m = 0.03
n = mt = 23 periods
Find: S and A
= 250(32.452883) = 8,113.22
A = = 250 = 250(16.443608) = 4,110.90

Example 2: A car was purchased under these terms:

30,000 down and 5,000 each month for 5 years. If money is worth 12%
compounded monthly, find the cash price of the car.

Solution:
Cash price = downpayment + present value of the installment payments (the a
= downpayment + present value of 60 monthly payments at 5,00
Cash price = 30,000 + A
= 30,000 + 5,000
= 30,000 + 5,000(44.955038)
= 254,775.19

Example 3: Find the amount of an annuity of 2,500 a month for 15 years at 8%

compounded monthly.
Assignment:
Page 55, item: 6
Page 58, items: 1 and 5

Finding the Periodic Payment of an Ordinary Annuity.

If the present value or the amount of an annuity is known, the periodic pay
can be determined by solving the annuity formulas for R. Hence, we have
and

A=

Example 1: What sum must be deposited every 3 months in a fund paying 1

compounded quarterly in order to have 25,000 in 8 years?

Example 1: What sum must be deposited every 3 months in a fund paying 12

compounded quarterly in order to have 25,000 in 8 years?
Solution:
Given: S = 25,000
t = 8 years
n = 32 periods
i = 0.12/4 = 0.03
Find : R

= 476.17

Example 2: A dress costs 500. It is purchased with a downpayment of 20

8 monthly payments. If money is worth 24% compounded monthly, find the
monthly payment.

Example 3: A man borrows 10,000. He agrees to pay the principal and inte
paying a sum each year for 4 years. Find his annual payment if he pays inte
8 % compounded annually.

Assignment:
Page: 61
Item: 1, and 8