CHAPTER 5:

ANNUITIES

Capital Budgeting
Capital budgeting is a process used by
companies for evaluating
investments/expenditures.

Capital budgeting usually involves the

calculation of each project's future by
considering time value of money.

Time Value of Money

FV = PV (1+r)^n

PV =

FV
(1+r)^n

FV = Future Value
PV = Present Value
r= Rate of interest
n = term in years

Example
What is the balance in an account at the end of
10 years if $2,500 is deposited today and the
account earns 4% interest compounded
annually?
FV = PV (1+r)^n
= $2,500 (1+0.04)^10
= $3,700.61

Example
How much I have to deposit in an account today
that pays 12% interest, compounded annually,
so that I have a balance of $20,000 in the
account at the end of 10 years.
PV = FV
(1+r)^n
PV = $20,000
(1+0.12)^10 = $6,439.46

Annuity
Annuity is a series of (usually) equal
payments made at (usually) equal intervals of
time. EX of annuity:
Shop rentals
Insurance policy premium
regular deposits to saving accounts
installment payments

Classes of Annuity
FVa(normal)

= PM

(1+r/n)^nt 1
r/n

Payment made end of the year/month

PM = Periodic payment
A= Amount, after value
r = rate of interest
t= time in years
n= no of interest converted in years

Classes of Annuity
FVa(due)

= PM

(1+r/n)^nt 1
r/n

x (1+r)

Payment made beginning of the year/month

PM = Periodic payment
A= Amount, after value
r = rate of interest
t= time in years
n= no of interest converted in years

Example
Investment was set up and quarterly payments
of $1,500 have to be made for 6 years at the
end of each month. If annual interest rate is
16%, what is the value of investment after 6
years.

Sinking Fund
If a person wants to purchase
asset/ordinary annuity to guarantee
certain amount of money in future, person
can determine the amount of payment by
using sinking fund payment method

Sinking Fund Formula

SF=

FV x r
[ (1+r)^n 1]

SF- Sinking Fund Payment

FV- Future Value
r- period of interest rate
n- Number of periods

Example
Jeannette, owner of Jeanettes Health
Club, wants to purchase new pec-deck
machine in 3 years. The cost of machine
is $900. Find the sinking fund method if
the interest rate is 10% annually.

SF=

FV x r
[ (1+r)^n 1]
FV- $900
r- 10%x1 , 0.1 x 1
n- 3x1
$900x0.1/((1+0.10)^3-1) = $271.90

Amortization
The process of paying off a loan (plus
interest) by making a series of regular,
equal payments is called amortization,
and such a loan is called an amortized
loan.

Amortization
Table value for Interest factor for mortgage

Years

7%

8%

9%

10%

10

11.61

12.14

12.67

13.22

20

7.75

8.37

9.00

9.66

30

6.65

7.34

8.05

8.78

Steps to Do Amortization Schedule

Month

1st Month
2nd Month
3rd Month

Interest

Amount Paid
to Principal

Balance of
Principal

Amortization Schedule Steps

1. Find the interest (I)
I = Prt
P= Principal
r= Rate of interest
t= Term in months

Amortization Schedule Steps

2. Find amount paid to the principal (Monthly
Payment (MP) Interest (I))
MP=

Principle
1000

x table value

Amortization Schedule Steps

3. Find balance of principle by subtract amount
obtained in Step 2.
Balance of Principal= Principal Amount Paid
to principle
Repeat the step with latest principal to get new
interest,amount paid & new balance

Example
1. A person purchased a home with $80,000
loan at 8% for 20 years. Make amortization
table for 3 months.
Find amortization for month 1
I = Prt
= $80,000x0.08x1/12
= $533.33

Example
Monthly payment
MP=

80,000 x 8.27
1,000
= 669.6
Amount paid to principal
MP-I
669.6- 533.33
= 136.27

Example
Balance of principle (Principle Amt paid to
principle)
80,000-136.27 = 79,863.73
Month 2
I=Prt
= 79,863.73 x 0.08 x 1/12
= 532.42 continue step 2 and 3

THE END