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Annuities

Introduction

• Annuity is a series of equal instalment payment

amounts made over agreed time intervals for a
specified time period.
• Ordinary (deferred) annuity – whereby payments
are made at the end of each period, e.g. loans,
mortgages,
• Annuity due – where payments are made at the
beginning of each period, e.g. rentals, medical aid.

FV of an Ordinary Annuity

• Example 1
• Assume that instead of 1 lump sum payment of P200, you
actually deposit P200 at the end of each year for 3 years
in your savings account. How much money will you have
in you account at the end of 3 years, if you earn 6%
interest per year.

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Solution

• Formula approach
{(1+i)n −1}
• FVA n = PMT[ ]
i
{FVIFn −1}
• FVA n = PMT[ ]
i
{(1+0.06)3−1}
• FVOA 3 = 200x [ ]
0.06
{(1.191016)−1}
• FVOA 3 = 200x [ ]
0.06
• FVOA 3 = 200x 3.1836 = P636.72

• Using Interest tables

• FVOA = PMTxFVIFOA(6%,3)
• FVOA = PMT*FVIFOA(6%,3) Note sometimes we use * as the multiplication sign
• FVOA = 200(3.1834) =P 636.68
• Note that we are able to directly get the FVIFA(6%,3) of 3.1834 from
the table which is a little quicker. 4

FV of an Annuity Due

• Example 2
• Assume the P200 in the previous example is deposited at the
at the beginning of each period(annuity due) for three years.
• Formula Approach

• FVAdue = FVA x(1+i)

• FVAD = FVOA x(1+i)

• FVAD = 636.72*(1.06) = P674.92

Using Interest tables

• FVAdue = PMTxFVIFAdue(6%,3)

• FVAD = PMT*FVIFAD(6%,3)

• FVAD = 200(3.3746) = P674.92

• Note that FVAD > FVOA, thus 674.92 > 636.72, this is
because each payment occur one period earlier with
annuity due, hence all of the payments earn interest for
one additional period.

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PV of an Ordinary Annuity

• Example 1
• Assume that the series of P200 is actually deposit at the
beginning of each year for 3 years in your savings
account. How much money will you have in you account
at the end of 3 years, if you earn 6% interest per year.
• Formula Approach
1
1−{
(1+i)n }
• PVA n = PMT [ 𝑖
]
1
1−{
(1+i)n }
• PVA n = PMT [ 𝑖
]
7

1
1−{
(1.06)3 }
• PVA n = [
200
0.06
]
PMT[ ]
1−0.8396
• PVA n =
0.06

• PVOA n = 200[ ]
1−0.8396
0.06

200[ ]
0.1604
• PVOA n =
0.06

• PVOA n = 200[2.673]
8

• PVOA = P534.60

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Using Financial tables

• PVOA = PMT*PVIFOA(6%,3)
• PVOA = 200(2.673) = P534.60
• PV of an Annuity Due(PVAD)

• PVAD = PVOA*(1+i)
• PVAD = 534.60* 1.06 = P566.68
• Using Financial table: PVAD = PMT*PVIFAD(6%,3)
• PVAD = 200*2.8334 = P566.68
• Note that the PV of Annuity due > PV of Ordinary annuity.
This is because with Annuity due, each PMT is discounted
back one less year.

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PERPETUITIES

• A perpetuity is actually an annuity but with an extended life

into the future
• They pay equal instalments forever, for eternity
• Preferred stock dividend is an example of a perpetuity.
• Another example was the UK and US Govt Bond called
Consols issued in 1751 and 1877 Respectively
• Perpetuities can be valued using the following formula:
𝑃𝑀𝑇
• PV of a perpetuity =
𝑖

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Example

• Example: Assume a preference stock dividend of P2.50

per annum indefinitely. What is the PV of the perpetual
dividends assuming discount rate of 10%?

• Solution
𝑃𝑀𝑇
• PV of a perpetuity =
𝑖
2.50
• PV = 0.10
• PV = P25

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Uneven Cash Flows

• So far our discussion has been based on constant (even)

cash flows (CF) in the form of annuity payments.
• However some situations may by nature require the use of
non-constant (uneven) cash flows.
• For e.g common stock dividend & CFs from capital
projects are usually uneven and increase over time.
• Uneven cash flows have two classes:

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1. Constant plus a lumpsum

• In stream 1 the Cashflow(CFs) stream consists of annuity PMT +

Additional final lump sum PMT ( e.g Bonds)

Periods 0 1 2 3
i=6%

Cash Flows P0.00 P200.00 P200.00 P200.00

P1000.00
P1200.00

• 2. Irregular Stream
• In this instance the payouts are uneven or irregular streams (e.g
Stocks & Capital Investments)
0 1 2 3
Periods i=6%

Cash Flows P0.00 P100.00 P300.00 P250.00

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Finding PV of Uneven Cash Flows

• Examples
• Calculate the PV for Stream 1 above.
• PV = PMT(PVIFOA6%,3) + Principal(PVIF6%,3)
• PV = 200(2.673) + 1000(0.840)
• PV = 534.60 + 840 = P1,374.60
• You can also the USE FORMULA for (PVOA + PV)

• Calculate the PV for Stream 2 in the previous illustrations

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇
• PVn = + +
(1+𝑖)𝑛−2 (1+𝑖)𝑛−1 (1+𝑖)𝑛−0

• PV0 = 100/(1+0.06)1 + 300/(1+0.06)2 + 250/(1+0.06)3

• PV0 = 94.34 + 267.00 + 209.90

15 = P571.54

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FV of Uneven Cash Flows

• Calculate the FV for Stream 1 above.

• FV = PMT(FVIFOA(6%,3) ) + Principal
• FV = 200(3.1836) + 1000
• FV = 636.72 + 1000 = P1,636.72
• You can also use a use formula to find (FVOA + Principal)

• Calculate the PV for Stream 2

• FVn= PMT(1+i)n-1 + PMT(1+i) n-2 +….PMT(1+i) n-n

• FV3 = 100(1+0.06)2 + 300(1+0.06)1 + 250(1+0.06)0

• FV3 = 112.36 +318.00 + 250 = P680.36

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SEMI-ANNUAL AND OTHER COMPOUNDING PERIODS

• Different securities yield returns at different intervals

in a year
• Bonds may compound semi-annually.
• Bank loans may be monthly compounded.
• Whilst dividends usually compound quarterly.
• In the event of multiple periodic
payments/compounding in a year the following two
adjustments applies for any security or loan

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1. Annual interest rate(i)

• Has to be convert to a periodic rate.

Stated annual rate
• Periodic rate(r) =
number of payments per year

6%
• E.g 6% annual rate becomes 2
= 3% semi-annual
6%
• 4
= 1.5% Quarterly
6%
• = 0.5% Monthly
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Investment Period(n)

• The annual or number of years have to be converted to the

correct number of periods.
• No. periods(n) = No. years X compounding periods per year
• Example: 3 years becomes :
• 3 x 2 = 6 periods; Semi-annually
• 3 x 4 = 12 periods; Quarterly
• 3 x 12 = 36 periods; Monthly

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Example

• P20 000 is deposited into a savings account paying 16%

interest for 5 years. Compute the FV of the investment
assuming the interest is compounded:
i. Annually
ii. Semi-annually
iii. Quarterly
iv. Daily (365 days in a year)

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Solution

i) Annually:
• FVn = PV(1 + i)n
= 20 000(1.16)5
= P 42,006.83
ii) Semi - Annually
• FVn = PV(1 + i)n
0.16
• Periodic Rate(i) = = 0.08
2
• No. Periods(n) = 5x2 = 10
• FV = 20 000(1.08)10
= P43,178.50
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3) Quarterly
• FVn = PV(1 + i)n
0.16
• Periodic Rate = = 0.04
4
• No. Periods (n) = 5x4 = 20
• FV = 20 000 (1.04)20
= P43,822.46

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Contin…

iv) Daily
• FVn = PV(1 + i)n
0.16
• Periodic Rate = = 0.0004
365
• No. Periods (n) = 5 x 365 = 1,825
• FV = 20 000(1.0004)1825
= 20 000 (2.2251)
= P44,503.02

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CONT

• We conclude that

A. The more the compounding periods a year the greater

the FV of the investment at the end of the period, and
B. By extension, the higher the actual interest or return rate
paid by the investment
• This is basically a measure of effective annual rate

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Effective annual rate (EFF%)

• Different types of investments and loans use different

compounding periods (eg loans compound monthly; bonds
compound semi-annually (pay Coupons twice a year); while
company shares usually pay dividends quarterly).
• Different compounding periods will yield different FVs & PVs
for loans and investments that have the same annual
percentage rate ( APR) also called Nominal Interest rate
(INOM)
• Therefore to compare different investments or loans, that have
different compounding periods a year, you need to put them on
a common base called Effective Annual rate (EAR) or
Equivalent Annual Rate (EAR)

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• Given the Nominal Rate (INOM) and the number of

compounding periods per year, we can find the
effective annual rate (EFF/EAR%).

Where:
• INOM = nominal rate expressed as a decimal
• M = number of compounding periods per year
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Effective or Equivalent rate

• Periodic or compounding more than once in a year has

been proven to provide a progressively higher return that
annual compounding
Compounding Periodic Rate(r) FVn
Annually 0.16 P 42,006.83
Semi-Annually 0.08 P43,178.50
Quarterly 0.04 P43,822.46
Daily 0.0004 P44,503.02

• This means that the actual return in each instance is

higher. This is referred to as the Effective Annual
Rate(EAR) or Equivalent Annual Rate(EAR)
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Example

• Assume you have two equally risky investment options, Investment A

pays 20% compounded semi-annually and Investment B pays 20.6%
compounded annually. Which investment will you choose?

Solution
• First convert 20% semi-annual to an effective annual rate (EFF%)

• Therefore we choose investment A since 21% expected interest in

annual terms for Investment A is greater than 20.6% expected for
investment B.
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Application of Time Value of Money

Concepts

Amortisation

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Amortised Loans

• Some loans are paid off in equal instalments over time

• Examples include Mortgages and automobile loans
• These kind of loans are called amortised loans
• One might be interested in knowing the periodic
PMTs, interest, what they still owe at the end or
beginning of each period etc.
• To determine these details you have to create what is
called a loan amortisation schedule.
• Lets take an example:

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• Example
• Assume a homeowner borrows P100,000 as a
mortgage loan and the loan is to be repaid in five
equal instalments at the end of the next 5 years. 6%
interest is charged on the balance of the loan at the
end of each year.
(a)Construct the loan amortisation schedule.
(b)What is the Total interest Paid on the loan?
(c)How much will be owed on the loan at the beginning
and end of 5th year?
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Solution

• First we need to calculate the PMT to be paid by the

borrower each year. PMTs should be such that the
sum of their PVs is equals the original loan amount.
• Notice that this PMTs are equal and constant over
time for 5 years.
• This represents an annuity; it is an ordinary annuity
since PMTs are made at end of each year.
• Remember when using interest tables:
• PVOA = PMT*PVIFOA(i,n)

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(a) Solution

i. Determine PMT:
• PVOA = PMTxPVIFOA(6%,5)
• 100 000 = PMT(4.2124)
100 000
• Solve for PMT: PMT = 4.2124 = P23,739.44

• or you can use the formula to solve for PMT

ii. Next construct the payment table as shown below:

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Loan Amortisation Schedule

Amount Borrowed BWP 100 000.00

Maturity 5 years
Rate 6%
PMT BWP -23 739.44
BEGINNIN PRINCIPAL ENDING
YEAR AMOUNT PAYMENT INTEREST REPAYMENT BALANCE

1 100 000.00 23 739.44 6 000.00 17 739.44 82 260.56

2 82 260.56 23 739.44 4 935.63 18 803.81 63 456.75
3 63 456.75 23 739.44 3 807.41 19 932.03 43 524.72
4 43 524.72 23 739.44 2 611.48 21 127.96 22 396.76
5 22 396.76 23 739.44 1 343.81 22 395.63 1.13

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The Amortisation Schedule

Amount Borrowed BWP 100 000.00

Maturity 5 years
Rate 6%
PMT BWP -23 739.44

BEGINNIN PRINCIPAL ENDING

YEAR AMOUNT PAYMENT INTEREST REPAYMENT BALANCE
(1) (2) (3) (2) X (i) = (4) (3)-(4) = (5) (2)-(5) = 6

1 100 000.00 23 739.44 6 000.00 17 739.44 82 260.56

2 82 260.56 23 739.44 4 935.63 18 803.81 63 456.75
3 63 456.75 23 739.44 3 807.41 19 932.03 43 524.72
4 43 524.72 23 739.44 2 611.48 21 127.96 22 396.76
5 22 396.76 23 740.57 1 343.81 22 396.76 0.00
Total ----- 118 698.33 18,698.33 100 000 -----

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Solution Conti

(a) Payment Schedule is given above

(b) Total interest paid = P18,698.33
(c) Beginning of year 5, P22396.76 will be owed
• End of year 5, nothing (P0.00) owed, as the loan is fully
amortised.

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TVM CONCLUSION

• WHAT IS FINANCE
• Finance involves making decisions about the best
alternative option that will either:
• Maximise the return/profitability of an organisation or
• Minimise it’s costs
• It is a study of decision making processes about money
• Such decisions are premised/based upon three basic
principles, viz;

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TVM CONCLUSION (CONT)

• 1. MORE VALUE IS PREFERABLE OVER LESS

• P100 now vs P70 now
• 2. THE SOONER CASH IS RECEIVED THE MORE
VALUABLE IT IS
• Prefer to receive cash now than at end of year; because you can
reinvest it and, earn interest for the rest of the year.
• Or the person/(organisation) that had promised you the money may
become bankrupt or cease to exist
• 3. LESS RISKY ASSETS ARE MORE VALUABLE
THAN LESS RISKY ASSETS
• Shares vs Bonds vs Money Market vs Cash (vs Loan to Risky
Colleague)
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TVM CONCLUSION (CONT)

• TVM CONCEPT
• - when making such decisions you have got to compare
“like with like”
• - thus you must restate/translate all the cashflows that
you are comparing to a single reference time; either “t=0”
(present value) or “t=n” (future value)
• - to achieve this, we use the time value of money concepts

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TVM CONCLUSION (CONT)

• -this TVM Concept is used to move the value of money across

time to bring it to the comparator reference date, viz;
• 1. MOVING A LUMPSUM PAYMENT BACK (PV via
discounting) OR FORWARD (FV via compounding)
• 2.MOVING THE VALUE OF A SERIES OF EQUAL
CASHFLOWS RECEIVED OVER A SPECIFIED PERIOD,
TO A REFERENCE DATE
• -DISCOUNTING (PV); COMPOUNDING (FV)
• - FOR ORDINARY ANNUITY VS ANNUITY DUE

• 3. FINDING THE VALUE OF AN

UNENDING/PERPERTUAL, CONSTANT-VALUE, SERIES
OF PAYMENTS
• -PV of a PERPETUITY
• -WHERE “n=infinity” 40

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TVM CONCLUSION (CONT)

• 4. FINDING THE FUTURE/PRESENT VALUES OF AN

UNEVEN STREAM OF CASHFLOWS/PAYMENTS
• -Getting the Summation of the Present Values of
Each one of the Cashflows
• -(you might sometimes identify annuities within the
series; which can make your calculations/work
easier)

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TVM CONCLUSION (CONT)

• 4 METHODS OF SOLVING TVM PROBLEMS

– 1. CASHFLOW TIMELINE METHOD
– 2. EQUATION (FORMULA) METHOD
– 3. INTEREST FACTOR TABLES
– 4. USING TECHNONOLGY – financial calculator
and spreadsheet

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TVM CONCLUSION (CONT)

• -TVM is also used to quantify the true expected

cost/return of a loan/investment, at t=0, regardless of
how many times interest is compounded per year.
• - APR (simple/nominal rate) vs Effective Annual Rate
• - APR vs EAR
• -LOAN ARMORTISATION SCHEDULE
-a schedule of a series of equal loan repayments, broken down
into the principal and interest repayment components
-
(the longer the repayment period the more interest the borrower
pays to the bank in money terms)

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